Fixed Income Securities

Tools for Today's Markets

Bruce Tuckman, Angel Serrat

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118133965
• Edition: 3
• Topic: Negocios y empresa
• Subtopic: Finanzas

Fixed income practitioners need to understand the conceptual frameworks of their field; to master its quantitative tool-kit; and to be well-versed in its cash-flow and pricing conventions. Fixed Income Securities, Third Edition by Bruce Tuckman and Angel Serrat is designed to balance these three objectives. The book presents theory without unnecessary abstraction; quantitative techniques with a minimum of mathematics; and conventions at a useful level of detail.

The book begins with an overview of global fixed income markets and continues with the fundamentals, namely, arbitrage pricing, interest rates, risk metrics, and term structure models to price contingent claims. Subsequent chapters cover individual markets and securities: repo, rate and bond forwards and futures, interest rate and basis swaps, credit markets, fixed income options, and mortgage-backed-securities.

Fixed Income Securities, Third Edition is full of examples, applications, and case studies. Practically every quantitative concept is illustrated through real market data. This practice-oriented approach makes the book particularly useful for the working professional.

This third edition is a considerable revision and expansion of the second. Most examples have been updated. The chapters on fixed income options and mortgage-backed securities have been considerably expanded to include a broader range of securities and valuation methodologies. Also, three new chapters have been added: the global overview of fixed income markets; a chapter on corporate bonds and credit default swaps; and a chapter on discounting with bases, which is the foundation for the relatively recent practice of discounting swap cash flows with curves based on money market rates.

[FOR THE UNIVERSITY EDITION]

This university edition includes problems which students can use to test and enhance their understanding of the text.

Part One

The Relative Pricing of Securities with Fixed Cash Flows

Consumers and businesses are willing to pay more than $1 in the future in exchange for $1 today. A newly independent adult borrows money to buy a car today, agreeing to repay the loan price plus interest over time; a family takes a mortgage to purchase a new home today, assuming the obligation to make principal and interest payments for years; and a business, which believes it can transform $1 of investment into $1.10 or $1.20, chooses to take on debt and pay the prevailing market rate of interest. At the same time, this willingness of potential borrowers to pay interest attracts lenders and investors to make consumer loans, mortgage loans, and business loans. This fundamental fact of financial markets, that receiving $1 today is better than receiving $1 in the future, or, equivalently, that borrowers pay lenders for the use of their funds, is known as the time value of money.

Borrowers and lenders meet in fixed income markets to trade funds across time. They do so in very many forms: from one-month U.S. Treasury bills that are almost certain to return principal and interest to the long-term debt of companies that have already filed for bankruptcy; from assets with a simple dependence on rates, like Eurodollar futures, to callable bonds and swaptions; from assets whose value depends only on rates, like interest rate swaps, to mortgage-backed securities or inflation-protected securities; and from fully taxable private-sector debt to partially or fully tax-exempt issues of governments and municipalities.

To cope with the challenge of pricing the vast number of existing and potential fixed income securities, market professionals often focus on a limited set of benchmark securities, for which prices are most consistently and reliably available, and then price all similar assets relative to those benchmarks. Sometimes, as when pricing a UK government bond in terms of other UK government bonds, or when pricing an EUR swap in terms of other EUR swaps, relative prices can be determined rigorously and for the most part accurately by arbitrage pricing. This methodology is developed in Chapter 1, where it is also shown that discounting, i.e., calculating present values with discount factors, is really just shorthand for arbitrage pricing.

While discount factors in many ways solve the relative pricing problem, they are not very intuitive for understanding the time value of money that is embedded in market prices. For this purpose, markets rely on spot, forward, and par rates. Chapter 2 introduces these rates and derives the relationships linking them to each other and to discount factors. The trading case study in Chapter 2, inspired by an abnormally shaped EUR forward swap curve, illustrates how fixed income analytics, market technicals (due to institutional factors described in the Overview), and a macroeconomic setting all contribute to a trade idea.

While the interest rates of Chapter 2 provide excellent intuition with respect to the time value of money embedded in market prices, other quantities provide intuition with respect to the returns offered by individual securities. The first half of Chapter 3 defines returns, spreads, and yields. Spreads describe the pricing of particular securities relative to benchmark government bond or swap curves and yields are the widely used, although somtimes misunderstood, internal rates of return on individual securities. The second half of Chapter 3 breaks down a security's return into several component parts. First, how does the security perform if rates and spreads stay the same? Second, how does the security perform if rates change? Third, how does the security perform if spreads change?

Given the central role of benchmarks in Part One, it is worth describing which securities are used as benchmarks and why. Until relatively recently, benchmark curves in U.S. and Japanese markets were derived from the histori...