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Since the hedged portfolio is riskfree, the payo of the portfolio can be
discounted by the riskfree rate.
Valuation is all about getting the forecasts right and assigning the
appropriate price for the forecasted risk fair wrt future cashows
(and your risk preference).
Q: Risk-neutral probabilities that we can use to aggregate expected future
payos and discount them back with riskfree rate, regardless of how risky
the cash ow is.
Since the intention is to hedge away risk under all scenarios and
discount back with riskfree rate, we do not really care about the actual
probability of each scenario happening.
We just care about what all the possible scenarios are and whether our
hedging works under all scenarios.
Q is not about getting close to the actual probability, but about being
fair wrt the prices of securities that you use for hedging.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 5 / 67
A Micky Mouse example
Consider a non-dividend paying stock in a world with zero riskfree interest rate.
Currently, the market price for the stock is $100. What should be the forward
price for the stock with one year maturity?
The forward price is $100.
Standard forward pricing argument says that the forward price should
be equal to the cost of buying the stock and carrying it over to
maturity.
Shorting a forward at $100 is still safe for you if you can buy the stock
at $100 to hedge.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 6 / 67
Investing in derivative securities without insights
If you can really forecast the cashow (with inside information), you
probably do not care much about hedging or no-arbitrage modeling.
You just lift the market and try not getting caught for inside trading.
But if you do not have insights on cash ows (earnings growth etc) and still
want to invest in derivatives, the focus does not need to be on forecasting,
but on cross-sectional consistency.
r
X
t
.
Nothing about the forecasts: The risk-neutral dynamics are estimated to
match historical term structure shapes.
A model is well-specied if it can t most of the term structure shapes
reasonably well.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 8 / 67
A 3-factor ane model
with adjustments for discrete Fed policy changes:
Pricing errors on USD swap rates in bps
Maturity Mean MAE Std Auto Max R
2
2 y 0.80 2.70 3.27 0.76 12.42 99.96
3 y 0.06 1.56 1.94 0.70 7.53 99.98
5 y -0.09 0.68 0.92 0.49 5.37 99.99
7 y 0.08 0.71 0.93 0.52 7.53 99.99
10 y -0.14 0.84 1.20 0.46 8.14 99.99
15 y 0.40 2.20 2.84 0.69 16.35 99.90
30 y -0.37 4.51 5.71 0.81 22.00 99.55
Superb pricing performance: R-squared is greater than 99%.
Maximum pricing errors is 22bps.
Pricing errors are transient compared to swap rates (0.99):
Average half life of the pricing errors is 3 weeks.
The average half life for swap rates is 1.5 years.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 9 / 67
Investing in interest rate swaps based on dynamic term
structure models
If you can forecast interest rate movements,
Forget about dynamic term structure model: It does not help your
interest rate forecasting.
If you cannot forecast interest rate movements (it is hard), use the dynamic
term structure model not for forecasting, but as a decomposition tool:
y
t
= f (X
t
) + e
t
What the model misses (the pricing error e) is the more transient and
hence more predictable component.
Form swap-rate portfolios that
Y
e
a
r
S
w
a
p
,
%
It is much easier to predict the hedged portfolio (left panel) than the unhedged
swap contract (right panel).
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 12 / 67
Back-testing results from a simple investment strategy
95-00: In sample. Holding each investment for 4 weeks.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 13 / 67
Caveats
Convergence takes time: We take a 4-week horizon.
Accurate hedging is vital for the success of the strategy. The model needs to
be estimated with dynamic consistency:
At normal times, the currency price (dollar price of a local currency, say
peso) follows a diusive process with stochastic volatility.
When the country defaults on its foreign debt, the currency price jumps
by a large amount.
Capital structure arbitrage: Volatility and default rates are not static,
but vary strongly over time in unpredictable ways.
The math and implementation are both simpler for term structure
models than for option pricing models.
Model estimation:
R
T
t
f (t,s)ds
r (t) the instantaneous interest rate dened by the limit:
r (t) = f (t, t) = lim
Tt
y(t, T).
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 24 / 67
The pricing kernel
If there is no arbitrage in a market, there must exist at least one strictly
positive process M
t
such that the deated gains process associated with any
trading strategy is a martingale:
M
t
P
t
= E
P
t
[M
T
P
T
] , (1)
where P
t
denotes the time-t value of a trading strategy, P denotes the
statistical probability measure.
Consider the strategy of buying a zero-coupon bond at time t and hold it to
maturity at T, we have M
t
B(t, T) = E
P
t
[M
T
B(T, T)] = E
P
t
[M
T
] .
If the market is complete, this process M
t
is unique.
If the available securities cannot complete the market, there can be multiple
processes that satisfy equation (1).
If we cannot nd a single positive process that can price all securities, there
is arbitrage.
M
t
is called the state-price deator. The ratio M
t,T
= M
T
/M
t
is called the
stochastic discount factor, or the pricing kernel: B(t, T) = E
P
t
[M
t,T
].
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 25 / 67
From pricing kernel to exchange rates
Let M
h
t,T
denote the pricing kernel in economy h that prices all securities in
that economy with its currency denomination.
The h-currency price of currency-f (h is home currency) is linked to the
pricing kernels of the two economies by,
S
fh
T
S
fh
t
=
M
f
t,T
M
h
t,T
The log currency return over period [t, T], ln S
fh
T
/S
fh
t
equals the dierence
between the log pricing kernels of the two economies.
Let S denote the dollar price of pound (e.g. S
t
= $2.06), then
ln S
T
/S
t
= ln M
pound
t,T
ln M
dollar
t,T
.
If markets are completed by primary securities (e.g., bonds and stocks),
there is one unique pricing kernel per economy. The exchange rate
movement is uniquely determined by the ratio of the pricing kernels.
If the markets are not completed by primary securities, exchange rates (and
currency options) help complete the markets by requiring that the ratio of
any two viable pricing kernels go through the exchange rate.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 26 / 67
Multiplicative decomposition of the pricing kernel
In a discrete-time representative agent economy with an additive CRRA
utility, the pricing kernel equals the ratio of the marginal utilities of
consumption,
M
t,t+1
=
u
(c
t+1
)
u
(c
t
)
=
_
c
t+1
c
t
_
_
T
t
r
s
ds
_
E
_
_
T
t
s
dX
s
_
r is the instantaneous riskfree rate, E is the stochastic exponential
martingale operator, X denotes the risk sources in the economy, and is the
market price of the risk X.
If X
t
= W
t
, E
_
_
T
t
s
dW
s
_
= e
R
T
t
s
dW
s
1
2
R
T
t
2
s
ds
.
r is normally a function of X.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 27 / 67
Bond pricing
Recall the multiplicative decomposition of the pricing kernel:
M
t,T
= exp
_
_
T
t
r
s
ds
_
E
_
_
T
t
s
dX
s
_
Given the pricing kernel, the value of the zero-coupon bond can be written as
B(t, T) = E
P
t
[M
t,T
]
= E
P
t
_
exp
_
_
T
t
r
s
ds
_
E
_
_
T
t
s
dX
s
__
= E
Q
t
_
exp
_
_
T
t
r
s
ds
__
where the measure change from P to Q is dened by the exponential
martingale E().
The risk sources X and their market prices matter for bond pricing
through the correlation between r and X.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 28 / 67
Measure change dened by exponential martingales
Consider the following exponential martingale that denes the measure change
from P to Q:
dQ
dP
t
= E
_
_
t
0
s
dW
s
_
,
If the P dynamics is: dS
i
t
=
i
S
i
t
dt +
i
S
i
t
dW
i
t
, with
i
dt = E[dW
t
dW
i
t
],
then the dynamics of S
i
t
under Q is: dS
i
t
=
i
S
i
t
dt +
i
S
i
t
dW
i
t
+E[
t
dW
t
,
i
S
i
t
dW
i
t
] =
_
i
t
i
i
_
S
i
t
dt +
i
S
i
t
dW
i
t
If S
i
t
is the price of a traded security, we need r =
i
t
i
i
. The risk
premium on the security is
i
t
r =
i
i
.
How do things change if the pricing kernel is given by:
M
t,T
= exp
_
_
T
t
r
s
ds
_
E
_
_
T
t
s
dW
s
_
E
_
_
T
t
s
dZ
s
_
,
where Z
t
is another set of Brownian motions independent of W
t
or W
i
t
.
Z does not aect bond pricing if it is not correlated with r .
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 29 / 67
Measure change dened by exponential martingales: Jumps
Let X denote a pure jump process with its compensator being (x, t) under
P.
Consider a measure change dened by the exponential martingale:
dQ
dP
t
= E (X
t
),
The compensator of the jump process under Q becomes:
(x, t)
Q
= e
x
(x, t).
Example: Merton (176)s compound Poisson jump process,
(x, t) =
1
2
e
(x
J
)
2
2
2
J
. Under Q, it becomes
(x, t)
Q
=
1
2
e
x
(x
J
)
2
2
2
J
=
Q 1
2
e
(x
Q
J
)
2
2
2
J
with
Q
=
J
2
J
and
Q
= e
1
2
(
2
J
2
J
)
.
Reference: K uchler & Srensen, Exponential Families of Stochastic Processes, Springer, 1997.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 30 / 67
Dynamic term structure models
A long list of papers propose dierent dynamic term structure models:
Specic examples:
Leippold, Wu, 2002, JFQA: Spot rates are quadratic functions of state
variables.
First, we state the form of solution that we want for bond prices (spot
rates).
_
T
t
r (X
s
)ds
__
= exp
_
a() b()
X
t
_
Implicit assumptions:
By writing B(X
t
, ) and r (X
t
), and solutions A(), b(), I am implicitly
focusing on time-homogeneous models. Calendar dates do not matter.
This assumption is for (notational) simplicity more than anything else.
_
T
t
r (X
s
)ds
_
T
_
,
where
T
denotes terminal payo, the value satises the following partial
dierential equation:
f
t
+Lf = rf , Lf innitesimal generator
with boundary condition f (T) =
T
.
Apply the PDE to the bond valuation problem,
B
t
+ B
X
(X) +
1
2
B
XX
(X)(X)
= rB
with boundary condition B(X
T
, 0) = 1.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 34 / 67
Back lling
Starting with the PDE,
B
t
+ B
X
(X) +
1
2
B
XX
(X)(X)
= rB, B(X
T
, 0) = 1.
If B(X
t
, ) = exp(a() b()
X
t
), we have
B
t
= B
_
a
() + b
()
X
t
_
, B
X
= Bb(), B
XX
= Bb()b()
,
y(t, ) =
1
_
a() + b()
X
t
_
, r (X
t
) = a
(0) + b
(0)
X
t
= a
r
+ b
r
X
t
.
Plug these back to the PDE,
a
() +b
()
X
t
b()
(X) +
1
2
b()b()
(X)(X)
= a
r
+b
r
X
t
Question: What specications of (X) and (X) guarantee the above PDE
to hold at all X?
() + b
()
X
t
b()
(X) +
1
2
b()b()
(X)(X)
= a
r
+ b
r
X
t
Set (X) = a
m
+ b
m
X + c
m
XX
+ and
[(X)(X)
]
i
=
i
+
i
X +
i
XX
() b()
a
m
+
1
2
b()b()
i
= a
r
X b
()
b()
b
m
+
1
2
b()b()
i
= b
r
XX
b()
c
m
+
1
2
b()b()
i
= 0
The quadratic and higher-order terms are almost surely zero.
We thus have the conditions to have exponential-ane bond prices:
(X) = a
m
+ b
m
X, [(X)(X)
]
i
=
i
+
i
X, r (X) = a
r
+ b
r
X.
We can solve the coecients [a(), b()] via the following ordinary
dierential equations:
a
() = a
r
+ b()
a
m
1
2
b()b()
i
b
() = b
r
+ b
m
b()
1
2
b()b()
i
starting at a(0) = 0 and b(0) = 0.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 36 / 67
From Q to P, not from P to Q
The ane conditions,
(X) = a
m
+ b
m
X, [(X)(X)
]
i
=
i
+
i
X, r (X) = a
r
+ b
r
X.
are about the Q-dynamics, not about the P-dynamics.
Traditionally, researchers start with the P-dynamics (the real thing), and
specify risk preferences (market prices of risks). From these two, they derive
the Q-dynamics and derivative (bond) prices.
But the back-lling exercise shows that the real requirement for tractability
(e.g., ane) is on Q-dynamics.
Hence, we should also back ll the specication:
_
T
t
s
dW
t
_
, with
s
=
0
+
1
r
t
+ (c/
r
)r
2
t
+ (d/
r
)r
3
t
+ (d/
r
)r
4
t
.
Can you price zero-coupon bonds based on this specication?
Reversely, if the Q-dynamics are given by
(X) = a
m
+ b
m
X, [(X)(X)
]
i
=
i
+
i
X
and the measure change is dened by E
_
_
T
t
s
dW
t
_
, we have the drift
of the P-dynamics as
(X)
P
= a
m
+ b
m
X + (X)
t
The market price of risk
t
can be anything...
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 38 / 67
Quadratic and others
Can you identify the conditions for quadratic models: Bond prices are
exponential quadratic in state variables?
Can you identify the conditions for cubic models: Bond prices are
exponential cubic in state variables?
Ane bond prices: Recently Xavier Gabaix derive a model where bond
prices are ane (not exponential ane!) in state variables.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 39 / 67
Model design
The models that we have derived can have many many factors.
How many factors you use depend on the data (how many sources of
independent variation) A PCA analysis is useful.
The super general specication has many parameters that are not
identiable. You need to analyze the model carefully to get rid of redundant
parameters.
Once you know that you have the capability to go complex, you actually
want to go as simple as possible.
Everything should be made as simple as possible, but not simpler.
Albert Einstein.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 40 / 67
Data
We estimate a DTSM using US dollar LIBOR and swap rates:
_
1
P(X
t
,)
1
_
, (simple compounding rates)
SWAP(X
t
, ) = 200
1P(X
t
,)
P
2
i =1
P(X
t
,i /2)
, (par bond coupon rates).
LIBOR and swaps on other currencies have slightly dierent day-counting
conventions.
Sample period: I want it as long as possible, but data are not fully available
before 1995.
Sampling frequency: For model estimation, I often sample data weekly to
avoid weekday eects.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 41 / 67
Data: Time series and term structure
95 96 97 98 99 00 01 02 03 04 05 06 07
0
1
2
3
4
5
6
7
8
9
L
I
B
O
R
a
n
d
s
w
a
p
r
a
t
e
s
,
%
USLBOR and swap rates
0 1 2 3 4 5 6 7 8 9 10
0
1
2
3
4
5
6
7
8
9
Maturity, years
L
I
B
O
R
a
n
d
s
w
a
p
r
a
t
e
s
,
%
USLBOR and swap rates
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 42 / 67
Data: Summary statistics
Maturity Mean Std Skew Kurt Auto
1m 4.329 1.807 -0.703 -1.077 0.998
2m 4.365 1.813 -0.710 -1.067 0.998
3m 4.399 1.818 -0.708 -1.055 0.998
6m 4.474 1.814 -0.705 -0.998 0.998
9m 4.550 1.800 -0.689 -0.935 0.997
12m 4.638 1.780 -0.659 -0.874 0.996
2y 4.887 1.576 -0.547 -0.691 0.994
3y 5.100 1.417 -0.421 -0.651 0.993
4y 5.265 1.301 -0.297 -0.686 0.991
5y 5.397 1.213 -0.187 -0.751 0.990
7y 5.594 1.096 -0.015 -0.873 0.989
10y 5.793 1.003 0.136 -0.994 0.987
Average weekly autocorrelation for swap rates () is 0.991:
Half-life = ln /2/ ln 78 weeks(1.5years)
Interest rates are highly persistent; forecasting is dicult.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 43 / 67
Data: Principal component analysis
0 1 2 3 4 5 6 7
0
10
20
30
40
50
60
70
80
Principal components
E
x
p
l
a
i
n
e
d
v
a
r
i
a
t
i
o
n
,
%
0 1 2 3 4 5 6 7 8 9 10
0.8
0.6
0.4
0.2
0
0.2
0.4
0.6
Maturity, years
F
a
c
t
o
r
l
o
a
d
i
n
g
Compute the covariance () of the weekly changes in LIBOR/swap rates.
Perform eigenvalue/eigenvector decomposition on the covariance matrix.
[V,D]=eigs().
The eigenvalues (after normalization) represents the explained variation.
The eigenvector denes the loading of each principal component.
t
dW
Q
t
, [
t
]
ii
=
i
+
i
X
t
.
r
X
t
Bond pricing: Zero-coupon bond prices:
B(X
t
, ) = exp
_
a() b()
X
t
_
.
Ane forecasting dynamics (P): dX
t
=
P
_
P
X
t
_
dt +
t
dW
P
t
Specication is up to identication.
Dai, Singleton (2000): A
m
(3) classication with m = 0, 1, 2, 3.
[
t
]
ii
=
_
X
t,i
i = 1, , m;
1 +
i
X
t
, i = m + 1, , n.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 45 / 67
Model design: A 3-factor Gaussian ane model
The simplest among all A
m
(3) models:
The specication and normalization:
dX
t
=
P
X
t
dt + dW
P
t
dX
t
= ( X
t
) dt + dW
Q
t
, r (X
t
) = a
r
+ b
r
X
t
.
X
t
_
, with
a
() = a
r
+ b()
1
2
b()
b() and b
() = b
r
b().
b
r
.
Properties: Bond yields (spot, forward rates) are ane functions of Gaussian
variables.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 46 / 67
Estimation: Maximum likelihood with UKF
State propagation (discretization of the forecasting dynamics):
X
t+1
= A + X
t
+
_
Q
t+1
.
A = 0, = e
P
t
, Q =
_
t
0
e
s
e
s
ds
.
= t.
Measurement equation: Assume LIBOR and swap rates are observed with
error:
y
t
=
_
LIBOR(X
t
, i )
SWAP(X
t
, j )
_
+
e
t
,
i = 1, 2, 3, 6, 12 months
j = 2, 3, 5, 7, 10, 15, 30 years.
Unscented Kalman Filter (UKF) generates conditional forecasts of the mean
and covariance of the state vector and observations.
Likelihood is built on the forecasting errors:
l
t+1
=
1
2
log
V
t+1
1
2
_
_
y
t+1
y
t+1
_
_
V
t+1
_
1
_
y
t+1
y
t+1
_
_
.
Choose model parameters (
P
, , , a
r
, b
r
, ) to maximize the sum of the
weekly log likelihood function.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 47 / 67
The Classic Kalman lter
Kalman lter (KF) generates ecient forecasts and updates under
linear-Gaussian state-space setup:
State : X
t+1
= A + X
t
+
Q
t+1
,
Measurement : y
t
= HX
t
+
e
t
The ex ante predictions as
X
t
= A +
X
t1
;
t
=
t1
+ Q;
y
t
= HX
t
;
V
t
= HV
t
H
+ .
The ex post ltering updates are,
X
t+1
= X
t+1
+ K
t+1
_
y
t+1
y
t+1
_
;
t+1
=
t+1
K
t+1
V
t+1
K
t+1
,
where K
t+1
=
t+1
H
_
V
t+1
_
1
is the Kalman gain.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 48 / 67
The Extended Kalman lter: Linearly approximating the
measurement equation
In our application, LIBOR and swap rates are NOT linear in states:
State : X
t+1
= A + X
t
+
Q
t+1
,
Measurement : y
t
= h(X
t
) +
e
t
One way to use the Kalman lter is by linear approximating the
measurement equation,
y
t
H
t
X
t
+
e
t
, H
t
=
h(X
t
)
X
t
X
t
=
b
X
t
It works well when the nonlinearity in the measurement equation is small.
Numerical issue
e
t
The Kalman lter applies Bayesian rules in updating the conditionally
normal distributions.
Instead of approximating the measurement equation h(X
t
), we directly
approximate the distribution and then apply Bayesian rules on the
approximate distribution.
There are two ways of approximating the distribution:
t,0
=
X
t
,
t,i
=
X
t
_
(k + )(
t
+ Q)
j
(2)
with corresponding weights w
i
given by
w
0
= /(k + ), w
i
= 1/[2(k + )].
We can regard these sigma vectors as forming a discrete distribution with w
i
as the corresponding probabilities.
We can verify that the mean, covariance, skewness, and kurtosis of this
distribution are
X
t
,
t
+ Q, 0, and k + , respectively.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 51 / 67
The unscented Kalman lter
Given the sigma points, the prediction steps are given by
X
t+1
= A +
2k
i =0
w
i
(
t,i
);
t+1
=
2k
i =0
w
i
(A +
t,i
X
t+1
)(A +
t,i
X
t+1
)
;
y
t+1
=
2k
i =0
w
i
h (A +
t,i
) ;
V
t+1
=
2k
i =0
w
i
_
h (A +
t,i
) y
t+1
_
h (A +
t,i
) y
t+1
+ ,
The ltering updates are given by
X
t+1
= X
t+1
+ K
t+1
_
y
t+1
y
t+1
_
;
t+1
=
t+1
K
t+1
V
t+1
K
t+1
,
with K
t+1
= S
t+1
_
V
t+1
_
1
.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 52 / 67
Alternative estimation approaches
Instead of estimating the model on LIBOR and swap rates, we can estimate
the model on stripped continuously compounded spot or forward rates,
which are ane in the state vector.
For our trading strategy, we actually need to know the pricing error on
tradable securities.
Exact matching: Assume that three of the LIBOR/swap rates (or three spot
rates) are priced exactly by the 3 factors. Then, we can directly invert the
state variables at each date exactly.
Which rate series are priced fair? Which rates have error?
_
0.002 0 0
(0.02)
0.186 0.480 0
(0.42) (1.19)
0.749 2.628 0.586
(1.80) (3.40) (2.55)
_
_
_
_
0.014 0 0
(11.6)
0.068 0.707 0
(1.92) (20.0)
2.418 3.544 1.110
(10.7) (12.0) (20.0)
_
_
The t-values are smaller for
P
than for .
The largest eigenvalue of
P
is 0.586
Weekly autocorrelation 0.989, half life 62 weeks.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 55 / 67
Summary statistics of the pricing errors (bps)
Maturity Mean MAE Std Max Auto R
2
1 m 1.82 6.89 10.53 60.50 0.80 99.65
3 m 0.35 1.87 3.70 31.96 0.73 99.96
12 m 9.79 10.91 10.22 55.12 0.79 99.70
2 y 0.89 2.93 4.16 23.03 0.87 99.94
5 y 0.20 1.30 1.80 10.12 0.56 99.98
10 y 0.07 2.42 3.12 12.34 0.70 99.91
15 y 2.16 5.79 7.07 22.29 0.85 99.40
30 y 0.53 8.74 11.07 34.58 0.90 98.31
Average 0.79 4.29 5.48 27.06 0.69 99.71
The errors are small. The 3 factors explain over 99%.
The average persistence of the pricing errors (0.69, half life 3 weeks) is
much smaller than that of the interest rates (0.991, 1.5 years).
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 56 / 67
4-week ahead forecasting
Three strategies:
(1) random walk (RW); (2) AR(1) regression (OLS); (3) DTSM.
Explained Variation = 100 [1 var (Err )/var (R)]
Maturity RW OLS DTSM
6 m 0.00 0.53 -31.71
2 y 0.00 0.02 -7.87
3 y 0.00 0.13 -0.88
5 y 0.00 0.44 0.81
10 y 0.00 1.07 -3.87
30 y 0.00 1.53 -36.64
OLS is not that much better than RW, due to high persistence (max 1.5%).
DTSM is the worst! DTSM can be used to t the term structure (99%),
but not forecast interest rates.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 57 / 67
Use DTSM as a decomposition tool
Linearly decompose the LIBOR/swap rates (y) as
y
i
t
H
i
X
t
+ e
i
t
, H
i
=
y
i
t
X
t
X
t
=0
Form a portfolio (m = [m
1
, m
2
, m
3
, m
4
]
i =1
m
i
y
i
t
4
i =1
m
i
H
i
X
t
+
4
i =1
m
i
e
i
t
=
4
i =1
m
i
e
i
t
.
Choose the portfolio weights to hedge away its dependence on the three
factors: Hm = 0.
Y
e
a
r
S
w
a
p
,
%
Hedged 10-yr swap Unhedged 10-yr swap
(half life): 0.816 (one month) vs. 0.987 (one year).
R
t+1
= 0.0849 0.2754R
t
+ e
t+1
, R
2
= 0.14,
(0.0096) (0.0306)
R
2
= 1.07% for the unhedged 10-year swap rate.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 59 / 67
Predictability of 4-rate portfolios
0 10 20 30 40 50 60
0
10
20
30
40
50
60
70
80
90
100
Percentage Explained Variance, %
FourInstrument Portfolios
12 rates can generate 495 4-instrument portfolios.
Improved predictability for all portfolios (against unhedged single rates)
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 60 / 67
Predictability of 2- and 3-rate portfolios
0 10 20 30 40 50 60
0
10
20
30
40
50
60
70
80
90
100
Percentage Explained Variance, %
TwoInstrument Portfolios
0 10 20 30 40 50 60
0
10
20
30
40
50
60
70
80
90
100
Percentage Explained Variance, %
ThreeInstrument Portfolios
No guaranteed success for spread (2-rate) and buttery (3-rate) portfolios.
Predictability improves dramatically after the 3rd factor.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 61 / 67
A simple buy and hold investment strategy
on interest-rate portfolios
Form 4-instrument swap portfolios (m). Regard each swap contract as a par
bond.
At each time, long the portfolio if the portfolio swap rate is higher than the
model value. Short otherwise:
w
t
= c
_
m
(y
t
SWAP(X
t
))
For discounting, one can use piece-wise constant forward to strip the
yield curve.
Remark: The (over-simplied) strategy is for illustration only; it is not an
optimized strategy.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 62 / 67
P&L calculation
Consider a 4-instrument swap portfolio with xed portfolio weights m.
At time t, the investment in this portfolio is w
t
(based on whether this
portfolio value is higher or lower than the model value.
The initial cost of this investment is C
t
= 100w
t
4
i =1
m
i
, regarding each
swap contract as a par bond with $100 par value.
At the end of the holding horizon T (4 weeks later), liquidate the portfolio.
The revenue from the liquation is:
P
T
= w
t
4
i =1
m
i
_
S
i
t
t
i
D(T, t
i
) + 100D(T, T
i
)
_
D(T, t
i
) the time-T discount factor at expiry date t
i
.
t
i
the coupon dates of the i th bond with coupon rate being the
time-t swap rate S
i
t
.
P&L = P
T
C
t
e
r
t
(Tt)
, with r
t
denoting the continuously compounded rate
corresponding to the time-t three-month LIBOR, the nancing rate of the
swap contract.
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 63 / 67
Protability of investing in four-instrument swap portfolios
Jan96 Jan98 Jan00 Jan02
0
50
100
150
200
C
u
m
u
l
a
t
i
v
e
W
e
a
l
t
h
0.4 0.5 0.6 0.7 0.8 0.9
0
1
2
3
4
5
6
Annualized Information Ratio
Liuren Wu Dynamic Term Structure Model Statistical Arbitrage Fall, 2007 64 / 67
The sources of the protability
Risk and return characteristics
The investment returns are not related to traditional stock and bond
market factors (the usual suspects):
Rm, HML, SMB, UMD, Credit spread, interest rate volatility,...