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An Error Correction Factor Model of Term Structure Slopes in International Swaps Markets

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Abstract

The first two principal components in the vector of term structure slopes from IRS markets in eight major currencies can be approximately identified as the slopes for the US dollar and Deutsche mark. Each of the eight slopes considered is cointegrated with these two factors. The implied Error Correction models can be very fruitful for short and medium term slope forecasting for the eight currencies. This scheme achieves a drastic reduction of dimensionality, since the eight slopes can be predicted using just univariate forecasts for the two factors. Adding more factors to the model does not lead to a significant improvement in forecasting performance, while forecasts obtained using just one factor are not as good as those from two-factor Error Correction models.

Suggested Citation

  • Pilar Abad & Alfonso Novales, 2002. "An Error Correction Factor Model of Term Structure Slopes in International Swaps Markets," Documentos de Trabajo del ICAE 0222, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico.
    • Handle: RePEc:ucm:doicae:0222
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    1. Krylova, Elizaveta & Nikkinen, Jussi & Vähämaa, Sami, 2009. "Cross-dynamics of volatility term structures implied by foreign exchange options," Journal of Economics and Business, Elsevier, vol. 61(5), pages 355-375, September.

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    More about this item

    Keywords

    Factor models; Term structure of interest rates; Principal components; Swap markets; IRS.;
    All these keywords.

    JEL classification:

    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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