A comprehensive guide to the current theories and methodologies intrinsic to fixed-income securities
Written by well-known experts from a cross section of academia and finance, Handbook of Fixed-Income Securities features a compilation of the most up-to-date fixed-income securities techniques and methods. The book presents crucial topics of fixed income in an accessible and logical format. Emphasizing empirical research and real-life applications, the book explores a wide range of topics from the risk and return of fixed-income investments, to the impact of monetary policy on interest rates, to the post-crisis new regulatory landscape.
Well organized to cover critical topics in fixed income, Handbook of Fixed-Income Securities is divided into eight main sections that feature:- An introduction to fixed-income markets such as Treasury bonds, inflation-protected securities, money markets, mortgage-backed securities, and the basic analytics that characterize them
- Monetary policy and fixed-income markets, which highlight the recent empirical evidence on the central banks’ influence on interest rates, including the recent quantitative easing experiments
- Interest rate risk measurement and management with a special focus on the most recent techniques and methodologies for asset-liability management under regulatory constraints
- The predictability of bond returns with a critical discussion of the empirical evidence on time-varying bond risk premia, both in the United States and abroad, and their sources, such as liquidity and volatility
- Advanced topics, with a focus on the most recent research on term structure models and econometrics, the dynamics of bond illiquidity, and the puzzling dynamics of stocks and bonds
- Derivatives markets, including a detailed discussion of the new regulatory landscape after the financial crisis and an introduction to no-arbitrage derivatives pricing
- Further topics on derivatives pricing that cover modern valuation techniques, such as Monte Carlo simulations, volatility surfaces, and no-arbitrage pricing with regulatory constraints
- Corporate and sovereign bonds with a detailed discussion of the tools required to analyze default risk, the relevant empirical evidence, and a special focus on the recent sovereign crises
A complete reference for practitioners in the fields of finance, business, applied statistics, econometrics, and engineering,
Handbook of Fixed-Income Securities is also a useful supplementary textbook for graduate and MBA-level courses on fixed-income securities, risk management, volatility, bonds, derivatives, and financial markets.
Pietro Veronesi, PhD, is Roman Family Professor of Finance at the University of Chicago Booth School of Business, where he teaches Masters and PhD-level courses in fixed income, risk management, and asset pricing. Published in leading academic journals and honored by numerous awards, his research focuses on stock and bond valuation, return predictability, bubbles and crashes, and the relation between asset prices and government policies.
Table of Contents
Notes on Contributors xix
Preface xxv
PART I FIXED INCOME MARKETS 1
1 Fixed Income Markets: An Introduction 3
1.1 Introduction 3
1.2 U.S. Treasury Bills, Notes, and Bonds 7
1.3 Interest Rates, Yields, and Discounting 8
1.4 The Term Structure of Interest Rates 9
1.5 Pricing Coupon Notes and Bonds 17
1.6 Inflation-Protected Securities 19
1.7 Floating Rate Notes 22
1.8 Conclusion 24
References 24
2 Money Market Instruments 25
2.1 Overview of the Money Market 25
2.2 U.S. Treasury Bills 26
2.3 Commercial Paper 27
2.4 Discount Window 29
2.5 Eurodollars 29
2.6 Repurchase Agreements 32
2.7 Interbank Loans 35
2.8 Conclusion 40
References 40
3 Inflation-Adjusted Bonds and the Inflation Risk Premium 41
3.1 Inflation-Indexed Bonds 41
3.2 Inflation Derivatives 42
3.3 No-Arbitrage Pricing 43
3.4 Inflation Risk Premium 43
3.5 A Look at the Data 45
3.6 Conclusion 50
3.7 Appendix 50
3.8 Data Appendix 51
References 52
4 Mortgage-Related Securities (MRSs) 53
4.1 Purpose of the Chapter 53
4.2 Introduction to MRSs 54
4.3 Valuation Overview 57
4.4 Analyzing an MRS 62
4.5 Summary 72
References 73
PART II MONETARY POLICY AND FIXED INCOME MARKETS 75
5 Bond Markets and Monetary Policy 77
5.1 Introduction 77
5.2 High-Frequency Identification of Monetary Policy Shocks 78
5.3 Target Versus Path Shocks 84
5.4 Conclusions 90
References 91
6 Bond Markets and Unconventional Monetary Policy 93
6.1 Introduction 93
6.2 Unconventional Policies: The Fed, ECB, and BOE 94
6.3 Unconventional Policies: A Theoretical Framework 101
6.4 Unconventional Policies: The Empirical Evidence 104
6.5 Conclusions 115
References 116
PART III INTEREST RATE RISK MANAGEMENT 117
7 Interest Rate Risk Management and Asset Liability Management 119
7.1 Introduction 119
7.2 Literature Review 120
7.3 Interest Rate Risk Measures 120
7.4 Application to Asset Liability Management 127
7.5 Backtesting ALM Strategies 141
7.6 Liability Hedging and Portfolio Construction 142
7.7 Conclusions 144
7.8 Appendix: The Implementation of Principal Component Analysis 145
References 146
8 Optimal Asset Allocation in Asset Liability Management 147
8.1 Introduction 147
8.2 Yield Smoothing 150
8.3 ALM Problem 151
8.4 Method 155
8.5 Single-Period Portfolio Choice 156
8.6 Dynamic Portfolio Choice 160
8.7 Conclusion 164
8.8 Appendix: Return Model Parameter Estimates 165
8.9 Appendix: Benchmark Without Liabilities 165
References 166
PART IV THE PREDICTABILITY OF BOND RETURNS 169
9 International Bond Risk Premia 171
9.1 Introduction 171
9.2 Literature Review 172
9.3 Notation and International Bond Market Data 174
9.4 Unconditional Risk Premia 174
9.5 Conditional Risk Premia 177
9.6 Understanding Bond Risk Premia 185
9.7 Conclusion and Outlook 187
References 189
10 Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity 191
10.1 Introduction 191
10.2 Brief Literature Review 192
10.3 Bond Data and Definitions 193
10.4 Estimating the Liquidity Differential Between Inflation-Indexed and Nominal Bond Yields 194
10.5 Bond Excess Return Predictability 201
10.6 Conclusion 206
References 208
11 U.S. Treasury Market: The High-Frequency Evidence 210
11.1 Introduction 210
11.2 The U.S. Treasury Markets During the Financial Crisis 211
11.3 The Reaction of Bond Prices and Interest Rates to Macroeconomic News 217
11.4 Market-Microstructure Effects 228
11.5 Bond Risk Premia 232
11.6 The Impact of High-Frequency Trading 234
11.7 Conclusions 236
References 236
PART V ADVANCED TOPICS ON TERM STRUCTURE MODELS AND THEIR ESTIMATION 239
12 Structural Affine Models for Yield Curve Modeling 241
12.1 Purpose and Structure of This Chapter 241
12.2 Structural Models 242
12.3 A Simple Taxonomy 242
12.4 Why do we Need No-Arbitrage Models After All? 243
12.5 Affine Models and the Drivers of The Yield Curve 244
12.6 Introducing No-Arbitrage 247
12.7 Which Variables Should One use? 247
12.8 Risk Premia Implied by Affine Models with Constant Market Price of Risk 249
12.9 Testable Predictions: Constant Market Price of Risk 251
12.10 What Do We Know About Excess Returns? 251
12.11 Understanding the Empirical Results on term Premia 252
12.12 Enriching the First-Generation Affine Models 254
12.13 Latent Variables: The D’Amico, Kim, and Wei Model 254
12.14 From Linear Regressors to Affine Models: the ACM Approach 255
12.15 Affine Models using Principal Components as Factors 256
12.16 The Predictions from the “Modern” Models 258
12.17 Conclusions 261
References 263
13 The Econometrics of Fixed-Income Markets 265
13.1 Introduction 265
13.2 Different Types of Term Structure Models 266
13.3 Parametric Estimation Methods 269
13.4 Maximum Likelihood Estimation 272
13.5 Constructing the Likelihood Function: Expansion of the Transition Density 275
13.6 Concluding Remarks 278
References 279
14 Recent Advances in Old Fixed-Income Topics: Liquidity, Learning, and the Lower Bound 282
14.1 Introduction 282
14.2 Liquidity 283
14.3 Learning 291
14.4 Lower Bound 301
14.5 Conclusion 309
14.6 Appendix: Moments of Truncated Bivariate Distribution 310
References 311
15 The Economics of the Comovement of Stocks and Bonds 313
15.1 Introduction 313
15.2 A Brief Literature Survey 313
15.3 The Stock–Bond Covariance and Learning about Fundamentals 315
15.4 Beliefs from Surveys and from the Model 319
15.5 Survey and Model Beliefs and the Stock–Bond Covariance 319
15.6 Some International Evidence 322
15.7 Summary 325
References 325
PART VI DERIVATIVES: MARKETS AND PRICING 327
16 Interest Rate Derivatives Products and Recent Market Activity in the New Regulatory Framework 329
16.1 Introduction 329
16.2 Background on the New Derivatives Regulatory Framework 331
16.3 Exchange-Traded Derivatives 335
16.4 Noncleared Swaps 341
16.5 Cleared Swaps 354
16.6 Comparative Market Activity Across Execution Venues 360
16.7 Liquidity Fragmentation in Nondollar Swaps 366
16.8 Prospects for the Future 368
16.9 Appendix: The New Regulatory Framework for Interest Rate Derivatives in the United States and European
Union 371
References 385
17 Risk-Neutral Pricing: Trees 389
17.1 Introduction 389
17.2 Binomial Trees 389
17.3 Risk-Neutral Pricing on Multistep Trees 394
17.4 From Diffusion Models to Binomial Trees 403
17.5 Trinomial Trees 406
References 413
18 Discounting and Derivative Pricing Before and After the Financial Crisis: An Introduction 414
18.1 Introduction 414
18.2 Forward Rate Agreements (FRAs) 415
18.3 Overnight Index Swaps (OISs) 422
18.4.1 LIBOR Discount Curve with Single-Curve Pricing 426
18.5 The Crisis and the Double-Curve Pricing of LIBOR-Based Swaps 426
18.6 The Pricing of LIBOR-Based Interest Rate Options 430
18.7 Conclusions 433
References 433
PART VII ADVANCED TOPICS IN DERIVATIVES PRICING 435
19 Risk-Neutral Pricing: Monte Carlo Simulations 437
19.1 Introduction 437
19.2 Risk-Neutral Pricing 437
19.3 Risk-Neutral Pricing: Monte Carlo Simulations 446
19.4 Valuation by Monte Carlo Simulation 451
19.5 Monte Carlo Simulations in Multifactor Models 461
19.6 Conclusion 467
References 467
20 Interest Rate Derivatives and Volatility 469
20.1 Introduction 469
20.2 Markets and the Institutional Context 469
20.3 Dissecting the Instruments 473
20.4 Evaluation Paradigms 479
20.5 Pricing and Trading Volatility 487
20.6 Conclusions 507
20.7 Appendix 508
References 512
21 Nonlinear Valuation under Margining and Funding Costs with Residual Credit Risk: A Unified Approach 514
21.1 Introduction 514
21.2 Collateralized Credit and Funding Valuation Adjustments 516
21.3 General Pricing Equation Under Credit, Collateral, and Funding 522
21.4 Numerical Results: Extending the Black–Scholes Analysis 527
21.5 Extensions 535
21.6 Conclusions: Bilateral Prices or Nonlinear Values? 536
References 537
PART VIII CORPORATE AND SOVEREIGN BONDS 539
22 Corporate Bonds 541
22.1 Introduction 541
22.2 Market and Data 542
22.3 A Very Simple Model 544
22.4 Structural Models 546
22.5 Reduced-form Models 550
22.6 Risk Premia in Intensity Models 554
22.7 Dealing with Portfolios 556
22.8 Illiquidity as a Source of Spreads 557
22.9 Some Additional Readings 558
22.10 Conclusion 559
References 559
23 Sovereign Credit Risk 561
23.1 Introduction 561
23.2 Literature Review 563
23.3 Modeling Sovereign Default 564
23.4 Credit Risk Premia 568
23.5 Estimating Intensity Models 569
23.6 Application to Emerging Markets 570
23.7 Application to the European Debt Crisis 575
23.8 Conclusion 580
23.9 Appendix: No Arbitrage Pricing 580
23.9.1 The Risk-Neutral Default Intensity 583
References 584
Index 587
