Fat Tails in Indian Debt Market : Implications for Risk Modelling

Abstract

The paper examines the tail behaviour in financial returns in the Indian debt market.Focussing on the Government securitries Market in India, the study examines whether the behaviour of the tail in the distribution of financial returns exhibit departures from Guaussian assumptions , and if so, what are the implications for risk modeling that assume normal distribution and are widely used in the financial sector. Using three Government Securities Indices ( for residual maturities of 1-3 years, 3-8 years and above 8 years) derived from the NSE Zero coupon yield curve(ZCYC), the present study conducts an empirical exercise to examine the presnce of fat tails in Indian Government Securities Market. The paper conducts tests of normality to determine the existence of fat tails . It further compares the normal distribution based Variance Co-Variance Model of Value at Risk ( VaR) to determine market risk with a Garch model based on conditional volatility. Backtesting using Kupiek POF ( proportion of Failure) test was conducted to judge the model efficiency.The major observation of the paper include (1) the Indian debt market is characterized by presnce of fat tails in the distribution of daily returns; (2) in the presence of thick tails, the parametric VaR that relies on normal distribution produces erroneous assessment of risk; (3) GARCH models give superior market risk estimates in Indian debt market.