Monday, June 1, 2020

Yield Curve Construction

An interesting new paper by Liu and Wu, and below, is the latest in traditional two-step yield curve construction (summarize bond prices with synthetic zero-coupon yields, and then treat the zero-coupon yields as data).  I wonder how their results would compare to the one-step approach of Andreasen, Christensen, and Rudebusch (2019), which directly analyzes the universe of bond prices, and below.  The one-step approach seems highly appealing. Liu and Wu may have built a better mousetrap, but Andreasen, Christensen, and Rudebusch arguably dispense with the need for a mousetrap.

Reconstructing the Yield Curve

Yan LiuJing Cynthia Wu

NBER Working Paper No. 27266
Issued in May 2020
NBER Program(s):Asset PricingEconomic Fluctuations and GrowthMonetary Economics
The constant-maturity zero-coupon Treasury yield curve is one of the most studied datasets. We construct a new dataset using a non-parametric kernel-smoothing method with a novel adaptive bandwidth specifically designed to fit the Treasury yield curve. Our curve is globally smooth while still capturing important local variation. Economically, we show that applying our data leads to different conclusions from using the leading alternative data of Gurkaynak et al. (2007) (GSW) when we repeat two popular studies of Cochrane and Piazzesi (2005) and Giglio and Kelly (2018). Statistically, we show our dataset preserves information in the raw data and has much smaller pricing errors than GSW. Our new yield curve is maintained and updated online, complemented by bandwidths that summarize information content in the raw data:

Term Structure Analysis with Big Data: One-Step Estimation Using Bond Prices


Nearly all studies that analyze the term structure of interest rates take a two-step approach. First, actual bond prices are summarized by interpolated synthetic zero-coupon yields, and second, some of these yields are used as the source data for further empirical examination. In contrast, we consider the advantages of a one-step approach that directly analyzes the universe of bond prices. To illustrate the feasibility and desirability of the one-step approach, we compare arbitrage-free dynamic term structure models estimated using both approaches. We also provide a simulation study showing that a one-step approach can extract the information in large panels of bond prices and avoid any arbitrary noise introduced from a first-stage interpolation of yields.

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