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Methodology for Constructing the Zero Coupon Yield Curve

Methodology for Constructing the Zero Coupon Yield Curve

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Published by Darryl Foo
Financial Engineering & Research paper I wrote on yield curve construction
Financial Engineering & Research paper I wrote on yield curve construction

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Published by: Darryl Foo on Aug 09, 2008
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Bondweb Malaysia Research Series

Methodology For Constructing the Zero Coupon Yield Curve
April 2008

Darryl Foo darrylfoo@bondweb.com.my Ken Poh ken@bondweb.com.my

Methodology For Constructing The Zero Coupon Yield Curve

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TABLE OF CONTENTS
1 2 3 3.1 3.2 3.3 3.4 3.5 4 4.1 4.2 5 5.1 5.2 5.3 6 6.1 7 Introduction Notation Basic Concepts 2 2 2

The Law Of One Price .................................................................................................................. 2 Zero Coupon Rates ...................................................................................................................... 3 Yield To Maturity........................................................................................................................... 3 The Coupon Effect........................................................................................................................ 3 Par Yield ....................................................................................................................................... 4 Yield Curve Construction 4

Par Yield Curve ............................................................................................................................ 4 Zero Coupon Yield Curve ............................................................................................................. 5 Bootstrapping Interpolation Functions 6

Linear Interpolation ....................................................................................................................... 6 Forward Constant Interpolation..................................................................................................... 7 Cubic Spline Interpolation ............................................................................................................. 7 Appendix 8

Cubic Spline Interpolation Mathematics........................................................................................ 8 References 10

Methodology For Constructing The Zero Coupon Yield Curve

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1

Introduction
The zero coupon yield curve is one of the most fundamental tool in finance and is essential in the pricing of various fixed income securities. Unfortunately, zero coupon rates are not observable in the market for a range of maturities. Therefore, an estimation methodology is required to derive the zero coupon yield curves from observable data. There are many methodologies and each can provide surprisingly different results. Nevertheless, each seeks to provide an estimation that fit the data well while maintaining an easily interpretable form. The primary objective of this paper is to provide a conceptual understanding of Bondweb Malaysia’s (BWM) methodology in yield curve construction, in particular, the zero coupon yield curve. BWM’s methodology contains fundamental yield curve modelling techniques while integrating local market practices and conventions.

2

Notation
Notation f(“ ”, “ ”, …, “ ”) t T ti(i=1,…,n) f c k=1,…,K F dr(t,T) y(t, T; c, f) = y r(t1, t2, ;f) = r df(t, T) CP(t,T;c,f) P(t,T;c,f) GP(t,T;c,f) AI Descriptions function with inputs “ ” start year end year / maturity future time coupon payment frequency in a year coupon amount time to coupon payment face amount = notional discount rate(%) yield to maturity(%) zero coupon rate (%) discount factor clean price gross price=dirty price accrued interest Remarks

t =t0<t1<t2<…<tn=T f=1, 2, 4, 12, ∞

if t1=t2, then the zero coupon rate represents from t1 to t2.

3

Basic Concepts
We briefly visit important concepts related to the construction of yield curves. For further details, readers are recommended to seek sources listed in the reference section.

3.1

The Law Of One Price The law of one price states that two securities with identical cash flows and risk should sell for the same price. Hence it is possible for a security to be priced identically to a combination of other securities by way of a replicating portfolio on the security’s cash flows.

Methodology For Constructing The Zero Coupon Yield Curve

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Figure 1.1a: Law of one price on a security and a replicating portfolio
Security with constant cash flow
c c c

Replicating Portfolio
c

Security and the portfolio should yield the same price
c

c

3.2

Zero Coupon Rates A zero coupon rate is an interest rate or bond yield that corresponds to a single cash payment at a single point of time in the future. Also commonly known as spot rates, it is the compounded return from investing in a zero coupon bond with t time to maturity. By the law of one price, a coupon bond is identical to a replicating portfolio of zero coupon bonds. Thus, pricing the coupon bond is equivalent to summing its cash flows and discounting each cash flow with the corresponding zero coupon rates at the specific time of coupon dissemination.

3.3

Yield To Maturity The yield to maturity (YTM) is a single rate that represents the internal rate of return of a bond’s stream of cash flows. In other words, it can be seen as the average of a portfolio of zero coupon rates weighted by the timing of the corresponding cash flows with an assumption that all intermediate cash flows are reinvested. In simple mathematics, the relationship between YTM and zero coupon rates is defined as follows: P + AI

=∑

c F c c c F + = + + ... + + k n 2 n 1 + r1 (1 + r2 ) (1 + y ) (1 + rn ) (1 + rn ) n k =1 (1 + y )

n

The left equation represents pricing for a fixed coupon bond discounted with the YTM, y, and the right equation is pricing using the zero coupon rates, r. By pricing using r, the coupon bond’s cash flows are discounted with the zero coupon rates corresponding to the appropriate timing of cash flow dissemination. 3.4 The Coupon Effect Since YTM is seen as a time weighted average of cash flow returns, it follows that coupon levels will have an impact on the resulting yield. Thus two bonds with differing coupons but same maturities will have different YTM. This is called the coupon effect. Because of the coupon effect, using YTM to price a bond can only be done for the specific bond to which it was derived from. Zero coupon rates though, can be used to price any single cash flow as

Methodology For Constructing The Zero Coupon Yield Curve

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it is not affected by the coupon effect.

3.5

Par Yield Par yield is an YTM rate that a bond would have if priced at approximately its par, i.e. a bond’s YTM must equal to its coupon rate. This means in curve terms, samples of bonds are used to estimate the hypothetical par yields at the given tenure followed by usage of estimation methodologies to obtain a good fit to all the observed YTMs. It is the theoretical rate for the various YTMs of existing bonds that have the same maturity to provide par valuation. Like YTMs, par yield is a time weighted average of zero coupon rates with reinvestment assumption but its representation is for the sample at the specific tenure rather than a single bond.

4

Yield Curve Construction
As mentioned, zero coupon rates are often not observable in the market hence estimation methodology is required to derive the zero coupon curves from observable data. On the other hand, the availability of market data such as YTM and YTM derived prices means par yield curves may be modelled and constructed directly. Recall that the par yield is an aggregation of observed YTMs for a given tenure. For example, a sample of seven year tenure AAA bonds traded and issued at par for the day may be used to derive the AAA par yield curve’s rate at seven year tenure point. Therefore, critical to the construction of zero coupon yield curves are par yield curves. After the par yield curve is constructed, using bootstrapping techniques, zero coupon yield curves are extracted from the constant maturity par yield curves.

4.1

Par Yield Curve Two important issues are addressed; curve tenure point selection and data sample of observable rates. Prior to constructing the par yield curve, constant tenure points are set. Classification of tenure points would be above the mean of the preceding adjacent tenure point to the mean of the next adjacent tenure point. For example, if the set tenure points are 5, 7 and 10 years, seven year tenure point is defined as time to maturity of above 6 to 8.5 years i.e. 6 < tenure(7) < 8.5. Raw data are then sourced for manipulation. Data sources include: Broker’s live quotes End of day indicative quotes Daily trades BWM’s mark to market rates Interest rate swaps Bankers’ weekly par yield curve contribution KLIBOR rates Indicative deposit rates or deposit rate fixings Overnight policy rates Repo rates Bankers acceptance rate Bills Bands

Included for short term tenure points

The raw data are aggregated based on a ranged period into a segmented sample pool for each Bondweb Research Series April 2008

Methodology For Constructing The Zero Coupon Yield Curve

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class. For example, a cumulation of one week data prior from today for the AAA par yield curve. In most cases, due to the Malaysian bond market’s illiquidity, a ranged period is necessary in order to obtain enough samples. The data samples are then filtered. Several filtration methods are done. One of which involves omitting traded data samples which transacted at off market levels. These may include pass through, position parking, cross trading and odd lot transactions. Once data samples are segmented to their relevant classes and tenure points, the corresponding yield points are derived using an averaging function on all the filtered samples. 4.2 Zero Coupon Yield Curve Once the par yield curve is obtained, the zero coupon yield curve may be extracted using a recursive technique called bootstrapping. The technique essentially breaks down the par yield curve into its cash flows and values each independent cash flow separately as a single zero coupon bond, r1 ,..., ri −1 , ri , ri +1 ... . Using descriptive notation, the concept is described in the following. First, assume that r1 ,..., ri −1 have been calculated through the bootstrapping procedure from security 1 to security i-1 (setting reasonable arbitrary numbers accepted). Security i is a bond with coupon rate c that is paid semi-annually. Therefore the price of the bond can be computed with the following formula:

pt n (c;2) =
where

c n ∑ exp(−r (t , tk ) × tk ) + exp(−r (t , tn) × tn) × FaceValue 2 k =1

t k = T k (k=1,…,K) is the time to coupon payment
r (t , tk ) = r k is the continuously compounding spot rate of t K
By assuming that the spot rates r of unknowns to one.
K −2

, r

K −1

, r

K

and ri are dependent through an interpolation

function, all but one spot rate ri is unknown; the rest are determined from it, bringing the number

r 1 = f (r1 , r2 ,..ri−1 , T 1 ) r 2 = f (r1 , r2 ,..ri−1 , T 2 )
. . . well defined inputs with function makes r known

r K −3 = f (r1 , r2 ,..ri −1 , T K −3 ) r K −2 = f (r1 , r2 ,..ri −1 , ri , T K − 2 ) r
K −1 K

= f (r1 , r2 ,..ri −1 , ri , T
K

K −1

)

despite having a well defined function, r is not known because of undefined rate ri

r = f (r1 , r2 ,..ri −1 , ri , T )
Although

ri is unknown, i bond’s price, is given by the market. Since ri can be derived by the

bond pricing formula stated above (given the price of the bond), then the rest of the unknown rates can be determined by interpolation functions. There are three interpolation functions; Linear Function, Cubic Function, and Constant Forward Step. Figure 4.2a illustrates the difference between the three interpolation functions.

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Methodology For Constructing The Zero Coupon Yield Curve

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Figure 4.2a: Illustration of curves generated by the linear, cubic and constant forward interpolations

Rate Constant Forward

ri

Linear Cubic

ri −1

Ti −1

T K −2

T K −1

T K = Ti

Time

BWM uses the cubic spline interpolation function. Cubic spline interpolation has a favourable smoothing effect which is able to reflect the concave property of rate curves particularly at longer tenure points. Since the data samples generally have different conventions, all zero coupon rates are converted to a common day count basis of Actual/Actual, semiannual compounding and settlement date of one day (T+1).

5

Bootstrapping Interpolation Functions
During bootstrapping and curve fitting, one may come across unknown variables given a set of known inputs. Interpolation functions would then be needed. Three common interpolation functions are discussed. Cubic spline interpolation mathematics is discussed in the appendix section.

5.1

Linear Interpolation

r K − 2 = f (r1 , r2 ,..., ri −1 , ri , T K − 2 ) = ri −1 + (ri − ri −1 ) × r K −1 = f (r1 , r2 ,..., ri −1 , ri , T K −1 ) = ri −1 + (ri − ri −1 ) × r K = f (r1 , r2 ,..., ri −1 , ri T K ) = ri −1 + (ri − ri −1 ) ×

T K − 2 − Ti −1 Ti − Ti −1

T K −1 − Ti −1 Ti − Ti −1

T K − Ti −1 = ri Ti − Ti −1

Bondweb Research Series April 2008

Methodology For Constructing The Zero Coupon Yield Curve

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5.2

Forward Constant Interpolation

ri can be directly derived from the instantaneous forward rate f i as follows:

ri =

1 (ri −1 × Ti −1 + f i × (Ti − Ti −1 )) Ti f i instead of ri . Assume that f s is constant for the

Therefore, Constant Forward calibrates range Hence

s ∈ [Ti −1 , Ti ) . r K − 2 , r K −1 , and r K are computed by
1 T
K −2

r K −2 = r K −1 =

(ri −1 × Ti −1 + f i × (T K − 2 − Ti −1 ))

1 (ri −1 × Ti −1 + f i × (T K −1 − Ti −1 )) T K −1 1 r K = K (ri −1 × Ti −1 + f i × (T K − Ti −1 )) = ri T

For further details, readers are recommended to refer to reference [3].

5.3

Cubic Spline Interpolation Let r = a i + bi t + ci t + d i t
2 3

t ∈ [Ti −1 , Ti ] , i =1, 2, …, n

To estimate the parameters a i , bi , ci , and d i , the following equations are established (1) ri −1 = a i + bi Ti −1 + ci Ti −1 + d i Ti −1
2 3

i = 1,..,n i = 1,..,n
2

(2) ri = a i + bi Ti + ci Ti + d i Ti
2 2

3

(3) bi −1 + 2ci −1Ti −1 + 3d i −1Ti −1 = bi + 2c i Ti −1 + 3d i Ti −1 (4) 2ci −1

i = 2,..,n i = 2,..,n

+ 6d i −1Ti −1 = 2ci + 6d i Ti −1

where Eq. 3 is the first order differentiation and Eq. 4 is the second order differentiation. But, the above equations require two more equations to estimate the parameters because the number of unknown, 4n, is greater than the number of the equation, 4n-2. To overcome this, usually the first order differentiations of the start point and last point assume the following: (5) the first order differentiation of start point = 0 (6) the first order differentiation of last point = the first order differentiation of last-1 point After the parameters of the cubic function have been estimated, r computed by:
K −2

, r

K −1

, and r

K

can be

r K −2 = ai + bi (T K − 2 ) + ci (T K − 2 ) 2 + d i (T K −2 ) 3
r K −1 = ai + bi (T K −1 ) + ci (T K −1 ) 2 + d i (T K −1 ) 3
Bondweb Research Series April 2008

Methodology For Constructing The Zero Coupon Yield Curve

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r K = ai + bi (T K ) + ci (T K ) 2 + d i (T K ) 3 = ri
For further details, readers are recommended to refer to reference [5] and [6].

6
6.1

Appendix
Cubic Spline Interpolation Mathematics Cubic spline interpolation is a numerical method to draw smooth lines through a number of data points. Figure 6.1a: Illustration of Cubic Spline Interpolation
Cubic spline 3 Cubic spline 2 Knot Point 1-2

Knot Point 0-1 Cubic spline1

Using a cubic polynomial form, weights are used to concave / convex the line without breaking the line’s continuity as it passes through each data points. Under a third degree polynomial function, the form is defined as:

r (t ) = ai + bi (t − t i ) + ci (t − t i ) 2 + d i (t − t i ) 3

i=0,1,2,…,(n-1)

Eq(1)

As it is continuous, the cubic spline will connect two end points (knots) t i , t i +1 of the i-th interval. Naturally, the first order (representing ‘slope’) and second order (representing ‘curvature’) will also be continuous. Hence, r(t) may be defined as:

r (t i ) = z i = ai + bi (t i − t i ) + ci (t i − t i ) 2 + d i (t i − t i ) 3 = ai r (t i +1 ) = z i +1 = ai + bi (t i +1 − t i ) + ci (t i +1 − t i ) + d i (t i +1 − t i )
2 3

Eq(2) Eq(3)

First and second order derivative of r(t) is then defined as:

r ' (t ) = z ' (t ) = bi + 2ci (t − t i ) + 3d i (t − t i ) 2 r ' ' (t ) = z ' ' (t ) = 2ci + 6d i (t − t i )
Simplifying, define

Eq(4) Eq(5)

hi = t i +1 − t i and r ' ' = z ' ' (t i ) = M i
Eq(3) now is defined as

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Methodology For Constructing The Zero Coupon Yield Curve

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z i +1 = ai + bi hi + ci hi2 + d i hi3
Coefficients bi , ci , d i can now be defined using M. From Eq(5);

Eq(6)

M i = 2ci + 6d i (t i − t i ) = 2ci M i +1 = 2ci + 6d i (t i +1 − t i ) = 6d i hi 2ci M ci = i 2 M − Mi d i = i +1 6hi

Eq(7) Eq(8) Eq(9) Eq(10)

Using values of a i , ci , d i given by Eq(2), Eq(9) and Eq(10), we obtain from Eq(3)

M i 2 M i +1 − M i 3 hi + hi 2 6hi z − z i 2hi M i + hi M i +1 bi = i +1 − 6 hi z i +1 = z i + bi hi +

Eq(11)

At each knot points, the second order (slope) of two cubics meeting at ( t i , z i ) are equal from (i-1)th and i-th intervals. Hence at t = t i , Eq(4)’s left end in the i-th interval is:

z ' (t i ) = z ' i = 3d i (t i − t i ) 2 + 2ci (t i − t i ) + bi = bi

Eq(12)

while in the (i-1)-th interval ( t i −1 , t i ), the slope at the right end at t = t i is:

z ' (t i ) = z ' i = 3d i −1 (t i − t i −1 ) 2 + 2ci −1 (t i − t i −1 ) + bi −1 = 3d i −1 hi2−1 + 2ci −1 hi −1 + bi −1

Eq(13)

Now we connect the left and right end of the slope and equate Eq(12) and Eq(13) while using Eq(9), Eq(10) and Eq(11) to obtain:

z i +1 − z i 2hi M i + hi M i +1 − 6 hi M − M i −1 2 z − z i −1 2hi −1 M i −1 + hi −1 M i =3 i hi −1 + M i −1 hi −1 + i − 6hi −1 6 hi −1
Simplifying, we obtain:

Eq(13)

⎛ z − z i z i − z i −1 ⎞ ⎟ − hi −1 M i −1 + (2hi −1 + 2hi ) M i + hi M i +1 = 6⎜ i −1 ⎜ h hi −1 ⎟ i ⎝ ⎠

Eq(14)

Eq(14) is a form of (n-1) linear equations in (n+1) unknowns of M. To solve M, there are many types of end conditions discussed in various literatures (natural splines, parabolic runout spline, cubic runout spline, clamped cubic spline, constrained spline etc.) which has its own assumptions. The most popular would be the natural spline:

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Methodology For Constructing The Zero Coupon Yield Curve

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r0 = rn = 0 ∴M0 = Mn = 0
With the assumption of natural spline end conditions, Eq(14) would give us:

⎛ z − z1 z1 − z 0 ⎞ ⎟ − 2(h0 + hi ) M 1 + h1 M 2 = 6⎜ 2 ⎜ h h0 ⎟ 1 ⎝ ⎠ ⎛ z − z i z i − z i −1 ⎞ ⎟ hi −1 M i −1 + 2(hi −1 + hi ) M 1 + hi M i +1 = 6⎜ i +1 − ⎜ h hi −1 ⎟ i ⎝ ⎠ ⎛ z − z n z n −1 − z n − 2 hn − 2 M n − 2 + 2(hn − 2 + hn −1 ) M n −1 = 6⎜ n +1 − ⎜ h hn − 2 n −1 ⎝
where i = 2,3…,(n-2) In matrix notation;

⎞ ⎟ ⎟ ⎠

⎫ ⎪ ⎪ ⎪ ⎪ ⎬ ⎪ ⎪ ⎪ ⎪ ⎭

Eq(15)

h1 ⎡2(h0 + h1 ) ⎢ 2(h1 + h2 ) h1 ⎢ ⎢ ⎢ ⎣

h2 M hn − 2 2(hn − 2

⎡ z 2 − z1 z1 − z 0 ⎤ − ⎢ ⎥ h1 h0 ⎢ ⎥ M1 ⎤ ⎤ ⎡ ⎢ z 3 − z 2 z 2 − z1 ⎥ ⎥ ⎢M ⎥ − ⎥ ⎥ × ⎢ 2 ⎥ = 6⎢ h2 h1 ⎢ ⎥ ⎥ ⎢M ⎥ ⎢ ⎥ M ⎥ ⎢ ⎥ + hn +1 )⎦ ⎣ M n −1 ⎦ ⎢ ⎥ ⎢ z n − z n −1 − z n −1 − z n − 2 ⎥ ⎢ hn −1 hn − 2 ⎥ ⎣ ⎦

As an (n-1 x n-1) tridiagonal system, Crout’s reduction method can be used to solve the matrix. Solving the matrix will provide coefficients a,b,c and d which would then allow r(t)s to be solved. For further details, readers are recommended to refer to reference [6]. There are numerous algorithms to compute the mathematics such as those offered in reference [5] and software packages such as Matlab from MathWorks.

7

References
[1] Bolder, D., Stréliski, D., (1999), “Yield Curve Modelling at the Bank of Canada”, http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1082845_code495799.pdf?abstractid=1082 845&mirid=1 [accessed 4 Apr 2008] Fabozzi, F.J., (2005), The Handbook of Fixed Income Securities (7th edition), New York, McGraw-Hill Malz, A., (2002), “Estimation of zero-coupon curves in DataMetrics”, RiskMetrics Journal, Volume 3(1), pp. 27-39 McKinley, S., Levine, M., (1998), “Cubic Spline Interpolation”, http://online.redwoods.cc.ca.us/instruct/darnold/laproj/Fall98/SkyMeg/Proj.PDF [accessed 4 Apr 2008]

[2]

[3]

[4]

Bondweb Research Series April 2008

Methodology For Constructing The Zero Coupon Yield Curve

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[5]

Press, W.H., et al, Numerical Recipe in C: The Art of Scientific Computing (2 York, Cambridge University Press

nd

Edition), New

[6]

Rao, K.S., (2007), Numerical Methods for Scientists and Engineers (3rd Edition), New Delphi, Prentice Hall India Tuckman, B., (2002), Fixed Income Securities (2 Edition), New Jersey, John Wiley & Sons
nd

[7]

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