METHODOLOGY OF THE CNI BOND VALUATION AND YIELD CURVE DATA SERIES INTEREST RATE PRODUCTS

Transcription

1 METHODOLOGY OF THE CNI BOND VALUATION AND YIELD CURVE DATA SERIES INTEREST RATE PRODUCTS Shenzhen Securities Information Co., Ltd March, 2015

2 TABLE OF CONTENTS 1.0 INTRODUCTION 2.0 BOND UNIVERSE 3.0 SAMPLE BOND OF YIELD CURVE 4.0 PRICE DATA INPUT 5.0 YIELD CURVE MODEL AND ESTIMATION METHOED 6.0 EVALUATED PRICING FORMULAE AND CALCULATION METHOD APPENDICES A. FURTHER INFORMATION

3 SECTION INTRODUCTION 1.1 This paper sets out the Methodology of the CNI Bond Valuation and Yield Curve Data Series: Interest Rate Products (`CNI Bond Valuation`). The data series are developed by Shenzhen Securities Information Co., Ltd (`SSI`). CNI is a trade mark owned by Shenzhen Securities Information Co., Ltd. Copies of the Methodology are available from SSI on the website The CNI Bond Valuation aim to serve investors of onshore RMB bond market, reflect the term structure of bond yields, and provide transparent and rule-based evaluation prices. The data series comprise the evaluated pricing at the individual bond level and fitted yield curve in category-specific subsectors. Classification of Interest Rate Products and the scope of evaluated pricing are described in Section The design of CNI Bond Valuation is based on a basket of sample bonds, as determined by bond category and eligibility criteria. A model of yield curve takes the sample bonds as input and generates the curve through curve fitting, which forms the basis of valuation for bonds in the respective category. 1.4 The Methodology is set out into five further sections. Section 2 describes bond classification and the scope of evaluated pricing. Section 3 describes the determination of sample bonds for curve fitting. Section 4 introduces the hierarchy of price data inputs. Section 5 develops the yield curve model and estimation method. Section 6 develops the formulae and calculation method of evaluated pricing. 1.5 The CNI Bond Valuation are calculated on each trading day of the Shenzhen Stock Exchange, and published at around 18:30 of the trading day.

4 SECTION BOND UNIVERSE 2.1 Bond Classification Bond universe includes only RMB denominated bonds. For inclusion, bonds must be listed on the Shenzhen or Shanghai Stock Exchange, or the Inter-bank Bond Market Bonds are classified based on the principle activities of the issuer. In addition, a bond s indenture provisions are evaluated. There are three categories for Interest Rate Products, as defined in this paper. Book-Entry Treasury Bond ISSUER Ministry of Finance (PRC) CATEGORY ABBREVIATION Treasury Bond Policy Bank Bond A China Development Bank Policy Bank Bond (CDB) Policy Bank Bond B Agricultural Development Bank of China, The Export-Import Bank of China 2.2 Scope of Evaluated Pricing Policy Bank Bond (ADBC&EIBC) For each category in the bond universe, bonds with the following characteristics are included in the calculation of evaluated pricing: Fixed rate coupon bonds Repayment upon maturity bonds Zero coupon bonds The following bonds are specifically excluded: Bonds with embedded options Amortizing bonds and sinking funds Floating rate bonds and fixed to floater bonds Convertible bonds Asset backed securities Private placement, or retail bonds in OTC market of commercial banks Other bonds of which the indenture provisions are not publicly available

5 SECTION SAMPLE BOND OF YIELD CURVE 3.1 Eligibility Criteria For each bond category aforementioned, bonds that are included in the scope of evaluated pricing, are eligible for sample bonds in the respective category Time to maturity: To qualify for potential inclusion, all bonds must have a remaining time to maturity of at least 0.25 year (91 days) as of the respective re-balancing date Age:Bonds must be less than three years old, and new issues must be listed for at least five trading days Amount Outstanding: Bonds must have a minimum notional amount outstanding, and the following shows the cut-off levels for each bond category: a) Treasury bond: CNY 10 billion. b) Policy Bank Bond (CDB): CNY 5 billion. c) Policy Bank Bond (ADBC&EIBC): CNY 5 billion Liquidity Conditions: Bonds must have any of the following observable prices on at least three quarters of the trading days between the two adjacent re-balancing dates: a) Quoted price from the interbank market makers that fulfills the maximum yield spread of 200BP; and / or. b) Traded price from the interbank market that fulfills the minimum volume of CNY 10 million, and/or. c) Traded price from the exchange market hat fulfills the minimum volume of CNY 1 million. 3.2 Maturity Bands Each eligible bond must be within one of the following maturity bands measured on the respective re-balancing date: 1 Year: Maturity 0.25 to <1.25 Years 2 Years: Maturity 1.25 to < 2.25 Years 3 Years: Maturity 2.25 to < 3.25 Years 4 Years: Maturity 3.25 to < 4.25 Years 5 Years: Maturity 4.25 to < 5.25 Years 6 Years: Maturity 5.25 to < 6.25 Years 7 Years: Maturity 6.25 to < 7.25 Years 8 Years: Maturity 7.25 to < 8.25 Years 9 Years: Maturity 8.25 to < 9.25 Years 10 Years:Maturity 9.25 to < Years

6 SECTION Year, 3 Years, 5 Years, 7 Years, and 10 Years are identified as `critical band` for the input of model generated yield curve Bonds with maturity above 10 years are usually illiquid, and not eligible for criteria in rules 3.1. Additionally, the bond is selected according to rules 3.5, so that the yield curve could be generated beyond 10 years. 3.3 Sampling Process The composition of sample bonds is reviewed regularly on a monthly basis. The sample bonds are rebalanced on the last trading day each month after the last calculation of CNI Bond Valuation The maximum number of sample bonds is 20 in each bond category, and the distribution of sample bonds must satisfy the following restrictions: a) For each maturity band, the number of sample bonds from any issuer is limited to 3, and the subtotal is capped at 5. b) For each of the critical band aforementioned, there must be at least one sample bond Bonds are assigned to Set A or B depending on market-making activities. A bond is assigned to Set A if it satisfies the following requirement; otherwise, it s assigned to Set B: a) Bond fulfils the maximum yield spread of 200 BP on at least three quarters of the trading days between the two adjacent re-balancing dates; And/or. b) Bond has at least three market makers on the re-balancing date Subject to rules on the composition, sample bonds are selected from Set A market-making bonds. In the event that the number of chosen bonds is less than the maximum of sample size, the rest eligible bonds of Set B are considered for inclusion as well. a) In accordance with rule 3.4, each eligible bond is assigned an overall ranking order in the respective category. b) For each of the critical band aforementioned, one bond is defined as benchmark if it ranks the top among Set A market-making bonds in that band, and admitted directly as sample bond. If no benchmark could be defined, benchmark in the previous period will be preserved in the sample. c) The remaining Set A bonds are selected by their overall ranking. If it does not reach the maximum number of sample bonds, the eligible bonds of Set B are then selected by the overall ranking.

7 SECTION Ranking Criteria The ranking of each bond is determined by a combination of the following: a) Effective Amount: is the notional amount adjusted by age of issuance. The following shows the adjustment formula: Where, AdjAmount refers to effective amount after the adjustment Amount refers to notional amount on the re-balancing date Age refers to time in years since issuance refers to the adjustment factor, assuming effective amount decays at the rate of 35% annually b) Cumulated Turnover: is the daily trading volume between the two adjacent re-balancing dates, including trades in the Shenzhen Stock Exchanges, Shanghai Stock Exchanges and Interbank Bond Market. Trades in the first 3 trading days are excluded for new issues Bonds are ranked according to their effective amount and cumulated turnover in descending order, respectively. Ties are broken by the following criteria: a) More recent issue date. b) Higher amount outstanding. c) Longer time to maturity The overall ranking of a bond is then the greater of its effective amount rank and liquidity rank, Where, refers to the rank of effective amount refers to the rank of cumulated turnover The overall ranking is re-ordered in ascending orders to define the bond hierarchy. If there is a tie, the position of each bond is determined by the effective amount rank. 3.5 Additional Criteria for Selection of Long Term Bond The number of long term bond with maturity above 10 years is limited to 1 in each bond category. The eligible bond must have a minimum bond life of 20 years at issuance.

8 SECTION For treasury bonds, the selection of long term bond is usually the one that has the maximum price input coverage between the two adjacent re-balancing dates. In the event there are new issues, the bond with consecutive prices is considered for inclusion. If there are no observable prices in the long term band, the bond used in the previous sample period will be adopted Due to lack of liquidity, the selection of policy bank bonds takes synthetic form in the long term range. The synthetic bond is constructed using the sample of long term treasury bond in the same period, for which the coupon rate is adjusted by the following formula: Where, AdjCoupon refers to the coupon rate (%) of the synthetic bond Coupon refers to the coupon rate of the long term treasury bond refers to the adjustment factor, assuming a constant spread of 0.15 between treasury bonds and policy bank bonds in the long term band

9 SECTION PRICE DATA INPUT 4.1 Data Sources The price data is collected from multi-sources, including quoted prices from market makers, and traded prices from the exchange and interbank bond market. 4.2 Price Input Hierarchy A hierarchy of price inputs is defined for the CNI Bond Valuation, which aims to obtain the consolidation of market observable prices Level 1: Mid Price of best quote from market makers, given the following restrictions: a) Quotes are non-negative, and yield spread exceeds -5BP. b) Yield spread must be within the threshold level for each bond category, which is the larger of the following: A pre-set threshold of 50BP. For bonds with maturity less than 1 year, the pre-set threshold is enlarged by linear extrapolation to 200 BP; If there are at least five market-making bonds, a threshold value is calculated specifically for the day Where, P75 and P25 refer to the yield spread of the bond that ranks at the top and bottom 25% among all the market making bonds in the same category Level 2: Close Price from the exchange market, given the following restrictions. If both Shenzhen and Shanghai Stock Exchange satisfy the conditions below, then the one that has a greater trading volume will be adopted. a) The daily trading volume exceeds CNY 1 million. b) The daily price fluctuation is not greater than 10%. c) The price deviation is less than 2%, compared to CNI evaluated prices on the previous trading day Level 3: Volume Weighted Average Price from the interbank bond market, given the following restrictions: a) The daily trading volume exceeds CNY 10 million. b) The daily price fluctuation is not greater than 10%. c) The price deviation is less than 2%, compared to CNI evaluated prices on the previous trading day If no price can be obtained from the aforementioned pricing hierarchy, the price used in curve fitting on the previous day will be adopted for sample bonds. Historical prices can be used up to 14 consecutive calendar days.

10 SECTION If there is still no valid price after applying rule 4.2.5, CNI evaluated price on the previous day will be adopted. The bond will be excluded from sample bond, unless it needs to be preserved in the curve fitting process (usually long term bond).

11 SECTION YIELD CURVE MODEL AND ESTIMATION METHOD 5.1 Yield Curve Model A model based on cubic spline is adopted for the fitting of yield curve. The cubic spline is a piecewise cubic polynomial function, which gives the following set up of the model: i=1,2,,k-1 Where refers to the logarithmic of the discount factor, i.e. the present value in logarithm of 1 unit payoff t years later } refer to the pre-set knot points of the cubic spline, as determined in rule { } refer to the unknown parameters in the cubic spine, of which a set of constrains must be met in rule The following gives the knot points in the cubic spline function, which are considered to be appropriate for the Chinese bond market: The first knot in the nearest range is set as 0.25 The last knot in long-term range is set as the time to maturity of the long-term sample bond (rounding up in years) Internal knots are set as the critical bands aforementioned, i.e. {1, 3, 5, 7, 10} The following constraints are applied to the spline parameters, so that the model generated yield curve is more representative of market behavior: a) Continuous and twice differential at the knot points b) Initial Condition: Discount factor at zero maturity is zero in logarithm, and the implied forward rate has a linear trend c) Long-term Convergence: The implicit forward rate converges to a stable level at the last knot point of Tk For each bond category, a set of zero coupon, par and forward yield curves are produced according to the respective relationship with the discount factors:

12 SECTION 5 a) Zero Coupon Yield Curve Where, r (t) is the annualized zero coupon yield, also known as the spot rate; b) Forward Rate Yield Curve Where, is the annualized forward rate during time interval t and t+h, and the length of step h is set to be 1 year. The forward rates can be related to discount factors by calculus, as shown below: c) Par Yield curve Where, y(t,f) is the par yield of synthetic bond with a uniform coupon, which is defined as the coupon rate so that the redemption yield is equal to annual coupon, and thus the bond s price would stay at par value. f is the coupon frequency with value of 2 (semi-annual payment). 5.2 Estimation Method The yield curve model is estimated each day to minimize the error between price inputs and model generated prices for sample bonds The target function of `Error minimization` is defined as : Where, MSE is the mean squared pricing error of the yield curve model is the price inputs of the sample bonds used in curve fitting is the model generated prices, as determined in Section 6 is the weighting factor of each sample bond All sample bonds are equally weighted in the process of curve fitting.

13 SECTION The coefficients in the target function can be solved with the method of iterative nonlinear least square. The set of yield curves is produced once all coefficients are obtained. 5.3 Tax Effects on Treasury Bonds Currently, the interest from treasury bonds are tax free, but capital gains (losses) of the bonds will be taxable at the ordinary rate of 25%. Others bonds are not eligible for tax exemption The system of taxation on treasury bonds yields a premium on bonds with higher coupons, of which the price is usually above par and the expected capital loss if held-to-maturity can be deduced from taxable income The CNI Bond Valuation take account of tax effects on treasury bonds in the calculation of evaluated pricing in Section 6.

14 SECTION EVALUATED PRICING FORMULAE AND CALCULATION METHOD 6.1 Full Price If a bond is eligible for evaluated pricing, full price is calculated as the present value for the future cash flows of the bond, where the discounting factor is set as per yield curve in the respective bond category. Full price compromise two parts: clean price and accrued interest as shown below: Where is the evaluated full price of bond i at time t is the evaluated clean price of bond i at time t, as determined in rules 6.2 is the accrued interest of bond i at time t, as determined in rules Clean Price The clean price is calculated by deducing accrued interest from the evaluated full price. In addition to the discounted cash flows, an adjustment of tax effects is applied for treasury bonds The following gives the calculation formulae of clean price: Where is the present value for future cash flows of bond i at time t is the jth coupon payments of bond i after time t is the time to jth coupon payments of bond i at time t is the face value of bond i is the time to maturity of bond i at time t is the discounting factor, as determined by the yield curve model is the adjustment for tax effects on treasury bonds is the capital gains of bond i at time t, compared to the issuing price is the effective tax rate on capital gains, assuming to be 15%

15 SECTION For the evaluation of treasury bonds, the following formula is equivalent to rules 6.2.2: 6.3 Accrued Interest A day count convention of Actual/365 is used for the computation of accrued interest to a notional of For fixed rate coupon bonds, Where is the coupon rate in the current coupon period is number of days since last coupon payment or issuance for new issues For repayment upon maturity bond, Where, is number of days since the beginning of current coupon period For zero coupon bond, is the number of years between valuation date and issue date Where is number of days since issuance is the number of days between issue date and maturity date is the issuing price of the bond

16 APPENDIX A A. FURTHER INFORMATION Further information on the CNI Bond Valuation & Yield Curve Data Series is available from SSI (website: who will also welcome comments on the Methodology and on the Valuation Data. Enquiries should be addressed in the first instance to: Index Department Shenzhen Securities Information Co., Ltd. 10 th Floor, Block 1 Shenzhen Investment International Business Center No.1061 Xiangmei Road, , Futian District Shenzhen, P.R.China +86 (0) (0) (fax) Website: index.service@cninfo.com.cn Shenzhen Securities Information Co., Ltd ( SSI ), CNI is a trade mark of Shenzhen Securities Information Co., Ltd ( SSI ). All rights in and to the CNI Bond Valuation & Yield Curve Date Series ( CNI Bond Valuation ) vest in SSI. No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of SSI. Distribution of CNI Bond Valuation data and the use to create financial products requires a license with SSI. All information is provided for information purposes only. SSI makes no claim, prediction, warranty or representation whatsoever, expressly or impliedly, as to the results of the use of the CNI Bond Valuation Data. Every effort is made to ensure that all information given in this publication is accurate, but no responsibility or liability can be accepted by SSI or its licensors for any errors or for any loss from use of this publication.