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Forecasting interest rates through Vasicek and CIR models: a partitioning approach

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  • Giuseppe Orlando
  • Rosa Maria Mininni
  • Michele Bufalo
Abstract
The aim of this paper is to propose a new methodology that allows forecasting, through Vasicek and CIR models, of future expected interest rates (for each maturity) based on rolling windows from observed financial market data. The novelty, apart from the use of those models not for pricing but for forecasting the expected rates at a given maturity, consists in an appropriate partitioning of the data sample. This allows capturing all the statistically significant time changes in volatility of interest rates, thus giving an account of jumps in market dynamics. The performance of the new approach is carried out for different term structures and is tested for both models. It is shown how the proposed methodology overcomes both the usual challenges (e.g. simulating regime switching, volatility clustering, skewed tails, etc.) as well as the new ones added by the current market environment characterized by low to negative interest rates.

Suggested Citation

  • Giuseppe Orlando & Rosa Maria Mininni & Michele Bufalo, 2019. "Forecasting interest rates through Vasicek and CIR models: a partitioning approach," Papers 1901.02246, arXiv.org, revised Jan 2019.
    • Handle: RePEc:arx:papers:1901.02246
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    References listed on IDEAS

    as
    1. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    2. Giuseppe Orlando & Rosa Maria Mininni & Michele Bufalo, 2019. "Interest rates calibration with a CIR model," Journal of Risk Finance, Emerald Group Publishing Limited, vol. 20(4), pages 370-387, September.
    3. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(4), pages 627-627, November.
    4. John C. Cox & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2005. "A Theory Of The Term Structure Of Interest Rates," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 5, pages 129-164, World Scientific Publishing Co. Pte. Ltd..
    5. Hull, John & White, Alan, 1990. "Pricing Interest-Rate-Derivative Securities," The Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 573-592.
    6. Moreno, Manuel & Platania, Federico, 2015. "A cyclical square-root model for the term structure of interest rates," European Journal of Operational Research, Elsevier, vol. 241(1), pages 109-121.
    7. Jushan Bai & Pierre Perron, 2003. "Computation and analysis of multiple structural change models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 18(1), pages 1-22.
    8. Giuseppe Orlando & Rosa Maria Mininni & Michele Bufalo, 2019. "A new approach to forecast market interest rates through the CIR model," Studies in Economics and Finance, Emerald Group Publishing Limited, vol. 37(2), pages 267-292, September.
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    Cited by:

    1. Gareth Liu-Evans, 2021. "Improving the Estimation and Predictions of Small Time Series Models," Working Papers 202106, University of Liverpool, Department of Economics.
    2. Bufalo, Michele & Orlando, Giuseppe, 2023. "A three-factor stochastic model for forecasting production of energy materials," Finance Research Letters, Elsevier, vol. 51(C).
    3. Giuseppe Orlando & Michele Bufalo, 2022. "A generalized two‐factor square‐root framework for modeling occurrences of natural catastrophes," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 41(8), pages 1608-1622, December.
    4. Bufalo, Michele & Ceci, Claudia & Orlando, Giuseppe, 2024. "Addressing the financial impact of natural disasters in the era of climate change," The North American Journal of Economics and Finance, Elsevier, vol. 73(C).
    5. Giuseppe Orlando & Michele Bufalo, 2021. "Interest rates forecasting: Between Hull and White and the CIR#—How to make a single‐factor model work," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 40(8), pages 1566-1580, December.
    6. Giuseppe Orlando & Michele Bufalo, 2021. "Empirical Evidences on the Interconnectedness between Sampling and Asset Returns’ Distributions," Risks, MDPI, vol. 9(5), pages 1-35, May.
    7. Marco Di Francesco & Kevin Kamm, 2021. "How to handle negative interest rates in a CIR framework," Papers 2106.03716, arXiv.org.
    8. Ascione, Giacomo & Mehrdoust, Farshid & Orlando, Giuseppe & Samimi, Oldouz, 2023. "Foreign Exchange Options on Heston-CIR Model Under Lévy Process Framework," Applied Mathematics and Computation, Elsevier, vol. 446(C).
    9. Anna Battauz & Francesco Rotondi, 2022. "American options and stochastic interest rates," Computational Management Science, Springer, vol. 19(4), pages 567-604, October.

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