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The estimation of nominal and real yield curves from government bonds in Israel

Zvi Wiener (School of Business Administration, The Hebrew University of Jerusalem, Jerusalem, Israel)
Helena Pompushko (Monetary Department, Bank of Israel, Jerusalem, Israel)

Journal of Risk Finance

ISSN: 1526-5943

Article publication date: 1 October 2006

808

Abstract

Purpose

The purpose of this research is to develop and test a mathematical method of deriving zero yield curve from market prices of government bonds.

Design/methodology/approach

The method is based on a forward curve approximated by a linear (or piecewise constant) spline and should be applicable even for markets with low liquidity. The best fitting curve is derived by minimizing the penalty function. The penalty is defined as a sum of squared price discrepancies (theoretical curve based price minus market closing price) weighted by trade volume and an additional penalty for non‐smoothness of the yield curve.

Findings

This method is applied to both nominal and CPI linked bonds traded in Israel (some segments of these markets have low liquidity). The resulting two yield curves are used for derivation of market expected inflation rate.

Research limitations/implications

The main problems are low liquidity of some bonds and imperfect linkage to inflation in the CPI linked market.

Practical implications

A stable numerical procedure applicable even in markets with low liquidity.

Originality/value

Usage of forward curves as the state space for the minimization problem leads to a stable solution that fits the data very well and can be used for calculating forward rates.

Keywords

Citation

Wiener, Z. and Pompushko, H. (2006), "The estimation of nominal and real yield curves from government bonds in Israel", Journal of Risk Finance, Vol. 7 No. 5, pp. 488-502. https://doi.org/10.1108/15265940610712650

Publisher

:

Emerald Group Publishing Limited

Copyright © 2006, Emerald Group Publishing Limited

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