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Nonlinear Kalman Filtering in Affine Term Structure Models

Author

Listed:
  • Peter Christoffersen
  • Christian Dorion
  • Kris Jacobs
  • Lotfi Karoui

Abstract

The extended Kalman filter, which linearizes the relationship between security prices and state variables, is widely used in fixed income applications. We investigate if the unscented Kalman filter should be used to capture nonlinearities, and compare the performance of the Kalman filter to that of the particle filter. We analyze the cross section of swap rates, which are mildly nonlinear in the states, and cap prices, which are highly nonlinear. When caps are used to filter the states, the unscented Kalman filter significantly outperforms its extended counterpart. The unscented Kalman filter also performs well when compared to the much more computationally intensive particle filter. These findings suggest that the unscented Kalman filter may prove to be a good approach for variety of problems in fixed income pricing.

Suggested Citation

  • Peter Christoffersen & Christian Dorion & Kris Jacobs & Lotfi Karoui, 2014. "Nonlinear Kalman Filtering in Affine Term Structure Models," Cahiers de recherche 1404, CIRPEE.
    • Handle: RePEc:lvl:lacicr:1404
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    More about this item

    Keywords

    Kalman filtering; nonlinearity; term structure models; swaps; caps;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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