Interest Rate Models

Damir Filipović
University of Munich
2
Contents

1 Introduction 7

2 Interest Rates and Related Contracts 9

2.1 Zero-Coupon Bonds . . . . . . . . . . . . . . . . . . . . . . . . 9
2.2 Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.2.1 Market Example: LIBOR . . . . . . . . . . . . . . . . 12
2.2.2 Simple vs. Continuous Compounding . . . . . . . . . . 12
2.2.3 Forward vs. Future Rates . . . . . . . . . . . . . . . . 13
2.3 Bank Account and Short Rates . . . . . . . . . . . . . . . . . 14
2.4 Coupon Bonds, Swaps and Yields . . . . . . . . . . . . . . . . 15
2.4.1 Fixed Coupon Bonds . . . . . . . . . . . . . . . . . . . 16
2.4.2 Floating Rate Notes . . . . . . . . . . . . . . . . . . . 16
2.4.3 Interest Rate Swaps . . . . . . . . . . . . . . . . . . . 17
2.4.4 Yield and Duration . . . . . . . . . . . . . . . . . . . . 20
2.5 Market Conventions . . . . . . . . . . . . . . . . . . . . . . . . 22
2.5.1 Day-count Conventions . . . . . . . . . . . . . . . . . . 22
2.5.2 Coupon Bonds . . . . . . . . . . . . . . . . . . . . . . 23
2.5.3 Accrued Interest, Clean Price and Dirty Price . . . . . 24
2.5.4 Yield-to-Maturity . . . . . . . . . . . . . . . . . . . . . 25
2.6 Caps and Floors . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.7 Swaptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

3 Statistics of the Yield Curve 33

3.1 Principal Component Analysis (PCA) . . . . . . . . . . . . . . 33
3.2 PCA of the Yield Curve . . . . . . . . . . . . . . . . . . . . . 35
3.3 Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

3
4 CONTENTS

4 Estimating the Yield Curve 39

4.1 A Bootstrapping Example . . . . . . . . . . . . . . . . . . . . 39
4.2 General Case . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
4.2.1 Bond Markets . . . . . . . . . . . . . . . . . . . . . . . 45
4.2.2 Money Markets . . . . . . . . . . . . . . . . . . . . . . 46
4.2.3 Problems . . . . . . . . . . . . . . . . . . . . . . . . . 48
4.2.4 Parametrized Curve Families . . . . . . . . . . . . . . . 49

5 Why Yield Curve Models? 65

6 Arbitrage Pricing 67
6.1 Self-Financing Portfolios . . . . . . . . . . . . . . . . . . . . . 67
6.2 Arbitrage and Martingale Measures . . . . . . . . . . . . . . . 69
6.3 Hedging and Pricing . . . . . . . . . . . . . . . . . . . . . . . 73

7 Short Rate Models 77

7.1 Generalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
7.2 Diffusion Short Rate Models . . . . . . . . . . . . . . . . . . . 79
7.2.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . 82
7.3 Inverting the Yield Curve . . . . . . . . . . . . . . . . . . . . 83
7.4 Affine Term Structures . . . . . . . . . . . . . . . . . . . . . . 83
7.5 Some Standard Models . . . . . . . . . . . . . . . . . . . . . . 85
7.5.1 Vasicek Model . . . . . . . . . . . . . . . . . . . . . . . 85
7.5.2 Cox–Ingersoll–Ross Model . . . . . . . . . . . . . . . . 86
7.5.3 Dothan Model . . . . . . . . . . . . . . . . . . . . . . . 87
7.5.4 Ho–Lee Model . . . . . . . . . . . . . . . . . . . . . . . 88
7.5.5 Hull–White Model . . . . . . . . . . . . . . . . . . . . 89
7.6 Option Pricing in Affine Models . . . . . . . . . . . . . . . . . 90
7.6.1 Example: Vasicek Model (a, b, β const, α = 0). . . . . 92

8 HJM Methodology 95

9 Forward Measures 97
9.1 T -Bond as Numeraire . . . . . . . . . . . . . . . . . . . . . . . 97
9.2 An Expectation Hypothesis . . . . . . . . . . . . . . . . . . . 99
9.3 Option Pricing in Gaussian HJM Models . . . . . . . . . . . . 101
CONTENTS 5

10 Forwards and Futures 105

10.1 Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . 105
10.2 Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . 106
10.3 Interest Rate Futures . . . . . . . . . . . . . . . . . . . . . . . 108
10.4 Forward vs. Futures in a Gaussian Setup . . . . . . . . . . . . 109

11 Multi-Factor Models 113

11.1 No-Arbitrage Condition . . . . . . . . . . . . . . . . . . . . . 115
11.2 Affine Term Structures . . . . . . . . . . . . . . . . . . . . . . 117
11.3 Polynomial Term Structures . . . . . . . . . . . . . . . . . . . 118
11.4 Exponential-Polynomial Families . . . . . . . . . . . . . . . . 122
11.4.1 Nelson–Siegel Family . . . . . . . . . . . . . . . . . . . 122
11.4.2 Svensson Family . . . . . . . . . . . . . . . . . . . . . 123

12 Market Models 127

12.1 Models of Forward LIBOR Rates . . . . . . . . . . . . . . . . 129
12.1.1 Discrete-tenor Case . . . . . . . . . . . . . . . . . . . . 130
12.1.2 Continuous-tenor Case . . . . . . . . . . . . . . . . . . 140

13 Default Risk 145

13.1 Transition and Default Probabilities . . . . . . . . . . . . . . . 145
13.1.1 Historical Method . . . . . . . . . . . . . . . . . . . . . 146
13.1.2 Structural Approach . . . . . . . . . . . . . . . . . . . 148
13.2 Intensity Based Method . . . . . . . . . . . . . . . . . . . . . 150
13.2.1 Construction of Intensity Based Models . . . . . . . . . 156
13.2.2 Computation of Default Probabilities . . . . . . . . . . 157
13.2.3 Pricing Default Risk . . . . . . . . . . . . . . . . . . . 157
13.2.4 Measure Change . . . . . . . . . . . . . . . . . . . . . 160
6 CONTENTS
Chapter 1

Introduction

These notes have been written for a graduate course on fixed income models
that I held in the fall term 2002–2003 at the Department of Operations Re-
search and Financial Engineering at Princeton University.

The number of books on fixed income models is growing, yet it is difficult

to find a convenient textbook for a one-semester course like this. There are
several reasons for this:
• Until recently, many textbooks on mathematical finance have treated
stochastic interest rates as an appendix to the elementary arbitrage
pricing theory, which usually requires constant (zero) interest rates.
• Interest rate theory is not standardized yet: there is no well-accepted
“standard” general model such as the Black–Scholes model for equities.
• The very nature of fixed income instruments causes difficulties, other
than for stock derivatives, in implementing and calibrating models.
These issues should therefore not been left out.
I will frequently refer to the following books:
B[3]: Björk (98) [3]. A pedagogically well written introduction to mathe-
matical finance. Chapters 15–20 are on interest rates.
BM[6]: Brigo–Mercurio (01) [6]. This is a book on interest rate modelling
written by two quantitative analysts in financial institutions. Much
emphasis is on the practical implementation and calibration of selected
models.

7
8 CHAPTER 1. INTRODUCTION

JW[12]: James–Webber (00) [12]. An encyclopedic treatment of interest

rates and their related financial derivatives.

J[14]: Jarrow (96) [14]. Introduction to fixed-income securities and interest

rate options. Discrete time only.

MR[20]: Musiela–Rutkowski (97) [20]. A comprehensive book on financial

mathematics with a large part (Part II) on interest rate modelling.
Much emphasis is on market pricing practice.

R[23]: Rebonato (98) [23]. Written by a practitionar. Much emphasis on

market practice for pricing and handling interest rate derivatives.

Z[28]: Zagst (02) [28]. A comprehensive textbook on mathematical finance,

interest rate modelling and risk management.

Since this text had been written, new good books on interest rates have
been published. I want to mention in particular the excellent introductory
textbook by Cairns (04) [7].
I did not intend to write an entire text but rather collect fragments of the
material that can be found in the above books and further references.

Munich, October 2005

Chapter 2

Interest Rates and Related

Contracts

Literature: B[3](Chapter 15), BM[6](Chapter 1), and many more

2.1 Zero-Coupon Bonds

A dollar today is worth more than a dollar tomorrow. The time t value of
a dollar at time T ≥ t is expressed by the zero-coupon bond with maturity
T , P (t, T ), for briefty also T -bond . This is a contract which guarantees the
holder one dollar to be paid at the maturity date T .

P(t,T) 1
| |
t T

→ future cashflows can be discounted, such as coupon-bearing bonds

C1 P (t, t1 ) + · · · + Cn−1 P (t, tn−1 ) + (1 + Cn )P (t, T ).

In theory we will assume that

• there exists a frictionless market for T -bonds for every T > 0.

• P (T, T ) = 1 for all T .

• P (t, T ) is continuously differentiable in T .

9
10 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

In reality this assumptions are not always satisfied: zero-coupon bonds are
not traded for all maturities, and P (T, T ) might be less than one if the issuer
of the T -bond defaults. Yet, this is a good starting point for doing the
mathematics. More realistic models will be introduced and discussed in the
sequel.
The third condition is purely technical and implies that the term structure
of zero-coupon bond prices T 7→ P (t, T ) is a smooth curve.

US Treasury Bonds, March 2002

1

0.8

0.6

0.4

0.2

Years
1 2 3 4 5 6 7 8 9 10

Note that t 7→ P (t, T ) is a stochastic process since bond prices P (t, T ) are
not known with certainty before t.

PHt,10L

0.8

0.6

0.4

0.2
t
1 2 3 4 5 6 7 8 9 10

A reasonable assumption would also be that T 7→ P (t, T ) ≤ 1 is a de-

creasing curve (which is equivalent to positivity of interest rates). However,
already classical interest rate models imply zero-coupon bond prices greater
than 1. Therefore we leave away this requirement.
2.2. INTEREST RATES 11

2.2 Interest Rates

The term structure of zero-coupon bond prices does not contain much visual
information (strictly speaking it does). A better measure is given by the
implied interest rates. There is a variety of them.
A prototypical forward rate agreement (FRA) is a contract involving three
time instants t < T < S: the current time t, the expiry time T > t, and the
maturity time S > T .
P (t,T )
• At t: sell one T -bond and buy P (t,S)
S-bonds = zero net investment.

• At T : pay one dollar.

P (t,T )
• At S: obtain P (t,S)
dollars.
P (t,T )
The net effect is a forward investment of one dollar at time T yielding P (t,S)
dollars at S with certainty.
We are led to the following definitions.

• The simple (simply-compounded) forward rate for [T, S] prevailing at t

is given by
µ ¶
P (t, T ) 1 P (t, T )
1+(S −T )F (t; T, S) := ⇔ F (t; T, S) = −1 .
P (t, S) S − T P (t, S)

• The simple spot rate for [t, T ] is

µ ¶
1 1
F (t, T ) := F (t; t, T ) = −1 .
T −t P (t, T )

• The continuously compounded forward rate for [T, S] prevailing at t is

given by

P (t, T ) log P (t, S) − log P (t, T )

eR(t;T,S)(S−T ) := ⇔ R(t; T, S) = − .
P (t, S) S−T

• The continuously compounded spot rate for [T, S] is

log P (t, T )
R(t, T ) := R(t; t, T ) = − .
T −t
12 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

• The instantaneous forward rate with maturity T prevailing at time t is

defined by
∂ log P (t, T )
f (t, T ) := lim R(t; T, S) = − . (2.1)
S↓T ∂T
The function T 7→ f (t, T ) is called the forward curve at time t.

• The instantaneous short rate at time t is defined by

r(t) := f (t, t) = lim R(t, T ).

T ↓t

Notice that (2.1) together with the requirement P (T, T ) = 1 is equivalent to

µ Z T ¶
P (t, T ) = exp − f (t, u) du .
t

2.2.1 Market Example: LIBOR

“Interbank rates” are rates at which deposits between banks are exchanged,
and at which swap transactions (see below) between banks occur. The most
important interbank rate usually considered as a reference for fixed income
contracts is the LIBOR (London InterBank Offered Rate) 1 for a series of
possible maturities, ranging from overnight to 12 months. These rates are
quoted on a simple compounding basis. For example, the three-months for-
ward LIBOR for the period [T, T + 1/4] at time t is given by

L(t, T ) = F (t; T, T + 1/4).

2.2.2 Simple vs. Continuous Compounding

One dollar invested for one year at an interest rate of R per annum growths
to 1 + R. If the rate is compounded twice per year the terminal value is
(1 + R/2)2 , etc. It is a mathematical fact that
µ ¶m
R
1+ → eR as m → ∞.
m
1
To be more precise: this is the rate at which high-credit financial institutions can
borrow in the interbank market.
2.2. INTEREST RATES 13

Moreover,
eR = 1 + R + o(R) for R small.
Example: e0.04 = 1.04081.
Since the exponential function has nicer analytic properties than power
functions, we often consider continuously compounded interest rates. This
makes the theory more tractable.

2.2.3 Forward vs. Future Rates

Can forward rates predict the future spot rates?
Consider a deterministic world. If markets are efficient (i.e. no arbitrage
= no riskless, systematic profit) we have necessarily

P (t, S) = P (t, T )P (T, S), ∀t ≤ T ≤ S. (2.2)

Proof. Suppose that P (t, S) > P (t, T )P (T, S) for some t ≤ T ≤ S. Then we
follow the strategy:

• At t: sell one S-bond, and buy P (T, S) T -bonds.

Net cost: −P (t, S) + P (t, T )P (T, S) < 0.

• At T : receive P (T, S) dollars and buy one S-bond.

• At S: pay one dollar, receive one dollar.

(Where do we use the assumption of a deterministic world?)

The net is a riskless gain of −P (t, S)+P (t, T )P (T, S) (×1/P (t, S)). This
is a pure arbitrage opportunity, which contradicts the assumption.
If P (t, S) < P (t, T )P (T, S) the same profit can be realized by changing
sign in the strategy.

Taking logarithm in (2.2) yields

Z S Z S
f (t, u) du = f (T, u) du, ∀t ≤ T ≤ S.
T T

This is equivalent to

f (t, S) = f (T, S) = r(S), ∀t ≤ T ≤ S

14 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

(as time goes by we walk along the forward curve: the forward curve is
shifted). In this case, the forward rate with maturity S prevailing at time
t ≤ S is exactly the future short rate at S.
The real world is not deterministic though. We will see that in general
the forward rate f (t, T ) is the conditional expectation of the short rate r(T )
under a particular probability measure (forward measure), depending on T .
Hence the forward rate is a biased estimator for the future short rate.
Forecasts of future short rates by forward rates have little or no predictive
power.

2.3 Bank Account and Short Rates

The return of a one dollar investment today (t = 0) over the period [0, ∆t]
is given by
µZ ∆t ¶
1
= exp f (0, u) du = 1 + r(0)∆t + o(∆t).
P (0, ∆t) 0

Instantaneous reinvestment in 2∆t-bonds yields

1 1
= (1 + r(0)∆t)(1 + r(∆t)∆t) + o(∆t)
P (0, ∆t) P (∆t, 2∆t)

at time 2∆t, etc. This strategy of “rolling over”2 just maturing bonds leads
in the limit to the bank account (money-market account) B(t). Hence B(t)
is the asset which growths at time t instantaneously at short rate r(t)

B(t + ∆t) = B(t)(1 + r(t)∆t) + o(∆t).

For ∆t → 0 this converges to

dB(t) = r(t)B(t)dt

and with B(0) = 1 we obtain

µZ t ¶
B(t) = exp r(s) ds .
0

2
This limiting process is made rigorous in [4].
2.4. COUPON BONDS, SWAPS AND YIELDS 15

B is a risk-free asset insofar as its future value at time t + ∆t is known (up

to order ∆t) at time t. In stochastic terms we speak of a predictable process.
For the same reason we speak of r(t) as the risk-free rate of return over the
infinitesimal period [t, t + dt].
B is important for relating amounts of currencies available at different
times: in order to have one dollar in the bank account at time T we need to
have
µ Z T ¶
B(t)
= exp − r(s) ds
B(T ) t

dollars in the bank account at time t ≤ T . This discount factor is stochastic:

it is not known with certainty at time t. There is a close connection to the
deterministic (=known at time t) discount factor given by P (t, T ). Indeed,
we will see that the latter is the conditional expectation of the former under
the risk neutral probability measure.

Proxies for the Short Rate

→ JW[12](Chapter 3.5)
The short rate r(t) is a key interest rate in all models and fundamental
to no-arbitrage pricing. But it cannot be directly observed.
The overnight interest rate is not usually considered to be a good proxy
for the short rate, because the motives and needs driving overnight borrowers
are very different from those of borrowers who want money for a month or
more.
The overnight fed funds rate is nevertheless comparatively stable and
perhaps a fair proxy, but empirical studies suggest that it has low correlation
with other spot rates.
The best available proxy is given by one- or three-month spot rates since
they are very liquid.

2.4 Coupon Bonds, Swaps and Yields

In most bond markets, there is only a relatively small number of zero-coupon
bonds traded. Most bonds include coupons.
16 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

2.4.1 Fixed Coupon Bonds

A fixed coupon bond is a contract specified by

• a number of future dates T1 < · · · < Tn (the coupon dates)

(Tn is the maturity of the bond),

• a sequence of (deterministic) coupons c1 , . . . , cn ,

• a nominal value N ,

such that the owner receives ci at time Ti , for i = 1, . . . , n, and N at terminal

time Tn . The price p(t) at time t ≤ T1 of this coupon bond is given by the
sum of discounted cashflows
n
X
p(t) = P (t, Ti )ci + P (t, Tn )N.
i=1

Typically, it holds that Ti+1 −Ti ≡ δ, and the coupons are given as a fixed
percentage of the nominal value: ci ≡ KδN , for some fixed interest rate K.
The above formula reduces to
à n
!
X
p(t) = Kδ P (t, Ti ) + P (t, Tn ) N.
i=1

2.4.2 Floating Rate Notes

There are versions of coupon bonds for which the value of the coupon is
not fixed at the time the bond is issued, but rather reset for every coupon
period. Most often the resetting is determined by some market interest rate
(e.g. LIBOR).
A floating rate note is specified by

• a number of future dates T0 < T1 < · · · < Tn ,

• a nominal value N .

The deterministic coupon payments for the fixed coupon bond are now re-
placed by
ci = (Ti − Ti−1 )F (Ti−1 , Ti )N,
2.4. COUPON BONDS, SWAPS AND YIELDS 17

where F (Ti−1 , Ti ) is the prevailing simple market interest rate, and we note
that F (Ti−1 , Ti ) is determined already at time Ti−1 (this is why here we have
T0 in addition to the coupon dates T1 , . . . , Tn ), but that the cash-flow ci is
at time Ti .
The value p(t) of this note at time t ≤ T0 is obtained as follows. Without
loss of generality we set N = 1. By definition of F (Ti−1 , Ti ) we then have
1
ci = − 1.
P (Ti−1 , Ti )
The time t value of −1 paid out at Ti is −P (t, Ti ). The time t value of
1
P (Ti−1 ,Ti )
paid out at Ti is P (t, Ti−1 ):

• At t: buy a Ti−1 -bond. Cost: P (t, Ti−1 ).

• At Ti−1 : receive one dollar and buy 1/P (Ti−1 , Ti ) Ti -bonds. Zero net
investment.

• At Ti : receive 1/P (Ti−1 , Ti ) dollars.

The time t value of ci therefore is

P (t, Ti−1 ) − P (t, Ti ).

Summing up we obtain the (surprisingly easy) formula

n
X
p(t) = P (t, Tn ) + (P (t, Ti−1 ) − P (t, Ti )) = P (t, T0 ).
i=1

In particular, for t = T0 : p(T0 ) = 1.

2.4.3 Interest Rate Swaps

An interest rate swap is a scheme where you exchange a payment stream
at a fixed rate of interest for a payment stream at a floating rate (typically
LIBOR).
There are many versions of interest rate swaps. A payer interest rate
swap settled in arrears is specified by
• a number of future dates T0 < T1 < · · · < Tn with Ti − Ti−1 ≡ δ
(Tn is the maturity of the swap),
18 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

• a fixed rate K,

• a nominal value N .

Of course, the equidistance hypothesis is only for convenience of notation

and can easily be relaxed. Cashflows take place only at the coupon dates
T1 , . . . , Tn . At Ti , the holder of the contract

• pays fixed KδN ,

• and receives floating F (Ti−1 , Ti )δN .

The net cashflow at Ti is thus

(F (Ti−1 , Ti ) − K)δN,

and using the previous results we can compute the value at t ≤ T0 of this
cashflow as
N (P (t, Ti−1 ) − P (t, Ti ) − KδP (t, Ti )). (2.3)
The total value Πp (t) of the swap at time t ≤ T0 is thus
à n
!
X
Πp (t) = N P (t, T0 ) − P (t, Tn ) − Kδ P (t, Ti ) .
i=1

A receiver interest rate swap settled in arrears is obtained by changing

the sign of the cashflows at times T1 , . . . , Tn . Its value at time t ≤ T0 is thus

Πr (t) = −Πp (t).

The remaining question is how the “fair” fixed rate K is determined. The
forward swap rate Rswap (t) at time t ≤ T0 is the fixed rate K above which
gives Πp (t) = Πr (t) = 0. Hence

P (t, T0 ) − P (t, Tn )
Rswap (t) = P .
δ ni=1 P (t, Ti )

The following alternative representation of Rswap (t) is sometimes useful.

Since P (t, Ti−1 ) − P (t, Ti ) = F (t; Ti−1 , Ti )δP (t, Ti ), we can rewrite (2.3) as

N δP (t, Ti ) (F (t; Ti−1 , Ti ) − K) .

2.4. COUPON BONDS, SWAPS AND YIELDS 19

Summing up yields
n
X
Πp (t) = N δ P (t, Ti ) (F (t; Ti−1 , Ti ) − K) ,
i=1

and thus we can write the swap rate as weighted average of simple forward
rates n
X
Rswap (t) = wi (t)F (t; Ti−1 , Ti ),
i=1

with weights
P (t, Ti )
wi (t) = Pn .
j=1 P (t, Tj )

These weights are random, but there seems to be empirical evidence that
the variability of wi (t) is small compared to that of F (t; Ti−1 , Ti ). This is
used for approximations of swaption (see below) price formulas in LIBOR
market models: the swap rate volatility is written as linear combination of
the forward LIBOR volatilities (“Rebonato’s formula” → BM[6], p.248).

Swaps were developed because different companies could borrow at dif-

ferent rates in different markets.

Example
→ JW[12](p.11)

• Company A: is borrowing fixed for five years at 5 1/2%, but could

borrow floating at LIBOR plus 1/2%.

• Company B: is borrowing floating at LIBOR plus 1%, but could borrow

fixed for five years at 6 1/2%.

By agreeing to swap streams of cashflows both companies could be better

off, and a mediating institution would also make money.

• Company A pays LIBOR to the intermediary in exchange for fixed at

5 3/16% (receiver swap).

• Company B pays the intermediary fixed at 5 5/16% in exchange for

LIBOR (payer swap).
20 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

Net:

• Company A is now paying LIBOR plus 5/16% instead of LIBOR plus

1/2%.

• Company B is paying fixed at 6 5/16% instead of 6 1/2%.

• The intermediary receives fixed at 1/8%.

5 1/2 % 5 3/16 % 5 5/16 %

Company A Intermediary Company B

LIBOR LIBOR LIBOR + 1%

Everyone seems to be better off. But there is implicit credit risk; this is
why Company B had higher borrowing rates in the first place. This risk has
been partly taken up by the intermediary, in return for the money it makes
on the spread.

2.4.4 Yield and Duration

For a zero-coupon bond P (t, T ) the zero-coupon yield is simply the continu-
ously compounded spot rate R(t, T ). That is,

P (t, T ) = e−R(t,T )(T −t) .

Accordingly, the function T 7→ R(t, T ) is referred to as (zero-coupon) yield

curve.
The term “yield curve” is ambiguous. There is a variety of other ter-
minologies, such as zero-rate curve (Z[28]), zero-coupon curve (BM[6]). In
JW[12] the yield curve is is given by simple spot rates, and in BM[6] it is a
combination of simple spot rates (for maturities up to 1 year) and annually
compounded spot rates (for maturities greater than 1 year), etc.
2.4. COUPON BONDS, SWAPS AND YIELDS 21

US Yield Curve, March 2002

0.1

0.08

0.06

0.04

0.02

Years
1 2 3 4 5 6 7 8 9 10

Now let p(t) be the time t market value of a fixed coupon bond with
coupon dates T1 < · · · < Tn , coupon payments c1 , . . . , cn and nominal value
N (see Section 2.4.1). For simplicity we suppose that cn already contains N ,
that is,
Xn
p(t) = P (t, Ti )ci , t ≤ T1 .
i=1

Again we ask for the bond’s “internal rate of interest”; that is, the constant
(over the period [t, Tn ]) continuously compounded rate which generates the
market value of the coupon bond: the (continuously compounded) yield-to-
maturity y(t) of this bond at time t ≤ T1 is defined as the unique solution
to n
X
p(t) = ci e−y(t)(Ti −t) .
i=1

Remark 2.4.1. → R[23](p.21). It is argued by Schaefer (1977) that the

yield-to-maturity is an inadequate statistics for the bond market:

• coupon payments occurring at the same point in time are discounted by

different discount factors, but

• coupon payments at different points in time from the same bond are
discounted by the same rate.

To simplify the notation we assume now that t = 0, and write p = p(0),

y = y(0), etc. The Macaulay duration of the coupon bond is defined as
Pn
Ti ci e−yTi
DM ac := i=1 .
p
22 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

The duration is thus a weighted average of the coupon dates T1 , . . . , Tn , and

it provides us in a certain sense with the “mean time to coupon payment”.
As such it is an important concept for interest rate risk management: it acts
as a measure of the first order sensitivity of the bond price w.r.t. changes in
the yield-to-maturity (see Z[28](Chapter 6.1.3) for a thourough treatment).
This is shown by the obvious formula
à n !
dp d X −yTi
= ci e = −DM ac p.
dy dy i=1

A first order sensitivity measure of the bond price w.r.t. parallel shifts of
the entire zero-coupon yield curve T 7→ R(0, T ) is given by the duration of
the bond Pn n
−yi Ti
i=1 Ti ci e ci P (0, Ti )
X
D := = Ti ,
p i=1
p
with yi := R(0, Ti ). In fact, we have
à n !
d X
ci e−(yi +s)Ti |s=0 = −Dp.
ds i=1

Hence duration is essentially for bonds (w.r.t. parallel shift of the yield curve)
what delta is for stock options. The bond equivalent of the gamma is con-
vexity: Ã n ! n
d2 X −(yi +s)Ti X
C := 2 ci e |s=0 = ci e−yi Ti (Ti )2 .
ds i=1 i=1

2.5 Market Conventions

2.5.1 Day-count Conventions
Time is measured in years.
If t and T denote two dates expressed as day/month/year, it is not clear
what T − t should be. The market evaluates the year fraction between t and
T in different ways.
The day-count convention decides upon the time measurement between
two dates t and T .
Here are three examples of day-count conventions:
2.5. MARKET CONVENTIONS 23

• Actual/365: a year has 365 days, and the day-count convention for
T − t is given by

actual number of days between t and T

.
365

• Actual/360: as above but the year counts 360 days.

• 30/360: months count 30 and years 360 days. Let t = (d1 , m1 , y1 ) and
T = (d2 , m2 , y2 ). The day-count convention for T − t is given by

min(d2 , 30) + (30 − d1 )+ (m2 − m1 − 1)+

+ + y 2 − y1 .
360 12
Example: The time between t=January 4, 2000 and T =July 4, 2002 is
given by

4 + (30 − 4) 7 − 1 − 1
+ + 2002 − 2000 = 2.5.
360 12

When extracting information on interest rates from data, it is important

to realize for which day-count convention a specific interest rate is quoted.
→ BM[6](p.4), Z[28](Sect. 5.1)

2.5.2 Coupon Bonds

→ MR[20](Sect. 11.2), Z[28](Sect. 5.2), J[14](Chapter 2)
Coupon bonds issued in the American (European) markets typically have
semi-annual (annual) coupon payments.
Debt securities issued by the U.S. Treasury are divided into three classes:

• Bills: zero-coupon bonds with time to maturity less than one year.

• Notes: coupon bonds (semi-annual) with time to maturity between 2

and 10 years.

• Bonds: coupon bonds (semi-annual) with time to maturity between 10

and 30 years3 .
3
Recently, the issuance of 30 year treasury bonds has been stopped.
24 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

In addition to bills, notes and bonds, Treasury securities called STRIPS

(separate trading of registered interest and principal of securities) have traded
since August 1985. These are the coupons or principal (=nominal) amounts
of Treasury bonds trading separately through the Federal Reserve’s book-
entry system. They are synthetically created zero-coupon bonds of longer
maturities than a year. They were created in response to investor demands.

2.5.3 Accrued Interest, Clean Price and Dirty Price

Remember that we had for the price of a coupon bond with coupon dates
T1 , . . . , Tn and payments c1 , . . . , cn the price formula
n
X
p(t) = ci P (t, Ti ), t ≤ T1 .
i=1

For t ∈ (T1 , T2 ] we have

n
X
p(t) = ci P (t, Ti ),
i=2

etc. Hence there are systematic discontinuities of the price trajectory at

t = T1 , . . . , Tn which is due to the coupon payments. This is why prices are
differently quoted at the exchange.
The accrued interest at time t ∈ (Ti−1 , Ti ] is defined by

t − Ti−1
AI(i; t) := ci
Ti − Ti−1

(where now time differences are taken according to the day-count conven-
tion). The quoted price, or clean price, of the coupon bond at time t is

pclean (t) := p(t) − AI(i; t), t ∈ (Ti−1 , Ti ].

That is, whenever we buy a coupon bond quoted at a clean price of pclean (t)
at time t ∈ (Ti−1 , Ti ], the cash price, or dirty price, we have to pay is

p(t) = pclean (t) + AI(i; t).

2.6. CAPS AND FLOORS 25

2.5.4 Yield-to-Maturity
The quoted (annual) yield-to-maturity ŷ(t) on a Treasury bond at time t = Ti
is defined by the relationship
n
X rc N/2 N
pclean (Ti ) = j−i
+ n−i
,
j=i+1
(1 + ŷ(Ti )/2) (1 + ŷ(Ti )/2)

and at t ∈ [Ti , Ti+1 )

n
X rc N/2 N
pclean (t) = j−i−1+τ
+ n−i−1+τ
,
j=i+1
(1 + ŷ(t)/2) (1 + ŷ(t)/2)

where rc is the (annualized) coupon rate, N the nominal amount and

Ti+1 − t
τ=
Ti+1 − Ti
is again given by the day-count convention, and we assume here that

Ti+1 − Ti ≡ 1/2 (semi-annual coupons).

2.6 Caps and Floors

→ BM[6](Sect. 1.6), Z[28](Sect. 5.6.2)

Caps
A caplet with reset date T and settlement date T + δ pays the holder the
difference between a simple market rate F (T, T + δ) (e.g. LIBOR) and the
strike rate κ. Its cashflow at time T + δ is

δ(F (T, T + δ) − κ)+ .

A cap is a strip of caplets. It thus consists of

• a number of future dates T0 < T1 < · · · < Tn with Ti − Ti−1 ≡ δ
(Tn is the maturity of the cap),

• a cap rate κ.
26 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

Cashflows take place at the dates T1 , . . . , Tn . At Ti the holder of the cap

receives
δ(F (Ti−1 , Ti ) − κ)+ . (2.4)
Let t ≤ T0 . We write

Cpl(i; t), i = 1, . . . , n,

for the time t price of the ith caplet with reset date Ti−1 and settlement date
Ti , and
Xn
Cp(t) = Cpl(i; t)
i=1

for the time t price of the cap.

A cap gives the holder a protection against rising interest rates. It guar-
antees that the interest to be paid on a floating rate loan never exceeds the
predetermined cap rate κ.
It can be shown (→ exercise) that the cashflow (2.4) at time Ti is the
equivalent to (1 + δκ) times the cashflow at date Ti−1 of a put option on a
Ti -bond with strike price 1/(1 + δκ) and maturity Ti−1 , that is,
µ ¶+
1
(1 + δκ) − P (Ti−1 , Ti ) .
1 + δκ
This is an important fact because many interest rate models have explicit
formulae for bond option values, which means that caps can be priced very
easily in those models.

Floors
A floor is the converse to a cap. It protects against low rates. A floor is a
strip of floorlets, the cashflow of which is – with the same notation as above
– at time Ti
δ(κ − F (Ti−1 , Ti ))+ .
Write F ll(i; t) for the price of the ith floorlet and
n
X
F l(t) = F ll(i; t)
i=1

for the price of the floor.

2.6. CAPS AND FLOORS 27

Caps, Floors and Swaps

Caps and floors are strongly related to swaps. Indeed, one can show the
parity relation (→ exercise)

Cp(t) − F l(t) = Πp (t),

where Πp (t) is the value at t of a payer swap with rate κ, nominal one and
the same tenor structure as the cap and floor.
Let t = 0. The cap/floor is said to be at-the-money (ATM) if
P (0, T0 ) − P (0, Tn )
κ = Rswap (0) = P ,
δ ni=1 P (0, Ti )

the forward swap rate. The cap (floor) is in-the-money (ITM) if κ < Rswap (0)
(κ > Rswap (0)), and out-of-the-money (OTM) if κ > Rswap (0) (κ < Rswap (0)).

Black’s Formula
It is market practice to price a cap/floor according to Black’s formula. Let
t ≤ T0 . Black’s formula for the value of the ith caplet is

Cpl(i; t) = δP (t, Ti ) (F (t; Ti−1 , Ti )Φ(d1 (i; t)) − κΦ(d2 (i; t))) ,

where ³ ´
F (t;Ti−1 ,Ti )
log κ
± 12 σ(t)2 (Ti−1 − t)
d1,2 (i; t) := √
σ(t) Ti−1 − t
(Φ stands for the standard Gaussian cumulative distribution function), and
σ(t) is the cap volatility (it is the same for all caplets).
Correspondingly, Black’s formula for the value of the ith floorlet is

F ll(i; t) = δP (t, Ti ) (κΦ(−d2 (i; t)) − F (t; Ti−1 , Ti )Φ(−d1 (i; t))) .

Cap/floor prices are quoted in the market in term of their implied volatil-
ities. Typically, we have t = 0, and T0 and δ = Ti − Ti−1 being equal to three
months.
An example of a US dollar ATM market cap volatility curve is shown in
Table 2.1 and Figure 2.1 (→ JW[12](p.49)).
It is a challenge for any market realistic interest rate model to match the
given volatility curve.
28 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

Table 2.1: US dollar ATM cap volatilities, 23 July 1999

Maturity ATM vols

(in years) (in %)
1 14.1
2 17.4
3 18.5
4 18.8
5 18.9
6 18.7
7 18.4
8 18.2
10 17.7
12 17.0
15 16.5
20 14.7
30 12.4

Figure 2.1: US dollar ATM cap volatilities, 23 July 1999

18%

16%

14%

12%

5 10 15 20 25 30
2.7. SWAPTIONS 29

2.7 Swaptions
A European payer (receiver) swaption with strike rate K is an option giving
the right to enter a payer (receiver) swap with fixed rate K at a given future
date, the swaption maturity. Usually, the swaption maturity coincides with
the first reset date of the underlying swap. The underlying swap lenght
Tn − T0 is called the tenor of the swaption.
Recall that the value of a payer swap with fixed rate K at its first reset
date, T0 , is
n
X
Πp (T0 , K) = N P (T0 , Ti )δ(F (T0 ; Ti−1 , Ti ) − K).
i=1

Hence the payoff of the swaption with strike rate K at maturity T0 is

à n !+
X
N P (T0 , Ti )δ(F (T0 ; Ti−1 , Ti ) − K) . (2.5)
i=1

Notice that, contrary to the cap case, this payoff cannot be decomposed
into more elementary payoffs. This is a fundamental difference between
caps/floors and swaptions. Here the correlation between different forward
rates will enter the valuation procedure.
Since Πp (T0 , Rswap (T0 )) = 0, one can show (→ exercise) that the payoff
(2.5) of the payer swaption at time T0 can also be written as
n
X
+
N δ(Rswap (T0 ) − K) P (T0 , Ti ),
i=1

and for the receiver swaption

n
X
+
N δ(K − Rswap (T0 )) P (T0 , Ti ).
i=1

Accordingly, at time t ≤ T0 , the payer (receiver) swaption with strike rate

K is said to be ATM , ITM , OTM , if

K = Rswap (t), K < (>)Rswap (t), K > (<)Rswap (t),

respectively.
30 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS

Black’s Formula
Black’s formula for the price at time t ≤ T0 of the payer (Swptp (t)) and
receiver (Swptr (t)) swaption is
n
X
Swptp (t) = N δ (Rswap (t)Φ(d1 (t)) − KΦ(d2 (t))) P (t, Ti ),
i=1
n
X
Swptr (t) = N δ (KΦ(−d2 (t)) − Rswap (t)Φ(−d1 (t))) P (t, Ti ),
i=1

with ³ ´
Rswap (t)
log K
± 12 σ(t)2 (T0 − t)
d1,2 (t) := √ ,
σ(t) T0 − t
and σ(t) is the prevailing Black’s swaption volatility.
Swaption prices are quoted in terms of implied volatilities in matrix form.
An x × y-swaption is the swaption with maturity in x years and whose un-
derlying swap is y years long.
A typical example of implied swaption volatilities is shown in Table 2.2
and Figure 2.2 (→ BM[6](p.253)).
An interest model for swaptions valuation must fit the given today’s
volatility surface.
2.7. SWAPTIONS 31

Table 2.2: Black’s implied volatilities (in %) of ATM swaptions on May 16,
2000. Maturities are 1,2,3,4,5,7,10 years, swaps lengths from 1 to 10 years.

1y 2y 3y 4y 5y 6y 7y 8y 9y 10y
1y 16.4 15.8 14.6 13.8 13.3 12.9 12.6 12.3 12.0 11.7
2y 17.7 15.6 14.1 13.1 12.7 12.4 12.2 11.9 11.7 11.4
3y 17.6 15.5 13.9 12.7 12.3 12.1 11.9 11.7 11.5 11.3
4y 16.9 14.6 12.9 11.9 11.6 11.4 11.3 11.1 11.0 10.8
5y 15.8 13.9 12.4 11.5 11.1 10.9 10.8 10.7 10.5 10.4
7y 14.5 12.9 11.6 10.8 10.4 10.3 10.1 9.9 9.8 9.6
10y 13.5 11.5 10.4 9.8 9.4 9.3 9.1 8.8 8.6 8.4

Figure 2.2: Black’s implied volatilities (in %) of ATM swaptions on May 16,
2000.

Maturity
2 4
6 8
10
16
14 Vol
12
10
8 10
4 6
2
Tenor
32 CHAPTER 2. INTEREST RATES AND RELATED CONTRACTS
Chapter 3

Some Statistics of the Yield

Curve

3.1 Principal Component Analysis (PCA)

→ JW[12](Chapter 16.2), [22]

• Let x(1), . . . , x(N ) be a sample of a random n × 1 vector x.

• Form the empirical n × n covariance matrix Σ̂,
PN
(xi (k) − µ[xi ])(xj (k) − µ[xj ])
Σ̂ij = k=1
N −1
PN
xi (k)xj (k) − N µ[xi ]µ[xj ]
= k=1 ,
N −1
where
N
1 X
µ[xi ] := xi (k) (mean of xi ).
N k=1

We assume that Σ̂ is non-degenerate (otherwise we can express an xi

as linear combination of the other xj s).
• There exists a unique orthogonal matrix A = (p1 , . . . , pn ) (that is,
A−1 = AT and Aij = pj;i ) consisting of orthonormal n × 1 Eigenvectors
pi of Σ̂ such that
Σ̂ = ALAT ,

33
34 CHAPTER 3. STATISTICS OF THE YIELD CURVE

where L = diag(λ1 , . . . , λn ) with λ1 ≥ · · · ≥ λn > 0 (the Eigenvalues

of Σ̂).
• Define z := AT x. Then
n
X ³ ´
Cov[zi , zj ] = ATik Cov[xk , xl ]ATjl = AT Σ̂A = λi δij .
ij
k,l=1

Hence the zi s are uncorrelated.

• The principal components (PCs) are the n × 1 vectors p1 , . . . , pn :
x = Az = z1 p1 + · · · zn pn .
The importance of component pi is determined by the size of the cor-
responding Eigenvalue, λi , which indicates the amount of variance ex-
plained by pi . The key statistics is the proportion
λ
Pn i ,
j=1 λj
the explained variance by pi .
√ √
• Normalization: let w̃ := (L1/2 )−1 z, where L1/2 := diag( λ1 , . . . , λn ),
and w = w̃ − µ[w̃] (µ[w̃]=mean of w̃). Then
µ[w] = 0, Cov[wi , wj ] = Cov[w̃i , w̃j ] = δij ,
and n
X p
1/2
x = µ[x] + AL w = µ[x] + pj λ j wj .
j=1

In components
n
X p
xi = µ[xi ] + Aij λ j wj .
j=1

• Sometimes the following view is useful (→ R[23](Chapter 3)): set

à n !1/2
³ ´1/2 X
σi := V ar[xi ]1/2 = Σ̂ii = A2ij λj
j=1
Pn p
xi − µ[xi ] j=1 Aij λ j wj
vi := = , i = 1, . . . , n.
σi σi
3.2. PCA OF THE YIELD CURVE 35

Then we have µ[vi ] = 0, µ[vi2 ] = 1 and

xi = µ[xi ] + σi vi .

It can be appropriate to assume a parametric functional form (→ re-

duction of parameters) of the correlation structure of x,
Pn
Σ̂ij Aik Ajk λk
Corr[xi , xj ] = Cov[vi , vj ] = = k=1 = ρ(π; i, j),
σi σj σi σj

where π is some low-dimensional parameter (this is adapted to the

calibration of market models → BM[6](Chapter 6.9)).

3.2 PCA of the Yield Curve

Now let x = (x1 , . . . , xn )T be the increments of the forward curve, say

xi = R(t + ∆t; t + ∆t + τi−1 , t + ∆t + τi ) − R(t; t + τi−1 , t + τi ),

for some maturity spectrum 0 = τ0 < · · · < τn .

PCA typically leads to the following picture (→ R[23]p.61): UK market
in the years 1989-1992 (the original maturity spectrum has been divided into
eight distinct buckets, i.e. n = 8).
The first three principal components are
     
0.329 −0.722 0.490
0.354 −0.368 −0.204
     
0.365 −0.121 −0.455
     
0.367  0.044  −0.461
p1 = 
0.364 , p2 =  0.161  , p3 = −0.176 .
    
     
0.361  0.291   0.176 
     
0.358  0.316   0.268 
0.352 0.343 0.404

• The first PC is roughly flat (parallel shift → average rate),

• the second PC is upward sloping (tilt → slope),

• the third PC hump-shaped (flex → curvature).

36 CHAPTER 3. STATISTICS OF THE YIELD CURVE

Figure 3.1: First Three PCs.

0.6
0.4
0.2

2 3 4 5 6 7 8
-0.2
-0.4
-0.6
-0.8

Table 3.1: Explained Variance of the Principal Components (PCs).

PC Explained
Variance (%)
1 92.17
2 6.93
3 0.61
4 0.24
5 0.03
6–8 0.01

The first three PCs explain more than 99 % of the variance of x (→ Table 3.1).

PCA of the yield curve goes back to the seminal paper by Litterman
and Scheinkman (91) [18] (Prof. J. Scheinkman is at the Department of
Economics, Princeton University).

3.3 Correlation
→ R[23](p.58)
A typical example of correlation among forward rates is provided by
3.3. CORRELATION 37

Brown and Schaefer (1994). The data is from the US Treasury yield curve
1987–1994. The following matrix (→ Figure 3.2)
 
1 0.87 0.74 0.69 0.64 0.6

 1 0.96 0.93 0.9 0.85 

 1 0.99 0.95 0.92


 1 0.97 0.93 
 1 0.95
1

shows the correlation for changes of forward rates of maturities

0, 0.5, 1, 1.5, 2, 3 years.

Figure 3.2: Correlation between the short rate and instantaneous forward
rates for the US Treasury curve 1987–1994

0.9

0.8

0.7

0.6
0.5 1 1.5 2 2.5 3

→ Decorrelation occurs quickly.

→ Exponentially decaying correlation structure is plausible.

38 CHAPTER 3. STATISTICS OF THE YIELD CURVE
Chapter 4

Estimating the Yield Curve

4.1 A Bootstrapping Example

→ JW[12](p.129–136)
This is a naive bootstrapping method of fitting to a money market yield
curve. The idea is to build up the yield curve

from shorter maturities to longer maturities.

We take Yen data from 9 January, 1996 (→ JW[12](Section 5.4)). The

spot date t0 is 11 January, 1996. The day-count convention is Actual/360,
actual number of days between T and S
δ(T, S) = .
360

Table 4.1: Yen data, 9 January 1996.

LIBOR (%) Futures Swaps (%)

o/n 0.49 20 Mar 96 99.34 2y 1.14
1w 0.50 19 Jun 96 99.25 3y 1.60
1m 0.53 18 Sep 96 99.10 4y 2.04
2m 0.55 18 Dec 96 98.90 5y 2.43
3m 0.56 7y 3.01
10y 3.36

39
40 CHAPTER 4. ESTIMATING THE YIELD CURVE

• The first column contains the LIBOR (=simple spot rates) F (t0 , Si ) for
maturities
{S1 , . . . , S5 } = {12/1/96, 18/1/96, 13/2/96, 11/3/96, 11/4/96}
hence for 1, 7, 33, 60 and 91 days to maturity, respectively. The zero-
coupon bonds are
1
P (t0 , Si ) = .
1 + F (t0 , Si ) δ(t0 , Si )

• The futures are quoted as

futures price for settlement day Ti = 100(1 − FF (t0 ; Ti , Ti+1 )),
where FF (t0 ; Ti , Ti+1 ) is the futures rate for period [Ti , Ti+1 ] prevailing
at t0 , and
{T1 , . . . , T5 } = {20/3/96, 19/6/96, 18/9/96, 18/12/96, 19/3/97},
hence δ(Ti , Ti+1 ) ≡ 91/360.
We treat futures rates as if they were simple forward rates, that is, we
set
F (t0 ; Ti , Ti+1 ) = FF (t0 ; Ti , Ti+1 ).

To calculate zero-coupon bond from futures prices we need P (t0 , T1 ).

We use geometric interpoliation
P (t0 , T1 ) = P (t0 , S4 )q P (t0 , S5 )1−q ,
which is equivalent to using linear interpolation of continuously com-
pounded spot rates
R(t0 , T1 ) = q R(t0 , S4 ) + (1 − q) R(t0 , S5 ),
where
δ(T1 , S5 ) 22
q= = = 0.709677.
δ(S4 , S5 ) 31
Then we use the relation
P (t0 , Ti )
P (t0 , Ti+1 ) =
1 + δ(Ti , Ti+1 ) F (t0 ; Ti , Ti+1 )
to derive P (t0 , T2 ), . . . , P (t0 , T5 ).
4.1. A BOOTSTRAPPING EXAMPLE 41

• Yen swaps have semi-annual cashflows at dates

 

 11/7/96, 13/1/97, 

 


 11/7/97, 12/1/98, 


 


 13/7/98, 11/1/99, 


 


 12/7/99, 11/1/00, 


 
11/7/00, 11/1/01,
{U1 , . . . , U20 } = .

 11/7/01, 11/1/02, 

 


 11/7/02, 13/1/03, 


 


 11/7/03, 12/1/04, 


 


 12/7/04, 11/1, 05, 


 
11/7/05, 11/1/06

For a swap with maturity Un the swap rate at t0 is given by

1 − P (t0 , Un )
Rswap (t0 , Un ) = Pn , (U0 := t0 ).
i=1 δ(Ui−1 , Ui ) P (t0 , Ui )

From the data we have Rswap (t0 , Ui ) for i = 4, 6, 8, 10, 14, 20.
We obtain P (t0 , U1 ), P (t0 , U2 ) (and hence Rswap (t0 , U1 ), Rswap (t0 , U2 ))
by linear interpolation of the continuously compounded spot rates
69 22
R(t0 , U1 ) = R(t0 , T2 ) + R(t0 , T3 )
91 91
65 26
R(t0 , U2 ) = R(t0 , T4 ) + R(t0 , T5 ).
91 91

All remaining swap rates are obtained by linear interpolation. For

maturity U3 this is
1
Rswap (t0 , U3 ) = (Rswap (t0 , U2 ) + Rswap (t0 , U4 )).
2

We have (→ exercise)
Pn−1
1 − Rswap (t0 , Un ) i=1 δ(Ui−1 , Ui ) P (t0 , Ui )
P (t0 , Un ) = .
1 + Rswap (t0 , Un )δ(Un−1 , Un )

This gives P (t0 , Un ) for n = 3, . . . , 20.

42 CHAPTER 4. ESTIMATING THE YIELD CURVE

Figure 4.1: Zero-coupon bond curve

0.8

0.6

0.4

0.2

2 4 6 8 10
Time to maturity

In Figure 4.1 is the implied zero-coupon bond price curve

P (t0 , ti ), i = 0, . . . , 29

(we have 29 points and set P (t0 , t0 ) = 1).

The spot and forward rate curves are in Figure 4.2. Spot and forward
rates are continuously compounded

log P (t0 , ti )
R(t0 , ti ) = −
δ(t0 , ti )
log P (t0 , ti+1 ) − log P (t0 , ti )
R(t0 , ti , ti+1 ) = − , i = 1, . . . , 29.
δ(ti , ti+1 )

The forward curve, reflecting the derivative of T 7→ − log P (t0 , T ), is very

unsmooth and sensitive to slight variations (errors) in prices.
Figure 4.3 shows the spot rate curves from LIBOR, futures and swaps. It
is evident that the three curves are not coincident to a common underlying
curve. Our naive method made no attempt to meld the three curves together.

→ The entire yield curve is constructed from relatively few instruments. The
method exactly reconstructs market prices (this is desirable for interest
rate option traders). But it produces an unstable, non-smooth forward
curve.
4.1. A BOOTSTRAPPING EXAMPLE 43

Figure 4.2: Spot rates (lower curve), forward rates (upper curve)

0.06
0.05
0.04
0.03
0.02
0.01

2 4 6 8 10
Time to maturity

Figure 4.3: Comparison of money market curves

0.012
0.011
0.01
0.009
0.008
0.007
0.006
0.005

0.5 1 1.5 2
Time to maturity

→ Another method would be to estimate a smooth yield curve parametri-

cally from the market rates (for fund managers, long term strategies).

The main difficulties with our method are:

• Futures rates are treated as forward rates. In reality futures rates are
greater than forward rates. The amount by which the futures rate is
above the forward rate is called the convexity adjustment, which is
44 CHAPTER 4. ESTIMATING THE YIELD CURVE

model dependend. An example is

1
forward rate = futures rate − σ 2 τ 2 ,
2
where τ is the time to maturity of the futures contract, and σ is the
volatility parameter.
• LIBOR rates beyond the “stup date” T1 = 20/3/96 (that is, at S5 =
11/4/96) are ignored once P (t0 , T1 ) is found. In general, the segments
of LIBOR, futures and swap markets overlap.
• Swap rates are inappropriately interpolated. The linear interpolation
produces a “sawtooth” in the forward rate curve. However, in some
markets intermediate swaps are indeed priced as if their prices were
found by linear interpolation.

4.2 General Case

The general problem of finding today’s (t0 ) term structure of zero-coupon
bond prices (or the discount function)

x 7→ D(x) := P (t0 , t0 + x)

can be formulated as
p = C · d + ²,
where p is a vector of n market prices, C the related cashflow matrix, and
d = (D(x1 ), . . . , D(xN )) with cashflow dates t0 < T1 < · · · < TN ,

Ti − t0 = xi ,

and ² a vector of pricing errors. Reasons for including errors are

• prices are never exactly simultaneous,
• round-off errors in the quotes (bid-ask spreads, etc),
• liquidity effects,
• tax effects (high coupons, low coupons),
• allows for smoothing.
4.2. GENERAL CASE 45

4.2.1 Bond Markets

Data:

• vector of quoted/market bond prices p = (p1 , . . . , pn ),

• dates of all cashflows t0 < T1 < · · · < TN ,

• bond i with cashflows (coupon and principal payments) ci,j at time Tj

(may be zero), forming the n × N cashflow matrix

C = (ci,j ) 1≤i≤n .
1≤j≤N

Example (→ JW[12], p.426): UK government bond (gilt) market, Septem-

ber 4, 1996, selection of nine gilts. The coupon payments are semiannual.
The spot date is 4/9/96, and the day-count convention is actual/365.

Table 4.2: Market prices for UK gilts, 4/9/96.

coupon next maturity dirty price

(%) coupon date (pi )
bond 1 10 15/11/96 15/11/96 103.82
bond 2 9.75 19/01/97 19/01/98 106.04
bond 3 12.25 26/09/96 26/03/99 118.44
bond 4 9 03/03/97 03/03/00 106.28
bond 5 7 06/11/96 06/11/01 101.15
bond 6 9.75 27/02/97 27/08/02 111.06
bond 7 8.5 07/12/96 07/12/05 106.24
bond 8 7.75 08/03/97 08/09/06 98.49
bond 9 9 13/10/96 13/10/08 110.87

Hence n = 9 and N = 1 + 3 + 6 + 7 + 11 + 12 + 19 + 20 + 25 = 104,

T1 = 26/09/96, T2 = 13/10/96, T3 = 06/11/97, . . . .

46 CHAPTER 4. ESTIMATING THE YIELD CURVE

No bonds have cashflows at the same date. The 9 × 104 cashflow matrix is
 
0 0 0 105 0 0 0 0 0 0 ...
 0 0 0 0 0 4.875 0 0 0 0 ... 
 
 6.125 0 0 0 0 0 0 0 0 6.125 . . . 
 
 0 0 0 0 0 0 0 4.5 0 0 ... 
 
C=  0 0 3.5 0 0 0 0 0 0 0 . .. 

 0 0 0 0 0 0 4.875 0 0 0 ... 
 
 0 0 0 0 4.25 0 0 0 0 0 ... 
 
 0 0 0 0 0 0 0 0 3.875 0 ... 
0 4.5 0 0 0 0 0 0 0 0 ...

4.2.2 Money Markets

Money market data can be put into the same price–cashflow form as above.

LIBOR (rate L, maturity T ): p = 1 and c = 1 + (T − t0 )L at T .

FRA (forward rate F for [T, S]): p = 0, c1 = −1 at T1 = T , c2 = 1+(S−T )F

at T2 = S.

Swap (receiver, swap rate K, tenor t0 ≤ T0 < · · · < Tn , Ti − Ti−1 ≡ δ):

since
n
X
0 = −D(T0 − t0 ) + δK D(Tj − t0 ) + (1 + δK)D(Tn − t0 ),
j=1

• if T0 = t0 : p = 1, c1 = · · · = cn−1 = δK, cn = 1 + δK,

• if T0 > t0 : p = 0, c0 = −1, c1 = · · · = cn−1 = δK, cn = 1 + δK.

→ at t0 : LIBOR and swaps have notional price 1, FRAs and forward swaps
have notional price 0.

Example (→ JW[12], p.428): US money market on October 6, 1997.

The day-count convention is Actual/360. The spot date t0 is 8/10/97.

LIBOR is for o/n (1/365), 1m (33/360), and 3m (92/360).

4.2. GENERAL CASE 47

Futures are three month rates (δ = 91/360). We take them as forward

rates. That is, the quote of the futures contract with maturity date (settle-
ment day) T is

100(1 − F (t0 ; T, T + δ)).

Swaps are annual (δ = 1). The first payment date is 8/10/98.

Table 4.3: US money market, October 6, 1997.

Period Rate Maturity Date

LIBOR o/n 5.59375 9/10/97
1m 5.625 10/11/97
3m 5.71875 8/1/98
Futures Oct-97 94.27 15/10/97
Nov-97 94.26 19/11/97
Dec-97 94.24 17/12/97
Mar-98 94.23 18/3/98
Jun-98 94.18 17/6/98
Sep-98 94.12 16/9/98
Dec-98 94 16/12/98
Swaps 2 6.01253
3 6.10823
4 6.16
5 6.22
7 6.32
10 6.42
15 6.56
20 6.56
30 6.56

Here n = 3 + 7 + 9 = 19, N = 3 + 14 + 30 = 47, T1 = 9/10/97,

T2 = 15/10/97 (first future), T3 = 10/11/97, . . . . The first 14 columns of
48 CHAPTER 4. ESTIMATING THE YIELD CURVE

the 19 × 47 cashflow matrix C are

c11 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 c23 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 c36 0 0 0 0 0 0 0 0
0 −1 0 0 0 0 c47 0 0 0 0 0 0 0
0 0 0 −1 0 0 0 c58 0 0 0 0 0 0
0 0 0 0 −1 0 0 0 c69 0 0 0 0 0
0 0 0 0 0 0 0 0 −1 c7,10 0 0 0 0
0 0 0 0 0 0 0 0 0 −1 c8,11 0 0 0
0 0 0 0 0 0 0 0 0 0 −1 0 c9,13 0
0 0 0 0 0 0 0 0 0 0 0 0 −1 c10,14
0 0 0 0 0 0 0 0 0 0 0 c11,12 0 0
0 0 0 0 0 0 0 0 0 0 0 c12,12 0 0
0 0 0 0 0 0 0 0 0 0 0 c13,12 0 0
0 0 0 0 0 0 0 0 0 0 0 c14,12 0 0
0 0 0 0 0 0 0 0 0 0 0 c15,12 0 0
0 0 0 0 0 0 0 0 0 0 0 c16,12 0 0
0 0 0 0 0 0 0 0 0 0 0 c17,12 0 0
0 0 0 0 0 0 0 0 0 0 0 c18,12 0 0
0 0 0 0 0 0 0 0 0 0 0 c19,12 0 0
with
c11 = 1.00016, c23 = 1.00516, c36 = 1.01461,
c47 = 1.01448, c58 = 1.01451, c69 = 1.01456, c7,10 = 1.01459,
c8,11 = 1.01471, c9,13 = 1.01486, c10,14 = 1.01517
c11,12 = 0.060125, c12,12 = 0.061082, c13,12 = 0.0616,
c14,12 = 0.0622, c15,12 = 0.0632, c16,12 = 0.0642,
c17,12 = c18,12 = c19,12 = 0.0656.

4.2.3 Problems
Typically, we have n ¿ N . Moreover, many entries of C are zero (different
cashflow dates). This makes ordinary least square (OLS) regression
min {k²k2 | ² = p − C · d} (⇒ C T p = C T Cd∗ )
d∈RN

unfeasible.
4.2. GENERAL CASE 49

One could chose the data set such that cashflows are at same points in
time (say four dates each year) and the cashflow matrix C is not entirely full
of zeros (Carleton–Cooper (1976)). Still regression only yields values D(xi )
at the payment dates t0 + xi

→ interpolation technics necessary.

But there is nothing to regularize the discount factors (discount factors of

similar maturity can be very different). As a result this leads to a ragged
spot rate (yield) curve, and even worse for forward rates.

4.2.4 Parametrized Curve Families

Reduction of parameters and smooth yield curves can be achieved by using
parametrized families of smooth curves
µ Z x ¶
D(x) = D(x; z) = exp − φ(u; z) du , z ∈ Z,
0

with state space Z ⊂ Rm .

For regularity reasons (see below) it is best to estimate the forward curve

R+ 3 x 7→ f (t0 , t0 + x) = φ(x) = φ(x; z).

This leads to a nonlinear optimization problem

min kp − C · d(z)k ,
z∈Z

with µ Z ¶
xi
di (z) = exp − φ(u; z) du
0

for some payment tenor 0 < x1 < · · · < xN .

Linear Families
Fix a set of basis functions ψ1 , . . . , ψm (preferably with compact support),
and let
φ(x; z) = z1 ψ1 (x) + · · · + zm ψm (x).
50 CHAPTER 4. ESTIMATING THE YIELD CURVE

Cubic B-splines A cubic spline is a piecewise cubic polynomial that is

everywhere twice differentiable. It interpolates values at m + 1 knot points
ξ0 < · · · < ξm . Its general form is

3
X m−1
X
σ(x) = ai x i + bj (x − ξj )3+ ,
i=0 j=1

hence it has m + 3 parameters {a0 , . . . , a4 , b1 , . . . , bm−1 } (a kth degree spline

has m + k parameters). The spline is uniquely characterized by specification
of σ 0 or σ 00 at ξ0 and ξm .
Introduce six extra knot points

ξ−3 < ξ−2 < ξ−1 < ξ0 < · · · < ξm < ξm+1 < ξm+2 < ξm+3 .

A basis for the cubic splines on [ξ0 , ξm ] is given by the m + 3 B-splines

k+4
à k+4
!
X Y 1
ψk (x) = (x − ξj )3+ , k = −3, . . . , m − 1.
j=k i=k,i6=j
ξi − ξj

The B-spline ψk is zero outside [ξk , ξk+4 ].

Figure 4.4: B-spline with knot points {0, 1, 6, 8, 11}.

0.06

0.05

0.04

0.03

0.02

0.01

2 4 6 8 10 12
4.2. GENERAL CASE 51

Estimating the Discount Function B-splines can also be used to esti-

mate the discount function directly (Steeley (1991)),

D(x; z) = z1 ψ1 (x) + · · · + zm ψm (x).

With
     
D(x1 ; z) ψ1 (x1 ) · · · ψm (x1 ) z1
 ..   .. ..   ..  =: Ψ · z
d(z) =  . = . . · . 
D(xN ; z) ψ1 (xN ) · · · ψm (xN ) zm

this leads to the linear optimization problem

min kp − CΨzk.
z∈Rm

If the n × m matrix A := CΨ has full rank m, the unique unconstrained

solution is
z ∗ = (AT A)−1 AT p.
A reasonable constraint would be

D(0; z) = ψ1 (0)z1 + · · · + ψm (0)zm = 1.

Example We take the UK government bond market data from the last
section (Table 4.2). The maximum time to maturity, x104 , is 12.11 [years].
Notice that the first bond is a zero-coupon bond. Its exact yield is
365 103.822 1
y=− log =− log 0.989 = 0.0572.
72 105 0.197

• As a basis we use the 8 (resp. first 7) B-splines with the 12 knot points

{−20, −5, −2, 0, 1, 6, 8, 11, 15, 20, 25, 30}

(see Figure 4.5).

The estimation with all 8 B-splines leads to

min kp − CΨzk = kp − CΨz ∗ k = 0.23

z∈R8
52 CHAPTER 4. ESTIMATING THE YIELD CURVE

Figure 4.5: B-splines with knots {−20, −5, −2, 0, 1, 6, 8, 11, 15, 20, 25, 30}.

0.07
0.06
0.05
0.04
0.03
0.02
0.01

5 10 15 20 25 30

with  
13.8641

 11.4665 


 8.49629 

∗
 7.69741 
z = ,

 6.98066 


 6.23383 

 −4.9717 
855.074
and the discount function, yield curve (cont. comp. spot rates), and for-
ward curve (cont. comp. 3-monthly forward rates) shown in Figure 4.7.

The estimation with only the first 7 B-splines leads to

min kp − CΨzk = kp − CΨz ∗ k = 0.32
z∈R7

with  
17.8019

 11.3603 


 8.57992 

∗
z =
 7.56562 ,


 7.28853 

 5.38766 
4.9919
4.2. GENERAL CASE 53

and the discount function, yield curve (cont. comp. spot rates), and
forward curve (cont. comp. 3-month forward rates) shown in Figure 4.8.

• Next we use only 5 B-splines with the 9 knot points

{−10, −5, −2, 0, 4, 15, 20, 25, 30}

(see Figure 4.6).

Figure 4.6: Five B-splines with knot points {−10, −5, −2, 0, 4, 15, 20, 25, 30}.

0.035
0.03
0.025
0.02
0.015
0.01
0.005

5 10 15 20 25 30

The estimation with this 5 B-splines leads to

min5 kp − CΨzk = kp − CΨz ∗ k = 0.39

z∈R

with  
15.652

 19.4385 

∗
z =
 12.9886 ,

 7.40296 
6.23152
and the discount function, yield curve (cont. comp. spot rates), and for-
ward curve (cont. comp. 3-monthly forward rates) shown in Figure 4.9.
54 CHAPTER 4. ESTIMATING THE YIELD CURVE

Figure 4.7: Discount function, yield and forward curves for estimation with
8 B-splines. The dot is the exact yield of the first bond.
1

0.8

0.6

0.4

0.2

2 4 6 8 10 12
0.14
0.12
0.1
0.08
0.06
0.04
0.02

2 4 6 8 10 12
0.25

0.2

0.15

0.1

0.05

2 4 6 8 10 12
4.2. GENERAL CASE 55

Figure 4.8: Discount function, yield and forward curves for estimation with
7 B-splines. The dot is the exact yield of the first bond.
1

0.8

0.6

0.4

0.2

2 4 6 8 10 12
0.14
0.12
0.1
0.08
0.06
0.04
0.02

2 4 6 8 10 12
0.25

0.2

0.15

0.1

0.05

2 4 6 8 10 12
56 CHAPTER 4. ESTIMATING THE YIELD CURVE

Figure 4.9: Discount function, yield and forward curves for estimation with
5 B-splines. The dot is the exact yield of the first bond.
1

0.8

0.6

0.4

0.2

2 4 6 8 10 12
0.14
0.12
0.1
0.08
0.06
0.04
0.02

2 4 6 8 10 12
0.25

0.2

0.15

0.1

0.05

2 4 6 8 10 12
4.2. GENERAL CASE 57

Discussion
• In general, splines can produce bad fits.
• Estimating the discount function leads to unstable and non-smooth
yield and forward curves. Problems mostly at short and long term
maturities.
• Splines are not useful for extrapolating to long term maturities.
• There is a trade-off between the quality (or regularity) and the correct-
ness of the fit. The curves in Figures 4.8 and 4.9 are more regular than
those in Figure 4.7, but their correctness criteria (0.32 and 0.39) are
worse than for the fit with 8 B-splines (0.23).
• The B-spline fits are extremely sensitive to the number and location of
the knot points.

→ Need criterions asserting smooth yield and forward curves that do not
fluctuate too much and flatten towards the long end.
→ Direct estimation of the yield or forward curve.
→ Optimal selection of number and location of knot points for splines.
→ Smoothing splines.

Smoothing Splines The least squares criterion

min kp − C · d(z)k2
z

has to be replaced/extended by criterions for the smoothness of the yield or

forward curve.

Example: Lorimier (95). In her PhD thesis 1995, Sabine Lorimier sug-
gests a spline method where the number and location of the knots are deter-
mined by the observed data itself.
For ease of notation we set t0 = 0 (today). The data is given by N
observed zero-coupon bonds P (0, T1 ), . . . , P (0, TN ) at 0 < T1 < · · · < TN ≡
T , and consequently the N yields
Y1 , . . . , YN , P (0, Ti ) = exp(−Ti Yi ).
58 CHAPTER 4. ESTIMATING THE YIELD CURVE

Let f (u) denote the forward curve. The fitting requirement now is for the
forward curve Z Ti
√
f (u) du + ²i / α = Ti Yi , (4.1)
0

with an arbitrary constant α > 0. The aim is to minimize k²k2 as well as the
smoothness criterion Z T
(f 0 (u))2 du. (4.2)
0

Introduce the Sobolev space

H = {g | g 0 ∈ L2 [0, T ]}

with scalar product

Z T
hg, hiH = g(0)h(0) + g 0 (u)h0 (u) du,
0

and the nonlinear functional on H

"Z N µ Z ¶2 #
T X Ti
0 2
F (f ) := (f (u)) du + α Yi Ti − f (u) du .
0 i=1 0

The optimization problem then is

min F (f ). (*)
f ∈H

The parameter α tunes the trade-off between smoothness and correctness of

the fit.

Theorem 4.2.1. Problem (*) has a unique solution f , which is a second

order spline characterized by
N
X
f (u) = f (0) + ak hk (u) (4.3)
k=1

where hk ∈ C 1 [0, T ] is a second order polynomial on [0, Tk ] with

h0k (u) = (Tk − u)+ , hk (0) = Tk , k = 1, . . . , N, (4.4)

4.2. GENERAL CASE 59

and f (0) and ak solve the linear system of equations

N
X
ak Tk = 0, (4.5)
k=1
à N
!
X
α Yk Tk − f (0)Tk − al hhl , hk iH = ak , k = 1, . . . , N. (4.6)
l=1

Proof. Integration by parts yields

Z Tk Z Tk
g(u) du = Tk g(Tk ) − ug 0 (u) du
0 0
Z Tk Z Tk
0
= Tk g(0) + Tk g (u) du − ug 0 (u) du
0 0
Z T
= Tk g(0) + (Tk − u)+ g 0 (u) du = hhk , giH ,
0

for all g ∈ H. In particular,

Z Tk
hl du = hhl , hk iH .
0

A (local) minimizer f of F satisfies

d
F (f + ²g)|²=0 = 0
d²
or equivalently
Z T N µ
X Z Tk ¶Z Tk
0 0
f g du = α Yk Tk − f du g du, ∀g ∈ H. (4.7)
0 k=1 0 0

In particular, for all g ∈ H with hg, hk iH = 0 we obtain

Z T
hf − f (0), giH = f 0 (u)g 0 (u) du = 0.
0

Hence
f − f (0) ∈ span{h1 , . . . , hN }
60 CHAPTER 4. ESTIMATING THE YIELD CURVE

what proves (4.3), (4.4) and (4.5) (set u = 0). Hence we have
Z T XN µ Z Tk ¶ X N Z Tk
0 0
f (u)g (u) du = ak −Tk g(0) + g(u) du = ak g(u) du,
0 k=1 0 k=1 0

and (4.7) can be rewritten as

N
à à N
!! Z
X X Tk
ak − α Yk Tk − f (0)Tk − al hhl , hk iH g(u) du = 0
k=1 l=1 0

for all g ∈ H. This is true if and only if (4.6) holds.

Thus we have shown that (4.7) is equivalent to (4.3)–(4.6).
Next we show that (4.7) is a sufficient condition for f to be a global
minimizer of F . Let g ∈ H, then
Z T XN µ Z Tk ¶2
0 0 0 2
F (g) = ((g − f ) + f ) du + α Yk Tk − g du
0 k=1 0
Z T XN µZ Tk Z Tk ¶2
(4.7) 0 0 2
= F (f ) + (g − f ) du + α f du − g du
0 k=1 0 0

≥ F (f ),
where we used (4.7) with g − f ∈ H.
It remains to show that f exists and is unique; that is, that the linear sys-
tem (4.5)–(4.6) has a unique solution (f (0), a1 , . . . , aN ). The corresponding
(N + 1) × (N + 1) matrix is
 
0 T1 T2 ··· TN
 αT1 αhh1 , h1 iH + 1 αhh1 , h2 iH · · · αhh1 , hN iH 
 
A =  .. .. ... ... ..  . (4.8)
 . . . 
αTN αhhN , h1 iH αhhN , h2 iH · · · αhhN , hN iH + 1

Let λ = (λ0 , . . . , λN )T ∈ RN +1 such that Aλ = 0, that is,

N
X
Tk λk = 0
k=1
N
X
αTk λ0 + α hhk , hl iH λl + λk = 0, k = 1, . . . , N.
l=1
4.2. GENERAL CASE 61

Multiplying the latter equation with λk and summing up yields

° N °2 N
°X ° X
λ2k = 0.
° °
α° λk hk ° +
° °
k=1 H k=1

Hence λ = 0, whence A is non-singular.

The role of α is as follows:
• If α → 0 then by (4.3) and (4.6) we have f (u) ≡ f (0), a constant
function. That is, maximal regularity
Z T
(f 0 (u))2 du = 0
0

but no fitting of data, see (4.1).

• If α → ∞ then (4.7) implies that

Z Tk
f (u) du = Yk Tk , k = 1, . . . , N, (4.9)
0

a perfect fit. That is, f minimizes (4.2) subject to the constraints (4.9).
To estimate the forward curve from N zero-coupon bonds—that is, yields
Y = (Y1 , . . . , YN )T —one has to solve the linear system
µ ¶ µ ¶
f (0) 0
A· = (see (4.8)).
a Y

Of course, if coupon bond prices are given, then the above method has
to be modified and becomes nonlinear. With p ∈ Rn denoting the market
price vector and ckl the cashflows at dates Tl , k = 1, . . . , n, l = 1, . . . , N , this
reads
 Ã " N 
Z T n
X X · Z Tl ¸#!2 
min (f 0 )2 du + α log pk − log ckl exp − f du .
f ∈H  0 0 
k=1 l=1

If the coupon payments are small compared to the nominal (=1), then this
problem has a unique solution. This and much more is carried out in Lorim-
ier’s thesis.
62 CHAPTER 4. ESTIMATING THE YIELD CURVE

Exponential-Polynomial Families

Exponential-polynomial functions

p1 (x)e−α1 x + · · · + pn (x)e−αn x (pi =polynomial of degree ni )

form non-linear families of functions. Popular examples are:

Nelson–Siegel (87) [21] There are 4 parameters z1 , . . . , z4 and

φN S (x; z) = z1 + (z2 + z3 x)e−z4 x .

Svensson (94) [27] (Prof. L. E. O. Svensson is at the Economics Depart-

ment, Princeton University) This is an extension of Nelson–Siegel, in-
cluding 6 parameters z1 , . . . , z6 ,

φS (x; z) = z1 + (z2 + z3 x)e−z4 x + z5 e−z6 x .

Figure 4.10: Nelson–Siegel curves for z1 = 7.69, z2 = −4.13, z4 = 0.5 and 7

different values for z3 = 1.76, 0.77, −0.22, −1.21, −2.2, −3.19, −4.18.

5 10 15 20

Table 4.4 is taken from a document of the Bank for International Settle-
ments (BIS) 1999 [2].
4.2. GENERAL CASE 63

Table 4.4: Overview of estimation procedures by several central banks. BIS

1999 [2]. NS is for Nelson–Siegel, S for Svensson, wp for weighted prices.

Central Bank Method Minimized Error

Belgium S or NS wp
Canada S sp
Finland NS wp
France S or NS wp
Germany S yields
Italy NS wp
Japan smoothing prices
splines
Norway S yields
Spain S wp
Sweden S yields
UK S yields
USA smoothing bills: wp
splines bonds: prices

Criteria for Curve Families

• Flexibility (do the curves fit a wide range of term structures?)

• Number of factors not too large (curse of dimensionality).

• Regularity (smooth yield or forward curves that flatten out towards the
long end).

• Consistency: do the curve families go well with interest rate models?

→ this point will be exploited in the sequel.
64 CHAPTER 4. ESTIMATING THE YIELD CURVE
Chapter 5

Why Yield Curve Models?

→ R[23](Chapter 5)
Why modelling the entire term structure of interest rates? There is no
need when pricing a single European call option on a bond.
But: the payoffs even of “plain-vanilla” fixed income products such as caps,
floors, swaptions consist of a sequence of cashflows at T1 , . . . , Tn , where
n may be 20 (e.g. a 10y swap with semi-annual payments) or more.
→ The valuation of such products requires the modelling of the entire covari-
ance structure. Historical estimation of such large covariance matrices
is statistically not tractable anymore.
→ Need strong structure to be imposed on the co-movements of financial
quantities of interest.
→ Specify the dynamics of a small number of variables (e.g. PCA).
→ Correlation structure among observable quantities can now be obtained
analytically or numerically.
→ Simultaneous pricing of different options and hedging instruments in a
consistent framework.
This is exactly what interest rate (curve) models offer:
• reduction of fitting degrees of freedom → makes problem manageable.
=⇒ It is practically and intellectually rewarding to consider no-arbitrage
conditions in much broader generality.

65
66 CHAPTER 5. WHY YIELD CURVE MODELS?
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