Mispricing Due to Nelson-Siegel-Svensson model

Sammanfattning: Most trading software in the market uses linear interpolation in the bootstrap procedure to create a zero coupon interest rate curve. Forward interest rate curves created by interpolation method have a zigzag form that is inconsistent with arbitrage condition. Furthermore in the real world we are not able to detect the spot rates for all periods because the number of traded instruments is limited. Nelson and Siegel in 1987 proposed a model to estimate the interest rates. They demonstrated that their model was flexible to capture the various possible shapes of the yield curve and estimates the term structure of interest rates over time. Many Central banks are using the extended Nelson-Siegel model (sometimes called the Nelson-Siegel-Svensson model). This curve is parameterized with exponential functions, is smooth in both zero rate and forward rate and overcome those barrier (data mining problems and zigzag shape of forward interest rate curve), that we face by using linear interpolation to build the yield curve. The objective of this thesis is to study the Nelson and Siegel model and its extended version by Svensson, furthermore, study the adequacy and forecast performance of Nelson-Siegel-Svensson model in building the term structure of interest rate comparing with the linear interpolation method.