Professional Documents
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Patrick S. Hagan
Chief Investment Office, JP Morgan 100 Wood Street London, EC2V 7AN, England,
e-mail: patrick.s.hagan@jpmorgan.com
Graeme West
Financial Modelling Agency, 19 First Ave East, Parktown North, 2193, South Africa
e-mail: graeme@finmod.co.za, www.finmod.co.za
Abstract
In this paper we survey a wide selection of the interpolation algorithms that are in input is perturbed (the method is not local). In Hagan and West [2006] we introduced
use in financial markets for construction of curves such as forward curves, basis two new interpolation methods—the monotone convex method and the minimal
curves, and most importantly, yield curves. In the case of yield curves we also review method. In this paper we will review the monotone convex method and highlight
the issue of bootstrapping and discuss how the interpolation algorithm should be in- why this method has a very high pedigree in terms of the construction quality crite-
timately connected to the bootstrap itself. ria that one should be interested in.
As we will see, many methods commonly in use suffer from problems: they posit un-
reasonable expections, or are not even necessarily arbitrage free. Moreover, many Keywords
methods result in material variation in large sections of the curve when only one yield curve, interpolation, fixed income, discount factors
1 Basic Yield Curve Mathematics every redemption date t. In fact, such bonds rarely trade in the market.
Rather what we need to do is impute such a continuum via a process
Much of what is said here is a reprise of the excellent introduction in known as bootstrapping.
[Rebonato, 1998, §1.2]. It is more common for the market practitioner to think and work in
The term structure of interest rates is defined as the relationship be- terms of continuously compounded rates. The time 0 continuously com-
tween the yield-to-maturity on a zero coupon bond and the bond’s matu- pounded risk free rate for maturity t, denoted r(t), is given by the rela-
rity. If we are going to price derivatives which have been modelled in tionship
continuous-time off of the curve, it makes sense to commit ourselves to
using continuously-compounded rates from the outset. C(0, t) = exp(r(t)t) (1)
Now is denoted time 0. The price of an instrument which pays 1 unit of
currency at time t—such an instrument is called a discount or zero coupon Z(0, t) = exp(−r(t)t) (2)
bond—is denoted Z (0, t). The inverse of this amount could be denoted 1
r(t) = − ln Z(0, t) (3)
C(0, t) and called the capitalisation factor: it is the redemption amount t
earned at time t from an investment at time 0 of 1 unit of currency in said
zero coupon bonds. The first and most obvious fact is that Z(0, t) is decreas- In so-called normal markets, yield curves are upwardly sloping, with
ing in t (equivalently, C (0, t ) is increasing). Suppose Z(0,t1) < Z (0,t2) for some longer term interest rates being higher than short term. A yield curve
t1 < t2. Then the arbitrageur will buy a zero coupon bond for time t1 , and which is downward sloping is called inverted. A yield curve with one or
sell one for time t2 , for an immediate income of Z(0,t2)—Z(0,t1) > 0. At time t1 more turning points is called mixed. It is often stated that such mixed
they will receive 1 unit of currency from the bond they have bought, which yield curves are signs of market illiquidity or instability. This is not the
they could keep under their bed for all we care until time t2 , when they de- case. Supply and demand for the instruments that are used to bootstrap
liver 1 in the bond they have sold. the curve may simply imply such shapes. One can, in a stable market
What we have said so far assumes that such bonds do trade, with suf- with reasonable liquidity, observe a consistent mixed shape over long pe-
ficient liquidity, and as a continuum i.e. a zero coupon bond exists for riods of time.
70 WILMOTT magazine
TECHNICAL ARTICLE 2
d
f (t) = − ln(Z(t)) (7)
1 dt
Z (0, t2)
d
= r(t)t (8)
dt
0 t1 t2
Z (0, t1) So f (t) = r(t) + r (t)t , so the forward rates will lie above the yield
1 curve when the yield curve is normal, and below the yield curve when it
is inverted. By integrating,1
t
Figure 1: The arbitrage argument that shows that Z(0, t) must be decreasing. r(t)t = f (s)ds (9)
0
t
Z(t) = exp − f (s)ds (10)
0
The shape of the graph for Z(0, t) does not reflect the shape of the
yield curve in any obvious way. As already mentioned, the discount factor Also
curve must be monotonically decreasing whether the yield curve is nor-
ri ti − ri−1 ti−1 1 ti
mal, mixed or inverted. Nevertheless, many bootstrapping and interpola- = f (s)ds (11)
ti − ti−1 ti − ti−1 ti− 1
tion algorithms for constructing yield curves miss this absolutely
fundamental point. which shows that the average of the instantaneous forward rate over any
Interestingly, there will be at least one class of yield curve where the of our intervals [ti−1 , ti ] is equal to the discrete forward rate for that inter-
above argument for a decreasing Z function does not hold true — a real val. Finally,
(inflation linked) curve. Because the actual size of the cash payments t
that will occur are unknown (as they are determined by the evolution of r(t)t = ri−1 ti−1 + f (s)ds, t ∈ [ti−1 , ti ] (12)
a price index, which is unknown) the arbitrage argument presented ti− 1
above does not hold. Thus, for a real curve the Z function is not necessar- which is a crucial interpolation formula: given the forward function we
ily decreasing (and empirically this phenomenon does on occasion easily find the risk free function.
occur).
WILMOTT magazine 71
n might be risk free rates, forward rates, or some transformation of these—
[A ] = pi Z(0; tsettle , ti ) the log of rates, etc. Of course, many choices of interpolation function are
i=0
possible — according to the nature of the problem, one imposes require-
where
ments additional to continuity, such as differentiability, twice differen-
• A is the all-in (dirty) price of the bond; tiability, conditions at the boundary, and so on.
• tsettle is the date on which the cash is actually delivered for a pur- The Lagrange polynomial is a polynomial of degree n − 1 which pass-
chased bond; es through all the points, and of course this function is smooth. However,
• p0 , p1 , . . . , pn are the cash flows associated with a unit bond (typical- it is well known that this function is inadequate as an interpolator, as it
ly p0 = e 2c , pi = 2c for 1 ≤ i < n and pn = 1 + 2c where c is the annual demonstrates remarkable oscillatory behaviour.
coupon and e is the cum-ex switch); The typical approach is to require that in each interval the function is
• t0 , t1 , . . . , tn are the dates on which those cash flows occur. described by some low dimensional polynomial, so the requirements of
On the left is the price of the bond trading in the market. On the continuity and differentiability reduce to linear equations in the coeffi-
right is the price of the bond as stripped from the yield curve. We rewrite cients, which are solved using standard linear algebraic techniques. The
this in the computationally more convenient form simplest example are where the polynomials are linear, and these meth-
ods are surveyed in §4. However, these functions clearly will not be differ-
n
[A ] Z(0, tsettle ) = pi Z(0, ti ) (13) entiable. Next, we try quadratics—however here we have a remarkable
i=0 ‘zig-zag’ instability which we will discuss. So we move on to cubics—or
even quartics—they overcome these already-mentioned difficulties, and
Suppose for the moment that the risk free rates (and hence the dis-
we will see these in §5.
count factors) have been determined at t0 , t1 , . . . , tn−1 . Then we solve
All of the interpolation methods considered in Hagan and West [2006]
Z(0, tn ) easily as
appear in the rows of Table 1.
1
n−1
We will restrict attention to the case where the number of inputs is
Z(0, tn ) = [A ] Z(0, tsettle ) − pi Z(0, ti )
pn reasonably small and so the bootstrapping algorithm is able to price the
i=0
instruments exactly, and we restrict attention to those methods where
which is written in the form of risk-free rates rather than discount fac-
the instruments are indeed always priced exactly.
tors as
The criteria to use in judging a curve construction and its interpola-
1
n−1
tion method that we will consider are:
rn = ln pn − ln [A ] e −rsettle tsettle
− pi e −ri ti
(14)
tn
i=0 (a) In the case of yield curves, how good do the forward rates look? These
where the ti ’s are now denominated in years and the relevant day-count are usually taken to be the 1m or 3m forward rates, but these are vir-
convention is being adhered to. Of course, in general, we do not know the tually the same as the instantaneous rates. We will want to have posi-
earlier rates, neither exactly (because it is unlikely that any money mar- tivity and continuity of the forwards.
ket instruments expire exactly at ti ) nor even after some interpolation It is required that forwards be positive to avoid arbitrage, while
(the rates for the smallest few ti might be available after interpolation, continuity is required as the pricing of interest sensitive instruments
but the later ones not at all). However, as in the case of swap curves, (14) is sensitive to the stability of forward rates. As pointed out in
suggests an iterative solution algorithm: we guess rn , indeed other ex- McCulloch and Kochin [2000], ‘a discontinuous forward curve implies
piry-date rates for other bonds, and take the rates already known from either implausible expectations about future short-term interest
e.g. the money market, and insert these rates into our interpolation algo- rates, or implausible expectations about holding period returns’.
rithm. We then determine rsettle and r0 , r1 , . . . , rn−1 . Next, we insert these Thus, such an interpolation method should probably be avoided, es-
rates into the right-hand side of (14) and solve for rn . We then take this pecially when pricing derivatives whose value is dependent upon
new guess for this bond, and for all the other bonds, and again apply the such forward values.
interpolation algorithm. We iterate this process. Even for fairly wild Smoothness of the forward is desirable, but this should not be
curves (such as can often be the case in South Africa) this iteration will achieved at the expense of the other criteria mentioned here.
reach a fixed point with accuracy of about 8 decimal places in 4 or 5 iter- (b) How local is the interpolation method? If an input is changed, does
ations. This then is our yield curve. the interpolation function only change nearby, with no or minor
spill-over elsewhere, or can the changes elsewhere be material?
(c) Are the forwards not only continuous, but also stable? We can quanti-
3 How To Compare Yield Curve fy the degree of stability by looking for the maximum basis point
change in the forward curve given some basis point change (up or
Interpolation Methodologies down) in one of the inputs. Many of the simpler methods can have this
In general, the interpolation problem is as follows: we have some data x quantity determined exactly, for others we can only derive estimates.
as a function of time, so we have τ1 , τ2 , . . . , τn and x1 , x2 , . . . , xn known. (d) How local are hedges? Suppose we deal an interest rate derivative of a
An interpolation method is one that constructs a continuous function particular tenor. We assign a set of admissible hedging instruments,
x(t) satisfying x(τi ) = xi for i = 1, 2, . . . , n . In our setting, the x values for example, in the case of a swap curve, we might (even should)
72 WILMOTT magazine
TECHNICAL ARTICLE 2
decree that the admissible hedging instruments are exactly those in- t − ti−1 ti − t
Z(t) = Zi + Zi−1
struments that were used to bootstrap the yield curve. Does most of ti − ti−1 ti − ti−1
the delta risk get assigned to the hedging instruments that have ma-
which as a rate formula is
turities close to the given tenors, or does a material amount leak into
other regions of the curve? −1 t − ti−1 −ri ti ti − t −ri− 1 ti− 1
r(t) = ln e + r (18)
t ti − ti−1 ti − ti−1
We will now survey a handful of these methods, and highlight the issues
that arise. Again, the forward jumps at each node, and the Z function may not be
decreasing.
WILMOTT magazine 73
Curve, first scenario. Forward, first scenario. 5.1 Quadratic splines
0.07 0.2
To complete a quadratic spline of a function x, we desire coefficients
0.065 0.15
(ai , bi , ci ) for 1 ≤ i ≤ n − 1 . Given these coefficients, the function value at
0.06 0.1 any term τ will be
0.055 0.05
x(τ ) = ai + bi (τ − τi ) + ci (τ − τi )2 τi ≤ τ ≤ τi+1 (20)
0.05 0
0.045 −0.05 The constraints will be that the interpolating function indeed meets
0 5 10 0 5 10 the given data (and hence is continuous) and the entire function is
Curve, second scenario. Forward, second scenario.
differentiable. There are thus 3n − 4 constraints: n − 1 left hand function
0.065 0.2 values to be satisfied, n − 1 right hand function values to be satisfied,
and n − 2 internal knots where differentiability needs to be satisfied.
0.15
0.06 However, there are 3n − 3 unknowns. With one degree of freedom re-
0.1 maining, it makes sense to require that the left-hand derivative at τn be
0.055
0.05
zero, so that the curve can be extrapolated with a horizontal asymptote.
Suppose we apply this method to the rates (so xi = ri ). The forward
0.05
0 curves that are produced are very similar to the piecewise linear forward
0.045 −0.05 curves—the curve can have a ‘zig-zag’ appearance, and this zig-zag is sub-
0 5 10 0 5 10
ject to the same parity of input considerations as before.
So, next we try a cubic spline.
Figure 2: The piecewise linear forward method.
74 WILMOTT magazine
TECHNICAL ARTICLE 2
• xi = ri τi . Again, Bessel interpolation. first thing we do is calculate fid = ri τiτ−r i−1 τ i−1
i −τ i− 1
for 1 ≤ i ≤ n, r0 = 0 . (Here we
• Going one step further, quartic splines. According to Adams [2001] also check that these are all positive, and so conclude that the curve is
the quartic spline gives the smoothest interpolator of the forward legal i.e. arbitrage free (except in those few cases where forward rates
curve. The spline can proceed on instantaneous forward rates, this may be negative). As an interpolation algorithm the monotone convex
time there are 5n − 5 unknowns and 3 additional conditions at τ1 or method will now bootstrap a forward curve, and then if required recover
τn required. Although one must ask: when does one actually have a the continuum of risk free rates using (12).
set of instantaneous forwards as inputs for interpolation? One rather simple observation is that all of the spline methods we
Alternatively if we apply (9) then the inputs are risk free rates, and saw in §5 fail in forward extrapolation beyond the interval [τ1 , τn ]. Clearly
the spline is of the form r(τ ) = aτi + bi + ci τ + di τ 2 + ei τ 3 + gi τ 4 , with if the interpolation is on rates then we will apply horizonal extrapolation
6n − 6 unknowns and 4 additional conditions required. to the rate outside of that interval: r(τ ) = r1 for τ < τ1 and r(τ ) = rn for
• xi = ri . The monotone preserving cubic spline of Hyman [1983]. The τ > τn . So far so good. What happens to the forward rates? Perhaps sur-
method specifies the values of bi for 1 ≤ i ≤ n, in a way to be dis- prisingly we cannot apply the same extrapolation rule to the forwards, in
cussed in more detail shortly. fact, we need to set f (τ ) = r1 for τ < τ1 and f (τ ) = rn for τ > τn —consider
(8). This makes it almost certain that the forward curve has a material
Significant problems can become apparent when using some of these
discontinuity at τ1 , and probably one at τn too (the latter will be less se-
methods. The spline is supposed to alleviate the problem of oscillation
vere as the curve, either by design or by nature, probably has a horizontal
seen when fitting a single polynomial to a data set (the Lagrange polyno-
asymptote as τ ↑ τn ).
mial), nevertheless, significant oscillatory behaviour can still be present.
In order to avoid this pathology, we now have terms 0 = τ0 , τ1 , . . . , τn
Furthermore, the various types of clamping we see with some of the
and the generic interval for consideration is [τi−1 , τi ]. A ‘short rate’ (in-
methods above (clamping refers to imposing conditions at the bound-
stantaneous) rate may be provided, if not, the algorithm will model one.
aries τ1 or τn ) can compromise localness of the interpolator, sometimes
Usually the shortest rate that might be input will be an overnight rate, if
grossly. In fact, the iterative procedure from §2 often fails to converge for
it is provided, the algorithm here simply has some ‘overkill’—there will
the quartic interpolation methods, and we exclude them from further
be an overnight rate and an instantaneous short rate—but it need not be
analysis.
modified.
The method of Hyman is a method which attempts to address these
fid is the discrete rate which ‘belongs’ to the entire interval [τi−1 , τi ]; it
problems. This method is quite different to the others; it is a local
would be a mistake to model that rate as being the instantaneous rate at
method—the interpolatory values are only determined by local behav-
τi . Rather, we begin by assigning it to the midpoint of the interval, and
iour, not global behaviour. This method ensures that in regions of mo-
then modelling the instantaneous rate at τi . as being on the straight line
notonicity of the inputs (so, three successive increasing or decreasing
that joins the adjacent midpoints. Let this rate f (τi ) be denoted fi . This ex-
values) the interpolating function preserves this property; similarly if the
plains (22). In (23) and (24) the values f0 = f (0) and fn = f (τn ) are selected
data has a minimum/maximum then the output interpolator will have a
so that f (0) = 0 = f (τn ) . Thus
minimum/maximum at the node.
τi − τi−1 d τi+1 − τi d
fi = f + f , for i = 1, 2, . . . , n − 1 (22)
τi+1 − τi−1 i+1 τi+1 − τi−1 i
6 Monotone Convex
f0 = f1d − 12 (f1 − f1d ) (23)
Many of the ideas of the method of Hyman will now have a natural devel-
opment—the monotone convex method was developed to resolve the only
fn = fnd − 12 (fn−1 − fnd ) (24)
remaining deficiency of Hyman [1983]. Very simply, none of the methods
mentioned so far are aware that they are trying to solve a financial prob-
Note that if the discrete forward rates are positive then so are the fi for
lem—indeed, the breeding ground for these methods is typically engi-
i = 1, 2, . . . , n − 1 .
neering or physics. As such, there is no mechanism which ensures that
We now seek an interpolatory function f defined on [0, τn ] for
the forward rates generated by the method are positive, and some simple
f0 , f1 , . . . , fn that satisfies the conditions below (in some sense, they are
experimentation will uncover a set of inputs to a yield curve which give
arranged in decreasing order of necessity).
some negative forward rates under all of the methods mentioned here, as
seen in Hagan and West [2006]. Thus, in introducing the monotone con-
τi
(i) 1
τ i −τ i− 1
f (t)dt = fid , so the discrete forward is recovered by the
τ i− 1
vex method, we use the ideas of Hyman [1983], but explicitly ensure that curve, as in (11).
the continuous forward rates are positive (whenever the discrete forward (ii) f is positive.
rates are themselves positive). (iii) f is continuous.
The point of view taken in the monotone convex method is that the d
(iv) If fi−1 < fid < fi+1
d
then f (τ ) is increasing on [τi−1 , τi ], and if
inputs are (or can be manipulated to be) discrete forwards belonging to d d d
fi−1 > fi > fi+1 then f (τ ) is decreasing on [τi−1 , τi ].
intervals; the interpolation is not performed on the interest rate curve it-
self. We may have actual discrete forwards—FRA rates. On the other hand Let us first normalise things, so we seek a function g defined on [0, 1]
^
if we have interest rates r1 , r2 , . . . , rn for periods τ1 , τ2 , . . . , τn then the such that3
WILMOTT magazine 75
g (1)
(ii)
g (0)
(i) (iv)
0
x=0 x=0
τ = τi –1 τ = τi
(iii) D
g (1)
g (0)
(iii)
Figure 3: The function g.
(iv) g (0) = −2g (1)
(i)
(ii)
g(x) = f (τi−1 + (τi − τi−1 )x) − fid . (25) A
B
C g (1) = −2g (0)
Before proceeding, let us give a sketch of how we will proceed. We will
choose g to be piecewise quadratic in such a way that (i) is satisfied by Figure 4: The reformulated possibilities for g.
construction. Of course, g is continuous, so (iii) is satisfied. As a quadrat-
ic, it is easy to perform an analysis of where the minimum or maximum
occurs, and we thereby are able to apply some modifications to g to en-
sure that (iv) is satisfied, while ensuring (i) and (iii) are still satisfied. two sectors actually coincide (to preserve continuity). In actual fact the
Also, we see a posteriori that if the values of fi had satisfied certain treatment for every diametrically opposite pair of sectors is the same, so
constraints, then (ii) would have been satisfied. So, the algorithm will be we really have four cases to consider, as follows (refer Figure 4):
to construct (22), (23) and (24), then modify the fi to satisfy those con- (i) In these sectors g(0) and g(1) are of opposite signs and g (0) and g (1)
straints, then construct the quadratics, and then modify those quadrat- are of the same sign, so g is monotone, and does not need to be mod-
ics. Finally, ified.
(ii) In these sectors g(0) and g(1) are also of opposite sign, but g (0) and
τ − τi−1
f (τ ) = g + fid . (26) g(1) are of opposite sign, so g is currently not monotone, but needs
τi − τi−1
to be adjusted to be so. Furthermore, the formula for (i) and for (ii)
Thus, the current choices of fi are provisional; we might make some need to agree on the boundary A to ensure continuity.
adjustments in order to guarantee the positivity of the interpolating (iii) The situation here is the same as in the previous case. Now the for-
function f . mula for (i) and for (iii) need to agree on the boundary B to ensure
Here follow the details. We have only
1
three pieces of information about continuity.
g: g(0) = fi−1 − fid , g(1) = fi − fid , and 0 g(x)dx = 0. We postulate a func- (iv) In these sectors g(0) and g(1) are of the same sign so at first it appears
tional form g(x) = K + Lx + Mx2 , having 3 equations in 3 unknowns we get that g does not need to be modified. Unfortunately this is not the
⎡ ⎤⎡ ⎤ ⎡ ⎤
1 0 0 K g(0) case: modification will be needed to ensure that the formula for (ii)
⎣ 1 1 1 ⎦ ⎣ L ⎦ = ⎣ g(1) ⎦ , and easily solve to find that
and (iv) agree on C and (iii) and (iv) agree on D .
1 12 31 M 0
The origin is a special case: if g(0) = 0 = g(1) then g(x) = 0 for all x, and
g(x) = g(0)[1 − 4x + 3x2 ] + g(1)[−2x + 3x2 ] (27) d
fi−1 = fid = fi+1
d
, and we put f (τ ) = fid for τ ∈ [τi−1 , τi ].
So we proceed as follows:
Note that by (22) that (iv) is equivalent to requiring that if fi−1 < fid < fi
then f (τ ) is increasing on [τi−1 , τi ], while if fi−1 > fid > fi then f (τ ) is de- (i) As already mentioned g does not need to be modified. Note that
creasing on [τi−1 , τi ]. This is equivalent to requiring that if g(0) and g(1) on A we have g(x) = g(0)(1 − 3x2 ) and on B we have g(x) = g(0)
are of opposite sign then g is monotone. (1 − 3x + 32 x2 ).
Now (ii) A simple solution is to insert a flat segment, which
changes to a
1
g (x) = g(0)(−4 + 6x) + g(1)(−2 + 6x) quadratic at exactly the right moment to ensure that 0 g(x)dx = 0 .
So we take
g (0) = −4g(0) − 2g(1)
g(0) for 0 ≤ x ≤ η
g (1) = 2g(0) + 4g(1) g(x) = 2 (28)
g(0) + (g(1) − g(0)) 1−η
x−η
for η < x ≤ 1
g being a quadratic it is now easy to determine, simply by inspecting
g (0) and g (1), the behaviour of g on [0, 1]. The cases where g (0) = 0 and
g(0) g(1) + 2g(0)
g (1) = 0 are crucial; these correspond to g(1) = −2g(0) and η =1+3 = (29)
g(1) − g(0) g(1) − g(0)
g(0) = −2g(1) respectively. These two lines divide the g(0)/g(1) plane into
eight sectors. We seek to modify the definition of g on each sector, taking Note that η −→ 0 as g(1) −→ −2g(0) , so the interpolation formula
care that on the boundary of any two sectors, the formulae from those reduces to g(x) = g(0)(1 − 3x2 ) at A, as required.
76 WILMOTT magazine
TECHNICAL ARTICLE 2
(iii) Here again we insert a flat segment. So we take (1) Determine the fid from the input data.
2 (2) Define fi for i = 0, 1, . . ., n as in (22), (23) and (24).
g(1) + (g(0) − g(1)) η−x for 0 < x < η
g(x) = η (30) (3) If f is required to be everywhere positive, then collar f0 between 0
g(1) for η ≤ x < 1 and 2f1d , for i = 1, 2, . . . , n − 1 collar fi between 0 and 2min(fid , fi+1
d
),
d
and collar fn between 0 and 2fn . If f is not required to be everywhere
g(1)
η=3 (31) positive, simply omit this step.
g(1) − g(0)
(4) Construct g with regard to which of the four sectors we are in.
Note that η −→ 1 as g(1) −→ − 12 g(0) , so the interpolation formula (5) Define f as in (26).
reduces to g(x) = g(0)(1 − 3x + 32 x2 ) at B , as required. (6) If required recover r as in (12). Integration formulae are easily estab-
(iv) We want a formula that reduces in form to that defined in (ii) as we lished as the functions forms of g are straightforward.
approach C , and to that defined in (iii) as we approach D . This sug- Pseudo-code for this recipe is provided in an Appendix. Working code
gests for this interpolation scheme is available from the second author’s website.
⎧ 2
⎨ A + (g(0) − A) η−x for 0 < x < η
η
g(x) = 2 (32) 6.2 Amelioration
⎩ A + (g(1) − A) x−η for η < x < 1
1−η
In Hagan and West [2006] an enhancement of this method is considered
where the curve is ameliorated (smoothed). This is achieved by making
where A = 0 when g(1) = 0 - so the first line satisfies (iii)) and A = 0 the interpolation method slightly less local i.e. by using as inputs not only
when g(0) = 0 (so the second line satisfies (ii). Straightforward calcu- neighbouring information but also information which is two nodes away.
lus gives
1
2 η 1−η
0
g(x)dx = A + g(0) +
3 3 3
g(1) 7 Hedging
We can now ask the question: how do we use the instruments which
and so have been used in our bootstrap to hedge other instruments? In general
1
A = − [ηg(0) + (1 − η)g(1)]
2
g(1) 0 0 0 0
η= (33)
g(1) + g(0) −1 −1 −1 −1
0 0.5 1 0 0.5 1 0 0.5 1 0 0.5 1
1 1 1 1
g(0)g(1)
A=− (34) 0 0 0 0
g(0) + g(1)
−1 −1 −1 −1
0 0.5 1 0 0.5 1 0 0.5 1 0 0.5 1
1 1 1 1
6.1 Ensuring positivity 0 0 0 0
WILMOTT magazine 77
Hedging under waves.
1
0.5
0.5
1
3m 3x6 6x9 9x12 12x15 15x18 2y 3y 4y 5y 6y 7y 8y 9y 10y 15y 20y 25y 30y
−1
−2
3m 3x6 6x9 9x12 12x15 15x18 2y 3y 4y 5y 6y 7y 8y 9y 10y 15y 20y 25y 30y
0.6
0.4
0.2
0.2
3m 3x6 6x9 9x12 12x15 15x18 2y 3y 4y 5y 6y 7y 8y 9y 10y 15y 20y 25y 30y
Figure 6: The obvious superiority of using forward boxes to determine hedge portfolios: not only is the hedge portfolio simple and intuitive, but the portfolio
composition is practically invariant under the interpolation method.
the trader will have a portfolio of other, more complicated instru- changes whose moves are somehow representative. Some methods have
ments, and will want to hedge them against yield curve moves by using been suggested as follows:
liquidly traded instruments (which, in general, should exactly be those
• Perturbing the curve: creation of bumps. In bumping, we form new
instruments which were used to bootstrap the original curve). For sim-
curves indexed by i: to create the ith curve one bumps up the ith input
plicity, we will assume that these instruments are indeed available for
rate by say 1 basis point, and bootstraps the curve again.
hedging, and the risky instrument to be hedged is nothing more com-
• Perturbing the forward curve with triangles. One approach is to
plicated that another vanilla swap: for example, one with term which is
again form new curves, again indexed by i: the ith curve has the
not one of the bootstrap terms, is a forward starting swap, or is a
original forward curve incremented by a triangle, with left hand
stubbed swap.
endpoint at ti−1 , fixed height say one basis point and apex at ti , and
Suppose initially that, with n instruments being used in our boot-
right hand endpoint at ti+1 . (The first and last triangle will in fact
strap, there are exactly n yield curve movements that we wish to hedge
be right angled, with their apex at the first and last time points
against. It is easy to see that we can construct a perfect hedge. First one
respectively.)
calculates the square matrix P where Pij is the change in price of the jth
• Perturbing the forward curve with boxes. In boxes: the ith curve has
bootstrapping instrument under the ith curve. Next we calculate the
the original forward curve incremented by a rectangle, with left
change in value of our risk instrument under the ith curve to form a
hand endpoint at ti−1 and right hand endpoint at ti , and fixed height
column vector V . The quantity of the ith bootstrapping instrument re-
say one basis point. Such a perturbation curve corresponds exactly
quired for the perfect replication is the quantity Qi where Q is the solu-
with what we get from bumping, if one of the inputs is a ti−1 × ti FRA
tion to the matrix equation PQ = V . Assuming for the moment that P is
rate, we bump this rate, and we use the raw interpolation method.
invertible, we find the solution.
Of course, in reality, the set of possible yield curve movements is far, More generally the user might want to define generic key terms e.g.
far greater. What one wants to do then is find a set of n yield curve 1w, 1m, 3m, 6m, 1y, 2y, etc. and define triangles or boxes relative to these
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TECHNICAL ARTICLE 2
Yield curve type Forwards positive? Forward smoothness Method local? Forwards stable? Bump hedges local?
Linear on discount no not continuous excellent excellent very good
Linear on rates no not continuous excellent excellent very good
Raw (linear on log of discount) yes not continuous excellent excellent very good
Linear on the log of rates no not continuous excellent excellent very good
Piecewise linear forward no continuous poor very poor very poor
Quadratic no continuous poor very poor very poor
Natural cubic no smooth poor good poor
Hermite/Bessel no smooth very good good poor
Financial no smooth poor good poor
Quadratic natural no smooth poor good poor
Hermite/Bessel on rt function no smooth very good good poor
Monotone piecewise cubic no continuous very good good good
Quartic no smooth poor very poor very poor
Monotone convex (unameliorated) yes continuous very good good good
Monotone convex (ameliorated) yes continuous good good good
Minimal no continuous poor good very poor
WILMOTT magazine 79
FOOTNOTES & REFERENCES [3] Patrick S. Hagan and Graeme West. Interpolation methods for curve construction.
Applied Mathematical Finance, 13 (2):89—129, 2006.
t [4] James M. Hyman. Accurate monotonicity preserving cubic interpolation. SIAM Journal
1. We have r(s)s + C = f (s)ds, so r(t)t = [r(s)s]t0 = 0 f (s)ds .
2. It would be wrong to say that there is no new information; that would be the case under on Scientific and Statistical Computing, 4(4):645—654, 1983.
linear interpolation of rates, but not necessarily here. [5] J. Huston McCulloch and Levis A. Kochin. The inflation premium implicit in the US real
3. Strictly speaking, we are defining functions gi , each corresponding to the interval and nominal term structures of interest rates. Technical Report 12, Ohio State
[τi−1 , τi ]. As the gi are constructed one at a time, we suppress the subscript. University Economics Department, 2000. URL http://www.econ.ohio-
state.edu/jhm/jhm.html.
[1] Ken Adams. Smooth interpolation of zero curves. Algo Research Quarterly, [6] Ricardo Rebonato. Interest-Rate Option Models. John Wiley and Sons Ltd, second edi-
4(1/2):11—22, 2001. tion, 1998.
[2] Carl de Boor. A Practical Guide to Splines: Revised Edition, volume 27 of Applied
Mathematical Sciences. Springer-Verlag New York Inc., 1978, 2001.
Pseudo Code For Monotone Convex have already been dimensioned, the raw data inputs have already
been provided, and it has been specified with the boolean variable
Interpolation ‘InputsareForwards’ where those inputs are rates r1 , r2 , . . . , rn or discrete
First the estimates for f0 , f1 , . . . , fn . This implementation assumes that forwards f1d , f2d , . . . , fnd . Further, a ‘collar’ and ‘min’ utility functions
it is required that the output curve is everywhere positive. Various arrays are used (not shown). Of course, collar(a, b, c) = max(a, min(b, c)) .
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TECHNICAL ARTICLE 2
WILMOTT magazine 81