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On the predictability of common risk factors in the US and UK interest rate swap markets: Evidence from non-linear and linear models

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Author Info
Ilias Lekkos (Eurobank Ergasias)
Costas Milas () (Keele University)
Theodore Panagiotidis () (Loughborough University)

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Abstract

This paper explores the ability of common risk factors to predict the dynamics of US and UK interest rate swap spreads within a linear and a non-linear framework. We reject linearity for the US and UK swap spreads in favour of a regime-switching smooth transition vector autoregressive (STVAR) model, where the switching between regimes is controlled by the slope of the US term structure of interest rates. The first regime is characterised by a "flat" term structure of US interest rates, while the alternative is characterised by an "upward" sloping US term structure. We compare the ability of the STVAR model to predict swap spreads with that of a non-linear nearest-neighbours model as well as that of linear AR and VAR models. We find some evidence that the nearest-neighbours and STVAR models predict better than the linear AR and VAR models. However, the evidence is not overwhelming as it is sensitive to swap spread maturity. We also find that within the non-linear class of models, the nearest-neighbours model predicts better than the STVAR model US swap spreads in periods of increasing risk conditions and UK swap spreads in periods of decreasing risk conditions.

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Paper provided by Department of Economics, Loughborough University in its series Discussion Paper Series with number 2005_9.

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Date of creation: Sep 2005
Date of revision: Sep 2005
Handle: RePEc:lbo:lbowps:2005_9

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Related research
Keywords: Interest rate swap spreads; term structure of interest rates; regime switching; smooth transition models; nearest-neighbours; forecasting.;

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Find related papers by JEL classification:
C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation and Testing
C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Other Model Applications
E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates

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  21. Ilias Lekkos & Costas Milas, 2002. "Common risk factors in the US and UK interest rate swap markets:Evidence from a non-linear vector autoregression approach," Public Policy Discussion Papers 02-05, Economics and Finance Section, School of Social Sciences, Brunel University. [Downloadable!]
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