The Terminal Rate Model (TRM) is a yield curve model that belongs to the Nelson-Siegel family and defines the yield curve using four factors, representing the short-term interest rate, the long-term natural interest rate, and two term premium factors. The model is useful because of its interpretability, as it decomposes the yield curve into economically meaningful components. It also allows for a direct decomposition of yields into risk-free yields and the term premium. Results show that the TRM describes the shape of the yield curve well and that the term premium it implies is meaningful. The TRM factors follow a VAR(1) model, which makes the model useful for constructing macroeconomic scenarios by adjusting the transition matrix of the VAR(1) model. The generated scenarios can be used in optimal portfolio construction. Rather than selecting a portfolio solely based on a single forecast or historical data, the scenarios show what happens to returns, risk, and optimal portfolio weights under different assumptions. This allows us to assess whether the selected portfolio is robust across several possible environments or performs well only in a specific scenario.
|
