Modelling Term-Structure Dynamics for Risk Management: A Practitioner's Perspective
AbstractModelling term-structure dynamics is an important component in measuring and managing the exposure of portfolios to adverse movements in interest rates. Model selection from the enormous term-structure literature is far from obvious and, to make matters worse, a number of recent papers have called into question the ability of some of the more popular models to adequately describe interest rate dynamics. The author, in attempting to find a relatively simple term-structure model that does a reasonable job of describing interest rate dynamics for risk-management purposes, examines two sets of models. The first set involves variations of the Gaussian affine term-structure model by modestly building on the recent work of Dai and Singleton (2000) and Duffee (2002). The second set includes and extends Diebold and Li (2003). After working through the mathematical derivation and estimation of these models, the author compares and contrasts their performance on a number of in- and out-of-sample forecasting metrics, their ability to capture deviations from the expectations hypothesis, and their predictions in a simple portfolio-optimization setting. He finds that the extended Nelson-Siegel model and an associated generalization, what he terms the "exponential-spline model," provide the most appealing modelling alternatives when considering the various model criteria.
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Bibliographic InfoPaper provided by Bank of Canada in its series Working Papers with number 06-48.
Length: 89 pages
Date of creation: 2006
Date of revision:
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Interest rates; Econometric and statistical methods; Financial markets;
Find related papers by JEL classification:
- C0 - Mathematical and Quantitative Methods - - General
- C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
- E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
- G1 - Financial Economics - - General Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-01-02 (All new papers)
- NEP-CFN-2007-01-02 (Corporate Finance)
- NEP-CSE-2007-01-02 (Economics of Strategic Management)
- NEP-ECM-2007-01-02 (Econometrics)
- NEP-FMK-2007-01-02 (Financial Markets)
- NEP-FOR-2007-01-02 (Forecasting)
- NEP-MAC-2007-01-02 (Macroeconomics)
- NEP-RMG-2007-01-02 (Risk Management)
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