Modeling the interest rates term structure using Machine Learning: a Gaussian process regression approach

Abstract

The correct modeling of the interest rates term structure should definitely be considered an aspect of primary importance since the forward rates and the discount factors used in any financial and risk analysis are calculated from such structure. The turbulence of the markets in recent years, with negative interest rates followed by their recent substantial rise, the period of the COVID pandemic crisis, the political instabilities linked to the war between Ukraine and Russia have very often led to observe anomalies in the shape of the interest rate curve that are difficult to represent using traditional econometric models, to the point that researchers have to address this modeling problem using Machine Learning methodologies. The purpose of this study is to design a model selection heuristic which, starting from the traditional ones (Nelson-Siegel, Svensson and de Rezende-Ferreira) up to the Gaussian Process (GP) Regression, is able to define the best representation for a generic term structure. This approach has been tested over the past five years on term structures denominated in five different currencies: the Swiss Franc (CHF), the Euro (EUR), the British Pound (GBP), the Japanese Yen (JPY) and the U.S. Dollar (USD).