Convexity Adjustment for Constant maturity Swaps in a Multi-Curve Framework

In this paper we propose a double curving setup with distinct forward and discount curves to price constant maturity swaps (CMS). Using separate curves for discounting and forwarding, we develop a new convexity adjustment, by departing from the restrictive assumption of a flat term structure, and expand our setting to incorporate the more realistic and even challenging case of term structure tilts. We calibrate CMS spreads to market data and numerically compare our adjustments against the Black and SABR (stochastic alpha beta rho) CMS adjustments widely used in the market. Our analysis suggests that the proposed convexity adjustment is significantly larger compared to the Black and SABR adjustments and offers a consistent and robust valuation of CMS spreads across different market conditions

The role of time-varying risk premia in international interbank markets

We study international interbank spreads within a no‐arbitrage dynamic term structure model and attempt to disentangle time‐varying risk premia in the interbank market for major currencies. Our results suggest that, at the peak of financial crisis, the interbank spread was clearly driven by liquidity risk. In the aftermath of the crisis, credit risk has become the dominant driver of the spread. This effect is stronger in the Euro and UK markets, due to the escalation of the European sovereign debt crisis, and weaker in the Japanese market which experienced remarkably low credit pressures. Furthermore, we assess the effectiveness of monetary policy actions and demonstrate that the establishment of the unconventional policy programmes led to the deterioration of liquidity risk in the interbank market, and the policy of major Central banks to substantially cut interest rates kept credit pressures at low levels. We also partition the spread into expectation hypothesis and time‐varying risk premium components and reject the hypothesis of constant risk premium. We find strong evidence of predictability inferred from the interbank spread model with time‐varying risk premia

Foreign-law premium for European high-yield corporate bonds

We provide novel evidence on importance of governing laws for returns of high-yield corporate bonds. Around 29% of sample bonds are governed by laws which are different from laws of issuers’ countries of domicile. The most popular foreign law is English, followed by New York, and German laws. The foreign-law bonds exhibit higher excess returns than their domestic-law counterparts. The effect of foreign law on excess returns increases with an increase in downside risk. This conditional effect is particularly evident for English foreign governing law. The results are robust to controls for endogeneity concerns, alternative proxies, and model specifications

Dynamic Term Structure Models with Nonlinearities using Gaussian Processes

The importance of unspanned macroeconomic variables for Dynamic Term Structure Models has been intensively discussed in the literature. To our best knowledge the earlier studies considered only linear interactions between the economy and the real-world dynamics of interest rates in DTSMs. We propose a generalized modelling setup for Gaussian DTSMs which allows for unspanned nonlinear associations between the two and we exploit it in forecasting. Specifically, we construct a custom sequential Monte Carlo estimation and forecasting scheme where we introduce Gaussian Process priors to model nonlinearities. Sequential scheme we propose can also be used with dynamic portfolio optimization to assess the potential of generated economic value to investors. The methodology is presented using US Treasury data and selected macroeconomic indices. Namely, we look at core inflation and real economic activity. We contrast the results obtained from the nonlinear model with those stemming from an application of a linear model. Unlike for real economic activity, in case of core inflation we find that, compared to linear models, application of nonlinear models leads to statistically significant gains in economic value across considered maturities.Comment: arXiv admin note: text overlap with arXiv:2205.0009

Sequential learning and economic benefits from dynamic term structure models

We explore the statistical and economic importance of restrictions on the dynamics of risk compensation from the perspective of a real-time Bayesian learner who predicts bond excess returns using dynamic term structure models (DTSMs). The question on whether potential statistical predictability offered by such models can generate economically significant portfolio benefits out-of-sample is revisited while imposing restrictions on their risk premia parameters. To address this question, we propose a methodological framework that successfully handles sequential model search and parameter estimation over the restriction space in real time, allowing investors to revise their beliefs when new information arrives, thus informing their asset allocation and maximizing their expected utility. Empirical results reinforce the argument of sparsity in the market price of risk specification since we find strong evidence of out-of-sample predictability only for those models that allow for level risk to be priced and, additionally, only one or two of these risk premia parameters to be different than zero. Most importantly, such statistical evidence is turned into economically significant utility gains, across prediction horizons, different time periods and portfolio specifications. In addition to identifying successful DTSMs, the sequential version of the stochastic search variable selection scheme developed can be applied on its own and offer useful diagnostics monitoring key quantities over time. Connections with predictive regressions are also provided. This paper was accepted by Kay Giesecke, finance. Funding: T. Dubiel-Teleszynski acknowledges the support of the Economic and Social Research Council. Supplemental Material: The data files and online appendices are available at https://doi.org/10.1287/mnsc.2023.4801 .</p