ABSTRACT
This chapter discusses how to strip zero-coupon bond prices from coupon bonds. It shows how to obtain the initial forward rate curve from the zero-coupon bonds, and the volatility function estimation. The chapter illustrates these techniques by applying them to weekly observations of US Treasury security prices. The idea behind implicit volatility estimation is to use market prices from traded interest rate derivatives to estimate the volatility vectors. This is done by finding those volatility vectors such that a collection of computed interest rate derivative prices best match observed market prices. This technique is sometimes called curve-fitting. The chapter provides a procedure useful for estimating Heath, Jarrow, and Morton volatility functions. This alternative procedure utilizes additional structure obtained from specifying a fixed number of factors and a specific functional form for each volatility function.
