Interpolation Techniques

Copyright © 1996-2006
Investment Analytics
 Interpolation Techniques
„ Why interpolate?
„ Straight line interpolation
„ Cubic spline interpolation
„ Basis spline interpolation

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 Why Interpolate
„ Structuring
„ Project security cash flows
„ Need forward rates on coupon dates
„ Valuation
„ Need spot rates on coupon dates
„ In either case coupon dates may not
coincide with dates for which zero-
coupon yields are known.

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 Interpolation Methods
„ Straight Line
„ Polynomial
„ Single high order polynomial
„ Unstable between points and at ends
„ Splined polynomial
„ Low order polynomials linked together
„ Basis Splines
„ Represent discount function as weighted sum of
other functions

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 Straight Line Interpolation –
Pros and Cons
„ Simple to estimate intermediate points on
curve
„ Not accurate for undulating curves
„ Gives different results on discount factors
„ Produces discontinuous forward rate curve

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 Linear Interpolation
„ Intermediate values lie on a straight line
between the nearest data points. T2
Ti R2

T1 Ri

R1

„ Ri = R1 + (R2 - R1 ) x (Ti - T1) / (T2 - T1)

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 Linear Interpolation: Rates or
Discount Factors?
„ If interest rates lie on a straight line,
discount factors do not
„ Example:
„ Using Rates Using DF’s
R1 = R2 = 5.00% D1 = 0.9877
T1 = 90 D2 = 0.9756
T2 = 180 Di = 0.9836
Ti = 120
Ri = 5.00% Ri = 4.99%

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 Linear and Exponential
Interpolation
„ Linear interpolation on continuously
compounded interest rates is equivalent to
exponential interpolation on discount
factors −R T −R T
D1 = e 1 1
, D2 = e 2 2

Ri = (1 − α ) R1 + αR2
Ti − T1
α=
T2 − T1
Ti Ti
(1−α ) α
⇒ Di = D1 T1
D2 T2

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 Cubic Spline Interpolation
„ A different cubic polynomial is fitted
between each pair of data points
„ The polynomials are twice differentiable
„ Ensures that:
„ The slope of the curve is smooth
„ The rate of change of the slope is smooth
„ The curves “join” at the end points

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 Cubic Spline Curve Fitting
8.50% Ri+1(t)
8.00%

7.50%
Ri-1(t)
7.00%

6.50% Ri(t)
= ai(t-ti)3 + bi (t-ti)2 + ci (t-ti) + di
6.00%

5.50%

5.00%
0 200 400 600 800 1000 1200 1400 1600 1800 2000

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 Natural Splines
„ End Curve Conditions
„ Conditions of the two ends of the yield
curve must be specified for a solution.
„ Natural Spline
„ Second derivative (rate of change of the
slope of the yield curve) equal to zero at
both ends.
„ Slope of curve is constant at the ends
„ You typically only care about points in the
belly of the curve
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 Cubic Splines – Pros & Cons
„ Smooth curve -twice differentiable at
every data point
„ Can be used on both rates and DF’s
„ Works for undulating curves
„ Produces continuous forward rate curve
„ Not so easy to calculate
„ Can suffer from oscillation

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 Lab: Building Yield Curves
with Cubic Splines
„ Excel workbook; Yield Curve Modeling.xls
„ Worksheet: Cubic Spline Curve
„ Build 3m forward rate curve using:
„ Linearly interpolated DFs
„ Linearly interpolated spot rates
„ Cubic Spline interpolated spot rates
„ See Notes & Solution

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 Solution: Cubic Spline
Forward Curves
8.50%

8.00%

7.50%

7.00%

6.50%

Linear Interp on DF
6.00%
Linear Interp on R
5.50%
Cspline Interp on DF

5.00%
0 500 1000 1500 Days 2000

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 Basis Splines
„ Another widely used interpolation method
„ Used for modeling discount function
„ Typically combined with regression
analysis

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 Regression: More Payment
Dates than Bonds
„ This is the usual case, as bond coupon dates fall
on different days in the year.
„ Have to represent discount factors by a function
„ Insufficient bonds to estimate model parameters
„ Singular matrix
„ Use regression to determine parameters of the
discount function
„ Then calculate discount factors on any chosen date

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 Representing the Discount
Function by Basis Splines
„ Represent DF’s by function d(t):
L
l = 1...L: the number of basis spline
d (t ) = ∑ α l f l (t ) functions f.
l =1
α: weights applied to each function

„ Bond prices can be expressed as the sum of

discounted cash flows:
n L C: Bond cash flows
Pi = ∑ C ij ∑ α l f l (t ) P: Bond price
j =1 l =1

„ Determine values of weights to fit bond prices

to market data.
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 Estimating the Discount
Function
„ Rearrange bond price equation:
„ Sum of discounted cash flows
n L
Pi = ∑Cij ∑αl fl (t)
j =1 l =1

„ Sum of weighted cashflow x spline function

L n
Pi = ∑ α l ∑ C ij f l (t )
l =1 j =1
„ Spline functions are defined over the whole period
„ As long as we have more bonds than weighting factors α,
regression can be used.

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 Basis Splines & Knot Points
„ Basis Splines
„ The discount function is a weighted average of a
number of overlapping B-Splines.
„ Cubic B-Spline functions usually selected.
„ Individual spline functions are not linked.
„ Knot Points
„ Each spline function is non-zero over a well-
defined interval.
„ The start and end points of the splines are called
“knot points”.

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 Basis Spline Curves
„ The discount function is the weighted sum of individual splines
2.00E-04
1.80E-04
1.60E-04
1.40E-04
1.20E-04
1.00E-04
8.00E-05
6.00E-05
4.00E-05
2.00E-05
0.00E+00
0 500 1000 1500 2000 2500 3000

Knot Points
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 Selection of Knot Points
„ Results can be sensitive to placing of knot
points
„ Unless there is an even distribution of bonds.
„ Important to have an equal number of bonds
with maturities between each knot point.
„ Reduces estimation error.

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 Building a Zero Coupon Curve
from Treasury Bonds
„ Often have more payment dates than bonds
„ No unique set of discount factors that will price all bonds
„ Use Regression Analysis
„ Determine Least Squares Estimates of Discount Factors
„ Minimize the square of the difference between the observed bond
prices and those based on estimated discount factors.
„ Discount factors must be linked by a functional form
„ Cubic splines have problems due to correlation.
„ Basis splines are independent but watch “knot points”.

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 Lab: Building a Yield Curve
with Basis Splines
„ Worksheet: Basis Splines
„ Build yield curve using bond data
„ Method:
„ Basis Splines & Regression
„ See Notes & Solution

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 Spot and Forward Rate Curves
7.5%

7.0%

6.5%

6.0%

5.5%
Spot
Forw ard
5.0%
0 500 1000 1500 2000 2500 3000

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 Confidence Intervals
8%

7%

7%

6%

6%

5%

5%
Spot Rate
4% Upper 95%
4% Low er 95%

3%
0 500 1000 1500 2000 2500 3000

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 Interpolation Methods:
Summary
„ Straight Line Interpolation
„ Inaccurate.
„ Leads to discontinuous forward rates.
„ Cubic Splines
„ Better than linear interpolation.
„ Due to smoothness condition points on the yield curve are linked
together.
„ Linking causes multicollinearity.
„ Accuracy of and one discount factor cannot be determined.
„ Basis Splines
„ Functions go to zero at defined points.
„ Need to use a weighted combination of several B-Splines.

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