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Forecasting interest rate swap spreads using domestic and international risk factors: Evidence from linear and non-linear models

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Author Info

  • Ilias Lekkos

    ()
    (EFG Eurobank)

  • Costas Milas

    ()
    (Keele University)

  • Theodore Panagiotidis

    ()
    (Loughborough University)

Abstract

This paper explores the ability of factor models 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. 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 non-linear models predict better than the linear ones. At short horizons, the nearest-neighbours (NN) 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. At long horizons, the STVAR model increases its forecasting ability over the linear models, whereas the NN model does not outperform the rest of the models.

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Bibliographic Info

Paper provided by Department of Economics, Loughborough University in its series Discussion Paper Series with number 2006_6.

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Date of creation: Mar 2006
Date of revision: Mar 2006
Handle: RePEc:lbo:lbowps:2006_6

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

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References

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  1. Ang, Andrew & Bekaert, Geert, 2002. "Regime Switches in Interest Rates," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 163-82, April.
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Cited by:
  1. Chung, Hon-Lun & Chan, Wai-Sum, 2010. "Impact of credit spreads, monetary policy and convergence trading on swap spreads," International Review of Financial Analysis, Elsevier, vol. 19(2), pages 118-126, March.

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