Interpolation

Financial data is usually available for discrete time points. For example interest rate futures
contracts mature ever month for the first 6 months and then quarterly for 5 years. These contracts
are quite liquid and are based on the benchmark US interest rate. Therefore, they can be used to
create an interest rate curve that represents the term structure as of the quote date for the
futures. The resultin curve !ill have a set of discount factors, one for each future expiry date.

"hen valuin an instrument off this curve, some of the cash flo! dates !ill not fall exactly on the
rid dates in the curve. "e need to interpolate bet!een the rid dates to calculate the required
discount factors. The interpolation options provided by F#$%&' are described in the next section.
"hen interpolatin from a discount factor curve, it is hihly recommended that either exponential
interpolation or linear spot rate interpolation be used(
)xponential interpolation from a discount factor curve results in constant for!ard rates.
*inear spot rate interpolation converts each discount factor to a spot rate, performs linear
interpolation on the spot rates, then converts the interpolated spot rate back to a discount
factor.

#nterpolation is an important utility and can be used for any application that involves ettin a
continuous set of points from a discrete curve of data. #t is commonly used for interpolatin rates,
discount factors and volatilities form their respective curves.


Interpolation methods:

The functions aaInterp, aaInterp2 and aaInterp3 allo! four different types of interpolation. The
follo!in is a brief explanation of each.

The basic problem is( +iven a set of discrete data points
N k y x k k ,..., 0 )}, , {( =
, approximate the
curve they lie on, and use this approximation to determine other points ,x, y- on the curve.

The first method is Linear Interpolation. .ere, the curve is approximated by /oinin consecutive
points toether !ith straiht lines. +iven a point x in the interval
] , [
1 + k k
x x
,
y
is easily determined
via
) (
1
1
k
k k
k k
k x x
x x
y y
y y

+ =
+
+
.
The advantae of linear interpolation is its simplicity and in many cases it !ill be lead to a ood
enouh approximation. & disadvantae is the approximatin curve is not smooth, thouh the real
curve may be.

The Cubic Spline method allo!s one to construct smoother curves. & curve S,x- is a cubic
spline if
1) 1) in each interval
( , ) x x k k+1
it is a cubic polynomial,
3
k k4
2
k3 k2 k1
) x - (x a + ) x - (x a + ) x - (x a + a
k k
2) 2) it passes throuh each data point.
3) 3) it is continuous.
4) 4) its derivative is continuous.
5) 5) its second derivative is also continuous.
#n brief, the method constructs a smooth curve !hose derivative and second derivative are
continuous. The cubic Spline has 0$ derees of freedom and this is easily seen because there
are $ intervals and in each interval one must determine
ki
a
, i=1, , 4. From ,1-, $23 derees of
freedom are determined ,one from each point-. From ,4-, $53 are determined ,one at each
interior point- and from ,0- and ,5-, 1$51 are determined ,one each at the interior points-. Thus,
in total, 0$51 derees of freedom have been specified !hich leaves 1 to be determined, one at
each endpoint
0
x
and
N
x
. The function aa#nte uses so called natural Splines. These are the
Splines obtained !hen the conditions
0 ) ( ) (
"
0
"
= =
N
x S x S
are assined. .avin all derees of
freedom specified, it is no! /ust a matter of solvin the linear system for the
a
ki
. Finally, iven x
in the interval
] , [
1 + k k
x x
, one may solve for
y 6
3
k k4
2
k3 k2 k1
) x - (x a + ) x - (x a + ) x - (x a + a
k k
.

The third method is the so called Exponential Interpolation. This method should only be used if
one is approximatin an exponential curve. "hat does this mean7 +iven t!o points x3 and x1
and a point x bet!een them. "e suppose that the points ,x3, y3- and ,x1, y1- lie on a curve of
the form
mx
ke
, !here k and m are constants. Solvin for k and m,
1
1
1 2
1 2
,
) / ln(
mx
e y k
x x
y y
m

=

=
,
one may solve for
mx
ke y =
. This method is !ell suited for interpolatin from discount factor
curves ,!here the
x
values are dates and the
y
values are discount factors- and results in
constant for!ard rates.

The final method is Linear Spot Rate Interpolation. This method is intended to be used !hen
interpolatin from a discount factor curve. The set of discrete data points are assumed to be
dates and discount factors, !here the
x
values are dates and the
y
values are discount factors.
The method converts each discount factor to a spot rate, and performs linear interpolation on the
spot rates. Therefore, the resultin spot rate curve is piece!ise linear.

The method assumes
) exp(
i i i
t r y =
!here
i
r
is the spot rate, and
0
x x t
i i
=
. To find the
value of y iven a point
x
, the points
i
x
and
1 + i
x
are found such that
1 +
< <
i i
x x x
. The spot
rates
i
r
and
1 + i
r
are determined as
i
i
i
t
y
r
) ln(
=
and
1
1
1
) ln(
+
+
+

=
i
i
i
t
y
r
, and the spot rate
r
is
linearly interpolated from these. The point
y
is then calculated as
) exp( rt y =
.

"hen interpolatin bet!een the first pair of dates ,
0
x
and
1
x
-,
0
r
is not kno!n because
0
0
= t
.
#n this special case, the method !ill assume the form
) exp(
1 0
t r y y =
!here
1
0 1
1
) / ln(
t
y y
r

=
.

#n the special case of neative
y
values, if
i
y
and
1 + i
y
have opposite sins, then
y
is linearly
interpolated. #f
i
y
and
1 + i
y
are both neative, the method assumes the form
) exp( rt y =
.
These special cases !ould not arise in actual discount factor curves, but they are handled by the
functions if needed.