What does a term structure model imply about very long-term interest rates

Research output: Working paperProfessional

Abstract

We address two empirical issues related to the long end of the yield curve based on euro swap rates. First, for maturities longer than 20 years we find evidence for an `excess' downward slope that cannot be explained by convexity. Second, volatility at the very long end of the yield curve is larger than predicted by no-arbitrage models. We construct a model-based arbitrage-free extrapolation of the yield-curve and compare it to the regulatory discount curve. Because of near-zero mean reversion, there is no convergence towards an `ultimate forward rate' and convexity effects cause the arbitrage-free extrapolations to have slightly downward sloping curves. The low level of mean-reversion also implies that the volatility of long-term rates does not decline relative to the 20-year volatility. Therefore, we conclude that the mean-reversion and resulting smoothing adopted by the regulatory curve is much too strong.
Original languageEnglish
PublisherSSRN
Number of pages36
DOIs
Publication statusPublished - 19 Nov 2020

JEL classifications

  • g23 - "Pension Funds; Non-bank Financial Institutions; Financial Instruments; Institutional Investors"
  • g12 - "Asset Pricing; Trading volume; Bond Interest Rates"
  • c58 - Financial Econometrics

Keywords

  • term structure models
  • Parameter uncertainty
  • extrapolation
  • insurance supervision

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