Fixed-Income Securities and Derivatives Handbook: Analysis and Valuation(122 Bloomberg Financial)

Table of Contents:
Foreword xv Preface xvii Part One Introduction To Bonds 1 The Bond Instrument 3 The Time Value of Money 4 Basic Features and Definitions 5 Present Value and Discounting 6 Discount Factors 12 Bond Pricing and Yield: The Traditional Approach 15 Bond Pricing 16 Bond Yield 20 Floating Rate Notes 27 Accrued Interest 30 Clean and Dirty Bond Prices 30 Day-Count Conventions 32 2 Bond Instruments and Interest Rate Risk 35 Duration, Modified Duration, and Convexity 35 Duration 36 Properties of Macaulay Duration 40 Modified Duration 41 Convexity 45 3 Bond Pricing and Spot and Forward Rates 51 Zero-Coupon Bonds 51 Coupon Bonds 53 Bond Price in Continuous Time 55 Fundamental Concepts 55 Stochastic Rates 58 Coupon Bonds 60 Forward Rates 61 Guaranteeing a Forward Rate 61 The Spot and Forward Yield Curve 63 Calculating Spot Rates 64 Term Structure Hypotheses 67 The Expectations Hypothesis 67 Liquidity Premium Hypothesis 69 Segmented Markets Hypothesis 69 4 Interest Rate Modeling 71 Basic Concepts 71 Short-Rate Processes 72 Ito’s Lemma 74 One-Factor Term-Structure Models 75 Vasicek Model 75 Hull-White Model 76 Further One-Factor Term-Structure Models 77 Cox-Ingersoll-Ross (CIR) Model 78 Two-Factor Interest Rate Models 79 Brennan-Schwartz Model 80 Extended Cox-Ingersoll-Ross Model 80 Heath-Jarrow-Morton (HJM) Model 81 The Multifactor HJM Model 82 Choosing a Term-Structure Model 83 5 Fitting the Yield Curve 87 Yield Curve Smoothing 88 Smoothing Techniques 90 Cubic Polynomials 91 Non-Parametric Methods 92 Spline-Based Methods 92 Nelson and Siegel Curves 95 Comparing Curves 96 Fitting the Term Structure of Interest Rates: The Practical Implementation of Cubic Spline Methodology 96 Cubic Spline Methodology 97 The Hypothesis 99 Practical Approach 100 A Working Environment 100 The First Requirement 101 The Second Requirement 101 The Third Requirement 102 Meeting All Requirements Simultaneously 102 A Unique Solution 103 The Solution 108 A Look at Forward Rates 114 Conclusion 117 Part Two Selected Cash and Derivative Instruments 6 Forwards and Futures Valuation 121 Forwards and Futures 121 Cash Flow Differences 122 Relationship Between Forward and Futures Prices 124 Forward-Spot Parity 125 The Basis and Implied Repo Rate 127 7 Swaps 131 Interest Rate Swaps 132 Market Terminology 134 Swap Spreads and the Swap Yield Curve 135 Generic Swap Valuation 138 Intuitive Swap Pricing 138 Zero-Coupon Swap Valuation 139 Calculating the Forward Rate from Spot-Rate Discount Factors 139 The Key Principles of an Interest Rate Swap 143 Valuation Using the Final Maturity Discount Factor 143 Non–Plain Vanilla Interest Rate Swaps 146 Swaptions 148 Valuation 149 Interest Rate Swap Applications 150 Corporate and Investor Applications 150 Hedging Bond Instruments Using Interest Rate Swaps 153 8 Options 157 Option Basics 158 Terminology 160 Option Instruments 162 Option Pricing: Setting the Scene 164 Limits on Option Prices 165 Option Pricing 166 The Black-Scholes Option Model 168 Assumptions 169 Pricing Derivative Instruments Using the Black-Scholes Model 170 Put-Call Parity 173 Pricing Options on Bonds Using the Black-Scholes Model 174 Interest Rate Options and the Black Model 174 Comments on the Black-Scholes Model 180 Stochastic Volatility 180 Implied Volatility 180 Other Option Models 181 9 Measuring Option Risk 183 Option Price Behavior 183 Assessing Time Value 183 American Options 184 The Greeks 185 Delta 185 Gamma 187 Theta 189 Vega 189 Rho 190 Lambda 192 The Option Smile 193 Caps and Floors 194 10 Credit Derivatives 197 Credit Risk 198 Credit Risk and Credit Derivatives 200 Applications of Credit Derivatives 201 Credit Derivative Instruments 202 Credit Default Swap 202 Credit Options 203 Credit-Linked Notes 204 Total Return Swaps 205 Investment Applications 207 Capital Structure Arbitrage 209 Exposure to Market Sectors 210 Credit Spreads 210 Funding Positions 210 Credit Derivatives and Relative Value Trading 212 Relative Value Trading Strategies 212 Bond Valuation from CDS Prices: Bloomberg Screen VCDS 217 Credit-Derivative Pricing 218 Pricing Total Return Swaps 218 Asset-Swap Pricing 219 Credit-Spread Pricing Models 219 The Market Approach to CDS Pricing 220 Default Probabilities 220 Pricing a CDS Contract 226 Example Calculation 228 The ITraxx and CD-X Credit Indices Contracts 229 Index Tranche Market 236 Impact of the 2007–2008 Credit Crunch: New CDS Contracts 240 11 The Analysis of Bonds with Embedded Options 245 Understanding Option Elements Embedded in a Bond 245 Basic Options Features 246 Option Valuation 247 The Call Provision 248 The Binomial Tree of Short-Term Interest Rates 249 Arbitrage-Free Pricing 250 Options Pricing 252 Risk-Neutral Pricing 254 Recombining and Nonrecombining Trees 255 Pricing Callable Bonds 256 Price and Yield Sensitivity 261 Measuring Bond Yield Spreads 263 12 Option-Adjusted Spread Analysis 265 Introduction 265 A Theoretical Framework 266 The Methodology in Practice 272 13 Convertible Bonds 277 Basic Features 277 Trading Patterns of Convertible Bonds 279 Investor Analysis 280 Zero-Coupon Convertibles 284 Convertible Bond Default Risk 285 Advantages of Issuing and Holding Convertibles 285 Convertible Bond Valuation 288 Fair Value of a Convertible Bond: The Binomial Model 288 Model Parameters 297 Pricing Spreadsheet 299 14 Inflation-Indexed Bonds 303 Basic Concepts 303 Choice of Index 303 Indexation Lag 305 Coupon Frequency 306 Type of Indexation 306 Index-Linked Bond Cash Flows and Yields 308 TIPS Cash Flow Calculations 309 TIPS Price and Yield Calculations 309 Assessing Yields on Index-Linked Bonds 313 Which to Hold: Indexed or Conventional Bonds? 314 Analysis of Real Interest Rates 315 Indexation Lags and Inflation Expectations 315 An Inflation Term Structure 317 Inflation-Indexed Derivatives 318 15 Securitization and Asset-Backed Securities 327 The Concept of Securitization 328 Reasons for Undertaking Securitization 328 Benefits of Securitization to Investors 330 The Process of Securitization 331 Securitization Process 331 Credit Enhancement 335 Securitizing Mortgages 336 Growth of the Market 337 Mortgage Bond Risk 338 Types of Mortgage-Backed Securities 338 Cash Flow Patterns 339 Prepayment Analysis 340 Prepayment Models 344 ABS Structures: A Primer on Performance Metrics and Test Measures 345 Collateral Types 345 Summary of Performance Metrics 351 Securitization: Features of the 2007–2009 Financial Crisis 351 Impact of the Credit Crunch 351 16 Collateralized Debt Obligations 357 CDO Structures 359 Conventional CDO Structures 359 Synthetic CDO Structures 360 Motivation Behind CDO Issuance 362 Balance Sheet–Driven Transactions 362 Investor-Driven Arbitrage Transactions 363 Analysis and Evaluation 363 Portfolio Characteristics 363 Cash Flow Analysis and Stress Testing 364 Originator’s Credit Quality 365 Operational Aspects 365 Legal Structure of the Transaction 365 Expected Loss 366 CDO Market Overview Since 2005 366 Risk and Capital Management 368 Part Three Selected Market Trading Considerations 17 The Yield Curve, Bond Yield, and Spot Rates 373 Practical Uses of Redemption Yield and Duration 373 The Concept of Yield 374 Yield Comparisons in the Market 376 Measuring a Bond’s True Return 376 Illustrating Bond Yield Using a Microsoft Excel Spreadsheet 380 Implied Spot Rates and Market Zero-Coupon Yields 388 Spot Yields and Coupon-Bond Prices 389 Implied Spot Yields and Zero-Coupon Bond Yields 393 Determining Strip Values 394 Strips Market Anomalies 395 Strips Trading Strategy 396 Case Study: Treasury Strip Yields and Cash Flow Analysis 399 18 Approaches to Trading 401 Futures Trading 402 Yield Curves and Relative Value 406 Determinants of Government Bond Yields 406 Characterizing the Complete Term Structure 408 Identifying Relative Value in Government Bonds 409 Hedging Bond Positions 412 Simple Hedging Approaches 412 Hedge Analysis 413 Summary of the Derivation of the Optimum-Hedge Equation 415 19 Credit Analysis and Relative Value Measurement 417 Credit Ratings 418 Purpose of Credit Ratings 418 Formal Credit Ratings 419 Credit Analysis 420 The Issuer Industry 421 Financial Analysis 423 Industry-Specific Analysis 426 Utility Companies 426 Financial Sector Companies 427 The Art of Credit Analysis 428 Bond Spreads and Relative Value 429 Bond Spreads 429 Summary of Fund Managers’ Approach to Value Creation 438 Appendix I: The Black-Scholes Model in Microsoft Excel 443 Appendix II: Iterative Formula Spreadsheet 445 Appendix III: Pricing Spreadsheet 447 References 451 About the Author 463 Index 465

About the Author :
Moorad Choudhry (Surrey, UK) is head of treasury at Europe Arab Bank plc in London. Previously, he was head of treasury at KBC Financial Products, and a vice president in Structured Finance Service at JPMorgan Chase Bank. Prior to that, he was a sterling proprietary trader at Hambros Bank Limited and gilt-edged market maker and money markets trader at ABN Amro Hoare Govett Ltd. Choudhry is visiting professor at the Department of Economics, London Metropolitan University and a visiting research fellow at the ICMA Centre, University of Reading. He was educated at the University of Westminster and the University of Reading. He obtained his MBA from Henley Management School and his PhD from Birkbeck, University of London. He has written several books on the credit markets.