Bond Evaluation, Selection, and Management Second Edition R. STAFFORD JOHNSON WILEY John Wiley &c Sons, Inc.
Contents Preface Acknowledgments xvii xxi PART OWE Bond Evaluation 1 CHAPTER 1 Overview of the Financial System S 1.1 Real and Financial Assets 3 1.2 Types of Debt Claims 4 1.3 Financial Market 6 1.4 Types of Financial Markets 7 1.5 Regulations 15 1.6 Efficient Financial Markets 17 1.7 Characteristics of Assets 20 1.8 Conclusion 23 23 24 25 26 27 CHAPTER 2 Bond Valoe and Return 29 2.1 Introduction 29 2.2 Bond Valuation 29 2.3 The Yield to Maturity and Other Rates of Return Measures 43 2.4 Rates on Zero-Coupon Bonds 49 2.5 Total Return 51 2.6 Spot Rates and Equilibrium Prices 57 2.7 Geometric Mean 60 2.8 Conclusion 64 66 66 70 73 73 vii
Vjii CONTENTS CHAPTER 3 The Level and Structure of Interest Rates 75 3.1 Introduction 75 3.2 Level of Interest Rates 77 3.3 The Structure of Interest Rates 91 3.4 Conclusion 99 100 102 103 104 104 CHAPTER 4 The Term Structure of Interest Rates 105 4.1 Introduction 105 4.2 Market Segmentation Theory 107 4.3 Preferred Habitat Theory 118 4.4 Pure Expectations Theory 120 4.5 Liquidity Premium Theory 132 4.6 Summary of Term Structure Theories 132 4.7 Constructing the Benchmark Yield Curve 133 4.8 Conclusion, 138 140 140 142 143 144 CHAPTER 5 Bond Risk 147 5.1 Introduction 147 5.2 Default Risk 147 5.3 Call Risk 159 5.4 Market Risk 162 5.5 Duration and Convexity 169 5.6 Conclusion 182 182 184 187 188. 189 PARTTOO- Debt Markets 191 CHAPTER 6 Corporate Debt Securities 193 6.1 Introduction 193 6.2 Corporate Bonds 194
Contents ix 6.3 6.4 6.5 6.6 6.1 Bankruptcy The Markets for Corporate Bonds Medium-Term Commercial Paper Conclusion 207 209 214 215 217 218 220 222 223 224 CHAPTER 7 Treasury and Agency Securities 7.1 Introduction 7.2 Treasury Instruments 7.3 Repurchase Agreements 7.4 Federal Agency Securities 7.5 Conclusion CHAPTER 8 Municipal Securities 8.1 Introduction 8.2 Municipal Financing 8.3 Tax-Exempt Status 8.4 Types of Municipals 8.5 Special Features of Municipals 8.6 Credit Risk, Quality Ratings, and Credit Spreads 8.7 Municipal Bond Markets 8.8 Conclusion 225 225 225 240 243 252 252 253 255 257 258 259 259 259 260 261 266 267 274 276 276 278 279 280 280 CHAPTER 9 Intermediary Debt Securities 283 9.1 Introduction 283 9.2 Bank Securities 283 9.3 Banker's Acceptances 287 9.4 Mortgage-Backed and Asset-Backed Securities 288 9.5 Investment Funds 289 9.6 Insurance Companies and Pension Funds 303 9.7 Conclusion 309
CONTENTS 309 310 312 314 315 CHAPTER 10 International Debt Securities 317 10.1 Introduction 317 10.2 International Debt Securities 317 10.3 The Foreign Bond Market 318 10.4 The Eurobond Market 318 10.5 Non-U.S. Domestic Bonds 321 10.6 Emerging Market Debt 323 10.7 Global Fixed-Income Mutual Funds and ETFs 324 10.8 Foreign Bond Risk and Sovereign Bond Ratings 324 10.9 Eurocurrency Market 326 10.10 The Foreign Currency Market and Exchange-Rate Risk 333 10.11 Conclusion 336 337 338.-. 339 341 342 CHAPTER 11 Residential Mortgages and Mortgage-Backed Securities 343 11.1 Introduction 343 11.2 Residential Mortgage Loans 344 11.3 Mortgage Portfolio, 351 11.4 Mortgage-Backed Securities 360 11.5 Features of Mortgage-Backed Securities 361 11.6 Collateralized Mortgage Obligations and Strips 365 11.7 Evaluating Mortgage-Backed Securities 376 11.8 Conclusion. 377 379 380 387 388. 389 CHAPTER 12 Nonagency Residential MBSs, Commercial MBSs, and Other Asset-Backed Securities 391 12.1 Introduction 391 12.2 Nonagency Mortgage-Backed Securities 391 12.3 Commercial Mortgage-Backed Securities 394 12.4 Asset-Backed Securities 396
Contents Xj 12.5 Collateralized Debt Obligations 400 12.6 Conclusion 404 404 406 408 409 409 PART THREE Bond Strategies and the Evaluation of Bonds with Embedded Options 411 CHAPTER 13 Bond Investment Strategies 413 13.1 Introduction 413 13.2 Active Investment Strategies 414 13.3 Passive Bond Management Strategies 423 13.4 Bond Immunization Strategies 428 13.5 Conclusion 437 439 440 446 448 449 CHAPTER 14 Binomial Interest Rate Trees and the Valuation of Bonds with Embedded Options 451 14.1 Introduction 451 14.2 Binomial Interest Rate Model 452 14.3 Valuing Bonds with Other Option Features 461 14.4 Convertible Bond 466 14.5 Valuing Mortgage-Backed Securities 473 14.6 Conclusion 480 480 481 484 484 484 CHAPTER 15 Estimating the Binomial Tree 487 15.1 Introduction 487 15.2 Subdividing the Binomial Tree 487 15.3 Estimating the Binomial Tree 488 15.4 u and d Estimation Approach 492 15.5 Calibration Model 496 15.6 Option-Adjusted Spread 503
XII CONTENTS 15.7 15.8 15.9 Duration and Convexity A Note on the Black-Scholes Option Pricing Model Conclusion 505 506 508 509 509 512 513 513 PART-FOUR Oebt Derivatives: Futures and Options CHAPTER 16 Futures Contracts on Debt Securities: Fundamentals 16.1 16.2 16.3 16.4 16.5 16.6 CHAPTER 17 Introduction The Market and Characteristics of Futures on Debt The Nature of Futures Trading and the Role of the Clearinghouse and Margins Futures Hedging Futures Pricing Conclusion Interest Rate Options Contracts: Fundamentals 17.1 17.2 17.3 17.4 17.5 17.6 17.7 CHAPTER 18 Introduction Options Terminology Markets and Types of Interest Rate Options Option Positions Options Trading Microstructure Option Price Relationships Conclusion Managing Fixed-Income Positions with Interest Rate Derivatives 18.1 18.2 Introduction Hedeine Fixed-Income Positions Securities 515 517 517 520 526 531 536 541 541 542 546 546 547 549 549 550 552 556 566 571 576 576 577 580 580 580 583 583 583
Contents Xiii 18.3 Cross Hedging 590 18.4 Speculating with Interest Rate Derivatives 593 18.5 Synthetic Debt and Investment Positions 596 18.6 Using Options to Set a Cap or Floor on a Cash Flow 599 18.7 Conclusion 599 600 600 604 604 605 CHAPTER 19 Managing Fixed-Income Positions with OTC Derivatives 607 19.1 Introduction 607 19.2 Hedging with OTC Derivatives 607 19.3 Hedging a Series of Cash Flows: OTC Caps and Floors 612 19.4 Financing Caps and Floors: Collars and Corridors 615 19.5 Other Interest Rate Products 620 19.6 Hedging Currency Positions with Foreign Currency Options 624 19.7 Conclusion 627 627 628 633 633 PART-HUE. Swaps CHAPTER 20 Interest Rate Swaps 20.1 Introduction 20.2 Generic Interest Rate Swaps 20.3 Swap Market 20.4 Swap Valuation 20.5 Comparative Advantage and the Hidden Option 20.6 Swaps Applications 20.7 Credit Risk 20.8 Conclusion 635 637 637 637 644 648 650 653 657 658 659 659 665 665 665
XiV CONTENTS CHAPTER 21 Swap Derivatives: Forward Swaps and Swaptions 21.1 Introduction 21.2 Forward Swaps 21.3 Swaptions 21.4 Cancelable and Extendable Swaps 21.5 Nongeneric Swaps 21.6 Conclusion CHAPTER 22 Currency: and Credit Default Swaps 22.1 Introduction 22.2 Currency Swaps 22.3 Credit Default Swaps 22.4 Conclusion APPENDIX A Uses of Exponents and Logarithms 667 667 667 670 677 678 678 679 679 683 683 685 685 685 691 705 705 706 710 710 710 713 APPENDIX B Mathematical Statistical Concepts 719 APPENDIX C Primer on Return, Present Value, and Future Value 727 APPENDIX D Web Site Information and Examples 737 APPENDIX E Global Investments and Exchange Rates 745 APPENDIX F Arbitrage Features of the Calibration Model 747 APPENDIX 6 T-Bond Delivery Procedure and Equilibrium Pricing 749
Contents XV APPENDIX H Pricing Interest Rate Options with a Binomial Interest Tree 753 APPENDIX I Pricing Interest Rate Options with the Black Futures Option Model 763 What's on the Companion Web Site 760 Answers and Solutions to Select End-of-Chapter Problems 771 Glossary of Terms 831 Index 855