The M-Vector Model: Derivation and Testing of Extensions to M-Square

Abstract

This article derives and tests a multiple-factor extension of the M-square model (see Fong and Vasicek [1984] and Fong and Fabozzi [1985]), termed as the M-vector model. Tests of the M-square model indicate that the model reduces the interest rate risk inherent in the traditional duration model by more than half. The M-vector model demonstrates near-perfect hedging performance, eliminating more than 95% of interest rate risk inherent in the traditional duration model.

Keywords: Interest Rate Risk, Duration, Convexity, M-Square, M-Vector, Duration Vector

JEL Classification: G1, G10, G11, G12