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Introduction
Good estimate of the yield curve is of great importance for all financial institution. To assess the
points on interest rate curve various curve-fitting methods are used for example quadratic and cubic
spline, exponential spline etc. the main drawback of these methods is the undesirable economic
interpretations. To overcome these inadequacies, Nelson Siegel and Svensson proposed flexible
parametric curves that are competent to describe the observed term structure shapes.
Term structure refers to the relationship between the yield of bonds and their time to maturity. To
ease the situation we take the bonds as zero coupon govt. bods so that the duration is time to
maturity and no credit risk.
Discount Function : it is related to zero coupon bond price which is function of its maturity
Spot yield curve : it specifies zero coupon bond yield as function of maturity
Forward yield curve : it specifies zero coupon bond forward yield as function of maturity
Nelson-Siegel Model
Nelson-Siegel model provides the description of the yield that should be earned from the bond with
maturities that are not frequently traded. It is very flexible and facilitates most of the historical term
structure.
𝑌 𝑡
𝑡
−𝑡
𝑡,𝑡+𝛿= 𝛽0 + 𝛽1 𝑒 𝑡1 + 𝛽2 ( 𝑒 𝑡1 )
𝑇
𝛽0 = 𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠 This represents the sustenance level throughout the tenor unless
there is a change in the yield curve
𝛽2 = difference between medium and long term rates. It represents the curvature of the yield curve.
If the long term rates decrease the curvature increases and vice versa.
lim 𝑓(𝑚) = 𝛽0 This represents that when the maturity tends to grow towards infinity we can say
𝑚→∞
𝛽0 will represent the long term interest rate
lim 𝑓(𝑚) = 𝛽0 + 𝛽1 if the time to maturity tends to zero then the yield will become 𝛽0 + 𝛽1
𝑚→0
This equation helps to fit the slope between short- and long-term interest rate across the time
horizon, which is helpful to do the valuation of different bond with different time to maturity.
The NS model just have four standard shapes for zero coupon bond, which are:
Increasing Curve: which represents same slope of the interest rate curve throughout the
tenor
Decreasing Curve: The curve represents the decreasing rate of slope of the interest rate urve
throughout the tenor
Flat Rate curve: The curve represents constant level of interest rate throughout the tenor
Inverted Curve: The curve represents decreasing level of interest rate throughout the tenor.
Sevensson improved the model by writing a paper in the year 1994 and made some changes by
adding 2 additional parameters to capture the humps along the tenor.
𝑚 𝑚
1 − 𝑒 −(τ1) 𝑚
−( ) 1 − 𝑒 −(τ2) 𝑚
−( )
𝑟 = 𝛽0 + (𝛽1 + 𝛽2 ) ∗ 𝑚 − 𝛽2 ∗ 𝑒 τ1 + 𝛽 ∗
3 𝑚 − 𝛽3 ∗ 𝑒 τ2
τ1 τ2
Where,
β3 is again a function of m, which becomes zero when m=0 This parameter, which is
analogous to β2, determines the magnitude and direction of the second hump.
NSS Model has the following advantages over the NS Model:
The estimation is comparatively more simplified as it is computed through linear
regression.
The model is competent to construct yields for different maturities.
The interpretation is intuitive which leads to easier explanation
Historically the NSS model fits the information in a sensible manner
1. “Estimating the Yield Curve Using the Nelson‐Siegel Model” by Jan Annaert, Anouk G.P.
Claes, Marc J.K. De Ceuster, Hairui Zhang