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Jie Ren

School of Economics and Management, Wuhan University , Wuhan 430072, P.R.China

jay_renjie@yahoo.com

Abstract Although lots of literature has been discussed on the estimation of government bond yield curve, not much has been discussed on how to derive interest rate yield curve for corporate bonds. This paper first reviews the interest rate yield curve estimation methods and then discusses the probability of applying a parametric yield curve estimation approach to corporate bonds. Based on the perception of corporate bonds, its believed that it would be better to jointly estimate the Government bonds yield curve and the corporate spread other than directly applying the approximation methods to corporate bonds. A practicable procedure to estimate the corporate yield curve is then described. After that, I use the described procedure and UK market Data to calculate the corporate yield curves for the last trading days of each month in 2007. Keywords: corporate bond; yield curve; Svensson method; joint estimation

Svensson (1994) extension, and spline-based methods are widely used by researchers and practices. Regarding to the shape of the interest rate term structure, hypotheses have been suggested to explain the shape of zerocoupon yield curve. Among them, expectation hypothesis, segmentation theory and liquidity preference theory are the most important ones. Other extensions including preferred habitat theory which are combination of more than one hypothesis have been raised to explain the formation of the static interest rate term structure. By adopting those hypotheses, the calculated static yield curve can be used to explain market perception and peoples attitude. Other than the static term structure of interest rates, the evolution of interest rates over time is more important in pricing of interest rate derivates. Most of the interest rates models are focused on this area. Various dynamic models have been developed to track the evolution of the interest rate term structure such as Vacisek (1977), Cox, Ingersoll and Ross (1985), Ho and Lee (1986), Hull and White (1990), as well as Heath, Jarrow and Morton (1992). In practice, various extensions of above model such as Baz and Das (1996), LIBOR market model and Swap market model are used and gained great success on modeling and calibration in the real situation. While there are so many models in the market describing the current and future situation of interest rates, we need to realize that most of the interest rates models are developed based on risk free interest rates which are the inherent lied in the yields of default free government bonds. People believe that the default free interest rates are more fundamental and corporate bonds interest rates are the compositions of corporate spread and the risk free interest rates. Not every interest rate models are directly applicable to corporate bonds yield curves. In fact, there are models developed on modeling of corporate spread. Merton (1974) was the first to consider the relationship of default of corporate bonds with companys asset value. Black and Cox (1976), Longstaff and Schwartz (1995) et al follow Mertons framework define the default with a pre-specified default boundary. Jarrow and Turnbull (1995), Duffie and Singleton (1999) investigate the term

I. INTRODUCTION Interest rate has been always one focus of financial research and base stone for other topics in financial world. It represents the cost of money over time. By identifying the source of the money borrowed, interest rates for different assets are needed such as interest rates for government bonds and for corporate bonds. For example, if the investor would like to invest in corporate bonds markets, then the interest rates for corporate bonds are needed for the evaluation and management purpose. Since interest rate is such an important issue, almost every aspect of interest rates has been discussed. For example, yield curve fitting technologies have been raised to compose the yield curve for particular day. The most widely used static yield curve in security pricing, risk management and monetary regulations is the zero-coupon yield curve. Although its not directly observable in most cases, various technologies have been developed to estimate it form the market data. Bootstrapping method, parametric methods such as well known Nelson and Siegel (1987) method and

structure of credit-risk spreads over the government yield curve by assuming an exogenous hazard rate. Besides, Jarrow, Lando and Turnbull (1997) use the Markov chain framework to describe the likelihood of default. However, all those discussion on corporate spread try to explain the dynamics of credit spreads other than get accurate corporate spreads. Moreover, those models require accurate observations of the interest rates for different credit rating corporate bonds as the model inputs. In this research, we would like to test the various interest rates and find a proper way to derive reliable corporate bonds interest rates. We found that the joint parsimonious yield curve composed by the risk-free yield curve and corporate spread curve estimated following Svensson (1994) would be an economic and reliable representative of term structure of AA rating corporate bonds interest rates. The selection of the sample bonds for estimation is a vital issue to get satisfying results. The remainder of the paper is organized as follows. Section 2 gives a brief introduction of the existing statistic interest rate models. Section 3 shows the model I propose to calculate the corporate bond yield curve. Section 4 tests the results for UK 2007 corporate bonds. Section 5 is the conclusion.

McGulloch (1971, 1975) was the first to introduce parametric spline function as the underlying form of interest rate. The inherit assumption is that the spot rate yield curve can be expressed in spline functions. All we need to do is to calibrate the parameters of the spline functions. Then the yield curve in spline function form can be used. Litzenberger and Rolfo (1984), Fisher, Nychka and Zervos(1995) discussed more about the direction of spline based approximating functions and add smooth penalty function to ensure the smooth of the yield curve. Cubic splines, exponential splines, B-spline and are also introduced and compared by other authors such as Shea(1984). Since the spline function is not that easy to handle in calculation, Nelson and Siegel (1987) use a parsimonious function to fit the yield curve. They have get great success since the function is simple to handle and the approximation results are quite good. Their model has been extended by Svensson (1994) in adding another decay form brings in more flexibility when fitting the situation of the market. In the practice, its interesting to see all those methods mentioned in above are widely used. For example, Bloomberg declare that they use bootstrapping method to provide the FMC (fair market curve), Bank of England use cubic spline with smooth penalty to release the daily government liability curve, Frank Central bank use parsimonious function in Svensson form to calculate the spot rates (Bank for International Settlements 2005). Those static interest rates models are generally accepted to come out with reliable yield curves for risk-free interest rate term structures. However, it does not certainly mean that those interest rate models can be applied to credit securities using the same calculation process as with calculating yield curves for government bonds. Since the spot rates for credit bonds are generally viewed as the credit spread add the risk-free interest rates. Houweling, Hoek and Kleibergen (2001) proposed jointly estimating method by calculate sterling government bonds yield curve and double A corporate bonds credit spreads to approximate additional risk premium. For both of the government bonds yield curve and credit spread curve they use spline-based functions to fit the market bonds. This approach is accepted and used by others such as Jankowitsch and Pichler (2002), Skinner & Ioannides (2005).

II. STATIC INTEREST RATE MODELS We classify all the interest rate models which derive the term structure of interest rates form market trading bonds at a certain day as static interest rate models. For other models describe the revolution of interest rate over time we categorize them as dynamic models. The static models are going to get a snapshot of zero-coupon rates along with different maturities. The inputs for those models are the bonds information in the market such as the bonds maturity, coupon rates, coupon frequency, dirty price, etc. Since the zero-coupon rates (spot rates) in the market are not directly observable, we would only get a best estimation of the spot rates using static interest rate models. Among different kinds of interest rates, the term structure of Sovereign Government bonds which is supposed to be risk free have been paid much more attention than other credit interest rates. Many researchers have put efforts into this area since the zero-coupon interest rates for a certain day or to say initial yield curve is really important and widely used. Basically those methods could be classified into three categories: direct method, spline-based methods and parsimonious methods. The direct methods to derive the zero coupon bond curve have long existed as bootstrapping method before Fame and Bliss (1987) discussed it in detail. It directly follows the definition of zero-coupon interest rates but use a practical approach to calculate the spot rates for those maturities when there are corresponding bonds. Then use interpolation method to connect the calculated spot rates into a curve.

CURVE

We use joint Svensson method to estimate corporate bonds yield curves as a preferable approach for two reasons. The first is that there are longer maturity government bonds in the market than in corporate bonds thus provide a better fit of the risk free spot rates. The second reason is that by applying a separate Svensson function to corporate bonds can better approximate the factors influence on the corporate spreads than in the single-curve approximation.

Svensson model is constructed on the concept of continuous interest rate and modelled directly on instantaneous forward rate. The ultimate parametric forms of compound spot rates and discount factor for time to maturity t are as following:

r (t ) = 0 + 1 ( 1 e t / 1 1 e t / 1 1 e t / 2 ) + 2 ( e t / 1 ) + 3 ( e t / 2 ) t /1 t /1 t / 2

Pi (b) =

The estimated yield to maturity i for bond i is compared to the market yield to maturity to get the model squared yield error for bond i

ei (b) = ( yi y i (b)) 2

For all the bonds in the estimation sample, the root mean square yield error (RMSYE) which is the square root of the average bonds error can be calculated by

RMSYE =

N i =1

d (t ) = exp( r (t ) * t ) =

1 (1 + R ( t )) t

Where 0, 1, 2, 3, 1, and 2 are parameters need to be calibrated by market bonds data, and R(t) is the annualized spot rates corresponding to the compound spot rate r(t)for time to maturity t. After the Government bonds yield curves have been derive using the trading government bonds information, the svensson function is also used to estimate the corporate spreads:

1 e t / 2 1 e t / 2 1 e t / 5 Spread t) = 0 + 1 ( ( ) + 3 ( e t / 2 ) + 4 ( e t / 5 ) t / 2 t / 2 t / 5

ei (b ) N

The ultimate object is to find one set of the parameters 0, 1, 2, 3, 1, and 2 which provide minimized RMSYE.

Using Svensson method to jointly estimate the corporate spread is thought to be able to provide a better fit and robust across time since both government bonds and corporate bonds are used to jointly estimate the corporate yields. More information from the market is utilized. We applied our method to estimate end of month corporate yield curves for UK. The following table illustrate the corporate spot rate for some key terms as well as the estimated parameters for the corporate spreads.

TABLE I. Annulised Yield (%) Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07 Jul-07 Aug-07 Sep-07 Oct-07 Nov-07 Dec-07 TABLE II. 0 7-Jan 7-Feb 7-Mar 7-Apr Y1 5.79 5.68 5.79 5.91 5.91 6.05 6.51 6.47 6.36 6.54 6.30 5.87 Y3 5.89 5.70 5.85 5.92 6.19 6.39 6.29 6.25 6.04 6.07 5.90 5.71 KEY TERM SPOT RATES Y5 5.82 5.62 5.81 5.87 6.14 6.40 6.34 6.33 6.20 6.21 6.17 5.99 Y7 5.74 5.54 5.76 5.81 6.07 6.36 6.33 6.38 6.33 6.28 6.40 6.19 Y10 5.61 5.42 5.66 5.72 5.94 6.24 6.22 6.33 6.34 6.21 6.47 6.26 Y15 5.41 5.24 5.48 5.56 5.71 6.00 5.98 6.05 6.12 5.96 6.23 6.05 Y30 4.92 4.80 5.03 5.11 5.16 5.39 5.37 5.32 5.49 5.35 5.53 5.38

The following procedure is used to calibrate the parameters: The starting values of Svensson (1994) function are firstly given arbitrarily. Here we use default initial values for government bonds estimation is 4%, -0.5%, 10%, 5%, 2.5, and 0.7 for the government bonds parameters 0, 1, 2, 3, 1, and 2 respectively. For corporate bonds, the starting values are 5%, -0.5%, 10%, -5%, 2.5, and 0.7 since we expect there is a spread between the gilt yield and corporate yield. Accordingly, we use the starting values 1%, -0.5%, 10%, -5%, 2.5, and 0.7 for the credit spread estimation. Once the starting values of the parameters are given, one guessed spot rate yield curve can be derived according to the Svensson function described above discount function is then given by

where t is time to maturity and b refers to the given parameter vector. With classical assumption of financial market, the dirty price of the corporate bond can be accumulated as the present value of future cash flows. Thus the model price for bond i can be calculated by the following

Pi ( b) =

Mi m =1

ci ,tm d ( t m , b) + 100d (t M , b)

where Ci,tn is the bonds n th coupon payment and tn is the distance from the coupon payment with the evaluation day. Once the model price of bond i is derived, the model

the following function

7-May 7-Jun 7-Jul 7-Aug 7-Sep 7-Oct 7-Nov 7-Dec Mean Standard Deviation

0.8% 0.7% 0.8% 1.0% 0.7% 0.8% 0.7% 0.6% 0.8% 0.1%

-0.9% -2.3% -1.7% 0.8% 0.7% 1.1% 1.9% 2.0% -0.2% 1.4%

0.1% 1.1% 0.6% 0.5% 8.4% 7.0% 3.0% 8.2% 2.4% 3.4%

0.5% 3.4% 2.3% -3.4% -8.8% -8.4% -6.1% -9.4% -2.2% 4.7%

2.4 2.4 2.5 2.5 2.7 2.6 2.6 3.1 2.6 0.2

0.7 0.7 0.8 1.0 2.0 1.9 1.2 1.8 1.1 0.5

[7]

[8]

[9] [10]

[11]

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V. CONCLUSION

In the above discussion, we would see that even there is not any particular term structure estimation methods designed to derive the corporate yield curve, we could use some of the methods designed for government bonds yield curve to estimate the yield curve for corporate bonds. However, due to the credit characteristics of corporate bonds credit default probability they would have, directly applying those method to derive the corporate yield curve is not principally correct. Realizing peoples belief that corporate spot rates are actually the government bonds rates and the corporate spreads, and following Houweling et al (2001), we raise a practical procedure to use one of the parametric methods Svensson (1994) and apply it to both estimate government bonds curve as well as corporate spreads to derive a reliable corporate bond yield curve.

[13]

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[17] [18]

[19] [20]

REFERENCES

[1] [2] Anderson, N. and J. Sleath, New estimates of the UK real and nominal yield curves. Bank of England, 2001, Working Paper Baz,J. and S.R. Das, Analytical Approximation of the Term Structure for Jump-Diffusion Process: a Numerical Analysis. Journal of Fixed Income, 1996, 6, 78-86 Bank for Internal Settlements, Zero-coupon yield curves: technical documents, BIS papers No. 25, 2005 Black and Cox, Valuing Corporate Securities: Some Effects of Bond Indenture Provisions, Journal of Finance, 1976.

Cox J C. , Ingersoll J E. , Ross S A., A theory of the term structure of interest rates. Econometrica, 1985 , 53 : 385 407

Duffie, D., and K. Singleton, An Econometric Model of the Term Structure of Interest-Rate Swap Yields, The Journal of Finance, 1997, Vol. 52, No. 4, pp. 1287-1321.

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Fama, E. F. and R. R. Bliss, The Information in Long-Maturity Forward Rates, American Economic Review, 1987, Vol. 77, pp. 680692. Fisher, M., Nychka, D., Zervos, D, Fitting the term structure of interest rates with smoothing splines, Federal Reserve Bank Finance and Economics Discussion, 1995, Paper 95 Duffie, D., and K. Singleton, Modeling Term Structures of Defaultable Bonds, Review of Financial Studies, 1999, 687-720. Jarrow, R., D. Lando, and S. Turnbull, A Markov Model for the Term Structure of Credit Risk Spreads, The Review of Financial Studies, 1997, Vol. 10, No. 2, pp. 481-523. Jarrow, R., and S. Turnbull, Pricing Derivatives on Financial Securities Subject to Credit Risk, The Journal of Finance, 1995, Vol. 50, No. 1, pp. 53-85 Jankowitsch, Rainer and Stefan Pichler. Parsimonious Estimation of Credit Spreads. 2002, Available at SSRN: http://ssrn.com/abstract=306779 Skinner S., Frank and Ioannides, M., FRS17 and the Sterling Double A Corporate Yield Curve, Journal of Business Finance & Accounting, 2005, Vol. 32, pp.1141-1169. Ho. T.S.Y. and Lee, S.B., Term structure movements and pricing interest rate contingent claims, Journal of Finance, 1986, 41(5), December, 1011-1020 Houweling, Patrick, Jaap Hoek and Frank Kleibergen, "The Joint Estimation Of Term Structures And Credit Spreads," Journal of Empirical Finance, July 2001, pp. 297-323. Heath, D., Jarrow, R. and Morton, A, Bond pricing and the term structure of interest rates: a new methodology for contingent claim valuation, Econometrica, 1992, 60(1), 77-105. Hull, J., and A. White, Pricing Interest Rate Derivative Securities, Review of Financial Studies, 1990, 3,4, 573-92. Longstaff F A , Schwartz E S. Interest rate volatility and the term structure :A two factor general equilibrium model. The Journal of Finance, 1992 , 47 :1259 1282 Litzenberger, R. and J. Rolfo, An International Study of Tax Effects on Government Bonds, The Journal of Finance, 1984, 39, 1-22 Merton, R. C., On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance, 1974, 449-70. McCulloch, J.H, Measuring the Term Structure of Interest Rates, Journal of Business, 1971, Vol. 44, pp. 19-31. McCulloch, J.H, An estimate of the Liquidity premium Journal of Political Economy, 1973, Vol.83, pp.9-119. Nelson, Charles R. and Siegel, Andrew F., "Parsimonious Modeling Of Yield Curves," Journal of Business, 1987, Vol. 4, pp. 473-490. Shea, G, Pitfalls in Smoothing Interest Rate Term Structure Data: Equilibrium Models and Spline Approximations, Journal of Financial and Quantitative Analysis, 1984, 319-325 Svensson, L., Estimating and interpreting forward interest rates: Sweden 1992-1994. NBER, Working paper 4871, 1994, D95-1. Vasicek, O.A., and G. Fong, Term Structure Estimation Using Exponential Splines, Journal of Finance, 1982, Vol.38, pp. 339-348

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