A Factor Risk Model with Reference Returns for the Us Dollar and Japanese Yen Bond Markets
36 Pages Posted: 30 Jun 2006
Date Written: June 2006
This paper develops a new methodology for simulating fixed-income return distributions. It is shown that a traditional factor risk model, when augmented with reference returns, is capable of generating visually consistent return distributions for a broad range of fixed income instruments such as government and nongovernment instruments in the US dollar and Japanese yen bond markets. The reference returns result from a regime-switching Nelson-Siegel yield curve model following Bernadell, Coche and Nyholm (2005). Empirical results are encouraging: simulated distributions exhibit most characteristics observed in the fixed income markets such as non-normal right-skewed distributions for short maturity instrument while instruments with longer maturity are closer to being normally distributed.
Keywords: Regime switching, scenario analysis, factor risk model
JEL Classification: C15, C32, C53, G11, G15
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