An Orthogonal Polynomial Approach to Estimate the Term Structure of Interest Rates

Hans-Jürg Büttler

Issue
2007-08

Pages
27

JEL classification
C13, E43

Keywords
Term structure of interest rates, orthogonal polynomial

Year
2007

In this paper, we introduce a new algorithm to estimate the term structure of interest rates. It is obtained from a constrained optimization, where the objective is to minimize the integral of squared first derivatives of the instantaneous forward interest rate subject to the condition that the estimated bond prices lie within the range of observed bid and ask prices. We use a finite series of ordinary Laguerre polynomials to approximate the unknown function of the instantaneous forward interest rate. The objective function can be written explicitly as a quadratic form of the Laguerre constants and the nonlinear constraints can be obtained from a recurrence relationship. The estimation error is less than one basis point, given a sufficient number of bonds.