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RiskMetrics Monitor

J.P. Morgan/Reuters

Third quarter 1997 RiskMetrics® News


New York
September 15, 1997
• SEC issues final rule on the disclosure of market risks in financial instruments and deriva-
tives
• The first issue of the CreditMetrics™ Monitor is planned for release in November 1997
• Reuters has taken over production of RiskMetrics datasets
• RIMES Technologies offers its Windows application, HistDB, on the web

Morgan Guaranty Trust Company Research, Development, and Applications


Risk Management Research
Peter Zangari
(1-212) 648-8641
zangari_peter@jpmorgan.com • An investigation into term structure estimation methods for RiskMetrics 3
Prices of discount (zero coupon) bonds and their corresponding (spot) interest rates are an
Reuters Ltd important data source for the RiskMetrics® product. RiskMetrics® uses prices of discount
International Marketing bonds to calculate the volatility and correlation of future cashflows as well as to mark-to-
Martin Spencer market those cashflows. Since in many markets the prices of discount bonds are not
(44-171) 542-3260 observed, RiskMetrics constructs such prices (and interest rates) by estimating a so-called
martin.spencer@reuters.com
term structure of interest rates from a set of coupon bonds issued by governments. This term
structure is estimated each day that RiskMetrics produces volatility and correlation data files.

The purpose of this article is three-fold. First, we explain an algorithm to generate spot rates
from coupon-bearing government bonds that RiskMetrics plans to implement in its produc-
tion process. This algorithm, which is based on the bootstrap procedure, will replace the cur-
rent term structure estimation method. Second, as background material for the discussion on
term structure estimation methods, we present several definitions related to discount and
coupon bonds, and explain various bond market conventions (e.g., coupon payment fre-
quency, day count basis, etc.). And third, we present alternative term structure estimation
methods that are popular among academics and practitioners.

• When is a portfolio of options normally distributed? 33


When considering a portfolio of options, a risk manager is faced with two contrasting pieces
of information. On the one hand, the manager is well aware that the distribution of the return
on any one of the options is asymmetric and certainly not normal. On the other hand, the
manager knows that when a large number of independent options are considered, even if
their individual distributions are not normal, the distribution of their sum will be close to nor-
mal. In this article, we take up two practical questions: first, how large must a portfolio of
independent options be for the portfolio distribution to appear normal; and second, is it pos-
sible that “reasonably uncorrelated” portfolios of options will also appear to be normally dis-
tributed if the portfolios are large enough?

Previous editions of the RiskMetrics® Monitor 45


RiskMetrics® Monitor
Third Quarter 1997
page 2

RiskMetrics® News

Scott Howard SEC issues final rule on the disclosure of market risks in financial instruments and
Morgan Guaranty Trust Company
derivatives
Risk Management Advisory
(1-212) 648-4317
Below is a synopsis of who, when and what has to be disclosed about the market risk in financial instru-
howard_james_s@jpmorgan.com
ment and derivatives, as defined, and other financial instruments (i.e., those in scope of FAS 107). Mate-
riality is measured by, a) fair value at the end of the period (netting is permitted to the extent of FIN 39),
or b) potential loss of future earnings, fair values, or cash flows from reasonably possible near-term market
movements.

Who: SEC registrants with material market risk exposures (e.g., interest rate, foreign currency, commodity
and equity price risk) arising from all financial instruments, including derivatives.

When: Effective for periods ending after June 15, 1997 for banks, thrifts and registrants with market cap-
italization of $2.5 billion as of January 28, 1997. For other registrants one year later.

What: If a registrant has material market risk, they must provide outside of financial statements quantita-
tive and qualitative disclosures about such risks separately for trading and nontrading portfolios. Three al-
ternative exist:

• Tabular - Fair value information and contract terms relevant to determining future cash flows, cat-
egorized by maturity, grouped based on instrument characteristics.

• Sensitivity Analysis - Potential loss by risk type in future earning, fair values or cash flows from
selected hypothetical changes in market rates and prices.

• Value at Risk - Potential loss by risk type in future earning, fair values or cash flows from market
movements over a selected period of time and with a selected likelihood of occurrence.

The first issue of the CreditMetrics™ Monitor is planned for release in November 1997
The upcoming CreditMetrics™ Monitor will contain several articles. Likely topics will be: (a) additional
product coverage, e.g., credit derivatives, b) estimation of additional dimensions of risk,e.g.,credit spread
volatility, c) recovery rate correlation modeling, d) a case study discussion of model outputs, sensitivities
and applications, e)detailed illustrations of relevant calculations to include forward curve estimation

Reuters has taken over production of RiskMetrics


Since mid August the Reuters web and ftp sites (http://www.riskmetrics.reuters.com/WDown4.htm or ftp:/
/ftp.riskmetrics.reuters.com/datasets/) are the only places to get the RiskMetrics datasets. They are posted
on the same schedule as before.

RIMES Technologies offers its Windows application, HistDB, on the web


The RIMES HistDB offers access to historical data, e.g., economic, price, that can be combined and ana-
lyzed together into a familiar Windows NT application. DEaR and VaR measurements usingthe RiskMet-
rics® methodology can be computed “on-the-fly” using any of the assets (or custom porfolios) available
in the system. RIMES can be found at http://www.rimes.com.
RiskMetrics® and FourFifteen™ are registered trademark of J.P. Morgan in the United States and in other countries. They are written with the symbol ®
on its first occurrence and RiskMetrics and FourFifteen thereafter.
RiskMetrics® Monitor
Third Quarter 1997
page 3

An investigation into term structure estimation methods for RiskMetrics

Peter Zangari 1. Introduction and Overview


Morgan Guaranty Trust Company
Risk Management Research Prices of discount (zero coupon) bonds and their corresponding (spot) interest rates are an important data
(1-212) 648-8641 source for the RiskMetrics product. RiskMetrics uses prices of discount bonds to calculate the volatility
zangari_peter@jpmorgan.com and correlation of future cashflows as well as to mark-to-market those cashflows. Since in many markets
the prices of discount bonds are not observed, RiskMetrics constructs such prices (and interest rates) by
estimating a so-called term structure of interest rates from a set of coupon bonds issued by governments.
This term structure is estimated each day that RiskMetrics produces volatility and correlation data files.
1
In its most common representation, the term structure of interest rates is the relationship between the
interest rates on default-free fixed income investments, which generate only one payment (at maturity),
and the maturity dates of these cashflows. In other words, the term structure is the relationship between
interest rates on discount bonds and the maturity dates of the cashflows associated with those interest rates.
For any bond market, the complete term structure of interest rates is unobservable, that is to say, prices of
discount bonds (spot interest rates) for a continuum of maturity dates do not exist. Therefore, we must es-
timate of the term structure by applying a term structure estimation method to a set of observed bonds.
2
The observed bonds are usually taken to be coupon bonds issued by governments.

We classify term structure estimation methods into two groups: theoretical and empirical. Theoretical
term structure methods posit an explicit structure for coupon bond prices, whose values depend on a set
of parameters that govern the mean reversion and volatility of the so-called short interest rate. Various
forms of regression analysis can be used to estimate the value of these parameters. Examples of theoretical
methods include Vasicek (1977), and Cox et.al (1985). In fact, RiskMetrics currently uses a theoretical
term structure estimation method to compute spot interest rates from government bonds. Once estimat-
ed, these spot rates are converted to prices of discount bonds using a simple formula that relates the price
and interest rate of a discount bond.

Alternatively, empirical methods are available to compute spot interest rates. Unlike the theoretical meth-
ods, the empirical methods are independent of any model or theory of the term structure. Whereas the
theoretical methods attempt to explain typical features of the term structure, which may include how the
term structure evolves through time, the empirical methods merely try to find a close representation of the
term structure at any point in time, given some observed interest rate data. Examples of empirical methods
include a procedure known as bootstrapping (e.g., Fama and Bliss, 1987), applications of splines (e.g.,
Fischer et al 1994) and exponential polynomials (e.g., Nelson and Siegel, 1992 and Buono et. al 1992),
and the maximum smoothness approach (Adams and Van Deventer, 1994).

The purpose of this article is three-fold:

• First, we explain an algorithm to generate spot rates from coupon-bearing government


bonds that RiskMetrics plans to implement in its production process. This algorithm, which
is based on the bootstrap procedure, will replace the current (theoretical) term structure estima-
tion method. The principal reason for changing the term structure estimation method is that the
current method relies on a set of parameters that are market specific and must be updated fre-
quently. The proposed (bootstrap) method, on the other hand, is much simpler to implement and
can generate comparable results which are suitable to RiskMetrics.

1
In the academic and industry literature, the phrases‘term structure model’ and ‘yield curve model’ are sometimes used
interchangeably.
2
For a discussion about whether one should use government bonds or interbank rates when estimating the term structure, see
Oda, 1996 and Malz, 1996.
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Third Quarter 1997
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An investigation into term structure estimation methods for RiskMetrics

• Second, as background material for the discussion on term structure estimation methods, we
present several definitions related to discount and coupon bonds, and explain various bond
market conventions (e.g., coupon payment frequency, day count basis, etc.). This discussion
includes a review of the relationship between spot interest rates, forward interest rates and
prices of discount bonds.

• Third, we present alternative term structure estimation methods that are popular among aca-
demics and practitioners. The main goal of this discussion is to streamline and clarify a somewhat
disjointed literature on term structure estimation methods. By using the same notation and defini-
tions to explain six term structure estimation methods, this presentation will facilitate compari-
sons between the various term structure estimation methods.
The rest of this article is organized as follows:

• Section 2 provides an overview of bond pricing notation, formulae and terminology, and consists
of 4 sub-sections.
-- Section 2.1 presents some basic definitions related to the time value of money.
-- Section 2.2 explains how the term structure of interest rates can be expressed in terms of (1)
spot interest rates, (2) forward interest rates, and (3) prices of discount bonds. This section
includes a discussion on the relationship between spot and forward interest rates.
-- Section 2.3 relies on the definitions of the previous sections to define a coupon bond. We
present a numerical example to demonstrate how to find a coupon bond’s yield-to-maturity
(YTM) and how to calculate accrued interest.
-- Section 2.4 shows how a price of a coupon bond can be written as a set of discount bonds.

• Section 3 reviews the data on government bond spot rates that RiskMetrics currently provides.

• Section 4 presents the bootstrap procedure to extract spot interest rates from coupon government
bonds.
-- Section 4.1 presents the details of the bootstrap.
-- Section 4.2 discusses the practical implementation of the bootstrap. Specifically,
we explain how to bootstrap when either no or multiple bonds mature at a given bootstrap
maturity date.

• Section 5, which consists of 5 sub-sections, presents alternative term structure estimation meth-
ods. We discuss several popular models.
-- Section 5.1 explains how to bootstrap forward interest rates.
-- Section 5.2 reviews some research that estimates the term structure of interest rates with
polynomial and exponential splines.
-- Section 5.3 introduces the exponential polynomial method to estimate the term structure of
interest rates.
-- Section 5.4 discusses modeling and smoothing forward interest rates as a way to estimate
the term structure.
-- Section 5.5 demonstrates how a particular class of splines--cubic B-splines--can be applied
to estimate the term structure of interest rates.

• Section 6 concludes the article with a summary and discussion.


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Third Quarter 1997
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It is important to point out that while we plan to replace the theoretical term structure estimation
method with the bootstrap procedure, this change will have no effect, whatsoever, on an end-user’s
ability to download and use the RiskMetrics database.

2. A review of bond pricing notation, formulae and terminology3


In this section we explain and define various terms involving the time value of money, the term structure
of interest rates and coupon and discount bonds.

2.1 Some basic definitions


We begin with the fundamental notion of the time value of money. The present value of a future cash pay-
ment is the amount of money that must be paid now to receive that payment. The present value of a future
payment is determined by:

1. A discount factor: the interest rate applied to discount the future payment

2. Time to maturity: the time interval between the current and payment date, and

3. A compounding frequency: the frequency with which accrued interest is paid out and re-invested (e.g.
semi-annual)

First, to determine the present value of a future payment we must use a discount factor to convert the
future payment to the present. This factor is a function of an interest rate--which applies from the present
time to the time of the future payment--and the time until the future payment is received. Note that all
interest rates that we refer to in this article are annual rates (i.e., they are the rate for one year) and
are independent of any dating conventions presented below.

Second, time is measured in years to maturity. For example, let t 0 represent the current time (e.g., 18-
August-1997) and suppose that we receive some future payment at time t j (j > 0), which is exactly six-
months from the current time (e,g, 18-February-1998), the time between these two dates is represented as
τ j = t j – t 0 = 0.5 years. Chart 1 shows how we measure the time between the current and future dates.

Chart 1
Measuring time between current and future dates

τj












t0 tj

When we determine the value of fixed income investments we must be very precise on how we measure
the time ( τ j, j – 1 ) between two dates. In fact, we rely on a day count basis which not only defines the
number of days, d, in a year but also defines how to count the days between any two dates, n. The day
count basis is of particular importance in that it allows us to determine the fraction of a year, n/d,
between cashflows generated from fixed income instruments. For example, a coupon bond is a fixed
income instrument that pays periodic coupons and a lump-sum amount equal to its face value at maturity.

3
John Matero provided research support for this section.
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The day count basis for coupon bonds is used to measure the time between coupon payments. Table 1
provides a listing of some day count bases currently employed in fixed income markets.

Table 1
Day count conventions and bases
Counting the time between the j-1st and jth coupons
(1) Actual/Actual n = the actual number of days between t j – 1 and t j

d = the actual number of days between t j – 1 and t j multiplied by the coupon frequency.

(2) Actual/360 n = the actual number of days between t j – 1 and t j


d = 360

(3) Actual/365 n = the actual number of days between t j – 1 and t j


d = 365

(4) Actual/365L n = the actual number of days between t j – 1 and t j


d = 366 if the next coupon falls within a leap year, otherwise 365.

(5) 30/360 Given that d j – 1 , m j – 1 , and y j – 1 and d j , m j , and y j denote the day, month and year for
(general)
t j – 1 and t j , respectively then:
n = d j – d j – 1 + 30 ( m j – m j – 1 ) + 360 ( y j – y j – 1 )
d = 360

(6) 30/360 n = same as (5) except if d j – 1 falls on the 31st of the month, then change it to the 30th; if d j falls

on the 31st of the month, then change it to the 30th if d j – 1 falls on either the 30th or the 31st
d = 360

(7) 30E/360 n = same as (5) except if either d j – 1 or d j falls on the 31st of the month, then change it to the 30th
d = 360

(8) 30E+/360 n = same as (5) except if d j – 1 falls on the 31st of the month, then change it to the 30th; if d j falls

on the 31st, then change it to the 1st and increase m j by 1


d = 360

Consider a simple example where coupon payments occur on August 1, 1997 and August 15, 1997 and we
use the Actual/Actual method to measure the amount of time between payments. In this case, the basis’
numerator is 14 and the denominator is 364, which yields a basis of 0.0385 years.

The day count basis is also important for calculating accrued interest. In the context of pricing coupon
bonds, accrued interest is the amount of coupon payment that accrues between the last coupon payment
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Third Quarter 1997
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An investigation into term structure estimation methods for RiskMetrics

and the current (analysis) date. Chart 2 shows how accrued interest is related to the time between the pre-
vious coupon payment4, the analysis date and next coupon payment.5

Chart 2
Measuring accrued interest between coupon payments
Accrued interest






Last Analysis Next


coupon date coupon

The third determinant of present value is what often is referred to as the compounding frequency. Com-
pounding relates to the period of time that an investment earns interest. For example, on a US treasury
bond with semi-annual compounding, it is assumed that payments earn interest for six months and then
are “rolled-over” for another six months. In this case, the compounding frequency is 2. This is an example
of discrete compounding because compounding is done at discrete points in time. Continuous com-
pounding, on the other hand, assumes that payments are rolled-over and earn interest at every instant in
time.

2.2 Defining a term structure of interest rates


6
Recall that the term structure of interest rates is the relationship between the interest rates of default-free
fixed income securities (discount bonds) and the maturity dates of their cashflows. The term structure of
interest rates can be expressed in terms of; (1) spot rates, (2) forward rates, and (3) the prices of discount
bonds.

2.2.1 Discount bonds and spot interest rates


A discount bond is a fixed-income investment with only one payment at maturity. A spot, or zero-coupon
interest rate, is the rate of interest paid on a discount bond. Let z ( τ j, f ) represent a spot interest rate
with maturity τ j and compounding frequency f. This spot rate is the annual rate of interest that a bond’s
value must grow to reach $1.00 at time t j ( τ j years into the future), if compounded f times a year. Also,
let z ( τ j ) represent the spot rate over the time period τ j when compounding is continuous (i.e, f approach-
es infinity). Note that the spot rate is always measured from the current time ( t 0 ).

The spot curve with discrete compounding, referred to as the discrete spot curve, represents the relation-
ship between spot interest rates z ( τ j, f ) and time to maturity τ j . Since a discrete spot curve is defined for
every possible compounding frequency, numerous discrete spot curves can be generated in practice--one
curve per compounding frequency.

For any compounding frequency, f, the relationship between the price of a discount bond p ( τ j ) and the
spot rate z ( τ j, f ) is given by

τj ⋅ f
[1] p ( τ j ) ( 1 + z ( τ j, f ) ⁄ f ) = 1

4
Accrued interest is also measured between the value date, when interest begins to accrue, and the first coupon payment
5
For an exact definition on how to measure accrued interest between coupon dates, see the current edition of the J.P. Morgan
Government Bond Outlines.
6
Note, however, that term structures may be defined for particular class of creditworthy bonds. For example, we may con-
struct an AAA curve, BBa curve, etc.
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An investigation into term structure estimation methods for RiskMetrics

Unlike other bonds that can take on any type of compounding frequency, discount bonds have a com-
pounding frequency equal to the reciprocal of their time to maturity. For example, if a discount bond
pays $1.00 in τ j years, then the compounding frequency is 1 ⁄ τ j and we have:

[2] p ( τ j ) ( 1 + z ( τ j, τ j )τ j ) = 1 or p ( τ j ) = 1 ⁄ ( 1 + z ( τ j, τ j )τ j )
–1 –1

The spot curve based on continuous compounding, referred to as the continuous spot curve, represents
the relationship between the spot rate, z ( τ j ) , and time to maturity τ j . In contrast to the numerous discrete-
ly compounded spot curves, there is only one continuously compounded spot curve
τj ⋅ f
With continuous compounding, the expression ( 1 + z ( τ j, f ) ⁄ f ) becomes exp ( z ( τ j )τ j ) where exp(x)
τj ⋅ f
= e . In other words, ( 1 + z ( τ j, f ) ⁄ f ) converges to exp ( z ( τ j )τ j ) as f approaches infinity. There-
x

fore, the price of a discount bond [1] can be written as

[3] p ( τ j ) = exp ( – z ( τ j )τ j )

2.2.2 The relationship between spot and forward rates


In this section we explain the relationship between spot and forward interest rates, assuming continuous
compounding. This relationship plays a fundamental role in various types of term structure estimation
methods.

A forward interest rate, assuming discrete compounding, is the annual interest rate contracted at time
t 0 to be paid from time t 1 and t 2 , compounded f times a year. We denote this forward rate by F ( t 1, t 2, f ) .
Note that the forward rate is simply an interest rate that takes effect at some future point in time. Similar
to a spot rate, a forward rate is defined in terms of a compounding horizon and a time to maturity. Chart 3
shows the relationship between current and future dates and the forward rate.

Chart 3
Demonstration of forward interest rate time profile
F(t1,t2,f)

t0 t1 t2

Using continuous compounding, the forward interest rate in terms of the short z ( τ 1 ) and long z ( τ 2 ) in-
terest rates can be written as:

[4] exp ( z ( τ 1 ) ⋅ τ 1 ) ⋅ exp ( F 2 ( τ 2, 1 ) ⋅ τ 2, 1 ) = exp ( z ( τ 2 ) ⋅ τ 2 )

where τ 2, 1 is the time between t 1 and t 2 , and F 2 ( τ 2, 1 ) is the continuously compounded forward rate
between t 1 and t 2 .

Using [4], we can solve for the forward rate, F 2 ( τ 2, 1 ) , as


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An investigation into term structure estimation methods for RiskMetrics

z ( τ2 ) – z ( τ1 )
F 2 ( τ 2, 1 ) = z ( τ 2 ) + ------------------------------- ⋅ τ 1
[5] τ2 – τ1
= z ( τ 2 ) + α ( τ 1, τ 2 ) ⋅ τ 1

The second term in [5], α ( τ 1, τ 2 ) , represents the slope of the continuous spot curve. In the limit, i.e., as
τ 2 ( z ( τ 2 ) ) approaches τ 1 ( z ( τ 1 ) ) , the forward rate for a very short period of time beginning at τ 1 is

dz ( τ 1 )
[6] F ( τ 1 ) = z ( τ 2 ) + --------------- ⋅ τ 1
dτ 1

F ( τ 1 ) is the instantaneous forward rate for a maturity of τ 1 . In general, the instantaneous forward rate
describes the rate of return on a very short-term investment at time τ j in the future. Using [6] and [3], we
can establish mathematical relationships between the instantaneous forward rate, the spot rate and
price of a discount bond. For example, take the natural logarithm of [3]

[7] – log ( p ( τ j ) ) = z j ( τ j ) ⋅ τ j

and then a total differential with respect to maturity

dz j
[8]
d
– log ( p ( τ j ) ) = z j + τ
dτ j dτ j j

It follows from [6] that the right-hand side of [8] is the instantaneous forward rate, i.e.,

dz j
[9] F(τ j ) = z j + τ
dτ j j

Therefore, we are left with

[10]
d
F(τ j ) = – log ( p ( τ j ) )
dτ j

Next, write [10] as

[11] dτ j F ( τ j ) = – d log ( p ( τ j ) )

integrate (sum) from time 0 to τ j and then exponentiate. The result is,

τj
[12] exp  –
 ∫ 0
F ( s ) ds = p ( τ j )

Expression [12] is important because it allows us to write the price of a discount bond as a function of
instantaneous forward interest rates. The forward rates exist at every instant in time from 0 to τ j . In
addition, we can derive the relationship between spot and instantaneous forward rates by taking the loga-
rithm of [12], using the definition given in [3], and solving for the spot rate, z ( τ j ) .
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An investigation into term structure estimation methods for RiskMetrics

τj
[13]

1
z ( τ j ) = ---- F ( s ) ds
τj 0

Expression [13] states that the spot interest rate is an average of instantaneous forward interest rates
between 0 and τ j .

We now summarize the main findings of this section. First, we derived the instantaneous forward rate
from the simple relationship that links short, long and forward interest rates ([6]). Second, we showed how
the price of a discount bond can be written explicitly as a function of the forward rates ([12]). And third,
we derived an expression that relates spot and forward interest rates ([13]). We will make use of such re-
lationships when we discuss term structure estimation methods in sections 4 and 5.

2.3 Coupon bonds


Suppose we have a set of N coupon bonds, i=1,2,...,N. The ith coupon bond makes M i regular payments,
c i (coupons), at times τ 1 < τ 2 <....< τ M i = T i and a final payment of principal, P, at maturity date T i . The
coupon is paid f times per year and the bond has a yield-to-maturity (YTM) of y c ( i ) . The yield-to-maturity
is a function of c i , P, T i and f. When compounding is discrete, we can write the price of the ith coupon
bond with T i years to maturity as follows:

Mi
ci ⁄ f
[14] ∑ (----------------------------------------
P
p c ( i, M i ) = τj ⋅ f
- + -------------------------------------------
τM ⋅ f
j=1 1+ y ⁄ f) c(i) ( 1 + yc ( i ) ⁄ f )
i

where M i = T i × f is the number of coupon payments made by the bond and the YTM, given p c ( i ) , c i ,
7
f, T i and P, is the rate that solves [14] . A particular type of coupon bond that trades at its face value is
known as a par bond. For a par bond, the YTM is equal to the coupon rate, that is, y c ( i ) = c i .

Assuming that compounding is continuous, we can write [14] as

Mi
ci ⁄ f
[15] ∑ ----------------------------
P
p c ( i, M i ) = - + --------------------------------
exp ( y τ ) exp ( y τ )
c(i) j c (i) Mi
j=1

The expressions for a bond’s price given in [14] and [15] imply that the first coupon payment occurs ex-
actly 1/f years from the current date (i.e., t 1 = t 0 + 1 ⁄ f ). Alternatively expressed, [14] and [15] assume
that the price of a bond is computed on a coupon date. In practice, however, we may be asked to compute
the price of a bond at some time between coupon dates, or shortly before the first coupon date. When we
need to price a bond between coupon payments, we must allow for accrued interest. Accrued interest is
what distinguishes a bond’s clean price (the price that does not include accrued interest) from its dirty
price (the price that includes accrued interest). The formula for accrued interest for the ith bond is:

tt – t p
[16] Ad = c i ⁄ f ⋅ --------------
tn – t p

7
Note that we cannot analytically solve for the YTM so we must employ some numerical method to find a solution. Refer to
a single variable calculus textbook for details.
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where t t denotes the analysis (current) date and t p and t n denote the previous and next coupon payment
dates, respectively.

2.2.1 A numerical example


Consider the purchase of a coupon bond with the characteristics presented in table 2:

Table 2
Bond characteristics
Price USD 98.00
Coupon rate 8.000%
Coupon frequency Semi-annual
Day count basis Actual/Actual
Trade date 12 Feb 1997
Effective date 15 Feb 1997
Maturity date 15 Aug 2001

This bond was purchased on February 12, 1997 and it pays coupons of 4 US dollars every six-months up
until August 15, 2001 when it matures and pays (in addition to the final coupon) its par value of 100 US
dollars. Table 3 shows the cash flow profile of this bond:

Table 3
Bond characteristics
As of February 15, 1997
j (cashflow) Date n d τj Coupon
-- 15-Feb-97 -- -- 0.0000 --
1 15-Aug-97 181 362 0.5000 4
2 15-Feb-98 365 368 0.9918 4
3 15-Aug-98 546 362 1.5083 4
4 15-Feb-99 730 368 1.9837 4
5 15-Aug-99 911 362 2.5166 4
6 15-Feb-00 1,095 368 2.9755 4
7 15-Aug-00 1,277 364 3.5082 4
8 15-Feb-01 1,461 368 3.9701 4
9 15-Aug-01 1,642 362 4.5359 104

Given the price of the bond (98 US dollars) and the information presented in table 3, we use [14] to solve
for the bond’s YTM which is 8.489%.

Calculating a bond’s price between coupon payment days requires that we determine accrued interest.
Consider the same bond discussed above, but now we would like to compute its price 21 days after (March
8, 1997) the first coupon payment (February 15, 1997). Using equation [16], the accrued interest, Ad, is
calculated as follows:

[17]
8 21
Ad = --- × --------- = 0.4641
2 181

Recall that at any point in time over the life of a bond, its price can be decomposed into a clean price p c ,
c

(the price that does not include accrued interest) and dirty price p c (the price that includes accrued inter-
est).
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It follows that p c = Ad + p c . We keep the dirty price at USD 98.000, therefore the clean price of this
c

bond on March 8 is USD 97.536 and the YTM must satisfy:

9
[18] ∑ ----------------------------
4 104
0.4641 + 97.536 = - + --------------------------------
exp ( y τ ) exp ( y τ )
c(i) j c (i) Mi
j=1

Table 4 shows the bond’s coupon dates, the bond’s coupons and the number of days until the coupon pay-
ments.

Table 4
Bond characteristics
As of March 8, 1997, refer to table 1 for definitions

j (cashflow) Date n d τj Payment

-- 15-Feb-97 n/a n/a n/a n/a


-- 8-Mar-97 21 181 0.1160 0.4641
1 15-Aug-97 160 362 0.4420 4
2 15-Feb-98 344 368 0.9348 4
3 15-Aug-98 525 362 1.4503 4
4 15-Feb-99 709 368 1.9266 4
5 15-Aug-99 890 362 2.4586 4
6 15-Feb-00 1,074 368 2.9185 4
7 15-Aug-00 1,256 364 3.5450 4
8 15-Feb-01 1,440 368 3.9130 4
9 15-Aug-01 1,621 362 4.4779 104

The YTM of the bond as of March 8, 1997 is 8.750%.

2.4 Expressing the price of a coupon bond as a set of discount bonds


Each coupon and principal payment, taken individually, has the structure of a discount bond. Accordingly,
a coupon bond can be viewed as a set of discount bonds. Such a structure allows us to relate coupon
bond prices to the spot curve. For example, for any coupon bond, the jth coupon payment is equivalent
to a “j times f period deposit” at an annual rate c i . If this coupon payment were traded separately, its price
(present value) at t 0 would be c i ⋅ p ( τ j ) . Similarly, the price of the P principal payment at t 0 would be
P ⋅ p ( τ Mi ) .

We can formalize the relationship between coupon and discount bonds as follows. Starting with a set of N
coupon bonds, the price of the ith bond (i=1,...,N) is given by the expression

Mi

[19] p c ( i, M i ) = ∑w i, j p ( τ i, j )
j=1
where

Mi is the number of cashflows (including principal) generated by the ith coupon bond
(j=1,..., M i ).

p c ( i, M i ) is the dirty price of the coupon bond (that is, the clean price plus accrued interest) that
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matures in τ M i years.

w i, j is the jth cashflow generated from the ith coupon bond. Note that w i, M i is equal to the last
coupon payment plus principal.

τ i, j is the time until the jth cashflow of the ith coupon bond (in years)

p ( τ i, j ) is the price of a discount bond from time t 0 until time t j associated with the ith coupon bond.
Recall from section 2.2.1, that the price of a discount bond, j=1,...,. M i , is given by

 exp ( – z ( τ j ) ⋅ τ j ) (Continuous compounding)


[20] p(τ j ) =  τ ⋅f
 1 ⁄ ( 1 + z ( τ j, f ) ⁄ f ) j (Discrete compounding)

3. RiskMetrics discount bond prices and spot rates


RiskMetrics produces discount bond prices and spot interest rates ranging in maturity from 2 to 30 years
for the government bond markets included in the J.P. Morgan Government Bond Index as well as the
Irish, ECU, and New Zealand markets. Table 5 shows the markets and the maturities of the discount
bonds for which RiskMetrics produces prices and interest rates.

Table 5
RiskMetrics government bond spot interest rates

Term structure
Market 2y 3y 4y 5y 7y 9y 10y 15y 20y 30y
Australia • • • • • • • •
Japan • • • • • • •
New Zealand • • • • • • • •

Belgium • • • • • • • • •
Denmark • • • • • • • • • •
France • • • • • • • • • •
Germany • • • • • • • • • •
Ireland • • • • • • • • •
Italy • • • • • • • • • •
Netherlands • • • • • • • • • •
South Africa • • • • • • • • •
Spain • • • • • • • •
Sweden • • • • • • • •
U.K. • • • • • • • • • •
ECU • • • • • • •

Canada • • • • • • • • • •
U.S. • • • • • • • • • •

As was discussed in the Introduction and Overview to this article, RiskMetrics currently relies on a theo-
retical term structure estimation method to construct spot interest rates from daily coupon bond prices.
Often, this type of estimation method is used in the context of finding the ‘theoretically’ correct value of
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a bond, or set of bonds. That is to say, when pricing bonds, the theoretical approach provides a way to
describe price of bonds as a function of certain parameters such as the mean-reversion of the short-term
interest rate.

RiskMetrics, however, provides rates and prices to be used for risk management--rather than pric-
ing. Therefore, the methodology it uses to construct spot interest rates does not necessarily have to be
consistent with a bond pricing model that attempts to explain the variation of bond prices across various
maturities. Moreover, as table 5 shows, RiskMetrics requires a set of spot rates (and prices of discount
bonds) on relatively few maturities. Such a requirement is unlike that found in a pricing framework
where researchers seek to value bonds that may have slightly different maturities.

Considerations such as the number and type of spot interest rates required, as well as their use (risk man-
agement), motivate the new term structure estimation method that RiskMetrics plans to employ.

4. Bootstrapping spot interest rates and discount functions


Bootstrapping is probably the most widely used empirical method for estimating spot interest rates from
a set of coupon bonds. According to the bootstrapping technique, spot (or forward) interest rates are iter-
atively extracted using a standard formula for pricing a coupon bond. Once the (bootstrapped) spot interest
rates corresponding to each coupon payment period (e.g., every six-months) have been obtained, we can
generate a complete universe of spot rates by either smoothing or interpolating the bootstrapped rates.

The proposed RiskMetrics term structure estimation method is based on the bootstrap algorithm applied
to a set of coupon bonds. Table 6 presents a typical sample of coupon bond information, the universe of
Finnish government bonds on March 10, 1997.

Table 6
Finnish government bonds
As of March 10, 1997, 30/360 basis, annual coupon payment,

Description Maturity Price Accrual Coupon


date
FIN GOV 11.00% Jan 99 15-Jan-1999 112.782 1.772 11.00
FIN GOV 10.00% Sep 01 15-Sep-2001 121.203 4.944 10.00
FIN GOV 10.75% Mar 02 15-Mar-2002 125.877 10.69 10.75
FIN GOV 9.50% Mar 04 15-Mar-2004 122.745 9.447 9.50
FIN GOV 7.25% Apr 06 18-Apr-2006 108.916 6.545 7.25
FIN GOV 8.25% Oct 10 15-Oct-2010 116.899 3.392 8.25

For a given set of coupon bonds, such as those shown in table 5, the bootstrap procedure solves for spot
rates and prices of discount bonds by making use of the standard bond pricing formula [19].

4.1 The bootstrap


The starting point for the bootstrap procedure is equation [19] where we write the price of a coupon bond
that matures in τ Mi years as follows:

[21] p c ( i, M i ) = p ( τ i, 1 )c i + p ( τ i, 2 )c i + … + p ( τ i, M i ) ( P + c i )

For ease of exposition, we assume the following when describing the bootstrap:
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1. Coupons are paid on a semi-annual basis

2. Exactly one bond matures every six-months. In this case, we can ignore the ‘i’ subscript on the time
to maturity variable. That is, τ i, j becomes τ j . As we will discuss in more detail in section 4.2, this
assumption is unrealistic, however, it facilitates the exposition of the bootstrap.

Using a set of coupon bond prices and their characteristics (e.g., day count basis) we can apply [20] to
solve for the implied term structure of interest rates. Starting with a six-month bond, which under our
assumptions is a discount bond, we have

[22] p c ( 1, M 1 ) = p ( τ 1 )P which implies p̃ ( τ 1 ) = p c ( 1, M 1 ) ⁄ P .

(Note that the tildes ‘~’ signify solved values).We can then solve for the spot rate z̃ ( τ 1 ) using [20].
Now, given p̃ ( τ 1 ) we can solve for p̃ ( τ 2 ) , the price of the one-year discount bond. Since

[23] p c ( 2, M 2 ) = p̃ ( τ 1 )c 2 + p ( τ 2 ) ( P + c 2 )

the price of the one-year discount bond is p̃ ( τ 2 ) = ( p c ( 2, M 2 ) – p̃ ( τ 1 )c 2 ) ⁄ ( P + c 2 ) from which we can


solve for z̃ ( τ 2 ) . Next, we would solve for the price of the eighteen-month discount bond, given p̃ ( τ 1 ) ,
p̃ ( τ 2 ) , c 3 and P since

[24] p c ( 3, M 3 ) = p̃ ( τ 1 )c 3 + p̃ ( τ 2 )c 3 + p ( τ 3 ) ( P + c 3 )

Proceeding in an iterative manner, given a series discount bond prices p̃ ( τ 1 ), …, p̃ ( τ n – 1 ) and the price
of the n-1 coupon bond p c ( n – 1, M n – 1 ) , we can solve for nth price of a discount bond p̃ ( τ n ) and spot rate
z̃ ( τ n ) using the formula

p c ( n – 1, M n – 1 ) – p̃ ( τ n – 1 ) c n – … – p̃ ( τ n ) c n
[25] p̃ ( τ n ) = --------------------------------------------------------------------------------------------
P + cn

4.2 Practical implementation of the bootstrap procedure


For the bootstrap to work properly, one needs a bond price, principal payment and coupon rate at each
bootstrap maturity (as well as the bond’s characteristics). In practice, however, we may find that at any
given maturity, either more than one bond matures or no bonds mature. Both issues can make the imple-
mentation of the bootstrap quite cumbersome.

The procedure described in section 4.1 assumed that one bond matures every six months. However, it is
not uncommon to find more than one bond maturing on any bootstrap maturity date. This may result from
long-dated coupon bonds “rolling” down the yield curve. In such a situation, we can calculate the average
of the bootstrapped rates at each bootstrap maturity date, and use this rate to continue bootstrapping. We
explain this concept with a simple example and then present a general approach for dealing with multiple
bonds maturing at a bootstrap maturity date.

Continuing with the framework set forth in section 4.1, suppose that three bonds mature in one year. In
this case we would apply [23] to each of the three bonds which would yield prices of the discount bonds
p̃ ( τ 1, 2 ) , p̃ ( τ 2, 2 ) and p̃ ( τ 3, 2 ) and the spot rates z̃ ( τ 1, 2 ) , z̃ ( τ 2, 2 ) and z̃ ( τ 3, 2 ) . We would then find the
price of the discount bond and spot rate at the one-year date by averaging over the individual bootstrapped
prices and rates, respectively.
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3
[26] ∑ p̃ ( τ (price of discount bond)
1
p̃ ( τ 2 ) = --- k, 2 )
3
k=1

3
[27] ∑ z̃ ( τ (spot interest rate)
1
z̃ ( τ 2 ) = --- k, 2 )
3
k=1

We would then apply this price (or rate) when bootstrapping at eighteen months. In general, we can write
out the details of this averaging procedure as follows:

• First, let τ' r represent the rth maturity date required in the bootstrap procedure (r=1,..,R) where R
is the total number of maturity dates required to bootstrap. Each τ' r is referred to as a boot-
strap maturity date. For example, if a bond has exactly 5 years to maturity with semi-annual
compounding then R = 5x2 = 10. Moreover, τ' 1 represents the six-month date, τ' 2 denotes the
one-year date, and so on, up until τ' 10 which represents the five-year date.

• Second, calculate N' r , the total number of bonds maturing at time τ' r . That is, N' r is the total
number of bonds such that τ i, M i = τ' r for r = 1,...,R.

• Third, at every τ' r , calculate the N' r prices of discount bonds (or spot rates). That is to say, cal-
culate the prices of discount bonds for every bond that matures on a bootstrap maturity date.

• Fourth, compute the average price of the discount bond (or spot rate) at each τ' r .
When no bonds exist at a required maturity date τ' r , the yield to maturity at that date is found by in-
terpolating (e.g. linearly) the two nearest yields, i.e., interpolating between the yields that exist at times
τ' r – 1 and τ' r + 1 . Given this yield, the price of the bond and coupon are determined by assuming that the
bond at that maturity is priced at par.

5. Alternative term structure estimation methods


In this section we explain alternative term structure estimation methods. The purpose of this section is to
present an overview of term structure estimation methods so that the reader can obtain a better understand-
ing of the various techniques used, by both academics and practitioners, to estimate the term structure of
interest rates. We focus on empirical term structure estimation methods. Excluding the bootstrap, such
methods consist of two basic steps:

• Model: First, assume that the price of a discount bond (or some variation of it) can be modeled
according to some mathematical function, such as a cubic spline or exponential polynomial,
whose value is determined by a set of parameters.

• Estimate: Second, use observed prices on coupon or discount bonds to estimate the parameters of
the model. Exactly how the parameters are estimated is determined by some smoothness crite-
rion. Smoothing refers to a statistical technique such as regression analysis that fits a line or
curve through a set of points. Smoothing in the context of term structure estimation assumes that
bond price data are measured with some error, i.e., they are noisy. Interpolation, on the other
hand, is predicated on nonnoisy data and simply ‘links’ nearby data points by some mathematical
function.
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5.1 Bootstrapping forward rates


In section 4 we explained a procedure to iteratively extract prices of discount bonds (spot rates) from a set
of coupon bonds. We now show how to bootstrap forward interest rates from the same data. Recall that we
can write the price of the ith coupon bond as

Mi

[28] p c ( i, M i ) = ∑w i, j p ( τ j )
j=1

Moreover, we can write the discount factor, assuming continuous compounding, in terms of forward rates
as follows;

p ( τ j ) = exp ( z ( τ j ) ⋅ τ j ) = exp ( F 1 ⋅ τ 1, 0 ) ⋅ exp ( F 2 ⋅ τ 2, 1 ) ⋅ … ⋅ exp ( F j ⋅ τ j, j – 1 )

[29]
j
= ∏ exp ( F s ⋅ τ s, s – 1 )
s=1

where F 1 = z ( τ 1 ) and to simplify notation set F s = F ( τ s – 1 ) . Note that with discrete compounding we
would have:

τj ⋅ f τ 1, 0 ⋅ f τ j, j – 1 ⋅ f
p ( τ j ) = ( 1 + z ( τ j, f ) ⁄ f ) = ( 1 + F1 ⁄ f ) ⋅ … ⋅ (1 + F j ⁄ f )
[30] j

∏ (1 + F
τ s, s – 1 ⋅ f
= s ⁄ f)
s=1

and F 1 = z ( τ 1, f ) . Given this framework, it should seem obvious that we can apply the general principals
of section 4.1 to bootstrap forward rates. For example, from [22] we know that

[31] p ( τ 1 ) = p c ( 1, M 1 ) ⁄ P

τ 1, 0 ⋅ f
We can solve for F 1 since p̃ ( τ 1 ) = ( 1 + F 1 ⁄ f ) . Given p̃ ( τ 1 ) , [23] implies

[32] p ( τ 2 ) = ( p c ( 2, M 2 ) – p̃ ( τ 1 )c 2 ) ⁄ ( P + c 2 )

τ 1, 0 ⋅ f τ 2, 1 ⋅ f
We can solve for F 2 since p̃ ( τ 2 ) = ( 1 + F̃ 1 ⁄ f ) ⋅ ( 1 + F2 ⁄ f ) . Proceeding in an iterative man-
ner we can extract all of the forward rates.

In cases where there are either multiple or no bonds mature at a bootstrap maturity date, we apply the tech-
niques described in section 4.2.

5.2 Polynomial and exponential splines


There is an extensive research literature in the area of fixed income on the best way to extract prices of
discount bonds and spot rates from coupon bonds. A large portion of this research has been dedicated to
finding mathematical functions that can approximate the true shape of the discount function or term struc-
ture of interest rates. By discount function we mean simply the price of a discount bond evaluated over
a set of maturities. Chart 4 shows a typical shape of the discount function p ( τ j ) .
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Chart 4
A plot of the discount function [from 0 to T]

p(τj)

0 T

A continuous and complete discount function is unobservable. That is, we do not observe prices of dis-
count bonds at all possible maturities since coupon bonds will only yield a set of discrete discount bond
prices. One approach to estimating a complete discount function is to find a mathematical function
(polynomial) that has a similar shape to the ‘true’ discount function. Such a function would be defined
over all maturities from time 0 to time T. Chart 5 shows how the shape of an approximating polynomial
may appear in comparison to the discount function.

Chart 5
Approximating the discount function with some polynomial

p(τj)

0 T

In many cases, rather than using one polynomial, defined over the entire set of maturities, we may more
accurately model the shape of the discount function by applying a piecewise polynomial. That is, in-
stead of approximating the function over the entire domain of maturities [0,T], we first break the maturities
up into segments, and find functions that locally describe the discount function over each of these seg-
ments. We then fit a polynomial to each segment [ τ j – 1, τ j ] for j=1,...,n and τ 0 =0 and τ n =T. Finally, we
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attach each of these functions at their so-called join points. Such a piecewise polynomial is known as a
polynomial spline and is represented in chart 6.

Chart 6
Applying a spline to the spot price curve

p(τj)

0 τ1 τ2 τ3 τ4 T

The original work on estimating the term structure of interest rates used splines to approximate the dis-
count function p ( τ j ) . Subsequent work on term structure estimation applied splines to some function of
p ( τ j ) such as

• – log ( p ( τ j ) ) , the negative logarithm of the discount function

• z ( τ j ) , the spot interest rates, and

• F ( τ j ) ,the forward interest rates.


We will discuss such applications in more detail in section 5.5 when we explain a general class of spline
functions known as B-splines.

McCulloch (1971,1975) and Shea (1984) where among the first to use splines to approximate the discount
function. McCulloch (1975) and Shea suggested the use of a cubic polynomial spline, which for the ith
bond and the jth maturity interval [ τ j – 1, τ j ] , models the discount function p ( τ j ) as

[33]
2 3
p ( τ j ) = 1 + β1 + β2 τ j + β3 τ j + β4 τ j

where β 1, β 2, β 3 and β 4 are parameters which are estimated from observed bond prices. Shea estimates
8
these parameters by restricted least squares (RLS) . In fact, he applied RLS to a polynomial spline and
shows that this technique is identical to McCulloch’s cubic spline. The main practical problem with us-
ing such splines, however, is that it is possible to generate unbounded positive and negative forward rates.

8
This follows from the work of Buse & Lim (1977). Note that Shea did not use coupon bonds when he estimated the spline.
Also, he applied his model to Nippon Telegraph and Telephone (NTT) zero-coupon issues--long-term discount bonds traded
in Japan’s bond market.
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Also, the term structure of interest rates tends to bend sharply toward the end of the maturity range ob-
served in the sample of bonds.

Vasicek and Fong (1982) argue that while splines constitute a flexible family of curves, there are several
drawbacks to fitting such functions. The problem with polynomial splines, they argue, is that they weave
9
around discount function resulting in highly unstable forward rates . They suggest approximating the dis-
count function with the exponential spline such as

[34] p ( τ j ) = β 1 + β 2 exp ( – ατ j ) + β 3 exp ( – 2ατ j ) + β 4 exp ( – 3ατ j )

where β 1, β 2, β 3 and β 4 are parameters and α is the instantaneous forward rate. Vasicek and Fong simply
propose this model and suggest a methodology to estimate the parameters. The authors do not fit the model
to any data.

Shea (1985) estimates the Vasicek and Fong model using the NTT zero-coupon bonds that were applied
in Shea (1984). The author concludes that the estimation of exponential splines is no more convenient
than estimation with polynomial splines, that is, both splines produce identical results.

5.3 Exponential polynomial method


Chambers, Carleton, and Waldman (1984) assume that the spot interest rate may be expressed as a sim-
ple polynomial

L
[35] ∑β τ
l–1
z(τ j ) = l j
l=1

where L is the length of the polynomial. Under the assumption of continuous compounding (see [3]), the
discount function, p ( τ j ) becomes the exponential of a polynomial. That is,

L
 l
[36] p ( τ j ) = exp  –

∑ β τ 
l j
l=1

Therefore, the price of a coupon bond can be written explicitly as a function of the parameters β l , l=1,...,L.
Mi L
 l
[37] p c ( i, M i ) = ∑ w i, j exp  –

∑ β τ 
l j
j=1 l=1

from which we get the regression equation


Mi L
 l
[38] p c ( i, M i ) = ∑ w i, j exp  –

∑ β τ  + ε
l j i
j=1 l=1

where ε i is a random error term and we estimate β l . Chambers et. al. estimate the polynomial’s parame-
ters using non-linear least squares.

9
Refer to section 2.2 for a discussion on the relationship between zero and forward rates.
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5.4 Modeling and smoothing forward rates


Nelson and Siegel (1987) model the forward rate, F ( τ j ) , as an exponential polynomial

[39] F ( τ j ) = β 1 + β 2 exp ( – τ j ⁄ c 1 ) + β 3 exp ( – τ j ⁄ c 2 )

where β 1, β 2 and β 3 are parameters and c 1 and c 2 are constants. To obtain the spot rate as a function of
maturity we integrate [39] from 0 to τ j and then divide by τ j . The resulting function is

[40] z ( τ j ) = β 1 + ( β 2 + β 3 ) [ 1- exp ( – τ j ⁄ c 1 ) ] ( – τ j ⁄ c 2 ) + – β 2 exp ( – τ j ⁄ c 1 )

Nelson and Siegel estimate the parameters of this model by least squares using US Treasury bills, thus
avoiding coupon bonds. For 37 samples covering January 22, 1981 through October 27, 1983, the matu-
rities on these bills ranged from 3 days to 1 year.

Svensson (1994) proposed the following modified form of Nelson and Siegel’s forward model:

[41] F ( τ j ) = β 1 + β 2 exp ( – τ j ⁄ c 1 ) + β 3 ( – τ j ⁄ c 2 ) exp ( – τ j ⁄ c 2 ) + β 4 ( – τ j ⁄ c 3 ) exp ( – τ j ⁄ c 3 )

This form of the Nelson and Siegel model has been noted in Oda (1991) and Malz (1997). Recently, Bliss
(1994) proposes estimating the Nelson and Siegel model using a nonlinear, constrained optimization pro-
cedure that accounts the bid and ask prices of bonds as well bonds durations. See Bliss (1994) for more
details.

Adams and Van Deventer (1994), while continuing to focus on the forward rate function, take a funda-
mentally different approach to estimating the term structure of interest rates. Their criterion for the best
fitted yield curve is in terms of the maximum smoothness for the forward rates. The starting point for
their analysis is a measure of the smoothest possible forward rate curve on some interval [0,T] which they
define as

[42]
∫ [ F'' ( s ) ] ds
2
Z =
0

where F'' ( s ) is the second derivative of the forward rate curve at maturity s. To understand why this is a
natural measure of smoothness, express [42] in discrete form:

T
[43] ∑ [ F'' ( s ) – 0 ] ( s –s
2
Zd = i i i – 1)
i=0

Recall that the second derivative measures rate of change of a curve, i.e., how the slope of the curve chang-
es as the independent variable (maturity, in this case) changes. Hence, the closer the second derivative is
to zero, the more smooth the curve. Smoothness also requires that the second derivative is small at each
point in time from the beginning (time 0) to the end (time T). Therefore, we should require that the sum
(or integral) of the squared deviations of the second derivatives F'' ( s ) from zero is as small as possible.

In practice, the minimization of [42] is meaningless unless it is combined with prices of observed discount
bonds. In section 2.2, we showed how to write the prices of discount bonds in terms of forward rates:
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τj
[44] p ( τ j ) = exp  – j=1,....,M
∫ 0
F ( s ) ds

Let p j represent the prices of observed discount bonds. Adams and Van Deventer define the maximum
smoothness criterion as that which minimizes Z subject to the constraint:

τj
[45] p j = exp  –
 ∫0
F ( s ) ds

Within this framework, we estimate a term structure of interest rates by modeling the forward rates as a
polynomial and estimate the parameters of the polynomial using the maximum smoothness criterion, i.e.,
minimize Z subject to [45]. Two suggested parameterizations of the forward rate include:

L
[46] ∑β τ (forward rate in polynomial form)
s–1
F(τ j ) = s j
l=1

L
[47] ∑ exp ( β τ (forward rate in exponential form)
s–1
F(τ j ) = s j )
l=1

The authors compare this maximum smoothness approach to alternative term structure estimation methods
using yen and US interest rate swap and money market data.

5.5 A detailed look at a general class of splines: B-splines


In this section we explain how a particular class of spline functions, known as cubic B (for basis)
splines, can be applied to estimate the term structure of interest rates. This class of splines has been
applied recently in Steely (1991) and Fisher et. al (1995). B-splines are appealing because they avoid
some of the difficulties associated with estimating the parameters of polynomial splines discussed in sec-
tion 5.2. The purpose of this section is to show exactly how to estimate the parameters of (B-) splines
from a set of coupon bonds by applying simple regression analysis. In addition, we provide a detailed
exposition of the mechanics of B-splines--which are often not published--to show the mathematical un-
derstanding necessary to implement a robust spline methodology.

To explain how B-splines work, we begin (again) with a general definition of the price of a coupon bond,
now written in vector form.

[48]
T
p c ( i, M i ) = w i p ( τ i )

where

w i is the vector [ w i, 1, w i, 2, …, w i, M i ] (M i × 1 )

τ i is the vector [ τ i, 1, τ i, 2, …, τ i, M i ] (M i × 1 )

p ( τ i ) is the vector [ p ( τ i, 1 ), p ( τ i, 2 ), …, p ( τ i, M i ) ] (M i × 1 )

and we assume that there are N bonds (i=1,...,N)


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Splines10 require that we divide the maturity space of all N bonds into K-1 intervals by using K knots
(break points). { s k } k = 1 denotes the K break points (k=1,...,K) and s 1 = 0 and s K = M and M is the
K

longest maturity bond.

In practice, when using a special class of B-splines known as cubic B-splines, it is suggested that research-
ers work with augmented knot points which are denoted by { d k } k = 1 where d 1 = d 2 = d 3 = 0 ,
K+6

d k + 4 = d k + 5 = d k + 6 = s K and d k + 3 = s k for 1 ≤ k ≤ K .

Let κ (kappa) represent the total dimension of the spline space, i.e., κ is the number of “independent” B-
splines that can be used to approximate any function.

κ = K + 2= # of intervals degree of polynomial


[49]















+
K–1 3

A cubic B-spline is given by the following recursive expression where r=4 and 1 ≤ k ≤ K .

r–1 r–1
φk ( τ j ) ( τ j – d k ) φk + 1 ( τ j ) ⋅ ( d k + r – τ j )
[50]
r
φ k ( τ j ) = ------------------------------------------ + -----------------------------------------------------
(dk + r – 1 – dk ) (dk + r – dk + 1)

 1 dk ≤ τ j < d k + 1
[51]
1
φk ( τ j ) = 
 0 otherwise

For each maturity, τ , we need to calculate φ k ( τ j ) for 1 ≤ k < κ .


1

A cubic B-spline basis which is a set of B-splines that are used to approximate a function is represented
by the κ × 1 vector

[52]
4 4 4
φ ( τ j ) = ( φ 1 ( τ j ), φ 2 ( τ j ), …, φ κ ( τ j ) )

From the B-spline basis we construct a cubic spline which is a weighted summation of B-splines. For ex-
ample, if we define a κ × 1 vector of coefficients (weights), β , β = ( β 1, …, β κ ) and let h s ( τ j ) , denote
the function we want to spline, then the cubic spline h s ( τ j ) is given by expression

κ
[53] hs ( τ j ) = ∑ β φ ( τ ) = φ ( τ )β
k k j j
k=1

where “s” denotes spline. Recall, that for each bond we have M i future payments that occur at particular
maturities, denoted by the vector ( τ i, 1, τ i, 2, …, τ i, M i ) , then for any of the k bases ( 1 ≤ k < κ ) , we have

[54] φ˜k ( τ i ) = ( φ k ( τ i, 1 ), φ k ( τ i, 2 ), …, φ k ( τ i, M i ) )
4 4 4

Using the k bases we can construct an M i × κ (collocation) matrix

10
This section is based on Fisher et. al (1995)
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4 4 4 
φ 1 ( τ i, 1 ) φ 2 ( τ i, 1 ) … φ κ ( τ i, 1 ) 

φ 1 ( τ i, 2 ) φ 2 ( τ i, 2 ) … φ κ ( τ i, 2 )  M
4 4 4
 i
[55] φ̃ ( τ i ) = … … … … 

φ 1 ( τ i, M i ) φ 2 ( τ i, M i ) … φ κ ( τ i, M i ) 
4 4 4
















κ

This matrix will prove useful when we try to estimate the β coefficients.

B-splines are used to approximate the discount function ( p ( τ j ) ), the negative logarithm of the dis-
count function ( l ( τ j ) ) and the forward rate ( F ( τ j ) ). We denote the function that we approximate by
h ( τ j ) . It follows that h ( τ j ) can take on any of three different forms-- p ( τ j ) , l ( τ j ) and F ( τ j ) --such that
there exists some function g() where g ( h ( τ j ), . ) = p ( τ j ) .

We can write the splined function for the ith bond as h s ( τ i, β ) = φ ( τ i )β which is an M i × 1 vector.
It follows that each bond of the N bonds has an M i × 1 vector of splined functions h s ( τ i, β ) . We now ex-
plain three parameterizations of h s ( τ i, β ) .

1. We approximate (spline) the discount function directly, i.e.,

[56] h(τ j ) = p(τ j )

By definition we know that h ( τ j ) = exp ( – z ( τ j )τ j ) . Solving for z ( τ j ) we get

log ( p ( τ j ) )
[57] z ( τ j ) = – -------------------------
-
τj

The splined function is simply

[58]
T
ps ( τ j ) = φ ( τ j ) β

where for each bond (i=1,...,N) we have M i discount functions

κ
p s ( τ i, 1 ) = ∑ φ (τ k i, 1 )β k
k=1
[59] …
κ
p s ( τ i, M i ) = ∑ φ (τ k i, M i )β k
k=1

Chart 7 shows how the splines relate to the discount function.


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Chart 7
Using B-splines to approximate discount func-

∑ φk ( τi1 ) βk
4
p(τi1)
k=1

K
tion p(τ ) ∑ φk ( τi2 ) βk
4
i2
k=1

0 τi1 τi2 T
d1 d2 d3

Let’s write the present value of the ith coupon bond as

p c ( i, M i ) = π i ( β ) = c i, 1 p s ( τ i, 1 ) + c i, 2 p s ( τ i, 2 ) + … + c i, M i p s ( τ i, M i )

[60]
κ κ κ
     
= c i, 1 

∑ φ k ( τ i, 1 )β k + c i, 2 
 
∑ φ k ( τ i, 2 )β k + … + c i, M i 
 
∑ φ (τ k i, M i )β k

k=1 k=1 k=1

we can re-write this as

Mi Mi Mi
     
[61] πi ( β ) =


∑ c i, j φ 1 ( τ i, j )

β1
+


∑ c i, j φ 2 ( τ i, j )

β2
…+


∑c i, j φ κ ( τ i, j )

βκ
j=1 j=1 j=1

























X i, 1 X i, 2  X i, κ

If we add the error term ε i to the definition p c ( i, M i ) = π i ( β ) , then we can get the regression equation

[62] p c ( i, M i ) = X i β + ε i (i=1,...,N)
where

X i = ( X i, 1, X i, 2, …, X i, κ ) (1 X κ)
T

Let Y represent the N × 1 vector of observed prices of coupon bonds. That is,
Y = ( p c ( 1, M 1 ), …, p c ( 1, M N ) ) . And let X denote the N x κ matrix of regressors, i.e., X = ( X 1, X 2, …, X κ ) .

Given the structure in [62], we can estimate the spline parameters β by ordinary least squares (OLS). The
simple OLS estimator is

[63]
OLS T –1 T
β = (X X) X Y
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Next, when we estimate β , we need to impose the restriction that the discount function at the current time
is one, i.e., p ( 0 ) = 1 . This is equivalent to

κ
[64] ∑ φ ( 0 )βk k
= 1
k=1

In order to estimate the spline parameters while imposing this restriction, we define the 1 x κ vector
R = ( φ 1 ( 0 ), φ 2 ( 0 ), …, φ κ ( 0 ) ) and set q = 1 such that Rβ = q .The restricted OLS estimator (ROLS)
4 4 4

is given by the expression.

[65]
ROLS OLS T –1 T T –1 T –1 OLS
β = β – ( X X ) R [ R ( X X ) R ] ( Rβ – q)

Finally, we obtain estimates of the prices of the discount bonds at each maturity using the relationship:

∑ φ (τ
ROLS
p̂ s ( τ i, 1 ) = k i, 1 )β̂ k
k=1
[66] …
κ

∑ φ (τ
ROLS
p̂ s ( τ i, M i ) = k i, M i )β̂ k
k=1

Similarly, estimates of the spot rates are given by:

log ( pˆs ( τ j ) )
[67] z ( τ j ) = – ---------------------------
-
τj

2. We approximate (spline) the negative logarithm of the discount function, i.e.,

[68] h(τ j ) = l(τ j )

In this case the splined function is given by the expression

[69]
T
l(τ j ) = (φ(τ j )) β
or
l ( τ j ) = – log ( p ( τ j ) ) = z ( τ j )τ j

We can write the spot rate in terms of l ( τ j ) as

l(τ j )
[70] z ( τ j ) = ----------
-
τj

Solving for the discount function yields

[71] p ( τ j ) = exp ( – l ( τ j ) ) = exp ( – φ ( τ j )β )


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In this case, the discount function associated with the ith bond is written as

κ
 
[72] p s ( τ i ) = exp  –

∑ φ ( τ )β  i k
k=1

We can write the price of a bond as

κ
 
p c ( i, M i ) = π i ( β ) = [ c i, 1, c i, 2, …, c i, M i ] exp  –

∑ φ(τ i, 1 )β k

k=1
κ
 
[73]
exp  –

∑ φ(τ i, 2 )β k

k=1

κ
 
exp  –

∑ φ(τ i, M i )β k

k=1

Or, more succinctly, as

κ
 
[74] ∑ φ ( τ )β 
T
p c ( i, M i ) = c i exp  – k i k

k=1

Now, define the regressor variable

κ
 
[75] ∑ φ ( τ )β 
T
X̃ i ( β ) = c i exp  – k i k

k=1

So the regression model can be written as:

[76] p c ( i, M i ) = X̃ i ( β ) + ε i (i=1,...,N)

In this situation there is a nonlinear relationship between the price of the bonds and the coefficient vector
β, so we must solve for β using nonlinear least squares algorithm.

3. Lastly, we approximate (spline) the forward rate, i.e.,

[77]
T
h(τ)= F(τ)= φ(τ) β

Recall from section 2.2.2 that instantaneous forward rate is given by

d log ( p ( τ j ) )
[78] F ( τ j ) = – -----------------------------
dτ j
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and the relationship between the forward rates and price of a discount bond is given by the expression:

τ
 j 
[79] p ( τ j ) = exp  – d s ⋅ F ( s )

 0
∫ 

Using [77] and re-arranging, we can write the set of discount functions associated with the ith bond

τ
 κ  i  
[80] p s ( τ i ) = exp  –
 ∑∫
 φ ( s )ds β 
 k  k
 k = 1 0  

Defining
τi

[81]

ψ k ( τi ) = d s ⋅ φk ( s )
0

it follows that [80] can be written as

κ
 
[82] p s ( τ i ) = exp  –

∑ ψ ( τ )β 
k i k
k=1

Write the present value of the ith coupon bond can now be written as

τ i, 1
 κ   

p c ( i, M i ) = π i ( β ) = [ c i, 1, c i, 2, …, c i, M i ]
exp  –
 ∑ ∫ φ ( s )ds β 

 k k
 k = 1 0  
τ i, 2
 κ   
[83] exp  –
 ∑ ∫ 

φ k ( s )ds β k
 
 k = 1 0  

τ i, M
 κ  i
 
 ∑ ∫ φ ( s )ds β 
exp  – 
 k k
 k = 1 0  

Or, more succinctly,

κ
 
[84] ∑ ( ψ ( τ ) ) β 
T
p c ( i, M i ) = c i exp  – k i k

k=1

Next, define the regressor variables X i ( β ) as


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κ
 
[85] ∑ ψ ( τ )β 
T
Xi(β) = c i exp  – k i k

k=1

so that the regression model is

[86] p c ( i, M i ) = X i ( β ) + ε i

As in the previous case, there is a nonlinear relationship between the price of the coupon bonds and the
coefficient vector β so we must solve for β using nonlinear least squares algorithm.

6. Discussion and Summary


RiskMetrics currently uses a theoretical term structure estimation method to generate spot interest rates
and prices on discount bonds from coupon bonds traded in 17 government bond markets. In this article,
we presented an alternative term structure estimation method, which is based on the bootstrap procedure,
that we plan to employ in the RiskMetrics production process. This algorithm will replace the (theoretical)
term structure estimation method that RiskMetrics currently uses.

The search for the “best” term structure estimation method requires that we analyze and assess the perfor-
mance of several competing estimation methods.The final decision on which term structure estimation
method to use depends on three key factors:

1. Use: The way in which the spot interest rates and their corresponding prices will be used. In RiskMet-
rics, for example, prices of discount bonds are used to calculate the volatility and correlations of future
cashflows as well as to determine the present value of those cashflows.

2. Coverage: The number and characteristics of the government bond markets used to estimate the term
structure of interest rates. RiskMetrics requires estimates of the term structure of interest rates for 13
bond markets. On any given day, the number of bonds traded in these markets ranges from approxi-
mately 160 (U.S.) to 8 (Finland).

3. Practical: We must consider the practical implementation of term structure estimation methodology.
That is, how many parameters are required to estimate the term structure and how do these parameters
vary across markets?

A quick perusal of the literature on term structure estimation methods will reveal that there is no shortage
of suggestions for ways to estimate the term structure of interest rates. In order to better understand the
alternative estimation methods, we presented six term structure estimation methods and explained, in de-
tail, how to estimate B-splines using standard regression analysis. The purpose of this discussion is to al-
low for a comparison between the bootstrap and alternative methods in terms of what it takes to implement
such algorithms in practice.

References
Adams, K.J., and D.R. Van Deventer. “Fitting Yield Curves and Forward Rate Curves With Maximum
Smoothness,” Journal of Fixed Income, 2 (June 1994) pp. 52-62.
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An investigation into term structure estimation methods for RiskMetrics

Bliss, R.R. “Testing Term Structure Estimation Methods,” Federal Reserve Bank of Atlanta Working Pa-
per 96-12a, (November 1996)

Buono, M., R.B Gregory-Allen, and Uzi Yaari. “The Efficacy of Term Structure Estimation Techniques:
A Monte Carlo Study,” Journal of Fixed Income, 1 (March 1992) pp. 52-59.

Buse, A., and L. Lim. “Cubic Splines as a Special Case of Restricted Least Squares,” Journal of the Amer-
ican Statistical Association, 72, (1977) pp. 64-68.

Chambers, D., W. Carleton, and D.W. Waldman. “A New Approach to Estimation of the Term Structure
of Interest Rates,” Journal of Financial and Quantitative Analysis, 19 (September 1984), pp. 233-252.

Cox, J.C., J.E. Ingersoll, Jr., and S. Ross. “A Theory of the Term Structure of Interest Rates,” Economet-
rica, 53 (March 1985) pp. 385-407.

Fama, E.F. and R.R. Bliss. “The Information in Long-Maturity Forward Rates,” American Economic Re-
view, 77 (September 1988) pp. 893-911.

Fisher, M., D. Nychka, and D. Zervos. “Fitting the Term Structure of Interest Rates with Smoothing
Splines,” Working Paper 95-1, Finance and Economics Discussion Series, Federal Reserve Board, (Janu-
ary 1995).

de Munnik, J.F.J, and P.C. Schotman. “Cross-sectional versus Time Series Estimation of Term Structure
Models: Empirical Results for the Dutch Bond Market,” Journal of Banking and Finance 18, (1994) pp.
997-1025.

Malz, A. M. “Interbank Interest Rates as Term Structure Indicators” manuscript, (June 1997)

Malz, A. M. “Interest-rate Mathematics” manuscript, (June 1997)

McCulloch, J.H. “Measuring the Term Structure of Interest Rates.” Journal of Finance, 34 (January 1971),
pp.19-31.

McCulloch, J.H. “Tax-Adjusted Yield Curve,” Journal of Finance, 30 (June 1975), pp. 811-829.

Nelson, C.R., and A.F. Siegel. “Parsimonious Modeling of Yield Curves,” Journal of Business, 60 (Octo-
ber 1987), pp. 473-489.

Oda, N. “A Note on the Estimation of Japanese Government Bond Yield Curves,” IMES Discussion Paper
96-E-27, (August 1996)

Shea, G.S. “Pitfalls in Smoothing Interest Rate Term Structure Data: Equilibrium Models and Spline Ap-
proximations.” Journal of Financial and Quantitative Analysis, 19 (September 1984), pp. 253-269.

Shea, G.S. “Interest Rate Term Structure Estimation with Exponential Splines: A Note.” Journal of Fi-
nance, 40 (March 1985), pp. 319-325.

Steely, J.M. “Estimating the Gilt-Edged Term Structure: Basis Splines and Confidence Intervals,” Jour-
nal of Business Finance and Accounting, 18, (June 1991) pp. 513-529.

Svensson, L.E.0. “Estimating and Interpreting Forward Interest Rates: Sweden 1992-1994,” IMF Working
Paper, WP/94/114, (1994).
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An investigation into term structure estimation methods for RiskMetrics

Vasicek, O.A, “An Equilibrium Characterization of the Term Structure.” Journal of Financial Economics,
37 (June 1977), pp. 177-188.

Vasicek, O.A., andH.G. Fong. “Term Structure Modeling Using Exponential Splines.” Journal of Finance,
37 (May 1982), pp. 339-348.

Wegman, E.J., and I.W. Wright. “Splines in Statistics,” Journal of the American Statistical Association,
78, (June 1983) pp. 351-363.
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RiskMetrics® Monitor
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When is a portfolio of options normally distributed?

Christopher C. Finger Introduction


Morgan Guaranty Trust Company
Risk Management Services When considering a portfolio of options, a risk manager is faced with two contrasting pieces of infor-
(1-212) 648-4657 mation. On the one hand, the manager is well aware that the distribution of the return on any one of the
finger_christopher@jpmorgan.com options is asymmetric and certainly not normal. On the other hand, the manager knows that when a
large number of random variables are considered, even if their individual distributions are not normal,
the distribution of their sum will be close to normal. Furthermore, the normal assumption is attractive
from a practical point of view, as it allows the manager to compute Value-at-Risk statistics through only
an analysis of the volatilities and correlations of the portfolio, rather than through full-blown simulation
techniques.

Thus is the dilemma: one option displays non-normal returns, while a portfolio of a large number of
reasonably uncorrelated options displays returns which are normally distributed. In this article, we will
attempt to shed some light on the questions of how many options constitute a “large number” and
what is the meaning of “reasonably uncorrelated”.

As the goal of this article is to give intuitive results rather than describe option portfolio distributions
with pinpoint accuracy, we will make a number of simplifying assumptions. We consider only Europe-
an options, and assume the following:
1
1. Every option in each portfolio is struck at the money forward .

2. Every option has the same expiration date.

3. Returns on the underlying assets are normally distributed, each with the same volatility.

4. Each pair of underlying assets has the same correlation.

Additionally, we will only consider the portfolio distribution at the options’ expiration date. Certainly,
departures from these assumptions will influence the portfolio distribution, but making these assump-
tions allows us to isolate the effects of the two parameters we wish to consider -- correlations and
portfolio size.

We begin by examining various option portfolios through simulations, and show that in almost all cas-
es, there is significant non-normality in the portfolio distributions. We then present a simple analytical
model which gives some intuition to these somewhat surprising findings. Finally, we summarize and
conclude.

Simulation results
In this section, we investigate portfolios of options through simulations. Our procedure will be to fix a
level of correlation, generate a large number (5000 in most cases) of scenarios for returns on the assets
2
underlying our options , and then compute the value of the option portfolio in each scenario. We will
be concerned with the shape of the portfolio distribution, and will examine two types of output. One is
simply a histogram of the portfolio scenarios, which we may compare visually with the normal dis-
tribution. The second set of output consists of percentile levels of the portfolio distribution. Recall
that one of the most useful properties of the normal distribution is that its percentile levels may be ob-

1
That is, the strike price is equal to the expected value of the price of the underlying at the expiration date.
2
For more information on the generation of return scenarios, refer to the RiskMetrics Technical Document, 4th edition,
Chapter 7 and Appendix E.
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When is a portfolio of options normally distributed?

tained by multiplying the standard deviation by an appropriate scaling factor. To compare the distribu-
tions of our option portfolios, then, to the normal, we will calculate how many standard deviations each
portfolio’s 90th, 95th, and 99th percentiles lie above the portfolio mean. If the portfolio distributions
are close to normal, we will expect to see these values close to 1.28, 1.65, and 2.33, respectively.

To begin, consider the distribution of value for one call option, as presented in Chart 1. Note the sig-
nificant skew due to the asymmetric payoff profile for the option -- in roughly half of the cases the op-
tion expires worthless, while in the other half, the option takes on one of many possible positive values.
This skewness manifests itself in the distribution’s percentile levels, as the 90th, 95th, and 99th percen-
tiles are 1.50, 2.12, and 3.34 standard deviations, respectively, above the mean.

Chart 1
Distribution of value for a single call option.

Frequency
550

500

450

400

100

50

0
0.09 0.41 0.72 1.03 1.34 1.65 1.96 2.28 2.59 2.90

Option value

Our intuition is that for large enough portfolios with weak enough correlations, this asymmetry
will disappear, and the portfolio distribution will become normal. Indeed, if we examine a portfolio
of just twenty options with independent underlyings, we obtain a distribution that appears close to nor-
mally distributed, as in Chart 2. If we examine the percentiles of portfolios of independent options, we
see a nice agreement with the normal distribution as well. In Chart 3, we present these percentiles as a
function of portfolio size. The flat lines represent the 90th, 95th, and 99th percentiles (in standard de-
viations above the mean) for the normal distribution, while the curves represent the same percentiles
for option portfolios. We see that the 90th and 95th percentiles are well predicted by the normal distri-
bution for portfolios of as few as twenty options, while beyond a portfolio size of about fifty, even the
99th percentile is well predicted.
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When is a portfolio of options normally distributed?

Chart 2
Distribution of value for a portfolio of twenty independent options.
Frequency
350

300

250

200

150

100

50

0
1.3 3.2 5.1 7.0 9.0 10.9 12.8 14.7 16.7 18.6

Option portfolio value

Chart 3
Percentiles of portfolios of independent options as a function of portfolio size.
Standard deviations
3.0

2.5
2.33
2.0

1.5 1.65
1.282
1.0

0.5

0
10 20 30 40 50 60 70 80 90 100

Number of Options

We may pursue the same investigations for portfolios of weakly correlated (here, we assume that re-
turns on the underlyings have a 10% correlation) options. In Chart 4, we present a distribution for a
portfolio of twenty weakly correlated options, and see that a slight skew still persists in the distribution;
in fact, the 90th, 95th, and 99th percentiles are 1.36, 1.81, and 2.87, respectively, far from those which
would be predicted by the normal distribution. (For contrast, recall the distribution for a portfolio of
twenty independent options in Chart 2.) We hope for such small correlations that there will still be a
significant benefit due to diversification, and that the portfolio distribution will appear normal once the
portfolio is large enough.

But we do not see this. Referring to Chart 5, we see that for portfolios of weakly correlated options, the
90th percentile is predicted well by the normal approximation, but the more extreme percentiles arepre-
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When is a portfolio of options normally distributed?

dicted poorly. What is of more concern, however, is that the portfolio distributions do not appear to be-
come more normal as portfolio size increases; in other words, the error from using the normal
approximation for a portfolio of two hundred options is as severe as the error in the case of fifty options.

Chart 4
Distribution of value for a portfolio of twenty weakly correlated options.
Frequency

350

300

250

200

150

100

50

0
0.32 3.55 6.78 10 13.23 16.46 19.68 22.91 26.14 29.37

Option portfolio value

Chart 5
Percentiles of portfolios of weakly correlated options as a function of portfolio size.
Standard deviations

3.0

2.5
2.33
2.0

1.65
1.5
1.282
1.0

0.5

0
10 30 50 70 90 110 130 150 170 190

Number of Options

At higher levels of correlation, these problems are even greater. Chart 6 and Chart 7 present results for
portfolios of options whose underlyings have a 40% correlation. Here, the twenty option portfolio ex-
hibits an even stronger skew, and we see again the phenomenon that the portfolio distributions do not
become more normal as portfolio size increases.

Thus, it appears that even at low levels of correlation, option portfolios are not normally distributed,
regardless of the portfolio size. In fact, portfolio size has very little influence at all on the shape of
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When is a portfolio of options normally distributed?

the portfolio distribution; that is, the percentile levels we have examined do not depend on the size
of the portfolio. In the next section, we present a simple analytical model which provides some insight
into these curious observations.

Chart 6
Distribution of value for a portfolio of twenty strongly correlated options.
Frequency

600

500

400

300

200

100

0
0.5 5.3 10.1 15.0 19.8 24.6 29.5 34.3 39.1 44.0

Option portfolio value

Chart 7
Percentiles of portfolios of strongly correlated options as a function of portfolio size.
Standard deviations

3.0

2.5
2.33
2.0

1.5 1.65
1.282
1.0

0.5

0
10 40 70 100 130 160 190

Number of Options

Analytical results
In order to explain the results of the previous section, we present here a simple analytical model. Let
Y 1, Y 2, …, Y n denote the change in value in each of the underlying assets for our options. (This change
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When is a portfolio of options normally distributed?

in value is from the present to the options’ expiration3.) If all of our options are calls, then we may write
the value of each by
[1] V i = max ( 0, Y i ) ,
and then the value of our portfolio is given by


n
[2] VP = Vi .
i=1

Our assumption that each option is at the money implies that each Y i has mean 0. Further, we assume
2
that each of the Y i is normally distributed, each with the same variance σ . Finally, we assume that the
correlation between distinct Y i and Y j is ρ .

A set of returns with the covariance structure we have assumed may be expressed as follows:
Y 1 = σ ρY M + σ 1 – ρ Ŷ 1
Y 2 = σ ρY M + σ 1 – ρ Ŷ 2
[3]

Y n = σ ρY M + σ 1 – ρ Ŷ n

where Y M, Ŷ 1, Ŷ 2, …, Ŷ n are independent standard normal random variables. We see that the correlation
between Y 1 and Y 2 , for example, comes only from these variables’ dependence on Y M . For this reason,
we refer to Y M as the market return, and Ŷ 1, Ŷ 2, …, Ŷ n as the idiosyncratic returns for each underlying
asset. The interpretation is that each asset moves somewhat due to the broad market (factors that influ-
4
ence all assets) and somewhat due to factors which only influence the particular asset . Observe that
the correlation between any underlying asset and the broad market is ρ .

Note that using the decomposition in Eq. [3], we may rewrite the value of each option in Eq. [1] as
[4] V i = σ 1 – ρ { γ Y M + max ( – γ Y M, Ŷ i ) },
where
ρ
[5] γ = ------------ .
1–ρ
Eq. [4] allows us to interpret the option returns in terms of market and idiosyncratic returns as well.
Note that there are two parts to the option value: the first, γ Y M , is simply a constant times the market
return; the second may be thought of as an option payoff where the underlying is Ŷ i and the strike price
is – γ Y M . Thus, if the market falls (that is, Y M is negative), then the market piece of the option falls as
well, but the idiosyncratic piece of the value goes well into the money, and at worst compensates for
the market loss.

An important observation on Eq. [4] is that the market piece is common to the value of all options,
while the idiosyncratic pieces, conditional on the value of Y M , are independent. Thus, it will be useful
to consider the distribution of each option value conditional on the market move. Note that for a stan-
dard normal random variable Z and any constant s , the expectation of the maximum of s and Z is
[6] E max ( s, Z ) = sΦ ( s ) + ϕ ( s ) ,

3
Technically, this should be the difference in value between the asset’s forward value at present and the realized value at
option expiry. However, this does not influence our analysis.
4
This is very similar to the Capital Asset Pricing Model (CAPM).
RiskMetrics® Monitor
Third Quarter 1997
page 39

When is a portfolio of options normally distributed?

where Φ is the cumulative distribution function and ϕ is the density function for the standard normal
distribution. Using Eq. [6], we see that the conditional mean of the option value, m ( y M ) 5,given a mar-
ket return of y M , is
[7] m ( y M ) = σ 1 – ρ { γ y M Φ ( γ y M ) + ϕ ( γ y M ) }.
We present a plot of m ( y M ) versus y M for various values of ρ in Chart 8. Note that for high levels of
correlation, the market return greatly influences the expected option value, whereas for zero correla-
tion, the option mean is not at all affected by the market return. Clearly, the mean portfolio value given
a market return of y M is just nm ( y M ) .

Chart 8
Conditional mean of option value versus market return.
Pairwise correlations of 0%, 10%, 40%, and 80%.
Mean option value

3.0
80%
2.5

2.0
40%
1.5

1.0 10%

0.5 0%

0
-3 -2 -1 0 1 2 3

Market return
Similarly, we may consider the conditional variance of the option value given a market return y M ,
which we denote by v ( y M ) . Recalling our observation that given the market return, all option values
are independent, we see that the conditional variance of the portfolio given the market is just nv ( y M ) .
Furthermore, we know from the previous section that a portfolio of roughly twenty or more indepen-
dent options is well described by a normal distribution. Thus, for a given market return, we may com-
pute the portfolio’s mean and variance, and obtain percentile levels using the normal assumption. For
example, given a market return of y M , there is only a 5% chance that the portfolio value will be less
than
[8] nm ( y ) – 1.65 nv ( y M ) .
Chart 9 presents conditional means and percentiles as a function of market return for correlations of
10% and 40%. Note that for the zero correlation case, the portfolio mean and percentile levels would
not depend at all on the market.

This quantity actually depends on ρ as well as y M , but we suppress this in the notation.
5
RiskMetrics® Monitor
Third Quarter 1997
page 40

When is a portfolio of options normally distributed?

Chart 9
Mean (solid) and upper and lower 5% bands (grey) for portfolio of 50 options.
Pairwise correlations of 10% and 40%.
Portfolio value

100
40%

75

50 10%

25

0
-3 -2 -1 0 1 2 3

Market return

Let us return now to the problem of the previous section. Why do portfolios with even the smallest
amount of correlation never exhibit normal distributions? At first glance, this behavior might seem con-
tradictory to our statement that conditional on the market return, the portfolio is normally distributed.
Actually, this is not contradictory, but rather the explanation.

Suppose the market return is positive. Given this, we have argued, the portfolio distribution is condi-
tionally normal with some mean and variance. If the market return is negative, the portfolio distribution
6
is still conditionally normal, but with a different mean and variance . Under this conditional normality,
the unconditional distribution (that is, the distribution without fixing a market return) only appears nor-
7
mal if the conditional mean and variance do not vary much . We can see in Chart 8 and Chart 9 that for
higher levels of correlation, the conditional mean varies more with the market return, and thus, the un-
conditional distribution is further from normal.

At this point, we have explained why for many levels of correlation increasing the portfolio size does
not lead to a more normal portfolio distribution. The remaining question is whether there are levels of
correlation which still allow for normal portfolio distributions.

To answer this last question, we consider the unconditional portfolio variance. There are two sources
of this variance. First, there is the variance that comes from the market; this source of variance may be
thought of as determining where our portfolio falls horizontally on the curves of Chart 9. The second
source of variance is at a fixed market return (a fixed point along the horizontal axis of Chart 9), where
the portfolio value varies within the bands. If the main source of portfolio variance is of the first type,
then the portfolio behaves essentially as an option position on the market, and the portfolio distribution
is never normal, regardless of portfolio size. If the main source of variance is of the second type, then
the largest contribution is due to the idiosyncratic components of the options, and the distribution will

6
The distribution is analogous to the mixed normal distribution used, for example, in “An improved methodology for
measuring VaR”, JP Morgan RiskMetrics Monitor Q2 96.
7
Technically, the unconditional distribution will only be normal if the conditional mean and variance do not vary at all.
RiskMetrics® Monitor
Third Quarter 1997
page 41

When is a portfolio of options normally distributed?

appear normal. What remains then is to specify which correlation levels lead to situations in which the
majority of the portfolio variance is of this second type.

In Chart 10, we show the percentage of portfolio variance which comes from the market component,
plotted against the pairwise correlation for the portfolio. We see that the percentage increases very
quickly, and only for correlations less than about 3% does the market component contribute less than
half of the total portfolio variance. Thus, the underlying assets must be virtually independent in or-
der for the portfolio distribution to be normal.

Chart 10
Market contribution to portfolio variance for a portfolio of 50 options.
Variance due to market Total portfolio variance
100% 900
90% 800
80% 700
70%
600
60%
500
50%
400
40%
300
30%
20% 200
10% 100
0% 0
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Pairwise correlation

Conclusions
We have shown that for all but the most minute levels of average portfolio correlation, increasing the
size of a portfolio of options does not lead to a more normal portfolio distribution. The most basic
intuition behind this conclusion is that a portfolio of options on (albeit weakly) correlated underlying
assets is implicitly an option on the market. In our example, where all of our options were calls with
the same strike, this option on the market had a distribution which looks like the distribution for a call.
In general, one can expect the portfolio distribution to be greatly influenced by the portfolio’s position
on the market. Thus, a portfolio with half calls and half puts at the same strike, while not expressing a
directional view on the broad market, will still behave like a straddle on the broad market, and will not
display a normal distribution.

In the end, there are only two ways to guarantee that the portfolio distribution is normal. The first
is to construct the portfolio of options on independent underlyings, which is clearly not practical.
The second is to maintain the portfolio such that the implicit position on the market is neutral.
Note that this goes beyond just “delta hedging” the portfolio -- the example above with equal numbers
of calls and puts would have zero delta -- but means that all positions on the market must be offset with-
in the portfolio. The job of maintaining a normally distributed portfolio thus falls on the shoulders of
the investor; the mathematician has little recourse.
RiskMetrics® Monitor
Third Quarter 1997
page 42
RiskMetrics® Monitor
Third Quarter 1997
page 43
RiskMetrics® Monitor
Third Quarter 1997
page 44
RiskMetrics® Monitor
Third Quarter 1997
page 45

Previous editions of the RiskMetrics® Monitor

2nd Quarter 1997: June 17, 1997

• A detailed analysis of a simple credit exposure calculator

• A general approach to calculating VaR without volatilities and correlations

1st Quarter 1997: March 14, 1997

• On Measuring credit exposure

• The effect of EMU on risk management

• Streamlining the market risk measurement process


4th Quarter 1996: December 19, 1996

• Testing RiskMetrics™ volatility forecasts on emerging markets data.

• When is non-normality a problem? The case of 15 time series from emerging markets.

3rd Quarter 1996: September 16, 1996

• Accounting for “pull to par” and “roll down” for RiskMetrics™ cash flows.

• How accurate is the delta-gamma methodology.

• VaR for basket currencies.

2nd Quarter 1996: June 11, 1996

• An improved RiskMetrics® methodology to help risk managers avoid underestimating VaR.

• A Value-at-Risk analysis of foreign exchange flows exposed to OECD and emerging market
currencies, most of which are not yet covered by the RiskMetrics® data sets.

• Estimating index tracking error for equity portfolios in the context of principal variables that
influence the process of portfolio diversification.

1st Quarter 1996: January 23, 1996

• Basel Committee revises market risk supplement to 1988 Capital Accord.

• A look at two methodologies that use a basic delta-gamma parametric VaR precept but achieve
results similar to simulation.
RiskMetrics® Monitor
Third quarter 1997
page 46

Previous editions of the RiskMetrics® Monitor

4th Quarter 1995: October 12, 1995

• Exploring alternative volatility forecasting methods for the standard RiskMetrics® monthly
horizon.

• How accurate are the risk estimates in portfolios that contain Treasury bills proxied by LIBOR
data.

• A solution to the standard cash flow mapping algorithm, which sometimes leads to imaginary
roots.

3rd Quarter 1995: July 5, 1995

• Mapping and estimating VaR for interest rate swaps

• Adjusting correlations obtained from nonsynchronous data.


RiskMetrics® Monitor
Third Quarter 1997
page 47
RiskMetrics® Monitor
Third quarter 1997
page 48

RiskMetrics® products Worldwide RiskMetrics® contacts


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broadly describes the RiskMetrics methodology for measuring authors or any other person listed below.
market risks.
North America

RiskMetrics® Directory: Available exclusively on-line, a list New York Peter Zangari (1-212) 648-8641
of consulting practices and software products that incorporate zangari_peter@jpmorgan.com
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moore_mike@jpmorgan.com
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schoffelen_paul@jpmorgan.com
order to compute market risks for trading and investment
horizons. The manual also describes the format of the volatility Toronto Dawn Desjardins (1-416) 981-9264
desjardins_dawn@jpmorgan.com
and correlation data and the sources from which daily updates
can be downloaded. Available in printed form as well as Adobe Europe
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coughlan_g@jpmorgan.com
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as well as new software products built by third-party vendors to fransolet_l@jpmorgan.com
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prices, with each data set totaling115,000+ data points. One set
Milan Roberto Fumagalli (39-2) 774-4230
is for computing short-term trading risks, the other for medium- fumagalli_r@jpmorgan.com
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carretero_jl@jpmorgan.com
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A RiskMetrics® Regulatory data set, which incorporates the tschirky_v@jpmorgan.com
latest recommendations from the Basel Committee on the use
Asia
of internal models to measure market risk, is also available.
Singapore Michael Wilson (65) 326-9901
wilson_mike@jpmorgan.com

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matsui_martin@jpmorgan.com

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robertson_d@jpmorgan.com

RiskMetrics® is based on, but differs significantly from, the market risk management systems developed by J.P. Morgan for its own use. J.P. Morgan does not warrant any results
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