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Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura. Read More

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Kamakura Corporation
2222 Kalakaua Avenue

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Honolulu HI 96815

Phone: 808.791.9888
Fax: 808.791.9898
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On Wednesday, August 5, 2009, the New York Times printed an advertisement from Standard & Poor’s entitled “Standard & Poor’s Commitment: Quality and Independence.” The advertisement was a partial response by the firm to the mountain of criticism that all of the rating agencies have received for both structured products and corporate ratings actions during the current credit crisis. This post comments on key points in the S&P advertisement and speculates on the evolving role of the rating agencies going forward.

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In Parts 1, 2 and 3 of this series, we outlined the pros and cons of the Nelson-Siegel approach to yield curve smoothing versus the spline based approach that dominates non-financial applications like computer graphics and computer animation.  In Part 2, we provided a worked example of the Nelson-Siegel approach.  In Part 3, we showed how the maximum smoothness forward rate approach can be used to improve on the Nelson-Siegel approach both in terms of accuracy in fitting observable bond prices and in terms of the smoothness of the forward rates produced.  In today’s post, we show with some simple examples that the Nelson-Siegel approach’s forward rate function is too simple to provide accurate mark to market valuations for realistically shaped forward rate curves.

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Yesterday’s blog post described an implementation of the popular Nelson-Siegel approach to yield curve smoothing.  In today’s post, we do a similar worked example for the maximum smoothness forward rate technique of Adams and van Deventer (1993), which is described in more detail in Chapter 8 of Advanced Financial Risk Management (van Deventer, Imai and Mesler, John Wiley & Sons, 2004). The maximum smoothness forward rate technique is superior to the Nelson-Siegel approach in every dimension that matters: it can fit observable market data perfectly, and it produces smoother (and therefore more reasonable) forward rate curves given equivalent restrictions on the right hand side (longest maturity) of the yield curve being fitted.  This post provides a worked example using the maximum smoothness forward rate approach.

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Our first blog on Nelson Siegel yield curve smoothing technology and its shortcomings compared to cubic and quartic splines generated quite a bit of interest.  This post and posts 3 and 4 detail how one can take simple market quotes and estimate forward rate and yield curves via Nelson Siegel and Maximum Smoothness Forward Rate methods.  Part 2 provides a worked Nelson Siegel implementation.  Part 3 provides a worked maximum smoothness forward rate implementation, and Part 4 compares the two methods, showing that Nelson Seigel fails from both a smoothness and a price-fitting point of view in many circumstances.

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Over the courses of this week, we'll post parts 2, 3 and 4 of our series on the legacy Nelson-Siegel smoothing approach versus more modern spline technologies, in particular the maximum smoothness forward rate technique published by Adams and van Deventer, with major help from Oldrich Vasicek,  in 1993.

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