Descriptive Bond Yield and Forward Rate Models for the Pricing of British Government Securities

This paper discusses possible approaches to the construction of gilt yield indices pub lished by the Financial Times The existing method described by Dobbie and Wilkie splits bonds into high medium and low coupon bands and ts separate yield curves to each In recent years this method has been identi ed as susceptible to catastrophic jumps when the least squares t jumps from one set of parameters to an other set of quite di erent 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 Indices Working Group Recent changes in the taxation of bonds has further prompted the need for a review of the yield indices Signi cantly since the announcement of the new tax regime the old coupon e ect has been removed This has made the use of a single forward rate curve appropriate for the rst 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 signi cantly better t than the present yield curve model It is also argued that the risk of catastrophic jumps has been reduced signi cantly