Yield Curve Construction Methodology

Methodology of Yield Curve Construction

The following is a description of the methodology used by the Horizon and Saracen Yield Curve modules.

General Overview

Each market instrument from the contributing data set is taken and added to a collection.The contributing data set differs from one currency to another

Available instruments are cash deposits, swaps, interest rate futures and (in principle) forward rate agreements (FRAs).

The collection of instruments is then subjected to a filtering process which determines which instruments will contribute to the term structure. A choice of filtering processes is possible. At present the choices which have been implemented in our Yield Curve program are the ‘do nothing’ process (that is, leave the original instrument collection in its unfiltered state) and the ‘liquidity filtering’ process.

In the liquidity filtering process, the interest rate futures strip (if futures are present in the collection) takes precedence over any instruments whose maturity dates overlap the futures strip. This means that any such instruments are removed from the filtered instrument collection. This procedure is standard practice in the market and originates because of the greater liquidity of interest rate futures by comparison with other instruments.

After the filtering process, the instrument collection is traversed in order of increasing instrument maturity, and each instrument is asked to calculate the discount factor corresponding to its maturity date. In the case of a futures rate or FRA, the ‘maturity date’ refers to the end of the underlying loan period rather than the maturity date of the instrument itself. Calculation of grid point discount factors involves a bootstrapping process in all cases (except cash instruments).

Having obtained a set of grid point discount factors, an interpolation mechanism must be used to obtain “off grid point” discount factors. At present, three choices of interpolation mechanism have been implemented into the Yield Curve module. These are

1.    Exponential interpolation on the discount curve
2.    Linear interpolation on the zero coupon curve
3.    Cubic Spline interpolation on the zero coupon curve.

From the discount curve, we construct a zero coupon curve, reverse engineered par curve and forward, forward curves of any specified deferment.
 

Get the answers to these questions and much more in-depth analysis of yield curve construction methodology by registering with us.

Q What is the difference between “Raw Data” and “Calculated Data” in Horizon?

Q How is the yield curve calculated where there are no LIBOR futures?

Q How is the yield curve calculated when the currency in question has actively traded LIBOR futures?

Q How is the yield curve data smoothed?

To see detailed answers to these questions click here to register.

If you are already a registered user please login here.  Once logged in you can view the detailed answers to these questions by clicking on Advanced Yield Curve Construction Methodology.