Tuesday, August 28, 2012

A Good Paper on Yield Curve Estimation

A very good paper by Kikuchi and Shintani titled "Comparative Analysis of Zero Coupon Yield Curve Estimation Methods Using JGB Price Data" (downloadable here; direct link here) on zero coupon yield curve fitting/estimating. They looked at various methods of curve fitting and concluded that the Steeley (1991) method is best suitable for estimating the Japanese zero coupon yield curve. These various methods include Svensson (1995), Nelson-Siegel (1987), as well as McCulloch (1975), and they judge the methods on the criteria of undesirable (negative) values, excessive unevenness, and fitness to market prices. They also make the estimated yield curve data from 1999 to 2011 available  (downloadable here).

One issue cause by the zero lower bound for many of the curve estimation methods is negative values at the short end of the curve. (The other common issue, particularly for yield curves estimated by Nelson Siegel or Svensson, being the up and down spike at the short end of the implied forward rate curve.)  You can see the negative value issue from the dataset used in Wright (2011) (data downloadable here). For example, the Japanese nominal 3-month zero coupon rate for 2002 October is -0.0132 in the dataset.

The main contribution of the Kikuchi and Shintani paper isnt't that Steeley (1991) is best for estimating the Japanese yield curve, but rather that the paper highlights additional considerations needed when estimating yield curves in addition to the standard tradeoff between fitting close to the market price and limiting excessive unevenness. If the purpose of the estimation is to find arbitrage opportunities, methods that fit close to the price would be preferred. If the purpose of the estimation is to understand the implications of the curve to the macroeconomics environment, a smoother curve is desired. If one were to use the curve to calculate implied forward rates, and find them to be the red line on the right (Figure 15 of Kikuchi and Shintani) – what implication should one draw about the macro economy?

image

Reference:
    Kikuchi and Shintani: Comparative Analysis of Zero Coupon Yield Curve Estimation Methods Using JGB Price Data (IMES) ,
    Steeley (1991): Estimating the Gilt-edged Term Structure: Basis Splines and Confidence Intervals (Journal of Business Finance and Accounting),
    Svensson 1995): Estimating Forward Interest Rates with the Extended Nelson and Siegel Method (Sveriges Riksbank Quarterly Review),
    Nelson and Siegel (1987): Parsimonious Modeling of Yield Curves (Journal of Business),
    McCulloch (1975): The Tax-adjusted Yield Curve (Journal of Finance),
    Wright (2011): Term Premia and Inflation Uncertainty: Empirical Evidence from an International Panel Dataset [http://pubs.aeaweb.org/doi/pdfplus/10.1257/aer.101.4.1514] (AER).