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Mcculloch 71
Mcculloch 71
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MEASURING THE TERM STRUCTURE OF INTEREST RATES
J. HUSTON MC CULLOCH*
1(m) = ao + Eajjf(m),
j=l
+ cf [1 + ajfj(m)J dm
0 j=l
when the value of the couponswas added
to that of the principal using (1), he
= 100 [1 + 2ajfj(mo)] would obtain
1.0?-
vaWV ___
0.2 -
0.6?
0.0 - I
0.6 - - - - - - - -
0 10 20 30 m
Yearsto Motart
~0.4 - -
FIG. 2.-Discount function for the close of
February1966 based on bid-askedmean pricesfor
taxable U.S. Governmentbills, notes, and bonds.
0.2- -
Redemptionof callable issues is assumedto be at
earliest call date if price is above par and at ma-
turity date when price is belowpar. In this regres-
0.0 - - - - -
40
sion, n = 78, k = 9, and v= 7.81. In spite of the
0 10 20 0
highervalue of this curve is better definedthan
A-,
Yeas to Maturity
that of fig. 1 becausebid-askedspreadsweresmaller
FIG. 1.-Discount functionfor the close of Feb- and becauseof the absenceof brokeragefees.
ruary1922based on bid-askedmeanpricesof high-
grade (Moody'sAa and Aaa) railroadbonds. Con- TABLE 1
vertibles and securitieswith any chance of being
called before maturity were excluded. The band MEAN VALUES
OF ERROR COEFFICIENT
showsthe best estimateplus and minusits standard
error.In this regression,n= 26, k = 5, and 0-
2.67. Mean
Period Type of Security Value
A
of
near future, and therefore does not de-
1920-1938....... High-graderailroad 2.6
fine the curve for the distant future with bonds
as great a precision. The calculation of 1/1/47-3/1/51.. Taxable U.S. govern- 15.9
these errorsis discussedin a later section. ment securities
4/1/51-1/1/62.. Taxable U.S. govern- 4.6
Mean values of f' for selected sub- ment securities
2/1/62-4/1/66.. Taxable U.S. govern- 9.0
periods are given in table 1. These fig- ment securities
ures would seem to indicate that prior to
the Treasury-Federal Reserve Accord
of March 4, 1951, and again after the a change in the special features of the
beginning of "OperationTwist" in mid- securities.
1961, some sort of "disarbitrageur"was Having estimated the parameters as
active in the market for U.S. Govern- we can estimate the true values pi of
ment securities. The fall in a from 13.9 the n securities:
MEASURING THE TERM STRUCTUREOF INTEREST RATES 23
+ E100f(mi)
dj + cif f(m)dm] 1+ djfj(m)
= (14)
This formula can even be used to esti- Forward curves correspondingto the
mate the value of securities that did not discountfunctionsshownin figures1 and
enter into the regression.It is of use to 2 are depicted in figures 3 and 4, plus
dealers,banks, insurancecompanies,and p(m)
large borrowerswho need to comparethe
values of securities differing in coupon
rate and maturity. Sophisticated users
may even want to adjust (1) for taxes
and for the value of special provisions.
Examination of the weighted residuals,
p- )/vi, shows that the ineligibility
for commercialbank purchase of many
bonds prior to the Accord (and to a __NS
4.0
lesser degree until 1954) tended to cause
negative residuals and that the special
tax status of deep discount bonds tended 0 10 20
Yearsto Maturity
3i0
6.5 - -.
6.0 --
5.5 > - - 0 A 92
4.5
0 2 4 6 8 10 12 14 16. 18 20 22 24 26 28 30 42 54 66 78 90
Yearsto Maturity
FIG.5B.-A Durandyield curvefor comparisonwith fig. 5A based on high-gradecorporatebond trans-
actionpricesfromthe firstquarterof 1922.
5.601 15,60
520 5=20
4 80 =480
A _
x
* I I tyr
4.40 | * --
x*C~d ,,|- * lse .ss
law.. 4.40
F77 T I= - C= =
1966 68 0 72 74 '76 '78 o' le '84 '8 '8 '90 '92 94 '96 9
curves under the bulk of the points in- If z is a k-vector of known values and
stead of through them, his curves tend 4 is the vector (l, ... ., hk), the es-
to have an upward-sloping shape too timator of the variance of the linear
often. Figures 5A and 5B illustrate one combination ZT4, for example, will be
case when Durand appears to have ob- the quadraticform zTCz.
tained an insufficiently downward-slop- The estimator of the variance of 8(m),
ing yield curve. The fact that Durand's definedby (8), is therefore
curves are biased to slope upward could vi [a(M)] = zTCz, (23a)
provide an alternative to the "liquidity where
preference"explanationof why the con- x; = fj(,m) (23b)
glomerateyield curve derivedby averag-
ing his annual curves is upwardsloping.9 Similarly, the estimator of the variance
of p n as definedin (9), is
ESTIMATION OF THE ERROR
var (pi)=XC (24a)
OF MEASUREMENT
where
The observed prices of securities are m,
,m - m 2, O< m< d2
fi(m) 2d2 (31a)
!'d2,7d2< m < mn
30 THE JOURNAL OF BUSINESS
- ci* i)2
2(Mdj-_1)2'
2(m d;-, < ms< di
f
k(Mn) l(m - dk_1)2 d C C(31c)
dt-0 42 A d.-m.
f,(m)
dj-O d2 d3 B d.-m.
f,(m)
FIG.7.-The preferredform of the f;(m). Thesef (m) make (m) piecewisequadraticand continuously
differentiable.
Since the vertical scales of the fj(m) are ters of elementary calculus, and will be
immaterial, we have arbitrarily chosen omitted here.1
them so that The specificationof the fr(m) given in
5'(d,) = afj(d,) (32) (31) was used for the regressionfits of the
11Otherspecificationsof the fi(m) will generate
= as.
exactlythe samefamilyof piecewisequadraticfunc-
Integration of fj(m) in order to evaluate tions. The one chosenwas selected only becauseit
can have the property(32) if the scales are chosen
(7d) and (24b) and differentiationin or- appropriately.The otherspecificationswill give the
der to evaluate (14) and (26b) are mat- same 5(m)if used with the same data.
MEASURINGTHE TERM STRUCTURE OF INTEREST RATES 31
discountfunctionshownin figures1 and 2. rangewe regardas reasonable,and select
Because a piecewise quadratic function that value which minimizes the un-
has a discontinuoussecondderivative,the biased estimator '2 of r2;
instantaneousforwardinterestratecurves
derived from these discount functions as_ 1 2 (I Pi)2~
have discontinuous first derivatives, n- k fr kV
which explains the angular shape of the
As k increases, the residuals generally
bands shownin figures3 and 4. However,
as mentioned earlier, the instantaneous decrease, but then so do the degrees of
freedom. The result is that a2 declines
forward rate p(m) is interesting mainly
as a theoretical construct. Its level at sharply as k increasesfrom 2 to 3 or 4,
one isolated value of m has little practi- but thereafterfluctuatesirregularlywith
cal significance.Consequentlywe are not a small amplitude, and often with more
worried by the outlying values of k(m) than one local minimum. Sometimes it
and its standard error that are some- showsno sign of permanentlyrising,even
times implied by our specificationof the after k becomesso largethat the discount
function adheresto outliers.
fj(m). In fact, our specificationis suffi- A secondapproachis simply to make k
cient to imply that mean forward rates
a fixed function of n. We would like this
r(mi, in2), which are of practical concern,
are continuously differentiablewith re- functionto have the followingproperties:
First, in orderto have resolutionincrease
spect to both mi and m2.The yield curve,
a special case of r(mi, m2) with ml = 0,
as the numberof observationsincreases,
is therefore also continuously differen- our function k(n) should increasewith n.
tiable, as may be seen in figures 5A Second, in order to make the number of
and 6A. observationsin the domainof each quad-
ratic segment increase with the total
THE VALUE OF k numberof observations,the ratio n/k(n)
The number k of parameters to be should also increase with n. An elemen-
estimated is another area where judg- tary function with these properties is
ment must be used. If k is too low, we k(n) = nearest integer to n'12.In prac-
will not be able to fit the discount func- tice, this formula gives approximately
tion closely when it takes on difficult the same results as the first approach,
shapes. If it is too high, the discount without the expensive search.12
function may conform too closely to 12Since the final revisionof this paper,a prece-
outliers instead of being smooth. If k is dent for the continuouslydifferentiable,piecewise
as high as n, there will be no way to quadraticfunctionalformhas cometo my attention
(see Wayne A. Fuller, "Grafted Polynomials as
estimate i2. In the spirit of least squares, ApproximatingFunctions," AustralianJournal of
we might try all values of k inside a AgriculturalEconomics13, no. 1 [June19691:35-46).