Bridge over ocean
1 November 2013 CFA Institute Journal Review

A Global Model of International Yield Curves: No-Arbitrage Term Structure Approach (Digest Summary)

  1. Mark K. Bhasin, CFA

The authors analyze the comovement between international interest rates by modifying a term-structure model to use multiple yield factors across three markets. Adapting the model to include the United States, the United Kingdom, and the euro area, while also incorporating exchange rates, provides a better description of broad trends in global interest rates than a model of individual yield curves. In addition, the model indicates that changes in exchange rates are determined primarily by time-varying exchange rate risk premiums.

What’s Inside?

Similar to previous work, the authors model international yield curves that allow for both global and local factors. The two global factors that account for a significant proportion of the variability in international bond yields are closely linked to global inflation and global economic activity measures. Local factors are intimately related to monetary policy expectations in their respective countries. In contrast to previous work, this approach allows the authors to model international yield curves using a class of no-arbitrage term-structure models that can account for time-varying risk premiums. This no-arbitrage approach allows for the decomposition of interest rates into risk premiums and risk-free rates, which permits further analysis into whether yield curves move because of changes in expectations or because of term premium dynamics.

How Is This Research Useful to Practitioners?

The authors estimate the significant global and local factors in their joint international model under the assumption of no arbitrage—a condition admitting the decomposition of interest rates into risk premiums and risk-free rates. When jointly estimating a model across multiple economies that includes the exchange rate, they demonstrate that they can produce a qualitatively better generalization of interest rate behavior than if yield curves are modeled individually. The authors’ approach also incorporates an assessment of the implications for foreign exchange rates. They demonstrate that movement in the exchange rate is largely determined by time-varying exchange rate risk premiums.

How Did the Authors Conduct This Research?

The authors extend a well-known term-structure model to jointly model bond markets and exchange rates from the United Kingdom, the United States, and the euro area. They make some meaningful contributions to the existing framework. First, they extend the standard two-country approach by estimating three-country models, which provides, among other things, an estimate of local and global factors across the three countries. Second, instead of assuming one model specification, they estimate a number of models, thus allowing for different combinations of global and local factors. Third, they incorporate deviations from uncovered interest rate parity.

The authors use models that belong to the “essentially affine” class of models. In individual country models of this type, both bond yields and related risk premiums are affine functions of underlying characteristic variables. A consistent finding among researchers is that time variation in term premiums is critical for describing the behavior of interest rates. The single economy model is derived from three basic factors: a process driving the unobservable factors, a formulation of the stochastic discount factor that ensures the model is essentially affine, and the assumption that bond prices reflect the fundamental asset pricing equation. The authors then generalize the model to handle the multiple-economy case. They estimate essentially affine models of the term structures in each of the three economies separately and jointly.

Abstractor’s Viewpoint

The authors verify the primary global and local factors that account for the majority of variation in international bond yields, which are consistent with the findings of previous work. But more importantly, the authors successfully extend a prevailing term-structure model by revising it to allow the decomposition of interest rates into risk premiums and risk-free rates, as well as concluding that changes in the exchange rate are largely determined by time-varying exchange rate risk premiums. These findings would be particularly interesting to those working with fixed-income investments.

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