Abstract
We propose an affine term structure model that allows for tenor-dependence of yield curves and thus for different risk categories in interbank rates, an important feature of post-crisis interest rate markets. The model has a Nelson–Siegel factor loading structure and thus economically well interpretable parameters. We show that the model is tractable in terms of estimation and provides good in-sample fit and out-of-sample forecasting performance. The proposed model is arbitrage-free across maturities and tenors, and thus perfectly suited for risk management and pricing purposes. We apply our framework to the pricing of caplets in order to illustrate its practical applicability and its suitability for stress testing.
Highlights
The global financial crisis of 2007/2008 has triggered some structural changes in interest rate markets that invalidated the classical notion of a single yield curve
Since it is free of arbitrage across maturities and tenors and has parameters with a sound economic interpretation, the model is well suited for derivative pricing and tailor-made for scenario generation, stress testing and other risk management purposes
The pricing of swaptions in our framework can in principle be done by adapting the results in [4, Section 4.2] to the proposed arbitrage-free multiple curve Nelson Siegel (AFMCNS) model along the same lines to what has been done in the case of caplets
Summary
The global financial crisis of 2007/2008 has triggered some structural changes in interest rate markets that invalidated the classical notion of a single yield curve. We construct an affine term structure model that (1) allows for tenordependent yield curves, (2) is free of arbitrage across maturities and tenors, (3) is computationally tractable with (4) economically interpretable parameters, and (5) provides superior in-sample fit and out-of-sample forecasting performance within the Nelson–Siegel class of models. The proposed model inherits advantages from both the affine models as well as the parsimonious Nelson–Siegel class of models: it can be estimated through standard techniques (Kalman filter) and presents good in- and out-of-sample performances Since it is free of arbitrage across maturities and tenors and has parameters with a sound economic interpretation, the model is well suited for derivative pricing and tailor-made for scenario generation, stress testing and other risk management purposes.
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