Pricing Bonds In The Australian Market Analysis

Pricing Bonds in the Australian Market is an article, which appeared in the 33rd Australian Journal of Management in 2008. Written by Bilson et al., the article does an incredible job in highlighting issues pertaining to the modeling of the term structure of interest rates. The article begins by appreciating the fact that there are various models associated with the yield curve. The authors highlight the significance of the term structure of interest rates by offering valid examples. For instance, the article points out that the yield curve plays a critical role in the valuation of a coupon bond (Christopher M. Bilson 2008). According to the authors, this demands that a coupon bond is reduced to individual cash flows valued as zero-coupon bonds (Christopher M. Bilson 2008). The article points out that theoretical application of the yield curve guarantees exceptional predictability of the term structure. However, realistic markets rule out the smoothness and predictability of the yield curve. The numerous challenges associated with the volatile nature of the market makes it vital for the application of various models of estimating the term structure (Christopher M. Bilson 2008). The article aptly highlights four broad categories of models of the term structure of interest rates. According to the authors, each model assumes unique functional forms of the discount function. The authors point out that in the polynomial and duration-based models, the yield curve can be effectively arrived at through the use of one polynomial discount function. The article further focuses on the Piece-Wise Linear Model whereby a straight line is plotted between two consecutive yield observations (Christopher M. Bilson 2008). The authors further point out the significance of Australia in the study mainly due to its sophisticated economic infrastructure. The article asserts that Australia’s fixed interest market is small and illiquid. Furthermore, lack of adequate research that documents consistent results in Australia, the authors set out to create a clear understanding of markets with differing characteristics. Furthermore, there is no agreement regarding the favorable model for estimating the yield curve. As a result of this, the authors conduct an empirical study of different term structure models that had never been used in previous examinations of the Australian yield curves. Through the use of an Australian data set, the authors examine methodologies associated with pricing of bonds. The authors reaffirm the fact that in the Australian market, empirical evidence has only been limited to short end models. In order to achieve the goals of the study, the authors fit alternative models across the yield curve. Subsequently, the authors repeat the analysis on a rolling-time series (Christopher M. Bilson 2008). Consequently, the authors can effectively undertake residual analysis in order to identify errors of underlying pricing equations as related to the yield curve (Christopher M. Bilson 2008). The article emphasizes the fact …show more content…
It also reflects the market participants’ assessment of various monetary policy conditions (Rogers 1995). Theoretically, an efficient market implies that various irregularities in the yield curve can be efficiently priced out by arbitrageurs thereby leading to significant predictability within the term structure (Christopher M. Bilson 2008). However, the nature of financial markets makes it quite difficult to identify an observable continuous term structure in reality. One of the basic uses of the term structure entails the valuation of a coupon bond (Christopher M. Bilson 2008). In this case, a coupon bond is reduced into individual cash flows valued as zero coupon bonds. However, coupon bonds are incapable of fully substituting of the term structure. Therefore, modeling the term structure of interest rates is crucial when it comes to comprehending the overall credit market scenario in any given …show more content…
This is mainly because the comparative analysis of the various models of estimating the yield curve remains largely untested in the country (Rogers 1995). Intriguingly, the bulk of Australian research has historically paid immense attention to the time-series of the short end of the yield curve (Rogers 1995). Majority of Australian studies follow the precedent set by tests of the Expectation Theory, which was mainly focused on the short end of the yield curve. Furthermore, the forecasting capabilities of Australian short rate models are considerably minimal. It is extremely clear that one-factor models cannot comprehensively account for the yield curve. Therefore, Australia’s evident focus on the short rate is a key limitation when it comes to comprehending the country’s term structure of interest