A Note on Yield Curve Reduction

Abstract

To ensure accurate market compliance, yield curves used for marking-to-market are typically constructed of as many liquid fixed income instruments as possible. This can result in curves of very high cardinality. The high cardinality associated with such curves renders them impractical for use during simulation or for the calculation of risk metrics. Thus, reduction of such curves is highly desirable. An approach is presented for the optimal reduction of market compliant yield curves. The optimality condition is portfolio specific, in order to minimize pricing errors for the portfolio whose risk metrics are being computed.

Keywords: Yield Curve, Fixed Income Instruments, Market Risk, Interest Rate Risk, Nonlinear Optimization, Interpolation, Bootstrap

JEL Classification: G00