Term Structure Estimation from On-the-Run Treasuries

Abstract

Five methods of estimating the term structure from on-the-run Treasuries are compared 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. The two discrete-time bootstrapping methods are based on linear and cubic interpolation of the yield curve. Two continuous-time bootstrapping methods are based on exponential functional forms for the yield curve and a third is based on a bilinear transformation of a power function. Simulated bond samples with and without random error are employed to study the relative importance of interpolation error and random pricing error. CRSP bond data are used in assessing the accuracy of the methods in pricing liquid and illiquid bonds. Two methods stand out in terms of good interpolation properties and robustness in the face of pricing errors. These are the Nelson and Siegel and the Mansi and Phillips methods. Both are based on exponential functions.

Keywords: Term Structure Estimation, Yield Curve Smoothing, On-the-run Treasuries, Bond Valuation

JEL Classification: D4, E4, G1, N2