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Relative%20Value%20Models%20(Feb04)

Relative%20Value%20Models%20(Feb04)

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Bond Relative Value Models

Detecting relative value refers to the process of comparing the potential returns
of alternative investments. This paper describes practical Excel/VBA
implementations of two such relative value models which provide information on
over-, respectively underpriced bonds. The first one is a simple model based on
traditional yield to maturity analysis (explained in section 1) and the second one
demonstrates the slightly more complex JP Morgan discount function model, an
approach of term-structure of interest modelling (shown in section 2). Both have
been tested in practical applications in bond relative value research but they
have here been adapted for academic purposes. In particular, the real time data
feeds have been generalized to be independent of a particular data provider. To
use them in a \u201creal world\u201d setting, they would require links to current price and
bond data as well as utility macros to maintain the bond baskets analysed.

The Excel files containing the models can be downloaded from the following
website:
http://www.mngt.waikato.ac.nz/kurt/
The detailed link is currently
http://www.mngt.waikato.ac.nz/kurt/frontpage/ModelMainpages/FixedIncomeMo
dels.htm#BondRelativeValueModels
February 2004

Kurt Hess
Senior Fellow
Department of Finance
Waikato Management School, University of Waikato,
Hamilton, New Zealand

kurthess@waikato.ac.nz
____________________________________________________________________________________________
Kurt Hess,kurthess@waikato.ac.nz
23/02/2004
Relative Value Models (Feb 23 04).doc
Page 2 of 18
1 Simple yield to maturity based benchmarking
Yield to maturity, also called redemption yield based measures to find relative value in a
universe of bonds is the traditional method used by most practitioners in the field.

As is commonly known, yield to maturity assumes that an investor holds the bond to
maturity and all the bond\u2019s cash flow is reinvested at the computed yield to maturity. It is
found by solving for the interest rate that will equate the current price to all cash flows
from the bond to maturity. In this sense, it is the same as the internal rate of return (IRR)
defined in many finance textbooks (e.g. in Reilly & Brown, 2002). Some technical
complications arise from the treatment of accrued interest which according to most
market conventions have to be paid upfront by the bond buyer. These and other issues
related to bond yields are discussed in specialized resources such as Fabozzi (1999)

The yield to maturity based model shown here has two sub-components, each stored in
a separate Excel workbook.
\u2022ConfBenchmark (Feb04).xls shows the implementation of a redemption yield
based benchmark model for the universe of Swiss government bonds. It is
explained in section 1.1.
\u2022Cheap Rich List (Feb04).xls produces a cheap/rich analysis for a universe of
Swiss domestic corporate bonds using the benchmark curve generated in the
Confbenchmark-model. It is explained in section 1.2.
1.1 Benchmark curve

The graphical depiction of the relationship between the yield of the bonds of the same
credit quality but different maturities is known as the yield curve. If one was able to
subdivide the universe of bonds into homogeneous baskets of bonds, drawing a yield
curve for each of them would allow benchmarking within the group. Unfortunately this is
not a simple undertaking as will be discussed in the next section. What is generally
done, is to compare yields is a well-established liquid benchmark curve. For most
markets this would be the government bond market but other rates such as swap rates
are also used a benchmarks.

Figure 1: Generic Time / Yield Chart with Bond Yield Curve
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
0
2
4
6
8
10
Years to Maturity
Yield
12
Yield Benchmark Bonds
Benchmark Curve
i
*
i
YY
____________________________________________________________________________________________
Kurt Hess,kurthess@waikato.ac.nz
23/02/2004
Relative Value Models (Feb 23 04).doc
Page 3 of 18

There are a number of methods to derive such a yield curve. For a small universe of
benchmark bonds, as for instance the one of New Zealand government bonds, one
could simply \u201clink\u201d the few bonds in the time/yield chart with straight line connectors
which means any intermediate yield would be found through linear interpolation. The
model implementation shown here derives a benchmark yield curve from observed
bond redemption yields of Swiss government bonds by fitting a polynomial that
minimizes the squared error of redemption yields. Many other ways such as fitting cubic
splines are employed in financial modelling software. This is not to speak of numerous
more advanced methods for yield curve interpolation and fitting for which, as an
example, the introduction to Krippner (2002) lists the leading references.

The following paragraph derives the calculation of the polynomial coefficients.
Defining \u2026
Redemption yield bond i:
with i = 1,2, \u2026 to n (number of bonds in basket)
i
Y
Interpolated yield bond i:
0
1
1
1
...
*
a
t
a
t
a
t
a
Y
i
m
i
m
m
i
m
i
+
+
+
+
=
\u2212
\u2212
where
: time to maturity of bond i
i
t
m
a
a
a
,...,
,1
0
: coefficients of m degree polynomial
\u2026 we need to minimize
(
)\u21d2
\u2212
\u2211=n
i
i
i
Y
Y
1
2
*
(
)
k
n
i
i
i
a
Y
Y\u2202
\u2212
\u2202\u2211=1
2
*
= 0 for k = 0,1,2 up to the
desired dimension of the polynomial m. These are m+1 equations for the unknown
coefficients
.
m
a
a
a
,...,
,1
0
Some algebra shows that
must be a solution of the following system of
linear equations:
m
a
a
a
,...,
,1
0
\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00b
\ue009
\ue004\ue004\ue004\ue004\ue004\ue004\ue004\ue004\ue004\ue004\ue005
\ue003
=
\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00b\ue009
\ue004\ue004\ue004\ue004\ue004\ue004\ue004\ue004\ue005\ue003
\u00d7
\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00a\ue00b
\ue009
\ue004\ue004\ue004\ue004\ue004\ue004\ue004\ue004\ue004\ue004\ue005
\ue003
\u2211\u2211\u2211\u2211
\u2211
\u2211
\u2211
\u2211
\u2211
\u2211
\u2211
\u2211
\u2211
\u2211
\u2211
\u2211
\u2211
\u2211
\u2211
+
+
++
n
m
i
i
n
i
i
n
i
i
n
i
m
n
m
i
n
m
i
n
m
i
n
m
i
n
m
i
n
i
n
i
n
i
n
m
i
n
i
n
i
n
i
n
m
i
n
i
n
i
t
Y
t
Y
t
YY
aaa
a
t
t
t
t
t
t
t
t
t
t
t
t
t
t
t
n
::
::
..
..
:
.
.
:
:
:
.
:
:
:
.
..
..
..
..
..
2
2
10
2
2
1
2
4
3
2
1
3
2
2
This system is typically solved numerically by one of many well known algorithms such
as the ones described in Press et al. (1992). Yet because a coefficient like
becomes an extremely large number for higher values of m, algorithms will lose
accuracy. However, this is not an issue in most cases because meaningful
interpolations will not exceed 3
\u2211n
m
i
t2
rd to 4th order polynomials. The VBA implementation in
the model uses the so-called LU decomposition to solve the system as described in
Press et. al (1992) p.43.
____________________________________________________________________________________________
Kurt Hess,kurthess@waikato.ac.nz
23/02/2004
Relative Value Models (Feb 23 04).doc

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