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An Orthogonal Polynomial Approach to Estimate the Term Structure of Interest Rates

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  • Hans-Jürg Büttler
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    Abstract

    In this paper, we introduce a new algorithm to estimate the term structure of interest rates. It is obtained from a constrained optimization, where the objective is to minimize the integral of squared first derivatives of the instantaneous forward interest rate subject to the condition that the estimated bond prices lie within the range of observed bid and ask prices. We use a finite series of ordinary Laguerre polynomials to approximate the unknown function of the instantaneous forward interest rate. The objective function can be written explicitly as a quadratic form of the Laguerre constants and the nonlinear constraints can be obtained from a recurrence relationship. The estimation error is less than one basis point, given a sufficient number of bonds.

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    File URL: http://www.snb.ch/n/mmr/reference/working_paper_2007_08/source/working_paper_2007_08.n.pdf
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    Bibliographic Info

    Paper provided by Swiss National Bank in its series Working Papers with number 2007-08.

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    Length: 27 pages
    Date of creation: 2007
    Date of revision:
    Handle: RePEc:snb:snbwpa:2007-08

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    Keywords: Term structure of interest rates; orthogonal polynomial;

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    1. Shea, Gary S., 1984. "Pitfalls in Smoothing Interest Rate Term Structure Data: Equilibrium Models and Spline Approximations," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(03), pages 253-269, September.
    2. David Jamieson Bolder & Scott Gusba, 2002. "Exponentials, Polynomials, and Fourier Series: More Yield Curve Modelling at the Bank of Canada," Working Papers 02-29, Bank of Canada.
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