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Interpolation of discount factors

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  • Cremers, Heinz
  • Schwarz, Willi

Abstract

This paper deals with the problem of interpolation of discount factors between time buckets. The problem occurs when price and interest rate data of a market segment are assigned to discrete time buckets. A simple criterion is developed in order to identify arbitrage-free robust interpolation methods. Methods closely examined include linear, exponential and weighted exponential interpolation. Weighted exponential interpolation, a method still preferred by some banks and also offered by commercial software vendors, creates several problems and therefore makes simple exponential interpolation a more logical choice. Linear interpolation provides a good approximation of exponential interpolation for a sufficiently dense time grid.

Suggested Citation

  • Cremers, Heinz & Schwarz, Willi, 1996. "Interpolation of discount factors," Frankfurt School - Working Paper Series 2, Frankfurt School of Finance and Management.
    • Handle: RePEc:zbw:fsfmwp:2
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    1. Shea, Gary S., 1984. "Pitfalls in Smoothing Interest Rate Term Structure Data: Equilibrium Models and Spline Approximations," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(3), pages 253-269, September.
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    Cited by:

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