Dr Gareth Peters and Dr Ioannis Kosmidis co-author Multiple Yield Curve Stress Testing White Paper
17 June 2017
Dr Gareth Peters, Dr Ioannis Kosmidis and Dr Emmanouil Karimalis have worked with the Bank of England over the last year to develop a stress testing white paper for banking models. In particular the white paper address development of a robust statistical framework to perform multiple yield curve stress testing. This is a core component of the vast majority of global stress testing done on capital in banks throughout the world. Yet this was a glaring gap in the practice, that these authors sought to address jointly with the Bank of England. The result is the following paper on the Bank of England website: "Staff Working Paper No. 655: Multi yield curve stress-testing framework incorporating temporal and cross tenor structural dependencies".
We develop a new multi-curve modelling framework for the term-structure of interest rates that can generate consistent cross-country stressed scenarios allowing for significant spillover effects between economies. Modern models of the term structure of interest rates typically fail to capture jointly time and cross-curve dependencies and are not used for stress-testing purposes. Our methodology is able to jointly model the temporal and cross-country dependence structure of interest rate curves and associate movements in the interest rates and cross-country spreads with movements in macroeconomic variables as well as market-wide and country-specific measures of liquidity and credit quality. We apply our methodology to generate contemporaneous stressed scenarios to a set of European yield curves. Motivated by the recent eurozone debt crisis, we apply shocks to Italian and Spanish liquidity and credit variables and evaluate the impact of these shocks on several bond portfolio strategies. The empirical findings suggest that both country-specific liquidity and credit measures are important in explaining the dynamic behaviour of European sovereign interest rate curves and their dependence structure. Nevertheless, their importance varies across time, shock types and investment horizons.