Bond Evaluation, Selection, and Management

BOND EVALUATION, SELECTION, AND MANAGEMENT......Page 0
CONTENTS......Page 5
List of Figures......Page 17
List of Exhibits......Page 18
List of Tables......Page 22
Preface......Page 25
PART I: BOND EVALUATION AND SELECTION......Page 29
1.1 Real and Financial Assets......Page 31
1.2 Types of Debt Claim......Page 32
1.3 Financial Market......Page 33
1.4.1 Primary and Secondary Market......Page 34
1.4.2 Direct and Intermediary Financial Markets......Page 35
1.4.3 Money and Capital Markets......Page 37
1.4.4 Foreign Security Markets......Page 38
1.5 Regulations......Page 39
1.6 Efficient Financial Markets......Page 42
1.7 Characteristics of Assets......Page 43
Key Terms......Page 45
Problems and Questions......Page 46
Selected References......Page 48
2.2.1 Pricing Bonds......Page 49
2.2.2 Bond Price Relations......Page 50
2.2.3 Pricing Bonds with Different Cash Flows and Compounding Frequencies......Page 53
2.3 The Yield to Maturity and Other Rates of Return Measures......Page 58
2.3.1 Common Measures of Rates of Return......Page 59
2.3.3 Bond-Equivalent Yields......Page 60
2.3.6 Bond Portfolio Yields......Page 61
2.4.3 Spot Rates and Equilibrium Prices......Page 62
2.4.4 Estimating Spot Rates: Bootstrapping......Page 63
2.5 Annual Realized Return......Page 65
2.6 Geometric Mean......Page 66
2.6.1 Implied Forward Rate......Page 67
2.6.2 Usefulness of the Geometric Mean......Page 68
2.7 Conclusion......Page 69
Problems and Questions......Page 70
Selected References......Page 74
3.1 Introduction......Page 75
3.2 Behavior of Interest Rates: Supply and Demand Analysis......Page 76
3.2.1 Bond Demand......Page 77
3.2.2 Bond Supply......Page 79
3.2.4 Comparative Analysis......Page 80
3.3.1 Risk Premium......Page 82
3.3.3 Taxability......Page 87
3.4.1 Market Segmentation Theory......Page 89
3.4.2 Preferred Habitat Theory......Page 95
3.4.3 Pure Expectations Theory......Page 102
3.4.5 Summary of Term Structure Theories......Page 106
3.4.6 Current and Expected Spot Yield Curves......Page 107
Key Terms......Page 109
Problems and Questions......Page 110
Selected References......Page 114
4.2 Default Risk......Page 115
4.2.1 Historical Default Rates......Page 116
4.2.3 Studies on Default Risk Premiums......Page 117
4.2.4 Bond Diversification and Quality Ratings......Page 118
4.3.1 Example of Call Risk......Page 119
4.3.2 Price Compression......Page 120
4.4.1 Example of Market Risk......Page 121
4.4.2 Duration and Bond Immunization......Page 122
4.5.1 Duration Measures......Page 125
4.5.2 Uses of Duration......Page 127
4.5.3 Convexity......Page 128
4.5.5 Uses of Convexity......Page 129
Key Terms......Page 130
Problems and Questions......Page 131
Notes......Page 133
Selected References......Page 134
PART II: DEBT MARKETS......Page 135
5.1 Introduction......Page 137
5.2.1 General Features of Corporate Bonds......Page 138
5.2.2 Corporate Bonds with Special Features......Page 144
5.3 Bankruptcy......Page 147
5.5.1 Primary Market......Page 149
5.5.2 Secondary Market......Page 151
5.6 Information on Corporate Bonds......Page 152
5.7.3 Features of Commercial Paper......Page 153
5.8.1 Issuing Process......Page 154
5.9 Conclusion......Page 155
Problems and Questions......Page 156
Notes......Page 159
Selected References......Page 160
6.2 Treasury Instruments......Page 161
6.2.1 Treasury Bills......Page 163
6.2.3 Treasury Inflation Protection Securities (TIPS)......Page 164
6.2.4 Treasury Strips......Page 165
6.2.5 The Markets for Treasury Securities......Page 166
6.2.6 Government Security Dealers......Page 168
6.3 Repurchase Agreements......Page 170
6.3.2 The Market for Repurchase Agreements......Page 171
6.3.3 Risk......Page 172
6.4 Federal Agency Securities......Page 173
6.4.1 Housing and Real Estate Financing......Page 175
6.4.2 Agriculture Credit Financing......Page 176
6.4.3 Savings and Loans and Bank Financing......Page 178
6.4.5 International Financing......Page 179
6.5.1 Tax-Exempt Status......Page 180
6.5.2 Types of Municipal Securities......Page 181
6.5.3 Special Features of Municipals......Page 183
6.5.4 Default Risk and Quality Ratings......Page 186
6.5.5 Municipal Bond Markets......Page 187
Key Terms......Page 189
Problems and Questions......Page 190
Selected References......Page 194
7.1 Introduction......Page 195
7.2.2 Markets......Page 196
7.3 Banker's Acceptances......Page 197
7.4 Mortgage-Backed and Asset-Backed Securities......Page 198
7.5.1 The Market for Funds......Page 199
7.5.2 Structure of Funds......Page 200
7.5.3 Types of Investment Funds......Page 201
7.5.7 Other Investment Funds......Page 202
7.6.1 Insurance Products......Page 204
7.7 Pension Funds......Page 206
7.8 International Debt Securities......Page 207
7.8.2 The Eurobond Market......Page 208
7.8.5 Emerging Market Debt......Page 211
7.8.6 Eurocurrency Market......Page 213
7.8.7 The Foreign Currency Market and Exchange-Rate Risk......Page 215
7.9 Conclusion......Page 217
Problems and Questions......Page 218
Notes......Page 222
Selected References......Page 223
8.1 Introduction......Page 224
8.2.1 Interest Rate-Anticipation Strategies......Page 225
8.2.2 Credit Strategies......Page 228
8.2.3 Fundamental Valuation Strategies......Page 231
8.2.4 Other Active Strategies......Page 232
8.3.1 Indexing......Page 233
8.3.2 Cash-Flow Matching: Dedicated Portfolios......Page 235
8.4.2 Rebalancing......Page 237
8.4.4 Surplus Management and Duration Gap Analysis......Page 240
8.4.5 Contingent Immunization......Page 241
8.5 Conclusion......Page 245
Key Terms......Page 246
Problems and Questions......Page 247
Notes......Page 253
Selected References......Page 254
PART III: EVALUATION OF BONDS WITH EMBEDDED OPTIONS......Page 257
9.2 Binomial Interest Rate Model......Page 259
9.2.1 Valuing a Two-Period Bond......Page 261
9.2.2 Valuing a Three-Period Bond......Page 262
9.2.3 Alternative Binomial Valuation Approach......Page 267
9.3.1 Putable Bond......Page 268
9.3.2 Sinking-Fund Bonds......Page 270
9.3.3 Convertible Bond......Page 271
9.4 Conclusion......Page 276
Problems and Questions......Page 278
Selected References......Page 281
10.2 Subdividing the Binomial Tree......Page 283
10.3 Estimating the Tree......Page 284
10.3.1 u and d Estimation Approach......Page 285
10.3.2 Calibration Model......Page 289
10.4 Option-Adjusted Spread......Page 296
10.5 Duration and Convexity......Page 297
10.7 Conclusion......Page 298
Problems and Questions......Page 299
Selected References......Page 303
11.2 Mortgage Loans......Page 304
11.2.1 Prepayment......Page 307
11.2.2 Estimating a Mortgage Pool's Cash Flow with Prepayment......Page 308
11.3 Mortgage-Backed Securities......Page 309
11.3.1 Government National Mortgage Association's Mortgage-Backed Securities......Page 310
11.3.4 Conventional Pass-Throughs......Page 311
11.4.2 Price Quotes......Page 312
11.4.3 Extension Risk and Average Life......Page 313
11.5.1 Sequential-Pay Tranches......Page 315
11.5.2 Planned Amortization Class......Page 321
11.5.3 Stripped Mortgage-Backed Securities......Page 323
11.6.1 Yield Analysis......Page 324
11.6.2 Monte Carlo Simulation......Page 325
11.8 Conclusion......Page 330
Problems and Questions......Page 331
Selected References......Page 339
PART IV: DEBT DERIVATIVES: FUTURES, OPTIONS, AND SWAPS......Page 341
12.1 Introduction......Page 343
12.2.1 Microstructure......Page 344
12.2.2 Types of Interest Rate Futures......Page 347
12.3.2 The Clearinghouse......Page 351
12.3.3 Margin Requirements......Page 353
12.3.4 Points on Margin Requirements......Page 354
12.4.1 Long Hedge......Page 355
12.4.2 Short Hedge......Page 356
12.4.3 Hedging Risk......Page 358
Key Terms......Page 359
Problems and Questions......Page 360
Selected References......Page 363
13.2 Hedging Debt Positions......Page 365
13.2.1 Naive Hedging Model......Page 366
13.3.1 Price-Sensitivity Model......Page 368
13.3.2 Cross-Hedging Examples......Page 369
13.4.1 Intracommodity Spread......Page 371
13.4.3 Managing Asset and Liability Positions......Page 372
13.5.1 Synthetic Fixed-Rate Loan......Page 373
13.5.2 Synthetic Floating-Rate Loan......Page 374
13.6.2 Pricing a T-Bill Futures Contract......Page 375
13.6.3 Other Equilibrium Conditions Implied by the Carrying-Cost Model......Page 377
13.6.4 T-Bond Delivery Procedure and Equilibrium Pricing......Page 379
13.6.5 Notes on Futures Pricing......Page 381
13.7.1 Hedging......Page 382
13.7.2 Pricing Futures and Forward Exchange Rates......Page 383
13.7.3 Investment Uses of the Interest Rate Parity Theorem......Page 385
Problems and Questions......Page 386
Selected References......Page 393
14.1 Introduction......Page 394
14.2.2 Futures Options......Page 395
14.3.1 Markets......Page 396
14.3.2 Types of Interest Rate Options......Page 397
14.4.1 Fundamental Spot Option Positions......Page 401
14.4.2 Fundamental Futures Options Positions......Page 405
14.4.3 Fundamental Interest Rate Call and Put Positions......Page 406
14.4.4 Other Option Strategies......Page 407
14.4.5 Speculation......Page 408
14.5.1 Standardization......Page 409
14.5.2 Continuous Trading......Page 410
14.5.3 Clearinghouse and Option Clearing Corporation......Page 411
14.5.5 Types of Option Transactions......Page 412
14.6.1 Call Price Relationships......Page 413
14.6.2 Put Price Relationships......Page 417
14.6.4 Put-Call Parity......Page 419
Key Terms......Page 421
Problems and Questions......Page 422
Selected References......Page 424
15.2.1 Hedging with Interest Rate Options......Page 426
15.2.2 Long Hedging Cases......Page 427
15.2.3 Short Hedging Cases......Page 431
15.3 Hedging a Series of Cash Flows: OTC Caps and Floors......Page 436
15.3.1 Example: Floating-Rate Loan Hedged with an OTC Cap......Page 437
15.3.3 Financing Caps and Floors: Collars and Corridors......Page 439
15.4.1 Barrier Options......Page 443
15.4.2 Path-Dependent Options......Page 445
15.4.4 Foreign Currency Options......Page 446
15.5.1 Valuing T-Bill Options with a Binomial Tree......Page 449
15.5.3 Valuing T-Bond Options with a Binomial Tree......Page 453
15.5.5 Realism......Page 456
15.6.1 Black Futures Model......Page 458
15.6.2 Pricing Caplets and Floorlets with the Black Futures Option Model......Page 459
Problems and Questions......Page 460
Selected References......Page 470
16.1 Introduction......Page 472
16.2.2 Interest Rate Swap: Example......Page 473
16.2.4 Similarities Between Swaps and Bond Positions and Eurodollar Futures Strips......Page 475
16.3.2 Swap Market Price Quotes......Page 479
16.3.3 Opening Swap Positions......Page 481
16.3.4 Closing Swap Positions......Page 482
16.4.1 Comparative Advantage......Page 483
16.5.1 Arbitrage Applications: Synthetic Positions......Page 484
16.5.2 Hedging Applications......Page 487
16.5.3 Speculation Applications......Page 488
16.5.4 Changing the Balance Sheet's Interest Rate Exposure......Page 489
16.6.1 Valuation of Off-Market Swaps......Page 490
16.6.3 Zero-Coupon Swap Yield Curve: Bootstrapping......Page 492
16.6.5 Break-Even Swap Rate......Page 494
16.7 Credit Risk......Page 495
Key Terms......Page 496
Problems and Questions......Page 497
Selected References......Page 502
17.2 Non-Generic Swaps......Page 504
17.3.1 Applications......Page 505
17.3.2 Valuation of Forward Swaps......Page 509
17.4.1 Applications......Page 510
17.4.2 Swaption Valuation......Page 517
17.5.1 Cancelable Swaps......Page 523
17.5.4 Credit Default Swaps......Page 524
17.6 Currency Swaps......Page 525
17.6.2 Valuation......Page 526
17.6.3 Comparative Advantage......Page 531
17.7 Conclusion......Page 533
Problems and Questions......Page 534
Selected References......Page 544
APPENDIX A: Uses of Exponents and Logarithms......Page 547
APPENDIX B: Mathematical Statistical Concepts......Page 550
APPENDIX C: CFA Questions......Page 556
Answers to Selected End-of-Chapter Problems......Page 563
Glossary of Terms......Page 621
Index......Page 640