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Fixed Income Securities Assignment - 3

Introduction

Good estimate of the yield curve is of great importance for all financial institution. To assess the
points on interest rate curve various curve-fitting methods are used for example quadratic and cubic
spline, exponential spline etc. the main drawback of these methods is the undesirable economic
interpretations. To overcome these inadequacies, Nelson Siegel and Svensson proposed flexible
parametric curves that are competent to describe the observed term structure shapes.

Term structure refers to the relationship between the yield of bonds and their time to maturity. To
ease the situation we take the bonds as zero coupon govt. bods so that the duration is time to
maturity and no credit risk.

Term structure has three descriptors:

 Discount Function : it is related to zero coupon bond price which is function of its maturity
 Spot yield curve : it specifies zero coupon bond yield as function of maturity
 Forward yield curve : it specifies zero coupon bond forward yield as function of maturity

Nelson-Siegel Model

Nelson-Siegel model provides the description of the yield that should be earned from the bond with
maturities that are not frequently traded. It is very flexible and facilitates most of the historical term
structure.

𝑌 𝑡
𝑡
−𝑡
𝑡,𝑡+𝛿= 𝛽0 + 𝛽1 𝑒 𝑡1 + 𝛽2 ( 𝑒 𝑡1 )
𝑇

t = maturity of the forward rate

𝛽0 = 𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠 This represents the sustenance level throughout the tenor unless
there is a change in the yield curve

𝛽1 = difference between Short term & Long term rates

𝛽2 = difference between medium and long term rates. It represents the curvature of the yield curve.
If the long term rates decrease the curvature increases and vice versa.

𝑡1 = decay rate of short and medium term rates

lim 𝑓(𝑚) = 𝛽0 This represents that when the maturity tends to grow towards infinity we can say
𝑚→∞
𝛽0 will represent the long term interest rate

lim 𝑓(𝑚) = 𝛽0 + 𝛽1 if the time to maturity tends to zero then the yield will become 𝛽0 + 𝛽1
𝑚→0

This equation helps to fit the slope between short- and long-term interest rate across the time
horizon, which is helpful to do the valuation of different bond with different time to maturity.
The NS model just have four standard shapes for zero coupon bond, which are:

 Increasing Curve: which represents same slope of the interest rate curve throughout the
tenor
 Decreasing Curve: The curve represents the decreasing rate of slope of the interest rate urve
throughout the tenor
 Flat Rate curve: The curve represents constant level of interest rate throughout the tenor
 Inverted Curve: The curve represents decreasing level of interest rate throughout the tenor.

It fails to allow the double hump and U- shaped.

Nelson-Siegel Svensson Model

Sevensson improved the model by writing a paper in the year 1994 and made some changes by
adding 2 additional parameters to capture the humps along the tenor.
𝑚 𝑚
1 − 𝑒 −(τ1) 𝑚
−( ) 1 − 𝑒 −(τ2) 𝑚
−( )
𝑟 = 𝛽0 + (𝛽1 + 𝛽2 ) ∗ 𝑚 − 𝛽2 ∗ 𝑒 τ1 + 𝛽 ∗
3 𝑚 − 𝛽3 ∗ 𝑒 τ2

τ1 τ2

Where,
 β3 is again a function of m, which becomes zero when m=0 This parameter, which is
analogous to β2, determines the magnitude and direction of the second hump.
NSS Model has the following advantages over the NS Model:
 The estimation is comparatively more simplified as it is computed through linear
regression.
 The model is competent to construct yields for different maturities.
 The interpretation is intuitive which leads to easier explanation
 Historically the NSS model fits the information in a sensible manner

The above equation has following:

𝛽0 represents the level


𝛽1 represents steepness
𝛽2 and 𝛽3 are the measures of the first and second humps of the curvature. Whereas the 𝛽3the
additional parameter provide the model flexibility to the model for short term rates. It is
volatile in nature and changes rapidly with unpredictable nature, which assist to better fit the
market prices of the bond following the changes in the short term changes in the interest
rates.
Difference
The main demerit of NS model is the failure to capture the humps across the tenor. The
model determines the curvature and slope from previous tenor, which leads to failure in
capturing the change. NSS model has overcome the drawback by adding two additional
factor, which provides smaller error term in comparison.
Reference

1. “Estimating the Yield Curve Using the Nelson‐Siegel Model” by Jan Annaert, Anouk G.P.
Claes, Marc J.K. De Ceuster, Hairui Zhang

2. “Term Structure Modelling by Using Nelson-Siegel Model#” by Hana HLADÍKOVÁ* – Jarmila


RADOVÁ**

3. “Computation of the implied and local volatility: elementary approaches” By Dominic


Barton, McKinsey-Chef