A Practical Guide to Interest Rate Curve Building Validations (W/ Excel Replica of Bloomberg Libor @ GitHub)

Curve building is an information extraction process defined by a set of bootstrapping instruments B, bootstrapping procedures P, interpolation technique I, and extrapolation technique E. The bootstrapping procedures allow one to deduce/bootstrap information about risk factors (such as future Libor rates) that can be used to derive a fair value of a financial instrument with payoff function dependent on these risk factors (such as interest rate swap). The bootstrapping procedures deduce information about either expected values of the risk factors (such as forward rate curve) or their distributions (such as volatility surface). The curve building process involves a number of steps that include instrument selection, market data prioritization, bootstrapping, interpolation, and extrapolation. The paper provides information about market conventions, common curve building issues, validation techniques, standard tests, and validation criteria. We will focus on the bootstrapping of the expected values of interest rates (such as future forward rates). Some of the validation techniques described in this paper (such as round-trip testing) can be extended onto other markets and other types of the risk factors (including volatility surfaces). The paper has a reference to the published Excel spreadsheet that demonstrates how to replicate Bloomberg Libor curve. The spreadsheet can be downloaded from GitHub repository