weakness of bootstrapping

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risk taker
Posts: 41
Joined: Wed Aug 10, 2011 12:52 pm

weakness of bootstrapping

Postby risk taker » Tue Jul 17, 2012 9:22 am

Hi Professor,

In the yield curve fitting section, it is said that a small amount of noise in the market prices of calibration securities could result in large spikes in the forward curve, especically at longer maturities. I have 2 questions.

1. how do you define what noise is?
2. intuitively speaking, how should I understand the large spike effects??

Thanks so much!

risk taker

coalexander
Posts: 815
Joined: Sun Sep 28, 2008 10:30 pm

Re: weakness of bootstrapping

Postby coalexander » Wed Jul 18, 2012 6:18 pm

How about banks 'fixing' money market quotes, for example, ha ha!

In general, market prices should be based on a minimum traded amount, but when trades are on small amounts they could be out of line (maybe fixed with personal deals, or as per the LIBOR fixing problem surfacing now) so that you have several instruments will approximately the same rates and outlier(s) which are far above or below.

Spikes occur when you get forward curves that don;t behave with a smooth (often hockey-stick-shaped) curve, but have an anomaly at one specific maturity.

Hope this is sufficient to answer your questions, Carol

risk taker
Posts: 41
Joined: Wed Aug 10, 2011 12:52 pm

Re: weakness of bootstrapping

Postby risk taker » Thu Jul 19, 2012 10:39 am

Hi Carol,

thank you hugely for helping me understand. I got the spikes question. But I dont quite follow the second paragraph. What do you mean by market prices should be based on minimum amount? And why when trades are on small amounts, the market prices could be out of line??

Thanks again!

risk taker
P.S I have a question about basis spline in the yield curve section, but i shall post it in a seperate thread!

coalexander
Posts: 815
Joined: Sun Sep 28, 2008 10:30 pm

Re: weakness of bootstrapping

Postby coalexander » Thu Jul 19, 2012 10:52 am

Banks can manipulate yield curves by making trades based on small amounts, on which they take a loss. Still a market rate at that quote is recorded. Banks can benefit by manipulating interest rates, as we know from the LIBOR scandal. Clear now?

risk taker
Posts: 41
Joined: Wed Aug 10, 2011 12:52 pm

Re: weakness of bootstrapping

Postby risk taker » Thu Jul 19, 2012 11:07 am

Yes! Absolutely clear now! Thank you!!!


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