1 Department of Economics and Business Economics - Center for Research in Econometric Analysis of Time Series (CREATES), Department of Economics and Business Economics, Aarhus BSS, Aarhus University2 HEC, Montréal3 C. T. Bauer College of Business, University of Houston4 Goldman, Sachs and Company5 Department of Economics and Business Economics - Center for Research in Econometric Analysis of Time Series (CREATES), Department of Economics and Business Economics, Aarhus BSS, Aarhus University
The extended Kalman filter, which linearizes the relationship between security prices and state variables, is widely used in fixed-income applications. We investigate whether the unscented Kalman filter should be used to capture nonlinearities and compare the performance of the Kalman filter with 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 with the much more computationally intensive particle filter. These findings suggest that the unscented Kalman filter may be a good approach for a variety of problems in fixed-income pricing.
Management Science, 2014, Vol 60, Issue 9, p. 2248-2268
Caps; Kalman filtering; Nonlinearity; Particle filtering; Swaps; Term structure models