TERM STRUCTURE ESTIMATION IN ILLIQUID GOVERNMENT BOND MARKETS: AN EMPIRICAL ANALYSIS FOR INDIA

Abstract

With increasing liquidity of the Indian sovereign debt market from 1997, it has become possible to estimate the term structure in India. However, several frictions that cause individual securities to be priced differently from the “average” pricing in the market characterize the market. In such a scenario, traditional estimation procedures like ordinary least squares using various functional forms do not perform well. In this paper, we find that mean absolute deviation is a better estimation procedure in illiquid markets than the ordinary least square. We further find out a novel liquidity weighted objective function for parameter estimation. We model the liquidity function using the exponential and hyperbolic tangent functions and suggest the most robust model for estimating term structures in India.