Resource Persons : NSE Research Team (Dr. Gangadhar Darbha, Dr. Sudipta Dutta Roy, Dr. Vardhana Pawaskar) and Dr. Susan Thomas, IGIDR.

National Stock Exchange of India Limited

While India has had a long history of securities trading, the markets have not kept pace with the changing trends and requirements to reach their full potential. Particular issues of concern in the securities industry have been lack of transparency, lack of trading facilities fair and accessible to all, undercapitalized trading members, dated procedures/ practices and long/ uncertain settlement cycles. National Stock Exchange of India Ltd. (NSEIL) has the genesis in the report of the High Powered study Group on Establishment of New Stock Exchanges, which recommended promotion of the Exchange by financial institutions to provide access to investors from all parts of the country. National Stock Exchange of India Ltd. (NSE) emerged as an endeavor by some of the institutional investors within the country to address these issues.

As a result, NSE was incorporated in November ' 92 under the Companies Act 1956 by leading institutions like IDBI, ICICI, IFCI, LIC, GIC and its subsidiaries, SBI, BoB, Canara Bank, PNB, Corporation Bank, Indian Bank, Oriental Bank of Commerce, Union Bank of India, SBI Caps, IL& FS and SHCIL with the objective of providing a fair, efficient and transparent securities market to Indian investors.

NSE has set up infrastructure that serves as a role model for the securities industry in terms of trading systems, clearing and settlement practices and procedures. High trading volumes recorded by NSE soon after inception speaks of the Exchange' s success. NSEIL thus emerged as a leader in addressing the structural deficiencies of the markets.

NSE presently operates from over 330 cities spread across the country. It provides screen- based automated trading with a high degree of transparency and equal access to investors based in any of these cities. The high level of information dissemination through on- line system has helped in integrating retail investors on a nation- wide basis.

The Exchange currently operates three market segments, namely Capital Market Segment, Wholesale Debt Market Segment and Futures an Options segment. The Exchange plans to introduce Retail Debt Market Segment which will take the debt market to the grass root level and a vibrant market on fixed income securities would emerge in India.

Apart from setting up NSCCL, NSE along with IDBI and UTI, has participated in setting up National Securities Depository Ltd. (NSDL), the first depository in the country. NSE together with CRISIL, has also taken lead in establishing India Index Services and Products Ltd. (IISL), India' s first specialist company dedicated to providing indices and index related services to investors. Standard & Poor' s, the world leader in indexing has licensed the co- branding of IISL' s equity indices. NSE has also set up NSE. IT to provide technology solutions in financial markets.

Product Development Initiative

It its effort to develop and facilitate the financial market, NSEIL has initiated the process of providing reference rates to the market in 1998 and today NSE MIBID / MIBOR is the market benchmark reference rate for overnight market and term markets of 14- day, 1- month and 3- months duration. Many market participants have designed their products linking to these reference rates. NSEIL has fulfilled a long- standing need of a reference rate in the market and in a short span of time, NSE MIBID / MIBOR has established itself as the prime reference rate for both overnight and term markets. The function of reference rate forecasting has become more meaningful as the information comes from a source, which is not only reliable but has no vested interest of its own in the market movements.

Why NSE Zero Curve ?

With the Exchange' s strong focus on the debt market segment that has witnessed substantial growth, it has felt a long standing need for providing a valuation product to market participants and institutions to value their holding in sovereign papers. A sound valuation methodology should satisfy the following criteria: (i) it should have a firm conceptual base, (ii) it should provide a framework that allows consistent valuation of all similar instruments, and (iii) it should be available at high frequency (preferably daily) so as to enable players to constantly value and, if required, reshuffle their portfolios. With its research initiative and innovations, the Exchange has developed a NSE Zero Curve that will help in valuation of securities across all maturities irrespective of its liquidity in the market and would create standardization across industry in so far as valuation of financial instruments are concerned, more particularly the sovereign papers. The tool will revolutionalize the valuation standards in the market. The product has been developed keeping in mind the need of the banking industry that have substantial investment in sovereign papers. The product will help improvement in Asset Liability Management of banks with realistic valuations of portfolio of sovereign papers.

The Product

The ' NSE Zero Curve' (NSE Zero Curve for short) starts from the basic premise of ' time value of money' - that a given amount of money due today has a value different from the same amount due at a future point of time. An individual willing to part with his money today has to be compensated in terms of a higher amount due in future - in other words, he has to be paid a rate of interest on the principal amount. The rate of interest to be paid would vary with the time period that elapses between today (when the principal amount is being foregone) and the future point of time (at which the amount is repaid). At any point of time therefore, we would observe different spot rates of interest associated with different terms to maturity; longer maturity offering a ' term spread' relative to shorter maturity. The term structure of interest rates, or NSE Zero Curve, is the set of such spot interest rates. This is the principal factor underlying the valuation of most fixed income instruments.

Fixed income instruments can be categorized by type of payments. Most fixed income instruments pay to the holder a periodic interest payment, commonly known as the coupon, and an amount due at maturity, the redemption value. There exist some instruments that do not make periodic interest payments; the principal amount together with the entire outstanding amount of interest on the instrument is paid as a lump sum amount at maturity. These instruments are also known as ' zero coupon' instruments (Treasury Bills provide an example of such an instrument). These are sold at a discount to the redemption value, the discounted value being determined by the interest rate payable (yield) on the instrument.

In empirical models of the NSE Zero Curve, the discounted stream of cashflows gives the underlying valuation of the bond. If the term structure is the only factor that influences the pricing of the bond, the present value relation, as we have mentioned earlier, should give us ' the' price of the bond. With the PV relation, and with information available on ' trade date' , ' traded price' , ' coupon rate' and ' date of maturity' of a bond, this essentially leaves as unknown only the set of interest rates. Trades on a given day provide us with such information for the sample of traded bonds. Estimation of the NSE Zero Curve now involves estimation of the appropriate set of interest rates that go into deriving the present value relation. This is done by specifying a functional form of the interest rate- maturity relation/ discount function/ forward rate function. The present exercise estimates the NSE Zero Curve using the 'Nelson- Siegel' (NS) functional form [Nelson & Siegel (Journal of Business, 1987)] using data on secondary market trades in Government securities reported on the Wholesale Debt Market segment of the National Stock Exchange (NSE- WDM).

The NSE Zero Curve depicts the relationship between interest rate and maturity for a set of ' similar' securities, as on a given date. To derive the ' true' term structure, we need to have a sample of bonds that are identical in every respect except in term to maturity. Government securities do, in practice, different by coupon rates; nonetheless, these come closest to satisfying the requirement, and hence most empirical studies have concentrated on this segment of the securities market.

We have mentioned earlier that the underlying valuation of the bond is given by the discounted stream of cash flows. This relation should give us ' the' price of the bond if the term structure is the only factor that influences the pricing of the bond. In practice, however, observed prices differ from this ' average' price. Factors other than the term structure that affect the price of a bond include, for instance, tax regulations (differential tax rates for income and capital gains) that affect the relative valuations of bonds with different cash flows. Further, illiquid bonds trade at a premium relative to liquid bonds of the same residual maturity. Other bond characteristics also influence valuation. For trades in the same bond conducted on the same day, dispersion in prices could be attributed to transaction costs that vary with the size of the trade, an intra- day effect on account of new developments during the day, or other factors (expectations about the directionality of the term structure being an example) that have not been explicitly accounted for in the estimation.

A usually held argument against NSE Zero Curve vis- à- vis YTM is that the former is more complicated both in terms of computation and interpretation. While the computation of YTMs is certainly less time- consuming, it takes far more time and ingenuity to use YTMs as a pricing / valuation methodology for portfolios of securities that include non- traded instruments. In addition, YTM would have limited applicability as the debt market develops and new instruments like STRIPS and other derivative products are introduced. NSE Zero Curve, on the other hand, is eminently suitable for valuation of such instruments. With sufficient number of secondary market trades in Government securities available to estimate a chosen model, it is possible to estimate the sovereign term structure daily, thus making it a useful valuation methodology to track changes in portfolios of Government securities on a day- to- day basis. Also, while the estimation of NSE Zero Curve, on the face of it, may appear time- consuming, our experience shows that generation of the daily NSE Zero Curve, along with the underlying prices of all outstanding Government securities, takes, on an average, not more than 10- 15 minutes.

Uses of NSE NSE Zero Curve

The uses that an estimate of the term structure can be put to are immense. Once an estimate of the term structure based on default- free government securities is obtained, it can be used to price all non- sovereign fixed income instruments after adding an appropriate credit spread. It can be used to value government securities that do not trade on a given day, or to provide default- free valuations for corporate bonds. Estimates of the NSE Zero Curve at regular intervals over a period of time provides us with a time- series of the interest rate structure in the economy, which can be used to analyze the extent of impact of monetary policy. This also forms an input for VaR systems for fixed income systems and portfolios. NSE Zero Curve can also be used by various issuers to price their new issues after adding the required spreads depending upon their respective ratings, etc. NSE NSE Zero Curve can be used by market participants to value their assets and liabilities at any point of time using spot rates for various future years.

Transparency:

The NSE Zero Curve is derived using the trade prices of securities captured in the NSE WDM trading system for the day. The methodology of estimation is clearly depicted in the Technical paper available in NSE website (www. nse. co. in). The time series data on NSE Zero Curve is available from January 01, 1998. The NSE Zero Curve is released to the market simultaneously through various media making it transparent. The Exchange ensures that NSE Zero Curve is disseminated daily to the market at about 6.00PM.

Reliability, being the hallmark of NSE products, is maintained as the estimation process has been tested with various constraints and stress situations duly taking market feedback into consideration. The methodology followed in the estimation of NSE Zero Curve has been found widely accepted by academic community and supported by many well- acclaimed international journals.

Accessibility:

The NSE Zero Curve is broadcast through Bulletin Board Service, NSE website, emails to various users. In addition, leading information vendors like Reuters and Bridge News carry these rates on a daily basis.

National Stock Exchange of India Limited
Mahindra Towers
1 st Floor, A Wing
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Mumbai- 400 018
September 2000