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when fitting gov bond curves, What are different logic's used by traders to set the weight for the different bonds ?

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2 Answers 2

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Let's define the problem as follows: Given a set of $N$ bonds, we wish to create a discount curve, composed of $M$ degrees of freedom, so as to minimize the weighted price errors: $$ \min_{m_1...m_M} \sum_{i}^N w_i(P_i - \hat{P}_i(m_1..m_M))^2, $$ where $P_i$ is the quoted price of bond $i$, $\hat{P}_i$ is the theoretical price of bond $i$ using the fitted discount curve, and $w_i$ is the weight assigned to bond $i$, and $m_j$ is the value taken by one of the degrees of freedom. You are specifically asking about how to choose $w_i$.

There are many options, depending on preferences and markets:

  1. The easiest is $w_i = 1$ so all the prices are weighted equally. This is actually a good option if you don't care about the short end of the yield curve that much (e.g., you are a long bond trader).

  2. The most popular choice is $w_i = 1 / \text{DV01}_i^2$. This roughly translates the minimization problem into minimizing yield errors. This would generate much better fit at the front end of the curve, while sacrificing the long end.

  3. The next option is to use a blended approach, setting $w_i = \lambda + (1 - \lambda) / \text{DV01}_i^2$. By choosing $\lambda\in[0,1]$, you effectively can control the relative importance of price errors and yield errors.

  4. More exotic schemes based on market segmentation are used as well; e.g., I've seen folks use duration-weighting for <1-year issues, uniform low weights for 1-10 year issues, and uniform high weights for 10-30 year bonds.

  5. On top of the more systematic weighting schemes above, you can also multiply $w_i$ by an additional ad-hoc adjustment factor to scale it up and down for specific bonds:

    • While traders in the US typically exclude on-the-run issues from curve fitting, JGB traders there fitted curves to closely mirror on-the-run issues. So in those cases, you simply multiply $w_i$ of benchmark bonds by a number greater than 1 (say 10).
    • Some prefer to lower the weights of seasoned, less liquid bonds. You can define liquidity in many ways, but the easiest method is to simply treat bonds that have rolled out of their original maturity bucket as illiquid (e.g., a 30-year Treasury bond with less than 10-years to maturity), in which case you may assign a very low weight to these bonds. I've also seen people set different weight factors depending on the distance to the original maturity.

There's no rule that fits all scenarios. It depends on the market generally, the market conditions in real-time, and how you plan to use the curve.

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  • $\begingroup$ Whilst the question asks directly about weights and this is an excellent response, there are also other factors with subjectivity, such as interpolation style(s) of the curve, whether to account for the convexity element of the coupon level, how many degrees of freedom the curve has etc. It may well be that some of these additional factors out weigh (pun intended?) the effect of how to choose the weights. $\endgroup$
    – Attack68
    Commented Mar 21 at 14:49
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    $\begingroup$ Thanks @Attack68. It'll be be great if you elaborate on these points in an answer as well =D $\endgroup$
    – Helin
    Commented Mar 21 at 22:37
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@Helin provided a great answer for the specific question.

I would note that when curve building your framework always falls under one of three regimes:

  • Completely specified: the number of degrees of freedom of the curve matches the number of (sufficient) instruments.

  • Overspecified: the number of degrees of freedom is less than the number of (sufficient) instruments.

  • Underspecified: the number of degrees of freedom is more than the number of (sufficient) instruments.

When completely specified, weights are essentially (to machine tolerance) irrelevant because the minimum solver solution is attained at zero.

When underspecified, the solver is chaotic. It is practical to add information (usually pseudo-instruments) to convert to the completely specified case (or overspecified).

Only in the overspecified case do weights have an impact.

But there are other subjective choices besides weights that influence the shape of resultant curves. Below are three example factors. Suppose calculating a matrix of curves from the following set of combinations:

  • Weights: [(1,1,1), ($1/3^2, 1/6^2, 1/10^2$)] (2 combinations)
  • Position of degrees of freedom: [(5y, 10y)] (1 combination)
  • Interpolation [(log linear), (log cubic)] (2 combinations)

Here is a numerical example of the first of those combinations, in an overspecified regime with 3 bonds: apprx 3y, 6y and 10y:

# PYTHON
from rateslib import *

b1 = FixedRateBond(dt(1999, 2, 4), "3y", fixed_rate=2.0, spec="ust", curves="curve")
b2 = FixedRateBond(dt(1999, 5, 10), "6y", fixed_rate=2.0, spec="ust", curves="curve")
b3 = FixedRateBond(dt(1999, 7, 4), "10y", fixed_rate=2.0, spec="ust", curves="curve")

curve = Curve(
    nodes={
        dt(2000, 1, 1): 1.0,  # 0y
        dt(2005, 1, 1): 1.0,  # 5y
        dt(2010, 1, 1): 1.0,  # 10y
    },
    id="curve",
)

solver = Solver(
    curves=[curve],
    instruments=[
        (b1, (), {"metric": "clean_price"}),
        (b2, (), {"metric": "clean_price"}),
        (b3, (), {"metric": "clean_price"}),
    ],
    s=[101.0243, 101.27159, 101.301937],
    weights=[1., 1., 1.]
)
SUCCESS: `conv_tol` reached after 5 iterations (levenberg_marquardt), `f_val`: 0.19429355288961916, `time`: 0.0296s

Constructing all these combinations and plotting curve.plot("1b", comparators=[curve2, curve3, curve4])

enter image description here

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  • $\begingroup$ How is the vector $s$ specified? $\endgroup$
    – Nick
    Commented Mar 23 at 8:25
  • $\begingroup$ s= observed (clean) prices of the bonds at close of day. $\endgroup$
    – nbbo2
    Commented Mar 23 at 9:57

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