Term Structure Of Interest Rates - 1302 Words

Contents: 1. Introduction 2 2. Method 2 3. Data 3 4. Results 4 5. Limitations 5 6. Suggested improvements 5 7. References 7 Introduction The term structure of interest rates describes the empirical relationship between the yields on fixed income securities and their term to maturity (Poitras, 2005). The yield curve is the term structure’s graphical representation, plotting the yields of fixed income securities as a â€Å"function of their maturity† (Stander 2005, Cochrane, 2005). Yield curves are widely used in pricing and valuation techniques, supporting subjective and objective decision-making processes. Yield curves offer information that assists practitioners in determining the current level of market†¦show more content†¦In this respect, the following model will be employed: y_i=a+bM_i+cM_i^2+dM_i^3+e_i where: y_i≠¡yield to maturity of the bond M_i≠¡bond^ s time to maturity a,b,c,d≠¡parameters to be estimated e_i≠¡the deviation of the actual yield from the fitted yield The input data will consist of yields to maturity and respective time to maturity of the sample bonds. The independent (explained) variable in this model will be the yield to maturity. The explanatory variables will consist of the bonds’ time to maturity at the power of 1, 2 and 3 respectively. Since the sample data provides the maturity dates of each bond, the bond’s time to maturity (M_i) is calculated using the following formula: M_i=(maturity date of bond i-today^ s date)/(number of days in a year) Today’s date is assumed to be 14/11/2014; number of days in a year are assumed to be 365.25 thus, allowing for leap years to be taken into account. Subsequently M_i^2 and M_i^3 are also calculated for each bond in the sample. The model will be estimated using OLS regression method. The regression parameters are being estimated employing Excel’s regression function. The yield to maturity of the new bond is being estimated by substituting the bond’s time to maturity (M_i) into the estimated yield curve equation: (y_i ) Ì‚=a Ì‚+b Ì‚M_i+c Ì‚M_i^2+d Ì‚M_i^3 From the definition of yield to