Hong Kong Dollar Yield Curve (Term Structure)

Peter Luk

27 November 2003
 Hong Kong Dollar Yield Curve (Term Structure)
Peter Luk 27 November 2003

Introduction

Actuaries are familiar with yield curve. A yield curve is a curve showing the yield (to
maturity) at various terms (to maturity). Many of such curves show terms from as
short as one week to as long as 30 years. Unfortunately for Hong Kong dollar interest
rates, information beyond 10 years is not readily available. A typical yield curve chart
showing HK dollar and US dollar yield curves is presented below.

US$ and HK$ Yield Curves at 31 October 2003

5.0%

4.5%

4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%
0 1 2 3 4 5 6 7 8 9 10

US$ HK$

Financial communities are increasing using term structure to depict such relationships.

For those who are not familiar with this terminology, a short description of the
relevant terms is presented below.

Spot rate is the yield to maturity of a zero-coupon bond.

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Short rate is the interest rate implied by the spot rate for a period of time (usually one
year) in the future.

Yield curve depicts the relationship between yields (to maturity) for various different
terms.

Term structure depicts the relationship between short rates for various different
terms.

The following chart shows the relationship between the spot rate and the short rate in a
graphical form.

If the spot rate for one year s1 = 1%, the spot rate for two years s2 = 2%, the spot rate
for three years s3 = 3%,

then the short rate r1 is also 1%:

the short rate r2 = 1.02/1.01-1 = 0.99% and

the short rate r3 = 1.03/1.02 1 = 0.98%

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A New Paradigm

Modern day actuaries and accountants are facing a new challenge. At present, each
country has its own GAAP (Generally Accepted Accounting Principles) for its
insurance companies such as US GAAP, Canadian PPM (or more recently CALM),
Australian MOS and UKs Achieved Profits, etc. These have caused a great deal of
confusion among investors as more and more insurance companies are becoming truly
global. The international accounting professional bodies have for quite some time
been trying to come up with a unified set of accounting standards applicable to
everybody. Originally planned for implementation in 2005, it is now apparent that
more work needs to be done and the final implementation day could be easily three to
five years late. The latest Exposure Draft No. 5 released by IASB (International
Accounting Standards Board) has attracted a lot of comments from various interested
parties, among which are Actuarial Society of Hong Kong and International Actuarial
Association.

While there are many forms of disagreement, it is significant that a consensus has been
reached: all insurance liabilities should be valued by the discounted cash flow method
using realistic interest rates. It is important to note that the so-called realistic interest
rates will not be the actuaries best estimates, as have been so in the past. These
realistic interest rates must be calibrated to (i.e., fit to) the market.

The present value of each cash flow at a particular point of time in the future shall
equal the cash flow discounted at the spot rate for that particular term, such spot rate
being the prevailing market rate at the time of valuation.

This method represents a drastic departure from the method our actuaries have been
used to for centuries, who have been using one average rate for all the liabilities in the
future. In essence, this one rate is going to be replaced by a series of rates. Worse (or
better?) is yet to come. For actuaries who have used deterministic interest rates all
their life, this could amount to a culture shock. It has been agreed that, where
appropriate (e.g., where there are guarantees or options), stochastically modeled
interest rates should be used instead of just one rate for each term.

Most stochastic models for interest rates are developed for short rates, not spot rates.
This means that one has to first determine the implied zero-coupon rates based on
information available from bonds with coupons. Then, one has to decompose the spot
rates into a series of short rates. Moreover, instead of valuing one particular cash flow
at a particular point of time in the future using a series of short rates, one has to replace
such short rates with a distribution of short rates with their appropriate probabilities
(usually normal or lognormal distributions are used, as described below).

One effect of doing so is, for instance, where there is interest guarantee, the liabilities
will no longer be a continuous and differentiable function of the interest rates all the
time.

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 Even though one has mastered all the mathematics, the time and expertise needed to
change the computer system to value the liabilities will be enormous.

Hong Kong Dollar Term Structure/Yield Curve

Extensive market data for HK dollar yields up to 10 years are available since 1997 (see
chart below).

10-Year Government Bond Yields

18

16

14

12

10
%

0
62

64

66

68

70

72

74

76

78

80

82

84

86

88

90

92

94

96

98

00

02
n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-

n-
Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Month

US Japan Hong Kong

For rates beyond 10 years, one may have to use US dollar yields as a proxy as long as
the peg stays. While admittedly this is far from satisfactory, there seems to be no
better alternative at the moment.

Practitioners have been using Exchange Fund rates as the risk free rates. Such rates
are available for terms from as short as one week, one month, etc. to as long as one
year, two years, up to 10 years. The intermediate rates can be easily obtained by

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interpolation. A straight linear interpolation is probably as good as any. Stochastic
models can then be built to produce results that are reasonably close to short rates
obtained from the market data.

The following section describes some commonly used stochastic models available and
their relative advantages and disadvantages.

Stochastic models for term structure

A stochastic model is trying, given the short rate today, to predict what it will be
tomorrow. Instead of giving a one-number (deterministic) answer, its answer is
invariably in terms of probability distribution (stochastic). There are three basic
aspects about stochastic models where subjective decision is required.

First, the most commonly used distributions are normal and log-normal. While the
normal distribution is much easier to work with, it is liable to produce negative interest
rates, particularly in the current low-interest environment. When interest rates are high,
both distributions often produce similar results and the normal distribution will be the
preferred choice.

Second, when interest rates are low, as they are currently, people generally believe that
the lowinterest environment will not last long and someday interest rates will move
higher. When interest rates are high, as in the early 1980s, people believed that the
high-interest environment will not last long and someday interest rates would move
lower. This intuitive experience-based belief that interest rates will revert to their
invisible long-run average (i.e., the mean) is often built in a stochastic model the so-
called mean reversion feature.

Third, a stochastic model is often expressed as a differential equation together with a

number of parameters. The more the number of parameters, the more complicated the
model is. General speaking, stochastic models can be classified into two broad
categories: the equilibrium models and the no-arbitrage models. Their main
difference is illustrated in the following chart.

Equilibrium Models

Parameters The model Short Rates

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No-arbitrage Models

Parameters The model Short Rates

With the equilibrium model, the parameters (i.e., the assumptions), were first
determined and the output short rates do not always fit the market rates. People find
this unsatisfactory, even though such models are relatively easier to implement.
Consequently, the no-arbitrage models are much more popular these days.

A brief description of the equilibrium models will be given below. Three one-factor
equilibrium models will be briefly discussed. Because of their complexity and
unpopularity, the so-called two-factor models (such as Fong and Vasicek model and
Longstaff and Schwartz model) will not be dealt with here.

For the one-factor model, the most important parameter is called drift rate. It is the
rate at which the interest rate will drift apart from the current rate. Under the
Rendelman and Bartter model, the drift is one direction, depending on whether this
parameter is positive or negative. Both Vasicek model and Cox, Ingersoll and
Ross models introduce mean reversion so that the drift is no longer one direction only.
In all these models, the parameters associated with the drift rate are constants.

Under the Vasicek model, the standard deviation of the drift rate is a constant. Under
the Rendelman and Bartter model, the standard deviation of the drift rate is in
proportion to the drift rate (a process that is called geometric Brownian motion) and
under the Cox, Ingersoll and Ross model, the standard deviation of the drift rate is in
proportion to the square root of the drift rate a compromise between the earlier two.

The no-arbitrage models use todays term structure to produce the parameters of the
models. Therefore they seem to be more credible and are more popular with the
practitioners.

Published in 1986, Ho-Lee (HL) model was the first (and the simplest) no-arbitrage
model. (Dr. Thomas Ho a familiar speaker at Society of Actuaries events came to
Hong Kong a few years ago to talk to a seminar on insurance products). The model
assumes the short rate has a constant standard deviation and its drift, instead of being a
constant, is a function of time so that the model can be calibrated to the market rates
(i.e., fit to the yield curve). HL model does not incorporate mean reversion.

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The Hull-White (HW) model, published in 1990, can be thought of as Vasicek fitted
to the term structure or Ho-Lee model with mean reversion. It assumes normally
distributed interest rates, has a great level of analytical tractability and is popular
among practitioners.

The Black-Derman-Toy (BDT) model, also published in 1990, is the most complicated
model among those visited here. Contrary to the above two models, this model
assumes the short rate is log-normally distributed, thus making it necessary to handle it
algorithmically. The most popular method is to construct a binomial tree for the short
rate. Many practitioners choose to fit the rate structure only, holding the volatility
(standard deviation) constant. In this way, this model can be regarded as a lognormal
version of HL model, in which case we have what is called Kalotay-Williams-Fabozzi
(KWF) model.

The Black-Karasinski (BK) model, published in 1991, is similar to the above BDT
model, but it is a more general model where the reversion rate is decoupled from the
volatility. Implementation of this model requires the construction of trinomial trees.

The most common method to use these models to value a future cash flow is to build a
binomial tree, just as it is used to calculate the option price, in which case the KWF
model is probably the easiest.

However, the HL model and HW model can be implemented analytically, which

means that one can apply Monte Carlo simulation method to value the future cash
flows. This may be a very useful feature for actuarial valuation. If this is the case, the
Hull-White model will be our model of choice. A simplified way to implement this
model is described here.

Assumptions:

Let all interest rates be expressed in the continuously compound form.

Let the time unit be 1. Let time (t) be represented as 0, 1, 2,etc. and t = 1.

Let P1, P2, P3, etc. represent the prices today of zero coupon bonds paying 1 at time 1,
2, 3, etc. ( and P0 = 1 ).

Let S1, S2, S3, etc. represent the spot rates for the corresponding terms. Therefore,
S1 = ln P1, S2 = ln P2, S3 = ln P3, etc. , and St = ln Pt,

Let rt represents the short rate today for the period from t to t+1. Then,

St = r0 + r1 + r2 + + rt-1

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rt = St+1 St = ln Pt ln Pt+1

Let represents the instantaneous rate at which the interest rate reverts to its normal
value (which itself is a function of time), often called the speed of reversion.

Let ft represents the future spot rate, i.e., the spot rate at time t for the period from t to
t+1 ( t = 0, 1, 2, ) , and represents the instantaneous volatility (standard deviation)
of ft . Under the Hull-White model, is a constant.

The model will produce the following output:

Output:

ft is a normally distributed variate with the following mean mt and standard deviation
:

mt = E (ft) = rt + t = ln Pt ln Pt+1 + t

where,

2 ( 1- k2 )
t = ( 1 + k + k2 + k3 + kt-1 )2 is an adjusting term to convert the
4
current short rates into the future spot rates for the same time period and

k = e-

Simulation:

Simulation is a very effective method to implement the HW model. The following

example shows how this can be done.

Assuming the time unit is one year and that the prices of zero coupon bonds P1, P2,
P10, are available. It is further assumed that and are also known and we want to
model the term structure for the first 10 years.

The above formula can be used to calculate m0, m1, m9, noting that m0 = ln P1.
Assuming, to start with, that we want to generate 1,000 iterations. For each iteration,
nine random standard normal variates (z) are to be generated to apply to m1, m9 such
that:

f = m + z

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For example, if there is an interest guarantee of 4% p.a., then any fs that is less than
4% can be replaced by 4% to arrive at a higher accumulated number.

The following is a very efficient program to generate random standard normal variates
using VBA on an Excel worksheet:

Function Normal()

Dim u, v, r, s
Static Flag As Integer, y As Variant
'
Flag = 1 - Flag
If Flag = 0 Then Normal = y: Exit Function
Do
u = Rnd * 2 - 1: v = Rnd * 2 - 1
r = u * u + v * v
Loop Until r < 1
s = Sqr(-2 * Log(r) / r)
Normal = u * s
y = v * s
End Function

For a reasonably fast PC, it takes less than one second to generate 1,000 random
standard normal variates.

To further improve the efficiency of the model, one can use the antithetic variance
reduction method. For each z produced by the random generator, we also use z for
another iteration. Therefore, to implement the model for 1,000 iterations (i.e., 9,000
normal variates produced) one gets effectively 2,000 iterations.

By generating enough iterations, this method can be used to value any interest
guarantee, options, etc. by calculating the mean, the value at risk, the conditional tail
expectation, etc. A simple example is given below.

A single premium of $1,000 is invested in a 10-year zero-coupon bond yielding 4.1%.

The policy guarantees an interest of 4.0% p.a. on annual basis (i.e., a hard guarantee).
Using the above method by generating 5,000 iterations (i.e., a total of 10,000 iterations
including the antithetic iterations), it is shown that the company is short by 3.3%.
There is 0.1% chance that the company may be short by 10% and 15% chance that the
company may be short by 5%. In other words, the company needs to charge an extra
premium of $33 just to cover the guarantee.

END

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References:

Options, Futures and Other Derivatives John C. Hull. 2002

Pricing and Investment Strategies for Guaranteed Equity-Linked Life Insurance

Michael J. Brennan (FIA), Eduardo S. Schwartz. 1979

Quantitative Modeling of Derivative Securities Marco Avellaneda, Peter Laurence.

2000

Options, Theory, Strategy, and Applications Peter Ritchken. 1987

Introduces Quantitative Finance Paul Wilmott. 2001

Implementing Derivatives Models Les Clewlow, Chris Strickland. 1999

Term-Structure Models using Binomial Trees Gerald W. Buetow, Jr., James

Sochacki. 2001

Option Embedded Bonds Israel Nelken. 1997

Pricing Convertible Bonds Kevin B. Connolly. 1998

Options, Futures and Exotic Derivatives Eric Briys, Mondher Bellalah, Huu Minh
Mai, Francois de Varenne. 1998

Options and the Management of Financial Risk Phelim P. Boyle (FCIA, FIA). 1992

Analytical Implementation of the Ho and Lee Model for the Short Interest Rate
Dwight Grant, Gautam Vora. 1999

Hull and White Model of the Short Rate: An Alternative Analytical Representation
Dwight Grand, Gautam Vora. 2001

Numerical Implementation of Hull-White Interest Rate Model: Hull-White Tree vs.

finite Differences Artur Sepp. 2002

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