Term Structure Estimation in Illiquid Markets

Government debt markets in the developing economies are generally less liquid than in developed ones. There are many fewer liquid on the run securities. Yield curve estimation must therefore include illiquid securities in the data set. Pooling liquid and illiquid securities to estimate the term structure leads to errors in the estimation methodology. The author suggests a method to circumvent this problem, proposing the use of liquidity-weighted objective functions for parameter estimation. The liquidity of individual securities is modeled using observable quantities like number and volume of trades in a security. The model is demonstrated using data from the Indian government bond market.