Interest Rate Derivatives Explained (eBook)

Jörg Kienitz is Director, Assurance FSI at Deloitte Germany, where he is responsible for business development, team management, pricing models research and risk management practices of the unit. Previously, he was Head of Quantitative Analytics at Deutsche Postbank AG where he was involved in developing and implementing models for pricing complex derivatives structures and for asset allocation. He also lectures at university level on advanced financial modelling and implementation at the University of Oxford's part-time Masters of Finance course. Jörg works as an independent consultant for model development and validation as well as giving seminars for finance professionals. He is a speaker at a number of major financial conferences including Global Derivatives, WBS Fixed Income and RISK. Jörg is the member of the editorial board of International Review of Applied Financial Issues and Economics and holds a Ph.D. in stochastic analysis from the University of Bielefeld.

Cover 1
Half-Title 2
Series 3
Title 4
Copyright 5
Dedication 6
Contents 8
List of Figures 11
List of Tables 14
Introduction Goals of this Book and Global overview 16
I.1 Introduction and management summary 16
I.2 Short overview 17
I.3 Use of the book 19
I.4 Credits 19
Part I Markets and Linear Products 20
1 Clearing, Collateral, Pricing 21
1.1 Introduction and objectives 21
1.2 Netting and collateral 21
1.3 Clearing 24
1.3.1 What is central clearing? 24
1.3.2 Clearing members 27
1.3.3 Resume 28
1.4 Counterparty credit risk 28
1.5 General pricing theory 31
1.5.1 Numeraire 36
2 Rates 38
2.1 Introduction and objectives 38
2.2 Daycount, rolling and other conventions 38
2.2.1 Daycount 39
2.3 Rates 41
2.3.1 Roll conventions – business dates 42
2.3.2 Discount factors 46
2.3.3 Forward rates 46
2.3.4 Other rates 47
2.3.5 Interest rate curves 47
2.4 Reading list 48
3 Markets and Products – Deposits, Bonds, Futures, Repo 49
3.1 Introduction and objectives 49
3.2 Deposits 49
3.2.1 Market quotes 49
3.3 Futures 49
3.4 Bonds 51
3.4.1 Bond math 52
3.4.2 Par rate 54
3.4.3 Yield to maturity 55
3.4.4 Bond risk measures 56
3.5 Repos 58
3.6 Market quotes 61
3.7 Reading list 61
4 Markets and Products – FRAs and Swaps 62
4.1 Introduction and objectives 62
4.2 FRAs 62
4.2.1 FRA math 63
4.2.2 FRA quotes 64
4.3 Swaps 64
4.3.1 Fixed against float interest rate swap 65
4.3.2 Swap quotes 67
4.3.3 In arrears swaps 68
4.4 Float against float interest rate swaps 76
4.4.1 Money market basis swaps 76
4.4.2 Constant maturity swaps (CMS) 79
4.4.3 Other type of swaps 79
4.5 Reading list 83
5 Using Curves 1
5.1 Introduction and objectives 84
5.2 Interpolation methods 84
5.2.1 Constant interpolation 85
5.2.2 Linear interpolation 85
5.2.3 Cubic spline interpolation 86
5.2.4 Which method to use and how? 91
5.3 Curve construction 91
5.3.1 Bootstrapping 93
5.3.2 Curve construction – optimization 113
5.4 Risk measures 117
5.4.1 Risk measures 1D 117
5.4.2 Risk measures nD 119
5.4.3 Forward buckets 120
5.5 Interpolation in two and three dimensions 126
5.6 Example: cap and floor volatilities 127
5.7 Reading list 127
Part II Markets and Non-Linear Products 131
6 Options I 132
6.1 Introduction and objectives 132
6.2 Market conventions 132
6.2.1 Black model 132
6.2.2 Normal model 133
6.2.3 Displaced diffusion model – shifted black model 134
6.3 Caps and floors 134
6.3.1 Cap/Floor math 135
6.3.2 Cap/Floor quotes 136
6.4 Swaptions 141
6.4.1 Swaption math 143
6.4.2 Swaption quotes 145
6.4.3 The swaption smile/skew 145
6.5 Transforming volatility 146
6.5.1 Transforming caplet volatilities 150
6.5.2 Transforming swaption volatilities 156
6.5.3 Examples 160
6.6 Bond options 161
6.7 Reading list 164
7 Options II 165
7.1 Introduction and objectives 165
7.2 CMS caps and floors 166
7.2.1 CMS math 168
7.2.2 CMS quotes 179
7.3 CMS spread options 1
7.3.1 CMS spread option math 183
7.4 Reading list 195
Part III Counterparty Credit Risk Adjustments 200
8 Adjustments 201
8.1 Introduction and objectives 201
8.2 The credit value adjustment (CVA) 201
8.3 Bilateral CVA (BCVA) and debit value adjustment (DVA) 205
8.4 The funding value adjustment (FVA) 206
8.5 CVA, DVA, FVA – what to do? 207
8.5.1 Example 208
8.6 Reading list 209
Bibliography 212
Index 216