London

17 October 1994
European Fixed Income Research: Technical Specification
Yield curve models are important components of
hedging tools and cheap dear analysis
The Exponential Model assumes that the theoretical
continuously-compounded instantaneous forward rate
curve r(d) satisfies:
r(d) a
0
+ a
1
e
k
1
d
++a
n
e
k
n
d
d being the forward date, the a
i
s & k
i
s being constants.
The Exponential Yield Curve Model
J.P. Morgan Securities Ltd.
European Fixed Income Research
Julian Wiseman (44 71) 325 5823
wiseman_j@jpmorgan.com
What is a yield curve model?
The simplest description of a yield curve model is that it is a
method of joining up the dots where the dots are bond
yields.
However, many market participants require more from a
yield curve model. In particular it should be able to:
Identify that bonds that are cheap (or dear), ie, identify
bonds that offer better (or worse) long term value;
Form par and forward rate curves from the prices of non-
par bonds;
Price new issues;
Describe the large scale shape of the curve for cross-
market comparisons;
Describe changes in the large scale shape of the curve for
use in hedging systems.
Some of these requirements are very similar. For example,
assume that we have a model able to price new issues. Hide
from the model the price of a particular existing bond, and
then ask the model where that bond would trade if it did
exist. If it actually trades at a lower price then this is
equivalent to that bond being labelled cheap by a cheap/dear
analysis.
Therefore the natural approach for a yield curve model is to
build a smoothed summary of the yield curve that fits
existing bond prices as well as possible. Bonds that are
trading anomalously will have markedly different theoretical
and market prices thus permitting identification of their
relative value. Forward and zero-coupon rates can be
extracted from the smoothed curve.
These general principles are widely accepted. The work lies
in choosing how the smoothing is to be done, and the
Exponential Model was devised to do this in a manner that
is elegant, sensible and in accordance with an intuitive
understanding of what shapes yield curves actually adopt.
The Exponential Model is driven by one equation: it
explicitly models the continuously-compounded instanta-
neous forward rate curve as:
r(d) a
0
+ a
1
e
k
1
d
++a
n
e
k
n
d
d being the forward date, the a
i
s & k
i
s being constants.
This guarantees that the theoretical forward rate curve will
be continuous, smooth and will not veer off towards
implausibly high or low values. As the theoretical forward
rate curve is smooth and well-behaved the theoretical par
and zero coupon curves will also be smooth and well-
behaved.
The Exponential Model in practice
Experience with the model suggests that it is very adept at
capturing the macro shape of the yield curve whilst not
fitting to the peculiarities of individual issues; this allows
the model to recognise their anomalousness. It is also
competent at extrapolating and interpolating over large gaps
in the yield curve. We strongly recommend that those
seeking long term value use the Exponential Model to
identify cheap and dear instruments.
The mathematics of the model are summarised on the
following pages.
London Page 2
17 October 1994
J.P. Morgan Securities Ltd.
European Fixed Income Research
Julian Wiseman (44 71) 325 5823
wiseman_j@jpmorgan.com
Summary of the Mathematics
The Exponential Model uses non-standard quotation
conventions for both dates and rates. Many models use a
time convention in which today is represented by t=0. The
Exponential Model works with dates rather than times, and
the unit of time is 1 day rather than 1 year. The advantage
with working with dates is that there is no roll: the forward
value of the parameters is the current value. Working with
days rather than years dispenses with all the awkwardness of
months of different lengths and leap years. Day 0 is
01Jan1990; hence (for example) 17Oct1994 is day 1750.
The quotation convention for rates is the mathematically
most elegant: all rates within the model all rates are quoted
continuously compounded. So, in the special (and rare) case
when the forward rate curve is flat and equal to 0021%, 1
today equals 1e
000021
tomorrow equals 1e
000021365
107966 in 365 days. Within this model rates appear to
be very low because time has units of days rather than years.
(But naturally output from the model will be formatted to
suit the users requirements.)
The major assumption from which the model works is
an assumption about the shape of the continuously-
compounded instantaneous forward rate curve. This
forward rate curve is r(d) on date d, and is assumed to
satisfy:
r(d) a
0
+ a
1
e
k
1
d
++a
n
e
k
n
d
01
where the a
i
s & k
i
s are real constants with k
i
>0 i1, n
being a fixed integer chosen in advance by the user. As a
matter of convention k
i
>k
i+1
i.
Our next objective is to derive the price of a zero coupon
bond. D(d) is defined to be the worth on date s (the
settlement date) of 1 payable on date d.
D(d) e
r( x)dx
xs
d

exp r(x)
xd
s

dx
( )
02
where exp(x)=e
x
x. For convenience define
S a
0
s
a
1
k
1
e
k
1
s

a
n
k
n
e
k
n
s
03
which is independent of d. Then equations 02 & 03 give
D(d) exp S a
0
d +
a
1
k
1
e
k
1
d
++
a
n
k
n
e
k
n
d



_
,

04
Almost all practical applications of the Exponential Model
are based on equation 04.
This allows us to calculate the theoretical dirty price
ThryDP of a bond which pays coupons c
i
on dates d
i
, the
principal being deemed to be a coupon.
ThryDP D(d
i
)c
i
i

05
This also shows the advantage of the separate definition of
S. When computing a numerical result to equation 05 there
is no need to recalulate S for each step of the summation. It
is independent of d and therefore need only be calculated
once per bond.
It will prove useful to have a measure of duration. However
the two most frequently used measures of duration
(Macauley and Modified) are not appropriate. Macauley
duration is the average amount of time until receipt of
cashflows, this average being weighted by the present value
of these cashflows; these present values being calculated
using the IRR of the bond. Modified duration is then
Macauley(1+yield/couponFrequency). Hence both of
these duration measures require the IRR of the bond. This
is unfortunate for two reasons: IRRs are computationally
expensive to calculate; and this model does not refer to
IRRs anywhere else if possible it would be cleaner to
avoid IRRs. It is both possible and easy.
For internal purposes this model uses measure of duration
that we call True Duration. True Duration is the average
amount of time until receipt of cashflows, this average being
weighted by the present value of these cashflows; these
present values being calculated using the appropriate
discount factors. Hence
TrueDur D(d
i
)c
i
d
i
i
( )
ThryDP
( )
s 06
Note that
D(d)
a
0
(s d)D(d) 07
and hence
ThryDP
a
0
1
ThryDP
TrueDur 08
So TrueDur is the proportional price sensitivity of the bond
to parallel movements in the forward rate curve.
We are now in a position where, given the values of the a
i
s
and the k
i
s we can calculate the theoretical (or fair) prices
and durations of fixed income instruments including bonds.
But how did we get the values a
i
s & k
i
s to start the whole
process?
Calculating the a
i
s and k
i
s
To calculate the a
i
s & k
i
s start by guessing the parameters.
From these guesses calculate the theoretical prices of each
Page 3 Sales and Trading Research
The Exponential Yield Curve Model
instrument which has a known market price. Compare the
theoretical prices with the market prices, and repeatedly
adjust the guessed parameters (recalculating the theoretical
prices) until these theoretical prices are as close as possible
to the market prices. When this optimum is reached record
the parameters.
This raises several questions. What do we mean by as
close as possible? What initial guess should we feed to the
optimiser? What algorithm should we use to adjust the
guessed parameters?
In order to define as close as possible we choose an error
function which is then to be minimised. The choice of error
function depends on which instruments we are fitting to; for
the moment assume that we are working with a bond
market. In this case we recommend minimising Error
2
where
Error
2

MarketDirty
j
ThryDP
j
MarketDirty
j
(TrueDur
j
)
f
L
j



_
,

2
j

TrueDur
j
2 f
L
j
j

09
The subscript j indexes over bonds and the constant f is
chosen by the user along with n; for advice on choosing n &
f see later. The L
j
are weights chosen to reflect liquidity or
issue size; we use L
j
=1 j.
Equation 09 can also be used as the error function when
fitting to known swap and FRA rates. This is achieved by
converting the derivatives into equivalent bonds. Treat the
swaps as bonds with coupons equal to the swap rates and
markets price of par. The FRAs are zero coupon
instruments costing par, settling on their deposit dates and
redeeming on the repayment date at par+interest. The
optimiser then attempts to set the theoretical prices of these
bonds to as close to par as possible, using the error
function defined in 09. (Note that this means that is
operationally useful to be able to specify different
settlement dates for different instruments.)
Having defined what the optimiser is to minimise, it is
usually computationally efficient to give the optimiser a
good first guess as to the parameters. Whilst it is difficult to
generalise across all markets and all market conditions the
following is generally effective.
k
i
2^
n39
4

i
2
( )
i 1
a
0

ln(1.08)
365
0.00021
a
i

t ln(1.01)
365
e
k
i
t
0.000027e
k
i
t
i 1

;



10
where t is any date near either the trade date or the
settlement date for whichever instrument settles soonest.
In 10 the choice of + or - is arbitary; use + i unless the
optimiser fails, in which case try other combinations of +
and -. If the optimisation is run daily the optimiser can be
saved a lot of effort by using yesterdays final result as
todays initial guess. Some optimisers also require a
characteristic scale for each parameter: estimate 1% of the
parameters value.
Having made the initial guess it is important to invoke the
optimiser in two steps. For the first step allow the optimiser
to vary the a
i
s only, whilst holding the k
i
s constant. After
the optimiser has completed this step reoptimise allowing
both the a
i
s and the k
i
s to vary. (There is almost never any
advantage in varying one of the k
i
s whilst holding the
matching a
i
constant always allow the optimiser to vary
the a
i
s.)
This brings us to the last of the questions raised at the start
of this section: which optimiser is recommended?
Assuming that the optimisation is done in the two steps
recommended in the previous paragraph (a
i
s only followed
by a
i
s & k
i
s together) then any robust multi-dimensional
algorithm is likely to be satisfactory. We use the variation
of Powells method detailed in Numerical Recipes in C.
Tidy the results by sorting the {a
i
, k
i
} pairs so that k
i+1
<k
i
.
Finally, progammers should be aware that this model
frequently uses very large and very small numbers. For
example, if k
i
=002, and d=15000 (which is 26Jan2031)
then exp(-k
i
d)=e
-300
. Ensure that the variable type used to
store numbers can comfortably handle this order of
magnitude.
Choosing n & f
The choice of n depends on how many instruments have
known market prices. It is recommended that the fit is done
using all the instruments for which reliable prices are
known; the larger the universe of bonds (or swaps or
whatever) the more reliable and meaningful the output.
If there are fewer than 7 instruments with known
market prices then n should be 1. If there are between
7 and 12 then n should be at most 2. With n greater
than 12 we suggest that n is at most 3. Whilst these are
only approximate guidlines it is vital that the number of
instruments with known market prices > 2n+1.
But what does n mean? n is the amount of freedom the
London Page 4
17 October 1994
J.P. Morgan Securities Ltd.
European Fixed Income Research
Julian Wiseman (44 71) 325 5823
wiseman_j@jpmorgan.com
theoretical curve has to fit the market. For example, the
number of turning points in the par curve is at most n-1; if
n=2 then the yield curve can have either a maximum or a
minimum but not both. Judging n is subjective it
depends on to what extent the yield curve should
accomodate the current structure of the market, and to what
extent it should identify potential sources of value by
disagreeing with the market.
Choosing f can be either simple or complicated. The simple
method says choose f=1. But to understand the rle of f we
must ponder equation 09.
If f=0 we are effectively minimising
MarketDirty
j
ThryDP
j
MarketDirty
j



_
,

2
j

in which case Error is average error in difference between

the theoretical and market prices (this being expressed as a
proportion).
If f=1 we are minimising the proportional error in price
duration. For bonds we know that
IRR
price
duration price
11
and hence setting f=1 is very similar to minimising the
errors in the yields of the instruments rather than their
prices.
Choosing 0<f<1 strikes a compromise between fitting to
prices and fitting to yields. Choosing 1<f<2 is similar to
fitting to yields, except that the fit is better for shorter
instruments and worse for longer instruments. However f>1
is not necessarily particularly meaningful, and if f<0 or f>2
the the results are very unlikely to have any useful meaning
whatsoever. If in doubt use f=1.
Awkward market features: perpetual bonds and end-
year effects.
Some markets have slightly non-standard features that can
cause difficulty. Exampes include the 35% perpetual War
Loan in the gilt market, and the discontinuities in forward
short term rates over year-end (USD), and over end-quarters
(JPY). By their nature these features exist case-by-case and
cannot be generalised, but the two difficulties already
mentioned can be solved. For completeness these are
shown below.
Perpetuals. First observe that equation 01 gives
Lim
d
r(d) a
0
12
and hence the forward rate far in the future tends to a
constant. In practice r(d) becomes exceedingly close to this
limit within 50 years or so.
This enables us to calculate the forward price of the
perpetual on this date; this is added to equation 05 as a
redemption amount. We then have
ThryDP
perp

z D(d
n
) 3.5 2
1 z
+ D(d
i
)c
i
i< last

13
where
z exp(a
0
365.25 2)
Similar reasoning (but more intricate algebra) gives
TrueDur
perp

3.5
2
D(d
n
)
z d
n
1 z
+
z 365.252
1 z
( )
2
( )
+ D(d
i
)c
i
d
i
i< last

ThryDP
perp
14
In both 13 and 14 the 3.5 is the notional coupon on the
bond, and the /2s refer to the semi-annual nature of the
payment stream.
End-year effects. The easiest method is to ignore end-
year discontinuities and this is recommended for most
practical purposes. However, on rare occasions it is
necessary to allow for this effect. Although the details will
vary according to perceived market practice it is suggested
that a factor such as
endYearFactor
numberYearBoundariesCrossed
be appended to equation 04. Only allow the optimiser to
vary endYearFactor if the optimiser has many different
instruments as inputs, including some instruments with large
cashflows just before year boundaries and some with large
cashflows just after. In general it is best to ignore year-
end effects.
Marking-to-market and convexity.
When choosing a universe of instruments from which to
build a yield curve it is important to consider the effect of
the marking-to-market of some derivatives but not others.
For example, swaps and FRAs are not marked-to-market
(and hence have convexity) whilst an interest rate future is
marked-to-market (and does not have convexity). Ideally all
the instruments should have the same mark-to-market
type, ie, either all or none should have mark-to-market
cashflows. In other words, if the parameters are estimated
from a bond curve then the calculated forward rates will be
Page 5 Sales and Trading Research
The Exponential Yield Curve Model
FRA rates not those of interest rate futures.
In practice the mark-to-market effect on short dated
instruments with low or moderate volatility is often small; in
these cases it is often convenient to ignore the convexity
effect.
Analysing market dynamics
Given a theoretical yield curve it can be very useful to
analyse the history of this curve. As this curve is described
by a small number of parameters there is a natural
temptation to track changes in the parameters directly
this approach can be very misleading.
The optimisation previously described minimises an error
function. This minimum can be very flat there can exist
relatively large changes in the parameters which adjust the
shape of the yield curve and the error function by only a
trivial amount. Hence small changes in the shape of the
yield curve can sometimes give rise to much larger changes
in the parameters.
Those wishing to study the history of the curve are advised
to calculate from the parameters the theoretical price of
some instruments (swaps, bonds, FRAs or whatever). Then
proceed to analyse the volatility, principal components or
other statistics of the movements in these theoretical prices,
not of the parameters. In other words, pay attention to
changes in the consequence of the parameters not to
changes in the parameters themselves.
Although this warning applies to all parameterised yield
curves, it is especially important in the Exponential Model
for the k
i
parameters and for the a
i
parameters when
i,

j:

k
i
k
j
1. Indeed, when this condition is persistently
true there is a strong case for reducing n by 1; this will
merge the two similar terms.
Real time pricing and tweak hedging
The Exponential Model can be used to price instruments in
real time. In brief summary this works as follows. For each
bond note its closing yield spread market-theoretical, and
calculate the partial derivative of its theoretical price with
respect to each of the a
i
; this calculation being either
analytic or numerical.
Next choose n+1 benchmarks (of quite different maturities)
which are to be used to determine intraday yield curve
movements. Let us say that these benchmarks have
theoretical prices B
0
B
n
, and that the off-the-runs have
theoretical prices R
0
R
m
. The partial derivatives allow us
to reprice the bonds given known small changes in the
parameters using:
B
0
B
1
B
n





_
,

B
0
a
0
B
0
a
1
B
0
a
n
B
1
a
0
B
1
a
1
B
1
a
n
B
n
a
0
B
n
a
1
B
n
a
n





_
,



a
0
a
1
a
n





_
,



15
and
R
0
R
1
R
2
R
m






_
,

R
0
a
0
R
0
a
1
R
0
a
n
R
1
a
0
R
1
a
1
R
1
a
n
R
2
a
0
R
2
a
1
R
2
a
n
R
m
a
0
R
m
a
1
R
m
a
n






_
,




a
0
a
1
a
n





_
,



16
Next define
M=
R
0
a
0
R
0
a
1
R
0
a
n
R
1
a
0
R
1
a
1
R
1
a
n
R
2
a
0
R
2
a
1
R
2
a
n
R
m
a
0
R
m
a
1
R
m
a
n






_
,

B
0
a
0
B
0
a
1
B
0
a
n
B
1
a
0
B
1
a
1
B
1
a
n
B
n
a
0
B
n
a
1
B
n
a
n





_
,



1
17
M does the work in hedging and pricing. Observe that
R
0
B
0
R
0
B
1
R
0
B
n
R
1
B
0
R
1
B
1
R
1
B
n
R
2
B
0
R
2
B
1
R
2
B
n
R
m
B
0
R
m
B
1
R
m
B
n






_
,




M 18
and hence that M is simply the matrix of sensitivities of the
off-the-runs to the benchmarks; so M describes how to
hedge the off-the-runs using benchmarks.
London Page 6
17 October 1994
J.P. Morgan Securities Ltd.
European Fixed Income Research
Julian Wiseman (44 71) 325 5823
wiseman_j@jpmorgan.com
Additional information is available upon request. Information herein is believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and
are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan
may hold a position or act as market maker in the financial instruments of any issuer discussed herein or act as advisor or lender to such issuer. J.P. Morgan Securities Limited is a member of The Securities and
Futures Authority and a member of the London Stock Exchange. Copyright 1994 J.P. Morgan & Co. Incorporated. Clients should contact analysts at and execute transactions through a J.P. Morgan entity in their
home jurisdiction unless governing law permits otherwise.
Equivalently, 17 implies
R
0
R
1
R
2
R
m






_
,




M
B
0
B
1
B
n





_
,



19
which allows the off-the-runs to be repriced given the
changes in the benchmarks.
In practice it is quite satisfactory not to recalculate M in real
time. This allows M to be calculated in advance (usually
overnight), and means that real-time repricing of the off-the-
runs can be done quickly at a low computational cost.
Outstanding questions
When displaying the output from an implementation of the
Exponential Model forward rate curves and par curves are
often required. When pondering curve shape rather than
individual issues it is natural to assume that bonds pay
coupons continuously; this avoids particular market features
(such as accrued calculations) and inconveniences such as
the sudden change in duration over ex-dividend dates.
Consider a par bond maturing on date d. Let it have yield
(and continuous coupon rate) R(d) and True duration
True(d). These satisfy:
R(d)
D(x)r(x)dx
x s
d

D(x)dx
x s
d

1 D(d) ( )
D(x)dx
xs
d

True(d) dD(d) + R(d) xD(x)dx

x s
d

s

;



20
Ideally these would admit of analytic solutions that could
easily be computed in a small number of spreadsheet cells.
Unfortunately neither an analytic solution nor a reliable
approximation is known: readers able to solve these
equations are asked to inform the author.