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Approximating Risk Premium on a Parametric Arbitrage-free Term Structure Model

Brazilian Review of Econometrics

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Title Approximating Risk Premium on a Parametric Arbitrage-free Term Structure Model
 
Creator Almeida, Caio
Ardison, Kym
Kubudi, Daniela
 
Subject Term structure of interest rates, parametric models , affine models, cross sectional estimation, time series analysis, forecasting
C1,C5,G1
 
Description In this paper we approximate the risk factors of a polynomial arbitrage-free dynamic term structure model by running a sequential set of linear regressions independent across time. This approximation avoids the cost of a full optimization procedure allowing for a simple method to extract the risk premium embedded in interest rate assets. Closed-form bond pricing formulas provide interpretation of each source of aggregate risk as known term structure movements. Assuming, for illustrative purposes, an economy with three sources of aggregate risk (level, slope and curvature), we test the validity of our approximation adopting a dataset of Brazilian zero coupon interest rates. The new methodology generates accurate parameters, standard deviations and risk premium dynamics when compared to the exact dynamic model. Moreover, an empirical illustration comparing the out-of-sample forecasting performance of the exact model, our approximation, and a standard Gaussian affine model against the Random Walk, reveals that the proposed approximation obtains favorable forecasting results providing a reliable substitute to the exact estimation method with a much smaller computational time.
 
Publisher Sociedade Brasileira de Econometria
 
Contributor —
 
Date 2015-05-04
 
Type info:eu-repo/semantics/article
info:eu-repo/semantics/publishedVersion
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Format application/pdf
 
Identifier http://bibliotecadigital.fgv.br/ojs/index.php/bre/article/view/48700
10.12660/bre.v34n22014.48700
 
Source Brazilian Review of Econometrics; Vol 34, No 2 (2014); 203-246
Brazilian Review of Econometrics; Vol 34, No 2 (2014); 203-246
1980-2447
 
Language eng
 
Relation http://bibliotecadigital.fgv.br/ojs/index.php/bre/article/view/48700/47967
 
Rights Copyright (c) 2015 Brazilian Review of Econometrics