Abstract
Estimating the government bond yield curve, and deriving forward interest rates from it, can provide both investors and policy makers with important information on principal macroeconomic variables, including the break-even inflation rate. As such, the yield curve derived from a model which estimates the real and nominal yields in the economy serves as a major tool for economic analyses. In this paper, we propose a model for estimating the yield curve through a nonparametric method, improving on the model proposed by Wiener and Pompushko (2006), which is used for determining monetary policy at the Bank of Israel. This paper proposes five improvements, which solve five potential problems with the Wiener and Pompushko model:
Ÿ A changing grid of forward interest rates, which reduces the volatility of the results.
Ÿ Optimization which focuses on bond yields rather than prices.
Ÿ The use of a higher order polynomial to describe segments of the curve, instead of a linear function.
Ÿ A varying penalty on lack of smoothness in the various parts of the curve, so that its short end will be more flexible and its long end will be more rigid, in line with the characteristics of the curve.
Ÿ A new method for screening outliers.


Empirical tests show that the improved model results in a smooth curve and with low deviations of bond prices calculated in the model from bond prices in the market. A test comparing the model with the one currently used by the Bank of Israel shows that the yields calculated by both models are very similar.
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