Redefining and Constructing Basic Term Structures of Interest Rates and Analyzing Price Errors of Indonesian Government Bonds and the US Treasuries

Abstract

Some researchers blame market liquidity for idiosyncratic price biases. Varying liquidities bias not only bond prices, but also term structure of interest rates and other asset valuations. To hinder volatile term structure, we need to realize basic yields which had been a concept since 1942 to produce stable reference of term structures. We have reviewed the basic yields from the current risk management concept and redefine the basic term structure as a liquidity-risk-premium-free term structure. To construct the basic term structure, a new methodology based on statistical modes of liquidity measures is available to calculate basic bond prices. We provide some liquidity measures, such as: bid-ask spread, quotation frequency and time-to-maturity. Since many previous literatures considered transaction frequency was not a significant measure, we split the measure into positive-return and negative-return quotation frequencies. Contrary to the previous literatures, our regression shows that the quotation frequency is a significant measure. The estimation have successfully implemented the methodology to estimate the data of on-the-run Indonesian domestic government and the US Treasuries' bonds from April 2013 to October 2013 to represent developing and developed markets. Using composite or nominal bootstrap estimation, we find out that between-maturity and between-day prices contain the mixtures of homoscedastic and heteroscedastic errors. The estimation has changed between-maturity price error becoming more homoscedastic. However, between-day price error stays heteroscedastic which it may come from country and inflation risk premiums.