Measuring the Term Structure of Interest Rates

Author(s): J. Huston McCulloch

Source: The Journal of Business, Vol. 44, No. 1 (Jan., 1971), pp. 19-31
Published by: The University of Chicago Press
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 MEASURING THE TERM STRUCTURE OF INTEREST RATES
J. HUSTON MC CULLOCH*

INTRODUCTION tenuouslydifferentiable.We may expect

This paper develops a technique of fit-
ting a smooth curve,called the "discount
function," to observations on prices of
securities with varying maturities and
coupon rates. The yield curve, instan-
taneous forward interest rates, mean
forward interest rates, and consistent
values for securitiesare derivedfromthis
discount function. Formulasfor estimat-
ing the variances of these derived statis-
tics are given. All formulas are worked
out for a broad family of discount func-
tions amenableto linearregression.A pre-
ferred form for the generalizeddiscount
functionis describedwhichfocusesresolu-
tion in the vicinity of concentrationsof
observations. It is used to compare re-
gressionyield curveswith those obtained
by Durand' and those shown in the
TreasuryBulletin.2
THE DISCOUNT FUNCTION
The most fundamental curve describ-
it to be monotonicallydecreasing.
Except for a few short-termsecurities
called "bills," none of the zero coupon
"bonds"whose prices are determineddi-
rectly from the discount function exists.
However, given the maturity moand the
coupon rate c of a security, its value p
can be computedas the sum of the values
of the payments that compriseit:
MO
p = 1006(mo)+ cf 3(m)dm. (1)
0
For simplicity, we have assumedthat the
coupons arrive in a continuous stream
instead of semiannually.This enables us
to use "and interest"pricesas quoted.3
In orderto fit a curve to the discount
function by linear regression, we must
postulate k continuously differentiable
functionsfj(m), and then express it as a
constant term plus a linear combination
of these functions:
h

ing the term structure of interest rates, 6(m) = ao + 2ajfj(m).

j=1
the one from which all others must be
derived, is the discountfunction 6(m). It Since the present value of present money
describes the present value of $1.00 re- is unity, we must have 6(0) = 1. The
payable in m years. It is natural to sup- only way to force the curve through this
pose that the discount function is con- point is to set ao = 1 and
* Departmentof Economics,Universityof Chi-
fj(O) = 0 . (2)
cago.I am indebtedto ProfessorsReubenA. Kessel,
MertonH. Miller,LesterG. Telser,andHenriTheil, Therefore the discount function takes
and Mr. MichaelMussafor helpfulsuggestions.The
commentsand suggestionsof the refereeswere es-
the form
peciallyfruitful,and resultedin a thoroughrevision k
of the paper. 6(m) + Fa fj(m). (3)
1 David Durand,Basic Yieldsof CorporateBonds, j1
1900-1942 (New York: National Bureau of Eco- ' A proratedshareof the next couponis addedto
nomicResearch,1942). the quoted "and interest" price to arrive at the
2 TreasuryBulletin (Washington,D.C.: Govern- "flat" price at which the securityactually changes
ment PrintingOffice,March 1966), p. 78. hands. Today, only bonds in default are quoted
19

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 20
The form of the functions fj(m) and
the value of k are very important to the
quality of our fit of the discount func-
tion. However, opinions may differ on
their specification and there is no in-
disputably best method. Therefore we
will develop all formulas at the present
level of generality. Possible forms of
these functions and rules for selecting k
will be considered at the end of this
paper.
Combining (1) and (3) we obtain
p = 100 [1 + Zajfj(mo)1
THE JOURNAL OF BUSINESS
We chose to start with the discount
function, expressingit as a linear combi-
nation in unknownsas in (3), becausewe
knew that the linearity of the integra-
tion operator in (1) would then also
make p a linear combinationin these un-
knowns, permitting estimation of the a1
by linear regression. Previous workers,
notably Cohen, Kramer, and Waugh,4
have instead started with the yield curve
a(m), a nonlinear transform of 6(m):
a(m) = -(1/rn) ln 6(m). If one were to
begin with this yield curve instead, so
that
h

1(m) = ao + Eajjf(m),
j=l
+ cf [1 + ajfj(m)J dm
0 j=l
when the value of the couponswas added
to that of the principal using (1), he
= 100 [1 + 2ajfj(mo)] would obtain

+ C [Mo + Eaji p = 100 exp -mo[ao + fajfj(mO)

fj(m)dm]
j=l 0

=100 + cm0 + cj exp -m[ao + Eajfj(m)] dm

+ Eaj [100fj(mo) + c ff(m)dmj. (4)Thisexpressionis not linearin the aj and
j=l 0
thereforethe a cannotbe estimatedby
Setting linearregression
withoutthe useof crude
y= p-100-cmo (5a) approximations. Consequently,we will
and use the approachof equation (3) and
will not develop the yield curve until
= lOfj(mo) + c ffj(m)dm, (5b) later.
0

ESTIMATION OF THE UNKNOWN

equation (4) becomes
PARAMETERS a1
y= Zaix,. (5c) At any momentin time therewill not
j=l be simultaneousactual sale prices for
Because c, io, and the postulated func- everysecurity.This is especiallytrue of
tionsfj(m) are given, the right-handside slow-movingcorporateissues.However,
of (5c) is a linear combination, in un- there often are enoughsecuritieswith
known constants aj, of known con- simultaneouslystandingbid and asked
stants x;. offersto makeinferencesaboutthe term
4Kalman J. Cohen, Robert L. Kramer, and
flat. However,a few prewarbonds have to be con- W. HowardWaugh, "RegressionYield Curvesfor
vertedto the "andinterest"basisbeforeequation(1) U.S. GovernmentSecurities,"ManagementScience
can be used. 13, no. 14 (December1966):B168-75.

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 MEASURINGTHE TERM STRUCTURE OF INTEREST RATES 21

structure. If we have such observations of a value consistent with the observa-

pb and p? on n securities, define mean tions on the other securities used. We
prices pi as pi = (pb + p')/2. Let ci and probably cannot expect the fit to be any
mi be the coupon rate and term to final better than 1.0.5
maturity of the ith security. Adapting (5) to the error term as-
Instead of (1) holding exactly for the sumption of (6), the regressionequation
bid-askedmean price, we will find that is:
k
m.
= 1008(m) + cif 3(m)dm + ei, (6) 'Yi= Eajxii + et, i = 1, 2, . .. n, (7a)
0
and
where et is an error term with positive
variance. These errorscan be caused by var (,s)) = a2V2 (7b)
transactions costs, tax exemption, the where
capital gains tax treatment of deep dis- Y= Pi- 100- Cimi (7c)
count bonds, callability, convertibility, m.
ineligibility for commercial bank pur- Xij= 100fj(mi) + cif fj(m)dm, (7d)
chase, ability to be surrenderedat par in 0

payment of estate taxes (true of so- and

called flowerbonds), risk of default, im- vi = (pia- p)/2 + b. (7e)
perfect arbitrage,and the rigidity which
will be introduced by postulating any We run a weighted least-squaresregres-
specific form forfi(m). Thanks to trans- sion on (7) to obtain estimates d1, d2,
actions costs alone, the absolute value * **, Ok and ff of the parameters a,, a2,
-
of et could be as high as vt = (pa p-)l * . ?, ?a and a. The discount function is
2 + b, where b is the brokerage fee of then estimated by
0.5 parts per 100 for the broker-traded k

corporate issues and zero for dealer- a (m) = 1 + Edvfi(m). (8)

quoted U.S. Governments. The differ-
ence between the maximum price to a
buyer and the minimumprice to the sell-
er is 2vi. Because of the other sources of
error,the errorterm will often be larger
than va.Nevertheless, it will have a vari-
ance that is related to vs. Since the other
sources of error are more difficult to
quantify, it is convenient to assume that
the standarderrorof ej is simply propor-
tional to vi: S.E. (e) = crvi.The value of
a, which is to be measured,gives us an
indicator of how well arbitrageis work-
ing and of the size of the factors other
than coupon and maturity which enter
into the value of the securities.If it is as
low as 1.0, the bid-asked mean price of
most of the securities observed will be
within the transactionscosts tolerancevi
j.l
We are not justified in extrapolating
6(m) or any of its derived functions be-
yond the longest maturity of the secu-
rities observed. Notice that we are able
to fit the discount function with a
smooth curve, even though we do not
have direct observationson it. We could
never have done this by hand, or even by
ordinarycurve-fittingtechniques.
I have actually fit (7) to observations
on railroad bonds for fifteen selected
dates from 1920 to 1938 and on U.S.
Government securities for the close of
every month from December 1946 to
5 In the context of this applicationof linearre-
gression,R2is a bad indicatorof goodnessof fit. It
has no obvious intuitive interpretationand almost
always is over .999. On the other hand, a"is mean-
ingfuland sensitive.

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22
March 1966. The discount functions for
two of these dates are shown in figures 1
and 2. They are displayedplus and minus
their estimated standard errors of mea-
surement. The estimated curve itself is
not shown in order to avoid clutter. It
lies halfway between the upper and low-
er edges of the band shown. Notice that
THE JOURNALOF BUSINESS
at the close of February 1951 to 5.6 at
the close of March 1951 was especially
dramatic. Since most of the same securi-
ties were still present in the market, this
fall could not have been entirely due to
1.0?

the error, relative to the value of the

curve, increases with time to maturity 2~0.0?

because the market is less concerned

with the distant future than with the

1.0?-

vaWV ___
0.2 -
0.6?

0.0 - I
0.6 - - - - - - - -
0 10 20 30 m
Yearsto Motart
~0.4 - -
FIG. 2.-Discount function for the close of
February1966 based on bid-askedmean pricesfor
taxable U.S. Governmentbills, notes, and bonds.
0.2- -
Redemptionof callable issues is assumedto be at
earliest call date if price is above par and at ma-
turity date when price is belowpar. In this regres-
0.0 - - - - -
40
sion, n = 78, k = 9, and v= 7.81. In spite of the
0 10 20 0
highervalue of this curve is better definedthan
A-,
Yeas to Maturity
that of fig. 1 becausebid-askedspreadsweresmaller
FIG. 1.-Discount functionfor the close of Feb- and becauseof the absenceof brokeragefees.
ruary1922based on bid-askedmeanpricesof high-
grade (Moody'sAa and Aaa) railroadbonds. Con- TABLE 1
vertibles and securitieswith any chance of being
called before maturity were excluded. The band MEAN VALUES
OF ERROR COEFFICIENT
showsthe best estimateplus and minusits standard
error.In this regression,n= 26, k = 5, and 0-
2.67. Mean
Period Type of Security Value
A
of
near future, and therefore does not de-
1920-1938....... High-graderailroad 2.6
fine the curve for the distant future with bonds
as great a precision. The calculation of 1/1/47-3/1/51.. Taxable U.S. govern- 15.9
these errorsis discussedin a later section. ment securities
4/1/51-1/1/62.. Taxable U.S. govern- 4.6
Mean values of f' for selected sub- ment securities
2/1/62-4/1/66.. Taxable U.S. govern- 9.0
periods are given in table 1. These fig- ment securities
ures would seem to indicate that prior to
the Treasury-Federal Reserve Accord
of March 4, 1951, and again after the a change in the special features of the
beginning of "OperationTwist" in mid- securities.
1961, some sort of "disarbitrageur"was Having estimated the parameters as
active in the market for U.S. Govern- we can estimate the true values pi of
ment securities. The fall in a from 13.9 the n securities:

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 MEASURING THE TERM STRUCTUREOF INTEREST RATES 23

Pi = 100 + cimt Consequentlywe can estimate (10) with

+ E100f(mi)
dj + cif f(m)dm] 1+ djfj(m)
= (14)
This formula can even be used to esti- Forward curves correspondingto the
mate the value of securities that did not discountfunctionsshownin figures1 and
enter into the regression.It is of use to 2 are depicted in figures 3 and 4, plus
dealers,banks, insurancecompanies,and p(m)
large borrowerswho need to comparethe
values of securities differing in coupon
rate and maturity. Sophisticated users
may even want to adjust (1) for taxes
and for the value of special provisions.
Examination of the weighted residuals,
p- )/vi, shows that the ineligibility
for commercialbank purchase of many
bonds prior to the Accord (and to a __NS
4.0
lesser degree until 1954) tended to cause
negative residuals and that the special
tax status of deep discount bonds tended 0 10 20
Yearsto Maturity
3i0

to cause positive residuals. These prop-

erties account in large measure for the FIG. 3.-Instantaneous forward interest rate
curve correspondingto the discountcurve of fig. 1
disappointinglyhigh values of 0ffor post- for the close of February1922.
war Treasury securities. Compensating
for such factors should give better fits
and reduce the unaccounted-forerror.
FORWARD INTEREST RATES
2.0?
The discount function 6(m) is an ex-
ponential decay curve whose rate of de-
cay need not be constant. Its rate of
decay is the instantaneousforward
interest
rate p(m):
P(m)-- '(m) (10) 0 40 20 30 m
Yearsto Maturity
Equivalently, FIG. 4.-Instantaneous forward interest rate
curve correspondingto the discount curve shown
in fig. 2 for the close of February1966. The high
5(m) = exp [- fp(x)dxl (11) resolutionat the short end is madepossibleby the
concentrationof bill observations.
and
and minus their standard errorsof mea-
p(m) = lin [8(m)/1(m + h) _] (12
surement.The calculationof these errors
will be discussed in a later section. The
By differentiating(3) we have "knuckles" in the bands are to be ex-
k pected, unless we are willing to specify
d'(m)= >ajfjf(m). (13) that 8(m) must be twice continuously
j=1

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24 THE JOURNAL OF BUSINESS
differentiableinstead of just once. As m age of that rate of decay over the inter-
goes to infinity, p(m) does not necessari- val from 0 to m. Thus,
ly approach an asymptote. Rather, its ' m
standard error of measurement will be (m)= - f p(x)dx. (18)
found to grow without limit, so that its m 0
value simply fades away. This effect is Equivalent formulationsare
moreapparentin figure4 than in figure3,
which goes off scale. (m) = exp [-mfl(m)], (19)
The instantaneousforwardrate curve
is a very importanttheoreticalconstruct. q(m) = --In (m), (20)
However, its value for a single maturity and
m is of little practical concern, because
w(m) = r(0, m)
it is prohibitively expensive in terms of
transactions costs to make a forward Equation (18) states that v stands in
contract between two points in the dis- the relation of an average curve to the
tant future if these points are only a marginal curve p. Although v and p are
small distance apart, as are m and m + h not cost curves, they still bear the same
in definition (12) of the instantaneous mathematical interrelationships as do
forwardrate. average and marginalcost curves:
Only the average of p(m) over a con-
siderableinterval in the future is of prac-
i) mn'(m) + n(m) = p(m) (21)
tical concern. Given any two values of ii) n(0) = P(O)
mn,say ml and in2, the meanforward in-
iii)Iff~isrising
terestrater(Ml,M2) is the averageof p(m) iii) X is
fcalling at m,
over the interval [i1, i2]:
then p is aboveOatM.
below t
r(minm2) = f p(m)dm. (15)
iv) If O'(m) = 0, theno(m) = p(m)
Equivalently,
The yield curve, as defined in equa-
r(ml, M2) = m in i(n1) (16) tion (20), can be estimated by
1 A

Computationally,(16) is more useful and 77(m) = ln6(m). (22)

can be estimated by
Yield curves correspondingto figures 1
r(ml, M2) = in (17) and 2 are given in figures 5A and 6A.
in1)
The figuresshow the estimatorsplus and
Notice that we have derived and esti- minus their standard errors of measure-
mated forwardinterest rates without use ment. Notice how the standard error is
of the yield curve. large for both large and small m on the
railroadcurve for 1922 and is smallerfor
THE YIELD CURVE intermediate m. The computation of
The instantaneous forward interest these errors will be discussed in a later
rate curve p(m) gives the rate of decay section.
of the discount function 5(m) at each Otherinvestigatorshave measuredthe
point m. The yield curvet7(m)is the aver- term structureof interest rates by fitting

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 'bS0:.0g~l40 4.:s0 1m
4.0 Years to Maturity

0.0 2E _FIG. 6A.-Yield curve corresponding to the dis-

0 10 20 30 40 m count curve shown in fig. 2 for the close of Febru-
Yearsto Maturity ary 1966.
FIG.5A.-Yield curve correspondingto the dis-
count curveof fig. 1, for the close of February1922.

6.5 - -.

6.0 --

5.5 > - - 0 A 92

4.5

0 2 4 6 8 10 12 14 16. 18 20 22 24 26 28 30 42 54 66 78 90
Yearsto Maturity
FIG.5B.-A Durandyield curvefor comparisonwith fig. 5A based on high-gradecorporatebond trans-
actionpricesfromthe firstquarterof 1922.

'68 70 '72 74 76 7 8 '84 X6 es 90 92 '94 I

.9S 8e
82
Percent ' 0 ' z ; W { s is, "as Po 119 0 &-9 -1--

5.601 15,60

520 5=20

4 80 =480
A _

x
* I I tyr
4.40 | * --
x*C~d ,,|- * lse .ss
law.. 4.40

|Othr deepdiscount ImesI

ITrs1urry billsIncludedare llmi to maturitiesows I
400 to 3 monts, 6 months, and 9 monthsandto th long 4
mat-~Ity.
Yid ala d to l t dli t whenpdi.. are
j l per and
tomatuoowpr i twhen prk es are at par or
below.
aar|et M ablenowbIsuedinexchng f ornonmorktak bI l
3.60 23?% InvdmentSries Bbonds. 3.60
'Isom withcouponmates of 3I% or I

F77 T I= - C= =
1966 68 0 72 74 '76 '78 o' le '84 '8 '8 '90 '92 94 '96 9

FIG.6B.-A TreasuryBulletinyield curvefor comparisonwith fig. 6A based on bid quotationsfor the

close of February1966.The smoothcurveis fitted by eye. Marketyields on couponissuesdue in less than
three monthsare excluded.Source:TreasuryBulletin,March 1966, p. 78.

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26 THE JOURNAL OF BUSINESS
a smooth curve to the average yields to
maturity of the securities observed.Du-
rand and the Treasury Bulletin6 hand
fitted the points with a French curve,
while Cohen, Kramer, and Waugh7 fit
them with a linear regression.A Durand
curve and a TreasuryBulletin curve are
shown in figures5B and 6B for compari-
son with figures5A and 6A.
Both the hand and the regressionap-
proaches to directly fitting the yield
curve are open to two seriousobjections.
First, unless the yield curve I(m) is flat,
there is no reason to expect the average
yield of a bond with a positive coupon
rate to lie on it. The pure yield curve is
definedfor hypothetical bonds with zero
coupon rates, so that the yield of an or-
dinary bond with maturity mo is a com-
plicated average of I(m) over the whole
interval [0, ino], with only one of many
weights at no, correspondingto the prin-
cipal. For instance, if a bond has more
than fifteen or twenty years to go before
maturity, less than half of its value is
due to the principal.The rest is embodied
in the coupons. This averaging process
washes out any shape the yield curve
might have at the long end. The upward
slope at the right end of the curve in
figure5A may be a pertinent exampleof
the shape the yield curve may still have
at the long end. Unfortunately,however,
its measurementerror becomes so large
that this upward slope may or may not
be statistically significant.
Second, any minor error incurred
while directly fitting the yield curve will
be magnified, especially for large m, if
one tries to use formula (21) to calculate
forwardrates from the yield curve. Du-
rand himself has insisted that his curves
should not be used to derive forward
6See nn. 1 and 2.
7See n. 4.
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rates.8 For example, Durand's 1922
curve, shown in figure 5B, could not be
used to infer the interestingly low for-
ward rates shown in figure 3 which
spanned the interval from 1937 to 1950
in the future (maturitiesfifteen to twen-
ty-eight years). These remarkablerates
foreshadowedthe low rates for that pe-
riod which were again to prevail during
the later part of the Depression. When
the data for 1922werefirst fit, the author
used a polynomial form for 6(m), and
similarlow forwardrates resulted. In an
effort to get rid of them, he devised the
piecewise quadratic formulation which
will be discussed in a later section,
screened the data more carefully for
bonds which were callable, convertible,
or were not entirely risk free, and added
more observations. In spite of these
efforts the low forwardrates persisted.
The tendency for the standard error
of measurementof q(m) to be large for
small m means that Durand's "basic"
yield curves are open to another objec-
tion: They are biased so that they tend
to have an upwardslope. In orderto ob-
tain rates for absolutely risk-freeloans,
he drew his yield curves to pass under
the bulk of the plotted points. This
would be a valid procedureif the width
of the observed band of points were
caused only by differencesin the premi-
ums for the risk of default. However, the
observedbid-askedmean price of a virtu-
ally default-free security often differs
from its predictedvalue by several times
the transactionscost involved. In terms
of yield, this differenceis more impor-
tant for short maturities than for long,
causing Durand's plotted points to di-
verge for short maturities. By fitting his
8 David Durand,"A QuarterlySeriesof Corpo-
rate Basic Yields, 1952-57, and Some Attendant
Reservations,"Journal of Finance 13 (1958):348-56.
 MEASURINGTHE TERM STRUCTUREOF INTEREST RATES 27

curves under the bulk of the points in- If z is a k-vector of known values and
stead of through them, his curves tend 4 is the vector (l, ... ., hk), the es-
to have an upward-sloping shape too timator of the variance of the linear
often. Figures 5A and 5B illustrate one combination ZT4, for example, will be
case when Durand appears to have ob- the quadraticform zTCz.
tained an insufficiently downward-slop- The estimator of the variance of 8(m),
ing yield curve. The fact that Durand's definedby (8), is therefore
curves are biased to slope upward could vi [a(M)] = zTCz, (23a)
provide an alternative to the "liquidity where
preference"explanationof why the con- x; = fj(,m) (23b)
glomerateyield curve derivedby averag-
ing his annual curves is upwardsloping.9 Similarly, the estimator of the variance
of p n as definedin (9), is
ESTIMATION OF THE ERROR
var (pi)=XC (24a)
OF MEASUREMENT
where
The observed prices of securities are m,

seldom even close to their true values as Xj= 1OOf,(mi)

given by (1). In fact, the observedprice
itself is indeterminate, since the maxi-
mum price to a buyer (the asked price
plus the brokerage fee, if any) is sub-
stantially higherthan the minimumprice
to a seller (the bid price minus any
brokeragefee). Consequently, the term
structure cannot be measured exactly,
and any estimator of a value derived
from it is subject to random measure-
ment errors.It is important to estimate
the variance of these errors and to ac-
companyany display of statistics derived
from our regression with estimates of
their standarderrors.This has been done
graphicallyin the diagramsaccompany-
ing this paper by displaying a band
whose upper and lower edges are the
actual estimate plus and minus its stan-
dard error.
The weighted least-squaresregression
on (7) producesa k X k matrix C which
is the estimator of the covariancematrix
of the estimatorsdi of the parametersai.
9 See ReubenA. Kessel, The CyclicalBehaviorof
the TermStructureof InterestRates(New York:Na-
tional Bureauof EconomicResearch,1965), p. 18.
+ cif fj(m)dm. (24b)
0
Just as (9) can help banks, dealers, and
financial intermediaries estimate the
proper bid-asked mean price to offer,
(24) can help estimate the proper bid-
asked spreadwith a little experience.For
instance, they might make their offers
differfrom 'i by 1-3 S.E., depending
upon how cautious they feel and the size
of the offer.
The variance of the quotient of two
random variables x and y with expected
values Ex and Ey can be approximated
by use of the formula
var (x/y) var (x) +var (y)
(Ex/Ey)2 (Ex)2 (Ey)2 (25)
- 2cov (x, y)
ExEy
providedthat var (x) <<(Ex)2, var (y) <<
(Ey)2, and that the distribution of y is
positive."0Using (25), it can be shown
10 Formula(25) in the case of independentlydis-
tributedvariablesand formula(27) are commonly
used in experimentalphysics and chemistry.Both
the varianceof a quotient and that of a logarithm
are related to the varianceof a product,which is

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28 THE JOURNAL OF BUSINESS
that the variance of , (m), as given in must be continuously differentiableand
(14), is approximatedby thatfj(O) must be 0.
The maturities of the securities we
var W ]I -_p)zICz,
W (26a) observewill not be uniformlydistributed
where
over the interval from 0 to m., the
zj= [fXm)]/[Y'(m)] (26b) longest maturity observed,except by ac-
cident. Whereconcentrationsof observa-
tions occur, the shape of the discount
The variance of the natural logarithm function is relatively well defined.Where
of a random variable x can be approxi- observationsare sparse,we are not justi-
mated by fied in distinguishing as much shape.
Therefore it will be desirable to make
var (In x) (Ex) (27) fj(m) depend on the distribution of the
mi in such a way as to provide greater
provided that var (x) << (Ex)2,and that resolution wherever maturities are clus-
the distribution of x is positive. Using tered. In the case of U.S. Treasurysecu-
(27), it can be shown that the variance rities, following this rule will place the
of the mean forward rate ri(m1,m2), as greatest resolution at the short end,
defined in (17), is approximatedby where there are many bills outstanding.
var [P(Mzl,M2)] z7'CZ, (28a) This is as it should be, since participants
in the market are more concernedwith
where small differencesin time in the near fu-
z = m m [fi(ml) fi(M2 . (28b) ture than in the far future. This greater
62m (ml) b(M2) concern means that the discount func-
tion 6(m) they define by the values they
Again using (27), we see at once that the place on the outstanding securities will
varianceof the yield curve '(m), as given have the most detailed shape at the
in (22), is approximatedby short end.
A relatively naive approachis simply
var [vm) a 0[(m)]I (29) to set
[ma(M)]2
fj(M) = mi =1, 2, ...,k. (30)
THE FORM OF THE FUNCTIONS fj(m) This assumption makes 6(m) a kth-
The choice of the functions fj(m) is degree polynomial with unity for its
central to the quality of our fit of the constant term. A polynomial is straight-
term structure. However, the selection forward,but it has no theoretical moti-
of a form will always be a matter of vation. Its formulationdoes not depend
judgment. Only a few hard and fast rules on the distribution of the mt, nor does
hold. Two of these are that the fj(m) it have a greater capability for provid-
ing resolution for values of m where the
rigorouslyderived by Leo A. Goodman,"On the mi are more likely to occur. As a result
Exact Variance of Products," Journal of the Ameri- of its uniform resolving power, when it
can Statistical Association (December 1960), pp. is used to fit a discount function which
708-13. An approximationfor productsanalogous
to (25) can be derivedfromhis exact formulawhen has a finely definedshape in the first 1 or
the variancesare relativelysmall. 2 percent of its length and is relatively

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 MEASURINGTHE TERM STRUCTUREOF INTEREST RATES
smooth thereafter, it will either ignore
the short end and conform only to the
remaining 98 or 99 percent, or else, if
there are so many bill observationsthat
they take over the regression,it will con-
form only to the short end and ignore
the long end. It would take an extremely
high-order polynomial to fit both the
long and short ends of such a curve.
Even so, this high-order polynomial
would probably take on extreme values
between observations at the long end,
and would not be monotonically de-
creasing, as the discount function must
be. On the other hand, a functionalform
which inherently permits greater resolu-
tion in the vicinity of data concentra-
tions would be consistent with such a
curve throughout its length, would re-
quire the estimation of only a few un-
known parameters,and would be mono-
tonic. The one portion would not have
to be sacrificedto suit the other.
A better functionalform for 8(m) than
a polynomial is a continuously differen-
tiable, piecewise quadratic function. To
define such a curve we must divide the
interval (0, m.) into k - 1 subintervals
(di, di+,). We will have di equal to 0 and
dk equal to mA.Our a8(m)will follow a
different quadratic function of m over
each of the subintervals. In order for
S(m) to be continuously differentiable,
the quadratics defined over adjacent
subintervals(dje, d1)and (dj, di+,) must
have a common slope, as well as a com-
mon value, at d3.The greaterthe number
of subintervalscovering any part of the
interval (0, mn), the greater will be the
resolvingpower of the discount function
in that part of the interval. Therefore,
,m -
fi(m) 2d2
!'d2,7d2<
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29
by defining the subintervals to contain
approximately equal numbers of the
terminalmaturitiesmi, we will get great-
er potential resolution where the data
observations are most numerous. Each
of the quadratic segments will have an
approximately equal number of obser-
vations to conformto. We can define the
subintervalsin this way by setting d, =
m1 + 0(mil+,- mn), where I = greatest
integer in [(j - 1)n]/(k - 1), and 0 =
[(j - 1)n]/(k - 1) - 1. (We have as-
sumed the securities to have been ar-
ranged in order by increasing terminal
maturity, so that mj < mj+i.)
The set of functions of the form
k
a(m) = 1+ Y ajfj(m)
j=l
will comprise the entire family of con-
tinuously differentiablefunctions which
satisfy 6(0) = 1 and which are piecewise
quadratic over the subintervals defined
above if we define the fj(m) as shown in
figure 7. The first one, f (m), starts with
value zero and with a positive slope at
m = 0, flattens until it has a zero slope
at m = d2, and remains constant there-
after, as in figure 7A. Intermediateones,
fj(m), where j = 2, 3,..., k-1, are
zero up until dj~_, There the slope be-
gins to increase from zero up to some
positive value at dj. Then the slope falls
from its dj value to zero at dj+c.Its value
is constant thereafter. Figure 7B shows
the particularcase off2(m). The last one,
fk(m), is definedthe same as the interme-
diate ones, except that it is undefined
after m = m., as shown in figure 7C.
Algebraically, the fj(m) are defined as
follows:
m 2, O< m< d2
(31a)
m < mn
30 THE JOURNAL OF BUSINESS

0, 0 < m < di-,

- ci* i)2
2(Mdj-_1)2'
2(m d;-, < ms< di

f6 (M) (i c)+() (m - d,) j 2, ...,Y-k-1 (31b)

2) =(d+l-dj)'

dj < m < dji

'(dj~l - dc), dj+l < m < mn

(O.0 < m< dk-1

f
k(Mn) l(m - dk_1)2 d C C(31c)

f(m) U| k__ _ <lM_ _ ____

dk__

dt-0 42 A d.-m.

f,(m)

dj-O d2 d3 B d.-m.

f,(m)

d,-O C dk., d-m.

FIG.7.-The preferredform of the f;(m). Thesef (m) make (m) piecewisequadraticand continuously
differentiable.

Since the vertical scales of the fj(m) are ters of elementary calculus, and will be
immaterial, we have arbitrarily chosen omitted here.1
them so that The specificationof the fr(m) given in
5'(d,) = afj(d,) (32) (31) was used for the regressionfits of the
11Otherspecificationsof the fi(m) will generate
= as.
exactlythe samefamilyof piecewisequadraticfunc-
Integration of fj(m) in order to evaluate tions. The one chosenwas selected only becauseit
can have the property(32) if the scales are chosen
(7d) and (24b) and differentiationin or- appropriately.The otherspecificationswill give the
der to evaluate (14) and (26b) are mat- same 5(m)if used with the same data.

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 MEASURINGTHE TERM STRUCTURE OF INTEREST RATES
discountfunctionshownin figures1 and 2.
Because a piecewise quadratic function
has a discontinuoussecondderivative,the
instantaneousforwardinterestratecurves
derived from these discount functions
have discontinuous first derivatives,
which explains the angular shape of the
bands shownin figures3 and 4. However,
as mentioned earlier, the instantaneous
forward rate p(m) is interesting mainly
as a theoretical construct. Its level at
one isolated value of m has little practi-
cal significance.Consequentlywe are not
worried by the outlying values of k(m)
and its standard error that are some-
times implied by our specificationof the
fj(m). In fact, our specificationis suffi-
cient to imply that mean forward rates
r(mi, in2), which are of practical concern,
are continuously differentiablewith re-
spect to both mi and m2.The yield curve,
a special case of r(mi, m2) with ml = 0,
is therefore also continuously differen-
tiable, as may be seen in figures 5A
and 6A.
THE VALUE OF k numberof observations,the ratio n/k(n)
The number k of parameters to be
estimated is another area where judg-
ment must be used. If k is too low, we
will not be able to fit the discount func-
tion closely when it takes on difficult
shapes. If it is too high, the discount
function may conform too closely to
outliers instead of being smooth. If k is
as high as n, there will be no way to
estimate i2. In the spirit of least squares,
we might try all values of k inside a
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31
rangewe regardas reasonable,and select
that value which minimizes the un-
biased estimator '2 of r2;
as_ 1 2 (I Pi)2~
n- k fr kV
As k increases, the residuals generally
decrease, but then so do the degrees of
freedom. The result is that a2 declines
sharply as k increasesfrom 2 to 3 or 4,
but thereafterfluctuatesirregularlywith
a small amplitude, and often with more
than one local minimum. Sometimes it
showsno sign of permanentlyrising,even
after k becomesso largethat the discount
function adheresto outliers.
A secondapproachis simply to make k
a fixed function of n. We would like this
functionto have the followingproperties:
First, in orderto have resolutionincrease
as the numberof observationsincreases,
our function k(n) should increasewith n.
Second, in order to make the number of
observationsin the domainof each quad-
ratic segment increase with the total
should also increase with n. An elemen-
tary function with these properties is
k(n) = nearest integer to n'12.In prac-
tice, this formula gives approximately
the same results as the first approach,
without the expensive search.12
12Since the final revisionof this paper,a prece-
dent for the continuouslydifferentiable,piecewise
quadraticfunctionalformhas cometo my attention
(see Wayne A. Fuller, "Grafted Polynomials as
ApproximatingFunctions," AustralianJournal of
AgriculturalEconomics13, no. 1 [June19691:35-46).