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 The Indian Bond Market I C R A B U L L E T I N

Money
SUCHISMITA BOSE &
Finance
DIPANKAR COONDOO
JAN.–MARCH.1999
SUMON KUMAR BHAUMIK

Abstract
It would perhaps be an understatement to say that the Indian bond
market is underdeveloped. The major problem is not even that the pricing algo-
rithms and instruments are not sophisticated; sustained competitive trading itself is
at a premium. Indeed, market insiders agree that once a bond is introduced in the
market, the process of price-search continues for a few months, and thereafter the
The paper examines
lion’s share of the bonds disappear from the secondary market. Typically, they are
held to maturity by banks, insurance companies and mutual funds. As a conse-
the extent of intra-
quence, trading is thin in the secondary market, especially for bonds with longer
maturities, and the situation is aggravated by the fact that bulk of the trading takes
month variations in
place among a handful of large traders. Hence, the secondary market is marked by
significant differences between prices-YTMs of bonds with similar characteristics,
prices and YTMs of
and of similar maturity. This indicates that the pricing process is divorced from
interest rate expectations which, at least in principle, should be the only determinant
government securities
of bond prices. The paper examines the extent of intra-month variations in prices
and YTMs of government securities over time, and concludes that price formation
over time, and con-
in the secondary market for bonds is indeed perverse and inconsistent with the
postulates of finance theory. cludes that price
Introduction formation in the
The Indian financial market has seen steady liberalisation since the
early 1990’s. All segments of the market have witnessed changes, but it is secondary market for
the banking sector and the equity markets that have remained at the heart of
coffee-table discussions and policy debates alike. The bond market has bonds is indeed
remained relatively neglected, even though, in the recent past, bonds of
various kinds have helped raise more than half the capital raised by the perverse and incon-
financial and non-financial companies. The government too has used the
bond market extensively to bridge its fiscal deficit. In other words, it is
sistent with the postu-
perhaps time that the trends in the Indian bond market are analysed me-
lates of finance theory.
thodically, and the evolution of the market traced over time.
The importance of the bond market does not lie merely in the fact
that bonds are a way to raise money for corporate and government spend-
ing. The prices of bonds in the secondary market reflect the interest rate
expectations of the market participants. These expectations, in turn, give us
the so-called yield curve. The yield curve is perhaps one of the most impor-
tant tools in the hands of financial analysts and economic policy makers.
On the one hand, it is essential for pricing new bonds and derivatives
products. On the other hand, it highlights the impact of changes in mon-
etary and other policies on the interest rate expectations of the market
participants.
45
 I C R A B U L L E T I N In an earlier issue of Money & Finance, we had shown that the
thinness of the Indian bond market results in perverse pricing. The conse-
Money
& quence of this phenomenon is easily understood. Suppose that only 2
government securities with 3 years to maturity are traded during a month.
Finance If, now, the weighted average yield to maturity (YTM) of one of the securi-
ties is 10.5 while that of the other is 11.5, then we face a unique dilemma.1
JAN.–MARCH.1999
It is obvious that the yield difference between the 2 bonds of similar riski-
ness cannot be 1 percentage point. But which of these YTMs can we accept
as the “accurate” one, given that both YTMs are market determined? If,
. . . thinness of the therefore, some average of these rates is used to construct the yield curve,
the curve would be largely meaningless, at least in so far as the yield for the
Indian bond market 3 year horizon is concerned.
It is evident from the above discussion that the extent of the pricing
results in perverse anomaly in the Indian bond market should come under scrutiny.
Specifically, we should verify whether, over time, the market has become
pricing.
more efficient, i.e., whether the variance in the prices/yields of comparable
securities measured within a reasonably short span of time, have declined
over time. If they have, the market can be said to have become more
. . . we should verify efficient. If not, we would have to speculate about possible changes in
infrastructure and trading practices that can yield the desired trend. This
whether, over time, the forms the crux of the current exercise.

market has become Data and Methodology

Data
more efficient, . . . Since government bonds constitute the bulk of trading in the
secondary market, the data for this exercise has been restricted to those from
secondary market transactions in government securities. The data consists of
Since government three major parts. The first of these has been obtained from the SGL ac-
counts of the Reserve Bank of India (RBI). This data spans 17 months, from
bonds constitute the September 1995 to January 1997. It consists of information about volumes,
prices, and settlement dates of all repo and non-repo transactions. The
bulk of trading in the second part of the data has been culled out of business dailies. This data
spans 12 months of the calendar year 1998. It consists of information about
secondary market, the the volume adjusted YTMs associated with non-repo trades in government
securities, and their dates of “settlement” at the wholesale debt segment
data for this exercise (WDM) of the National Stock Exchange (NSE). Finally, third and the
smallest part of the data has been obtained from the Weekly Supplement to
has been restricted to the Monthly Report of the RBI, and the NSE’s web site. The Weekly Supple-
ment has provided data for ranges of prices of government securities with
those from secondary
similar maturities for November-December 1998. The NSE web site, on the
market transactions in other hand, has provided the data about the trades (in government securi-
ties) recorded at the NSE during November 1998.
government securities. 1
For example, during January 1998, 7 government coupon bonds with 4 years or
less maturity were traded. Of these, the average YTM for the 13.31% security maturing in
November 2001 was 12.95, and that for the 13.55% security maturing in the same month
was 10.08. The average YTMs of the other bonds, with maturities between March and
July, were in the range 10.8-12.4. It is evident that the determination of the appropriate
46 average YTMs for the 3-4 year horizons would be extremely difficult.
 Methodology I C R A B U L L E T I N

The research exercise proceeds in some discreet steps. At the outset,

Money
the exercise seeks to verify whether the depth and the width of the gilts
market have increased over time. To this end, frequency distribution tables &
have been drawn up for the shorter (time-to-maturity less than equal to 3 Finance
years) and longer (greater than 3 years) bonds with respect to the number
JAN.–MARCH.1999
and average frequency of transaction, for a 17 month period (September 95
to January 97).
The relation between the number of bonds and the width of the The research exercise
market is easily understood: the greater the number of bonds traded in the
market, the more is the so-called width. But the choice of (average) fre- proceeds in some dis-
quency of transaction per bond as the proxy for the depth of the market creet steps. At the out-
needs some clarifications. The usual proxy for the market depth is the
(rupee) volume of transactions. However, at least in the Indian context, this set, the exercise seeks
measure can be notoriously unrevealing. For example, if a gilt is transacted
to the tune of Rs. 220 crore in a day, the market price of the bond being Rs. to verify whether the
110, it is not evident whether or not Rs. 110 is the market clearing price.
depth and the width of
The entire transaction of Rs. 220 crore could have been concluded between
two traders in a telephone market such that the market price is an aberra- the gilts market have
tion. If, on the other hand, the same volume is traded in (say) ten equal
transactions of Rs. 22 crore each, involving 10 pairs of traders, then Rs.110 increased over time.
in our opinion, is much more acceptable as a market clearing price. Even in
a telephone market, imperfect as it is, as the information about each trade
Next, the exercise
gets recorded, potential traders update their information set and revise their
expectations. At the very least, a number of transactions between independ- traces the prices of
ent and rational traders helps mimic a quasi efficient market. In other
words, if the market is dominated by a few large players, thereby leading to specific government
low frequency of transactions, the market is likely to remain inefficient.
securities over time
Next, the exercise traces the prices of specific government securities
over time and verifies whether (i) the prices converge to the sum of face and verifies whether
value plus coupon payment as the bonds near maturity, and (ii) the variance
of the prices of these bonds are significant for intra month trading, and (i) the prices converge
whether there is any pattern in the movement of these variances across the
months. The rationale underlying hypothesis (i) has its roots in the basic
to the sum of face
premise about bond pricing [see Appendix]. The logic for the first part of value plus coupon
hypothesis (ii) too is easily understood; in an efficient market, the variance
should be low within a short period like a month, so as not to offer payment as the bonds
arbitrage opportunities in the absence of significant changes in expectations
about the term structure of interest rates. near maturity, and (ii)
But why can we expect a trend or pattern in the movement of the the variance of the
variance over time? Suppose that, for a representative gilt, frequency of
trade increases with a decrease in its time to maturity. If, as argued above, prices of these bonds
greater frequency of trades implies greater market efficiency, the variance in
the traded prices should decline over time, as the gilt nears maturity. There are significant for intra
might be some deviations from this expected pattern because bond owners
month trading, . . .
might hold rather than sell immediately prior to the maturity of the bonds,
thereby reducing the frequency of trading sharply.
47
 I C R A B U L L E T I N Indeed the issue of efficiency is so central to any analysis about any
market that, as mentioned in the previous section, this has been the focus of
Money
& the exercise. The results obtained with the SGL data, therefore, have been
cross-verified with the data obtained from dailies and RBI’s Weekly Supple-
Finance ment. The results have been discussed in the following section.
JAN.–MARCH.1999
Results
Analysis of the data suggests that a necessary though not suffi-
ciently strong manifestation of market efficiency can be found in the second-
ary market for government securities. Over time, as a bond nears its
maturity, its price approaches the sum of its face value and coupon payable
[see Table 1]2 . As mentioned earlier, such price behaviour is consistent with
the theoretical basis for estimation of bond prices.

Analysis of the data

TABLE 1
suggests that a neces- ZCB 1999 maturing on 18/01/99

Month f Pa s Pmin Pmax

sary though not
Sep-95 14 63.84 6.0% 63.79 63.96
sufficiently strong Oct-95 3 64.35 0.5% 64.34 64.35
Nov-95 0
manifestation of Dec-95 1 66.00 0.0% 66.00 66.00
Jan-96 1 65.25 0.0% 65.25 65.25
market efficiency can Feb-96 6 66.25 11.7% 66.10 66.45
Mar-96 8 67.60 47.7% 66.98 68.44
be found in the sec- Apr-96 4 69.14 16.0% 69.00 69.33
May-96 3 70.06 20.0% 69.90 70.25
ondary market for Jun-96 12 70.83 20.3% 70.32 70.94
Jul-96 64 71.75 18.3% 71.00 71.94
government securities. Aug-96 24 72.20 11.8% 72.00 72.51
Sep-96 38 72.69 23.6% 72.50 73.30
Over time, as a bond Oct-96 54 74.80 80.2% 73.74 75.90
Nov-96 13 76.53 31.8% 75.90 76.90
nears its maturity, its Dec-96 21 76.95 27.7% 76.55 77.45
Jan-97 49 78.02 47.5% 77.42 79.25
price approaches the Note : f =frequency of trade
Pa = average price
sum of its face value s: standard deviation of prices
Pmin = minimum price
and coupon payable Pmax = maximum price

2
A zero coupon bond was chosen for the illustration because prices of coupon
bonds are affected by the magnitude of accrued coupon payments and their tax treatment.
However, the exercise was repeated with several other coupon and zero coupon bonds, and

48 the pattern highlighted in Table 1 was valid for all of them.

 However, both price and YTM data suggest that (i) during many a I C R A B U L L E T I N

month the variations have been significant, and (ii) there is no pattern or
Money
trend so far as the movements of the variance in price/YTM are concerned,
neither over time nor cross-sectionally across bonds of different maturities &
[see Tables 2 and 3]. This is somewhat inconsistent with the observation that Finance
bonds that are closer to maturity are on average traded more frequently
JAN.–MARCH.1999
than the bonds that are set to mature well into the future [see Figure 2]3 .
Given the aforementioned hypothesis linking frequency of transactions with
price discovery and low price/YTM variance, it would be reasonable to
expect that the variance of the prices/YTMs for near maturity bonds would
by and large be lower than those for longer maturity bonds. The data
clearly does not bear out this expected relationship.

TABLE 2 However, both price

S.Ds of prices of bonds of different maturities over the months

Month 12.75% 13.5% 13.5% 13.65% ZCB 12% 12.5% and YTM data suggest
1996 1997 1998 1998 1999 1999 2004
that (i) during many a
Sep-95 12.2% 1.6% 18.9% 6.0% 180.5% 10.1%
Oct-95 65.9% 7.2% 10.5% 0.5% 3.4% 0.0% month the variations
Nov-95 85.7% 26.0% 26.0% 6.3% 45.0%
Dec-95 14.1% 26.7% 0.0% 2.8% have been significant,
Jan-96 48.0% 52.1% 17.6% 0.0% 41.6% 31.0%
Feb-96 4.4% 6.6% 58.7% 11.7% 22.1% 366.0% and (ii) there is no
Mar-96 35.7% 17.6% 47.7% 45.5% 19.8%
Apr-96 12.3% 6.1% 11.8% 16.0% 80.7% 16.1% pattern or trend so far
May-96 4.1% 8.0% 0.0% 20.0% 16.4% 21.8%
Jun-96 6.6% 4.3% 20.3% 0.0% 12.4% as the movements of
Jul-96 23.8% 18.7% 30.4% 18.3% 14.5% 13.6%
Aug-96 18.8% 13.1% 4.4% 11.8% 8.4% 16.9% the variance in price/
Sep-96 7.3% 16.0% 6.4% 23.6% 9.0% 64.4%
Oct-96 49.9% 57.2% 34.5% 80.2% 41.9% 64.7% YTM are concerned,
Nov-96 50.8% 36.3% 0.0% 31.8% 28.8% 18.6%
Dec-96 29.2% 37.8% 0.0% 27.7% 28.9% 10.3% neither over time nor
Jan-97 22.3% 21.0% 6.4% 47.5% 17.6% 14.8%
cross-sectionally

across bonds of

different maturities . . .
3
Figure 1 indicates that longer term bonds are traded in larger numbers.
Although this is per se not inconsistent with the observation that shorter term bonds are
traded more frequently, it demands a closer examination of the data. Information available
from RBI’s publications and the NSE’s web site indicates that more longer term bonds are
traded simply because there are more longer term bonds in existence. However, a much
higher fraction of the outstanding shorter term bonds are traded than the outstanding
longer term bonds. For example, during November 1998, about 78% of the outstanding
bonds with less than one year to maturity were traded, compared to about 45% of the
outstanding bonds with greater than four years to maturity.
49
I C R A B U L L E T I N
TABLE 3
Money S.Ds of YTMs of bonds of different maturities over the months
& Month 13.5% 13.65% ZCB 12% ZCB 11.75% 12.5%
Finance 1998 1998 1999 1999 2000 2001 2004

JAN.–MARCH.1999 Jan-98 326.3% 533.5% 389.7% 142.8% 95.9% 157.0%

Feb-98 110.8% 103.0% 30.2% 356.4% 11.3% 11.3%
Mar-98 81.8% 70.9% 20.0% 70.4% 44.2% 47.7% 26.6%
Apr-98 62.1% 36.0% 68.3% 60.4% 25.6% 13.9% 11.5%
May-98 192.3% 132.4% 106.9% 45.2% 32.3% 6.5%
Jun-98 51.3% 19.8% 20.4% 11.2% 6.6% 7.2%
Jul-98 63.6% 37.1% 20.5% 11.7% 3.9% 7.5%
Aug-98 443.4% 16.8% 59.4% 22.0% 16.5% 7.8%
Sep-98 16.6% 21.9% 11.5% 3.2% 5.0%
Oct-98 11.3% 19.5% 21.7% 3.1% 10.5%
Nov-98 28.3% 47.1% 50.4% 3.1% 5.7%
Dec-98 38.2% 35.6% 44.3% 2.2% 4.2%

FIGURE 1 FIGURE 2
Bond Trades per Month Bond Trades Per Month
60

40 50
35
30 40
25
30
20
15 20
10
10
5
0 0

3 yrs or less to maturity > 3 yrs to maturity 3 yrs or less to maturity > 3 yrs to maturity

The latest scenario, involving the last six trading weeks of 1998,
with respect to variance in gilt prices too has been examined, albeit with
recourse to “looser” methodology. Data available from RBI’s Weekly
Supplement suggest that there still exists significant dispersion among
prices/YTMs of gilts with similar time to maturity [see Table 4]. The lower
spreads among prices of longer term securities possibly reflect the relative
flatness of the higher end of the yield curve.
The exercise has highlighted the fact that while the bond traders in
India are clearly rational in the economic sense of the word, the market as

50 yet is far from being efficient. The rationale for this phenomenon perhaps
 I C R A B U L L E T I N
TABLE 4
Range of YTMs for bonds of different maturities over weeks Money
Week ended
&
Time of
Maturity 27-Nov-98 4-Dec-98 11-Dec-98 18-Dec-98 25-Dec-98 1-Jan-99
Finance
JAN.–MARCH.1999
1998-99 125.0% 68.0% 55.0% 112.0% 80.0% 172.0%
1999-00 109.0% 95.0% 105.0% 141.0% 151.0% 121.0%
2000-01 138.0% 37.0% 39.0% 46.0% 32.0% 19.0%
2001-02 24.0% 125.0% 17.0% 6.0% 6.0% 4.0%
2002-03 4.0% 2.0% 17.0% 3.0% 1.0% 4.0%
2003-04 22.0% 72.0% 22.0% 20.0% 22.0% 22.0%
2004-07 76.0% 27.0% 71.0% 30.0% 27.0% 19.0%
2007-08 3.0% 9.0% 12.0% 14.0% 11.0% 13.0%
2008- 19.0% 23.0% 28.0% 95.0% 9.0% 9.0%
While the extent of

informational asymme-
lies in the nature of the market itself. Trading in government securities is
largely restricted to a “telephone” market, and on-line two way quotes are try is debatable, and
available from very few traders and for very few securities. The trades are
subsequently reported to the WDM segment of the NSE, but the reporting has been questioned
itself need not be real time. Finally, the trades are recorded in the SGL
account of the RBI, typically with a further lag. Hence, on the one hand, by some market
market making is limited and, on the other hand, informational asymmetry
continues to be a dominant feature of the market. While the extent of participants, there is
informational asymmetry is debatable, and has been questioned by some
market participants, there is no doubt about the fact that informational no doubt about the fact
transparency is not a hallmark of the Indian bond market, where on-line
that informational
quotes and interest rate movements are a very recent phenomenon, thanks to
information vendors like Reuters and Bloomberg. As mentioned earlier, this transparency is not a
transparency too has de facto been limited to a handful of securities, but at
least some progress has been made on this front. hallmark of the Indian
However, two-way quotes alone are unlikely to act as a panacea in
a market that is dominated by a few large traders. So long as the market bond market, where
remains limited to these participants, trades will continue to be settled on a
bilateral basis rather than through a competitive bidding process. The need on-line quotes and
of the hour therefore, is a manifold increase in the number of active
portfolio managers who would roll over their bond portfolios often, and interest rate move-
who would collectively provide two way quotes for a wide array of securi-
ties. Given that a two way quote is a proxy for a trade, albeit imperfect, the
ments are a very recent
depth of the bond market can then increase sufficiently, thereby increasing
phenomenon, . . .
the market’s efficiency. The government’s attempt to increase the depth of
the market by allowing foreign institutional investors (FIIs) to trade in both
T-bills and dated government securities has come to nought. The exposure
of the FIIs to Indian debt instruments is marginal at best. The salvation
perhaps lies in the opening up of the insurance and pension funds sectors.

51
 I C R A B U L L E T I N
Money
& should restrict itself to raising certain issues and highlighting some basic
Finance
JAN.–MARCH.1999
Two further areas of
study are:
i) there should be a
link between the yield
structure and expecta-
tions about financial
conditions of the
governments and the
PSUs in the future.
The strength and
nature of this link can
be explored in an
exercise,
ii) to verify the extent
to which the expecta-
tions about the spot
rates for period (t+i)
estimated during
period t, and the actual
spot rate for that
period have differed in
the recent past.
52
Summing Up
It was felt that this preliminary survey of the Indian bond market
characteristics of the market. Hence, as mentioned at the outset, this
exercise limited itself to an analysis of the extent of pricing anomaly (i.e.
imperfection) in the bond market. However, there are two other issues that
beg discussion, and that should be discussed in the future.
First we know that bond prices are determined by expectations
about the future spot rates. These spot rates are affected by the extent of
liquidity in the market, and in a country like India liquidity significantly
depends on the earning and expenditure patterns of the governments, and
the actions of the public sector undertakings (PSUs). Their bonds together
comprise of a very high proportion of the money raised through the bond
market. In other words, there should be a link between the yield structure
and expectations about financial conditions of the governments and the
PSUs in the future. The strength and nature of this link can be explored in
an exercise, subject to availability of appropriate data. Second, we have
already observed that near maturity bonds are traded much more often than
longer maturity bonds. If traders are rational, this phenomenon should be
observed only if the uncertainty about longer term interest rates are very
high, and if this is common knowledge. An interesting exercise, therefore,
would be to verify the extent to which the expectations about the spot rates
for period (t+i) estimated during period t, and the actual spot rate for that
period have differed in the recent past. This exercise is feasible, but a longer
time series would be required for it than what we have at our disposal.
The bond market is a fascinating area of research. Given the
functional relationship between the bond prices and expected interest rates,
it allows us to test interesting hypotheses that cannot be analysed within the
paradigm of the equity market. For example, whether or not an equity is
overpriced is anybody’s guess. But it is possible to verify whether or not a
bond is rich. The nature of bonds, particularly the array of possible struc-
tures that can be developed with embedded options, and the impact of
perceived creditworthiness of the issuer on a bond’s price make bond
markets a fascinating study even at the micro level. An analysis of the
Indian bond market, therefore, would be a recurring theme in future issues
of Money & Finance.
 APPENDICES 1: Pricing Bonds I C R A B U L L E T I N

Price as a discounted cash flow

Money
It is well known that the price of a bond (P) is given by the dis-
counted value of the income stream that is expected to be generated from it &
in the future. In other words, if a bond promises (say) annual coupon Finance
payments at the rate of x% of the face value, the amount available upon
JAN.–MARCH.1999
maturity is B, the discount rate is r, and T is the number of years to matu-
rity, then the price of the bond is given by:4

However, a price per se does not tell us whether a bond is worth

buying. A price might seem to be low but, given that economic agents make
their decisions in accordance with the opportunity costs of their actions, one
has to know whether the price is low enough such that the implicit return
from the bond is equal to the opportunity cost of the investment. Hence,
bonds are often traded on the basis of their yield to maturity (YTM). The
YTM of a bond is the value of r for which equation (1) holds, given P, x, B
and T. If the YTM of a bond is equal to or, on occasions, greater than the
YTM of comparable bonds, then it is deemed to be a good buy. Economic
theory suggests that the YTM of a bond varies inversely with the credit
worthiness of the bond issuer, and directly with the extent to which the
interest income from the bonds are taxed. These hypotheses are supported
by available market data.

Yields to maturity and call

While the YTM of a bond is an useful indicator of its
purchasability, it is not always an accurate measure of the richness of the
bond. For example, today an increasing number of bonds are bundled with
call and put options. In other words, some of these bonds might be redeemed
prior to their “maturity.” Further, coupon payments obtained from a bond
can be reinvested, and the returns from reinvestment can differ significantly.
Therefore, the difference between the overall returns from two comparable
bonds can differ significantly from the difference between their YTMs. It is
difficult to objectively compare the richness of two bonds based on their
overall returns, because the rates of return from reinvestment will vary
according to the preferences, risk appetite, and expectations of the investors.
Hence, market observers usually shy away from the concept of overall or
total return. But they try to deal with embedded options using measures of
return like the yield to call (YTC). The YTC of a bond can be computed
from equation (1) by substituting the exercise value of the call option (C) for
B, and the strike period for the maturity period, T.
4
Note that if the discount rate is a function of the opportunity cost of funds, it is
unlikely to be constant throughout the life of a bond. In that case, the discount rates shall
be given by ri for the i-th period, when rI is the forward rate for that period. However, the
current spot rate and the arbitrage-free forward rates are related such that “discounting
cash flows at the arbitrage-free forward …. rates is equivalent to discounting at the current
spot rates” (Kalotay et al., 1993).
53
I C R A B U L L E T I N Pricing bonds using binomial interest tree
More sophisticated pricing models for bonds, which take into
Money
& consideration the possibility of interest rate volatility, use the binomial
interest rate tree based pricing model. As suggested by Kalotay et al. (1993),
Finance “[t]his tree is nothing more than a discrete representation of the possible
evolution over time of the one-period rate based on some assumption about
JAN.–MARCH.1999
interest rate volatility.” How do we construct such a tree? Let us assume
that the spot interest rate for the present (or the base) period is r0, and that
the volatility of the interest rate during all future time periods is given by σ.
It is further assumed that, given any interest rate in period t, there are two
possible rates of interest in period t+1: a high rate and a low rate, and that
each of these rates occur with equal probability. In other words, it is as-
sumed that the forward rates follow a lognormal random walk, albeit with
a known and certain volatility (Fabozzi, 1996).
These assumptions ensure that the relationship between the low rate
and the high rate, one year into the future, is as follows:5
r1,H = r1,L(e2σσ) (2)
Similarly, the interest rates two years into the future would be given
by the following equations:
r2,HH = r2,LL(e4σσ) (3a)
r2,HL = r2,LH = r2,LL(e2σσ) (3b)
The high and low rates for the i-th period can be similarly ob-
tained. Therefore, the binomial interest tree for a three year period is given
by:
Figure 1

r3,LL(e6s)

r2,LL(e4s) ▲
▲

▲ ▲
r1,L(e2s) r3,LL(e4s)
▲

▲ ▲

r0 r2,LL(e2s)
▲

r1,L r3,LL(e2s)
▲

r2,LL
▲

r3,LL

In figure (1), the volatility of the forward interest rates at all nodes
has been ascribed the symbol σ. This, however, is a simplification. In

5
In effect, an investor would require to know only the value of r1,L. This rate,
known as the one-year forward rate (for period 0), can be estimated using the spot t-year
interest rates obtained from an yield curve, and the principle that interest rate arbitrage is
54 not possible in an efficient market. For details, see Kolatay et al. (1993).
reality, the volatility of a one-year forward rate is given by r0σ, when r0 is I C R A B U L L E T I N

the spot rate for the current period, and s is the current period volatility.
Money
The volatility of interest rate for all i periods can thus be obtained.
How can the binomial interest tree enable us to compute prices of &
bonds with embedded options? Let us go back to the example of the 3-year Finance
bond. For the moment, let us assume that it is a straight bond. The price of
JAN.–MARCH.1999
the bond in the current period, i.e., when t=0, should equal the discounted
value of the cash flows accruing in periods 1, 2 and 3, and the discount
rates would be given by the forward rates highlighted in figure (1). Suppose,
that the face value of the bond is B, and that the (annual) fixed coupon rate
is x. Then the cash flow expected to accrue at the end of period 3 is (1+x)B.
The price of the bond at any node of the second period is then given by:

when r2,j is the one-year rate at the j-th node of period 2, and ½
indicates that the high and low values of r are equally likely in period 3.6
These discounted values of cash flow from period 3 can be further dis-
counted using forward rates of period 1 to obtain the values of the bond at
the two nodes of period 1. One final round of discounting using the current
rate yields the current price of the bond, i.e., the discounted value of cash
flows as expected in period 0. The pricing process can be described with the
help of the following binomial tree:

Figure 2

V3,HHH = (1+x)B
▲
▲

V2,HH = ½(V3,HHH + V3,HHL)/(1+r2,HH)

▲▲
▲

V1,H = ½(V2,HH + V2,HL)/(1+r1,H) V3,HHL = (1+x)B

▲▲

V0 = ½(V1,H + V1,L)/(1+r0) V2,HL = ½(V3,HHL + V3,HLL)/(1+r2,HL)

▲ ▲
▲

V1,L = ½(V2,HL + V2,LL)/(1+r1,H) V3,HLL = (1+x)B

▲

V2,LL = ½(V3,HLL + V3,LLL)/(1+r2,LL)

▲

V3,LLL = (1+x)B

6
Clearly, this method also allows investors to value floating rate bonds. In that
event, the “coupons” for the bond will be xhigh and xlow for the high and low interest rate
regimes respectively. Hence, equation (4) has to be modified only modestly to take into
account the floating-rate nature of the bond. 55
I C R A B U L L E T I N Pricing bonds with embedded options
Suppose that the bond has an embedded call option that can be
Money
& exercised at the end of the first period at the discretion of the issuer. The
bond will be called if the one-year forward rate at the end of period 1 is
Finance lower than the expected level of interest rate at that point in time. If so, the
discounted value of future cash flows at one or more nodes of the first period
JAN.–MARCH.1999
will be greater than the face value of the bond, B. Let us assume that this
occurs at only one of the nodes, and let this discounted value be called B’. In
the binomial tree, therefore, the value B’ at the appropriate node will be
replaced by the value B, and the process of discounting will yield an option-
adjusted price for the bond. It is obvious that if a higher cash flow B’ is
replaced by a lower cash flow B, then the price of the bond in the current
period will be lower than the price of the option-free bond described in the
previous section. The difference between the prices of the straight bond, and
that with an embedded option is the (implicit) price of the call option that
benefits the issuer. It can easily be verified that if the option is a put which
benefits the buyer, then the price of the bond with the option will be higher
than the price of the option-free bond.

Option adjusted spread

As mentioned earlier, even though an investor de facto wants to
purchase a bond whose market price is lower than its option-adjusted value,
(s)he prefers to think in terms of yields on his/her investment, as opposed to
the prices themselves. If a bond is option-free then the investor can simply
compare its YTM with that of a comparable on-the-run bond.7 However,
since YTM is not a meaningful measure of the yield in the event that a bond
has an embedded option, an investor has to take into consideration the
option adjusted spreads of such bonds.8
What is an option adjusted spread (OAS)? Suppose that the theoreti-
cal price of a bond obtained from the binomial tree (P) is not equal to the
market or actual price of the bond (P’). Then the OAS of the bond is the
constant spread which, when added to all the forward rates of the tree, will
ensure that P’ equals P. It is obvious that the spread will be lower for a rich
bond and higher for a cheap bond. If the theoretical price of the bond equals
its market price then the OAS will be zero.

7
An on-the-run yield curve highlights “[t]he relationship between the yield-to-
maturity and maturity for bonds of similar credit quality trading at par” (Kolatay et al.,
1993).
8
Further, YTM is an average measure of yield, and does not take into considera-
tion the shape of the underlying yield curve. It is evident from the above discussion that the
shape of the yield curve, which will determine the forward rates, and hence the discount
rates for the different time periods, will have a significant impact on the theoretical
56 (option-adjusted) value of a bond.
 2. Duration and Convexity I C R A B U L L E T I N

Duration
Money
Apart from ensuring that the bonds in their portfolios are liquid and
have acceptable levels of counter-party risk, fixed-income portfolio manag- &
ers have to take into consideration the nature of the expected cash flow from Finance
these securities. For example, a pension fund manager has to ensure that the
JAN.–MARCH.1999
monthly returns from its portfolio is enough to meet the fund’s monthly
pension related obligations. Hence, (s)he would be much more interested in
a coupon bond with (say) quarterly coupon payments, than in a zero-coupon
bond with the same maturity as the coupon bond. Moreover, a fund man-
ager might have to take into account the possibility that (s)he might face a
short-term liquidity problem which will force him/her to liquidate a signifi-
cant part of the portfolio.9 In that case, (s)he would also be interested in the
extent to which bond prices change with changes in the interest rate. This
price-interest rate relationship is captured by two measures known as the
duration and the convexity of bonds.
“The duration of a bond is commonly defined as the weighted
average of the maturities of the bond’s coupon and principal repayment cash
flows, where the weights are the fractions of the bond’s price that the cash
flows in each time period represent” (Edwards and Ma, 1993, p. 318). The
mathematical relationship between duration and the cash flows is given by:

when D is the duration of the bond, P is its market price, r is the YTM of
the bond divided by the number of coupon payments in a year, m is the
number of payment periods, and Xt is the cash flow from the bond in period
t. Note that the duration of a bond is expressed in terms of number of
payment periods, as opposed to number of years. However, the year-
denominated duration of a bond can be obtained by multiplying the period-
denominated value by 1/f when f is the frequency of coupon payments per
year. Finally, the duration of a portfolio of bonds equals the weighted
average of the duration of the bonds in the portfolio.

Modified Duration
As evident from the above example involving a zero-coupon and a
coupon bond, in order to avoid a short-term liquidity problem, a fund
manager has to ensure that the duration of the firm’s assets is similar to the
duration of its liabilities.10 However, in order to realise the usefulness of

9
For example, suppose that a life insurance company has agreed to provide a
fixed rate loan to its policyholders. If, therefore, the market rate of interest exceeds this
agreed upon fixed rate, a significant proportion of the policyholders might take a loan,
thereby precipitating a liquidity crisis. In such an event, the fund manager of the life
insurance company might have to liquidate part of his/her portfolio to meet the company’s
contractual obligations.
10
It can easily be verified that the duration of a zero coupon bond equals its time
to maturity. For coupon bonds, the duration is typically lower than their time to maturity. 57
I C R A B U L L E T I N this measure in the context of marking to the market a bond portfolio, given
a change in the interest rate(s), one has to introduce a related measure
Money
& known as modified duration. Algebrically, the relationship between duration
and modified duration is given by:
Finance
JAN.–MARCH.1999

when R is the annualised YTM, and f is as defined in the previous

paragraph. More importantly, however, the modified duration of a bond
equals the ratio of the percentage change in its price to the percentage
change in its YTM. Hence, given any change in the interest rates, which
would also alter the YTM of a bond, the change in the bond’s price is given
by the following relationship:
percentage change in P = -Dmod x percentage change in (1+R) (7)

Convexity
Clearly, modified duration is the slope of the price-YTM curve.
However, while this curve is generally convex in nature, modified duration
is essentially the slope of a straight line approximation of this convex
curve. Hence, modified duration overestimates the price change if the yield
increases, and vice versa. Therefore, in order to obtain an accurate value of
the price change, given a change in the YTM, a portfolio manager will also
have to take into account the extent of the curvature of the price-YTM
curve.11 The resultant measure for a bond is its so-called convexity.
Mathematically, convexity is defined as:

when the symbols have the same interpretations as in the case of duration.
The relationsip between a bond’s C and its price is given by:
percentage change in price = ½ x C x (change in yield)11 (9)
As before, the year-denominated value of C can be obtained by
dividing the period-denominated value of C by the square of f.

Effective duration and convexity

The estimates of modified duration and convexity of a bond, as
described above, are obtained under the assumption that the future cash
from the instrument will not vary with changes in future interest rates.
However, this assumption is unlikely to hold if the bond has embedded
options. For example, the modified duration of a bond that is callable at the

11
An accurate measure of the extent of the change in a bond’s price can be
obtained by summing the estimates of the changes obtained using modified duration and
58 convexity.
discretion of the issuer is likely to be lower than that of a straight coupon I C R A B U L L E T I N

bond. Hence, portfolio managers are increasingly using effective duration

Money
and effective convexity, in lieu of modified duration and convexity. These
measures can be approximated as follows: &
Finance
JAN.–MARCH.1999

where P0 is the initial price of the bond, and P- and P+ are the prices that
can be obtained by shifting the aforementioned binomial tree by AR basis
points.

59
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