Term Structure Estimation from On-the-Run Treasuries

01 August 2003
By Dr. James Jordan with Sattar Mansi, Department of Finance, Insurance and Business Law, Pamplin College of Business, Virginia Polytechnic Institute and State University

The authors compare five methods of estimating the term structure from interest rates with respect to error in spot rate estimation, forward rate estimation and coupon bond pricing. The methods can all be considered variants of the bootstrapping technique, with the two discrete-time bootstrapping methods based on linear and cubic interpolation of the yield curve and the two continuous-time bootstrapping methods based on exponential functional forms for the yield curve. A third is based on a bilinear transformation of a power function. The authors employ simulated bond samples with and without random error to study the relative importance of interpolation error and random pricing error, and use CRSP bond data to assess the accuracy of the methods in pricing liquid and illiquid bonds. The authors find that two methods stand out in terms of good interpolation properties and robustness in the face of pricing errors: the Nelson and Siegel and the Mansi and Phillips methods, both of which are based on exponential functions.

This paper was published in the Journal of Banking and Finance, Volume 27, Issue 8, and can be purchased from the publisher by following the link to the right.