Pricing Fixed Income Securities

A Comparative Study using NSE’s and CCIL’S ZCYC∗

Abstract

The National Stock Exchange (NSE) and the Clearing Corporation

of India Limited (CCIL) estimate the parameters required to predict
the term structure of interest rates(or, ZCYC) on every trading day.
In this paper, we test the performance of the two rates by pricing some
frequently traded Government of India (GoI) bonds. We compare the
forecasts with the actual market prices of these bonds for the period
January 1, 2009 to February 26, 2010. The fixed income instruments
analysed cover bonds with different maturities and coupons (if any).
The results are heavily in favour of the rates from the ZCYC of the
CCIL. The absolute value of the forecast errors for CCIL are close to
zero and are less volatile. In addition, they are significantly lower in
comparison to the NSE forecast errors. The correlation between the
market and predicted prices is higher for CCIL across all categories
of bonds considered. One possible explanation for our results may be
the fact that in estimating the ZCYC, CCIL uses filters on the data
of traded price, while NSE does not.

∗
Zero Coupon Yield Curves

1
Contents
1 Introduction 3
1.1 How is a bond priced? . . . . . . . . . . . . . . . . . . . . . . 4
1.2 The Zero Coupon Yield Curve . . . . . . . . . . . . . . . . . . 4

2 Literature Review 7

3 Methodology 9

4 Results 11

5 Conclusion 14

A Graphs 17

2
1 Introduction

One of the most challenging tasks in the financial literature is to price a

financial instrument. One such class of products are the fixed income instru-
ments. These instruments can be categorised by the type of payments. Most
fixed income instruments pay to the holder a periodic interest payment, com-
monly known as the coupon, and an amount due at maturity, the redemption
value. Some instruments do not make periodic interest payments; the prin-
cipal amount together with the entire outstanding amount of interest on the
instrument is paid as a lump sum amount at maturity. These are known as
zero coupon instruments (for example, t-bills) and are sold at a discount to
the redemption value, the discounted value being determined by the interest
rate payable (yield) on the instrument.

The rate of interest offered by the issuer depends on its credit-worthiness.

Sovereign securities issued by the Government of any country, with minimal
default risk, usually offer lower rates of interest than a non-sovereign entity
with a non-zero default risk. The credit spread that has to be added by a
non-sovereign entity with non-zero probability of default risk, over and above
the interest rates offered by a sovereign body, is directly related to the default
risk of the issuer, higher the default risk, higher is the spread.

Owing to their least volatility in terms of returns, the Central Government

bonds are relatively the easiest to price when compared to other financial
instruments like corporate bonds, equity etc..

3
1.1 How is a bond priced?

A simple way to price a bond at time t is to estimate the Present Value (PV)
of all its future stream of cash-flows. If the spot rate of interest for every
future period is known, then the present value of a m period bond making
a series of coupon payments of value C every period, and with redemption
value R is:

C C C +R
PV = + 2
+ ..... + (1)
(1 + r1 ) (1 + r2 ) (1 + rm )m

This relation should give us the price of the bond if the different spot rates are
the only factors that influence the pricing of the bond. In reality, however,
observed prices differ from these model price. Other factors that affect the
price of a bond include tax regulations and liquidity. Illiquid bonds usually
trade at a premium relative to their liquid counterparts of the same residual
maturity. Dispersion in bond prices could also be attributed to transaction
costs that vary with the size of the trade or an intra-day effect on account
of new developments during the day that have not been explicitly accounted
for in the estimation.

1.2 The Zero Coupon Yield Curve

ZCYC starts from the basic premise of time value of money- a given amount
of money due today has a value different from the same amount due at a
future point of time. An individual willing to part with his money today
has to be compensated in terms of a higher amount due in future. In other
words, he will get an interest on the principal amount. The rate of interest
varies with the time period that elapses between today (when the principal

4
amount is being foregone) and the future point of time (at which the amount
is repaid). At any point of time, different spot rates are associated with
different terms to maturity; longer maturity offering higher rates relative to
shorter maturity. The spot interest rate (rt ) is the interest rate applicable to
a cash payment due after a time period t. The term structure of interest rates,
or ZCYC, is the set of such spot interest rates. This curve lays the foundation
for the valuation of sovereign securities across all maturities irrespective of
their liquidity. It aims at creating a uniform valuation standards in the
market.

The term structure of interest rates can be put to multiple uses. Once an
estimate of the term structure based on default-free government securities is
obtained, it can be used to price all non-sovereign fixed income instruments
after adding an appropriate credit spread. Some government securities do
not trade on all days. The ZCYC can give us an idea of what the price
could have been on those days. It can also provide default-free valuations for
corporate bonds. Estimates of the ZCYC at regular intervals over a period
of time provides us with a time-series of the interest rate structure in the
economy, which can be used to analyse the extent of impact of monetary
policy. This also forms an input for VaR systems for fixed income systems
and portfolios. In the Indian context, both the NSE and the CCIL estimate
the parameters used to predict the ZCYC on a daily basis.

Both the NSE Wholesale Debt Market (WDM) and the CCIL estimate the
ZCYC using the functional form developed in Nelson and Siegel (1987).
Darbha et al. (2000) have done the model for the NSE ZCYC. NSE uses
data on secondary market trades in Government securities reported on the
NSE-WDM1 . CCIL uses the data for trades in central government securities
1
NSE- Wholesale Debt Market

5
and t- bills conducted through/reported in RBI’s NDS2 . The trade data used
for the estimation is subjected to the following filtering process:

• Removal of market outliers.

• Each traded security is broken down into its constituent cash flows.

• An optimisation process is run to minimise the sum of the square of

price errors weighted with inverse of respective durations to arrive at
the parameters.

On a given date, the data on each individual trade include information on

traded price, traded volume, settlement date, days to settlement, issue date,
maturity date along with the information on cash flows for each bond. The
existing literature on the term structure estimation uses volume weighted
average (VWA) prices as the price to be used of a particular security for a
particular date. Although this technique provides accurate prices in liquid
and transparent markets, it may not be suited in the Indian case3 . NSE uses
prices for each individual trade for each bond traded on a given day.

On the other hand, CCIL observes:

“The yield curve generation process as described above has been

subjected by us to rigorous testing. Its sustainability under volatile
market conditions has also been analysed by generating yield curves
for the most volatile days for the period over past two years.”

– CCIL (2005)

2
Negotiated Dealing System
3
For Example, in 2000 The number of securities that are actively traded on a given
day vary in the range of 13-25, and each of them can observe around 45-60 trades. This
can lead to significant dispersion in prices across trades in the same bond. Empirical
estimation is complicated by the fact that the observed traded prices are not indexed with
time, which makes it tough to control for intra-day news in the data

6
2 Literature Review

First proposed by Nelson and Siegel (1987), this is a parametric function

with four parameters for estimating the Forward Rate.

−m m −m
f (m, β) = β0 + β1 exp( ) + β2 ( )exp( ) (2)
τ1 τ1 τ1
The integration of the Forward Rates across a continuum of maturities up to
a tenor point yields the Spot Rate function as

−m
(1 − e τ ) −m
r = β0 + (β1 + β2 ) m − β2 e τ (3)
τ
where, β0 , β1 , β2 , τ - are the parameters of interest and r & m are the Zero
Rate and the maturity.

The parameters above depend on the long term and short term interest rates,
slope of the yield curve and the extent of hump in the curve. This function
yields a continuous smooth curve with a hump along the entire tenor spec-
trum.

Since only a single function is used to define the Zero rates of the possible
tenors, the model becomes easier for application to valuation of fixed income
securities and estimation of VaR. With an intuitive understanding of the
model, the Zero Curve can be modulated on a given day for application in
various scenarios for Stress Testing; the scenarios being a parallel movement
or non-parallel movement of the curve and its impact on the valuation of the
portfolio of fixed income securities.

However, the NS model is not flexible to take different shapes as one traverses
along the tenor axis. In this model, the shape of the curve in various tenor
zones is to a great extent determined by the slope and curvature in the

7
preceding tenors. Hence, the change in the shape (slope & curvature) along
the tenors is not adequately captured by the model. To respond to this
limitation, an extension of the N-S model with two additional parameters
(to be estimated), the Nelson-Siegel-Svensson (N-S-S) model was made which
can take an additional hump (or U-Shape).

Svensson (1991) extended the N-S functional form to enable it to take one
more hump along the tenors.
−m −m
(1 − e τ1 ) −m (1 − e τ2 ) −m
r = β0 + (β1 + β2 ) m − β2 e τ1
+ β3 m − β3 e τ2 (4)
τ1 τ2

where β3 , τ2 are the additional parameters to incorporate an additional slope

change and a hump(or U-Shape). The parameters’ impact on the shape of
the forward curve are as follows:

β0 : This parameter, which must be positive, is the long term Zero Rate (rate
of a return on a Zero Coupon Console)
β1 : This parameter along with β0 determines the short term Zero Rate (the
vertical intercept)
τ1 : This parameter, which must also be positive, positions the first hump
β2 : This parameter determines the magnitude and direction of the hump
occurring at τ1
τ2 : This parameter, which must also be positive, positions the second hump
on the curve
β3 : This parameter, which is analogous to β2 , determines the magnitude and
direction of the second hump.

The basic process of determining the optimal parameters for the Zero Rate
function that best fits the traded data is as follows:

1. A vector of starting parameters [β0 , β1 ,τ1 , β2 , τ2 , β3 ] is selected.

8
2. The zero rates are determined, using these starting parameters.
3. The present value of the various bond cash flows and a vector of theoretical
bond prices is determined.
4. Price errors are calculated by taking the difference between the theoretical
and traded prices.

Steps 1 to 4 are repeated until the sum of the squares of the Price Errors
weighted by the inverse of the respective bond’s duration (which is the Ob-
jective Function) is minimised. [Source:CCIL]

3 Methodology

Owing to the different data used as input for the ZCYC estimation of NSE
and CCIL, the predicted valuation of a bond can potentially vary signifi-
cantly. Given this difference, the objective of our study is to test the forecast
performance of both techniques and come out with valuable insights that
can help in minimising losses when it comes to hedging risks in the bond
market. For this purpose, we price selected central government bonds that
vary with regard to their maturity and coupon structure. The time period
of our analysis starts from January 1, 2009 to February 26, 2010. The two
data sources are taken from different web pages on NSE and CCIL websites.
The data includes the parameter estimates used to predict the ZCYC as well
as the market (or actual) prices of the bonds.

We price t-bills with three different maturities (91 days, 182 days and 364
days) as well as a long term coupon yielding bond (6.35% CG2020). In order
to establish the robustness of our results (without the loss of generality), we
treat all the t-bills as equivalent, regardless of their issue date as long as their

9
maturity period at the time of issue was the same. Errors of prediction are
the difference of predicted and actual prices as a percentage of the actual
prices. Once price the bonds and corresponding errors are calculated, we
use summary statistics like the mean, median and standard deviation for
a preliminary insight. A difference of means test on the absolute means is
done to check if the average errors from one are significantly lower than the
other. This is a one tailed test. A comparison between the actual Yield To
Maturity (YTM) and an estimated YTM will also be done to strengthen the
argument. The literature suggests that even though a particular technique
may not be able to perfectly predict the market bond prices, it can still be
pretty useful in hedging risks. We will estimate the correlation coefficient
between the actual and the predicted bond prices and compare it across the
bonds studied in the paper.

Broadly, we consider the following set of questions to answer.

1. Is a particular ZCYC better at estimating bond prices in totality?

2. Which one of the two ZCYCs is more likely to lead to an under-pricing

(and over-pricing) of the bonds?

3. Is the behaviour of the price error different when the bond is under-
priced than when it is over-priced?

4. Is a particular ZCYC better at estimating bond prices of a specific

maturity?

5. Is the movement of the actual prices (in term of direction) more in line
with the model prices of one over the other?

6. Is the CCIL’s ZCYC better at pricing coupon yielding bonds as well?

10
4 Results

Table 1 Error Summary Statistics: all t-bills

Criterion NSE CCIL
Data Points 1280 1280
Mean -0.22 0.07
Std. Deviation 0.35 0.12
Median -0.14 0.04
Over Priced (%) 14.84 89.61
Mean 0.17 0.09
Std. Deviation 0.31 0.11
Median 0.06 0.05
Under Priced (%) 85.16 10.39
Mean -0.29 -0.05
Std. Deviation 0.30 0.06
Median -0.20 -0.02

Table 1 shows that the absolute value of the CCIL errors is lower than the
NSE errors for all observations. This also holds true for points on which it
over-priced and under-priced a bond. Moreover, the volatility of the errors
is lower in case of CCIL prices. A test of difference of means confirms that
the CCIL mean errors are significantly lower than their NSE counterparts.
While the CCIL has a tendency to over predict, the NSE has a tendency to
under predict the bond price. The plots in Appendix -I illustrate our findings
graphically.

11
Table 2 Error Summary Statistics: 91-day t-bills
Criterion NSE CCIL
Data Points 663 663
Mean -0.11 0.07
Std. Deviation 0.24 0.11
Median -0.09 0.03
Over Priced (%) 16.29 94.42
Mean 0.20 0.07
Std. Deviation 0.34 0.12
Median 0.05 0.03
Under Priced (%) 83.71 5.58
Mean -0.17 -0.01
Std. Deviation 0.15 0.01
Median -0.12 -0.01

Table 3 Error Summary Statistics: 182-day t-bills

Criterion NSE CCIL
Data Points 230 230
Mean -0.23 0.08
Std. Deviation 0.25 0.09
Median -0.18 0.05
Over Priced (%) 16.09 92.61
Mean 0.06 0.08
Std. Deviation 0.05 0.09
Median 0.05 0.06
Under Priced (%) 83.91 7.39
Mean -0.28 -0.02
Std. Deviation 0.24 0.02
Median -0.22 -0.01

12
Table 4 Error Summary Statistics: 364-day t-bills
Criterion NSE CCIL
Data Points 387 387
Mean -0.41 0.08
Std. Deviation 0.45 0.14
Median -0.32 0.05
Over Priced (%) 11.63 89.61
Mean 0.18 0.09
Std. Deviation 0.34 0.11
Median 0.11 0.08
Under Priced (%) 88.37 10.39
Mean -0.48 -0.05
Std. Deviation 0.41 0.06
Median -0.38 -0.05

The results for the 91-day t-bills (table 2) and 364-day t-bills (table 4) are
similar to our results in table 1. Only in case of over prediction, NSE seem-
ingly performs better than the CCIL. A test of difference of means does not
find NSE’s performance in over prediction to be a statistically significant at
5% level of significance. In addition, the magnitude by which CCIL is better
in case of underpricing is far greater than NSE being better at overpricing.
Hence, the CCIL continues to dominate the NSE even when t-bills of different
maturities are analysed individually.

Table 5 Correlation Between Actual and Model Prices

t-bills NSE CCIL
91-day 0.9144 0.9887
182-day 0.9561 0.9932
364-day 0.9729 0.9959

Table 5 shows that CCIL prices have a higher correlation with the actual

13
prices than the NSE prices. Broadly, we can conclude that the movement of
the actual prices are more in line with the CCIL prices.

Table 6 Error Summary Statistics: 6.35% CG 2020

Criterion NSE CCIL
Data Points 115 115
Mean -0.15 -0.52
Std. Deviation 1.03 0.56
Median -0.19 -0.50
Over Priced (%) 38.26 19.13
Mean 0.91 0.19
Std. Deviation 0.68 0.20
Median 0.68 0.12
Under Priced (%) 61.74 80.87
Mean -0.81 -0.69
Std. Deviation 0.53 0.48
Median -0.85 -0.65

The 6.35% CG2020 bond was issued by the Government of India on 2nd
January, 2003 at a face value of Rs. 100 and it matures on 2nd January,
2020. Table 6 shows that while the absolute mean error is lower in case of
NSE errors, they are way more volatile than the CCIL errors. The correlation
between market price and the model prices of NSE and CCIL are 0.83 and
0.94 respectively.

5 Conclusion

In case of pricing all the t-bills collectively, the absolute mean errors of CCIL
are significantly lower than the NSE errors for all observations in totality.
The pattern remains same for observations of over-pricing and under-pricing.

14
Moreover, the volatility of the errors is lower in case of the CCIL prices. This
result remains robust when all the t-bills are considered individually for a
similar analysis. While the CCIL has a tendency to over predict, the NSE has
a tendency to under predict the bond price. In case of the coupon yielding
bond, the performance of both the CCIL and NSE predictions deteriorates.
In general, as the time to maturity falls, the tendency to under-price a bond
rises. A high correlation shows that the movement in market prices are more
in line with the movement in CCIL prices. A possible explanation for our
results may be the fact that in estimating the ZCYC, CCIL uses filters on
the data on traded price, while NSE does not.

15
References
CCIL (2005). “Modelling of Yields of Sovereign Bonds Nelson-Siegel-
Svensson Model Securities Segment.” Clearing Corporation of India Ltd.

Darbha G, Roy SD, Pawaskar V (2000). “Estimating the Zero Coupon Yield
Curve.” NSE Working Paper.

Nelson CR, Siegel AF (1987). “Parsimonious Modelling of Yield Curves.”

Journal of Business, 60(4), 473–89.

Svensson L (1991). “The term structure of interest rate differentials in a tar-

get zone* 1:: Theory and Swedish data.” Journal of Monetary Economics,
28(1), 87–116. ISSN 0304-3932.

16
A Graphs

Figure 1 Density: Model and Actual Price for t-bills

0.5

Market Price
CCIL Price
NSE Price
0.4
0.3
Density

0.2
0.1
0.0

90 92 94 96 98 100

17
Figure 2 Density: CCIL and NSE errors

CCIL Error
10

NSE Error
8
Density

6
4
2
0

−1.0 −0.5 0.0 0.5

Figure 3 Actual and predicted prices for t-bills

96

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CCIL Price
95

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NSE Price
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94

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Price (in Rs.)

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93

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92

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91

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0 20 40 60 80 100

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Figure 4 CCIL and NSE Errors

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Error (%)

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0

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0 20 40 60 80 100

Figure 5 Density: actual and market prices (t-bills)

0.30

Market Price
CCIL Price
0.25

NSE Price
0.20
Density

0.15
0.10
0.05
0.00

85 90 95 100

19