53 - Estimating and fitting the term structure

Abstract

This chapter discusses fitting the spot and forward yield curve. It reviews the methods used to estimate spot and forward yield curves. The use of yield curves is standard in monetary policy analysis and central banks are increasingly making use of forward interest rates for this purpose as well. Forward rates are estimated from the yield curve that has been constructed from current market yields, generally T-bill and government bond yields. Central banks and market practitioners use interest rates prevailing in the government bond market to extract certain information, the most important of which is implied forward rates. The traditional approach to yield curve fitting involves the calculation of a set of discount factors from market interest rates. From this, a spot yield curve can be estimated. The market data can be money market interest rates, futures and swap rates, and bond yields. The McCulloch method describes the discount function as a linear combination of a specified number of approximating functions.