Best Intro To Fixed in Come

An Introduction to Yield-Curve Modeling
Jean-Paul Renne
Banque de France
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Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling
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Overview of the presentation
Generalities about fixed-income securities and yields

1
2
3
4
What is a fixed-income security?

The yields
Duration of a bond
Modeling the yield curve: first statistical approaches
1
2
Principal component analysis

Nelson-Siegel model
What accounts for the shape of the yield curve?

1
2
3
A world without uncertainty

A world with uncertainty but without risk-aversion
A more realistic world...
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What is a fixed income security?
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Fixed income refers to investments that yield a regular (or fixed)

return.
Example: If A lends money to a borrower B that has to pay interest
once a month, B has issued a fixed-income security.
There are several bond categories, depending on
The issuer (Corporate, Government, Supras, Agencies...)
Unsecured vs. Secured (collateral)
The type of payoffs (zero-coupon, annual coupons, semi-annual
coupons, floating or indexed payoffs)
Embedded options (callability, convertibility)
The maturity (bills, notes, bonds).
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Capital markets are markets for securities (debt or equity), where
entities (business enterprises or governments) can raise long-term
funds.
In these markets, money is provided for periods longer than a year
(raising short-term funds takes place on other markets, e.g., the
money market).
The capital market includes the stock market (equity securities) and
the bond market (debt).
Capital markets may be classified as primary markets and secondary
markets.
In primary markets, new stock or bond issues are sold to investors via a
mechanism known as underwriting.
In the secondary markets, existing securities are sold and bought
among investors or traders, usually on a securities exchange,
over-the-counter, or elsewhere.
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Source: Bloomberg.
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What is a yield-to-maturity?
Lets denote with P(t, h) the price of a riskless h-year bond paying
annually a coupon of c (in percentage point) and with a principal of
100 (that will be paid in h years).
The yield-to-maturity Rth (for the maturity h) is defined as that yield
that is such that
!
h
X
100
c
+
P(t, h) =
h
i
(1 + Rt )
(1 + Rth )h
i=1
Exercise
Assume that P(t, h) = 100 (that is, the bond is at par). Then, what
is the relationship between c and Rth ?
If P(t, h) < 100 , what is the relationship between c and Rth ?
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Duration of a bond
What is the sensitivity of P(t, h) to Rth ?
P(t, h)
Rth
h
X
=
1
= 1+R
h
t
ic
(1 + Rth )i+1
n100
(1 + Rth )h+1
i=1
" h
!
#
X
c
100
i
+n
h )i
(1
+
R
(1 + Rth )h
t
i=1
which can be rewriten

4P(t, h)
4Rth
=
D
P(t, h)
1 + Rth |{z}
Duration
with hP

i hP
h
h
100
c
D=
i
+
h
/
h
h
i
n
i=1
i=1 (1+R )
(1+R )
t
c
(1+Rth )i
100
(1+Rth )h
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Duration of a bond
The duration D is a weighted average of the maturities of the pay-offs

associated to the bond.
The modified duration DM is defined as D/(1 + Rth ). Therefore
4P(t, h)
= DM 4Rth
P(t, h)
Exercise
What is the duration of a zero-coupon bond if maturity h?
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Bond price and yield
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Stylized facts about yields

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CNO TEC indices (French government yields), Source: Datastream.
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Stylized facts about yields

Correlation matrix of French yields (1999-2009)
1Mth Yield
3Mth Yield
6Mth Yield
1Y Yield
2Y Yield
5Y Yield
10Y Yield
1Mth Yd
3Mth Yd
6Mth Yd
1Y Yd
2Y Yd
5Y Yd
10Y Yd
1
0.996
0.984
0.955
0.907
0.786
0.613
1
0.993
0.971
0.928
0.802
0.618
1
0.991
0.958
0.835
0.640
1
0.982
0.863
0.654
1
0.929
0.746
1
0.931
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Zero-coupon bonds
Payoffs schedule
A zero-coupon bond (also known as a discount bond ) makes a single

payment on its maturity date.
A coupon bond makes periodic interest payments prior to its maturity
when it also makes a final payment that represents repayment of
principal ( a portfolio of zero-coupon bonds).
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Zero-coupon yields
The zero-coupon yield (h 7 ZRth ) curve is central: once you have it at
your disposal, you can price any security that will respectively pay
C1 , C2 , . . . Ch at periods 1, 2, . . . , h:
!
h
X
Ci
100
P(t, h) =
.
+
h )h
i )i
(1
+
ZR
(1
+
ZR
t
t
i=1
In particular, the price of a coupon bond with a coupon of c is given
by:
!
h
X
c
100
P(t, h) =
+
i i
(1 + ZRth )h
i=1 (1 + ZRt )
(this bond is said to be at par if its value is equal to 100).
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The yield curve

5,25
5,00
4,75
4,50
4,25
4,00
3,75
3,50
3,25
3,00
2,75
2,50
2,25
2,00
1,75
1,50
1,25
1,00
0,75
0,50
0,25
2,5
Chart1
5,0
7,5 10,0 12,5 15,0 17,5 20,0 22,5 25,0 27,5 30,0 32,5 35,0 37,5 40,0 42,5 45,0
GOVT EUR Italian Government b-spline 11 fvr. 10 (L)
GOVT EUR French Government b-spline 11 fvr. 10 (L)
GOVT EUR German Government b-spline 11 fvr. 10 (L)
Source: Barclays Capital Live.

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Nelson-Siegel parametric model

The underlying principle of parametric models is the specification of a
single-piece function that is defined over the entire maturity domain.
Whilst the various approaches in this class of models advocate
different choices of this function, they all share the general approach
that the model parameters are determined through the minimisation of
some deviations of theoretical prices from observed prices.
In the Nelson-Siegel approach, the zero-coupon yield curve is given by
the following form (in period t):

1
h
h
h
ZR t = 0,t + 1,t 1 exp

1
1

1

!
h
h
h
+2,t
1 exp
exp
1
1
1
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Nelson-Siegel parametric model

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Nelson-Siegel Model
Influence of 0
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Nelson-Siegel Model
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Nelson-Siegel Model
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Nelson-Siegel Model
Estimation
The parameters can be estimated by minimizing the root mean

(across maturities) square deviation:
N h
0,t
i2
X
ht i (0 , 1 , 2 )
1,t = arg min
ZRt,hi ZR
0 ,1 ,2 i=1
2,t
If
this is done for any
0 period t, one get time series for the vector
0,t 1,t 2,t
and one can attempt to model this stochastic
vector (as a VAR for instance).
Alternatively, one can estimate thes by using a Kalman filter. In the
underlying state-space model, the measurement equations are given by
Equation (1), for different maturities.
Once one has a model describing the dynamics of thes, one can for
instance carry out some forecasts of future yield (of any maturity).
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Principal component analysis (PCA) is a classical and easy-to-use
statistical method.
This linear transform has been widely used, notably in data analysis
and compression.
It is a way of identifying patterns in data, and expressing the data in
such a way as to highlight their similarities and differences.
Principal component analysis is based on the statistical representation
of a random variable.
The other main advantage of PCA is that once you have found these
patterns in the data, and you compress the data, ie. by reducing the
number of dimensions, without much loss of information. This
technique used in image compression.
In the following, we suppose that we have T observations of a (n 1)
random vector x, denoted with x1 , x2 , . . . , xT .
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0
Let denote with X the matrix given by x1 x2 . . . xT . Besides,
the j th column of X is denoted with Xj .
For PCA to work properly, you have to subtract the mean from each
of the data dimensions. This produces a data set whose mean is zero.
We want to find the linear combination of the xi s (x.u), with
kuk = 1, with maximum variance, i.e. we want to solve:
u
arg max u 0 X 0 Xu.

s.t. kuk = 1
Since X 0 X is a positive definite matrix, it admits the following form:

X 0X
0
= PDP
= P
..
0
P
.
n
where P is an orthogonal matrix whose columns are the eigenvectors

of X 0 X .
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We can order the eigenvalues such that 1 . . . n .
Besides, since X 0 X is positive definite, we have 0 < n . . . 1 .
We have u 0 X 0 Xu = u 0 PDP 0 u = y 0 Dy where ky k = 1 since P is
orthogonal. Therefore, we have yi2 1 for any i n.
As a consequence:
y 0 Dy =
n
X
i=1
yi2 i 1
n
X
yi2 = 1 .
i=1
It is easily seen that the maximum is reached for y = [1, 0, , 0]0 .

Therefore, the maximum of the optimization program is obtained for
u = P [1, 0, , 0]0 , i.e. u is the eigenvector of X 0 X that is associated
with its larger eigenvalue (first column of P).
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Let us denote with F the vector that is given by the matrix product
XP (note that its last column is equal to Xu).
The columns of F are denoted with Fj and are called factors. We have:
F 0 F = P 0 X 0 XP = D.
Accordingly, the Fj are orthogonal.
Naturally, the Xj are some linear combinations of the factors since
i,j the part of Xi that is explained
X = FP 0 . Let us then denote with X
by factor Fj , we have:
i,j
X
Xi
= pij Fj
X
X
i,j =
=
X
pij Fj .
j
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Let us have a look at the share of variance that is explained through

the n variables (X1 , . . . , Xn ) by the first factor F1 :
i,1 X
0
X
i,1
P
0
i Xi Xi
P
=
pi1 F1 F10 pi1

tr (X 0 X )
2
pi1
1
0
tr (X X )
P1 .
i i
P
=
=
Intuitively, if the first eigenvaue is large, it means that the first factor
embed a large share of the fluctutions of the n Xi s.
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Application to 7 series of French-government yields (1m, 3m, 6m, 1y, 2y, 5y, 10y)
First three principal components

4.92
First PC
Second PC
Third PC
3.34
1.77
0.20
-1.37
-2.94
-4.52
-6.09
Feb97 Jan98 Jan99 Feb00 Feb01 Feb02 Feb03 Jan04 Feb05 Feb06 Feb07 Feb08 Jan09
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Application to 7 series of French-government yields (1m, 3m, 6m, 1y, 2y, 5y, 10y)
Factor loadings
First PC
Second PC
Third PC
0.739
0.554
0.369
0.184
-0.001
-0.186
-0.371
-0.556
0.08
0.85
1.61
2.37
3.13
3.90 4.66 5.42 6.19 6.95

Bond maturity (in years)
7.71
8.47
9.24
10.00
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A world with no uncertainty
Let us consider an agent that wants to invest 100 for 2 years.

He may
buy a two-year bond today (the yield being R(0, 2))
or buy a one-year bond today (the yield is R(0, 1)) and buy a one-year
bond in one year, when the principal payment of the previous bond falls
due (the yield will be R(1, 1)).
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A world with no uncertainty
We assume that there is no uncertainty, that is, the 1-period rate that
will prevail in period 1 (which is R11 ) is known in period 0. In this case,
we must have:
2

1 + R02 = 1 + R01 1 + R11
and, if the rates are small:
R02

1 1
R0 + R11 .
2
In the same way, we can get:

R0n

1 1
1
R0 + R11 + . . . + Rn1
.
n
Therefore, in a world with no uncertainty, the yield on long term

bonds equals the average of the future one-period interest rates.
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If there is uncertainty but no risk-aversion, the expectation hypothesis

(EH) is verified: the yield on long term bonds approximately equals
the average of the expected one-period interest rates.
Assume that at each period, the 1-period yield rt can be high (and
equal to rh ) with a probability 0.50 or low (and equal to rl ) with a
probability 0.50. Let us denote with r0 the average rate
(r0 = (rl + rh )/2). The 1-period bond is given by P(t, 1) = 1/(1 + rt ).
If the agents are risk-neutral, they are indifferent between (a) buying a
2-period bond in t and (b) buying a 1-period bond in t and another
1-period bond in t + 1. Consequently, the price of a 2-period bond is
given by

1 1
1
1
1
1 1
+
P(t, 2) =
E
=
1 + rt
1 + rt+1
1 + rt 2 1 + rh 2 1 + rl
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Because of the Jensen Inequality (x 1/(1 + x) being convex), we

have:
1
1
.
P(t, 2) >
1 + rt 1 + r0
By iterating:
1
P(t, h) =
1 + rt

1 1
1 1
1 1
1 1
+
...
+
2 1 + rh 2 1 + rl
2 1 + rh 2 1 + rl
and
Rth
1
=
P(t, h)
1/h
1.
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In the case where R01 = 10%:
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In the case where R01 = 0%:
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A more realistic world
Historically, the expectations hypothesis has been the most widely

used analytical tool to understand the shape of the yield curve.
If the expectations hypothesis were correct, we could use the slope of
the term structure to forecast the future path of the interest rate.
For example, if the yield curve slopes upward at the short end, it
would be because the interest rate is expected to rise.
One problem with this version of the expectations hypothesis is that in
fact the yield curve slopes upward at the short end on average, even
though interest rates do not rise on average.
One way to explain this divergence is to assume that investors are
simply wrong on average... But a good theory does not imply that
investors are wrong on average.
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The expectations hypothesis can be easily modified to account for this

persistent upward slope in a way that does not require systematic
errors on the part of investors.
Since bond prices do fluctuate over time, there is uncertainty (even for
default-free bonds) regarding the return from holding a long-term
bond over the next period.
Moreover, the amount of uncertainty increases with the maturity of
the bond.
If there were a risk premium associated with that uncertainty, then the
yield curve could slope upward on average without implying that
interest rates in- crease on average.
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If the risk premium were constant, then changes in the slope of the
yield curve would forecast changes in the future path of the interest
rate.
Empirical tests of this extended version of the expectations hypothesis
(using U.S. data) have shown that changes in the slope of the term
structure do a poor job of forecasting changes in the bond yields.
We went wrong by assuming that the risk premium was constant,
while in fact the risk-premium varies over time.
Risk premia are essentially covariances that change when either the
amount of risk or the price of risk changes.
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The pricing kernel
Consider a coin-flipping game:

A side (probability = 50%): you get X = 100 euros,
B side (probability = 50%): you get nothing (X = 0).
Basically, you will be willing to pay if the initial price is lower than the
expected value of the gain (50 euros).
Assume you are willing to play if the price is lower than 25 euros.
Someone that would be risk-neutral would be willing to play for that
price is the winning probability was such that
25 = p 100 + (1 p) 0, i.e. with a winning probability of 25%.
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The pricing kernel
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The absence of arbitrage
In recent years the theory of finance has produced convenient tools

that allow us to directly apply the conditions that guarantee the
absence of arbitrage opportunities in a world where there is
uncertainty.
The tools were developed as an outgrowth of the famous
BlackScholes model of option prices.
An arbitrage involves trading securities in such a way as to generate
something for nothing.
The most powerful tool for understanding the term structure of
interest rates is called the absence of arbitrage. This is short-hand
for the conditions that guarantee the absence of arbitrage
opportunities. An opportunity for arbitrage exists when there is an
inconsistency in the prices of securities that allows a valuable payoff to
be obtained at no cost.
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Macro-finance models
General framework (1/4)
Macro-finance modeling builds on the more general Affine Term

Structure Models popularized by Duffie and Kan (1996)
ATSM are factor models, so only a small number of sources of
variation underlie the pricing of the entire term structure of interest
rates
ATSM impose no-arbitrage restrictions: the dynamic evolution of
yields over time and across state of nature is consistent with the
cross-sectional shape of the yield curve (after accounting for risk)
In macro-finance models (pioneered by Ang and Piazzesi, 2003), the
factors are closely linked with macroeconomic variables
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Ingredients:
The dynamics of factors (observable or not) Ft
The specifications of the pricing kernel mt+1 (or stochastic discount
factor, SDF)
Price Pt of an asset providing the payoff g (FT ) in period T :

Pt = Et (mt+1 mt+2 . . . mT 1 mT g (FT ))
In Affine Term Structure Models (ATSM), zero-coupon bond yields of
maturity are given by:
i1,t
i2,t
.. = A + BFt
.
in,t
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Example 1: Pricing of a 2-period bond

If
Factors dynamics: Ft = Ft1 + t (t N(0, Id))
Pricing kernel: mt+1 = exp 12 0t t 0t t+1 i1,t with
t = 0 + 1 Ft
1-period bond (short rate): i1,t = Ft
Payoff: g (Ft+2 ) = 1, therefore Pt = Et (mt+1 mt+2 1)

i2,t
=
(I + ) Ft
|2
{z
}
average
short rate
( 12 [i1,t + Et (i1,t+1 )])
1
0 0
| 2 {z }
convexity
adjustment
E (exp(X )) >
exp(E (X ))

1
1
0 + 1 Ft
2
2
|
{z
}
risk
premium
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Example 2: Pricing of a 1-period inflation-linked bond

The framework makes it possible to price inflation-linked bonds (ILBs)
as soon as inflation is one of the factors Ft .
Lets inflation t = ln(CPIt /CPIt1 ) be the first component of Ft ,
then t = Ft where = 1 0 . . . 0 .
Payoff: g (Ft+1 ) =
i1,t r1,t =
CPIt+1
CPIt ,

therefore Pt = Et mt+1
F
| {z }t
expected
inflation
(= Et (t+1 ))
CPIt+1
CPIt
1
0 0 (0 + 1 Ft )
{z
}
| 2 {z } |
risk
convexity
premium
adjustment
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Figure: Model structure

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<467=#(&'>?7)&&#76'@ABCD
1.0/'1.1 .4
1 .3
E.'F'GE.H;'I'J1.
4-'/'15+6)-1)$
O./.I;F'#>E.I;C
2&&),+3-'/)&
K:=#67$'4#,$L'()*+,
B,7$'4#,$L'()*+,
#M/.'F'!>E.I;/MC >N:*'764'=7.)*#.4'MC
*M/.F'">E.I;/MC
!
The model! broadly follows the lines of Rudebusch
and Wus (2008) model
ENSTA
46 / 58
Model
Specifications: The short-term rate
The central bank sets the one-period nominal interest-rate (i1,t ),

according to
i1,t = 0 +
Lt
+
St
|{z}
|{z}
medium run
cyclically
inflation
responsive
component
where (Taylor rule)

St = S St1 + (1 S ) [gy yt1 + g (t1 Lt1 )] + S,t
and
Lt = L Lt1 + (1 L )t1 + L,t
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47 / 58
Model
Specifications: Phillips and IS curves
Phillips curve:
et = Lt + (e
t1 Lt1 ) + y yt1 + ,t
Investment-saving (IS) curve:
yt = y (L)yt1 r (i1,t1 Et1 (e
t )) + y ,t
These first equations form a VAR that reads:
Ft = Ft1 + t
The stochastic shocks t are assumed to be normally i.i.d.
ENSTA
48 / 58
Model
Specifications: SDF and price of risk
The stochastic discount factor (SDF) is given by

1 0
0
mt+1 = exp t t t t+1 i1,t
2
where the price of risk is given by
t = 0 + 1 Ft
If bj,t denote the price of a nominal j-period zero-coupon bond, it is
given by:
0
ln bj,t = Aj + B j Ft
where Aj and B j are calculated numerically by solving a series of linear
difference equations
All yields are assumed to be observed with a measurement error
ENSTA
49 / 58
Figure: Estimation data
Inflation and SPF expected inflation

10
8
monthly inflation
y-o-y inflation
Real activity
8
6
4
0
2
0
-4
-2
-4
Jan99 Jan00 Jan01 Jan02 Jan03 Jan04 Jan05 Jan06 Jan07 Jan08 Jan09
-8
Nominal yields
Real yields
-1
0
-2
ENSTA
50 / 58
Model
Data: Macroeconomic data
The data cover the period from January 1999 to June 2009 at the
monthly frequency (Eurozone data)
Real activity is represented by the first principal component of a set of
5 business and consumer confidence indicators (source: European
Commisson qualitative survey): industrial, construction, retail trade,
service and consumer confidence
The inflation series (HICP excl. tobacco, source: Eurostat) is
seasonally adjusted using Census X12
Inflation forecasts of the ECB Survey of Professional Forecasters are
included amongst the estimation series (3 additional measurement
equations: SPF forecasts = model-implied expectations + error term,
for 1-, 2- and 5-year horizons)
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51 / 58
Model
Data: Interest rates
Zero-coupon nominal and real (end-of-month) interest rates are

derived from
Government-bond yields (bootstrap on a spline-smoothened French
TEC yield curve) and
inflation swap quotes (source: Bloomberg)
Real yields are obtained as the difference between nominal yields and
inflation swap rates (corrected from lags inherent in Eurozone inflation
swaps)
The maturities of the zero-coupon bonds are as follows:
Nominal: 1, 3 and 6 months, 1, 2, 3, 5, 7 and 10 years
Real: 1, 2, 5 and 10 years
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52 / 58
Model
Estimation: A 2-step estimation procedure
In the first step, the macro-model parameters (+ the SPF error-term

standard deviation) are estimated by maximizing the log-likelihood
(the log-L is obtained by applying the Kalman filter)
Three parameters have been calibrated (the inflation parameter g
entering the Taylor rule, the two parameters defining the dynamics of
medium-term inflation, L and )
In a second step, the state-space model is enlarged by adding nominal
and real yields amongst the observed variables (the state-space model
is enlarged; all yields are assumed to be measured with errors)
The coefficients of the market price of risk (1 matrix) that load on
lagged macro variables are set to zero
ENSTA
53 / 58
Model
Estimation: Missing-data treatment
Missing-data problems stem from the fact that

1
2
real yields are only available from 2004 onwards

SPF inflation forecast are at the quarterly frequency
For each period, the Kalman filter calculates a prediction of the state
variables and computes the covariance matrix of the errors (prediction
step)
The filter then incorporates the new information given by the vector of
observable variables (updating step)
The updating step can be carried out even if the number
of observations varies with time
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54 / 58
Model
Estimation: Parameters
1
103
y
103
0.21
0.043
1.52
1.14
-0.14
0.06
0.35
(0.05)
(0.013)
(0.1)
(0.04)
gy
(0.04)
(0.03)
(0.02)
L
103
103
0.95
0.50
0.83
0.117
0.95
0.50
0.050
(0.018)
(-)
(0.24)
(0.009)
(-)
(-)
(0.01)
3mth
6mth
104
1yr
104
2yr
104
3yr
104
5yr
104
7yr
104
10yr
0.78
1.21
2.00
2.35
1.83
1.27
0.84
2.17
(0.05)
(0.08)
(0.13)
(0.15)
(0.12)
(0.09)
(0.08)
(0.15)
r
1yr
104
r
2yr
104
r
5yr
104
r
10yr
SPF
1yr
SPF
2yr
SPF
5yr
104
104
104
104
4.82
4.35
2.91
2.20
0.88
0.60
0.38
(0.44)
(0.37)
(0.26)
(0.2)
(0.13)
(0.07)
(0.05)
104
104
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55 / 58
Figure: Yield fit
6
5-yr zero-coupon yield (simulated)
5-yr zero-coupon yield (observed)
10-yr zero-coupon yield (simulate

10-yr zero-coupon yield (observed
6
5
4
4
3
3
2
Jan99
Jan01 Jan03 Jan05 Jan07 Jan09
2
Jan99
Jan01 Jan03
Jan05 Jan07
Jan09
ENSTA
56 / 58
Figure: Model properties: Risk premiums
5Y model-implied expected inflation and SPF
5Y risk premiums
4
300
Inflation risk premium

Term premium
250
Model-implied expected infl.

1
3
0.75
150
in %
in bp
200
0.5
100
0.25
50
0
Jan99Jan00Jan01Jan02Jan03Jan04Jan05Jan06Jan07Jan08Jan09
-50
Unconditional risk premiums
Unconditional yields
500
8
7
400
6
5
200
in %
in bp
300
100
4
3
2
1
0
-100
-200
0
-1
12
24
36
48
72
84
60
maturity (in months)
96
108
120
-2
12
24
36
48
84
60
72
maturity (in months)
96
ENSTA
108
120
57 / 58
References
Duffie, D. and Kan, R. (1996). A yield factor model of interest rates.

Mathematical Finance, vol. 6.
Fisher, M. (2001). Forces That Shape the Yield Curve. Working
Paper Series of the Federal Reserve Bank of Atlanta, No 2001-3.
Renne, J.-P. (2009). A frequency-domain analysis of debt service in a
macro-finance model for the euro area. Banque de France Working
Paper Series, No 261.
Rudebusch, G. and Wu, T. (2008). A macro-finance model of the
term-structure, monetary policy and the economy. The Economic
Journal, vol. 118.
ENSTA
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An Introduction to Yield-Curve Modeling

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

Overview of the presentation

Generalities about fixed-income securities and yields

What is a fixed-income security?

Principal component analysis

What accounts for the shape of the yield curve?

A world without uncertainty

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

What is a fixed income security?

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

What is a fixed income security?

Fixed income refers to investments that yield a regular (or fixed)

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

What is a fixed income security?

which can be rewriten

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

The duration D is a weighted average of the maturities of the pay-offs

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

Bond price and yield

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

Stylized facts about yields

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

CNO TEC indices (French government yields), Source: Datastream.

Stylized facts about yields

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

A zero-coupon bond (also known as a discount bond ) makes a single

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

The yield curve

GOVT EUR Italian Government b-spline 11 fvr. 10 (L)

GOVT EUR French Government b-spline 11 fvr. 10 (L)

GOVT EUR German Government b-spline 11 fvr. 10 (L)

Source: Barclays Capital Live.

Nelson-Siegel parametric model

ZR t = 0,t + 1,t 1 exp

Nelson-Siegel parametric model

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

The parameters can be estimated by minimizing the root mean

Principal component analysis

Principal component analysis

arg max u 0 X 0 Xu.

Since X 0 X is a positive definite matrix, it admits the following form:

where P is an orthogonal matrix whose columns are the eigenvectors

Principal component analysis

It is easily seen that the maximum is reached for y = [1, 0, , 0]0 .

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

Principal component analysis

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

Principal component analysis

Let us have a look at the share of variance that is explained through

pi1 F1 F10 pi1

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

Principal component analysis

First three principal components

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

Principal component analysis

3.90 4.66 5.42 6.19 6.95

Jean-Paul Renne (Banque de France) An Introduction to Yield-Curve Modeling

What accounts for the shape of the yield curve?