Fixed Income Markets and Their Derivatives

Front Cover......Page 1
Fixed Income Markets and Their Derivatives......Page 6
Copyright Page......Page 7
Contents......Page 10
Preface......Page 18
Acknowledgments......Page 20
PART 1 INSTITUTIONS AND CONVENTIONS......Page 22
1.1 Overview of Debt Contracts......Page 24
1.1.1 Cash-Flow Rights of Debt Securities......Page 28
1.2 Players and Their Objectives......Page 29
1.2.3 Federal Agencies and Government-Sponsored Enterprises (GSEs)......Page 31
1.2.7 Households......Page 32
1.3 Classification of Debt Securities......Page 33
1.4.1 Interest Rate Risk......Page 35
1.4.2 Credit Risk......Page 36
1.4.3 Liquidity Risk......Page 37
1.4.4 Contractual Risk......Page 39
1.4.5 Inflation Risk......Page 40
1.4.8 FX Risk......Page 41
1.5 Return-Risk History......Page 42
Suggested References and Readings......Page 45
2.1.1 Future Values......Page 46
2.1.2 Annuities......Page 48
2.1.3 Present Values......Page 50
2.2. Yield to Maturity or Internal Rate of Return......Page 52
2.2.1 Semiannual Compounding......Page 53
2.3. Prices in Practice......Page 54
2.4. Prices and Yields of T-Bills......Page 55
2.4.1 Yield of a T-Bill with n < 182 Days......Page 56
2.4.2 Yield of a T-Bill with n > 182 Days......Page 57
2.5. Prices and Yields of T-Notes and T-Bonds......Page 58
2.7. Conventions in Other Markets......Page 63
Suggested References and Readings......Page 65
3.1 Central Banks......Page 66
3.2.1 Open Market Operations......Page 67
3.2.2 The Discount Window......Page 69
3.2.3 Reserve Requirements......Page 70
3.3 Fed Funds Rates......Page 72
3.5 Fed\'s Actions to Stem the Credit Crunch of 2007–2008......Page 74
Suggested Readings and References......Page 77
4.1 Introduction......Page 78
4.2.2 Corporate Debt......Page 79
4.3 Interdealer Brokers......Page 80
4.4 Secondary Markets......Page 81
4.4.2 Indicators of Transparency......Page 82
4.4.3 Evidence on Trading Characteristics......Page 84
4.5 Evolution of Secondary Markets......Page 85
Suggested Readings and References......Page 87
5.1.1 Repo Contract Defined......Page 88
5.1.2 Reverse Repo Contract Defined......Page 90
5.2 Real-Life Features......Page 91
5.3 Long and Short Positions Using Repo and Reverse Repo......Page 95
5.4.1 GC Repo Contract and Market......Page 98
5.4.2 GC Repo Rates......Page 99
5.5 Special Collateral Repo Agreement......Page 103
5.7 Developments in Repo Markets......Page 105
Suggested Readings and References......Page 107
6.1 Benchmark Auctions Schedule......Page 108
6.1.2 Auctions of Treasury Notes......Page 110
6.1.4 Auctions of TIPS......Page 111
6.2.1 Auction Announcement......Page 112
6.2.3 Auction Mechanisms......Page 114
6.2.4 Uniform Price Auctions......Page 115
6.2.5 Discriminatory Auctions......Page 118
6.3.1 Winner\'s Curse and Bid Shading......Page 120
6.4 Auction Cycles and Financing Rates......Page 121
Suggested Readings and References......Page 122
PART 2 ANALYTICS OF FIXED INCOME MARKETS......Page 124
7.1 DV01/PVBP or Price Risk......Page 126
7.2 Duration......Page 130
7.2.1 Excel Applications......Page 134
7.2.3 PVBP and Duration of Portfolios......Page 137
7.3.1 Spread Trades: Curve Steepening or Curve Flattening Trades......Page 139
7.4 Convexity......Page 140
7.4.1 Bullet versus Barbell Securities (Butterfly Trade)......Page 143
7.5 Effective Duration and Effective Convexity......Page 146
Suggested Readings and References......Page 150
8.1 Yield-Curve Analysis......Page 152
8.1.1 Principal Components Analysis of Yield Curve......Page 156
8.1.2 Volatility of Short and Long Rates......Page 157
8.1.4 Economic News Announcements and Volatility......Page 159
8.1.6 Coupon and Vintage Effects......Page 161
8.2.1 Implied Zeroes......Page 164
8.2.2 Bootstrapping Procedure......Page 165
8.2.3 Par Bond Yield Curve......Page 171
8.3 Forward Rates of Interest......Page 172
8.4 STRIPS Markets......Page 176
8.5 Extracting Zeroes in Practice......Page 179
Suggested References and Readings......Page 184
9.1 Introduction......Page 186
9.2 Modeling Mean-Reverting Interest Rates......Page 193
9.2.1 The Vasicek Model......Page 196
9.2.2 The Cox, Ingersoll, and Ross Model......Page 199
9.3.1 The Black, Derman, and Toy Model......Page 201
9.3.2 General Implementation of the BDT Approach......Page 207
9.4 Interest Rate Derivatives......Page 209
9.5 A Review of One-Factor Models......Page 214
Suggested Readings and References......Page 216
10.1 Defaults, Business Cycles, and Recoveries......Page 218
10.2 Rating Agencies......Page 222
10.3 Structural Models of Default......Page 225
10.3.1 Probability of Default and Loss Given Default......Page 231
10.3.2 Market Prices......Page 233
10.4 Implementing Structural Models: The KMV Approach......Page 234
10.4.2 Safety Covenants......Page 237
10.5 Costs of Financial Distress and Corporate Debt Pricing......Page 238
10.6 Reduced-Form Models......Page 241
10.7 Credit Spreads Puzzle......Page 244
Suggested Readings and References......Page 245
PART 3 SOME FIXED INCOME MARKET SEGMENTS......Page 246
11.1 Overview of Mortgage Contracts......Page 248
11.1.1.1 Default Risk......Page 249
11.1.1.3 Interest Rate Risk......Page 250
11.2.1 Fixed-Rate Mortgages (FRMs)......Page 251
11.2.2 Adjustable-Rate Mortgages (ARMs)......Page 252
11.3 Mortgage Cash Flows and Yields......Page 254
11.4 Federal Agencies......Page 258
11.5 Federal Agency Debt Securities......Page 263
11.5.1 Empirical Evidence on Spreads......Page 264
Suggested Readings and References......Page 265
12.1 Overview of Mortgage-Backed Securities......Page 266
12.1.1 Securitization......Page 267
12.1.2 Guarantees and Credit Enhancement......Page 268
12.1.3 Creation of an Agency MBS......Page 270
12.1.4 Cash Flows and Market Conventions......Page 271
12.2.1.2 Constant Monthly Mortality......Page 272
12.2.2 FHA Experience......Page 273
12.2.3 PSA Experience......Page 274
12.2.4 Mortgage Cash Flows with Prepayments......Page 275
12.3.2 Seasonality Factor......Page 278
12.3.4 Family Circumstances......Page 279
12.3.6 Mortgage Status (Premium Burnout)......Page 280
12.4 Valuation Framework......Page 281
12.5 Valuation of Pass-Through MBS......Page 283
12.6 REMICS......Page 285
12.6.1 REMIC Structure......Page 286
12.6.2 Sequential Structure......Page 287
Suggested Readings and References......Page 288
13.1 Overview of Inflation-Indexed Debt......Page 290
13.2 Role of Indexed Debt......Page 294
13.3.1 Choice of Index......Page 296
13.3.2 Indexation Lag......Page 297
13.3.4 Strippability of TIPS......Page 298
13.4 Cash-Flow Structure......Page 299
13.4.2 Principal-Indexed Structure......Page 300
13.5 Real Yields, Nominal Yields, and Break-Even Inflation......Page 301
13.6 Cash Flows, Prices, Yields, and Risks of TIPS......Page 304
13.7 Investor\'s Perspective......Page 309
Suggested Readings and References......Page 311
PART 4 FIXED INCOME DERIVATIVES......Page 312
14.1 Overview......Page 314
14.2 Fed Funds Futures Contracts......Page 315
14.2.1 Recovering Market Expectations of Future Actions by the FOMC......Page 316
14.3.1 Contract Specifications......Page 318
14.4 Valuation of OIS......Page 320
14.5 OIS Spreads with Other Money Market Yields......Page 322
Suggested Readings and References......Page 323
15.1 Eurodollar Markets and LIBOR......Page 324
15.1.1 LIBOR Fixing......Page 325
15.1.2 Calculating Yields in the Cash Market......Page 326
15.2 Eurodollar Futures Markets and LIBOR......Page 327
15.2.1 Eurodollar Futures Settlement to Yields......Page 329
15.3 Deriving Swap Rates from ED Futures......Page 332
15.4 Intermarket Spreads......Page 336
15.5 Options on ED Futures......Page 337
15.5.1 Caps, Floors, and Collars on LIBOR......Page 338
15.6 Valuation of Caps......Page 342
Suggested Readings and References......Page 345
16.1 Swaps and Swap-Related Products and Terminology......Page 346
16.1.1 Asset Swaps......Page 347
16.1.2 Diversity of Swap Contracts......Page 348
16.2 Valuation of Swaps......Page 349
16.2.1 Forward Swap......Page 355
16.2.2 ED Futures and Swap Pricing......Page 357
16.2.3 Convexity Adjustment......Page 359
16.3 Swap Spreads......Page 360
16.3.1 Liquidity Factor or the Systemic Risk Factor......Page 364
16.3.3 Agency Activities......Page 365
16.4 Risk Management......Page 366
16.4.1 Management of the Credit Risk of Swaps......Page 367
16.5 Swap Bid Rate, Offer Rate, and Bid-Offer Spreads......Page 368
16.6 Swaptions......Page 369
16.6.1 Swaption Parity Relation......Page 372
Suggested Readings and References......Page 373
17.1 Forward Contracts Defined......Page 374
17.2 Futures Contracts Defined......Page 376
17.3.1 Delivery Specifications......Page 378
17.3.3 Margins......Page 379
17.5 Treasury Futures Contracts......Page 380
17.5.1 Delivery Options in Treasury Note Futures......Page 381
17.5.2 Conversion Factor......Page 384
17.5.3 Seller\'s Option in the September 2007 Contract......Page 385
17.5.3.1 Basis in T-Bond Futures......Page 386
17.5.4 Determination of Delivery......Page 387
17.5.5 Basis after Carry, or Net Basis......Page 390
17.5.6 Implied Repo Rate......Page 391
17.5.8 Hedging Applications......Page 394
Suggested Readings and References......Page 396
18.1 Credit Default Swaps......Page 398
18.3 Growth of CDS Market and Evolution......Page 401
18.4 Restructuring and Deliverables......Page 403
18.5 Settlement on Credit Events......Page 405
18.6 Valuation of CDS......Page 407
18.6.1 CDS Spreads, Probability of Default, and Recovery Rates......Page 409
18.6.2 Applications......Page 412
18.7 Credit-Linked Notes......Page 414
18.8 Credit Default Indexes......Page 415
Suggested Readings and References......Page 417
CHAPTER 19 Structured Credit Products: Collateralized Debt Obligations......Page 418
19.1 Collateralized Debt Obligations......Page 419
19.1.1 CDO Structure and Players......Page 420
19.1.2 Types of Cash CDOs......Page 421
19.2 Analysis of CDO Structure......Page 422
19.2.2 Extent of Subordination, Overcollateralization, and Waterfalls......Page 423
19.3 Growth of the CDO Market......Page 425
19.5 CDX Tranches......Page 426
19.6 Valuation of CDOs......Page 428
Suggested Readings and References......Page 431
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