Drift-invariant kernels for discount curve models
Andreas Celary, Zehra Eksi-Altay, Damir Filipovic, Paul Krühner
Abstract
Kernel ridge regression estimates the discount curve as the minimizer of a pricing error plus a penalty given by the norm of a reproducing kernel Hilbert space. By the representer theorem, the estimate lies in a finite-dimensional affine space that depends only on the kernel and on the cash flow dates of the instruments. We ask when this space is invariant under the risk-neutral drift of the discount curve, so that the estimated curves can be the states of a continuous-time arbitrage-free model. We show that this holds for every grid of cash flow dates if and only if the kernel is of the form $k(x,y)=\e^{b(x+y)}\big(c\,\e^{axy}+1-c\big)$, apart from kernels whose Hilbert space has dimension at most two. For this kernel the estimated curve is an affine combination of flat discount curves, each corresponding to a constant continuously compounded yield. The drift-invariant subspaces correspond to sub-grids of the cash flow dates, and the discounted coefficients have linear risk-neutral dynamics.
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