Bond and Money Markets (eBook)

Contents 7
Foreword 19
Preface 21
Organisation of the book 25
Study materials 26
Acknowledgements 26
Part I Introduction to the Bond Markets 29
1. The Debt Capital Markets 31
1.1 Description 32
1.2 Bond issuers 33
1.3 Capital market participants 34
1.4 World bond markets 36
1.5 Overview of the main bond markets 38
1.6 Financial engineering in the bond markets 40
Appendices 1 41
Selected bibliography and references 1 43
Questions and exercises 1 44
2. Financial Markets Arithmetic 45
2.1 Simple and compound interest 45
2.2 The time value of money 48
2.3 Multiple cash flows 52
2.5 Interpolation and extrapolation 59
2.6 Measuring the rate of return 60
2.7 Indices 62
Appendices 2 65
References 2 67
Questions and exercises 2 67
3. Traditional Bond Pricing 69
3.1 Pricing a conventional bond 69
3.2 Pricing zero-coupon bonds 73
3.3 Clean and dirty bond prices 74
3.4 Bond price and yield relationship 76
Selected bibliography and references 3 79
Questions and exercises 3 79
4. Bond Yield Measurement 81
4.1 Current yield 82
4.2 Simple yield to maturity 83
4.3 Yield to maturity 84
4.4 Yield on a zero-coupon bond 88
4.5 Modifying bond yields 89
4.6 Converting bond yields 90
4.7 Assumptions of the redemption yield calculation 92
4.8 Holding-period yield 93
4.9 Bonds with embedded options 93
4.10 Index-linked bonds 99
4.11 Yields on floating-rate bonds 103
4.12 Measuring yield for a bond portfolio 104
4.13 The price/yield relationship 108
4.14 Summary 108
Appendices 4 110
Selected bibliography and references 4 112
Questions and exercises 4 112
5. Review of Bond Market Instruments 114
5.1 Floating Rate Notes 114
5.2 Inverse/Reverse floating-rate bonds 117
5.3 Asset-backed bonds 118
5.4 PIBS 121
5.5 Callable bonds 122
5.6 Index-linked bonds 126
Appendices 5 128
Selected bibliography and references 5 128
Questions and exercises 5 129
6. The Yield Curve 130
6.1 Using the yield curve 130
6.2 Yield-to-maturity yield curve 131
6.3 The coupon yield curve 132
6.4 The par yield curve 132
6.5 The zero-coupon (or spot) yield curve 133
6.6 The forward yield curve 138
6.7 The annuity yield curve 142
6.8 Analysing and interpreting the yield curve 142
6.9 Interpreting the yield curve 152
6.10 Fitting the yield curve 154
6.11 Spot and forward rates in the market 158
6.12 Examples, exercises and calculations 165
6.13 Case Study: Deriving a discount function28 168
6.14 Case Study exercise: 172
Appendices 6 176
Selected bibliography and references 6 179
Questions and exercises 6 179
7. Price, Yield and Interest Rate Risk I 183
7.1 Revisiting the bond price/yield relationship 183
7.2 Duration 186
7.3 A summary of the duration measure 199
7.4 Duration for other securities 200
Appendices 7 201
Selected bibliography 7 202
Questions and exercises 7 202
8. Price, Yield and Interest Rate Risk II 203
8.1 Basis point value 203
8.2 Yield value of price change 205
8.3 Hedging using basis point value 206
8.4 Volatility weighting for hedging 207
Selected bibliography and references 8 209
Questions and exercises 8 209
9. Price, Yield and Interest Rate Risk III 210
9.1 Convexity 210
9.2 Summarising the properties of convexity 216
9.3 Dispersion 217
Appendices 9 218
Selected bibliography 9 221
Questions and exercises 9 221
10. Price, Yield and Interest Rate Risk IV 222
10.1 Yield curve changes 222
10.2 Portfolio duration and changes in the yield curve 223
10.3 Hedging strategy and duration 225
Appendices 10 226
Selected bibliography 10 227
Questions and exercises 10 227
Part II Government Bond Markets 229
11.The United Kingdom Gilt Market 231
11.1 Introduction and history 231
11.2 Market instruments 234
11.3 Taxation 243
11.4 Market structure 244
11.5 Market makers and brokers 244
11.6 Issuing gilts 246
11.7 The DMO and secondary market trading 248
11.8 Settlement 249
11.9 Index-linked gilts analytics 251
11.10 Gilt strips 256
11.11 Zero-coupon bond trading and strategy 261
11.12 Strips market anomalies 263
11.13 Trading strategy 263
11.14 Illustration: Yield and cash flow analysis 268
11.15 Future developments in strips 270
11.16 HM Treasury and the remit of the Debt Management Office 271
11.17 Gilt derivatives and repo markets 272
11.18 The Minimum Funding Requirement 274
11.19 Developments in electronic trading 275
Appendices 11 276
Selected bibliography 11 283
Questions and exercises 11 283
12.The US Treasury Bond Market 285
12.1 The US Treasury 285
12.2 The Federal Reserve 286
12.3 Market convention 286
12.4 The Primary Market 289
12.5 The Secondary Market 290
12.6 Treasury strips 292
12.7 Inflation-protected Treasury bonds 293
12.8 Treasury repo market 294
12.9 Federal Agency bonds 295
12.10 Derivatives markets 297
12.11 Historical long-bond yields 299
Appendices 12 300
Selected bibliography 12 303
Questions and exercises 12 303
13.International Bond Markets 305
13.1 Overview of government markets 307
13.2 Germany 310
13.3 Italy 312
13.4 France 315
13.5 Japan 320
13.6 Australia 322
13.7 New Zealand 325
13.8 Canada 326
13.9 Hungary 329
13.10 South Africa 329
13.11 Egypt 331
Appendices 13 333
Selected bibliography 13 343
Part III Corporate Debt Markets 345
14.Corporate Debt Markets 347
14.1 Introduction 348
14.2 Determinants of the development of a corporate market 350
14.3 The primary market 350
14.4 The secondary market 351
14.5 Fundamentals of corporate bonds 352
14.6 Bond security 354
14.7 Redemption provisions 356
14.8 Corporate bond risks 357
14.9 High-yield corporate bonds 360
14.10 Corporate bond offering circular 360
Selected bibliography 14 365
Questions and exercises 14 365
15.Analysis of Bonds With Embedded Options 367
15.1 Understanding embedded option elements in a bond 367
15.2 The Binomial tree of short-term interest rates 369
15.3 Pricing callable bonds 373
15.4 Price and yield sensitivity 375
15.5 Price volatility of bonds with embedded options 377
15.6 Sinking funds 378
Appendices 15 379
Selected bibliography 15 383
Questions and exercises 15 384
16.Convertible Bonds I 385
16.1 Basic description 385
16.2 Advantages of issuing and holding convertibles 390
Selected bibliography and references 16 391
17.Convertible Bonds II 392
17.1 Traditional valuation methodology 392
17.2 Fair value of a convertible bond 393
17.3 Further issues in valuing convertible bonds 399
17.4 Convertible bond default risk 400
Appendices 17 402
Selected bibliography 17 403
Questions and exercises 17 404
18.The Eurobond Market I 406
18.1 Eurobonds 406
18.2 Foreign bonds 407
18.3 Eurobond instruments 408
18.4 The issuing process: market participants 410
18.5 Fees, expenses and pricing 413
18.6 Issuing the bond 414
18.7 Covenants 416
18.8 Trust services 416
18.9 Form of the bond 418
18.10 Clearing systems 419
18.11 Market associations 420
18.12 Secondary market 421
18.13 Settlement 421
Selected bibliography 18 421
19.Eurobonds II 422
19.1 Legal and tax issues 422
19.2 The secondary market 422
19.3 Eurobonds and swap transactions 423
20.Warrants 424
20.1 Introduction 424
20.2 Analysis 424
20.3 Bond warrants 425
20.4 Comparison of warrants and convertibles 426
Selected bibliography and references 20 426
21.Medium-term Notes 428
21.1 Introduction 429
21.2 The primary market 429
21.3 MTNs and corporate bonds 431
21.4 Issue mechanism 433
21.5 The secondary market 434
21.6 The Euro-MTN market 436
21.7 Structured MTNs 436
Selected bibliography and references 21 441
Questions and exercises 21 441
22.Commercial Paper 442
22.1 Commercial Paper programmes 443
22.2 Commercial paper yields 444
Selected bibliography 22 445
Questions and exercises 22 445
23.Preference Shares and Preferred Stock 446
23.1 The size of the market 446
23.2 Description and definition of preference shares 447
23.3 Cost of preference share capital 450
23.4 The preference share market 451
23.5 Auction market preferred stock (Amps) 451
A lingering death in the corporate debt market 23 453
Selected bibliography 23 454
24.The US Municipal Bond Market 455
24.1 Description of municipal bonds 455
24.2 The municipal bond market 457
24.3 Municipal bonds credit ratings 458
24.4 Bond insurance 459
24.5 Taxation issues 459
24.6 Exotic municipal bonds 459
24.7 Municipal money market instruments 460
Appendices 24 460
Selected bibliography and references 24 460
25.Asset-Backed Bonds I: Mortgage-backed Securities 462
25.1 Mortgage-backed securities 462
25.2 Cash flow patterns 468
25.3 Evaluation and analysis of mortgage-backed bonds 472
Selected bibliography and references 25 478
Questions and exercises 25 478
26.Mortgage-backed Bonds II 480
26.1 Basic concepts 480
26.2 Pricing and modelling techniques 480
26.3 Interest rate risk 483
26.4 Portfolio performance 485
Selected bibliography and references 26 486
27.Asset-backed Securities III 487
27.1 Collateralised mortgage securities 487
27.2 Non-agency CMO bonds 493
27.3 Commercial mortgage-backed securities 495
27.4 Motor-car-backed securities 496
27.5 Credit card asset-backed securities 498
27.6 Static spread analysis of asset-backed bonds 501
27.7 Conclusion 503
Selected bibliography and references 27 504
Questions and exercises 27 504
28.Collateralised Debt Obligations 506
28.1 An overview of CDOs 506
28.2 Relative value analysis 512
28.3 Credit derivatives6 513
Selected bibliography 28 516
29.High-yield Bonds 517
29.1 Growth of the market 517
29.2 High-yield securities 518
29.3 High-yield bond performance 520
Selected bibliography and references 29 523
30.Corporate Bonds and Credit Analysis 524
30.1 Credit ratings 524
30.2 Credit analysis 526
30.3 Industry-specific analysis 530
30.4 The art of credit analysis 531
Selected bibliography and references 31 531
Questions and exercises 31 531
Part IV The Money Markets 533
31.The Money Markets 535
31.1 Introduction 535
31.2 Securities quoted on a yield basis 536
31.3 Securities quoted on a discount basis 540
31.4 Foreign exchange 545
Appendices 551
Selected bibliography and references 553
32.Banking Regulatory Capital Requirements 554
32.1 Regulatory issues 554
32.2 Capital adequacy requirements 555
32.3 Proposed changes to Basle rules 557
Selected bibliography and references 559
33.Asset and Liability Management 560
33.1 Introduction 560
33.2 The ALM desk 562
33.3 Liquidity and interest-rate risk 564
33.4 Critique of the traditional approach 571
33.5 Securitisation 572
Appendices 576
Selected bibliography and references 577
34.The Repo Markets 578
34.1 Development of the repo market 578
34.2 Introduction to repo 579
34.3 Uses and economic functions of repo 580
34.4 Repo mechanics 582
34.5 Other repo structures 584
34.6 Pricing and margin 586
34.7 Risks in dealing repo 588
34.8 Legal issues 590
34.9 Accounting, Tax and capital issues 591
34.10 Market participants 593
34.11 The United Kingdom gilt repo market 593
34.12 Market structure 595
34.13 Trading patterns 596
34.14 Open market operations 598
34.15 Gilts settlement and the CREST service 599
34.16 Gilt repo Code of Best Practice 600
34.17 Trading approach 600
34.18 Electronic repo trading 607
34.19 Repo netting 608
34.20 The implied repo rate and basis trading 610
34.21 Repo market structures 618
34.22 Central bank repo and overseas markets 621
Appendices 622
Selected bibliography and references 625
Questions and exercises 625
35.Money Markets Derivatives 627
35.1 Forward rate agreements 627
35.2 FRA mechanics 628
35.3 Long-dated FRAs 634
35.4 Forward contracts 635
35.5 Short-term interest rate futures 635
Appendices 35 643
Selected bibliography and references 35 644
Questions and exercises 35 644
Part V Risk Management 647
36.Risk Management 649
36.1 Introduction 649
36.2 Risk management 650
36.3 Non-VaR measure of risk 652
Selected bibliography and references 36 652
37.Bank Risk Exposure and Value-at-Risk 653
37.1 Value-at-Risk 653
37.2 Explaining Value-at-Risk 655
37.3 Variance-covariance Value-at-Risk 656
37.4 Historical VaR methodology 663
37.5 Simulation methodology 663
37.6 Value-at-risk for fixed interest instruments 664
37.7 Derivative products and Value-at-Risk 668
37.8 Stress testing 671
37.9 Value-at-Risk methodology for credit risk 673
Appendices 37 678
Selected bibliography and references 37 687
Questions and exercises 37 688
38.Interest-rate Risk and a Critique of Value- at- Risk 689
38.1 Interest-rate risk 689
38.2 Comparison with traditional duration-based risk measurement 691
38.3 A critique of Value-at-Risk 691
Part VI Derivative Instruments 695
39.Swaps I 697
39.1 Introduction 697
39.2 Interest rate swaps 700
39.3 Relationship between interest-rate swaps and FRAs 708
39.4 Generic swap valuation 708
39.5 Zero-coupon swap pricing 709
39.6 Non-vanilla interest-rate swaps 717
39.7 Cancelling a swap 720
39.8 Swaptions 720
39.9 Cross-currency swaps 722
39.10 Credit risk 724
Appendices 39 724
Selected bibliography and references39 730
Questions and exercises39 730
40.Swaps II 733
40.1 Using swaps 733
40.2 Hedging an interest-rate swap 735
40.3 The convexity bias 739
40.4 Swaps netting 744
Appendices 40. 745
Selected bibliography and references 40 747
Questions and exercises 40 747
41.Bond Futures 748
41.1 Introduction 748
41.2 Futures pricing 751
41.3 Hedging using futures 754
41.4 The margin process 758
Appendices 41 758
Selected bibliography and references 41 760
Questions and exercises 41 760
42.Options I 762
42.1 Introduction 762
42.2 Option instruments 766
42.3 Options and payoff profiles 767
42.4 Option pricing parameters 768
Appendices 42 770
Selected Bibliography and References 42 772
Questions and exercises 42 772
43.The Dynamics of Asset Prices 773
43.1 The behaviour of asset prices 773
43.2 Stochastic calculus models: Brownian motion and Itô calculus 780
43.3 Perfect capital markets 783
Appendices 43 785
Selected bibliography and references 43 788
Questions and exercises 43 788
44.Options II: Pricing and Valuation 790
44.1 Option pricing 790
44.2 Pricing derivative securities 791
44.3 Simulation methods 798
44.4 Valuation of bond options 799
44.5 Interest-rate options and the Black model 800
44.6 Critique of the Black–Scholes model 801
44.7 The Barone–Adesi and Whaley model 802
44.8 Valuation of American options 803
44.9 Describing stochastic volatilities 806
44.10 A final word on (and summary of) the models 808
Appendices 44 809
Selected bibliography and rederences 44 812
Questions and exercises 44 814
45.Options III: The Binomial Pricing Model 816
45.1 The binomial option pricing model 816
45.2 The binomial approach for interest-rate options 818
45.3 Comparison with B–S model 819
Appendices 45 819
Selected bibliography and references 45 821
46.Options IV: Pricing Models for Bond Options 822
46.1 Introduction 822
46.2 Pricing bond options 823
46.3 Using option models to price corporate bonds1 825
Appendices 46 827
Selected bibliography 46 827
Questions and exercises 46 828
47.Options V – Managing an Option Book 829
47.1 Behaviour of option prices 829
47.2 Measuring option risk: The Greeks 830
47.3 The option smile 837
Appendices 47 838
Selected bibliography and references 47 838
Questions and exercises 47 839
48.Options VI: Strategies and Uses 840
48.1 Introduction 840
48.2 Spreads 840
48.3 Volatility trades 844
48.4 Collars, caps and floors 848
48.5 Using options in bond markets 850
Appendices 48 852
Portfolio management case study2 48 854
Selected bibliography and references 48 859
Questions and exercises 48 859
49.Options VII: Exotic Options 860
49.1 Options with modified contract terms 860
49.2 Path-dependent options 861
49.3 Multi-asset options 865
49.4 Pricing and hedging exotic options 866
49.5 Using exotic options: case studies 868
Selected bibliography and references 49 870
Questions and exercises 49 871
Part VII Approaches to Trading and Hedging 873
50.Approaches to Trading and Hedging 875
50.1 Futures trading 876
50.2 Yield curves and relative value 879
50.3 Yield spread trades 883
50.4 Hedging bond positions 884
50.5 Introduction to bond analysis using spot rates and forward rates in continuous time7 886
Appendices 50 889
Selected bibliography 50 890
Questions and exercises 50 891
Part VIII Advanced Fixed Income Analytics 893
51.Interest-rate Models I 901
51.1 Introduction 901
51.2 Interest-rate processes 902
51.3 One-factor models 904
51.4 Arbitrage-free models 908
51.5 Fitting the model 912
51.6 Summary 914
Selected bibliography and references 51 914
Questions and exercises 51 915
52.Interest-rate Models II 916
52.1 Introduction 916
52.2 The Heath–Jarrow–Morton model 916
52.3 Multi-factor term structure models 920
52.4 Assessing one-factor and multi-factor models 923
Selected bibliography and references 52 926
Questions and exercises 52 928
53.Estimating and Fitting the Term Structure 929
53.1 Introduction 929
53.2 Bond market information 931
53.3 Curve-fitting techniques: parametric 932
53.4 The cubic spline method for estimating and 935
fitting the yield curve 935
53.5 The Anderson–Sleath evaluation 938
Appendices 53 942
Selected bibliography and references 53 943
Questions and exercises 53 944
54.Advanced Analytics for Index- Linked Bonds 946
54.1 Index-linked bonds and real yields 946
54.2 Duration and index-linked bonds 947
54.3 Estimating the real term structure of interest rates 949
Selected bibliography and references 54 953
Questions and exercises 54 953
55.Analysing the Long Bond Yield 954
55.1 Theories of long-dated bond yields 954
55.2 Pricing a long bond 957
55.3 Further views on the long-dated bond yield 959
55.4 Analysing the convexity bias in long-bond yields 960
Selected bibliography and references 55 960
56.The Default Risk of Corporate Bonds 962
56.1 Corporate bond default spread risk 962
56.2 Default risk and default spreads 963
Selected bibliography and references 56 966
Part IX Portfolio Management 967
57.Portfolio Management I 969
57.1 Generic portfolio management 969
57.2 Active bond portfolio management 971
Appendices 57 972
Selected bibliography and references 57 975
Questions and exercises 57 975
58.Portfolio Management II 976
58.1 Overview 976
58.2 Structured portfolio strategies 980
58.3 Immunisation 983
58.4 Extending traditional immunisation theory 987
58.5 Multiple liabilities immunisation 988
Selected bibliography and references 58 990
Questions and exercises13 58 990
59.Portfolio Management III 994
59.1 Introduction 994
59.2 Performance evaluation 994
Selected bibliography and references 59 996
Questions and exercises 59 996
60.Portfolio Yield Measurement 997
60.1 Portfolio yield 997
60.2 Value-weighted portfolio yield 998
Selected bibliography and references 60 999
61.Bond Indices 1000
61.1 Overview 1000
61.2 Maturity of an index 1001
61.3 Responding to events 1002
61.4 Composition of the index 1002
61.5 Calculation of index value2 1003
Appendices 61 1005
Selected bibliography and references 61 1005
62.International Investment 1006
62.1 Arguments for investing in international bonds 1006
62.2 International portfolio management 1007
Selected bibliography and references 62 1008
Part X Technical Analysis 1009
63.Technical Analysis 1011
63.1 Introduction 1011
63.2 Trading market profile 1013
63.3 Dow theory 1014
63.4 Chart construction 1015
63.5 Trend analysis 1017
63.6 Reversal patterns 1023
63.7 Continuation patterns 1028
63.8 Point and figure charting8 1031
63.9 Mathematical approaches 1033
63.10 Contrary opinion theory 1037
63.11 Volume and open interest 1037
63.12 Candlestick charting 1038
63.13 Elliott wave theory 1045
63.14 Stop losses 1047
63.15 Concluding remarks 1047
Questions and exercises 63 1048
Selected bibliography 63 1053
Part XI Introduction to Credit Derivatives 1055
64.Introduction to Credit Derivatives 1057
64.1 Overview 1057
64.2 Pricing 1060
64.3 Regulatory issues 1064
Appendices 1066
Selected bibliography and references 1072
65. Credit Derivatives II 1073
65.1 Theoretical pricing models 1073
65.2 Credit spread options 1075
65.3 Default options pricing 1076
Selected bibliography and references 65 1079
66.Credit Derivatives III: Instruments and Applications 1080
66.1 Credit default swaps 1080
66.2 Total return swap 1081
66.3 Credit options 1082
66.4 Credit-linked notes 1083
66.5 Applications 1083
Selected bibliography and references 66 1085
Part XII Emerging Bond Markets 1087
67.Emerging Bond Markets and Brady Bonds 1089
67.1 Overview 1089
67.2 Key features 1091
67.3 Trading in the emerging bond markets 1092
67.4 Brady bonds 1095
Appendices 1099
Selected bibliography and references 1100
68.Emerging Bond Markets II 1101
68.1 Analysing of relative value 1101
68.2 Selected emerging bond markets 1103
Selected bibliography and references 68 1108
Concluding Remarks 1109
Glossary 1113
Index 1135