Fixed-Income Securities and Derivatives Handbook

by Moorad Choudhry ( )

• ISBN13: 9781576601648
• ISBN10: 1576601641
• Format: Hardcover
• Copyright: 2005-04-01
• Publisher: Bloomberg Pr

Summary

In Fixed-Income Securities and Derivatives Handbook, respected practitioner Moorad Choudhry provides a concise and accessible overview of the main elements of the markets, the techniques used, and their applications. Covering a wide range of market instruments, the book will acquaint you with both simple and complex products and the mathematics behind them.

Author Biography

Moorad Choudhry runs the Treasury desk at KBC Financial Products, the London-based derivatives subsidiary of KBC Bank N.V., a major European financial-services company

Table of Contents

FOREWORD	xiii
PREFACE	xv
PART ONE INTRODUCTION TO BONDS
1 The Bond Instrument	3	(28)
The Time Value of Money	4	(11)
Basic Features and Definitions	5	(1)
Present Value and Discounting	6	(6)
Discount Factors	12	(3)
Bond Pricing and Yield: The Traditional Approach	15	(12)
Bond Pricing	15	(4)
Bond Yield	19	(8)
Accrued Interest	27	(4)
Clean and Dirty Bond Prices	27	(1)
Day-Count Conventions	28	(3)
2 Bond Instruments and Interest Rate Risk	31	(16)
Duration, Modified Duration, and Convexity	31	(16)
Duration	32	(4)
Properties of Macaulay Duration	36	(1)
Modified Duration	37	(4)
Convexity	41	(6)
3 Bond Pricing and Spot and Forward Rates	47	(20)
Zero-Coupon Bonds	47	(2)
Coupon Bonds	49	(2)
Bond Price in Continuous Time	51	(6)
Fundamental Concepts	51	(3)
Stochastic Rates	54	(2)
Coupon Bonds	56	(1)
Forward Rates	57	(6)
Guaranteeing a Forward Rate	57	(2)
The Spot and Forward Yield Curve	59	(1)
Calculating Spot Rates	60	(3)
Term Structure Hypotheses	63	(4)
The Expectations Hypothesis	63	(2)
Liquidity Premium Hypothesis	65	(1)
Segmented Markets Hypothesis	65	(2)
4 Interest Rate Modeling	67	(16)
Basic Concepts	67	(4)
Short-Rate Processes	68	(2)
Ito's Lemma	70	(1)
One-Factor Term-Structure Models	71	(2)
Vasicek Model	71	(1)
Hull-White Model	72	(1)
Further One-Factor Term-Structure Models	73	(2)
Cox-Ingersoll-Ross (CIR) Model	74	(1)
Two-Factor Interest Rate Models	75	(4)
Brennan-Schwartz Model	76	(1)
Extended Cox-Ingersoll-Ross Model	76	(1)
Heath-Jarrow-Morton (HJM) Model	77	(1)
The Multifactor HIM Model	78	(1)
Choosing a Term-Structure Model	79	(4)
5 Fitting the Yield Curve	83	(12)
Yield Curve Smoothing	84	(2)
Smoothing Techniques	86	(1)
Cubic Polynomials	87	(1)
Non-Parametric Methods	88	(4)
Spline-Based Methods	88	(3)
Nelson and Siegel Curves	91	(1)
Comparing Curves	92	(3)
PART TWO SELECTED CASH AND DERIVATIVE INSTRUMENTS
6 Forwards and Futures Valuation	95	(10)
Forwards and Futures	95	(4)
Cash Flow Differences	96	(2)
Relationship Between Forward and Futures Prices	98	(1)
Forward-Spot Parity	99	(2)
The Basis and Implied Repo Rate	101	(4)
7 Swaps	105	(28)
Interest Rate Swaps	106	(6)
Market Terminology	107	(2)
Swap Spreads and the Swap Yield Curve	109	(3)
Generic Swap Valuation	112	(7)
Intuitive Swap Valuation	112	(1)
Zero-Coupon Swap Valuation	113	(1)
Calculating the Forward Rate from Spot-Rate Discount Factors	113	(4)
The Key Principles of an Interest Rate Swap	117	(1)
Valuation Using the Final Maturity Discount Factor	118	(1)
Non-Plain Vanilla Interest Rate Swaps	119	(3)
Swaptions	122	(2)
Valuation	122	(2)
Interest Rate Swap Applications	124	(9)
Corporate and Investor Applications	124	(3)
Hedging Bond Instruments Using Interest Rate Swaps	127	(6)
8 Options	133	(26)
Option Basics	134	(3)
Terminology	136	(1)
Option Instruments	137	(3)
Option Pricing: Setting the Scene	140	(2)
Limits on Option Prices	141	(1)
Option Pricing	142	(2)
The Black-Scholes Option Model	144	(13)
Assumptions	145	(1)
Pricing Derivative Instruments Using the Black-Scholes Model	145	(4)
Put-Call Parity	149	(1)
Pricing Options on Bonds Using the Black-Scholes Model	149	(3)
Interest Rate Options and the Black Model	152	(3)
Comments on the Black-Scholes Model	155	(1)
Stochastic Volatility	156	(1)
Implied Volatility	156	(1)
Other Option Models	157	(2)
9 Measuring Option Risk	159	(14)
Option Price Behavior	159	(2)
Assessing Time Value	159	(1)
American Options	160	(1)
The Greeks	161	(8)
Delta	161	(2)
Gamma	163	(2)
Theta	165	(1)
Vega	165	(1)
Rho	166	(2)
Lambda	168	(1)
The Option Smile	169	(1)
Caps and Floors	170	(3)
10 Credit Derivatives	173	(16)
Credit Risk	175	(1)
Credit Risk and Credit Derivatives	175	(3)
Applications of Credit Derivatives	177	(1)
Credit Derivative Instruments	178	(6)
Credit Default Swap	178	(1)
Credit Options	179	(1)
Credit-Linked Notes	180	(1)
Total Return Swaps	181	(3)
Investment Applications	184	(2)
Capital Structure Arbitrage	184	(1)
Exposure to Market Sectors	184	(1)
Credit Spreads	184	(1)
Funding Positions	185	(1)
Credit-Derivative Pricing	186	(3)
Pricing Total Return Swaps	187	(1)
Asset-Swap Pricing	187	(1)
Credit-Spread Pricing Models	188	(1)
11 The Analysis of Bonds with Embedded Options	189	(22)
Understanding Option Elements Embedded in a Bond	189	(1)
Basic Options Features	190	(1)
Option Valuation	191	(1)
The Call Provision	192	(1)
The Binomial Tree of Short-Term Interest Rates	193	(1)
Arbitrage-Free Pricing	194	(2)
Options Pricing	196	(1)
Risk-Neutral Pricing	197	(1)
Recombining and Nonrecombining Trees	198	(2)
Pricing Callable Bonds	200	(5)
Price and Yield Sensitivity	205	(1)
Measuring Bond Yield Spreads	206	(1)
Price Volatility of Bonds with Embedded Options	207	(1)
Effective Duration	207	(1)
Effective Convexity	208	(1)
Sinking Funds	209	(2)
12 Inflation-Indexed Bonds	211	(16)
Basic Concepts	211	(5)
Choice of Index	211	(2)
Indexation Lag	213	(1)
Coupon Frequency	214	(1)
Type of Indexation	214	(2)
Index-Linked Bond Cash Flows and Yields	216	(7)
TIPS Cash Flow Calculations	217	(1)
TIPS Price and Yield Calculations	217	(4)
Assessing Yields on Index-Linked Bonds	221	(1)
Which to Hold: Indexed or Conventional Bonds?	222	(1)
Analysis of Real Interest Rates	223	(4)
Indexation Lags and Inflation Expectations	223	(2)
An Inflation Term Structure	225	(2)
13 Hybrid Securities	227	(14)
Floating-Rate Notes	228	(3)
Inverse Floating-Rate Notes	231	(2)
Hedging Inverse Floaters	233	(1)
Indexed Amortizing Notes	234	(3)
Advantages for Investors	236	(1)
Synthetic Convertible Notes	237	(1)
Investor Benefits	238	(1)
Interest Differential Notes	238	(3)
Benefits for Investors	240	(1)
14 Securitization and Mortgage-Backed Securities	241	(38)
Reasons for Undertaking Securitization	242	(1)
Market Participants	242	(2)
Securitizing Mortgages	244	(6)
Growth of the Market	244	(1)
Types of Mortgages and Their Cash Flows	245	(3)
Mortgage Bond Risk	248	(1)
Types of Mortgage-Backed Securities	249	(1)
Cash Flow Patterns	250	(14)
Prepayment Analysis	250	(4)
Prepayment Models	254	(1)
Collateralized Mortgage Securities	255	(2)
Sequential Pay	257	(1)
Planned Amortization Class	258	(2)
Targeted Amortization Class	260	(1)
Z-Class Bonds	261	(1)
Interest-Only and Principal-Only Classes	261	(3)
Nonagency CMO Bonds	264	(1)
Credit Enhancements	264	(1)
Commercial Mortgage-Backed Securities	265	(2)
Issuing a CMBS	265	(1)
Types of CMBS Structures	266	(1)
Evaluation and Analysis of Mortgage-Backed Bonds	267	(12)
Term to Maturity	268	(1)
Calculating Yield and Price: Static Cash Flow Model	268	(2)
Bond Price and Option-Adjusted Spread	270	(1)
Effective Duration and Convexity	271	(1)
Total Return	272	(2)
Price-Yield Curves of Mortgage Pass-Through, PO, and IO Securities	274	(5)
15 Collateralized Debt Obligations	279	(14)
CDO Structures	281	(3)
Conventional CDO Structures	281	(2)
Synthetic CDO Structures	283	(1)
Motivation Behind CDO Issuance	284	(2)
Balance Sheet-Driven Transactions	285	(1)
Investor-Driven Arbitrage Transactions	285	(1)
Analysis and Evaluation	286	(3)
Portfolio Characteristics	286	(1)
Cash Flow Analysis and Stress Testing	286	(1)
Originator's Credit Quality	287	(1)
Operational Aspects	287	(1)
Review of Credit-Enhancement Mechanisms	288	(1)
Legal Structure of the Transaction	288	(1)
Expected Loss	289	(4)
PART THREE SELECTED MARKET TRADING CONSIDERATIONS
16 The Yield Curve, Bond Yield, and Spot Rates	293	(22)
Practical Uses of Redemption Yield and Duration	293	(7)
The Concept of Yield	294	(2)
Yield Comparisons in the Market	296	(1)
Measuring a Bond's True Return	297	(3)
Implied Spot Rates and Market Zero-Coupon Yields	300	(4)
Spot Yields and Coupon-Bond Prices	300	(4)
Implied Spot Yields and Zero-Coupon Bond Yields	304	(3)
Determining Strip Values	307	(1)
Strips Market Anomalies	308	(1)
Strips Trading Strategy	309	(2)
Case Study: Treasury Strip Yields and Cash Flow Analysis	311	(4)
17 Approaches to Trading	315	(16)
Futures Trading	316	(4)
Yield Curves and Relative Value	320	(3)
Determinants of Government Bond Yields	320	(3)
Characterizing the Complete Term Structure	323	(3)
Identifying Relative Value in Government Bonds	323	(3)
Hedging Bond Positions	326	(3)
Simple Hedging Approaches	326	(1)
Hedge Analysis	327	(2)
Summary of the Derivation of the Optimum-Hedge Equation	329	(2)
APPENDIX: The Black-Scholes Model in Microsoft Excel	331	(2)
REFERENCES	333	(12)
INDEX	345