New Research Initiatives:

A Pricing and Risk Management System for Chinese Bonds

Based on the research led by Min Dai and Steven Kou at National University of Singapore

Starting from 2016, RMI has embarked on three new research initiatives and this issue of the newsletter will discuss the second research initiative on developing a pricing and risk management system for Chinese bonds.

In China, 99% of bond trading takes place in the National Interbank Funding Center between 9642 institutional investors such as commercial banks, insurance companies, public/private offering funds, overseas central banks, sovereign wealth funds, etc., whereas only one percent of bonds are traded over Stock Exchanges by institutional and individual investors. Although the total daily volume of bond trading in China is over two trillion RMB, the market is still in the development stage and no pricing or risk management system is currently in place to regulate the bond trading in China. This could lead to serious problems in terms of fair trading. This new research initiative at RMI will focus on using big data from Chinese markets and studying interesting financial models tailored to unique financial situations in China.

First topic under this project will study dual-purpose funds in China, whose market value is about 200 billion RMB, as of June 2016. In U.S. market, the payoff of dual-purpose funds resembles that of a European vanilla call option. However, the pricing models that work for U.S. market are not applicable to Chinese market, because the dual-purpose funds in China have a much more complicated payoff structure: (1) There is usually no maturity, (2) Lower risk/return funds (A shares) and higher risk/return funds (B shares) will be partially liquidated (called “reset") if the net asset value of the underlying fund exceeds (or falls below) a predetermined upper (lower) threshold, (3) At predetermined dates, holders of A shares receive periodical interest payments that may change due to reset events. Historical data indicates that many funds experienced upward or downward reset events, especially during the mid-2015 market crash. Given this the goal of this initiative is to provide models and conduct empirical study on these unique products, and to get an accurate implied risk-free rate in China, which is not currently available.

The second focus is on pricing and risk management systems of callable and puttable bonds in China. Among all the bonds traded (more than two trillion RMB) in the Interbank Funding Center in China, about 20% are callable and puttable bonds. The Hull-White model turns out to be robust, and has been widely used in bond markets worldwide. However, these standard financial models cannot price Chinese bonds accurately, due to liquidity constraints and credit rating considerations. The plan under this research initiative is to provide a pricing and risk management system for callable and puttable bonds, incorporating interest rate risk, credit risk, and liquidity risk, which is indispensable for both institutional investors and regulators. In addition, we aim to build a pricing and risk management IT system, so that the results can be readily used by regulators and institutional investors in China.

Lastly the research initiative will focus on Chinese convertible bonds, where the main concern is with their pricing and hedging. One of the distinctive features of the Chinese convertible bonds is that they are traded in exchanges, unlike in other countries where data is made available publicly. Additionally, most of the Chinese convertible bonds have unique clauses on the conversion ratio adjustments. For example, the Nanshan convertible bond contract stipulates that the conversion ratio may be raised subject to the approval of shareholders, if the underlying stock price has stayed below the conversion price for 10 days out of 20 consecutive trading days. These clauses make them difficult to be priced mathematically. Thus, there is a need to build models and empirically examine them using market data.

In conclusion the overarching goal of studying and developing a pricing and risk management system based on the above three topics is to provide industry reference prices for Chinese bonds and facilitate regulation during their trades.