Extrapolating the term structure of interest rates with parameter uncertainty

Abstract

Pricing extremely long-dated liabilities market consistently deals with the decline in liquidity of financial instruments on long maturities. The aim is to quantify the uncertainty of rates up to maturities of a century. We assume that the interest rates follow the affine mean-reverting Vasicek model. We model parameter uncertainty by Bayesian distributions over the parameters. The cross-sectional and time series parameters are obtained via the restricted bivariate VAR(1) model. The empirical example shows extremely low confidence in long term extrapolations due to the accumulated effect of the mean-reversion`s behaviour close to the unit root.