FORECASTING_SPREADS_24Oct2005.pdf (271.92 kB)
On the predictability of common risk factors in the US and UK interest rate swap markets: evidence from non-linear and linear models
preprint
posted on 2005-11-21, 13:04 authored by Ilias Lekkos, Costas Milas, Theodore PanagiotidisThis paper explores the ability of common risk factors 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. The first regime is characterised by a "flat" term
structure of US interest rates, while the alternative is characterised by an "upward" sloping US
term structure. 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 nearest-neighbours and STVAR models predict better than the
linear AR and VAR models. However, the evidence is not overwhelming as it is sensitive to
swap spread maturity. We also find that within the non-linear class of models, the nearestneighbours
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.
History
School
- Business and Economics
Department
- Economics
Pages
249509 bytesPublication date
2005-10Language
- en