Fixed-Income Securities and Derivatives Handbook

Analysis and Valuation

Moorad Choudhry

• Publisher: Bloomberg Press
• Year: 2010
• Print ISBN: 9781576603345
• eBook ISBN: 9780470911112
• Edition: 2
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

The definitive guide to fixed-come securities-revised to reflect today's dynamic financial environment

The Second Edition of the Fixed-Income Securities and Derivatives Handbook offers a completely updated and revised look at an important area of today's financial world. In addition to providing an accessible description of the main elements of the debt market, concentrating on the instruments used and their applications, this edition takes into account the effect of the recent financial crisis on fixed income securities and derivatives.

As timely as it is timeless, the Second Edition of the Fixed-Income Securities and Derivatives Handbook includes a wealth of new material on such topics as covered and convertible bonds, swaps, synthetic securitization, and bond portfolio management, as well as discussions regarding new regulatory twists and the evolving derivatives market.

• Offers a more detailed look at the basic principles of securitization and an updated chapter on collateralized debt obligations
• Covers bond mathematics, pricing and yield analytics, and term structure models
• Includes a new chapter on credit analysis and the different metrics used to measure bond-relative value
• Contains illustrative case studies and real-world examples of the topics touched upon throughout the book

Written in a straightforward and accessible style, Moorad Choudhry's new book offers the ideal mix of practical tips and academic theory within this important field.

PART ONE

INTRODUCTION TO BONDS

Part One describes fixed-income market analysis and the basic concepts relating to bond instruments. The analytic building blocks are generic and thus applicable to any market. The analysis is simplest when applied to plain vanilla default-free bonds; as the instruments analyzed become more complex, additional techniques and assumptions are required.

The first two chapters of this section discuss bond pricing and yields, moving on to an explanation of such traditional interest rate risk measures as modified duration and convexity, followed by a discussion of floating-rate notes (FRNs). Chapter 3 looks at spot and forward rates, the derivation of such rates from market yields, and the yield curve.

Yield-curve analysis and the modeling of the term structure of interest rates are among the most heavily researched areas of financial economics. The treatment here has been kept as concise as possible, at just two chapters. The References section at the end of the book directs interested readers to accessible and readable resources that provide more detail.

CHAPTER 1

The Bond Instrument

Bonds are the basic ingredient of the U.S. debt-capital market, which is the cornerstone of the U.S. economy. All evening television news programs include a slot during which the newscaster informs viewers where the main stock market indexes closed that day and where key foreign exchange rates ended up. Financial sections of most newspapers also indicate at what yield the Treasury long bond closed. This coverage reflects the fact that bond prices are affected directly by economic and political events, and yield levels on certain government bonds are fundamental economic indicators. The yield level on the U.S. Treasury long bond, for instance, mirrors the market’s view on U.S. interest rates, inflation, public-sector debt, and economic growth.

The media report the bond yield level because it is so important to the country’s economy—as important as the level of the equity market and more relevant as an indicator of the health and direction of the economy. Because of the size and crucial nature of the debt markets, a large number of market participants, ranging from bond issuers to bond investors and associated intermediaries, are interested in analyzing them. This chapter introduces the building blocks of the analysis.

Bonds are debt instruments that represent cash flows payable during a specified time period. They are essentially loans. The cash flows they represent are the interest payments on the loan and the loan redemption. Unlike commercial bank loans, however, bonds are tradable in a secondary market. Bonds are commonly referred to as fixed-income instruments. This term goes back to a time when bonds paid fixed coupons each year. Today that is not necessarily the case. Asset-backed bonds, for instance, are issued in a number of tranches—related securities from the same issuer—each of which pays a different fixed or floating coupon. Nevertheless, this is still commonly referred to as the fixed-income market.

In the past, bond analysis was frequently limited to calculating gross redemption yield, or yield to maturity. Today basic bond math involves different concepts and calculations. These are described in several of the references for Chapter 3, such as Ingersoll (1987), Shiller (1990), Neftci (1996), Jarrow (1996), Van Deventer (1997), and Sundaresan (1997). This chapter reviews the basic elements. Bond pricing, together with the academic approach to it and a review of the term structure of interest rates, are discussed in depth in Chapter 3.

In the analysis that follows, bonds are assumed to be default free. This means there is no possibility that the interest payments and principal repayment will not be made. Such an assumption is entirely reasonable for government bonds such as U.S. Treasuries and U.K. gilt-edged securities. It is less so when you are dealing with the debt of corporate and lower-rated sovereign borrowers. The valuation and analysis of bonds carrying default risk, however, are based on those of default-free government securities. Essentially, the yield investors demand from borrowers whose credit standing is not risk-free is the yield on government securities plus some credit risk premium.

The Time Value of Money

Bond prices are expressed “per 100 nominal”—that is, as a percentage of the bond’s face value. (The convention in certain markets is to quote a price per 1,000 nominal, but this is rare.) For example, if the price of a U.S. dollar-denominated bond is quoted as 98.00, this means that for every $100 of the bond’s face value, a buyer would pay $98. The principles of pricing in the bond market are the same as those in other financial markets: the price of a financial instrument is equal to the sum of the present values of all the future cash flows from the instrument. The interest rate used to derive the present value of the cash flows, known as the discount rate, is key, since it reflects where the bond is trading and how its return is perceived by the market. All the factors that identify the bond—including the nature of the issuer, the maturity date, the coupon, and the currency in which it was issued—influence the bond’s discount rate. Comparable bonds have similar discount rates. The following sections explain the traditional approach to bond pricing for plain vanilla instruments, making certain assumptions to keep the analysis simple. After that, a more formal analysis is presented.

Basic Features and Definitions

One of the key identifying features of a bond is its issuer, the entity that is borrowing funds by issuing the bond in the mar...

Table of contents

• Praise
• Title Page
• Copyright Page
• Foreword
• PREFACE
• PART ONE - INTRODUCTION TO BONDS
• PART TWO - SELECTED CASH AND DERIVATIVE INSTRUMENTS
• PART THREE - SELECTED MARKET TRADING CONSIDERATIONS
• APPENDIX I - The Black-Scholes Model in Microsoft Excel
• APPENDIX II - Iterative Formula Spreadsheet
• APPENDIX III - Pricing Spreadsheet
• REFERENCES
• ABOUT THE AUTHOR
• INDEX