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Dynamic Nelson–Siegel model for market risk estimation of bonds: Practical implementation

Author

Listed:
  • Makushkin, Mikhail

    (HSE University, Moscow, Russian Federation;)

  • Lapshin, Victor

    (HSE University, Moscow, Russian Federation;)

Abstract

The article is devoted to Value-at-Risk estimation of bonds based on Dynamic Nelson–Siegel model (DNS). Instead of dealing with estimation of future interest rates and their volatiles, DNS model forecasts several unobservable shape parameters of the yield curve. We illustrate that for practical purposes one factor model is enough to correctly estimate bond VaR — this factor being long-term level of interest rates. We recommend to use AR(1)-GARCH(1,1) model to describe the evolution of interest rates level. Such dynamics specification provides accurate risk estimates while minimizing the number of consecutive VaR violations. We emphasize that the choice of optimization algorithm for estimation of yield curve parameters is crucial for accurate VaR forecasting since it might bring additional model noise into time series of yield curve parameters.

Suggested Citation

  • Makushkin, Mikhail & Lapshin, Victor, 2023. "Dynamic Nelson–Siegel model for market risk estimation of bonds: Practical implementation," Applied Econometrics, Russian Presidential Academy of National Economy and Public Administration (RANEPA), vol. 69, pages 5-27.
  • Handle: RePEc:ris:apltrx:0462
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    References listed on IDEAS

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    More about this item

    Keywords

    market risk; risk management; Value-at-Risk; bonds; interest rate; term structure; Nelson–Siegel model.;
    All these keywords.

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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