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

  • Costas Milas


    (Keele University, Centre for Economic Research and School of Economic and Management Studies)

  • Ilias Lekkos

    (Research Department, Eurobank Ergasias, Greece)

  • Theodore Panagiotidis

    (Department of Economics, Loughborough University, UK)

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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Paper provided by Centre for Economic Research, Keele University in its series Keele Economics Research Papers with number KERP 2006/05.

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Length: 24 pages
Date of creation: Apr 2006
Date of revision:
Publication status: Forthcoming in Journal of Forecasting
Handle: RePEc:kee:kerpuk:2006/05
Contact details of provider: Postal: Department of Economics, University of Keele, Keele, Staffordshire, ST5 5BG - United Kingdom
Phone: +44 (0)1782 584581
Fax: +44 (0)1782 717577
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Order Information: Postal: Centre for Economic Research, Research Institute for Public Policy and Management, Keele University, Staffordshire ST5 5BG - United Kingdom
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