DevelopingaPracticalYieldCurveModel:AnOdyssey

M.A.H.Dempster*,JackEvans+&ElenaMedova*

*UniversityofCambridge&CambridgeSystemsAssociatesLimited,
Cambridge,UK
+evalueFELimited,London,UK

Contents
1IntroductionandBackground
2LiteratureReview
3ModelEvaluation
4OurSolution
5Conclusion
References

FirstDraft20thJuly2012
ThisDraft30thSeptember2012


1IntroductionandBackground
Whathappensifonewishestoimplementaninterestratemodelbasedoncurrentknowledgeabout
thesubject?Herecurrentknowledgemeansstateoftheartorbestpractice,butnotcuttingedge.
Whatwouldsomeonefamiliarwiththerecentliteratureandcurrentpracticebeledto?Thepurpose
ofthisarticleistoidentifyanddescribethechallengespresentedbysuchanexercise.
Thebackgroundoftheexerciseisthecreationofanewglobalcapitalmarketseconometricmodel
takingaccountofcurrentdevelopments,butinthespiritofearliermodelsdevelopedforvarious
financialservicesinstitutions,see,forexample,MulveyandThorlacious(1998)(TowersPerrin),
DempsterandThorlacious(1998)(SwissRe),DempsterandArbelecheGrela(2003)(UniCredit)and
thecurrentmodelsinusebyleadingactuarialconsultants.Theemphasisinthesemodelsisthe
abilitytosimulateforwardoverlonghorizonsforpricingvariousfinancialproducts(Dempsteretal.,
2010),providinginvestmentadvice(Medovaetal.,2008)andassetliabilitymanagement(Dempster
etal.,2003).SincethepioneeringsystemdescribedinMulveyandThorlacious(1998),thekeyto
accuratescenariogenerationfromthesemodelsaretheyieldcurvemodelswhichforecastinterest
ratesineachcurrencyanduponwhichthedeterminationofallothervariablesdepend.
Animmediatefirstquestioniswhatismeantbyaninterestratemodel.Clearlythetermcovers
manydifferentcreaturesandsowewillfirstdescribesomerequirementsfortheexercise.However
wealsohopetoillustratethechallengesinvolvedinmovingfromnaivedesiderata,throughpractical
specifications,toevaluationofsomemodelsdescribedinthecurrentliterature.Therearechallenges
ateachstage.
Identifyingwhatoutputisrequiredfromthemodelisprobablythemoststraightforwardaspect.
Afterthatthereisacompromisebetweenhopeandrealitytobemade,butonlywithalotofwork
thetwocommunicate.Someoftheissuesarewellknown.Forexample,twomajorgroupsofmodels
maybedistinguishedbywhethertheyconcentrateonmatchingawiderangeofmarketpricesfor
interestraterelatedproductsorinsteadaimtoreflectrealisticpropertiesofthetimeseriesofrates
andphenomenasuchasriskpremia.Thisisnotalogicaldistinction,butitisalreadyapracticalone
inthatamodelbuildercannotknowwhattheyneedtoaddresswithoutconsideringtheactually
availablemodels.Thusspecification,evenatthishighlevel,isalreadydependentonwhatmodels
areactuallyavailableandthemodelbuilder,likethebuildersofthechanneltunnel,muststartfrom
bothendsandhopetomeetinthemiddle.Thisisacommonenoughsituationinlife,but
unfortunatelyinthepresentcasethereisnoWhichDynamicTermStructureModelpublication
withahandyfeaturecomparisontabletosavethemodelbuilderfromhavingtoreadtheliterature
oneverymodel(althoughJamesandWebber[2000]isveryhelpfulontheearlierliterature).
Thelackofsuchacurrentguideisnotunexpected,butthereisnogoodreasonwhy,tothebestof
ourknowledge,suchasurveyarticledoesnotexist.Unfortunately,thesituationismorechallenging
thansimplyhavingtoreadabouteachmodelindividually,althoughtherearecertainlyimportant
featuresthatcanbeinferredfromreadingtheliterature.Forexample,somemodelsareintended
forderivativepricing(e.g.deJongetal.[2001])whileothersareintendedforeconometricstudy
(e.g.NelsonandSiegel[1987]andtheirdescendents),althoughuponcloseexaminationthis

distinctionbecomessomewhatmurky.Nevertheless,someimportantfeatureswerequirearenot
addressedintheliteratureatall.Themodelsthereforecannotbeassessedonourrequirements
withoutfirstdevotingsignificantefforttoimplementation.
Theobjectoftheexercisethatledtothisarticlewastounderstandhowcurrentbestpracticeinthe
implementationofadynamictermstructuremodelofinterestrateswouldlook.Asubsidiary
questionwaswhetherornotanoldermodelshouldbeupdatedinthelightofnewdevelopments.
Themodelarrivedatinthispaperisbeusedtosimulatelongtermfixedincomereturnsandto
providerealisticscenariosforthefuturepricesofinterestratelinkedliabilities.Inthecontextofthe
model,riskpremiashouldberealisticallyreflectedandratesandreturnsinallscenariosorpaths
consideredshouldbeplausiblewhentakenatfacevalue.Inaddition,ifatallpossiblethe
parametersofthemodelshouldberobustlydeterminedbyconsiderationofhistoricaldata.Thisis
bynomeansacompletespecificationofsuchamodelbut,sincewehavealreadymentionedthat
thereappearstobeadistinctionbetweeneconometricandderivativepricingmodels,wemust
acceptthatweareunlikelytobeabletogeteveryfeaturethatwemightwantinasinglemodel.
Theremainderofthispaperisstructuredasfollows.Thenextsectioncontainsabriefreviewofthe
currentliterature,followedbySection3whichdescribestheprocessbywhichwearrivedatourfinal
modelchoice,describedinSection4.Itisthesetwosectionswhichwehopewillprovidethe
interestedreaderwithsomesuggestionsandcaveats.Section5concludes,hintingattheissues
involvedinembeddingyieldcurvemodelsinthefullcapitalmarketmodelforacurrencyarea.

2LiteratureReview

Asonemightexpectforsuchanimportantandcomplexsubject,theliteratureoninterestrate
modellingisvast,andwecannotpretendtohavereadandprocesseditall.Thisarticleisaboutthe
searchforaninterestratemodelsuitableforourpurposesand,asmentionedpreviously,wefound
thewidestrangeandmostopenendeddiscussioninthebookbyJamesandWebber[2000].This
bookalsohasusefuldiscussionsonawiderangeofimplementationissues.Thevastnumberof
optionsavailablemakesmodelselectionakeyissue;thereisaccordinglymuchdiscussionofitinthe
literature.Unfortunately,fromourpointofviewmostofthisdiscussionisfocussedonareasthatare
notdirectlyrelevanttooursituation.Onepaperthatdoesaddresssomeofourconcernsis
NawalkhaandRebonato[2011]whichmakesclearsomeofthelimitationsofderivativepricing
modelswhentheyareappliedforotherpurposes.Theseissuesledustoconsiderinsteadmodels
orientedtowardseconometricestimation,andaffinemodelsinparticular.Whatisinvolvedinaffine
modelswasveryclearlylaidoutbyDaiandSingleton[2000],whoputmanyaffinemodelsintoa
usefulcontext.However,althoughtheirpaperisverysuggestive,estimationofthesemodelsisa
muchrichertopicthanacasualreadingmightleadonetoexpect.Anoverviewofsubsequent
developmentsissuppliedinPiazzesi[2010]andvitalhelpwithestimationcomesfromthetrioof
papersbyHamiltonandWu[2011],Joslin,SingletonandZhu[2011]andBauer,RudebuschandWu
[2011].Thesethreepapersproviderobustandefficientestimationmethodswhichprovideafirm
foundationfortheconclusionsderivedfromourexplorations.Ultimately,werejectstraightforward
affinemodelsforourpurposes.InsteadwepursuetheideaofFisherBlack[1995]whichhasbeen

implementedpreviouslyinlowerdimensionalmodelsbytheBankofJapan(seeIchiueandUeno
[2005]andUenoetal.[2006]andKimandSingleton[2011]).

Firstchallenge:Lotsofmodels
Morethanadecadeago,JamesandWebber(2000)werealreadyabletodescribetensofinterest
ratemodels.Intheinterveningyearsthosethatmightprimafaciebesuitableforourpurposeshave
notbeenwhittleddowntoamoremanageablenumber.Therangeofoptionsishugeandthismeans
thatchoicesmayneedtobemadebeforesomeavenuesarefullyexplored.
Thelackofacomprehensivecurrentcatalogueofmodelsisnotmerelyaninconvenience,itisalso
indicativeofthenarrowapplicationofmanyyieldcurvemodels,i.e.theirunderstandingtendsto
requireanarrowfocusontheoriginalapplicationofthemodel.Thismeansthatsomeoneseekinga
modelforanonstandardpurposewillhavetoconsiderpotentialmodelsinsomedetailinorderto
determinetheirsuitability.Italsounfortunatelymeansthattherearelimitstotheextentthatthe
requiredspecificationcanbesetdowninadvance:thereissimplynotenoughinformationavailable
aboutwhatispossible.Specificationisachallengetobeginwith,andthelackofcomparison
informationinthecurrentliteraturemakesitdifficulttounderstandwhatcompromiseswillbe
required,orindeedavailable.Thismeansthatthetaskspecificationmustnecessarilybeincomplete
beforetheactualsearchbegins.
Ononehand,thespecificationmuststartincompleteandbeimproveduponasinformationabout
therelevantcapabilitiesofmodelsbecomesavailableandtheirunexpectedfeaturesrevealed.On
theotherhand,candidatemodelsmustbeimplementedfarenoughtoassesstheirrelevant
properties.Asinvestigationsfromthetwosidesmakeprogresstheycanbothbeextendedinlightof
newinformationdiscoveredand,withluck,bepersuadedtomeetinthemiddle.

Whatdowerequire?

Herethetaskistoproducerealisticstochasticforecastsofthelongtermbehaviourofvariousfixed
incomeinvestmentsandinterestratelinkedliablities.Thatmeansthat,amongotherthings:

Ratesmustberealisticineachscenario,notonlyinaggregate

Returnsmustberealisticgiventheeconomicenvironment

Returnsshouldreflectanymarketriskpremium

Themodelshouldconsistentlyaddressawiderangeoffixedincomeproducts,

e.g.bondsofdifferentmaturities

Parametersshouldbeobjectivelyandempiricallydetermined

Simulationsshouldaccuratelyreflectinitialconditions.

Theserequirementsareprettyvague,butmakingthemlesssoisasmuchapartofthemodelling
processasachievingtheresultofourinvestigations.Theywillbemademorepreciseandconcrete
whenconfrontedwithspecificmodels.Thislistisalsolikelyfarfromcomplete,evenifanyparticular
issuecouldbeputunderoneormoreoftheaboveumbrellas.

Togiveanexampleofwhatismeantbyrealisticabove,thepopularLiborMarketModel(seee.g.
deJongetal.[2001])can,undercurrentactuallyoccurringlowinterestrateconditions,require
parameterestimatesthatmakevolatilitysohighthatsimulatedcashreturnsaremorevolatilethan
actualequityreturnswithsignificantweightgiventoratesofmorethan10,000%.Nevertheless,the
modelstillworksforitsintendedpurposebecauseinaderivativepricingsituationinbanksitonly
needstohavethecorrectaggregatebehaviorwhichinourcaseisnotadequate.

Whatsonoffer?

Ithelpstoattempttocategorizemodelsfirst,howevercrudely.Wehaveseenthatforinterestrate
modelsthetwomostimportantareasareeconometricsandderivativepricing.Acasecanbemade
thatthereisathirdarea,thedescriptivemodels,suchastheoriginalNelsonSiegelmodel.These
providefunctionalformsofyieldcurvesthatgiveeconomicdescriptionsofyieldcurveswithout
directconsiderationofthedynamicrelationshipstheyclearlyimply.Similarrequirementsareheavily
usedinbothoftheothercampsforderivativepricingtoefficientlyinterpolateyieldcurvesfrom
realpricedata,andineconometricstoprovideconvenientfactorbreakdownsofinterestrates.
However,aswiththetwomaincamps,ourmodellingcaseneedsanexplicitdynamicrepresentation,
sothatadescriptivemodelcanonlybeapartofoursolutionatbest.
Derivativespricingisavigorousfieldwhichisintrinsicallypracticalinitsfocus.Thatshouldbegood
newsforus,butunfortunatelytheimperativesofderivativepricingaresomewhatdifferenttoours.
Inmanyapplicationsaderivativepricingmodelmustexactlymatchawiderangeofmarketprices.
Toachievethisthemodelsfrequentlyincorporatetwofeaturesthatmakethemverydifficulttouse
forourapplications.Thefirstisthattheyaremostlybasedonriskneutralpricingandpayno
attentiontothenatureofanyriskpremiainvolved.Incorporatingariskpremiumthereforemeans
extendingthemodelinatypicallyunchartedway.Toapplytooursituationmanyofthe
implementationswillnotwork,orhavetobecompletelyreworked.Amoresubtleissueisthat
modelsarefrequentlygivenmultiparametertermorcrosssectionalstructureswhichare
determinedoutsidetheirdynamicsinordertoachieveaccuratepricing.Thismakessuchmodels
hardtoreasonaboutandestimatestatistically.ThisissueisdiscussedextensivelybyNawalkhaand
Rebonato[2011]fromaslightlylessspecificpointofview.
Fortheissueathandtherequirementforourmodeltobeobjectivelyandempiricallydetermined
translatesintothefollowingtwomorespecificrequirements:

Parsimony

Timehomogeneity.

Asalwayswehavelimiteddata,sowefirstwantthemodelstobeparameterizedbyan
appropriatelylimitednumberofparameters.Secondly,timehomogeneitycanbeseenasaparticular
aspectofparsimony,butitalsomeansthatamodelwiththispropertymakesiteasiertounderstand
whatisgoingoninsidethemodel,sinceitismoreselfcontainedthanthedoubleplusmodels
describedbyNawalkhaandRebonato.Thespecificationoftheirmodelsremovesasignificantpartof
eachmodelsabilitytoreflectmarketconditions.Inpractice,thisisaccommodatedbyappropriately
adjustingastringofmodelparameters.

Affinemodels

Econometricinterestratemodellingisdominatedbyaffinemodels.Thispopularityreflectsthe
attractivecombinationoftractabilityandarichrangeofspecifications.Incertainformstheyare
closelylinkedtoothereconometricworkhorsessuchasvectorautoregression(VAR)andan
impressiveamountofworkhasbeendonetoapplythesemodelstoawiderangeofsituations.They
owetheirtractabilitytohowsimply,quicklyandaccuratelyexpectations,andthereforeimplied
bondpricesandyields,canbecalculated,makingiteasilyfeasibletobuildmodelsofchanging
expectations.Suchmodelsspecifytransitionprobabilitiesbetweenstatesina(usually)finite
dimensionalstatespaceandallowexpected,ormean,futurestatestobecalculatedexplicitly
analyticallyorintermsofeasilysolvedordinarydifferentialordifferenceequations.
Theaffinepropertyhasbeenemployedinmanymodels,includingthefamousseminalworksof
Vasicek[1977]andCox,IngersollandRoss[1985].However,thelinksbetweenthevarious
specificationswerenotsystematizeduntiltheworkofDuffieandKan[1996]andDaiandSingleton
[2000],andtheircollaborators.Fromthepointofviewofsomeonetryingtonarrowtheirmodeling
options,itisespeciallyhelpfulthattheyprovideaclassificationofaffinemodelsintoatwo
parameterfamily.Oneparameterrepresentsthedimensionofthemodelstatespace,whilethe
secondparameteristhenumberofthosedimensionsthatarebounded.Roughlyspeaking,the
evolutionoftheunboundeddimensionsfollowsomesortofOrnsteinUhlenbeckprocess,whilethe
boundeddimensionsfollowaCoxIngersollRoss,orFellersquareroot,process.Thelatterarea
prioriappropriateformodelingquantitiesthatmustremainpositive,forexample,volatilityor
interestrates.Ofcoursethedetailsaremorecomplex,butthisisthepicturethatemergesfromthe
literature.
Moreconcretely,werepresenttheprocessestobemodelledinthenotationofDaiandSingletons
paper.TheretheyarepresentedassolutionsYtostochasticdifferentialequations(SDEs)ofthe
form1:

whereYisthendimensionalstatevector,WisanndimensionalBrownianmotion,isafixedpoint
intheY(Euclidean)space, andare
matricesandSisadiagonalmatrixwitheachentrya
constantaffinefunctionofY.The(instantaneous)shortrateristhengivenbyanaffinefunctionrof
Y,withlongertermratesbeingcalculatedasexpectationsofintegralsofr.
InmostcaseswewillworkwithtwoYprocessmeasures,onedescribingtheactualmarketevolution
oftheprocessandtheotherassumedforthepurposeofpricing.Thesetwospecifications,PandQ,
areusuallytermedrealworld(market)andriskneutral(pricing)measuresrespectively,andare
determinedbyinstancesof(1)whichdifferintheir andterms.
Specifically,zerocouponbondprices,ordiscountfactors,aregivenintermsofYunderthepricing
measureQas

Weindicaterandomentities,hereconditionallyrandom,usingboldface.

rt

( ) =

Q
0

+
E

Q
t

Q
Y

'Y

(2)

[e x p (

t +
t

rs d s )],

whereprimedenotestranspose,tiscurrenttime,denotesmaturityand EtQ denotesconditional

expectationunderQattimet.Theseexpressionsindicatetheoriginoftheterm(exponential)affine
model.
Equivalentyieldstomaturityforallmaturities,whichwewilltermratesinthisarticle,aregiven
frombondpricesby
y t ( ) : = lo g Pt ( ) / . (3)
ThekeyfeatureofaffinemodelsisthatforappropriateYprocessdescriptionstheexpectationsin
thebondpricesof(2)areeasilycalculated,eitherinclosedformornumerically.Asnotedabove,
bondpricesortheircorrespondingratesmaybeevaluatedforsomemodelsanalytically,seee.g.
JamesandWebber[2000].Forothers,thenvectorofratesRmaybecalculatedintermsofthen
statevariablesYbysolvingnumericallyannxnmatrixRicattiequationoftheform

R t ( ) / = K ' R t ( )

1
R t ( ) S ' R t ( ) ' + rt 1, (4)
2

withinitialcondition Rt (0) = 0, where1denotesthenunitvector.Expression(4)isanordinary

differentialequation(ODE)withrespecttoratematuritywithotherparametersdeterminedbythe
specificationsof(1)and(2).
Theroleoftheaffinefunctionindeterminingtheshortratehighlightsthefactthattherewill
typicallybemultiplemodelsthatgiveindistinguishablerateevolutionprocesses;ineconometric
termsthesemodelsareunidentified.OneofthemaincontributionsoftheDaiandSingletonpaperis
tospecifyanormalizedformforaffinemodels,atleastforthosemodelswithmaximumfreedom.
Therearesimilarformulaeforstateprocessesinvolvingjumps,whichisasubjectforourfuture
investigation.Moreusefulfromanestimationviewpointistheexistenceofdiscretetimeanalogues
forevencomplexversionsofthestateprocessevolutionofthesemodels.Theseanaloguescan
sometimesconsiderablysimplifythediscretizationalwaysnecessaryforestimation.Inthesecases,
theordinarydifferentialequation(4)fornumericallycalculatingexpectationscanbereplacedwitha
differenceequationwhichismucheasiertosolve.ThisapproachisdescribedinDai,LeandSingleton
[2010].
TherearemanymoreaffinemodelspecificationsthanthosebyDaiandSingletonintheircategories,
buttheyshouldallbenestedwithinatleastonesuchcategory,sotheseauthorsclassificationisa
goodplacetostartamodelsearch.Ideally,wewouldexamineallaffinemodelssystematically,but
thatisnotpossibleeveninprinciple.Indeed,thepracticalitiesarenotsowellworkedoutthat
thereisaneffectivealgorithmforselectingthebestspecification.Ofcoursevariousstatistical
informationcriteriaandothermodelselectiontoolscanbeapplied,butdoingsoremainssomething
ofanartform.

InsteadwestartbytakingaleadfromtheworkofLittermanandScheinkman[1991].They
performedaprincipalcomponentsanalysisofUSyieldcurve(rates)dataandconcludedthatatleast
threefactorswerenecessaryforasatisfactoryrepresentationofthebehaviourofyieldcurves.Since
wearealsodeterminedtoavoidcomplexity,weshouldalsoavoidusingmorethanthreefactorsifat
allpossible;sothesemodelsareourstartingpoint.

3ModelEvaluation
Basicconsiderations
TheanalysispresentedhereisbasedondataongiltyieldsfromtheBankofEnglandwebsite.The
dataseriesextendfrom1972tothepresentandarefreelydownloadable.Amongtheseries
availablearezerocouponyields(rates)formaturitiesatonemonthintervalsattheshortendandat
sixmonthlyintervalsouttoupto30yearmaturity.Thisdataisanexcellentresourcefor
development,butitisnotidealandmaynotbewhatweuseinproduction.Itsshortcomingsinclude
thefactthatinterpolationandcouponstrippingisdoneusingamodelwhichisnotnecessarily
consistentwiththeonesthatweareevaluating,andwhichcannotdistinguishontheruneffects
andothersimilarmicrostructureconsiderations.Therearealsogapsinthedata,althoughtobefair
thesemostlycorrespondtoperiodswhencertainmaturitiesdidnotexistorwerenotliquid.
Nevertheless,fullzerocouponyieldcurvedataatdailyfrequencyextendingasfarbackasthe
demiseofBrettonWoodsisextremelyusefulandissufficienttoaddressalltheissuestackledhere.
Weshallinfactuseendofmonthdataatmonthlyfrequencyfortheinvestigationsreportedinthe
sequel.
Modelparameterestimationwillbebasedonsomeversionofmaximumlikelihood
estimation(MLE)oritsapproximants.Tothisendweusenumericaloptimizationroutinesthat
combineaninitialsearchmethodwithanappropriatequasiNewtonmethodtorefinethemaximum
achievedbysearch.Sinceinpracticaluseparameterestimatesneedtobefrequentlyupdated,we
haveapredilectionforusingmarketdataatonlyafewdatapointsontheyieldcurveandthen
interpolatingorextrapolatingotherrequiredmaturitiesasnecessary,e.g.forpricing.Ifthesame
numberofobservedpointsasthestatespacedimensionisused,asisassumedin(1),(2)and(3)
above(here3),wecanoftenconsiderablyreducetheestimationcomputationsbythedirect
inversionofsquarematrices.
Thisrulesout,atleastinitially,mostfilterormethodofmomentsbasedestimationofunobservable
(latent)factorsastoocomputationallyexpensiveforourapplication.Moreover,althoughtypically
incorporatingmoreobservedratedata,allsuchcomplexmethodsrequiretenderlovingcarein
eachparticulardatainstance,whichisadifficultrequirementinaproductionenvironment.

Firstcandidatespecification

TheDaiandSingletonclassificationdescribesfourtypesofthreefactorexponentialaffinemodels
classifiedroughlyaccordingtohowmanyofthefactorsarebounded(asnotedabove).Whichto

investigate?Itwouldbehelpfultohaveamodelthatavoidsnegativerates.Thatcanonlyhappen
completelyinamodelinwhichallfactorsarebounded,whichmeansamodelof
3 type.
SuchmodelscanbethoughtofasathreefactorextensionofthewellknownCox,Ingersoll,Ross
[1985]squareroot(CIR)onefactormodel.TheyhavebeenfamouslyaddressedinChen&Scott
[1993],sothisshouldnotbeentirelyunknownterritory,andtheiruseguaranteesnonnegative
rates.
TheDaiandSingletonnormalformforthestochasticdifferentialequation(1)representationofthis
typeisrelativelysimple.Thematrix mustbepositiveonthediagonalandnegativeoffthediagonal
andtheparametervector musthavepositiveelements,butotherwisetheyareallowedfull
freedom,whileistheidentitymatrixandSisadiagonalmatrixwithYonthediagonal.Asaresult
theinstantaneousratecanbegivenbyalinearfunctionofYandaconstant,i.e.anaffinefunctionof
Y.Wecalculatemodelimpliedbondprices,andthecorrespondingratesusing(3),intermsofthe
modelparametersbynumericallysolvingtheappropriateversionof(4)todeterminethe
correspondinglikelihoodfunctionformaximumlikelihoodestimationwiththeobservedratedata
(seee.g.JamesandWebber[2000]).
Forthismodelwehave28coefficientstoestimate12forthemarketmeasureprocess,12forthe
pricingmeasureprocessand4fortheformoftheinstantaneousrate.Theriskpremiumisthenthe
differencebetweenthedrifttermsinthetwomodels.Notehoweverthatalthoughthereare28
degreesoffreedom,24ofthemareboundedfortechnicalreasonsandtheother4parameters,
whichcorrespondtotheaffineformoftheinstantaneousrate,mustberestrictedtobepositivefor
economicreasons.
3 modelinpracticeisnotassmoothaswehadhopedandproblems
Unfortunatelyusingan
aroseevenbeforeestimatingthelikelihood.Foragivenparametersetsuchamodelmapsthe
positiveorthantofalinearstatespacetothespaceofratesthroughanonnegativeaffinemapThis
boundseachratefrombelowandmeansthatsimplestylizedcharacteristicsofyieldcurves,suchas
itsslope,definedasthedifferencebetweenshortandlongtermrates,arealsobounded.Thislimits
therangeofpossibleresults,butunfortunatelyitisnottheonlyrestriction.Thereisaconditionon
Fellersquarerootprocesseswhichmustbesatisfiediftheprocessistoremainpositiveandthereis
alsoalinkbetweenthedifferentratesthroughtheirderivationasexpectationsofintegralsofthe
shortrateundertheQpricingmeasure.Boththeserestrictionsgivetheresultingmodelfurther
stiffness.
Theconsequenceisthattherangeofcombinationsofratesthatcanbeachievedforagiven
parametersetislimited,andfrequentlywillnotspanthesetofobservations.Inparticular,verylow
rates,negativeyieldcurvesandobservationsforwhichthemiddleratewasfarfromalinear
interpolationbetweenthelongandshortratesobserved,allprovidedexamplesthatwereoutside
thespanofapparentlyreasonableparametersets.Thisproblemisfairlyintractablebecausethe
parametersetsarealsoboundbytheneedtomatchmomentslikethestandarddeviationofthe
shortrate(whichprovidesalowerboundforthemeanoftheprocess)and,throughthese
requirements,tightrestrictionsontherangeofparametersandspannedyieldcurves.
Thisisaproblemontwofronts.Ontheonehand,therangeofyieldcurvesrenderedbysucha
modelasnotmerelyunlikely,butactuallyimpossible,isuncomfortablylarge.Ontheotherhand,

manyparametersetscouldnotprovidelikelihoodsforallobservations.Thismeansthatestimation
firstrequiresasearchforvalidspecificationsanditisnotclearthatthereareanyforthedataset
usedinthispaper.Unlesstheothermodelingpossibilitiesareevenworse,theseresultsimplya
prettydirectfailureofthismodeltoproviderealisticsimulatedyieldcurvescenarios.
Theproblemsarehowevernotonlyonthesimulationside.Ifthemodelcannotfitevenaminimal
setofobservationsexactly,anyestimationtechniquethatusesobservationsdirectlyorinfersastate
fromdirectinversionwillfailtoo.ChenandScott(2003)encounteredthisproblem,astheir
comparisonsbetweenobservedandfittedyieldcurvesshow.Togetaroundthedifficultythisposes
forestimation,ChenandScottresortedtoaformofKalmanfiltertoestimatetheexpectedstate
evolutionpathasaninputintoamaximumlikelihoodestimationfortheirstateevolution
parameters.Thisaddsawholeextralayerofmodeling,whichfromourviewpointfurther
underminesthe A3 (3) modeltypeasastartingpointforthisinvestigation.
Basedontheinvestigationofonemodelalonehoweverdisappointingtheresultsthereisof
coursestillthepossibilitythatitisthebestavailable.However,withthelimitationsinthe
performanceofsuchamodelinevidencerightfromthestartandtherequirementforsignificant
extratechnicalelaborationrequiredeventobegintomakeprogressitseemsreasonabletolook
elsewhere.

Anothercandidate

Havingturnedbackfromthesquarerootprocessmodels,anobviousplacetocontinuewouldbe
withoneofthemodelsexaminedintheDaiandSingleton[2000]paper.Theconcreteinvestigation
inthatpaperconcentratesonmodelsoftypes A1 (3) and A2 (3) .Sinceingeneralitappearsthat
GaussianmodelsareeasiertohandlethanCIRtypemodels,an A1 (3) typemodelmightbe
preferred.DaiandSingletonpresentarestricted A1 (3) modelwithapleasingintuitive
interpretation,originallygivenbyBalduzzi,Das,ForesiandSunderam[1996]andhenceforthtermed
theBDFSmodel.Thismodelproposesashortraterwithastochasticmeanandstochasticvolatility
v .RoughlyspeakingthelogshortrateandthemeanlogshortratefollowmeanrevertingGaussian
processes,whilethevolatilityfollowsaCIRtypeprocess,buttheshortrateisallowedsensitivityto
innovationsinthevolatility.
Moreprecisely,the(slightlyextended)modelprocessisgiveninthemarketmeasurePby

0
0
0

10

0
0

0
1

0
0
0

0
0
1
0
0

TheriskneutralversionundertheQmeasurewillhavethesameform,butwithdifferentparameter
valuesfor andandsobothmodelshavearelativelyparsimonious12parameters.Amodel
equivalenttotheoriginalBDFSmodelisgivenbysettingtheparameters 1 , 2 ,

and

to

zero,leavingonlytheinnovationsofrand correlated.Forthisaffinemodeltheshortrateand
ratesareoncemoreavailableinanalyticalclosedformunderthepricingmeasureQ.
Themodelagainhasthreefactors,sowemightoncemorehopebeabletoestimateitsuccessfully
usingeitherthreepoints(rates)ontheyieldcurveorthreeprincipalcomponentsfromthedata.A
featureofaffinemodelsisthatanypointontheyieldcurveismodelledbyanaffinefunctionofthe
statespaceandthereforesoisanylinearcombinationofthem.Hencethelinearcombinationsof
ratesthatareprincipalcomponentsofafinitedatasetarealsomodelled.Asaresult,arangeof
choicesofestimationstrategyareavailablewecanuseavarietyofcombinationsofthreepoints
ontheyieldcurve,orevenlevelsofprincipalcomponents,asobservables.

Atfirstthisapproachappearedtogoquitewell.Wewereabletofittheobservationsforavarietyof
specifications,anddistributionsofthemodelledyieldcurvepoints(rates)lookedreasonable.For
example,inthechartpresentedbelowthe A1 (3) modelwasfittedtothe1month,5yearand15year
rates.Ingeneral,themodelhadnotroublefittingtheobservationsandtheestimatedmoments
appearedplausible.
Sothisapproachappearedtobequitepromising,untilweplottedtheoutofsampleforwardrate
evolutionsimpliedbythemodelforvariouspointsontheyieldcurvetogetherwiththoseofthe
historicaldata(seeFigure1greyscale).

11


Figure1BDFSmodelimpliedyieldcurves

TheredlinesinFigure1aretheinsamplepathsofrateslinearlyinterpolatedbetweenfittedyield
curvepointsinthedataover18yearsfrom31stJanuary1994to31stDecember2011,whiletheblue
onesrepresentthecorrespondingpathsofyieldcurvepointsimpliedfromthemodel,bothin
sampleandoutofsamplebyaveragevaluesofsimulatedscenarios.Theunitsoftheverticalscale
areindiscountyieldpermonth,sothattheinsampleimpliedyieldcurveshaveratesfromabout
16%perannum(p.a.)at18months,canexceed13%p.a.at10yearsandcaneachreachover70%
p.a.at20years.Sonotonlywouldtheimpliedyieldcurvenotmatchobservations,butits
implicationscouldbewildlyimplausible.
Thischartwasanunpleasantsurprise,butitdemonstratedsomeofthelessobviouschallenges
involvedinimplementinganaffinetermstructuremodel,includingbutnotlimitedto:

negativerates

explosiveyieldcurves

importanceofratesbeyondthosedirectlyfittodatabothbeforeandafterthesampledates.

Afterseeingthiswewerestruckbyhowrarelyintheliteratureimpliedyieldcurveplotsaregiven
overtheinsampledataperiod,withthehonourableexceptionofChenandScotts1993paper.

12

TheimpliedyieldcurvesshownaboveinFigure1clearlyillustratedsubtletiesinthemodellingthat
wehadmissedinourdirectapproachtoestimatingthemodel.Furtherinvestigationalsorevealed
ratherextremevaluesoftheparameters.Inparticular,theyieldcurveblowsupbothbeforethe
samplebeginsandshortlyafterthelongestobservedterm.
Iftheoriginalunderstandingofthismodelwasthatthesquarerootstatevariableprocesswas
meanttocapturethevolatilityofvolatility,thentheactualestimatesareasignificant
disappointment.Theseestimationresultscouldbeinterpretedasconfirmingtheconclusionof
LittermanandScheinkmanthatthreefactorsarenecessarytocapturethedynamicbehaviorofthe
yieldcurve,butthatstochasticvolatilitydoesnotappeartobethenaturalthirdriskfactor.Thisin
turnsuggeststhatamisspecificationofstochasticvolatilityisillsuitedtomatchthebehaviourofa
thirdyieldcurvepointorprincipalcomponent.
Thatbeingthecase,wedecidedtostartatthebeginningandworkwithassimpleamodelas
possible.WithintheaffineframeworkthatmeanspurelyGaussianorextendedVasicekstylemodels.

Gaussianmodels

ThebasicextendedVasicekmodel,intheDaiSingletonterminologytype A0 (3) ,isgiveninthe

marketmeasurePby(1)with
0

0
0

0
0

0
0

0
1
0
0

0
1
0

0
0
1
.

Estimatingacompletespecificationmeansidentifying16parameters.
Thisspecificationisnotintendedtorestricttheprocess,butrathertorepresentafamilythatspans
therangeofspecificationswhicharenotequivalent.Sincewewishtoallowthebroadestrangeof
riskpremia,tofixtheprocessinthepricingmeasureQintheformabovewemustallownonzero
lowertriangularvaluesof butzerothevaluesof.Weassumeafixedriskpremiumandsothat
marketandpricingmeasureprocessSDEsdifferonlybythevalueof,givingtheriskneutralmodel
13parameters.

13

Suchamodelanditsvariationsaremucheasiertoworkwiththanotheraffinemodels.
Theyhaveclosedformformulaeforthedistributionofthestateoveranytimeperiodand
thereisabigoverlapwithstandardeconometrictechniques.Itshouldthereforebeeasierto
isolateandaddresstheissuespreviouslyidentifiedwiththeBDFSmodel.
Withhindsight,thiswouldhavebeentherightplacetostart,butitwashardtoidentifythe
challengeslikelytobeposedbyattemptstoimplementsuperficiallymoreattractivemodels.
Thereareofcoursestillmanychoicestobemadewiththismodel,andotherissuesto
address,butthebehaviourof A0 (3) modelsshouldbemuchmorepredictable.

Identification

OnemajorchangeingoingfromtheBDFSmodeltoapureGaussianframeworkisthatthedefault
modelisnowunrestricted.Thatdoesnotcauseanyimmediateoperationaldifficulties,buttheinitial
resultswerenotpromising.Actuallyrunningthemodeldoesnotcauseproblemsandthebehaviour
ofthedirectlycalculatedquantitieslooksreasonable,butplottingtheimpliedyieldcurvepaths(see
Figure2greyscale)onceagainrevealsproblems.

(8)

Figure2Vasicekmodelimpliedyieldcurves

14

TheyieldcurvemakesevenmoreviolentswingsthanfortheBDFSmodel,suggestingtwoyearrates
ofover20%p.a.and10yearratesofover60%perannum.Atthetimeofwritingtherearesome
peopletalkingasifthesewereinfactpossiblealternativescenarios,butthisseemsunlikelytous.
So,whatistheproblem?Oneobservationisthatintheanalysisappliedwepaidnoattentionatallto
thebehaviouroftheratesbetweenthemodelledyieldcurvepoints,sowehaveonlythesethree
pointstorelyupontodeliverreasonableinterpolations.
Amoresubtleissuelieswithintheestimationalgorithmitself.Thebasicideaisthat,givena
parameterset,wecanidentifythestatefromeachobservationanddeterminealikelihoodofeach
transitionofthecorrespondingprocesswhichwecanthenuseasabasisforlikelihoodoptimization.
Theproblemisthatweneedtodothisintermsofthemarket(physical)measure,whilewecanonly
determinetheexpectationsneededtocomputeratesordiscountfactorsintermsofapricing(risk
neutral)measure.Workingwiththeaboveassumptionthatthedifferencebetweenthetwoisa
constantvectorinthestateprocessdrift,asimpliedby(6),wecanobtainitsestimate.
However,theobservationsarenotusedtomakeadirectforecastofshorttermratechangesandthe
modelthereforehasthefreedomtotradeoffbetweentheriskpremiumandtheforecastrate
change.Thisfreedomleavesuswithanunidentifiedmodel;butalackofidentificationthatisnot
transparentlyobvious.Untilrecentlythispointwaslittlediscussedexplicitlyintheliterature,
presumablybecausemuchoftheparameterestimationforthesemodelsoftenworkswithanover
identifiedGeneralisedMethodofMoments(GMM)approach,whicheradicatestheproblem.
Inthisinstanceunrealisticdynamicshighlightedtheinadequacyofourestimationprocedure,and
thusthelackofidentification.Althoughthesurprisinglyslowconvergenceoftheoptimization
calculationsinvolvedmightalsohaveprovidedaclue,thisshortcomingwasnotimmediatelyevident
fromtheresults.

Careinlikelihoodoptimization

Theissueofidentificationandestimationisaddressedinsomedetailintherecentpapersof
HamiltonandWu[2011](HW)andJoslin,SingletonandZhu[2011](JSZ).Theestimationprocedure
iscompletedbyrequiringthatinadditiontotheobservationsfittedexactlybytheaffinemodel;
additionalpointsarefittedapproximatelyusingageneralizedleastsquarescriterion.Thisextra
informationisenoughtotiedowntheinteractionbetweenthedynamicsofthemodelandtherisk
premium,evenwhenthespecificationofriskpremiaisexpandedtoallowthedifferencebetween
themarketandpricingmeasurestobeanaffinefunctionofthestate,ratherthanmerelyaconstant.
Thisbroaderspecificationoftheriskpremiumallowsstatisticalconsiderationofthefitofthemodel
forpointsontheyieldcurvebetweenperfectlyfittedratesandalsogoessomewaytowards
addressingtheissueofreturnpredictionraisedinCochraneandPiazzesi[2005].
Althoughthestochasticdifferentialequationrepresentation(1)ofthismodelisfamiliarand
suggestive,itdoesobscureacoupleofitssubtlepoints.Representationsofmultidimensional
Gaussianprocessesinthisframeworkdemandthesquarerootofamatrixwhichintroducesextra
degreesoffreedomhavingnoobviousmeaninginthemodel.Thesecantosomeextentbedealt
withbynormalization,butthenormalizationmayobscurethesymmetriesofthemodel.Asecond

15

pointisthatthemodelisfundamentallyastatespacemodelwithobservablerates(yields)yina
linearstatespace.
Althoughwedonotproposetointroducethefullrelevantnotationhere,itcanbeusefultothinkin
termsofthephysicistsbraandketterminology.Inthesetermsastateisabravectorandan
observableisaketfunction,whichgivesaspecificvaluewhenevaluatedataparticularbravector.A
setofindependentketvectors,orobservables,canthusbethoughtofascoordinatesonthebra
space.Wecanthereforeparameterizethestatespaceintermsofgivenobservables.Iftheseare
affinefunctionsofthestatevector ,themodelcanbeexpressedintermsoftheobservablesandit
isagainanaffinemodelwithparametersthatdifferfromthoseoftheoriginalexpressionby
applicationofaknownaffinetransform.
Inaffinemodelsexpectationsofaffineobservablesareagainaffineandasaresultwecanwithout
lossofgeneralityexpressanaffinetermstructuremodelintermsofrates,oreventhekindoflinear
combinationofratesthatresultsfromaprincipalcomponentsanalysisofyieldcurveobservations.
Thisbringstermstructuremodelsmuchclosertotraditionaleconometricmethodsandalsomeans
thatdifferentestimationscanbeexpressedintermsofequivalentparameterizationsforcomparison
purposes.
Inoursituationthismeansthestatevectorcanbeexpressedintermsofspecificobservablesand
3 HW/JSZmodelcanbeexpressedinthemvectorform
thediscretizationofthe

(7)

wherem nof(1).
Theparametervectorcontainsonlythelongrunmeansoftherates(orprincipalcomponents)
chosentobefittothedataexactly,theirmeanreversionratesandtheratecovariancematrix
multiplyingtheindependentuncorrelatedstandardnormalGaussianinnovationsvector .The
exactlyfitratesarespecifiedbyappropriatelyspecifiedzeroesinthefullmxmmatrix.Herewewill
setm:=n+1=4.
Theloglikelihoodofthetransitionsofthisvectorautoregression(VAR)modelcanthereforebe
expressedasasumofsquaresandadditionaltermsthatdependuponthestateriskpremiaandthe
affineexpressionfortheinstantaneousshortrate.Theoverallparameterestimationcanthenbe
performedintwosteps:

theparametersofthestateprocessunderthemarketmeasurearefirstestimatedviathe
simple,quickrobustgeneralizedleastsquaresregressionprocedure,
thentheriskpremiaareestimatedbyaslightlymorecomplicatedMLEcalculationinvolving
oneextraobservableandahelpfulsimplificationbaseduponnormalizationofthedriftof
thestateprocessunderthepricingmeasure,seee.g.Joslin,SingletonandZhu[2011]for
details.

However,bothcitedpapersalsohighlighttheissueoflocaloptimainthistypeofaugmented
likelihoodoptimization.Indeed,HamiltonandWudemonstratethatanestimateobtainedinAng
andPiazzesishighlycitedpaper(AngandPiazzesi[2003])isinfactonlyalocalmaximum,andthata
globalmaximumnotonlyhasasignificantlyhigherlikelihood,butalsohasoppositesignsforkey
sensitivities.

16

Implementingalltheseconsiderationsusing4observedratesleadstoaconsiderableimprovement
fortheHW/JSZmodeloverthepreviouslyevaluatedmodelsusingonly3rates,buttheburdenof
needingtocalculatetensorhundredsofoptimizationsfromdifferentstartingpointsinordertohave
confidenceinattainingthemaximumaugmentedlikelihoodisunwelcome.
Moreovertheresultsarenotautomaticallyagreatdealmoreplausible.Forexample,theestimation
ofthemodelrepresentedabovegivestheunpleasantbehaviorshowninFigure3(greyscale).

Figure3HW/JSZlocaloptimummodelimpliedyieldcurves

ThischartshowsequivalentinformationtothatofFigure2foralocallyoptimalparameterset
obtainedwiththeHW/JSZmodelincorporatingtheadditionsdiscussedabove.Theoscillationis
causedbycomplexeigenvaluesinthematrixdriftcomponentofthemodel.Inarepresentative
maximumlikelihoodestimationoftheparametersofthismodel(underthepricingmeasure)which
correspondstoalocaloptimumwithmaximalrealeigenvalue0.96076,thelargestcomplex
eigenvalueis0.581612+/0.815219i.
Thesteepgradientofthecurveneartheobservationpointsmeansthatonlyverysmallchangesin
thestatearerequiredtodelivertheobservedmovements.Thustheresultingtransitiondensities

17

canhavevaluesofverylargemagnitude.Thereisofcoursenointrinsicreasonthatasolutionofthis
typeshouldnotbetheglobalaugmentedmaximum,butitsimplicationsareoflimitedpracticaluse
tosaytheleast.
Highfrequencyoscillationslikethoseillustratedabovecanbeavoidedbysomecombinationofa
judiciouschoiceofyieldcurvepointsforapproximatefitting,boundingtheimaginarycomponentof
theeigenvaluesofthedriftmatrix,andgoodfortune,sothattheresultingestimatesbegintolook
reasonablybehaved.Thesearchforoptimalsolutionsiscarriedoutusingseveralstartingpointsand
wehavemostlybeenfortunateinfindingthatthebestofthesedidnotinfacthavehighfrequency
oscillations.
However,werewetobeconfrontedwithsucharesult,orifweneededtorelyonanestimation
techniquenotproducingsuchanoutcome,thereareseveralapproachesavailabletoavoidit.The
mostdirectmethodistorestricttherangeofcomplexeigenvaluesallowed.IntheJSZmethodthisis
straightforwardbecauseitconsiderstheJordannormalformofthedriftmatrixandwecanapply
suchlimitstothedriftsdirectly.Itcanalsobeusefultoapplyapenalizedbufferzonebetween
unrestrictedparametersandthoseabsolutelyprohibitedinordertoavoidthelikelihoodsearchpath
fallingintoahole.
Itispossibletoextendthisanalysistoconsiderationofmoreratedatathan4pointsontheyield
curve,e.g.includingmorepointsbetweentheexactlyobservedpoints,butasaresulttheparameter
estimationalgorithmismadesubstantiallymorecomplex.

Negativeyieldcurves

Highfrequencyoscillationscanbereasonablystraightforwardlysuppressedusingthetechniques
suggestedabove,butitismuchhardertoavoidestimatednegativeyieldcurvesinthismodel.Thisis
notsimplythepossibilityofnegativerates,butalsothepossibilityofdiscountfactorsgreaterthan1
overlongtimeperiods.Insomeoftheearliermodelsevaluatedthiswasaproblem,but,havingby
thispointeliminatedmanyoftheexplanationsforsuchbehavior,theproblemstillariseswiththe
HW/JSZmodel.

18


Figure4HW/JSZlongtermyieldcurves

Figure4(greyscale)showsmorereasonablybehavedyieldcurveevolution(dataandmodelfor
variousyieldcurvematurities)overthe20yeardataperiod.Uptotheobserveddatahorizon(31
December2011)themodelfitsthedatawell,butforthemodelyieldcurveforecastat20years
forwardthecurvebecomesstronglynegative.Theseprojectedyieldcurvesarederivedbysimulating
(5)beyondthedataspan,using(6),andthenforeachmaturityaveragingclosedformmodelimplied
ratesacrossalargenumber(4,000)ofsimulatedscenariostoyieldanaccurateapproximationof
ratesderivedfromthecontinuoustimeandspacezerocouponbondprices(2).
Therootofthelongtermnegativeyieldcurveproblemisthattheweightingsoflowratescenarios
aremuchheavierthanthoseofhighratescenariosinthescenarioaverageratecalculations.
Althoughitisnotquiteinevitable,thisproblemisobdurateandtherestrictionsonthecombination
ofmeanlevel,meanreversionandvolatilitynecessarytopreventlongtermnegativeratescanbe
unrealisticforrealisticshortertermbehaviour.
Explicitorcomputableformulaeforexpectedratesareoneofthekeyfeaturesofaffinemodels,but
especiallyinhigherdimensionalversionsthesecanbequiteopaqueanddonotimmediatelyyieldan
intuitionaboutwhatisgoingon.Thekeyfeatureisthedistinctionbetweentheappropriatemean

19

coordinatesofthestateprocess:theexpectedfutureshortrateandtheexpectedforwardrateor
yieldtomaturityoftheappropriatezerocouponbond.ThefirstisvisibleintheappropriateOrnstein
Uhlenbeckequationandthesecondtakesintoaccountthetimeasymmetryofdiscounting,sothat
lowratescountformorethanhighrates.Theexpectedforwardrate,whichactuallydeterminesthe
yieldcurve,alsoreflectsthecovarianceofthefutureshortratewiththediscountfactoruptothe
timepointinquestion,thesocalledconvexityadjustment.
Toillustratethis,considertheSDEofasimpleonefactormodel:
,

(8)

with : 0.04 , :
0.01and
0.04.Theshortrateincrementhasameanof0.04,afuture
shortratethatisasymptoticallyzeroandforwardratesthatarenegative.Evenwhenthe
asymptoticallyfuturerateispositive,theforwardratescanbenegative.Infact,doublingthemean
reversionrategivesnegativeforwardratesdespitethepositivefutureshortrate,andmustbe
increasedbyafactorof15tomaketheimpliedyieldcurvepositiveinthisexample.
OurestimatesfortheJW/JSDmodeltypicallysuggestveryslowmeanreversionandthereforea
smallvalueofmeanreversioncoefficientsandmakeanultimatelynegativeyieldcurveverylikely.
Ontheotherhand,fastmeanreversionimpliesverylargeriskpremiaandstrongdivergencefrom
therationalexpectationshypothesiswhichleadstounitrootsunderthemarketmeasure.Ofcourse
therecentregimeofhistoricallylowinterestratesdoesnothelpthesituation,buttheproblem
appearsquitedeepseated.Unitrootmodelestimateswillcauseproblemswhatevertheactualrates
are.

Unitrootsolutions

Notonlydounitrootestimatesbringnegativeyieldcurves,therangeofreturnsgivenbyamodel
withaunitrootorsuperunitrootsbecomesextremelywide.Manyexamplesestimatedinthe
literaturehave(super)unitroots,seee.g.references.Moreover,wehavefoundthat
implementationsofthesmallsamplecorrectionsuggestedbyBauer,RudebuschandWu[2011]yield
adjustmentseasilylargeenoughtochangeameanrevertingestimateintoonewitharandomwalk
(orworse)byintroducingaunitroot.InarepresentativeestimationoftheJW/JSDmodelthis
correctionchangedamaximalrealeigenvalue0.96138intooneof1.03142.Ifwefollowtheauthors
suggestionsofapplyingashrinkagefactororrestrictingthesearchrangetomeanreverting
solutions,theseheuristictechniquesmayresultinexpungingunitrootestimates,buttheydelegate
tootherconsiderationsthedeterminationofwhetherornotthestateprocesshasaunitroot.
Despitethesignificanceofthisissueitdoesnotseemtobedirectlyaddressedinmuchofthe
literature.Clearlythereistypicallyaproblemwiththeamountsofdataavailable,butthe
observationthatthisdoesnotmattermuchforveryshorttermforecastsdoesnothelpdetermine
parametersthathavegreatsignificanceforlongtermbehaviour.Theliteraturefrequentlydefersthe
decisiononthelongtermstabilityofthemodeltooutsideconsiderationsandingeneralprovides
littlehelpintheempiricaldeterminationoftheestimatedstateprocessstability.

20

Negativerates

Asithappens,ourbestestimatesdonotsuggestunitrootsandthereforewearenotforcedto
considerwildlyunprecedentedriskcharacteristics.Whileitisregrettablethatwecannothaveboth
ourfirstchoiceestimatesandtheabilitytoextrapolateindefinitelybeyondtherangeofour
observations,ifwewereonlyconsideringaggregatestatisticsoverashorthorizonwewould
probablybeabletoworkwiththemodelsevaluatedsofar.
However,weneedeverysimulatedscenariotobeplausibleinitsownright,notmerelyaspartofan
aggregate.Atthispointtheissueofnegativeratesbecomesagenuineproblem.
Figure5(greyscale)showstheextentofthisproblem.Itdepictsquantilesofsimulatedtenyear
interestratesfromarecentstartingpoint,30thDecember2011.Nearly25%ofscenariosare
negative.Ifwemerelyassumedthatthosescenarioswerezeroinsteadofnegative,themeanrate
wouldbeabout25basispointshigheranamounttoolargetoignore.Thisisunacceptableeven
whenotheraspectsofthemodelarewellbehaved.

Figure5HW/JSZtenyearratedistributionoutofsampleevolutionquantiles

Typicalestimationonlylooksatconditionallikelihood

Muchrecentinterestratedataappearstohaveastrongdownwardtrend,reflectingthefactthat
ratesarecurrentlyverylow.IntheUnitedKingdomtheywereveryhighaftertheendofBretton
Woodsandinthelate1980s.Ifweconsideronlythelikelihoodofthetransitions,thetrendwilloften

21

bemadeplausiblebystrongmeanreversioneffects.Unfortunately,thiscanresultinestimated
modelsthatmakeevenrecenthistorypracticallyimpossible.Thisisbecauseanalysisoftransitions
withoutconsideringthelongrunrelevanceofinitialconditionsotherthanthefirstobservationpays
noattentiontohowtheworldgotintothefirststate.
Intermsofmaximumlikelihoodestimation,consideringonlythetransitionsisconsideringonly
conditionallikelihood.GeneraldescriptionsofMLEanddescriptionsofunivariateMLEusually
concernafullorunconditionallikelihoodfunction,butformultivariatetimeseriesanalysisthis
seemstoberarelyconsidered.Forinstance,Hamiltons[1994]bookopensdiscussionsofmaximum
likelihoodestimationwithafulldescriptionofunconditionallikelihoodintheunivariatecase,butin
themultivariatecaseitsaysthatunconditionalestimationisnotattempted.
Itisnotdifficulttoderivetheexpressionfortheunconditionallikelihoodwhentheprocessis
stationary,whenthelongrunmeanestimatecanbeusedastheinitialstate.Howeverusingthe
unconditionallikelihoodmakesestimationmoredifficultinanumberofways.Moreover,conditional
likelihoodestimationmightbenecessarytoensurethatthestationarityassumptionofratesis
reasonable.Thefirstorderlagsincorporatedinthediscretizedversionsofthemodelsconsidered
maketheirfulllikelihoodexpressionsmuchmorecomplicatedandstandardleastsquares
techniquesnolongerapply.Nevertheless,inoursituationunconditionalestimationappearstobe
thenaturalapproach.

Gaussianmodelshaveconstantvolatility

Thediscussionsofarhasaddressedrelativelybroadissueswiththeevaluatedmodelseffectively
theminimumrequirementsneededforviability.Atthestartofourattemptstoimplementan
interestratemodeltherewereother,subtler,issuesontheagenda.Oneoftheseisanempiricallink
betweenthelevelofratesandthevolatilityofrates.Theconnectioniswellknownandisillustrated
inRebonatos[2004]book.Instylizedtermsthebehaviourreferredtoispositivecorrelation
betweenvolatility(measuredinabsoluteterms)andthelevelofrates.InapurelyGaussianmodel
thereisnosuchlink,sovolatilitywilleitherbetoohighwhenratesarelowortoolowwhentheyare
high.Thisproblemisquitesubtlemodelswhichhavelognormalinterestrateshaveasimilar
problemofinflexibility,butthesignofthisbehaviourisreversed.Asaresult,whenhistoricalrates
areverylow,veryhighlevelsofparametricvolatilityarerequiredtomatchhistoricaloroption
impliedvolatilitylevels.

Lessonslearned

Beforedescribingourimplementedsolutioninthenextsection,wefirstdiscusswhatwedidfor
eachmodelinvestigatedsofarandwhatwehavelearnedfromtheseexercises.
Drawachart
Someoftheproblemsweencounteredwereeasilynoticedbydrawingagraph.Graphsofpathsof
yieldcurvepointsoverthedataperiodrarelyfeatureintheliterature.Thesamecommentappliesto
plottingquantilesoftheevolvingdistributionofinterestratesandreturns.Thisiseasiertodothan
mostofthemodelling,andprovidesextremelyusefulcontextformodelevaluation.

22

Takecareofspecifications

Asaruleofthumb,whenthinkingabouthowbigamodeltobuild,itseemssensibletotalkabout
thedimensionofthestatespaceofthemodelprocesses,butthereisinflexibilityintheCIRsquare
rootprocessesthatmeanstheydonotmapwelltothethreeprincipalcomponentsidentifiedinthe
LittermanandScheinkman[1991]paper.Fromthispointofviewitisprobablybettertocountthe
numberofGaussianvariablesinamodel.

Usemultiplelikelihoodoptimizationstartingpoints

Theloglikelihoodfunctionsofmodelsofthistypehavenumerouslocalmaxima.Asingle
optimizationwillmostlikelynotgivetheglobalmaximum.Unfortunatelytheparametersearch
spacewilltypicallybequitelargeandwillrequirecomputationallyintensivemultipleoptimization
startingpointcalculations,whichluckilycanbestraightforwardlyparallelized.

Considerusingunconditionallikelihood

Whileusingunconditionallikelihoodmakessomeproceduresmoredifficultorcomplexfrom
specifiedinitialstates,butifthecalculationsarefeasiblethereseemsnoreasonwhythisshouldnot
bethedefaultprocedure.ForGaussianaffineprocessesthecomputationsarerelativelysimple.
Takingunconditionallikelihoodintoaccountininterestrateserieswheretheratelevelsatthe
beginningandendoftheseriesareverydifferentwilltendtoyieldestimateswithgreaterlongterm
variance.Unfortunatesideeffectsofthisarethatthesamplestatisticsofthetimeseriesareno
longertheestimatedmodelparametersandsuperefficientleastsquarescalculationscannolonger
besimplyappliedtocalculatetheparameterestimates.Evenso,therequiredcalculationsarenot
terriblyonerous.

4Oursolution

Forourapplicationnegativeyieldsareafatalproblem.HoweverinGaussianmodelstheyare
unavoidableandcannotbesidesteppedinforwardsolutionsbysimplemeasuressuchassettingany
negativeratetozero,althoughsomeothermorecomplexproceduresareavailablewhichalleviate,
butnoteliminate,thedifficulty.
InsteadweappliedanoldideaofFischerBlacks.Theideaassertsthatinterestratesgenerallycome
withastuffitunderthemattressoptioninwhichinvestorsjustkeeptheirmoneywhenfacedwith
anegativeinterestrate.Thismeansthatwemightmodelinterestratesasoptionsonsomemore
fundamental,butpossiblyhardtoobserve,shadowrateswhichguaranteepositiveratesorset
minimumrates.
Theoriginalideaisdescribed,butnotimplemented,inFischerBlackslast(posthumously)published
paper,seeBlack[1995].Thecorrespondingyieldcurvemodelhasbeenimplementedanumberof
timesbefore,oftenwithJapaneseinterestratesinmind.Notableexamplesincludepapersbya
groupattheBankofJapan(seeUeno,Baba&Sakurai[2006]andIchiue&Ueno[2007])andbyKim

23

andSingleton[2011],butwithnomorethantwostatevariables.Inourcase,weusedthree
variables.
Specifically,theunderlyingprocessevolvesina3dimensionalstatespacelikethatoftheHW/JSZ
model,butnowtheforwardyieldobservablesarenonlinearfunctionsofthestatespacesincethey
arerepresentedintermsofexpectationsonintegralsofanoptiononshortrateaffinefunctionsof
thestatespace.Asaresult,unliketheHW/JSZexponentialaffinemodel,coordinatesarenolonger
uniformoverthestatespaceandtranslationbetweenyieldswhichwecanobserveandmodelstates
aboutwhoseprobabilitieswecanreasonaboutisnolongerastraightforwardcalculation.
Inotherwords,wehypothesizean
3 modeldescribingtheevolutionofashadowshortrateof
exactlytheformdescribedby(6)intheprevioussection,butadditionallyhypothesizethattheactual
shortrateisazerostrikecalloptiononthisrate,sothat
,

max 0,

. (9)

Thisisconceptuallysimple,butasnotedabovethenonlinearityintroducesconsiderablepractical
difficultyinmovingfromouryieldobservationstothecorrespondingstate.KimandSingleton[2011]
performthiscalculationbysolvingaparabolicpartialdifferentialequation(PDE)oftheform

Pt /

i , j =1

a ij 2 Pt / y i y j

b P
i =1

/ y i c Pt = 0 ,

(10)

withboundaryvalues P (0) = 0 andsufficientlylargestatespaceboundsfortherates.Howeverthe

alternatingdirectionimplicit(ADI)finitedifferenceschemetheyusetosolve(10)doesnoteasily
extendtothecorrespondingPDEinthreedimensionsandsofarwehavebeenunabletoimplement
aneffectivealternative.
Therearestillavenuestoexploreinthisdirection,butforthetimebeingwehaveadopteda
techniquewhichisacombinationofanalyticalclosedformyieldcalculationsandMonteCarlo
simulation.Theproceduremaybeconsideredtobearefinementofsolvingtheleastsquaresfitof
MonteCarlosimulatedyieldstoeachindividualobservation.Thisapproachisverycomputer
intensive,butitdoesappeartoprovideveryrobustresults.

Outofsampleforecasts
Wepresentherethequantilesofthesimulatedoutofsampleevolutionovertimeofthe
distributionofthe10yearratefromforthenewnonlinearBlackmodel.Figure6displaystheoutof
samplediagramanalogoustoFigure5(fromthesame30thDecember2011startingpoint)forthis
model.

24

Figure6Blackmodelnonnegative10yearratedistributionoutofsampleevolutionquantiles

Figure7showstheinandoutofsamplelongtermyieldcurvesimulationforecastsforthenew
modelanalogoustothatofFigure4anddemonstratestherequiredlongtermscenariosimulation
performanceoftheBlackmodelthatourapplicationsrequire.
Besidesdeliveringpositiveratesandthedirectconnectionbetweenratesandexpectations,the
mostnotabledifferencebetweenourearlierattemptsandtheBlackmodelseemstobethatit
allowsmuchslowershortratemeanreversionestimates,whichissignificant.Forexample,inthe
modelthatthisresearchismeanttoupdate(adevelopmentoftheonedescribedinMulveyand
Thorlacious[1998])disequilibriahaveanestimatedhalflifeofapproximately4years,whileinthis
modeltheestimatedhalflifeisnearly15yearsinthephysicalmeasure,andover1,000yearsinthe
pricingmeasureusedforyieldcurveextrapolation.Thedifficultiessuchslowmeanreversionwould
causeinastraightforwardGaussianmodelhavebeenclearlyillustratedabove.
Inconcreteterms,thispropertyofthenewmodelmeansthatwecanreflectthepossibilitythat
interestratesinourmainmodellingtargetstheUK,USandEUremainextremelylow,asJapans
havedoneforsometime,whilealsoentertainingthepossibilitythatrateswillblowup,likethoseof
ItalyandSpaincurrently.Indeed,themediumtermdistributionsofshortratesarebimodal.The
underlying(shadowexpectation)processesarestillOrnsteinUhlenbeckprocesses,buttheway
statesarenonlinearlymappedtoyieldcurvesisdifferentfromtheaffinemapofthestandardearlier
models.

25


Figure7Blackmodellongtermnonnegativeyieldcurves

5Conclusion
Inthisarticlewehavedescribedavoyageofdiscoverythathasresultedinanewtractableyield
curvemodelwhichpossessesthepropertiesrequiredbypractitionerswhointendtouselongterm
simulationsfromitforpricing,investmentadviceandassetliabilitymanagement.Itsestimation
fromsovereigninterestratedataiscomputationallyintensive,butstraightforwardandtractable,
andisamenabletofrequentupdating,asisrequiredbytheseapplications.
Table1summarizesthepropertiesofthemodelsevaluatedinthispaperregardingwellaccepted
stylizedfactsofyieldcurvesandtheirmodelsintheorderinwhichbothpropertiesandmodelsare
discussedinthepaper.OurnonlinearBlackmodelpossessesallthedesiredpropertiesexceptfor

26

closedformbondprices,butrapideffectivePDEbasednumericaltechniquesforbondpricinghave
beendescribedinSection4.

StylizedFactPropertiesYieldCurveModel
CIRBDFSVasicekHW/JSZHW/JSZ/BRWBlack
A3 (3) A3 (3) A3 (3)

A1 (3)

A0 (3)

A0 (3)

MeanRevertingRatesYesYesYesYesNoYes

NonnegativeRatesYesNoNoNoNoYes

StochasticRateVolatilityYesYesNoNoNoYes*

ClosedFormBondPricesYesYesYesYesYesNo
ReplicatesAllObservedCurvesNoYesYesYesYesYes
GoodforLongTermSimulationsNoNoNoNoNoYes
StateDependentRiskPremiaNoNoNoYesYesYes

+veRate/VolatilityCorrelationNoNoNoNoNoYes

EffectiveinLowRateRegimesNoNoNoNoNoYes

Table1.Propertiesofevaluatedyieldcurvemodelswithregardtostylizedfacts
*Ratevolatilitiesarepiecewiseconstantpunctuatedbyrandomjumpsto0atrate0boundary
hittingpoints.

Inongoingworkwearedevelopingtheinteractionofthismodelwiththeotherfinancialand
economicvariablesininteractingcapitalmarketmodelsofthefourmaincurrencyareas.Afirststep
exploresthestatisticalinteractionsofournewyieldcurvemodelwithmacroeconomicvariablessuch
asinflationrateandGDPbegunbyAngandPiazzesi[2003]inamacroeconomiccontextand
extendedinamannermoreappropriatetocapitalmarketmodelsbyDempster,MedovaandTang
[2012].

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