Evaluating Interest Rate Covariance Models within a Value-at-Risk Framework

FRB of San Francisco Working Paper No. 2004-03

56 Pages Posted: 8 Dec 2003

See all articles by Miguel A. Ferreira

Miguel A. Ferreira

Nova School of Business and Economics; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Jose A. Lopez

Federal Reserve Bank of San Francisco

Multiple version iconThere are 3 versions of this paper

Date Written: October 2004

Abstract

A key component of managing international interest rate portfolios is forecasts of the covariances between national interest rates and accompanying exchange rates. How should portfolio managers choose among the large number of covariance forecasting models available? We find that covariance matrix forecasts generated by models incorporating interest-rate level volatility effects perform best with respect to statistical loss functions. However, within a value-at-risk (VaR) framework, the relative performance of the covariance matrix forecasts depends greatly on the VaR distributional assumption, and forecasts based just on weighted averages of past observations perform best. In addition, portfolio variance forecasts that ignore the covariance matrix generate the lowest regulatory capital charge, a key economic decision variable for commercial banks. Our results provide empirical support for the commonly-used VaR models based on simple covariance matrix forecasts and distributional assumptions.

Keywords: Interest rates, GARCH, Forecasting, Value-at-Risk

JEL Classification: C52, C53, G12, E43

Suggested Citation

Ferreira, Miguel Almeida and Lopez, Jose Antonio, Evaluating Interest Rate Covariance Models within a Value-at-Risk Framework (October 2004). FRB of San Francisco Working Paper No. 2004-03. Available at SSRN: https://ssrn.com/abstract=476502 or http://dx.doi.org/10.2139/ssrn.476502

Miguel Almeida Ferreira (Contact Author)

Nova School of Business and Economics ( email )

Campus de Campolide
Lisbon, 1099-032
Portugal

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Jose Antonio Lopez

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States
415-977-3894 (Phone)
415-974-2168 (Fax)

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