A nonparametric method for term structure fitting with automatic smoothing

ABSTRACT

We present a nonparametric method for fitting the term structure of interest rates from bond prices. Our method is a variant of the smoothing spline approach, but within our framework we are able to determine the smoothing coefficient automatically from data using the generalized cross-validation or maximum likelihood estimates. We present an effective numerical algorithm to simultaneously find the term structure and the optimal smoothing coefficient. Finally, we compare the proposed nonparametric fitting method with other parametric and nonparametric methods to find its superior performance. We find that existing term structure fitting methods perform well in liquid markets while illiquid markets present new challenges, which we address in this article.

KEYWORDS:

• Term structure of interest rates
• automatic smoothing
• numerical algorithm
• illiquid bond markets

JEL CLASSIFICATION:

• E43
• C14

Disclosure statement

No potential conflict of interest was reported by the authors.

Additional information

Funding

The research leading to these results has received funding from the Basic Research Program at the National Research University Higher School of Economics.