The Advanced Fixed Income and Derivatives Management Guide

Saied Simozar

• Publisher: Wiley
• Year: 2015
• Print ISBN: 9781119014140
• eBook ISBN: 9781119014171
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

A highly-detailed, practical analysis of fixed income management

The Advanced Fixed Income and Derivatives Management Guide provides a completely novel framework for analysis of fixed income securities and portfolio management, with over 700 useful equations. The most detailed analysis of inflation linked and corporate securities and bond options analysis available;, this book features numerous practical examples that can be used for creating alpha transfer to any fixed income portfolio. With a framework that unifies back office operations, such as risk management and portfolio management in a consistent way, readers will be able to better manage all sectors of fixed income, including bonds, mortgages, credits, and currencies, and their respective derivatives, including bond and interest rate futures and options, callable bonds, credit default swaps, interest rate swaps, swaptions and inflation swaps. Coverage includes never-before-seen detail on topics including recovery value, partial yields, arbitrage, and more, and the companion website features downloadable worksheets that can be used for measuring the risks of securities based on the term structure models.

Many theoretical models of the Term Structure of Interest Rates (TSIR) lack the accuracy to be used by market practitioners, and the most popular models are not mathematically stable. This book helps readers develop stable and accurate TSIR for all fundamental rates, enabling analysis of even the most complex securities or cash flow structure. The components of the TSIR are almost identical to the modes of fluctuations of interest rates and represent the language with which the markets speak.

• Examine unique arbitrage, risk measurement, performance attribution, and replication of bond futures
• Learn to estimate recovery value from market data, and the impact of recovery value on risks
• Gain deeper insight into partial yields, product design, and portfolio construction
• Discover the proof that corporate bonds cannot follow efficient market hypothesis

This useful guide provides a framework for systematic and consistent management of all global fixed income assets based on the term structure of rates. Practitioners seeking a more thorough management system will find solutions in The Advanced Fixed Income and Derivatives Management Guide.

Chapter 1
Review of Market Analytics

This chapter reviews some of the basic analytics for fixed income securities and provides evidence for the inadequacies of the existing models. The simplest and most straightforward fixed income instrument is a bond. A bond is a security that pays interest at prescribed intervals, called coupon dates, and pays back the principal and final coupon on the maturity date.

Consider a company or a government that borrows $100 million for a period of 5 years at a rate of 7% per year payable at semi-annual intervals. The borrower, also known as the bond issuer, will have to make coupon payments equal to 3.5% of the borrowed amount or $3.5 million every 6 months to lenders, also known as bond holders or investors. At the end of 5 years, the borrower pays $3.5 million of interest plus the $100 million principal back to the lenders.

The above example is a typical bond, where the borrower, unlike mortgage borrowers, cannot pay back the principal earlier than scheduled. The bond holder can usually sell the bond in the secondary market and receive a fair price for it.

The primary risk of a bond holder, other than default, is a rise in interest rates. If inflation expectations increase, bond investors demand higher interest rates to compensate them for anticipated inflation that will lower their future buying power. Likewise, if inflationary expectations fall, interest rates are likely to fall as well. During rapid economic growth, demand for money rises, which can lead to higher interest rates. During recessions or low economic activity, demand for money falls, usually resulting in lower interest rates.

1.1 BOND VALUATION

If interest rates fall, the value of an existing bond increases since investors will pay a premium price for a bond that has a higher coupon payment than a newly issued bond with a lower coupon. This brings us to the simplest and most fundamental of all pricing formulas in the fixed income market, namely the present value of a bond, defined with a principal amount of 100 as

1.1

where p is the present value of the bond, y_m is the market yield or effective interest rate of the bond, m is the frequency of coupon payment (if the bond pays semi-annual interest, then m = 2, if it pays quarterly, then m = 4), c is the periodic coupon payment, and n is the number of interest payments. It can be easily shown that if the present value of the bond on issue date is equal to 100, then the following relationship holds:

1.2

In our prior example, the semi-annual coupon payment per 100 of principal would be 3.5. Inserting this value for c, and using m = 2, leads to a yield of 0.07 or 7%. Thus, on issue date, the yield of a bond priced at 100 (par) is equal to the annual coupon payment of the bond per 100 principal amount divided by 100. At all other times, the price/yield function of a bond is a little more complicated.

Nearly all bonds in the market are traded on the basis of what is known as the clean price. The clean price does not include the amount of interest that has been accrued but not paid to the bond holder. Accrued interest is the pro rata share of the next coupon payment that is due the seller at the time of the trade settlement. In our previous example, if after 3 months the bond holder sells his bonds, then the buyer has to pay half of the next coupon payment to the seller for holding the bonds for half the period of coupon payment.

Different bond markets have different conventions...

Table of contents

• Cover
• Title Page
• Copyright
• Table of Contents
• List of Tables
• List of Figures
• Abbreviations
• Notation
• Preface
• Acknowledgement
• Foreword
• About the Author
• Introduction
• Chapter 1: Review of Market Analytics
• Chapter 2: Term Structure of Rates
• Chapter 3: Comparison of Basis Functions
• Chapter 4: Risk Measurement
• Chapter 5: Performance Attribution
• Chapter 6: Libor and Swaps
• Chapter 7: Trading
• Chapter 8: Linear Optimization and Portfolio Replication
• Chapter 9: Yield Volatility
• Chapter 10: Convexity and Long Rates
• Chapter 11: Real Rates and Inflation Expectations
• Chapter 12: Credit Spreads
• Chapter 13: Default and Recovery
• Chapter 14: Deliverable Bond Futures and Options
• Chapter 15: Bond Options
• Chapter 16: Currencies
• Chapter 17: Prepayment Model
• Chapter 18: Mortgage Bonds
• Chapter 19: Product Design and Portfolio Construction
• Chapter 20: Calculating Parameters of the TSIR
• Chapter 21: Implementation
• References
• Index
• End User License Agreement