The Advanced Fixed Income and Derivatives Management Guide

351 Pages·2015·3.99 MB·English

by  Saied Simozar

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The Advanced
Fixed Income
and Derivatives
Management
Guide
SAIED SIMOZAR
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This edition first published 2015
© 2015 Saied Simozar
Registered office
John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom
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Library of Congress Cataloging-in-Publication Data is on file
ISBN 978-1-119-01414-0 (hardback) ISBN 978-1-119-01416-4 (ebk)
ISBN 978-1-119-01417-1 (ebk)
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Set in 10/12pt Times by SPi-Global, Chennai, India
Printed in Great Britain by TJ International Ltd, Padstow, Cornwall, UK
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Contents
List of Tables xi
List of Figures xv
Abbreviations xvii
Notation xix
Preface xxv
Acknowledgement xxix
Foreword xxxi
About the Author xxxiii
Introduction xxxv
CHAPTER 1
REVIEW OF MARKET ANALYTICS 1
1.1 Bond Valuation 1
1.2 Simple Bond Analytics 3
1.3 Portfolio Analytics 5
1.4 Key Rate Durations 8
CHAPTER 2
TERM STRUCTURE OF RATES 11
2.1 Linear and Non-linear Space 11
2.2 Basis Functions 13
2.3 Decay Coefficient 16
2.4 Forward Rates 17
2.5 Par Curve 18
2.6 Application to the US Yield Curve 18
v
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vi CONTENTS
2.7 Historical Yield Curve Components 20
2.8 Significance of the Term Structure Components 23
2.9 Estimating the Value of the Decay Coefficient 25
CHAPTER 3
COMPARISON OF BASIS FUNCTIONS 29
3.1 Polynomial Basis Functions 29
3.2 Exponential Basis Functions 30
3.3 Orthogonal Basis Functions 30
3.4 Key Basis Functions 31
3.5 Transformation of Basis Functions 32
3.6 Comparison with the Principal Components Analysis 39
3.7 Mean Reversion 44
3.8 Historical Tables of Basis Functions 45
CHAPTER 4
RISK MEASUREMENT 47
4.1 Interest Rate Risks 47
4.2 Zero Coupon Bonds Examples 49
4.3 Eurodollar Futures Contracts Examples 51
4.4 Conventional Duration of a Portfolio 52
4.5 Risks and Basis Functions 53
4.6 Application to Key Rate Duration 56
4.7 Risk Measurement of a Treasury Index 60
CHAPTER 5
PERFORMANCE ATTRIBUTION 63
5.1 Curve Performance 64
5.2 Yield Performance 65
5.3 Security Performance 65
5.4 Portfolio Performance 67
5.5 Aggregation of Contribution to Performance 73
CHAPTER 6
LIBOR AND SWAPS 77
6.1 Term Structure of Libor 79
6.2 Adjustment Table for Rates 80
6.3 Risk Measurement and Performance
Attribution of Swaps 83
6.4 Floating Libor Valuation and Risks 84
6.5 Repo and Financing Rate 86
6.6 Structural Problem of Swaps 87
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Contents vii
CHAPTER 7
TRADING 91
7.1 Liquidity Management 91
7.2 Forward Pricing 95
7.3 Curve Trading 97
7.4 Synthetic Securities 101
7.5 Real Time Trading 104
CHAPTER 8
LINEAR OPTIMIZATION AND PORTFOLIO REPLICATION 107
8.1 Portfolio Optimization Example 110
8.2 Conversion to and from Conventional KRD 112
8.3 KRD and Term Structure Hedging 113
CHAPTER 9
YIELD VOLATILITY 115
9.1 Price Function of Yield Volatility 116
9.2 Term Structure of Yield Volatility 118
9.3 Volatility Adjustment Table 122
9.4 Forward and Instantaneous Volatility 124
CHAPTER 10
CONVEXITY AND LONG RATES 127
10.1 Theorem: Long Rates Can Never Change 127
10.2 Convexity Adjusted TSIR 130
10.3 Application to Convexity 134
10.4 Convexity Bias of Eurodollar Futures 138
CHAPTER 11
REAL RATES AND INFLATION EXPECTATIONS 145
11.1 Term Structure of Real Rates 145
11.2 Theorem: Real Rates Cannot Have Log-normal Distribution 146
11.3 Inflation Linked Bonds 149
11.4 Seasonal Adjustments to Inflation 155
11.5 Inflation Swaps 160
CHAPTER 12
CREDIT SPREADS 165
12.1 Equilibrium Credit Spread 165
12.2 Term Structure of Credit Spreads 167
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viii CONTENTS
12.3 Risk Measurement of Credit Securities 167
12.4 Credit Risks Example 168
12.5 Floating Rate Credit Securities 170
12.6 TSCS Examples 172
12.7 Relative Values of Credit Securities 174
12.8 Performance Attribution of Credit Securities 176
12.9 Term Structure of Agencies 178
12.10 Performance Contribution 179
12.11 Partial Yield 181
CHAPTER 13
DEFAULT AND RECOVERY 185
13.1 Recovery, Guarantee and Default Probability 185
13.2 Risk Measurement with Recovery 189
13.3 Partial Yield of Complex Securities 195
13.4 Forward Coupon 197
13.5 Credit Default Swaps 197
CHAPTER 14
DELIVERABLE BOND FUTURES AND OPTIONS 201
14.1 Simple Options Model 202
14.2 Conversion Factor 204
14.3 Futures Price on Delivery Date 205
14.4 Futures Price Prior to Delivery Date 205
14.5 Early versus Late Delivery 209
14.6 Strike Prices of the Underlying Options 209
14.7 Risk Measurement of Bond Futures 210
14.8 Analytics for Bond Futures 211
14.9 Australian Bond Futures 213
14.10 Replication of Bond Futures 213
14.11 Backtesting of Bond Futures 216
CHAPTER 15
BOND OPTIONS 217
15.1 European Bond Options 218
15.2 Exercise Boundary of American Options 221
15.3 Present Value of a Future Bond Option 222
15.4 Feedforward Pricing 226
15.5 Bond Option Greeks 230
15.6 Risk Measurement of Bond Options 231
15.7 Treasury and Real Bonds Options 233
15.8 Bond Options with Credit Risk 234
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Contents ix
15.9 Theorem: Credit Prices Are Not Arbitrage-Free 236
15.10 Correlation Model 238
15.11 Credit Bond Options Examples 239
15.12 Risk Measurement of Complex Bond Options 241
15.13 Remarks on Bond Options 242
CHAPTER 16
CURRENCIES 245
16.1 Currency Forwards 246
16.2 Currency as an Asset Class 247
16.3 Currency Trading and Hedging 248
16.4 Valuation and Risks of Currency Positions 249
16.5 Currency Futures 251
16.6 Currency Options 251
CHAPTER 17
PREPAYMENT MODEL 253
17.1 Home Sale 254
17.2 Refinancing 255
17.3 Accelerated Payments 256
17.4 Prepayment Factor 257
CHAPTER 18
MORTGAGE BONDS 259
18.1 Mortgage Valuation 260
18.2 Current Coupon 262
18.3 Mortgage Analytics 264
18.4 Mortgage Risk Measurement and Valuation 268
CHAPTER 19
PRODUCT DESIGN AND PORTFOLIO CONSTRUCTION 273
19.1 Product Analyzer 275
19.2 Portfolio Analyzer 278
19.3 Competitive Universe 279
19.4 Portfolio Construction 280
CHAPTER 20
CALCULATING PARAMETERS OF THE TSIR 287
20.1 Optimizing TSIR 289
20.2 Optimizing TSCR 292
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20.3 Optimizing TSCR with No Convexity 294
20.4 Estimating Recovery Value 295
20.5 Robustness of the Term Structure Components 295
20.6 Calculating the Components of the TSYV 296
CHAPTER 21
IMPLEMENTATION 299
21.1 Term Structure 299
21.1.1 Primary Curve 299
21.1.2 Real Curve 300
21.1.3 Credit Curve and Recovery Value 301
21.2 Discount Function and Risk Measurement 302
21.3 Cash Flow Engine 303
21.4 Invoice Price 306
21.5 Analytics 306
21.6 Trade Date versus Settle Date 308
21.7 American Options 309
21.8 Linear Programming 313
21.9 Mortgage Analysis 314
REFERENCES 317
INDEX 319