The following invention relates to a financial index and, in particular, to a method for selecting securities for inclusion in a fixed income index.
A financial index is a statistical construct that measures price changes, returns, interest rates and/or other financial data in stock markets, fixed income markets, currencies or futures markets. The purpose of forming an index is to provide a summary measure whose behavior is representative of the movements of prices or rates of a basket of securities and thus indicative of the behavior of a broad market. Because indices serve as a barometer for the overall performance of a particular market, they are used as benchmarks against which investment results are measured as well as for implementing various investment strategies such as asset allocation, relative value analysis, and portfolio analysis. Furthermore, indices are often used as a basis for other products and strategies—including derivative products—that provide investors with a convenient way of profiting from overall market movements. Examples of indices are the S&P 500, an equity index that tracks the performance of 500 publicly traded companies, and the J. P. Morgan Government Bond Index, a benchmark used for measuring performance and quantifying risk across international sovereign bond markets.
An index is typically formed by first selecting a universe of instruments whose performance the index is to track. For example, in forming a corporate bond index, the universe may be selected by including all corporate bonds having a maturity greater than one year, an outstanding debt of $150 million or greater, and a credit rating below S&P BBB-. Once the universe is identified, the index may be formed by including all the instruments in the universe on a weighted-average basis. An index formed using this technique, sometimes called a complete market index, is simple to construct. Because a complete market index contains all of the bonds in the universe, it is by definition representative of the universe of underlying instruments.
Complete market indices formed using the prior art techniques have several drawbacks. First, for broad and diverse markets, data quality may become compromised due to the sheer volume of data. Second, because these indices include all the instruments contained in the universe, it is difficult to obtain accurate, timely and contemporaneous pricing for all of the issues in the index. This is particularly important in broad and diverse markets because of the illiquidity of certain constituent instruments. Third, indices comprising large numbers of securities are difficult or impossible to replicate. This is also especially true in broad, diverse and less liquid markets. Furthermore, because a substantial portion of the underlying instruments contained in the index are not trader priced or priced with prices available in the market, it becomes more difficult or sometimes impossible to replicate the index. An index that is not replicable is not suitable for use in most investment situations including, by way of non-limiting for example, where the index is used as a hedging tool, used in the construction of an investment portfolio or used to design baskets to track the index.
To overcome the lack of accurate and timely pricing, many indices use a technique known as matrix pricing. In matrix pricing a portion of the instruments contained in the universe are priced using direct market observation of trader bids and offers or actual transactions. The prices of the remaining instruments are not based on such trader pricing but rather are estimated based on assumptions and using formulas or computer models. As an example, it may be assumed that all instruments issued by the same company or within the same sector as the instruments that have trader pricing move together. Thus, because trader pricing is not directly obtained for each instrument in the universe, matrix pricing improves the speed at which the price of an index can be updated.
Although matrix pricing improves somewhat the speed at which the price of an index can be updated, pricing an index using such techniques diminishes the accuracy of the index in representing the actual behavior of the universe.
Another drawback of prior art indices exists with respect to those designed to represent the fixed income market that typically includes multi-dimensional risks that arise from a variety of factors including bond specific factors, such as coupon, maturity, credit rating, etc., and othe factors, such as, the issuer, industry, and country/region. Because the prior art indices generally can only reflect such multi-dimensional risk by including the entire universe of instruments in the index, prior art fixed income indices are difficult to price and replicate, as described above.
Accordingly, it is desirable to provide a method for forming a fixed income index that is representative of a universe of instruments and that can be accurately priced in a timely and replicable manner.