The Case of Missing Maturities

The first case is one where out of a set of bonds issued by a certain entity, only a few are so illiquid as not to have any market information associated to them. In this case we apply a simple interpolation between the price of neighboring bonds (neighboring both in case of maturities and coupon size) and price the illiquid ones.

The Case of Quasi Government Entities

A phenomenon present in emerging markets (but not limited to them) is the one of state-owned or state-backed enterprise. This is an entity that competes on a local or global stage but has a strong link to a particular government. When this entity issues debt it is not exactly identical to government debt, but an investor can be assured that the government would intervene in case of trouble. If we had to price an illiquid bond issued by a quasi government entity we would take a reference spread of the respective government (say a z-spread or survival probabilities calibrated on CDS rates), add a further spread because of liquidity and the fact that, all considered, the entity must be at least a little riskier than the government, and price the bond.

Similar Countries

When trying to price an illiquid sovereign bond a sensible starting point is to look at similar countries. Similarity can be considered in many forms. The first option is to look at neighboring countries.

Let us say that we need to price a bond^[1] issued by the Kingdom of Cambodia. We could use the credit information of Vietnam. This, however, would be a bit simplistic since Vietnam is far larger and wealthier than Cambodia and participates more actively in the wider financial system.

We could then consider a proxy basket and, Cambodia belonging to ASEAN (the Association of South East Asian Nations^[2]), we could take an average of the credit information (in the form, as usual, of z-spreads, benchmarks, or CDS rates) of the liquid members, add some spread, and price Cambodian debt. In this case a lot would depend on the spread we are adding since the liquid members have a considerably higher credit standing due to their wealth.

Another option would be to forgo regional similarity and focus on using proxies based on alternative economic indicators such as credit ratings, similar GDP, similar level of debt, or similar type of economy. Sometimes similarity can group countries very far from each other. One could argue that as members of the BRIC countries,^[3] Russia and Brazil have more in common with each other than with some of their neighbors. This is not necessarily useful for our exercise since BRIC countries have fairly liquid debt (however, not all of them have USD-denominated debt).

• [1] We discuss bonds in this section, but the same principles could be applied without modification to the fair value of loans as seen in Section 3.3.1.
• [2] The other members are Brunei, Burma, Indonesia, Laos, Malaysia, Philippines, Thailand, Singapore, and Vietnam.
• [3] The term BRIC was coined by Goldman Sachs to group together Brazil, Russia, India, and China. In the press there have been modifications in the form of an extra I and/or S to include Indonesia and South Africa.