Fixed Income Trading and Risk Management

The Complete Guide

Alexander During

• Publisher: Wiley
• Year: 2020
• Print ISBN: 9781119756330
• eBook ISBN: 9781119756354
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

A unique, authoritative, and comprehensive treatment of fixed income markets

Fixed Income Trading and Risk Management: The Complete Guide delivers a comprehensive and innovative exposition of fixed income markets. Written by European Central Bank portfolio manager Alexander During, this book takes a practical view of how several different national fixed income markets operate in detail.

The book presents common theoretical models but adds a lot of information on the actually observed behavior of real markets. You'll benefit from the book's:

• Fulsome overview of money, credit, and monetary policy
• Description of cash instruments, inflation-linked debt, and credit claims
• Analysis of derivative instruments, standard trading strategies, and data analysis
• In-depth focus on risk management in fixed income markets

Perfect for new and junior staff in financial institutions working in sales and trading, risk management, back office operations, and portfolio management positions, Fixed Income Trading and Risk Management also belongs on the bookshelves of research analysts and postgraduate students in finance, economics, or MBA programs.

PART One
Preliminaries

CHAPTER 1
Introduction

This book deals with the fixed income markets and the best point to start is to define what this means. The book will follow market usage by defining fixed income instruments as contracts that specify payment obligations that are not linked to the economic situation of the obligor. It also excludes from the scope contracts that establish payments depending on the performance of physical assets, such as commodities or weather. The book will further discuss a range of fixed income derivatives, namely contracts that specify obligations that depend on the performance of fixed income instruments.

Fixed income instruments can be broadly divided in to bilateral contracts and securities. Securities differ from bilateral contracts in that they are transferrable without the consent of all parties. Note that some features of securities may be linked to bilateral contracts. Table 1.1 lists various fixed income instruments in these two categories.

In German, fixed income instruments are referred to as ‘Renten’ and the same word is also used to refer to pensions. In the English vernacular, the scope of the word ‘rent’ to signify income streams has been narrowed down significantly to refer to payments linked to the use of physical assets. The Latin translation of the word ‘rent’, ‘pension’, is now used in English to designate the income stream that accrues to people after a lifetime of work. On the other hand, ‘Pension’ in financial German refers to the renting out of financial assets¹. This etymological divergence between otherwise related languages highlights an important point, namely that the notion of fixed income instruments is not new but underwent several changes of connotation over time.

TABLE 1.1 Non‐exclusive list of instrument types

Bilateral contracts	Securities
Deposits	Bonds
Loans	Commercial paper
Swaps	Certificates of deposit
Futures	Asset‐backed securities

Apart from commodity contracts, the definition above rules out common and preferred equity instruments where the issuer has some discretion about the timing and amount of payments. This is a strong restriction because the party to the contract that is obliged to make a payment has no rights versus the payee. The very word ‘equity’ implies an equitable relationship between payer and payee, whereas in the fixed income setting, the obligor usually has limited discretion.

The ancient Greeks despised money lending, as evidenced in Aristotle's Politics:

There are two sorts of wealth‐getting, as I have said; one is part of household management, the other is retail trade: the former necessary and honourable, while that which consists in exchange is justly censured; for it is unnatural, and a mode by which men gain from one another. The most hated sort, and with the greatest reason, is usury, which makes a gain out of money itself, and not from the natural object of it. For money was intended to be used in exchange, but not to increase at interest.

The three book religions, Judaism, Christianity, and Islam, severely restrict the lending of money against interest and hence the majority of fixed income instruments. In scriptural terms, only Judaism permits charging interest at all, and only in the case of Jews charging interest to gentiles according to the usual intepretation of Deuteronomy 23:19–20:

Thou shalt not lend upon usury to thy brother; usury of money, usury of victuals, usury of anything that is lent upon usury. Upon a stranger thou mayest lend upon usury; but unto thy brother thou shalt not lend upon usury; that the LORD thy God may bless thee in all thou settest thine hand to in the land whither thou goest to possess it.

For Christians, the encyclical Vix pervenit [88] issued by Benedict XIV. on 1 November 1745 opened a legal distinction between usury and lending money at interest, although it reaffirmed the general prohibition of usury. Even earlier, the Pax Westphalica [67] in 1648 casually refers to fixed interest obligations. Today, the issue presents no particular problem for Christians. However, many countries retain prohibitions on excessive interest charges that relate back to usury concepts.

In contrast, Islamic law (Shar'iah) has retained its prohibition to lending at interest (riba), or indeed unconditional repayment obligations. Together with gharar (uncertainty) and maysir (gambling), such practices are strictly forbidden by the Qur'an. This rules out investing money for interest (but not the earning of profits from equity investments) and also the concept of pure options. These restrictions present an obstacle for Muslim investors to interact with the western financial system. Accordingly, a system of Islamic finance has developed that allows profitable investments at low risk.

In order to understand why fixed income is apparently such a new concept, it is instructive to study the prohibitions above, setting aside the issue of divine inspiration. For instance, in Exodus 22:25, Jews are instructed:

If thou lend money to any of my people that is poor by thee, thou shalt not be to him as an usurer, neither shalt thou lay upon him usury.

The implication is that a lender of money is somebody with surplus cash while a borrower is in an emergency situation and needs cash to make ends meet. Exploiting such an emergency situation is morally reprehensible and therefore forbidden. Aristotle's aversion to lending is similarly explained in that he abhors the idea of a necessary social process being abused for pecunary gain. Human beings have to trade in order to exist, but the act of trading does, in his eyes, not contribute to the production of goods. Profiting from something that is not actually increasing the store of wealth of humankind is therefore despicable.

These arguments do not sound too unfamiliar today and debts are still viewed negatively in some parts of the political spectrum [43]. The innovation of some newer critical authors is to draw a distinction between social convention of debts that have to be served unconditionally on one hand, and more flexible moral notions of obligations on the other. The latter are alleged by these authors to be more in line with human development. Setting aside the question whether there is indeed an anthropological basis for distinguishing between morals and social convention, there remains a question as to whether lenders are willingly absorbing an ambiguity in their relationship with borrowers, or instead view their claims as legally absolute. An argument made in Henry V [74] (4.1) may be instructive:

KING HARRY So, if a son is by his father sent about merchandise do sinfully miscarry upon the sea, the imputation of his wickedness, by your rule, should be imposed on his father, that sent him. Or if a servant, under his master's command transporting a sum of money, be assailed by robbers, and die in many irreconciled iniquities, you may call the master the author of the servant's damnation. But this is not so. The King is not bound to answer the particular endings of his soldiers, the father of his son, nor the master of his servant, for they purpose not their deaths when they propose their services.

Similarly, most lenders do not ‘purpose’ inability to repay when they lend money and indeed tend to prefer to lend to borrowers who repay on schedule. A pensioner who has invested in a mortgage does not seek the destitution that may befall the borrower who is dispossessed upon default and would usually prefer not to face the risk of his or her own destitution should the process of liquidating the property faily to reproduce the originally expected income stream.

What has changed in recent times is that lenders are no longer necessarily rich and borrowers are not necessarily poor. People now generally accept that individuals need to put money aside to prepare for their old age and that if they were unable to do so without being paid interest, inflation and credit risk would erode the value of their savings. They also have no reason to enter a relationship based on equity with whoever has use of their money at the time. The association of fixed income with pension in the German word ‘Rente’ is therefore now quite natural. On the borrower side, it is now also co...

Table of contents

• Cover
• Table of Contents
• Title Page
• Copyright
• Foreword
• PART One: Preliminaries
• PART Two: Cash Instruments
• PART Three: Inflation‐Linked Debt
• PART Four: Defaultable Claims
• PART Five: Derivatives
• PART Six: Standard Trading Strategies
• PART Seven: Risk Management
• PART Eight: References
• Bibliography
• Index
• End User License Agreement