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Interpolation Methods for Curve Construction 

Authors: Patrick S. Hagan a; Graeme West b
Affiliations:   a Bloomberg, LP, New York, NY 10022, USA
b Programme in Advanced Mathematics of Finance, School of Computational & Applied Mathematics, University of the Witwatersrand, Wits 2050, South Africa
DOI: 10.1080/13504860500396032
Publication Frequency: 6 issues per year
Published in: journal Applied Mathematical Finance, Volume 13, Issue 2 June 2006 , pages 89 - 129
Formats available: HTML (English) : PDF (English)
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Abstract

This paper surveys a wide selection of the interpolation algorithms that are in use in financial markets for construction of curves such as forward curves, basis curves, and most importantly, yield curves. In the case of yield curves the issue of bootstrapping is reviewed and how the interpolation algorithm should be intimately connected to the bootstrap itself is discussed. The criterion for inclusion in this survey is that the method has been implemented by a software vendor (or indeed an inhouse developer) as a viable option for yield curve interpolation. As will be seen, many of these methods suffer from problems: they posit unreasonable expections, or are not even necessarily arbitrage free. Moreover, many methods lead one to derive hedging strategies that are not intuitively reasonable. In the last sections, two new interpolation methods (the monotone convex method and the minimal method) are introduced, which it is believed overcome many of the problems highlighted with the other methods discussed in the earlier sections.
Keywords: Yield curve; interpolation; bootstrap
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