Abstract - Nonlinear Term Structure Dependence: Copula Functions, Empirics, and Risk Implications

This paper documents nonlinear cross-sectional dependence in the term structure of U.S. Treasury yields and points out risk management implications. The analysis is based on a Kalman filter estimation of a two-factor affine model which specifies the yield curve dynamics. We then apply a broad class of copula functions for modeling dependence in factors spanning the yield curve. Our sample of monthly yields in the 1982 to 2001 period provides evidence of upper tail dependence in yield innovations; i.e., large positive interest rate shocks tend to occur under increased dependence. In contrast, the best fitting copula model coincides with zero lower tail dependence. This asymmetry has substantial risk management implications. We give an example
in estimating bond portfolio loss quantiles and report the biases which result from an application of the normal dependence model.

Niklas Wagner
TU München, Department of Financial Management and Capital Markets
08.Feb 2005

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