How does one estimate the erm structure / ZCYC?
In empirical models of the ZCYC, the underlying valuation of the bond is given by the discounted stream of cashflows. If the term structure is the only factor that influences the pricing of the bond, the present value relation, as we have mentioned earlier, should give us ‘the’ price of the bond. With the PV relation defined as in (3) above, and with information available on ‘trade date’, ‘traded price’, ‘coupon rate’ and ‘date of maturity’ of a bond, this essentially leaves as unknown only the set of interest rates. Specifying an estimable relationship of the form , where ei denotes the residual, estimation of the ZCYC now involves estimation of the appropriate set of interest rates. Specification of a relation between maturity and interest rates therefore forms the first step in the estimation of the ZCYC.
