Fitting Forward Rates to Market Data

Abstract

Fitting the forward curve to market data forms the foundation for most of modern fixed income capital markets. This paper outlines a general framework for fitting the forward curve to market data. We then discuss three particular functional forms. The first two, piece-wise constant forward rates and piece-wise linear zero rates, are simple and commonly used in the markets. The third functional form, piece-wise linear forward rates, retains much of the simplicity and ease of use from the first two, while solving a problem (large jumps in the instantaneous forward rates) exhibited by them. Results are reported for US dollar swap curves for October 1994 and June 1997.

Keywords: Forward Curve, Forward Rates, Yield Curve, Term Structure of Interest Rates

JEL Classification: G10, G12