Introduction to Bonds The Bond Instrument p. 3 The Time Value of Money p. 4 Basic Features and Definitions p. 5 Present Value and Discounting p.

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1 Foreword p. xv Preface p. xvii Introduction to Bonds The Bond Instrument p. 3 The Time Value of Money p. 4 Basic Features and Definitions p. 5 Present Value and Discounting p. 6 Discount Factors p. 12 Bond Pricing and Yield: The Traditional Approach p. 15 Bond Pricing p. 16 Bond Yield p. 20 Floating Rate Notes p. 27 Accrued Interest p. 30 Clean and Dirty Bond Prices p. 30 Day-Count Conventions p. 32 Bond Instruments and Interest Rate Risk p. 35 Duration, Modified Duration, and Convexity p. 35 Duration p. 36 Properties of Macaulay Duration p. 40 Modified Duration p. 41 Convexity p. 45 Bond Pricing and Spot and Forward Rates p. 51 Zero-Coupon Bonds p. 51 Coupon Bonds p. 53 Bond Price in Continuous Time p. 55 Fundamental Concepts p. 55 Stochastic Rates p. 58 Coupon Bonds p. 60 Forward Rates p. 61 Guaranteeing a Forward Rate p. 61 The Spot and Forward Yield Curve p. 63 Calculating Spot Rates p. 64 Term Structure Hypotheses p. 67 The Expectations Hypothesis p. 67 Liquidiry Premium Hypothesis p. 69 Segmented Markets Hypothesis p. 69 Interest Rate Modeling p. 71 Basic Concepts p. 71 Shore-Rare Processes p. 72 Ico's Lemma p. 74 One-Factor Term-Structure Models p. 75

2 Vasicek Model p. 75 Hull-White Model p. 76 Further One-Factor Term-Structure Models p. 77 Cox-Ingersoll-Ross (CIR) Model p. 78 Two-Factor Interest Rate Models p. 79 Brennan-Schwartz Model p. 80 Extended Cox-Ingersoll-Ross Model p. 80 Heath-Jarrow-Morton (HJM) Model p. 81 The Multifactor HJM Model p. 82 Choosing a Term-Structure Model p. 83 Fitting the Yield Curve p. 87 Yield Curve Smoothing p. 88 Smoothing Techniques p. 90 Cubic Polynomials p. 91 Non-Parametric Methods p. 92 Spline-Based Methods p. 92 Nelson and Siegel Curves p. 95 Comparing Curves p. 96 Fitting the Term Structure of Interest Rates: The Practical Implementation of Cubic Spline Methodology p. 96 Cubic Spline Methodology p. 97 The Hypothesis p. 99 Practical Approach p. 100 A Working Environment p. 100 The First Requirement p. 101 The Second Requirement p. 101 The Third Requirement p. 102 Meeting All Requirements Simultaneously p. 102 A Unique Solution p. 103 The Solution p. 108 A Look at Forward Rates p. 114 Conclusion p. 117 Selected Cash and Derivative Instruments Forwards and Futures Valuation p. 121 Forwards and Futures p. 121 Cash Flow Differences p. 122 Relationship between Forward and Futures Prices p. 124 Forward-Spot Parity p. 125 The Basis and Implied Repo Rate p. 127 Swaps p. 131 Interest Rare Swaps p. 132 Market Terminology p. 134

3 Swap Spreads and the Swap Yield Curve p. 135 Generic Swap Valuation p. 138 Intuitive Swap Pricing p. 138 Zero-Coupon Swap Valuation p. 139 Calculating the Forward Rate from Spot-Rate Discount Factors p. 139 The Key Principles of an Interest Rate Swap p. 143 Valuation Using the Final Maturity Discount Factor p. 143 Non-Plain Vanilla Interest Rate Swaps p. 146 Swaptions p. 148 Valuation p. 149 Interest Rate Swap Applications p. 150 Corporate and Investor Applications p. 150 Hedging Bond Instruments Using Interest Rate Swaps p. 153 Options p. 157 Option Basics p. 158 Terminology p. 160 Option Instruments p. 162 Option Pricing: Setting the Scene p. 164 Limits on Option Prices p. 165 Option Pricing p. 166 The Black-Scholes Option Model p. 168 Assumptions p. 169 Pricing Derivative Instruments Using the Black-Scholes Model p. 170 Put-Call Parity p. 173 Pricing Options on Bonds Using the Black-Scholes Model p. 174 Interest Rate Options and the Black Model p. 174 Comments on the Black-Scholes Model p. 180 Stochastic Volatility p. 180 Implied Volatility p. 180 Other Option Models p. 181 Measuring Option Risk p. 183 Option Price Behavior p. 183 Assessing Time Value p. 183 American Options p. 184 The Greeks p. 185 Delta p. 185 Gamma p. 187 Theta p. 189 Vega p. 189 Rho p. 190 Lamda p. 192

4 The Option Smile p. 193 Caps and Floors p. 194 Credit Derivatives p. 197 Credit Risk p. 198 Credit Risk and Credit Derivatives p. 200 Applications of Credit Derivatives p. 201 Credit Derivative Instruments p. 202 Credit Default Swap p. 202 Credit Options p. 203 Credit-Linked Notes p. 204 Total Return Swaps p. 205 Investment Applications p. 207 Capital Structure Arbitrage p. 209 Exposure to Market Sectors p. 210 Credit Spreads p. 210 Funding Positions p. 210 Credit Derivatives and Relative Value Trading p. 212 Relative Value Trading Straregies p. 212 Bond Valuation from CDS Prices: Bloomberg Screen VCDS p. 217 Credit-Derivative Pricing p. 218 Pricing Total Return Swaps p. 218 Asset-Swap Pricing p. 219 Credit-Spread Pricing Models p. 219 The Market Approach to CDS Pricing p. 220 Default Probabilities p. 220 Pricing a CDS Contract p. 226 Example Calculation p. 228 The ITraxx and CD-X Credit Indices Contracts p. 229 Index Tranche Market p. 236 Impact of the Credit Crunch: New CDS Contracts p. 240 The Analysis of Bonds with Embedded Options p. 245 Understanding Option Elements Embedded in a Bond p. 245 Basic Options Features p. 246 Option Valuation p. 247 The Call Provision p. 248 The Binomial Tree of Short-Term Interest Rates p. 249 Arbitrage-Free Pricing p. 250 Options Pricing p. 252 Risk-Neutral Pricing p. 254 Recombining and Nonrecombining Trees p. 255 Pricing Callable Bonds p. 256

5 Price and Yield Sensitivity p. 261 Measuring Bond Yield Spreads p. 263 Option-Adjusted Spread Analysis p. 265 Introduction p. 265 A Theoretical Framework p. 266 The Methodology in Practice p. 272 Convertible Bonds p. 277 Basic Features p. 277 Trading Patterns of Convertible Bonds p. 279 Investor Analysis p. 280 Zero-Coupon Convertibles p. 284 Convertible Bond Default Risk p. 285 Advantages of Issuing and Holding Convertibles p. 285 Convertible Bond Valuation p. 288 Fair Value of a Convertible Bond: The Binomial Model p. 288 Model Parameters p. 297 Pricing Spreadsheet p. 299 Inflation-Indexed Bonds p. 303 Basic Concepts p. 303 Choice of Index p. 303 Indexation Lag p. 305 Coupon Frequency p. 306 Type of Indexation p. 306 Index-Linked Bond Cash Flows and Yields p. 308 TIPS Cash Flow Calculations p. 309 TIPS Price and Yield Calculations p. 309 Assessing Yields on Index-Linked Bonds p. 313 Which to Hold: Indexed or Conventional Bonds? p. 314 Analysis of Real Interest Rates p. 315 Indexation Lags and Inflation Expectations p. 315 An Inflation Term Structure p. 317 Inflation-Indexed Derivatives p. 318 Securitization and Asset-Backed Securities p. 327 The Concept of Securitization p. 328 Reasons for Undertaking Securitization p. 328 Benefits of Securitization to Investors p. 330 The Process of Securitization p. 331 Securitization Process p. 331 Credit Enhancement p. 335 Securirizing Mortgages p. 336 Growth of the Market p. 337

6 Mortgage Bond Risk p. 338 Types of Mortgage-Backed Securities p. 338 Cash Flow Patterns p. 339 Prepayment Analysis p. 340 Prepayment Models p. 344 ABS Structures: A Primer on Performance Metrics and Test Measures p. 345 Collateral Types p. 345 Summary of Performance Metrics p. 351 Securitization: Features of the Financial Crisis p. 351 Impact of the Credit Crunch p. 351 Collateralized Debt Obligations p. 357 CDO Structures p. 359 Conventional CDO Structures p. 359 Synthetic CDO Structures p. 360 Motivation Behind CDO Issuance p. 362 Balance Sheet-Driven Transactions p. 362 Investor-Driven Arbitrage Transactions p. 363 Analysis and Evaluation p. 363 Portfolio Characteristics p. 363 Cash Flow Analysis and Stress Testing p. 364 Originator's Credit Quality p. 365 Operational Aspects p. 365 Legal Structure of the Transaction p. 365 Expected Loss p. 366 CDO Market Overview Since 2005 p. 366 Risk and Capital Management p. 368 Selected Market Trading Considerations The Yield Curve, Bond Yield, and Spot Rates p. 373 Practical Uses of Redemption Yield and Duration p. 373 The Concept of Yield p. 374 Yield Comparisons in the Market p. 376 Measuring a Bond's True Return p. 376 Illustrating Bond Yield Using a Microsoft Excel Spreadsheet p. 380 Implied Spot Rates and Market Zero-Coupon Yields p. 388 Spot Yields and Coupon-Bond Prices p. 389 Implied Spot Yields and Zero-Coupon Bond Yields p. 393 Determining Strip Values p. 394 Strips Market Anomalies p. 395 Strips Trading Strategy p. 396 Case Study: Treasury Strip Yields and Cash Flow Analysis p. 399 Approaches to Trading p. 401

7 Futures Trading p. 402 Yield Curves and Relative Value p. 406 Determinants of Government Bond Yields p. 406 Characterizing the Complete Term Structure p. 408 Identifying Relative Value in Government Bonds p. 409 Hedging Bond Positions p. 412 Simple Hedging Approaches p. 412 Hedge Analysis p. 413 Summary of the Derivation of the Optimum-Hedge Equation p. 415 Credit Analysis and Relative Value Measurement p. 417 Credit Ratings p. 418 Purpose of Credit Ratings p. 418 Formal Credit Ratings p. 419 Credit Analysis p. 420 The Issuer Indusrry p. 421 Financial Analysis p. 423 Industry-Specific Analysis p. 426 Utility Companies p. 426 Financial Sector Companies p. 427 The Art of Credit Analysis p. 428 Bond Spreads and Relative Value p. 429 Bond Spreads p. 429 Summary of Fund Managers' Approach to Value Creation p. 438 The Black-Scholes Model in Microsoft Excel p. 443 Iterative Formula Spreadsheet p. 445 Pricing Spreadsheet p. 447 References p. 451 About the Author p. 463 Index p. 465 Table of Contents provided by Blackwell's Book Services and R.R. Bowker. Used with permission.

FIXED INCOME SECURITIES

FIXED INCOME SECURITIES Valuation, Risk, and Risk Management Pietro Veronesi University of Chicago WILEY JOHN WILEY & SONS, INC. CONTENTS Preface Acknowledgments PART I BASICS xix xxxiii AN INTRODUCTION