Descriptive Bond-Yield and Forward-Rate Models for the British Government Securities' Market: [forms Part Of: Report of the Fixed-Interest Working Group, B.A.J. 4, II Pg.213–383]

Abstract

This paper discusses possible approaches to the construction of gilt yield indices published by the Financial Times. The existing method, described by Dobbie & Wilkie (1978) splits bonds into high, medium and low-coupon bands and fits separate yield curves to each. This method has been identified as susceptible to ‘catastrophic’ jumps when the least-squares fit jumps from one set of parameters to another set of quite different values. This problem is a result of non-linearities in the least-squares formula which can give rise to more than one local minimum. A desire to remove the risk of catastrophic changes prompted this research, which is being carried out as part of the work of the Fixed Interest Working Group.Recent changes in the taxation of bonds has, further, prompted the need for a review of the yield indices. Significantly, since the announcement of the new tax regime, the old coupon effect has been removed. This has made the use of a single forward-rate curve appropriate for the first time.A particular form of forward-rate curve is proposed as the basis for a revision of the gilt yield indices. This curve appears to give a significantly better fit than the present yield–curve model. It is also argued that the risk of catastrophic jumps has been reduced significantly.