Academic journal article UTMS Journal of Economics

Parametric Yield Curve Modeling in an Illiquid and Undeveloped Financial Market

Academic journal article UTMS Journal of Economics

Parametric Yield Curve Modeling in an Illiquid and Undeveloped Financial Market

Article excerpt

Abstract:

This paper examines the possibility of applying two most popular parametric yield curve models (Nelson-Siegel and Svensson) in the Croatian financial market. In such an illiquid and undeveloped financial market yield curve modeling presents a special challenge primarily regarding the available market data. The use of the yield curve models is limited compared to the developed markets and the interpretation of the resulting yield curves requires much more cautiousness. However this paper clearly shows that the yield curve model is able to capture changes in the business cycle according to the macroeconomic theory and therefore provide valuable information to the financial industry and other economic subjects. It also suggests that the Svensson model which is an extension of the Nelson-Siegel model (and is therefore often preferred over the Nelson-Siegel model in the developed markets) suffers from overparameterization in the illiquid and undeveloped Croatian financial market.

Keywords: parametric yield curve models, illiquidity.

Jel Classification: G12, E43, E44

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

The yield curve plays a crucial role in the modem financial markets. A wide body of literature has therefore appeared since 1970's concerning the yield curve modeling. Most of the research (especially during the 20th century) has reasonably been more or less directly related to the most developed financial markets in the world. More recently a significant portion of research dedicated to yield curve modeling in the illiquid and undeveloped financial markets has emerged wherever such conditions in the financial markets may appear. In the past decade papers have been published regarding yield curve modeling in the financial markets of India, China, Taiwan, Russia, Slovenia and Serbia among others. Liquidity issues have been specifically addressed in the work of Dutta, Basu, and Vaidyanathan (2005), Chou et al. (2009) and Smirnov and Zakharov (2003) concerning the Indian, Taiwanese and Russian financial markets respectively. In the mentioned papers various yield curve modeling approaches were considered and empirically tested including the parametric Nelson-Siegel and Svensson models. Table 1. below summarizes key research findings of the selected papers for the above mentioned financial markets.

Table 1. seems to suggest that parametric (Nelson-Siegel and Svensson) models dominate spline and other yield curve modeling approaches in illiquid and undeveloped financial markets. Furthermore it should be noted that in the case of the smallest financial market in the table, the Slovenian one, Nelson-Siegel model is preferred rather than the Svensson model. This is contrary to research concerning the Indian and Taiwanese financial markets. Regarding this issue it should also be mentioned that papers referring to probably the least developed financial market - Serbian financial market, continuously used the Nelson Siegel model exclusively. Papers published by the Jefferson Institute (2005), Drenovak (2006) and Zdravkovic (2010) modeled the yield curve relying only on the Nelson Siegel model2. Since the Croatian financial market is much more similar to Slovenian and Serbian financial markets in any aspect than the other markets in Table 1. it is likely to expect that the Nelson-Siegel could be preferred over the Svensson model in the Croatian financial market too. For analysis regarding the size and liquidity of the Croatian financial market refer to Bogdan et al. (2012) and Zoricic (2012).

1. METHODOLOGY

Parametric yield curve modeling is based on a single-piece polynomial function3 for the whole maturity spectrum of yields (Choudhry 2004, 104). The parametric approach is therefore usually characterized by parsimony and the fact that the estimated parameters make economic sense (Martellini et al. 2003, 116). The most popular parametric model is the Nelson-Siegel yield curve model. …

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