Post-Crisis Interest Rate Markets: Analysing, Modelling and Stress Testing of Multiple Yield Curves

• Applicant: Professorin Dr. Eva-Maria Lütkebohmert-Holtz
• Subject Area: Accounting and Finance
• Term: from 2019 to 2021
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 416416014

The financial crisis of 2007/2008 has led a new era of interest rate markets characterized by multiple (tenor-dependent) yield curves. The term structure of interest rates (or yield curve) describes the interest rate as a function of maturity and is an important tool for pricing, risk management and monetary policy. It is constructed by bootstrapping from interest rate products of different maturities that are linked to the same reference rate as e.g. the 6-month EURIBOR (i.e. for a tenor of 6 months) or the Overnight Indexed Swap (OIS) rate (for the risk-free discount curve). While spreads between interest rates that have the same maturity but are based on different tenors were negligible before the crisis of 2007/2008, they increased to levels above 250 bps at the peak of the crisis. Most notably these spreads remained at significant levels also after the crisis. As a consequence of this structural change, a completely new treatment of post-crisis interest rate markets is required.In the proposed project we face this challenge and we plan to achieve the following four major contributions:• First, we will identify economic factors that determine the dynamics of the whole term-structure of interest rates and of the corresponding spreads. Our approach will take into account interdependencies between yield curves of different tenors and allows to study how dependence patterns vary over time. This will be particularly interesting for portfolio allocation and policy decisions.• Second, we will develop a new class of macro-finance models for multiple yield curves that allows to study interactions between the macroeconomy, the discount curve and the term structure of tenor basis spreads. Moreover, we will analyse how risk premia depend on economic factors and whether the decomposition of risk premia is varying with time. Our results will have important implications for understanding the impact of various monetary policy rules on yield spreads and the whole interbank market. • Third, we will apply new techniques from machine learning to predict future term structures of interest rates. Through detecting certain patterns in yield curve parameters and in combining these methods with the inclusion of macroeconomic variables, we expect a significant improvement of the forecasting precision. In this way, the project will provide a major contribution to the forecasting of yield curves. • Fourth, in building on the previous contributions, we will construct new stress testing frameworks suitable for post-crisis interest rate markets, which allow to study how shifts in tenor-dependent yield curves as well as cross-tenor dependencies affect market portfolios and banks’ share price. This will have important implications for banks’ internal risk management as well as for regulators. With this rich agenda the proposal provides important contributions to both the empirical and theoretical analysis of post-crisis interest rate markets.

• DFG Programme: Research Grants