CHAPTER 11Estimating and Fitting the Yield Curve II

There are a number of techniques that can be used to fit the yield curve. These include the regression methods and spline techniques introduced in Chapter 10. More recent methods such as kernel approximations and linear programming are also used by practitioners. In this chapter, we provide an introduction to some of these. We discuss fitting the spot and forward yield curve, and review the methods used to estimate spot and forward yield curves.

For a number of reasons, practitioners, investors, central banks, and government authorities are interested in fitting the zero‐coupon yield curve, or the true term structure of interest rates, from market observed yields. Practitioners used the curve for valuation and investment decision making, whilst central banks use it for this as well as monetary policy formulation. The use of yield curves is standard in monetary policy analysis, and central banks use forward interest rates for this purpose as well. Forward rates must be estimated from the yield curve that has been constructed from current market yields, generally T‐bill and government bond yields. Particularly useful information that can be derived from government bond prices includes the yield curve for implied forward rates, as these reflect the market's expectations of the future path of interest rates.1 They are also used by the market to price bonds and determine the extent of the credit spread applicable to corporate bonds. ...

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