SEVENTH EDITION Frank J. Fabozzi, CFA Professor in the Practice of Finance Yale School of Management Boston San Francisco New York London Toronto Sydney Tokyo Singapore Madrid Mexico City Munich Paris Cape Town Hong Kong Montreal
Preface Introduction Sectors of the U.S. Bond Market Overview of Bond Features Risks Associated with Investing in Bonds Secondary Market for Bonds Financial Innovation and the Bond Market Overview of the Book Pricing of Bonds Review of Time Value of Money Pricing a Bond Complications Pricing Floating-Rate and Inverse-Floating-Rate Securities Price Quotes and Accrued Interest Measuring Yield Computing the Yield or Internal Rate of Return on Any Investment Conventional Yield Measures Potential Sources of a Bond's Dollar Return Total Return < Applications of the Total Return (Horizon Analysis) Calculating Yield Changes Bond Price Volatility Review of the Price-Yield Relationship for Option-Free Bonds Price Volatility Characteristics of Option-Free Bonds Measures of Bond Price Volatility Convexity Additional Concerns When Using Duration Do Not Think of Duration as a Measure of Time XI 1 1 2 3 7 10 11 12 13 15 15 15 21 27 29 31 32 33 35 35 36 39 46 49 54 54 55 55 58 58 59 60 62 73 82 82 IV
Contents Approximating a Bond's Duration and Convexity Measure Measuring a Bond Portfolio's Responsiveness to Nonparallel Changes in Interest Rates Factors Affecting Bond Yields and the Term Structure of Interest Rates Base Interest Rate Benchmark Spread Term Structure of Interest Rates Swap Rate Yield Curve Treasury and Agency Securities Treasury Securities Stripped Treasury Securities Federal Agency Securities Corporate Debt Instruments Corporate Bonds Medium-Term Notes Commercial Paper Bank Loans Bankruptcy and Creditor Rights Municipal Securities Types and Features of Municipal Securities Municipal Money Market Products Municipal Derivative Securities Credit Risk Risks Associated with Investing in Municipal Securities Yields on Municipal Bonds Municipal Bond Market The Taxable Municipal Bond Market 83 85 88 89 92 92 93 94 99 120 122 123 127 127 127 137 139 143 144 146 146 147 166 169 172 175 177 179 181 181 182 192 193 196 197 197 199 202 203 204
vi Contents 9 10 11 12 13 Non-U.S. Bonds Classification of Global Bond Markets Foreign Exchange Risk and Bond Returns Eurobond Market Non-U.S. Government Bond Markets The European Covered Bond Market Emerging Market Bonds Residential Mortgage Loans Origination of Residential Mortgage Loans Types of Residential Mortgage Loans Conforming Loans Home Equity Loans Risks Associated with Investing in Mortgage Loans Agency Mortgage Pass-Through Securities Sectors of the Residential Mortgage-Backed Securities Market General Description of an Agency Mortgage Pass-Through Security Issuers of Agency Pass-Through Securities Prepayment Conventions and Cash Flow Factors Affecting Prepayments and Prepayment Modeling Cash Flow Yield Prepayment Risk and Asset/Liability Management Secondary Market Trading Agency Collateralized Mortgage Obligations and Stripped Mortgage-Backed Securities ( Agency Collateralized Mortgage Obligations Agency Stripped Mortgage-Backed Securities Nonagency Residential Mortgage-Backed Securities Credit Enhancement Cash Flow for Nonagency Mortgage-Backed Securities 206 206 207 209 210 214 219 221 222 222 225 225 226 227 235 236 236 237 238 239 239 240 241 244 250 260 266 268 269 270 271 275 275 276 308 310 311 313 313 314 319
Contents vii 14 15 16 17 18 Actual Transaction Commercial Mortgage Loans and Commercial Mortgage-Backed Securities Commercial Mortgage Loans Commercial Mortgage-Backed Securities Asset-Backed Securities Creation of an Asset-Backed Security Collateral Type and Securitization Structure Credit Risks Associated with Investing in Asset-Backed Securities Review of Several Major Types of Asset-Backed Securities Collateralized Debt Obligations Structure of a Collateralized Debt Obligation Arbitrage Transactions Cash Flow Transactions Market Value Transactions 'Synthetic Collateralized Debt Obligations Interest-Rate Models Mathematical Description of One-Factor Interest-Rate Models Arbitrage-Free versus Equilibrium Models Empirical Evidence on Interest-Rate Changes Selecting an Interest-Rate Model Estimating Interest-Rate Volatility Using Historical Data Analysis of Bonds with Embedded Options Drawbacks of Traditional Yield Spread Analysis Static Spread: An Alternative to Yield Spread Callable Bonds and Their Investment Characteristics Components of a Bond with an Embedded Option Valuation Model 322 327 327 330 330 331 333 351 353 354 354 355 362 363 366 378 380 382 382 383 385 387 393 396 397 398 400 400 401 404 406 408 409 412 413 414 414 415 415 420 422 424
VIII Contents Option-Adjusted Spread Effective Duration and Convexity 19 Analysis of Residential Mortgage-Backed Securities Static Cash Flow Yield Methodology Monte Carlo Simulation Methodology Total Return Analysis 20 Analysis of Convertible Bonds Convertible Bond Provisions Categorization of Convertible Securities Basic Analytics and Concepts for Convertible Bond Analysis Option Measures Profile of a Convertible Bond Pros and Cons of Investing in a Convertible Bond Convertible Bond Arbitrage Options Approach to Valuation 21 Corporate Bond Credit Analysis Overview of Corporate Bond Credit Analysis Analysis of Business Risk Corporate Governance Risk Financial Risk Corporate Bond Credit Analysis and Equity Analysis 22 Credit Risk Modeling Difficulties in Credit Risk Modeling Overview of Credit Risk Modeling Credit Ratings versus Credit Risk Models Structural Models Estimating Portfolio Credit Risk: Default Correlation and Copulas Reduced-Form Models Incomplete Information Models 436 437 438 439 442 442 443 451 461 462 463 465 465 465 467 468 472 474 475 477 479 480 480 483 483 484 486 489 491 494 495 495 497 497 498 499 500 500 506 507 510
Contents 1 IX 23 24 25 26 27 Active Bond Portfolio Management Strategies Overview of the Investment Management Process Tracking Error and Bond Portfolio Strategies Active Portfolio Strategies The Use of Leverage Indexing Objective of and Motivation for Bond Indexing Factors to Consider in Selecting an Index Bond Indexes Indexing Methodologies Logistical Problems in Implementing an Indexing Strategy Enhanced Indexing Liability-Driven Strategies General Principles of Asset/Liability Management Immunization of a Portfolio to Satisfy a Single Liability Structuring a Portfolio to Satisfy Multiple Liabilities Extensions of Liability-Driven Strategies Combining Active and Immunization Strategies Liability-Driven Strategies for Defined Benefit Pension Funds Bond Performance Measurement and Evaluation Requirements for a Bond Performance and Attribution Analysis Process Performance Measurement Performance Attribution Analysis Interest-Rate Futures Contracts Mechanics of Futures Trading Futures versus Forward Contracts 511 511 512 512 513 516 526. 544 550 551 555 555 555 557 557 560 562 562 563 564 565 565 566 571 586 589 590 591 592 593 598 598 599 599 605 611 613 615 615 616 618
Contents Risk and Return Characteristics of Futures Contracts 619 Currently Traded Interest-Rate Futures Contracts 619 Pricing and Arbitrage in the Interest-Rate Futures Market 628 Bond Portfolio Management Applications 635 649 650 28 Interest-Rate Options 652 652 Options Defined 653 Differences between an Option and a Futures Contract 653 Types of Interest-Rate Options 653 Intrinsic Value and Time Value of an Option 656 Profit and Loss Profiles for Simple Naked Option Strategies 658 Put-Call Parity Relationship and Equivalent Positions 670 Option Price 672 Models for Pricing Options 673 Sensitivity of Option Price to Change in Factors 683 Hedge Strategies 687 694 694 29 Interest-Rate Swaps, Caps, and Floors 697 697 Interest-Rate Swaps 698 Interest-Rate Caps and Floors 721 J 727 728 30 Credit Derivatives, 731 731 Types of Credit Risk 732 Categorization of Credit Derivatives 733 International Swaps and Derivatives Association Documentation 733 Asset Swaps 735 Total Return Swaps 737 Credit Default Swaps 739 Single-Name Credit Default Swap 740 Credit Spread Options 748 Credit Spread Forwards 750 Structured Credit Products 750 752 754 Index 756