Hi,
I would be interested in the interpolation methods predominantely used in the street. imO one should always keep it as simple as possible, i.e. use the most simplistic method that does not produce any undesired effects. Luckily live becomes much easier if you assume you have a library that clearly distinguishes between discount curves (e.g. FedFund) and forward curves (e.g. USDLIB3M):
- For forward curves I would always bootstrap and then work directly on forwardLiborRates (instead of pseudo discount factors) and interpolate linearly on these rates. For me there is no reason why to use a more sophisticated method (like spline interpolation) unless my traders tell me that it is not in line with what the market does
- For pure discounting curves I'm indifferent to using linear Interpolation on DFs, log DF or zeroRates. I do not care about how weird the forwardLiborRates would look on these curves as I simply never derive any forwardLiborRates from any such curve.
I'm still a bit uncertain about the FedFund case. This curves is in fact not a pure discounting curve but both a discount as well as a forward curve. However, I will never use it to calculate forwards from while not using it to discount these forwards at the same time (so the weird looking forwards will cancel out). So I think there shouldn't be any problem with using a simple interpolation method here either.
I would be very intersted in your thoughts on that.
Thanks,
Bernd