This discussion paper was produced by a Working Party in April 1997 to put forward some possible ways of improving the United Kingdom financial regulatory process. It was written to contribute to the expected post General Election debate on this topic. Although the new Government announced plans in May 1997 for a new Securities and Investment Board (SIB) with statutory powers, this has not reduced the value of this discussion paper which raises some wider issues on methods of regulation.

The paper excludes the supervision and regulation of banks, building societies, insurance companies and exchanges and concentrates on areas that directly affect the public on an ongoing basis. It looks at the expectations of the main parties involved in regulation, the theory and practice of regulation, opportunities and concerns, and concludes with a summary of key issues for discussion. The thrust of the paper is that self regulation should be replaced by statutory regulation and that the present ‘prescriptive’ regulatory process should be replaced by one based on ‘outcomes’ supported by guidance.

The text of these papers, together with the abstract of the discussion held by the Institute of Actuaries on 19 May 1997, are printed in British Actuarial Journal, 3, V, 969-1058.

Actuarial models of the market in conventional British Government Stocks, also known as the Gilt-Edged market, are reviewed and contrasted with the methods which have been developed, during the last twenty years, by financial economists.

Following the Treasury's announcement in May 1995 (regarding the taxation of institutional bond holdings), the so-called ‘coupon effect’ has largely disappeared and gilt prices can now be fitted very closely by using the same simple discounting functions for both income and capital flows. A new model suitable for the calculation of yield indices is proposed and is contrasted with the model currently underlying the FTSE Actuaries Government Securities (FTSEAGS) Yield Indices. A number of new possible applications of the reformulated yield indices, such as forward pricing, asset/liability matching and stochastic simulation, are discussed. An analogous model for index-linked gilts leads to applications involving the forward market in the retail prices index.

A survey of professional users of the FTSEAGS Indices is described, and a revised presentation for the published yield indices is suggested. A summary of current statutory references to the indices is presented.

This paper discusses possible approaches to the construction of gilt yield indices published by the Financial Times. The existing method, described by Dobbie & Wilkie (1978) splits bonds into high, medium and low-coupon bands and fits separate yield curves to each. This method has been identified as susceptible to ‘catastrophic’ jumps when the least-squares fit jumps from one set of parameters to another set of quite different values. This problem is a result of non-linearities in the least-squares formula which can give rise to more than one local minimum. A desire to remove the risk of catastrophic changes prompted this research, which is being carried out as part of the work of the Fixed Interest Working Group.

Recent changes in the taxation of bonds has, further, prompted the need for a review of the yield indices. Significantly, since the announcement of the new tax regime, the old coupon effect has been removed. This has made the use of a single forward-rate curve appropriate for the first time.

A particular form of forward-rate curve is proposed as the basis for a revision of the gilt yield indices. This curve appears to give a significantly better fit than the present yield–curve model. It is also argued that the risk of catastrophic jumps has been reduced significantly.

The literature on ‘Term-Structure Models’ is extensive with many contributions from financial economists over the last twenty years. This paper reviews examples of term-structure models from different categories (‘equilibrium’, ‘evolutionary’ and ‘descriptive’) with particular emphasis on their intended application. The Vasicek (one-factor equilibrium), Richard (two-factor), and Hull & White (evolutionary) models are discussed in some detail.

The paper reviews a particular class of descriptive polynomial models which is flexible and in widespread use both in the academic and the practitioner community. The model is cast in terms of forward rates, applied to the gilt market, and techniques are used to determine how many terms in the polynomial expansion are statistically required in order to describe the market accurately. The model is a linear model of forward and spot rates and is stable; this allows the calculation of risk measures for each bond which give a superior approach, in principle, to portfolio hedging.

Selection of model should be driven by its application. If the objective is a reasonably accurate description of the curve and, by implication, an accurate indication of yields which can be obtained in the market, then a model which fits the market accurately is preferable. The ‘descriptive’ approach is therefore most appropriate in this context.

Consolidation of the FTSE Actuaries Share Indices and of the revised 1994 industry classification system. All-Share Index now in ‘real time’.