Modeling a Two-currency Affine Arbitrage-free Nelson-Siegel Term Structure Model.
Masters thesis, National University of Ireland Maynooth.
This thesis contains two papers. In the first paper, we provide a general
overview of the most popular term structure of interest rate models. In order to
understand different features of each model, we classify by means of general
characteristics, from single-factor to multi-factor and forward rate based models. Each
of these existing term structure models has its own advantages and disadvantages. We
also highlight the recently advocated models in the literature: the Nelson-Siegel model,
the affine and the quadratic arbitrage-free model. In the second paper we extend the
affine arbitrage-free Nelson-Siegel model to a two-currency (3+1) factor structure
model that incorporates the properties of interest rate term structure and foreign
exchange rates simultaneously within one arbitrage-free framework by decomposing
the pricing kernel into two independent portions: one portion contains three factors that
model the affine Nelson-Siegel term structure of interest rate, the other portion contains
one factor that captures the effect of the currency movement, which is independent of
the term structure.
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