Calibrating Interest Rate Models Across Changing Rate Regimes

Summary

The document raises a calibration problem for classical short-rate models, including Black-Karasinski and Hull-White, during the sharp rate increases of 2022–2023. The author is concerned that model parameters may struggle to fit current rate levels while also reproducing a historical period that included negative rates. In the example, shifting the Black-Karasinski model to accommodate past negative rates appears to impair its fit to higher current rates, even after increasing volatility assumptions.

This is a question about practice rather than a proposed solution. It supplies no calibration data, model equations, backtest results, or industry responses, and it does not establish that the models are generally unsuitable. The useful issue is the tension between fitting distinct rate regimes and passing historical backtests; the document leaves open how practitioners resolve that tension.

Key ideas

• The author questions whether classical short-rate models can fit both negative historical rates and higher current levels.
• A shift used to accommodate past negative rates may impair the fit to higher rates.
• Increasing volatility alone is described as insufficient in the stated example.
• The document poses an industry-practice question without supplying a tested resolution.

Tags

# Interest Rate Calibration and Backtesting under Fed's raising rates 2022-2023


# Interest Rate Calibration and Backtesting under Fed's raising rates 2022-2023












With the Fed raising interest rates so fast and so drastically, classical interest rate models such as the Black Karasinski (BK), Hull-White (HW), etc., may have trouble calibrating to current rate levels and at the same time passing backtesting due to resent negative rates,

For example, you can shift BK to capture the past negative rates, but then you fail to capture high-interest rates (even when reasonably increasing the volatility terms)...

I wonder what is being done in practice under the current market environment in industry.

Any suggestions? I appreciate any available references.

Thank you.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.