J.P. Morgan/Reuters
The purpose of this article is threefold. First, we explain an algorithm to generate spot rates
from couponbearing 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.
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
(1212) 6484317
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 nearterm 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
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 socalled 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).
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.
RiskMetrics® Monitor
Third Quarter 1997
page 4
• 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 subsections.
 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 yieldtomaturity
(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 subsections, 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 splinescubic Bsplinescan be applied
to estimate the term structure of interest rates.
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 enduser’s
ability to download and use the RiskMetrics database.
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 reinvested (e.g.
semiannual)
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 ratewhich applies from the present
time to the time of the future paymentand 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
August1997) 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, 18February1998), 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 lumpsum amount equal to its face value at maturity.
3
John Matero provided research support for this section.
RiskMetrics® Monitor
Third Quarter 1997
page 6
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 j1st 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.
(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
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
RiskMetrics® Monitor
Third Quarter 1997
page 7
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
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 semiannual compounding, it is assumed that payments earn interest for six months and then
are “rolledover” 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 rolledover and earn interest at every instant in
time.
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 practiceone
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.
RiskMetrics® Monitor
Third Quarter 1997
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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
[3] p ( τ j ) = exp ( – z ( τ j )τ j )
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:
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 .
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 shortterm 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
dz j
[8]
d
– log ( p ( τ j ) ) = z j + τ
dτ j dτ j j
It follows from [6] that the righthand side of [8] is the instantaneous forward rate, i.e.,
dz j
[9] F(τ j ) = z j + τ
dτ j j
[10]
d
F(τ j ) = – log ( p ( τ j ) )
dτ j
[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 ) .
RiskMetrics® Monitor
Third Quarter 1997
page 10
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.
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 .
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.
RiskMetrics® Monitor
Third Quarter 1997
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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.
Table 2
Bond characteristics
Price USD 98.00
Coupon rate 8.000%
Coupon frequency Semiannual
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 sixmonths 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
 15Feb97   0.0000 
1 15Aug97 181 362 0.5000 4
2 15Feb98 365 368 0.9918 4
3 15Aug98 546 362 1.5083 4
4 15Feb99 730 368 1.9837 4
5 15Aug99 911 362 2.5166 4
6 15Feb00 1,095 368 2.9755 4
7 15Aug00 1,277 364 3.5082 4
8 15Feb01 1,461 368 3.9701 4
9 15Aug01 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).
RiskMetrics® Monitor
Third Quarter 1997
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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
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
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
RiskMetrics® Monitor
Third Quarter 1997
page 13
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
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
RiskMetrics® Monitor
Third Quarter 1997
page 14
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 meanreversion of the shortterm
interest rate.
RiskMetrics, however, provides rates and prices to be used for risk managementrather 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.
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,
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].
[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:
RiskMetrics® Monitor
Third Quarter 1997
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2. Exactly one bond matures every sixmonths. 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 sixmonth bond, which under our
assumptions is a discount bond, we have
(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 oneyear discount bond. Since
[23] p c ( 2, M 2 ) = p̃ ( τ 1 )c 2 + p ( τ 2 ) ( P + c 2 )
[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 n1 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
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
longdated 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 oneyear date by averaging over the individual bootstrapped
prices and rates, respectively.
RiskMetrics® Monitor
Third Quarter 1997
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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 semiannual
compounding then R = 5x2 = 10. Moreover, τ' 1 represents the sixmonth date, τ' 2 denotes the
oneyear date, and so on, up until τ' 10 which represents the fiveyear 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.
• 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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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;
[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.
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
RiskMetrics® Monitor
Third Quarter 1997
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attach each of these functions at their socalled 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
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) zerocoupon issueslongterm 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
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 zerocoupon 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.
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
where ε i is a random error term and we estimate β l . Chambers et. al. estimate the polynomial’s parame
ters using nonlinear least squares.
9
Refer to section 2.2 for a discussion on the relationship between zero and forward rates.
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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
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:
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.
To explain how Bsplines 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 )
Splines10 require that we divide the maturity space of all N bonds into K1 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
In practice, when using a special class of Bsplines known as cubic Bsplines, 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.
+
K–1 3
A cubic Bspline 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
A cubic Bspline basis which is a set of Bsplines 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 Bspline basis we construct a cubic spline which is a weighted summation of Bsplines. 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
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.
Bsplines 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 ) .
log ( p ( τ j ) )
[57] z ( τ j ) = – 

τj
[58]
T
ps ( τ j ) = φ ( τ j ) β
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
Using Bsplines 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
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
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
[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
log ( pˆs ( τ j ) )
[67] z ( τ j ) = – 

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

τj
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
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
κ
[74] ∑ φ ( τ )β
T
p c ( i, M i ) = c i exp – k i k
k=1
κ
[75] ∑ φ ( τ )β
T
X̃ i ( β ) = c i exp – k i k
k=1
[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.
[77]
T
h(τ)= F(τ)= φ(τ) β
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 rearranging, 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
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
κ
[84] ∑ ( ψ ( τ ) ) β
T
p c ( i, M i ) = c i exp – k i k
k=1
κ
[85] ∑ ψ ( τ )β
T
Xi(β) = c i exp – k i k
k=1
[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.
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 Bsplines 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. 5262.
RiskMetrics® Monitor
Third Quarter 1997
page 30
Bliss, R.R. “Testing Term Structure Estimation Methods,” Federal Reserve Bank of Atlanta Working Pa
per 9612a, (November 1996)
Buono, M., R.B GregoryAllen, and Uzi Yaari. “The Efficacy of Term Structure Estimation Techniques:
A Monte Carlo Study,” Journal of Fixed Income, 1 (March 1992) pp. 5259.
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. 6468.
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. 233252.
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. 385407.
Fama, E.F. and R.R. Bliss. “The Information in LongMaturity Forward Rates,” American Economic Re
view, 77 (September 1988) pp. 893911.
Fisher, M., D. Nychka, and D. Zervos. “Fitting the Term Structure of Interest Rates with Smoothing
Splines,” Working Paper 951, Finance and Economics Discussion Series, Federal Reserve Board, (Janu
ary 1995).
de Munnik, J.F.J, and P.C. Schotman. “Crosssectional versus Time Series Estimation of Term Structure
Models: Empirical Results for the Dutch Bond Market,” Journal of Banking and Finance 18, (1994) pp.
9971025.
Malz, A. M. “Interbank Interest Rates as Term Structure Indicators” manuscript, (June 1997)
McCulloch, J.H. “Measuring the Term Structure of Interest Rates.” Journal of Finance, 34 (January 1971),
pp.1931.
McCulloch, J.H. “TaxAdjusted Yield Curve,” Journal of Finance, 30 (June 1975), pp. 811829.
Nelson, C.R., and A.F. Siegel. “Parsimonious Modeling of Yield Curves,” Journal of Business, 60 (Octo
ber 1987), pp. 473489.
Oda, N. “A Note on the Estimation of Japanese Government Bond Yield Curves,” IMES Discussion Paper
96E27, (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. 253269.
Shea, G.S. “Interest Rate Term Structure Estimation with Exponential Splines: A Note.” Journal of Fi
nance, 40 (March 1985), pp. 319325.
Steely, J.M. “Estimating the GiltEdged Term Structure: Basis Splines and Confidence Intervals,” Jour
nal of Business Finance and Accounting, 18, (June 1991) pp. 513529.
Svensson, L.E.0. “Estimating and Interpreting Forward Interest Rates: Sweden 19921994,” IMF Working
Paper, WP/94/114, (1994).
RiskMetrics® Monitor
Third Quarter 1997
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Vasicek, O.A, “An Equilibrium Characterization of the Term Structure.” Journal of Financial Economics,
37 (June 1977), pp. 177188.
Vasicek, O.A., andH.G. Fong. “Term Structure Modeling Using Exponential Splines.” Journal of Finance,
37 (May 1982), pp. 339348.
Wegman, E.J., and I.W. Wright. “Splines in Statistics,” Journal of the American Statistical Association,
78, (June 1983) pp. 351363.
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Third Quarter 1997
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RiskMetrics® Monitor
Third Quarter 1997
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Thus is the dilemma: one option displays nonnormal 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 .
3. Returns on the underlying assets are normally distributed, each with the same volatility.
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 nonnormality 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.
RiskMetrics® Monitor
Third Quarter 1997
page 34
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.
RiskMetrics® Monitor
Third Quarter 1997
page 35
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
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
RiskMetrics® Monitor
Third Quarter 1997
page 36
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
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
RiskMetrics® Monitor
Third Quarter 1997
page 37
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
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
RiskMetrics® Monitor
Third Quarter 1997
page 38
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
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
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
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
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Third Quarter 1997
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RiskMetrics® Monitor
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RiskMetrics® Monitor
Third Quarter 1997
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• When is nonnormality a problem? The case of 15 time series from emerging markets.
• Accounting for “pull to par” and “roll down” for RiskMetrics™ cash flows.
• A ValueatRisk 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.
• A look at two methodologies that use a basic deltagamma parametric VaR precept but achieve
results similar to simulation.
RiskMetrics® Monitor
Third quarter 1997
page 46
• 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.
RiskMetrics® Directory: Available exclusively online, a list New York Peter Zangari (1212) 6488641
of consulting practices and software products that incorporate zangari_peter@jpmorgan.com
the RiskMetrics methodology and/or data sets. Chicago Michael Moore (1312) 5413511
moore_mike@jpmorgan.com
RiskMetrics®—Technical Document: A manual describing Mexico Jose Maria de la Torre (525) 5401769
the RiskMetrics methodology for estimating market risks. It de_la_torre_jose_m@jpmorgan.com
specifies how financial instruments should be mapped and
San Francisco Paul Schoffelen (1415) 9543240
describes how volatilities and correlations are estimated in
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 (1416) 9819264
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
pdf format.
London Guy Coughlan (4471) 3255384
coughlan_g@jpmorgan.com
RiskMetrics® Monitor: A quarterly publication that discusses
broad market risk management issues and statistical questions Brussels Laurent Fransolet (322) 5088517
as well as new software products built by thirdparty vendors to fransolet_l@jpmorgan.com
support RiskMetrics. Paris Guilliame Saloman (331) 4015 4245
salomon_guillaum@jpmorgan.com
RiskMetrics® data sets: Two sets of daily estimates of future Frankfurt Robert Bierich (4969) 7124331
volatilities and correlations of approximately 480 rates and bierich_r@jpmorgan.com
prices, with each data set totaling115,000+ data points. One set
Milan Roberto Fumagalli (392) 7744230
is for computing shortterm trading risks, the other for medium fumagalli_r@jpmorgan.com
term investment risks. The data sets currently cover foreign
exchange, government bond, swap, and equity markets in up to Madrid Jose Antonio Carretero (341) 5771299
carretero_jl@jpmorgan.com
31 currencies. Eleven commodities are also included.
Zurich Viktor Tschirky (411) 2068686
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) 3269901
wilson_mike@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
obtained from use of the RiskMetrics® data, methodology, documentation or any information derived from the data (collectively the “Data”) and does not guarantee its sequence,
timeliness, accuracy, completeness or continued availability. The Data is calculated on the basis of historical observations and should not be relied upon to predict future market
movements. The Data is meant to be used with systems developed by third parties. J.P. Morgan does not guarantee the accuracy or quality of such systems.
Additional information is available upon request. Information herein is believed to be reliable, but J.P. Morgan does not warrant its completeness or accuracy. Opinions and estimates constitute our judgement and are
subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. J.P. Morgan may hold a
position or act as market maker in the financial instruments of any issuer discussed herein or act as advisor or lender to such issuer. Morgan Guaranty Trust Company is a member of FDIC and SFA. Copyright 1997 J.P.
Morgan & Co. Incorporated. Clients should contact analysts at and execute transactions through a J.P. Morgan entity in their home jurisdiction unless governing law permits otherwise.
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