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Choosing Interest Rate Curves for Swap Stress Testing

Article Quant Q&A · Author: CNHN
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Summary

The document asks which representation of interest rates should be used when applying principal component analysis or other stress tests to interest rate swaps: par swap rates, spot rates, or forward rates. It notes that the studies the author has encountered commonly use spot rates, while some use forward rates and another compares par rates with spot rates. The concern is whether a par rate, which reflects multiple cash flows, introduces complications when measuring swap risk.

This is a research question rather than a worked method or a resolved recommendation. It provides no calculations, comparison results, or guidance on curve construction, shock application, or repricing. A useful takeaway is that the choice of rate representation is part of stress-test design and should be evaluated in relation to the instrument’s cash flows and the risk measure being estimated.

Key ideas

  • The document frames rate representation as a design choice in interest rate swap stress testing.
  • It identifies par, spot, and forward rates as possible inputs to principal component analysis.
  • The author is concerned that par rates aggregate information across multiple cash flows.
  • The document cites prior work but supplies no empirical comparison or final recommendation.

Tags

Fixed incomeRisk managementStatistics
Full text
# Is there no problem when par rate is used for IRS stress-test?


# Is there no problem when par rate is used for IRS stress-test?












I want to do stress-test such as principle component analysis on IRS(interest rate swap) in order to calculate risk for the future change in interest rate. However it is so confusing which interest rate(par rate, spot rate, forward rate) should I use for stress-test. Most of papers I read use spot rate. There are also some studies using forward rate (ref.1). One research used par rate and compared to spot rate(ref.2).

Question is that is there no problem when par rate is used for IRS stress-test? I think the fact that par(swap) rate includes several cash flows makes some problem (dirty price? something like that)

Thank you in advance.

------------------- ref. -------------------

ref.1: Ilias Lekkos, A Critique of Factor Analysis of Interest Rates, The Journal of Derivates, 2000 ref.2: http://quantlabs.net/academy/download/free_quant_instituitional_books_/%5BSalomon%20Smith%20Barney%5D%20Principles%20of%20Principal%20Components%20-%20A%20Fresh%20Look%20at%20Risk,%20Hedging%20and%20Relative%20Value.pdf

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