Characteristics of Yield Curve Construction Methods

Hard Term Structure Dynamics Yield Curve Construction

In the context of fixed income securities, yield curves represent the relationship between the interest rates (or yields) of bonds with different maturities, and they are essential for pricing and risk assessment. When constructing a yield curve, one of the most critical aspects is ensuring that it accurately reflects the market's expectations for future interest rates.

Consider the following methods for constructing a yield curve:

1. The Bootstrapping Method uses the prices of zero-coupon bonds to derive the yield curve directly.

2. The Nelson-Siegel model, which assumes a specific functional form for the yield curve and allows for flexibility in its shape.

3. The Cubic Spline Method, where interpolation techniques create a smooth yield curve from various maturities without assuming a certain functional form.

Which of the following statements correctly identifies the characteristics of these yield curve construction methods?

The Bootstrapping Method is prone to significant distortions in interest rate expectations if there is a lack of sufficient liquid zero-coupon bonds.

The Nelson-Siegel model is limited in that it cannot represent a downward sloping yield curve.

The Cubic Spline Method inherently adjusts for discontinuities in the yield curve by relying on fixed functional forms.

Hint

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