Introduction

The use of public debt is as old as financial institutions themselves. Treasury securities are the best way for national governments to raise money from the public, which in todays advance financial world means the whole world. In Bangladesh though, this is limited to national market. Here the instruments are primarily used for maintenance of Cash Reserve Requirement (CRR) and Statutory Liquidity Reserve (SLR) for commercial banks. But the potential is limitless here for both the Government and Investors if the market can be developed. This paper discusses the importance and untapped possibility that can be offered by the treasury securities in Bangladesh.

Origin of the report:

This paper entitled TREASURY SECURITIES OF BANGLADESH: AN EMPIRICAL STUDY OF TREASURY BILLS & BONDS is the terminal requirement of the internship program for the degree of Bachelor of Business Administration Program offered by Department of Finance under University of Dhaka. It is compact professional progress rather than specialized. This report has been prepared as per academic requirement after comprehensive study and under supervision and guidance of the full-time faculty of Department of Finance.

Objectives of the report:

This report searches for the answers to the following problem: The Treasury security sector of Bangladesh and of developed countries. What are the yield curves of T-Bills and T-Bonds? What financial innovations and reengineerings can be done to increase liquidity and reduce transaction costs in this market? Why Theoretical spot rates and curves using zero-coupon securities (Arbitrage-free approach) and Arbitrage-Free valuation approach is not relevant for Bangladeshi market? Because of current interest rate rise, are the recent off-the-run treasury securities loosing value? When buying corporate bonds rather than closest maturity treasury-bonds, should the investor keep in mind the impact of differing interest rate risk? Or are they the same? Which independent factor (s) have impact on treasury security issued (Face value)? Is the multiple regression model valid? Does volatility of yields play a role in treasury securities?

Scope of the report:

The scope of the report incorporates the treasury securities currently available. Before 2008, no data of such security is available at Bangladesh Bank on a consistent monthly basis. Thus the hypothesis testing and multiple regression done in this report are based on monthly data. This report works with samples of off-the-run security for valuation. Only relevant analysis is used like traditional valuation models, volatility calculation, bootstrapping, multiple regression, duration estimates and hypothesis testing.

Methodology:
This report uses primarily secondary data, as information regarding treasury security is found exclusively at Bangladesh bank. For corporate bonds, the information is collected from DSE library. The economic data is collected from Statistical Bureau of Bangladesh and internet information is consulted extensively for this data. The information of treasury securities of different countries is collected from their respective financial institutions websites. One of the biggest source of background theoretical information is CFA level-1 book of Equity & Fixed Income, from which some data are directly input. The analysis used here are using Bootstrapping to calculating yield curves, Valuation of T-Bonds using Traditional Valuation method, Hypothesis testing using both parametric and nonparametric tests, Multiple regression and validity testing and Volatility calculation of T-Bonds.

Limitations:
The limitations of this report as I have faced are: The lack of primary data compelled me to rely of data from Bangladesh Bank, Statistical Bureau, DSE and internet. This leaves the probability of faulty primary data. Because of lack of arbitrage opportunities in treasury securities in Bangladesh I could not conduct accepted industry analysis like Theoretical spot rates using zero-coupon securities(Arbitrage-free approach) and Arbitrage-Free valuation approach. The T-Bills & T-Bonds data before 2008 are not available, so I could not incorporate 25-year T-Bond in yield curve calculation. In 2006 and 2007 the T-Bonds coupon rates were excessively high. Such values do not conform to general data and can be considered outliers. Lack of samples in the whole report is a severe limitation. This might put the whole the analysis in question. So where ever possible tests (e.g., Test of Normality, Validity test) is conducted. In case of hypothesis testing, the data are assumed to be random. 4

Because of lack of instrument and comparable corporate bonds, Convertible bond of BRAC is compared with both 5-year and 10-year T-Bonds.

Structure of the report

The report is divided into 4 chapters. 1. Chapter-1: Provides background information on treasury securities in Bangladesh, its history and securities around the world. 2. Chapter-2: Calculated the yield curves using linear interpolation, valuation of T-Bonds are done. Theory and interpretation are also given. 3. Chapter-3: Discusses various risks of fixed income securities and relevance with treasury securities, Calculation of interest rate risk, Duration and convexity adjustment. Whether or not duration of corporate bonds differ from that of close maturity T-Bonds is tested using hypothesis technique. 4. Chapter-4: Scatterplot analysis is conducted, Multiple regression is done and tests of normality, anova table, test of serial correlation and multicollinearity is taken, and finally tested from validity. In the end the volatility of T-Bonds are calculated.

Chapter:01
1.1 Fixed-Income securities:
In its simplest form, a fixed income security is a financial obligation of an entity that promises to pay a specified sum of money at specified future dates. The entity that promises to make the payment is called the issuer of the security. Some example of the issuers are central government such as the U.S government and the French government, government related agencies of a central government such as Fannie Mae and Freddie Mae in the United States, a municipal government such as the state of New York in the United States and the city of Rio de Janerio in Brazil, a corporation such as Coca-Cola in the United States and Yorkshire Water in the United Kingdom, and supranational government such as the World Bank. Fixed income securities fall into two general categories: debt obligations and preferred stock. In the case of a debt obligation, the issuer is called the borrower. The investor who purchases such a fixed income security is said to be the lender or creditor. The promised payments that the issuer agrees to make at the specified dates consist of two components: interest and principal (principal represents repayment of funds borrowed) payments. Fixed income securities that are debt obligations include bonds, mortgage-backed securities, asset-backed securities and bank loans. Prior to 1980, fixed income securities were simple investment products. Holding aside default by the issuer, the investor knew how long interest would be received and when the amount borrowed would be repaid. Moreover, most investors purchased these securities with the intent of holding them to their maturity date. Beginning in the 1980s, the fixed income world changed. First fixed income securities became more complex. These are features in many fixed income securities that make it difficult to determine when the amount borrowed will be repaid and for how long interest will be received. For some securities it is difficult to determine the amount of interest that will be received. Second, the hold-to-maturity investor has been replaced by institutional investors who actively trade fixed income securities. (CFAI, 2011)

1.2 What are treasury securities?

In many countries that have a bond market, the largest sector is often bonds issued by a countrys central government. These bonds are referred to as sovereign bonds. A government can issue securities in its national bond market which are subsequently traded within the market. A government can also issue bonds in the Eurobond market or the foreign sector of another countrys bond market. While the currency denomination of a government security is 6

typically the currency of the issuing country, a government can issue bonds denominated in any currency.

1.3 Credit ratings:

An investor in any bond is exposed to credit risk. The perception throughout the world is that bonds issued by the U.S government are virtually free of credit risk. Consequently, the market views these bonds as default-free bonds. Sovereign bonds of non-U.S central governments are rated by the credit rating agencies. These ratings are referred to as sovereign ratings. Standard & Poors and Moodys rate sovereign debt. The rating agencies assign two types of ratings to sovereign debt. One is a local currency debt rating and the other is foreign currency debt rating. The reason for assigning two ratings is that historically, the default frequency differs by the currency denomination of the debt. Specifically, defaults have been greater on foreign currency denominated debt. The reason for the difference in default rates for local currency debt and foreign currency debt is that if a government is willing to raise taxes and control its domestic financial system, it can generate sufficient local currency to meet its local currency debt obligation. This is not the case with foreign currency denominated debt. A central government must purchase foreign currency to meet a debt obligation in that foreign currency and therefore has less control with respect to its exchange rate. Thus, a significant depreciation of the local currency relative to a foreign currency denominated debt obligation will impair a central governments ability to satisfy that obligation. (CFAI, 2011)

1.4 Methods of distributing new Government Securities

Four methods have been used by central governments to distribute new bonds that they issue: 1) 2) 3) 4) Regular auction cycle/multiple-price method, Regular auction cycle/single-price method Ad hoc auction method and Tap method.

With the regular auction cycle/multiple-price method, there is a regular auction cycle and winning bidders are allocated securities at the yield (price) they bid. For the regular auction cycle/single-price method, there is a regular auction cycle and all winning bidders are awarded securities at the highest yield accepted by the government. For example if the highest yield for a single-price auction is 7.14% and someone bid 7.12%, that bidder would be awarded the securities at 7.14%. In contrast, with a multiple-price auction that bidder would be awarded 7

securities at 7.12%. U.S government bonds are currently issued using a regular auction cycle/single-price method. In the ad hoc auction system, governments announce auctions when prevailing market conditions appear favorable. It is only at the time of the auction that the amount to be auctioned and the maturity of the security to be offered are announced. This is one of the methods used by the Bank of England in distributing British government bonds. In a tap system, additional bonds of a previously outstanding bond issue are auctioned. The government announces periodically that it is adding this new supply. The tap system has been used in the United Kingdom, The United States and Netherlands.

1.5 A Bangladesh perspective:

In terms of Government notification no. MF/FD/RDMS-1/ Policy & Organization -3/2006/147 dated 24 June 2007 issued by the Finance Division of Ministry of Finance and as per the Auction Calendar approved by the Cash and Debt Management Committee (CDMC) of the government, each treasury security is issued in Bangladesh. (Bangladesh Bank) Investment in treasury bills has grown 15.44 xs during 2005-2011. It indicates that due to maintaining expansionary monetary and fiscal policy by the subsequent governments, the deposits registered a high growth while scope of investment has not been sufficient to channel the deposit, forcing the banks to resort to treasury bills with low and declining yields. Bangladesh government treasury bills are zero coupon bonds in nature with maturities of 91, 182, 364 days. Though they are transferable such transfer is not in practice. Yield of the bills is determined by market through weekly auctions. The auctions are participated by the Primary Dealers (PDs). Individuals are not qualified to participate in the auction Treasury Bills issued by the government as an important tool of raising public finance and up to 1994 were of three types, although all of them were 90-day bills. Among these three types, bulk was represented by ad-hoc treasury bills issued to meet the cash balance need of the government. A second type was the 3-months treasury bills on tap introduced in August 1972 and their purpose was to mop up the excess liquidity of banks. The third type was the 3-months treasury bills introduced for subscription exclusively by the non-bank financial institutions, nonfinancial enterprises and the public. Initially, a limit of Tk 250 million was set for the issue of such treasury bills. Later this limit was withdrawn and Bangladesh bank was empowered to issue any amount of treasury bills for the non-bank public. Despite the withdrawal of the limit, the holdings of non-banking sectors remained small and commercial banks comprised the main market for the treasury bills. These 8

bills continued to be reissued in every ninety days. In December 1994, however, treasury bills on tap and the treasury bills for non-banks were abolished. The holdings of treasury bills by the deposit money banks generally did not exceed the amount needed to meet the liquidity requirement. A substantial part of the treasury bills issued, therefore, needed to be held by Bangladesh Bank. Of the total Treasury bill holdings, the amount of holdings by the deposit money banks was 57% at the end of 1973 and amidst fluctuation, they came down to 27% at the end of June 1982. Later, the share started to rise and stood at 68% at the end of 1992. Thereafter, it fell sharply and came down to a lowest minimum of 4% at the end of June 1995. That the Bangladesh Bank bills were allowed as approved securities for the statutory liquidity requirement of the banks and these bills were of yields higher than the treasury bill rate, might have induced the banks to reduce their holdings of treasury bills. This trend continued up to February 1997. In March 1997, the auctioning of Bangladesh Bank bills was suspended and only the 90-day treasury bills were sold through auction. Up to 25 October 1995, the treasury bills of ninety days maturity were sold at pre-determined rate usually fixed time to time by the government. Thereafter, these were sold through auction at market determined rate of interest. Subsequently, on 7 February 1996, the government introduced 30-days and 180-days treasury bills and on 16 March 1997, 1-year treasury bills for auction. Up to August 1998, four categories of treasury bills viz, 30-day, 90-day, 180-day and 1-year bills were sold regularly through weekly auction basis. From 6 September 1998, these were replaced by newly introduced 28-days, 91-days, 182-days, 364-days, 2-years and 5-years treasury bills. (Banglapedia author, 2008) Treasury bonds are issued from time to time to meet issue specific financial need (closed end) of the government with maturities ranging from 5 to 20 years. Bangladesh government issued such bonds for funding jute sector rehabilitation programs, Biman Bangladesh Airlines, Bangladesh Telephone and Telegraph (T&T) projects, Bangladesh Shilpa Rin Shangstha (BSRS). The change of 2006-07: With regard to treasury management, various reform measures were taken in FY07 for the purpose of prudent management of cash and debt of the Government. Many important steps were taken in FY07 for the purpose of increasing efficiency and maintaining discipline in the management of cash and debt of the Government. These were as follows: Structural change of record keeping system of Government transactions: The recordkeeping system of Government transactions was changed for ensuring transparency and accountability. For this purpose, Ministry / Division wise accounting system was introduced with effect from 1 July 2006.

Formation of Cash and Debt Management Committee (CDMC) and separation of Government Cash and Debt Management: A Cash and Debt Management Committee (CDMC), which was formed in the last fiscal year, started functioning during FY07. Deficit financing, which was made by auto monetization through ad hoc Treasury Bills was discontinued. Earlier, the system of automatic monetization through ad hoc Treasury Bills used to cater to both the Government's borrowing to finance budget deficit and its financing requirement to meet cash flow mismatches. In FY07, Government debt management was separated from cash management through enhancing Ways and Means Limit and arrangement of drawing facilities with Bangladesh Bank beyond this limit, and through identification of sources of financing budget deficit through specific debt instrument. Ways and Means Limit was raised from Taka 64 crore to Taka 1000 crore with effect from 1 July 2006 for the purpose of eliminating difference of intra-year cash. It was decided that the amount exceeding the Ways and Means limit would be treated as Current Overdraft bearing interest rate of Reverse-repo + 1% and the rate of interest for the amount within the Ways and Means Limit would equal to the interest rate of Reverse-repo. Outstanding amount of ad hoc Treasury Bills was transferred to OD-Blocked Account and repayment of outstanding amount was decided to be made according to an amortization schedule. Paving the way for a completely market based primary auction system : A volume based system of auctions of Government Treasury Bills and Government Treasury Bonds was introduced in FY07 through publishing auction calendar for both Treasury Bills and Treasury Bonds stating auction date and amount to be auctioned. This system has ensured transparency in the auction of Government Securities and has also helped determine competitive price. The CDMC prepared the first pre-announced volume based Auction Calendar of FY07 with effect from September, 2006. It was decided that amount borrowed through auctions of Treasury Bills /Bonds and repayment of principal and interest of the same instruments would be credited and debited directly to and from Government account with effect from 1 July 2006. Priority to Treasury Bonds as a means of deficit financing: The system of issuing 2-year and5-year Treasury Bills was abolished to match the tenor of Treasury Bills with international convention with effect from 1 September 2006. Priority was given to Treasury Bonds as a means of deficit financing to ease the burden of shorter-term debt obligation of the Government. It was decided that 15-year and 20-year Treasury Bonds would be issued from FY08. Moreover, Treasury Bills was evened out for minimizing Refinance Risk arising from the issuance of shorter-term Bills. Devolvement and Private Placement of Treasury Bills and Treasury Bonds: A system devolvement and private placement of Treasury Bills and Treasury Bonds with Bangladesh Bank was introduced in FY07 to mitigate the risk of inadequate response from the market. 10

Introduction of issuance of Treasury Bonds at Face Value: It was decided that the Treasury Bonds would be issued at Face Value through Yield based auctions from 1 July 2007 instead of fixed coupon bonds issued at a discount to lessen long-term Government debt liability arising from issuance of bonds. Ensuring active participation of Primary Dealers in securities market: Steps were taken to ensure active participation of the Primary Dealers in the securities market for the development of a vibrant bond market through revision of existing guidelines for the Primary Dealers

1.6 Treasury securities around the world:

United States Treasury Securities: U.S Treasury securities are issued by the U.S Department of the Treasury and are backed by the full faith and credit of the U.S government. As noted above, market participants throughout the world view U.S Treasury securities as having no credit risk. Because of the importance of the U.S government securities market, we will take a close look at this market. Treasury securities are sold in the primary market through sealed-bid auctions on a regular cycle using a single-price method. Each auction is announced several days in advance by means of a Treasury Department press release or press conference. The auction for treasury securities is conducted on a competitive bid basis. The secondary market for Treasury securities is an over-the-counter market where a group of U.S government securities declares offer continues bid and ask prices on outstanding Treasuries. There is virtually 24-hour trading of the most recently auctioned issue for a maturity referred as the on-the-run issue or the current issue. Securities that are replaced by the on-therun issue are called off-the-run issues. Treasury securities are categorized as fixed-principal securities or inflation-indexed securities. Fixed-Principal Treasury Securities: Fixed-principal securities include Treasury bills, Treasury notes and Treasury bonds. Treasury bills are issued at a discount to par value, have no coupon rate, mature at par value and have a maturity date of less than 12 months. As discount securities, treasury bills do not pay coupon interest; the return to the investor is the difference between the maturity value and the purchase price. How the price and the yield for a Treasury bill are computed in the next chapter. Treasury coupon securities issued with original maturities of more than one year and no more than 10 years are called Treasury notes. Coupon securities are issued at approximately par 11

value and mature at par value. Treasury coupon securities with original maturities greater than 10 years are called Treasury bonds. While a few issues of the outstanding bonds callable, the U.S Treasury has not issued callable Treasury securities since 1984. As of this writing, the U.S Department of the Treasury has stopped issuing Treasury bonds. (CFAI, 2011) Inflation-Indexed Treasury Securities: The U.S department of the Treasury issues Treasury notes and bonds that provide protection against inflation. These securities are popularly referred to as Treasury inflation protection securities or TIPS. (The Treasury refers to these securities as Treasury inflation indexed securities, TIIS). TIPS work as follows, The coupon rate on an issue is set at a fixed rate. That rate is determined via the auction process described later in this section. The coupon rate is called the real rate because it is the rate that the investor ultimately earns above the inflation rate. The inflation index that the government uses for the inflation adjustment is the non-seasonally adjusted U.S City Average All Items Consumers Price Index for All Urban Consumers (CPI-U). Treasury STRIPS: The Treasury does not issue zero-coupon notes or bonds. However, because of the demand for zero-coupon instruments with no credit risk and a maturity greater than one year, the private sector has created such securities. Stripped Treasury securities are simply referred to as Treasury strips. Strips created from coupon payments are called coupon strips and those created from the principal payments are called principal strips. Non-U.S. Sovereign Bond Issuers: It is not possible to discuss the bonds/ notes of all governments in the world. Instead, I will take a brief look at a few major sovereign issuers. Germany: The German government issues bonds (called Bunds) with maturities from 8-30 years and notes (Bundesobligationen, Bobls) with a maturity of five years. Ten year Bunds are the largest sector of the German government securities market in terms of amount outstanding and secondary market turnover. Bunds and Bobls have fixed-rate coupons and are bullet structures. United Kingdom: The bonds issued by the United Kingdom are called gilt-edged stocks or simply gilts. There are more types of gilts than there are types of issues in other government bond markets. The largest sector of the gilt market is straight fixed-rate coupon bonds. The second major sector of the gilt market is index-linked issues, referred to as linkers. There are a few issues of outstanding gilt called irredeemables. These are issues with no maturity date

12

and are therefore called undated gilt. Government-designated gilt issues may be stripped to create gilt strips, a process that began in December1997. France: The French Treasury issues long-dated bonds, Obligation Assimilable du Trsor (OATs), with maturities up to 30 years and notes. Bons du Trsor Taux Fixe et Intrt annuel (BTANs), with maturities between 2 and 5 years. OATs are not callable. While most OAT issues have a fixed-rate coupon, there are some special issues with a floating-rate coupon. Long-dated OATs can be stripped to create OAT strips. The French government was one of the first countries after the United States to allow stripping. Italy: The Italian government issues 1) bonds, Buoni del Tresoro Poliennali (BTPs), with a fixedrate coupon that are issued with original maturities of 5, 10 and 30 years, 2) floating-rate notes, Certificati di Credito del Tresoro (CCTs), typically with a 7-year maturity and referenced to the Italian Treasury bill rate,3) 2-year zero-coupon notes, Certificati di Tresoro a Zero Coupon (CTZs), and 4) bonds with put options, Certificati del Tresoro con Opzione (CTOs). The putable bonds are issued with the same maturities as the BTPs. The investor has the right to put the bond to the Italian government halfway through its stated maturity date. The Italian government has not issued CTOs since 1992. Canada: The Canadian government bond market has been closely related to the U.S government bond market and has a similar structure, including types of issues. Bonds have a fixed coupon rate except for the inflation protection bonds (called real return bonds). All new Canadian bonds are in bullet form; that is, they are not callable or putable. Australia: About three-quarters of the Australian government securities market consists of fixed- rate bonds and inflation protections bonds called Treasury indexed bonds. Treasury indexed bonds have either interest payments or capital linked to the Australian Consumer Price Index. The balance of the market consists of floating-rate issues, referred to as Treasury adjustable bonds, that have a maturity between 3 to 5 years and the reference rate is the Australian Bank Bill Index. Japan: There are two types of Japanese government securities (referred to as JGBs) issued publicly: 1) medium-terms bonds and 2) long-dated bonds. There are two types medium-terms bonds: bonds with coupons and zero-coupon bonds. Bonds with coupons have maturities of 2, 3 and 4 years. The other type of medium-term bond is the 5-year zero-coupon bond. Long dated bonds are interest bearing. Emerging market bonds: The financial market of Latin America, Asia (with the exception of Japan) and Eastern Europe are viewed as emerging markets. Investing in the government bonds of emerging market countries entails considerably more credit risk than investing in the government bonds of major industrialized countries. A good amount of secondary trading of 13

government debt of emerging markets is in Brady bonds, which represent a restructuring of nonperforming bank loans to emerging market governments into marketable securities. There are two types of Brady bonds. The first type covers the interest due on these loans (past-due interest bonds). The second type covers the principal amount owed on the bank loans (principal bonds).

14

Chapter: 02
2.1 Yield Curve calculation
Theoretical spot rates: The theoretical spot rates for Treasury securities represent the appropriate set of interest rates that should be used to value default-cash flows. A default-free theoretical spot rate curve can be constructed from the observed Treasury yield curve. There are several approaches that are used in practice. The approach that is described below for creating a theoretical spot curve is called bootstrapping. (The bootstrapping method described here is also used in constructing a theoretical spot rate curve for LIBOR). Bootstrapping: Bootstrapping begins with the yield for the on-the-run Treasury issues because there is no credit risk and no liquidity risk. In practice, however there is a problem of obtaining a sufficient number of data points for constructing the Bangladesh. Treasury yield curve. In Bangladesh, the Bangladesh Bank currently issues 91-days,182-days and 364-days Treasury bills and 5-year, 10-year, 15-year and 20-year Treasury bonds. Treasury bills are zerocoupon instruments and Treasury bonds are coupon paying instruments. Hence, there are not many data points from which to construct a Treasury yield curve, particularly after 1 year. At one time, the Bangladesh Bank issued 25-year Treasury bonds. Since the Treasury no longer issues 25-year bonds, market participants currently use the last issued Treasury bond (which has a maturity less than 25 years) to estimate the 25-year yield. The 5-year, 10-year and 20-year Treasury bonds and an estimate of the 25-year Treasury bond are used to construct the Treasury yield curve. Example from Lehman Brothers: On September 5, 2003, Lehman Brothers reported the following values for these four yields:
2 year 5 year 10 year 30 year
Figure 1

1.71% 3.25% 4.35% 5.21%

To fill in the yield for the 25 missing whole year maturities (3 year, 4yea, 6year, 7year, 8 year, 9year, 11 year, and so on the 29-year maturity), the yield for the 25 whole year maturities are interpolated from the yield on the surrounding maturities. The simplest interpolation, and the one most commonly used in practice, is simple linear interpolation. (Lehman brothers, 2003) 15

For example, suppose that one wants to fill in the gap for each one year of maturity. To determine the amount to add to the on-the-run Treasury yield as we go from the lower maturity to the higher maturity, the following formula is used:

The estimated on-the-run yield for all intermediate whole-year maturities is found by adding the amount computed from the above formula to the yield at the lower maturity. For example, using the September 5, 2003 yields, the 5-year yield of 3.25% and the 10-year yield of 4.35% are used to obtain the interpolated 6-year, 7-year, 8-year and 9-year yields by first calculating:

Then, interpolated 6-year yield interpolated 7-year yield interpolated 8-year yield interpolated 9-year yield

Thus, when market participants talk about a yield on the Treasury yield curve that is not one of the on-the-run maturities for example, the 8-year yield it is only an approximation. Notice there is a large gap between maturity points. This may result in misleading yields for the interim maturity points when estimated using the linear interpolation method, a weakness commonly demonstrated by this method. Calculation: The yields of on-the-run treasury securities are (October 2011) in appendix A-1.

These spot rates have been derived using the linear interpolation method shown above. the 3 yields from recent most auction have been used to interpolate 0 .75-yr yield. When these yields are plotted against maturity,

16

Yield Curve of T-Bills

8.8 8.6 8.4 Yield 8.2 8 7.8 7.6 0.25 0.5 Years 0.75 1 Yield Curve of T-Bills

Figure 2: Yield Curves of T-bills

When compared with the curve calculated by Bangladesh Bank, The accuracy can be verified.

Figure 3: Yield curve of T-bills Ban. Bank

Next when doing the same to T-Bonds, refer to Appendix A-2.

Using linear interpolation if yield curve is plotted, the yield curve of T-Bonds can be found. 17

Yield Curve of T-Bonds

14 12 10 Yield 8 6 4 2 0 Years Yield Curve of T-Bonds

Figure 4: Yield curve of T-Bonds

Again it is compared with the yield curve calculated by Bangladesh Bank. The difference here is explained by the fact that here up to 20 years are referred for calculation, where as Bangladesh Bank uses only up to 15-year maturity.

Figure 5 Bangladesh Bank yield curve of T-Bonds

18

Limitations: Linear interpolation assumes a straight line between available yields. So volatility makes the curves credibility lower. The alternative way would have been to calculate assuming that because of arbitrage opportunities the longer maturity interest bearing bond should have the same value as the package of zero-coupon securities making the same maturity. So using the 182-days BG treasury bills, theoretical spot rates can be derived. But in the case of Bangladesh, stripping of bonds are not permitted. So such an approach will be faulty.

2.2 TRADITIONAL APPROACH TO VALUATION

The traditional approach to valuation has been to discount every cash flow of a fixed income security by the same interest rate (or discount rate). For example, if considered the three hypothetical 10-year Treasury securities showed in Figure a 12% coupon bond, an 8% coupon bond and a zero-coupon bond. The cash flows for each bond are shown in the appendix. Since the cash flows of all three bonds are viewed as default free, the traditional practice is to use the same discount rate to calculate the present value of all three bonds and use the same discount rate for the cash flow for each period. The discount rate used is the yield for the on-the-run issue obtained from the Treasury yield curve. For example, suppose that the yield for the 10year on-the-run Treasury issue is 10%. Then, the practice is to discount each cash flow for each bond using a 10% discount rate. For a no-Treasury security, a yield premium or yield spread is added to the on-the-run Treasury yield. The yield spread is the same regardless of when a cash flow is to be received in the traditional approach. For a 10-year non-Treasury security, suppose that 90 basis points is the appropriate yield spread. Then all cash flows would be discounted at the yield for the on-therun 10-year Treasury issue of 10% plus 90 basis points. (CFAI, 2011)

Period 1-19 20

12% 6tk 106

Each Period is Six Months Coupon Rate 8% 4tk. 104

Figure 6 example

0% 0tk. 100

Using the same principle the valuation of each 5-year, 10-year, 15-year and 20-year Bangladesh Government Treasury Bond is calculated in Appendix B. Interpretation: For a 5-year BGTB which has recently paid 1st haly yearly interests ( issued in April2011 @ 8.26% coupon) with 100tk. Par value the present value (October2011) should be 99.45. (Refer to Appendix B-1) 19

For a 10-year BGTB which has recently paid 1st haly yearly interests (issued in April2011 @ 9.45% coupon) with 100tk. Par value the present value (October2011) should be 99.38. (Refer to Appendix B-2) For a 15-year BGTB which has recently paid 1st haly yearly interests (issued in April2011 @ 9.3% coupon) with 100tk. Par value the present value (October2011) should be 87.88. (Refer to Appendix B-3) For a 20-year BGTB which has recently paid 1st haly yearly interests (issued in April2011 @ 9.65% coupon) with 100tk. Par value the present value (October2011) should be 85.73. (Refer to appendix B-4)

2.3 THE ARBITRAGE- FREE VALUATION APPROACH

The fundamental flow of the traditional approach is that it views each security as the same package of cash flows. For example, a 10-year U.S. Treasury issue with an 8% coupon rate. The cash flows per $100 of par value would be 19 payments of $4 every six months and $104 twenty 6-month periods from now. The traditional practice would discount each cash flow using the same discount rate. The proper way to view the 10-year 8% coupon Treasury issue is as a package of zero-coupon bonds whose maturity value is equal to the amount of the cash flow and whose maturity date is equal to each cash flows payment date. Thus, the 10-year 8% coupon Treasury issue should be viewed as 20 zero-coupons bond. The reason this is the proper way to value a security is that it does not allow arbitrage profit by taking apart or stripping a security and selling off the stripped securities at a higher aggregate value than it would cost to purchase the security in the market. This approach to valuation is referred to as the arbitrage-free valuation approach. By viewing any financial asset as a package of zero-coupon bonds, a consistent valuation framework can be developed. Viewing a financial asset as a package of zero-coupon bonds means that any two bonds would be viewed as different packages of zero-coupon bonds and valued accordingly. Irrelevance with Bangladesh: As stated in the section of yield curve calculation, as stripping of bonds are not seen in Bangladesh, an arbitrage free valuation approach of bond, even though accepted as standard practice all over the world would be irrelevant. So here the calculation would not be made.

20

Chapter: 3
3.1 Risks Associated with Treasury securities
With this brief review of Treasury securities, lets look at their risks. I wil liste the general risks associated with investing in bonds 1) interest rate risk 2) call and payment risk 3) yield curve risk 4) reinvestment risk 5) credit risk 6) liquidity risk 7) exchange rate risk 8) volatility risk 9) inflation or purchasing power risk, and 10) event risk INTEREST RATE RISK: The price of a typical bond will change in the opposite direction to the change in interest rates or yields. Since the price of a bond fluctuates with market interest rates, the risk that an investor faces is that the price of a bond held in a portfolio will decline if market interest rates rise. This risk is referred to as interest rate risk and is the major risk faced by investors in the bond market. All fixed income securities, including Treasury securities, expose investors to interest rate risk. However, the degree of interest rate risk is not the same for all securities. The reason is that maturity and coupon rate affect how much the price changes when interest rates change. One measure of a securitys interest rate risk is its duration. Since Treasury securities, like other fixed income securities have different durations, they have different exposures to interest rate risk as measured by duration. YIELD CURVE RISK: There is not one interest rate or yield in the economy. There is a structure of interest rates. One important structure is the relationship between yield and maturity. The graphical depiction of this relationship is called yield curve. As we can see in section on measuring yield curve, when interest rates change, they typically do not change by an equal number of basis points for all maturities. The point here is that portfolios have different exposures to how the yield curve shifts. This risk exposure is called yield curve risk. The implication is that any measure of interest rate risk that 21

assumes that the interest rates changes by an equal number of basis points for all maturities (referred to as a parallel yield curve shift) is only an approximation. It is associated with treasury securities. CALL AND PREPAYMENT RISK: There are 3 disadvantages to call provision: Disadvantage1: The cash flow pattern of a callable bond is not known with certainty because it is not known when the bond will called. Disadvantage2: Because the issuer is likely to call the bonds when interest rates have declined below the bonds coupon rate, the investor is exposed to reinvestment risk, i.e., the investor will have to reinvest the proceeds when the bond is called at interest rates lower than the bonds coupon rate. Disadvantage3: The price appreciation potential of the bond will be reduced relative to an otherwise comparable option-free bond. (This is called price compression). Because of these three disadvantages faced by the investor, a callable bond is said to expose the investor to call risk. The same disadvantages apply to mortgage-backed and asset-backed securities where the borrower can prepay principal prior to schedule principal payment dates. This risk is referred to as prepayment risk. REINVESTMENT RISK: Reinvestment risk is the risk that the proceeds received from the payment of interest and principal (i.e., scheduled payments, called proceeds and principal prepayments) that are available for reinvestment must be reinvest at a lower interest rate than the security that generated the proceeds. I have already explained how reinvestment risk is present when an investor purchases a callable or principal pre payable bond. When the issuer calls a bond, it is typically done to lower the issuers interest expense because interest rates have declined after the bond is issued. The investor faces the problem of having to reinvest the called bond proceeds received from the issuer in a lower interest rate environment. Because Treasury securities are non-callable, there is no reinvestment risk due to an issue being called Treasury coupon securities carry reinvestment risk because in order to realize the yield offered on the security, the investor must reinvest the coupon payments received at an interest rate equal to the computed yield. So, all Treasury coupon securities are exposed to reinvestment risk. Treasury bills are not exposed to reinvestment risk because they are zerocoupon instruments.

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CREDIT RISK: An investor who lends funds by purchasing a bond issue is exposed to credit risk. There are three type of credit risk: 1. 2. 3. Default risk Credit spread risk Downgrade risk

They are as follows: Default Risk Default risk is defined as the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and principal. Credit Spread Risk Treasury issues are the benchmark yields because they are to believed to be default free, they are highly liquid and they are not callable (with the exception of some old issues). The part of the risk premium or yield spread attributable to default risk is called the credit spread. The price performance of a non-Treasury bond issue and the return over some time period will depend on how the credit spread changes. If the credit spread increases, investors say that the spread has widened and the market price of the bond issue will decline (assuming U.S Treasury rates have not changed). The risk that an issuers debt obligation will decline due to an increase in the credit spread is called credit spread risk. This risk exists for an individual issue, for issues in a particular industry or economic sector and for all non-Treasury issues in the economy. For example, in general during economic recessions, investors are concerned that issuers will face a decline in cash flows that would be used to service their bond obligations. As a result, the credit spread tends to widen for U.S nonTreasury issuers and the price of all such issues through the economy will decline. Downgrade Risk A credit rating is an indicator of the potential default risk associated with a particular bond issue or issuer. It represents in simplistic way the credit rating agencys assessment of an issuers ability to meet the payment of principal and interest in accordance with the terms of indenture. Credit rating symbols or characters are uncomplicated representations of more complex ideas. In effect, they are summary opinions. Once a credit rating is assigned to a debt obligation, a rating agency monitors the credit quality of the issuer and can reassign a different credit rating. An improvement in the credit quality of an issue or issuer is rewarded with a better credit rating, referred to as an upgrade; deterioration in the credit rating of an issue or issuer is penalized by the assignment of an inferior credit rating, referred to as downgrade. An unanticipated downgrading of an issue or issuer increases the credit spread and results in a 23

decline in the price of the issue or the issuers bond. This risk is referred to as downgrade risk and is closely related to credit spread risk. As for credit risk, the perception in the global financial community is that Treasury securities have no credit risk. In fact, when market participants and the popular press state that Treasury securities are risk free, they are referring to credit risk.

LIQUIDITY RISK: Liquidity risk is the risk that the investor will have to sell a bond below to indicated value, where the indication is revealed by a recent transaction. The recent primary measure of liquidity is the size of the spread between the bid price (the price at which dealer is willing to sell a security). The wider the bid-ask spread, the greater the liquidity risk. Treasury securities are highly liquid. However, on-the-run and off-the-run Treasury securities trade with different degrees of liquidity. Consequently, the yields offered by on-the-run and offthe-run issues reflect different degrees of liquidity.

EXCHANGE RATE OR CURRENCY RISK: The risk of receiving less of domestic currency when investing in a bond issue that makes payments in a currency other than the managers domestic currency is called exchange rate risk or currency risk. Since Bangladesh Government Treasury securities are Taka denominated, there is no exchange rate risk for an investor whose domestic currency is the BDT. However, non-BD investors whose domestic currency is not the BDT are exposed to exchange-rate risk.

INFLATION OR PURCHASING POWER RISK: Inflation risk or purchasing power risk arises from the decline in the value of a securitys cash flow due to inflation, which is measured in terms of purchasing power. For all but inflation protection bonds, an investor is exposed to inflation risk because the interest rate the issuer promises to make is fixed for the life of the issue. Fixed-rate Treasury securities are exposed to inflation risk. Treasury inflation protection securities (TIPS) have a coupon rate that is effectively adjusted for the rate of inflation and therefore have protection against inflation risk. But such instruments do not exist in Bangladesh.

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VOLATTILITY RISK: This risk that the price of a bond with an embedded option will decline when expected yield volatility changes is called volatility risk. Below is a summary of the effect of changes in expected yield volatility on the price of callable and putable bonds. EVENT RISK: Occasionally the ability of an issuer to make interest and principal payments changes dramatically an unexpectedly because of factors including the following: A natural disaster (such as an earthquake or hurricane) or an industrial accident that impairs an issuers ability of an issuer to make interest and principal payments changes dramatically an unexpectedly because of factors including the following: 1. A natural disaster (such as an earthquake or hurricane) or an industrial accident that impairs an issuers ability to meet its obligations. 2. A takeover or corporate restructuring that impairs an issuers ability to meet its obligation. 3. A regulatory change. These factors are commonly referred to as event risk. The first type of event risk results in a credit rating downgrade of an issuer by rating agencies and is therefore a form of downgrade risk. However, a downgrade risk is typically confined to the particular issuer whereas event risk from a natural disaster usually affects more than one issuer. The second type of event risk also results in a downgrade and can also impact other issuers. An excellent example occurred in the fall of 1988 with the leveraged buyout (LBO) of RJR Nabisco, Inc. The yield on Treasury securities is impacted by a myriad of events that can be classified as political risks, a form of event risk. The actions of monetary and fiscal policy in Bangladesh, as well as the actions of other central banks and governments, can have an adverse or favorable impact on Bangladesh Government Treasury yields.

SOVEREIGN RISK: Sovereign risk is the risk that a foreign governments actions cause a default or an adverse price decline on its bond issue.

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3.2 Calculation of Interest rate risk: Duration and Convexity

With the background about the price volatility characteristics of a bond,( which will be discussed further in the later part) an alternate approach to full valuation can be considered: the duration/convexity approach. As explained before, duration is a measure of the approximate price sensitivity of a bond to interest rate changes. More specifically, it is the approximate percentage change in price for a 100 basis point change in rates. Duration is the first (linear) approximation of the percentage price change. To improve the approximation provided by duration, an adjustment for convexity can be made. Hence, using duration combined with convexity to estimate the percentage price change of a bond caused by changes in interest rates is called the duration/convexity approach. (CFAI, 2011) CALCULATING DURATION: The duration of a bond is estimated as follows:

Where,

Duration
Interpretation: Generic description of the sensitivity of a bond's price (as a percentahe of initial price) to a change in yield.

Modified Duration
Duration measury in which it is assumed that yield changes do not change the expected cash flows

Effective Duration
Duration measure in which recognition is given to the fact that yield changes may change the expected cash flows

Figure 7 Duration

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Modified Duration versus Effective Duration: One form of duration that is citied by practitioners is modified duration. Modified duration is the approximate percentage change in a bonds price for a 100 basis point change in yield assuming that the bonds expected cash flows do not change when the yield changes. What this means is that is calculating the values in Equation stated before, the same cash flows are used. Therefore, the change in the bonds price when the yield is changed is due solely to discounting cash flows at the new yield level. The assumption that the cash flows will not change when the yield is changed makes sense for option-free bonds such as non-callable Treasury securities. This is because the payments made by the U.S. Department of the Treasury to holders of its obligations do not change when interest rates change. However, the same cannot be said for bonds with embedded options (i.e., callable and putable bonds and mortgage-backed securities). For these securities, a change in yield may significantly alter the expected cash flows. Some valuation models for bonds with embedded options take into account how changes in yield will affect the expected cash flows. Thus, when are produce from these valuation models, the resulting duration takes into account both the discounting at different interest rates and how the expected cash flows may change. When duration is calculated in this manner, it is referred to as effective duration or option-adjusted duration. (Lehman Brothers refers to this measure in some of its publications as adjusted duration.) figure 7 summarizes the distinction between modified duration and effective duration. In this report, the modified duration approach is used because the option adjustment would be irrelevant from the perspective of Bangladesh. Macaulay duration and Modified Duration: It is worth comparing the relationship between modified duration to another duration measure, Macaulay duration. Modified duration can be written as.

The expression in the brackets of the modified duration formula given by Equation 3is a measure formulated in 1938 by Frederick Macaulay. This measure is popularly referred to as Macaulay duration. Thus modified duration is commonly expressed as:

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The general formulation for duration as given by this Equation which provides a shortcut procedure for determining a bonds modified duration. Because it is easier to calculate the modified duration using the short-cut procedure, most vendors of analytical software will use this Equation rather than the previous Equation to reduce computation time. Limitaion: However, modified duration is a flawed measure of a bonds price sensitivity to interest rate changes for a bond with embedded options and therefore so is Macaulay duration. But as in Bangladehi treasuty securities this in not the concern, use of modified duration is justified. Rate Shocks and Duration Estimate: In calculating duration using the previous Equation, it is necessary to shock interest rates (yields) up and down by the same number of basis points to obtain the values for . Now the question is how large should the shock be? That is, how many basis points should be used to shock the rate?

CONVEXITY ADJUSTMENT: The duration measures indicate that regardless of whether interest rates increase or decrease, the approximate percentage price change is the same. However this is not consistent with Properties of a bonds price volatility. Specifically, while for small changes in yield the percentage price change will be the same for an increase or decrease in yield, for large changes in yield this is not true. This suggests that duration is only a good approximation of the percentage price change for small changes in yield. The reason for this result is that duration is in fact a first (linear) approximation for a small change in yield. The approximation can be improved by using a second approximation. This approximation is referred to as the convexity adjustment. It is used to approximate the change in price that is not explained by duration. The formula for the convexity adjustment to the percentage price change is Convexity adjustment to the percentage price change Where the change in yield for which the percentage price change is sought and

The notation is same as used in the equation for duration. (CFAI, 2011) 28

3.3 Hypothesis testing

Now with a clear concept of Durations a hypothesis testing will be conducted. Corporate bonds have higher interest rates. So should they have higher interest rate risk than equivalent maturity treasury security? This paper will conduct this hypothesis testing using subordinated 25% convertible 7yr bond of Brac bank limited with 5-year and 10-year Bangladesh Government Treasury Bonds. So hypothesis propositions are,

9 monthly data points starting from February2011 to October2011 is used. The lack of data points is a limitation of this study. So the randomness of data is assumed. The reason for choosing subordinated 25% convertible 7yr bond of Brac bank limited for study is that the alternative 2 corporate bonds (ACI zero coupon Bond) and (IBBL convertible bond) are irrelevant for the study for lack of comparable treasury bonds. Testing for Normality (Kolmogorov-Smirnov Goodness of Fit test): With 95% confidence level first to test the normality assumption, Kolmogorov-Smirnov goodness of fit test is conducted. The hypotheses are

Referring to Appendix C-1 first the normality of duration of 3 bonds is tested. Next the normality of difference between corporate bond and the T-Bonds is tested. Conducting interpretation, all five Kolmogorov-Smirnov Z value are below the critical value. Looking at the significance value also confirms the fact that there is failure to reject the null hypothesis of conformity with hypothesized distribution. So the data sets are normally distributed. The effect of this test is that because of normality the use of parametric tests like one-sample ttest is justified. So t-testing will be conducted. 29

So the decision rule is: With a two-tailed test and 5% significance level (0.025 one tailed probability) and 8 degrees of freedom, the null hypothesis is rejected if the t-value is outside the -2.306 to +2.306 intervals. Conducting first the non-parametric test (One sample sign test) of difference between the durations, both data sets are found to be significant (Refer to Appendix C-2). So the Null hypothesis of mean of duration being not different from zero is rejected. Next the parametric test (One sample t-test) is conducted.(Refer to Appendix C-3). With a very high t value well over the critical value, the null hypothesis is rejected. The significance level confirms this decision. So the result is that in case of Corporate Bonds in Bangladesh, They have different interest rate risk than that of the closest maturity treasury bonds. The implication of this study is that when buying corporate bonds rather than closest maturity treasury-bonds, the investor should keep in mind the impact of differing interest rate risk in mind.

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Chapter: 4
4.1 Regression Analysis
Bangladesh Government primarily borrows from the financial sector by issuing treasury securities of varying maturities. But what determines this decision? Is this done To fight inflation? Raise money to increase foreign reserve? As an alternative to currencies? To raise money for government by taking the opportunity when call money rate lowers? As an alternative to share market investment for financial institutions?

To answer these questions, this paper will try to derive linear multiple regression. But before diving further, a scatter plot will be used to visually try to understand the relationships of dependent variable with each independent variable. Scatterplot analysis: Here the dependent variable is always in the y axis. The interpretation given is visual only. Quantitative analysis is needed here to assess the significance, which is done later in this chapter. When compared with the market capital, a slight negative relation is seen. Quantitative analysis is need here to assess the significance. (Figure-8). When compared with currency in circulation there seems to be a positive relation (Refer to Figure-9).

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Figure 8

Figure 9

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When compared with inflation, there seems very slight positive relation.(Figure 10)

Figure 10

Figure 11

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When compared with Foreign exchange reserve, there seems to be no relationship.(Figure 11)

Figure 12

And Finally, when compared with callmoney rate, there seems to be a positive relationship. (Figure 12)

Now the quantitative analysis using multiple linear regression will be done to test whether the findings in scatterplot analysis are correct. Multiple linear regression: The equation of multiple regression is:

Where, Natural logarithm of number of total securities issued (Dependent variable) Constant Coefficient of independent variable Natural logarithm of market capital of Dhaka stock exchange (taka in cr.) 34

Natural logarithm of total currency in circulation (taka in cr.) Inflation with base period as 195-96 Foreign exchange reserve (In million USD) Natural logarithm of call money rate

The sample period is June2010 to August2011 and monthly data is taken. Total number of observation is 15 for each dataset. The lack of data is a problem in conducting the regression. The assumptions of this multiple regression are, 1. The relationship between the dependent variable, Y, and the independent variables (X1, X2, . Xn) is linear as described in the equation 2. The independent variables (X1, X2, . Xn) are not random. Also, no exact linear relation exists between two or more of the independent variables. 3. The expected value of the error term, conditioned on the independent variables, is 0:E(|X1, X2, . Xn)=0 4. The variance of the error term is the same for all observations. 5. The error term is uncorrelated across observations 6. The error term is normally distributed. To make the data compatible and to reduce misspecification, Natural logarithms of relevant data are taken. Because most independent variables are initially found in enter regression method are insignificant along with an insignificant model (Refer to Appendix D-1) , the stepwise regression method is used where the regression equation is formed based on significant independent variables only.(refer to Appendix D-2) Interpreting the adjusted R square the independent variable explains 27.1% of the change in dependent variable. The standard error of the model is 0.45554163. Conducting the Anova table, the model is significant even at 5% significance level (Indicated by Both F-value and the Pvalue) At 10% level of significance, the regression equation is found to be,

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Because except X2, other independent variables are insignificant.(refer to the coefficients and excluded variables table of Appendix D-2), In the excluded variables tables the t-value shows its insignificance. Violation of Assumptions: Serial correlation: Serial correlation means violation of the 5th assumption, the error term is uncorrelated across observations. To test, Durbin Watson test statics is used. The hypothesis are: H0=There in no serial correlation H1=There is serial correlation Referring to Appendix D-2 (model summary table), The DW statistic is 2.171. As this is slightly greater than 2 (+0.171), there is the possibility of negative serial correlation. Here for k=1, and n=14, the dL=1.08 and dU=1.36. Clearly as DW test statistic exceeds dU, there is failure to reject null hypothesis of no serial correlation. Multicollineariry: When the sign test is conducted, the variables coefficients seem to indicate the expected signs. (which is interpreted as no multicollinearity problem). So pearson cross correlation is conducted and tested for significance at both 5% two tailed significance level. (Refer to Appendix D-3) Here the correlation of currency in circulation seems to be highly correlated with (.824) callmoney rate, thus indicating multicollinearity. So, one of them should be excluded. So to correct for multicollinearity, the natural logarithm of callmoney rate is excluded. Now this has no impact on the predicted model as natural logarithm of callmoney rate is insignificant (Refer to Appendix D-2) and is already excluded in model calculation.

Validity of regression model: To test if the regression equation is valid, here the in-sampledata test is used (Refer to Appendix D-4). Looking at figure 13, it can be said the model closely resembles the actual value of the in-sample-data.(With mean difference or mean error as 0.4509748)

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Actual and Predicted Dependent variable

10 9 8 7 6 5 4 3 2 1 0 June July August September October November December January February March April May June July August

Value

Actual value of dependent variable Predicted value of dependent variable

Month 2010-2011
Figure 13

4.2 YIELD VOLATILITY

What has not yet been considered is the volatility of interest rates. For example, as explained in the section on risks associated with treasury bonds, all other factors equal, the higher the coupon rate, the lower the price volatility of a bond to changes in interest rates. In addition, the higher the level of yields, the lower the price volatility of a bond to changes in interest rates. But when the yield level is high, a change in interest rates does not always produce a large change in the initial price. However, when the yield level is low and a change in interest rates of the same number of basis points produces a large change in the initial price.

Figure 14:The charted relationship between bond price and required yield appears as a negative curve (Investopedia author)

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This can also be cast in term of duration properties: the higher the coupon, the lower the duration; the higher the yield level, the lower the duration. Given these two properties, a 10year non-investment grade bond has a lower duration than a current coupon 10-year Treasury bond since the former has a higher coupon rate and trades at a higher yield level. Does this mean that a 10-year non-investment grade bond has less interest rate risk than a current coupon 10-year Treasury note? If I consider also for example, that a 10-year Swiss government bond has a lower coupon rate than a current coupon 10-year BGTB and trades at a lower yield level. Therefore, a 10-year Swiss government bond will have a higher duration than a current coupon 10-year Treasury bond. Does this means that a 10-year Swiss government bond has greater interest rate risk than a current coupon 10-year BGTB? The missing link is the relative volatility of rates, which shall be referred to as yield volatility or interest rate volatility. The greater the expected yield volatility, the greater the interest rate risk for a given duration and current value of a position. In the case of non-investment grade bonds, while their durations are less than current coupon Treasuries of the same maturity, the yield volatility of non-investment grade bonds is greater than that of current coupon Treasuries. For the 10- year Swiss government bond, while the duration is greater than for a current coupon 10-year BGTB, the yield volatility of 10-year Swiss bonds is considerably less than that of 10-year BGTB. Consequently the measure the exposure of a portfolio or position to interest rate changes, it is necessary to measure yield volatility. This requires an understanding of the fundamental principles of portability distributions. The measure of yield volatility is the standard deviation of the yield changes. Calculations: In Appendix E are the yield of 51 months of 5-year, 10-year, 15-year and 20-year BGTB. Using the standard deviation of those bonds, The reader will be able to adjust and compare it with any bonds in the world even if they might possess lower duration than BGTB. Now if the data are analyzed for the mean, standard deviation, variance and stander error of estimate for each, the result shows standard deviation of 4 bond types

Interpretation: It can be clearly seen here that with rise in interest along with the rise in maturity the volatility increases. The data is now available to be compared with that of any other countrys similar maturity Treasury-Bonds.

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Findings
The Primary findigs of this report are: The yield curve of both T-Bills and T-Bonds are upward sloping(normal). Major changes took treasury security sector in 2006-2007, but more reform is needed. With newer financial innovation in The treasury security market, both government and institutional investors will benefit. Theoretical spot rates using arbitrage-free approach and Arbitrage-Free valuation approach is not relevant for Bangladeshi market. Because of current interest rate rise, the recent off-the-run treasury securities are loosing value. When buying corporate bonds rather than closest maturity treasury-bonds, the investor should keep in mind the impact of differing interest rate risk. As the duration of corporate bonds differ from the duration of close maturity T-Bonds Only natural logarithm of currency in circulation has impact on the natural logarithm of treasury security issued (Face value). The multiple regression model is verified on in-sample data. With rise in interest along with the rise in maturity the volatility increases. The data is now available to be compared with that of any other countrys similar maturity Treasury securities.

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Recommendations
This report suggests: Use of 24-hour trading is vital for treasury security as the liquidity nature is one of the most important reason for investing in treasury securities. Primary Dealers(PDs) should be allowed by regulation financial innovations, technology (electronic trading and bidding platform) and reengineering on treasury securities like treasury strips to increase liquidity and reduce transaction costs. Introduction of TIPS (Treasury Inflation Protected Securites) is vital now. With alaming rates of inflation crippling the economy right now, TIPS would provide secured real returns and store confidence in bond market. At present, Stable monetary and fiscal management of Bangladesh earns Ba3 (Moody's) and BB-(S&P) sovereign rating with stable outlook for two consecutive years 2010, 2011. With such outlook bangladesh government can issue sovereign bonds in international markets ( the opportunity is there as Srilanka with similar ratings is already doing the same) which will reduce pressure on local financial sector and will reduce the crowding out effect currently causing liquidity crisis in Bangladeshs economy. Introduction of market driven interest rates. Allow repo facilities under the standing facility in addition to existing assured liquidity support to minimize the PDs liquidity risk. Accounting treatment of revaluation gain/loss on held for trading (HTF) may be revised.

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Conclusion
A well functioning treasury security market not only works as a secured and stable source for government to meet its liquidity needs quickly, but also provides risk averse investors with a secured source of investment. Immediate reform in this market will crate a stable platform for newer corporate bond to be isseued and compared with the equivalent maturity benchmark bonds.

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Sakib Ahmed Chowdh ury

Digitally signed by Sakib Ahmed Chowdhury DN: cn=Sakib Ahmed Chowdhury, email=sak_2ac@yah oo.com, l=Dhaka Date: 2011.11.12 08:07:20 +06'00'