Scenario Generation for Long-Run Interest Rate Risk Assessment

Abstract

We propose a statistical model of the term structure of sovereign yields tailored for long-term probability-based scenario generation and forecasts. While being simple to estimate, our model is able to reproduce simultaneously the positivity of the yield curve, high persistence, factor structure and time varying volatilities and correlations. It features a regime switching short rate model. A complete benchmark of the model following Diebold and Li is performed in terms of forecasting ability and coverage properties. We show that the proposed model improves performance relative to a standard model from the literature.

Keywords: Interest Rate Forecast, Regime Switching, Factor Model

JEL Classification: C32, C53, C58