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Interpolation Methods for CurveConstruction
PATRICK S. HAGAN* & GRAEME WEST**
*Bloomberg, LP, 499 Park Avenue, New York, NY 10022, USA, **Programme in Advanced Mathematics of Finance, School of Computational & Applied Mathematics, University of the Witwatersrand, Private Bag 3,Wits 2050, South Africa
(Received 30 November 2004; in revised form 6 July 2005)
A
BSTRACT
This paper surveys a wide selection of the interpolation algorithms that are in use in financial markets for construction of curves such as forward curves, basis curves, and mostimportantly, yield curves. In the case of yield curves the issue of bootstrapping is reviewed and how the interpolation algorithm should be intimately connected to the bootstrap itself is discussed.The criterion for inclusion in this survey is that the method has been implemented by a softwarevendor (or indeed an inhouse developer) as a viable option for yield curve interpolation. As will beseen, many of these methods suffer from problems: they posit unreasonable expections, or are noteven necessarily arbitrage free. Moreover, many methods lead one to derive hedging strategiesthat are not intuitively reasonable. In the last sections, two new interpolation methods (themonotone convex method and the minimal method) are introduced, which it is believed overcomemany of the problems highlighted with the other methods discussed in the earlier sections.
K
EY
W
ORDS
: Yield curve, interpolation, bootstrap
Curve Fitting
There is a need to value all instruments consistently within a single valuationframework. For this we need a risk-free yield curve which will be a continuous zerocurve (because this is the standard format, for all option pricing formulae). Thus, ayield curve is a function
r
5
r
(
t
), where a single payment investment for time
t
willearn a continuous rate
r
5
r
(
t
), that is, a payment of 1 at initiation will be redeemedby a payment of exp(
r
(
t
)
t
) at time
t
.As explained in Zangari (1977) and Lin (2002) term structure estimation methodscan be classified into two groups: theoretical and empirical. Theoretical termstructure methods typically posit an explicit structure for a variable known as theshort rate of interest, whose value depends on a set of parameters that might be
Correspondence Address:
Graeme West, Programme in Advanced Mathematics of Finance, School of Computational & Applied Mathematics, University of the Witwatersrand, Private Bag 3, Wits 2050, SouthAfrica. Tel.:
+
27-11-4472901; Email: graeme@finmod.co.za
Applied Mathematical Finance,Vol. 13, No. 2, 89–129, June 2006
1350-486X Print/1466-4313 Online/06/020089–41
#
2006 Taylor & FrancisDOI: 10.1080/13504860500396032
determined using statistical analysis of market variables. Early examples of theoretical methods include Vasicek (1977) and Cox
et al.
(1985). From such amethod the yield curve can be derived. Because the theoretical method isparsimonious, the yield curve will fall into one of a few basic categories in termsof shape. In some circumstances, negative rates are possible.Empirical methods are available to compute spot interest rates. Unlike thetheoretical methods, the empirical methods are independent of any model or theoryof the term structure. Whereas the theoretical methods attempt to explain typicalfeatures of the term structure, which may include how the term structure evolvesthrough time, the empirical methods merely try to find a close representation of theterm structure at any point in time, given some observed interest rate data.Later developments, in particular the approach of Hull and White (1990), allowedthe use of a empirically determined yield curve in a theoretical model. Furthermore,the classification scheme of Heath
et al.
(1990) takes as input the same empiricallydetermined yield curve. Thus, while the practitioner has several choices for thetheoretical model that will govern their evolution of the yield curve, and hencegovern their pricing of derivative products, they will almost certainly have as startingpoint an empirically determined yield curve. This document is concerned with thattask of determining the yield curve, a process typically called bootstrapping. In fact,our treatment is slightly more general, as it covers the construction of spread curves,forward curves, etc. as well.As explained in several sources, for example Ron (2000), there is no single correctway to complete the term structure of a yield curve from a set of rates. It is desiredthat the derived yield curve should be smooth, but there must not be over-smoothing, as this might cause the elimination of valuable market pricinginformation. It may or may not be a criterion that all inputs to the yield curveshould price back exactly after the construction of that curve, although we certainlyprefer an approach where there are fewer inputs and hence this perfect replication isfeasible. We will typically be following this approach, although the issue of errorminimization when there is a large set of inputs will be mentioned later. Certainlythis approach is completely feasible when bootstrapping a swap curve, it may or maynot be feasible when bootstrapping a bond curve, this will depend on the number of liquid bonds available in the market. Even when we require that the curve perfectlyreplicates the price of the input instruments, the yield curve is not constructeduniquely; we need to select an interpolation method with which to build the curve.In this paper we survey a wide, but not exhaustive, selection of the interpolationmethods that are in use in financial markets and their systems. In later sections weintroduce two new interpolation methods, which we believe overcome many of theproblemshighlightedwithothermethodsthathavebeendiscussedintheearliersections.
Desirable Features of an Interpolation Scheme
The criteria to use in judging a curve construction and its interpolation method thatwe will consider are:(1) In the case that we have a small set of instruments with which we are buildingan exact empirical curve, does this indeed occur? In the case that we are using a90
P. S. Hagan and G. West
large set of instruments, does the algorithm to find the best fit curve convergesufficiently rapidly, and is the degree of error in the created curve sufficientlysmall?(2) In the case of yield curves, how good do the forward rates look? These areusually taken to be the 1 month or 3 month forward rates, but these arevirtually the same as the instantaneous rates. We will want to have positivityand continuity of the forwards. It is required that forwards be positive to avoidarbitrage, while continuity is required as the pricing of interest-sensitiveinstruments is sensitive to the stability of forward rates. As pointed out inMcCulloch & Kochin (2000), ‘a discontinuous forward curve implies eitherimplausible expectations about future short-term interest rates, or implausibleexpectations about holding period returns’. Thus, such an interpolationmethod should probably be avoided, especially when pricing derivatives whosevalue is dependent upon such forward values.(3) How local is the interpolation method? If an input is changed, does theinterpolation function only change nearby, with no or minor spill-overelsewhere, or can the changes elsewhere be material?(4) Are the forwards not only continuous, but also stable? We can quantify thedegree of stability by looking for the maximum basis point change in theforward 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, forothers we can only derive estimates.(5) How local are hedges? Suppose we deal with an interest rate derivative of aparticular tenor. We assign a set of admissible hedging instruments, forexample, in the case of a swap curve, we might (even should) decree that theadmissible hedging instruments are exactly those instruments that were used tobootstrap the yield curve. Does most of the delta risk get assigned to thehedging instruments that have maturities close to the given tenors, or does amaterial amount leak into other regions of the curve?We will discuss criteria (1) and (2) as we proceed with each method that weanalyse. Criteria (3), (4) and (5) will be discussed much later.In most cases we have the rates
r
1
,
r
2
, …,
r
n
at the nodes
t
1
,
t
2
, …,
t
n
and need todetermine the rate
r
(
t
) where
t
is not necessarily one of the
t
i
. Occasionally we willhave the forward rates rather than the rates themselves, and are required to performthe interpolation on these. In these cases, we may wish to recover the rates using therelationship
f
t
ð Þ
~
LL
t
r
t
ð Þ
t
.For any
t
=
[
t
1
,
t
n
½
, the value of
r
(
t
) or
f
(
t
) will be that rate found at the nearer of
t
1
or
t
n
.Note that the forward is positive if and only if the capitalization function isincreasing, equivalently,
r
(
t
)
t
is increasing.
Interpolation and Bootstrap of Yield Curves – not two Separate Processes
As has been mentioned, many interpolation methods for curve construction areavailable. What needs to be stressed is that in the case of bootstrapping yield curves,
Interpolation Methods for Curve Construction
91
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