Zvi Wiener and Helena Pompushko
The purpose of this research is to develop and test a mathematical method of deriving zero yield curve from market prices of government bonds.
Abstract
Purpose
The purpose of this research is to develop and test a mathematical method of deriving zero yield curve from market prices of government bonds.
Design/methodology/approach
The method is based on a forward curve approximated by a linear (or piecewise constant) spline and should be applicable even for markets with low liquidity. The best fitting curve is derived by minimizing the penalty function. The penalty is defined as a sum of squared price discrepancies (theoretical curve based price minus market closing price) weighted by trade volume and an additional penalty for non‐smoothness of the yield curve.
Findings
This method is applied to both nominal and CPI linked bonds traded in Israel (some segments of these markets have low liquidity). The resulting two yield curves are used for derivation of market expected inflation rate.
Research limitations/implications
The main problems are low liquidity of some bonds and imperfect linkage to inflation in the CPI linked market.
Practical implications
A stable numerical procedure applicable even in markets with low liquidity.
Originality/value
Usage of forward curves as the state space for the minimization problem leads to a stable solution that fits the data very well and can be used for calculating forward rates.