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A Brief Comparison of Interpolation Methods in Yield Curve Construction

This 3-page document compares various interpolation methods for constructing yield curves, including linear, piecewise linear, quadratic, cubic, and monotone convex methods. It evaluates the methods based on their ability to produce positive forward rates, continuous forwards, local changes, stable forwards under input changes, and local hedges. The monotone convex method is identified as the best performing and only method that adequately satisfies all evaluation criteria. In conclusion, while the best method depends on the specific application, the monotone convex method is recommended as it performs well on all qualitative and quantitative measures outlined.

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353 views3 pages

A Brief Comparison of Interpolation Methods in Yield Curve Construction

This 3-page document compares various interpolation methods for constructing yield curves, including linear, piecewise linear, quadratic, cubic, and monotone convex methods. It evaluates the methods based on their ability to produce positive forward rates, continuous forwards, local changes, stable forwards under input changes, and local hedges. The monotone convex method is identified as the best performing and only method that adequately satisfies all evaluation criteria. In conclusion, while the best method depends on the specific application, the monotone convex method is recommended as it performs well on all qualitative and quantitative measures outlined.

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mannyishere
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Contents

1 Curve Construction Quality Criteria 2 A comparison of the methods 3 Conclusions 2 2 3

A brief comparison of interpolation methods for yield curve construction

Financial Modelling Agency Tel: +27 11 447 2901 Fax: +27 11 447 2901 Website: www.nmod.co.za General E-mail: [email protected] Physical Address: 19 First Avenue East Parktown North Gauteng 2193 South Africa 6 April 2009 Authors: Graeme West [email protected]
In our opinion, the following conditions are essential desiderata of a yield curve bootstrap: (1) all input instruments to the bootstrap are exactly reproduced as outputs of the bootstrap, (2) the instantaneous forward curve is guaranteed to be positive if the inputs allow it (in particular, the curve is arbitrage free), and (3) the instantaneous forward curve is typically continuous. In Hagan and West [2006], Hagan and West [2008] several interpolation methods are considered. All of the methods considered there satisfy the nance exactly, for any input set which is not too dense. There a new method of interpolation is introduced, the monotone convex method. To the best of our knowledge the monotone convex method is the rst published method where the above criteria are satised. In addition, as bonuses (4) the method is local i.e. changes in inputs at a certain location do not aect in any way the value of the curve at other locations. (5) the forwards are stable i.e. as inputs change, the instantaneous forwards change more or less proportionately. (6) hedges constructed by perturbations of this curve are reasonable and stable.

Page 1 of 3

Financial Modelling Agency

www.nmod.co.za

A brief comparison of interpolation methods for yield curve construction

6 April 2009

Curve Construction Quality Criteria

The criteria to use in judging a curve construction and interpolation should be: (a) In the case of yield curves, is the curve arbitrage free? Thus we want positivity of the forwards. (b) In the case of yield curves, how good do the forward rates look? These are usually taken to be the 1m or 3m forward rates, but these are virtually the same as the instantaneous rates. We want as much as possible continuity of the forwards. (c) How local is the interpolation method? If an input is changed, does the interpolation function only change nearby, with no or minor spill-over elsewhere, or can the changes elsewhere be material? (d) Are the forwards not only continuous, but also stable? We can quantify the degree of stability by looking for the maximum basis point change in the forward curve given some basis point change (up or down) in one of the inputs. Many of the simpler methods can have this quantity determined exactly, for others we can only derive estimates. (e) How local are hedges? Suppose we deal an interest rate derivative of a particular tenor. We assign a set of admissible hedging instruments, for example, in the case of a swap curve, we might (even should) decree that the admissible hedging instruments are exactly those instruments that were used to bootstrap the yield curve. Does most of the delta risk get assigned to the hedging instruments that have maturities close to the given tenors, or does a material amount leak into other regions of the curve?

A comparison of the methods


Forwards Yield curve type positive? Linear on discount Linear on rates Raw (linear on log of discount) Linear on the log of rates Piecewise linear forward Quadratic Natural cubic Hermite/Bessel Financial Quadratic natural Hermite/Bessel on rt function Monotone piecewise cubic Quartic Monotone convex (unameliorated) Monotone convex (ameliorated) Minimal no no yes no no no no no no no no no no yes yes no not not not not Forward smoothness continuous continuous continuous continuous continuous continuous smooth smooth smooth smooth smooth continuous smooth continuous continuous continuous Method Forwards Bump hedges local? stable? local? excellent excellent excellent excellent poor poor poor very good poor poor very good very good poor very good good poor excellent excellent excellent excellent very poor very poor good good good good good good very poor good good good very good very good very good very good very poor very poor poor poor poor poor poor good very poor good good very poor

Table 1: A synopsis of the comparison between methods

Page 2 of 3

Financial Modelling Agency

www.nmod.co.za

A brief comparison of interpolation methods for yield curve construction

6 April 2009

Conclusions

It is our opinion that the monotone convex method should be the method of choice for interpolation as it is the only method that we know of which performs well on all the criteria agged. (In fact, it is the only method which even performs adequately under all the criteria: the fact that it performs well is a bonus.) In the nal analysis, the choice of which method to use will always be subjective, and needs to be decided on a case by case basis. But we hope to have provided some warning ags about many of the methods, and have outlined several qualitative and quantitative criteria for making the selection in which method to use.

References
Patrick S. Hagan and Graeme West. Interpolation methods for curve construction. Applied Mathematical Finance, 13(2):89129, 2006. 1 Patrick S. Hagan and Graeme West. Methods for constructing a yield curve. WILMOTT Magazine, May:7081, 2008. URL http://www.finmod.co.za/interpreview.pdf. 1

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Financial Modelling Agency

www.nmod.co.za

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