A tractable framework for zero lower bound Gaussian term structure models

Release date
01/08/2013
Reference
DP2013/02
Author
Leo Krippner
When nominal interest rates are near their zero lower bound (ZLB), as in many developed economies at the time of writing, it is theoretically untenable to apply the popular class of Gaussian affine term structure models (GATSMs) given their inherent material probabilities of negative interest rates. Hence, I propose a new and tractable modification for GATSMs that enforces the ZLB, and which approximates the fully arbitrage-free but much less tractable framework proposed in Black (1995). I apply my framework to United States yield curve data, with robust estimation via the iterated extended Kalman filter, and first show that the two-factor results are very similar to those from a comparable Black model. I then estimate two- and three-factor models with longer-maturity data sets to illustrate that my ZLB framework can readily be applied in circumstances that would be computationally burdensome or infeasible within the Black framework.