Parametric Immunization of Interest Rate Risk via Term Structure Models

Abstract

The paper considers the parametric hedging of non-parallel shifts in the yield curve. In order to determine capital requirements and stress testing, Basel committee recommends taking into account the risk of non-parallel interest rate shifts [Basel Committee on Banking Supervision, 2016]. As of April 2017, only one Russian bank took this risk into account in calculating interest rate risk, and one was developing a methodology [Central bank of Russia, 2017]. We use several term structure models for hedging non-parallel interest rate shifts. The study uses a 5-year span of Russian bond market data. We use VaR and MAE to assess the effectiveness of hedging approaches.

The novelty of the work lies in the application of different term structure models, most of which have not previously been used for parametric hedging. We also present an original methodology for assessing the effectiveness of hedging. For the first time a study is conducted on the Russian bond market.

Cross-validation shows that the Nelson – Siegel (and also its shortened version), Svensson and Cox – Ingersoll – Ross models within the parametric hedging problem give better results than the generally accepted Fisher – Weil duration model. The results of this work have practical significance for fixed income managers.