Developing a Practical Yield Curve Model: An Odyssey

Abstract

This paper describes the search for a yield curve model that embodies current research but will be used for product pricing, investment advice and asset liability management over long horizons. A variety of available 3-factor affine models are implemented and tested, often with surprising results. The existing model evaluation process leads to a new nonlinear model based on an observation of Black and possessing all the required stylized features for our applications. The examined alternatives all fail in some of these. The efficient implementation developed for the new yield curve model is expected to be the keystone of capital market models in the four major currencies and the paper concludes with some considerations in this direction.

Keywords: Capital markets, 3-factor affine yield curve models, long term horizons, low rate regimes, nonlinear Black model

JEL Classification: E43, E44, E47