The author wishes to thank his colleague, Managing Director for Research Prof. Robert A. Jarrow, for twenty years of guidance and helpful conversations on this critical topic.
As zero interest rate policies and negative interest rates ripple through world financial markets, many legacy interest rate risk systems and asset and liability management systems have been unable to keep pace. In this note, we use 100,000 scenarios from a modern 9 factor Heath, Jarrow and Morton interest rate simulation from Kamakura Corporation to illustrate the model validation issues that arise when one admits that negative interest rates have a probability that is not zero.
The model validation procedures we outline are used by Kamakura in both its Kamakura Risk Information Services macro factor scenario sets and in Kamakura Risk Manager (“KRM”). KRM has allowed users to simulate and analyze negative interest rates for more than 20 years.
Negative Interest Rates: An International Perspective
Even with negative interest rates making the headlines in European markets daily, one sometimes hears the phrase “It can’t happen in the United States.” The same phrase, of course, was used to deny the possibility that home prices could fall in the United States prior to the 2006-2010 financial crisis. Negative interest rates have already been observed in the secondary market for U.S. Treasury securities, as confirmed by this phrase quoted from the February 17 version of the U.S. Department of the Treasury yield reporting web page: