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I am trying to investigate the stability of spread between two short-term interest rates by the example of 1M and 12M Euribor.

I don't think only looking at correlations over time is statisically enough to infer the stability of the spread.

My first thought would be to use a regression framework in which I regress 12M euribor (Y) on 1M (X) and suppress the intercept, because the difference between Y and X will be then only the residual and thus the spread.

Then, it could be tested whether the regression coefficient (Beta) = 1 and whether has remained 1 over time (implying that 12M - 1M is the term spread), and tested whether the residual (term spread) is stationary implying constant spread over time.

I was thinking to use the Engle Granger cointegration test. However, I don't know if it will test what I am aiming at.

My question is:

Does my line of reasoning (regressing, testing beta over time and residual stationarity) make sense? If so, which methods are suitable?

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You are right that looking at correlations on their own would be erroneous. This is because time series tend to demonstrate both autocorrelation and cross-correlation over time. e.g. Over the past 10 years, the S&P 500 and the height of a 5-year old child back in 2010 have both since increased - but the two have no theoretical connection to each other.

Instead, you want to test whether such correlations actually have theoretical relevance.

One way of doing this is the two-step Engle-Granger cointegration test. The null hypothesis of this test is no cointegration.

You could implement this test using Python: https://www.statsmodels.org/stable/generated/statsmodels.tsa.stattools.coint.html

As an example, let's consider monthly data for the Euribor benchmark rates obtained from: https://datahub.io/core/euribor

Here is a snippet of the data:

snippet

>>> coin_result = ts.coint(rate1, rate2)
>>> coin_result
(-2.8260965381927488,
 0.15752245371775692,
 array([-3.94714772, -3.36417226, -3.06387292]))

Here, the p-value is 0.15, which implies that no cointegration is present at the 5% level of significance. -2.82 is the cointegration score, while -3.94, -3.36, -3.06 are the respective scores at the 5%, 10%, and 15% levels of significance.

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Change points can be difficult in a frequentist framework. Most methods involve identifying the change point as a fixed location, ignoring the uncertainty inherent in estimating it. In addition, fixing a particular parameter (the slope in segment 1) may require a few tricks to get working on many packages.

Change points and fixing parameters come more naturally in a Bayesian context. The R package mcp can flexibly model changes in means and the standard deviation of the residuals, among other things. You may be interested in comparing four models:

model1 = list(y ~ 0 + x)  # No change in slope or sigma
model2 = list(y ~ 0 + x, ~ 0 + x)  # Change in slope only
model3 = list(y ~ 0 + x, ~ 0 + sigma(1))  # Intercept change in sigma only
model4 = list(y ~ 0 + x, ~ 0 + x + sigma(1))  # Change in both

Then fix the first slope to be 1 using a point prior, and do the fit:

library(mcp)
prior = list(x_1 = 1)  # fix the slope on x in segment (x_1) to be 1
fit1 = mcp(model1, data, prior)
fit2 = mcp(model2, data, prior)
fit3 = mcp(model3, data, prior)
fit4 = mcp(model4, data, prior)

You can use leave-one-out cross-validation to compare the models' predictive performances or hypothesis() to compare parameter values:

loo::loo_compare(fit1, fit2, fit3, fit4)
hypothesis(fit2, "x_2 < x_1")  # Has the slope flattened in segment 2?

Read more about:

Disclosure: I am the author of the mcp package.

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