Market Prices versus Fair Value Pricing for Fixed Income: Why the Diff?

Abstract

Market participants are unfailingly amazed that so much of US fixed income is illiquid. Given the sheer number of individual bonds, not every bond trades every day, yet many participants require a price each day for each bond. Consequently, fair value pricing services have arisen to supply a price. This article will show that market prices and fair value pricing are not directly interchangeable and can even have different statistical properties as a result of the illiquidity in the bond market. For the corporate market, this article will show how fair value pricing can be inferred from the likely market price. In the opposite direction, for the mortgage market, this article shows how the most liquid mortgages can influence the generic mortgages held in the benchmarks. To calibrate the appropriate model to the appropriate goal, it is important that quantitative analysts appreciate these relationships.