A real-world stochastic model for projecting nominal interest rates in a Monte Carlo setting

11 Pages Posted: 29 Apr 2020 Last revised: 3 Aug 2020

See all articles by John Southall

John Southall

Legal & General Investment Management Limited

Date Written: April 16, 2020

Abstract

We present a real-world stochastic projection of nominal interest rate curves intended to integrate with Monte Carlo economic scenario generators. The model projects three time-varying parameters arising from a singular value decomposition of transformed historic interest rates, rather than modelling tenor points directly. A key feature is that we devise an empirically-motivated, rather than an assumed convenient form, transform function to apply to interest rates before performing the decomposition. This choice reflects an observed relationship between the volatility and level of interest rates. The resulting time-varying parameters, which we call time components, are projected as mean-reverting arithmetic random walks with mean reversion strength calibrated to historic behaviour. The drift of the model is adjusted so that the mean average of discount factors across simulations is in line with initial market-implied expectations. This adjustment preserves the required relationship between the level and the volatility of interest rates.

Keywords: Monte Carlo, singular value decomposition, interest rates

JEL Classification: C53, G12

Suggested Citation

Southall, John, A real-world stochastic model for projecting nominal interest rates in a Monte Carlo setting (April 16, 2020). Available at SSRN: https://ssrn.com/abstract=3577777 or http://dx.doi.org/10.2139/ssrn.3577777

John Southall (Contact Author)

Legal & General Investment Management Limited ( email )

United States

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