Fitting term structure of interest rates using B-splines: the case of Taiwanese Government bonds

Bing-Huei Lin

Applied Financial Economics, 2002, vol. 12, issue 1, 57-75

Abstract: The B-spline curve fitting technique is one of the most popular empirical methodologies for estimating the term structure of interest rates, due to its stability and reliability in practical applications. This paper applies the B-spline technique to estimating the term structure for an important small-sized emerging bond market, the Taiwanese Government Bond (TGB) market. Regardless of the efficiency of the obsrved market data, several issues are investigated when applying this fitting technique. The application of the B-spline functions is first discussed to approximate the discount function, spot yield curve and forward yield curve respectively. The coupon payment effect on the TGB price is identified and is incorporated into the model estimation. A sensitivity analysis for the B-spline technique is performed with respect to changes in the within-sample knots, and a feasible method suggested for choosing the optimal knots within the approximation space in view of standard pricing error minimization. The results show that the B-spline methodology, when applied to discount fitting and spot fitting, is satisfactory in obtaining reliable term structure. It is also not very sensitive to some ad hoc choices in the model estimation.

Date: 2002
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DOI: 10.1080/09603100110088058

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