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Fixed Income Trading and Risk Management. The Complete Guide. Edition No. 1. Wiley Finance

  • Book

  • 464 Pages
  • February 2021
  • John Wiley and Sons Ltd
  • ID: 5840313

A unique, authoritative, and comprehensive treatment of fixed income markets

Fixed Income Trading and Risk Management: The Complete Guide delivers a comprehensive and innovative exposition of fixed income markets. Written by European Central Bank portfolio manager Alexander During, this book takes a practical view of how several different national fixed income markets operate in detail.

The book presents common theoretical models but adds a lot of information on the actually observed behavior of real markets. You’ll benefit from the book’s:

  • Fulsome overview of money, credit, and monetary policy
  • Description of cash instruments, inflation-linked debt, and credit claims
  • Analysis of derivative instruments, standard trading strategies, and data analysis
  • In-depth focus on risk management in fixed income markets

Perfect for new and junior staff in financial institutions working in sales and trading, risk management, back office operations, and portfolio management positions, Fixed Income Trading and Risk Management also belongs on the bookshelves of research analysts and postgraduate students in finance, economics, or MBA programs.

Table of Contents

Foreword xv

Part One Preliminaries

Chapter 1 Introduction 3

Chapter 2 Money, Credit and Banking 9

2.1 Abstract properties of money 9

2.2 Early forms of money 11

2.2.1 Paper money and bank notes 14

2.3 Fiat money 15

2.3.1 Fiat money and trade 15

Chapter 3 Banks 17

3.1 Banks and bank money creation 17

3.2 Categories of banks 18

Chapter 4 Bank Money Creation 20

4.1 Single-bank introduction 20

4.2 Extension to multiple banks 22

4.3 Transfer settlement in central bank money 25

4.4 Trade and non-bank credit 28

4.4.1 Non-cash trading instruments 29

4.4.2 Discounting 30

4.4.3 Delineating payment instruments from money 30

4.5 Digital token monies and cryptocurrencies 31

4.6 The money multiplier 32

Chapter 5 The Role of Central Banks 34

5.1 Introduction 34

5.2 Monetary financing 39

Chapter 6 Monetary Policy 40

6.1 Objectives of monetary policy 40

6.2 Monetary policy under inflation targeting 43

6.3 Central bank operational frameworks 46

6.3.1 Symmetric interest rate corridors 47

6.3.2 Asymmetric lending corridors 49

Chapter 7 Operational Frameworks 50

7.1 Control of the money supply 50

7.2 Liquidity provision: Rediscounting, outright purchases and Lombard lending 51

7.3 Liquidity absorption: Asset sales and reverse repos 52

7.4 The impact of FX operations 52

Chapter 8 Interaction between Frameworks and Policy 54

8.1 Volatility 54

8.2 Collateral 55

Chapter 9 Non-Standard Monetary Policy 57

9.1 Quantitative easing 57

9.1.1 The Monetary Effect of Large-Scale Asset Purchases 61

9.1.2 Market liquidity and central bank asset purchases 62

9.1.3 Helicopter money 63

9.1.4 Choice of methods and assets 65

9.2 Practical experience 67

9.2.1 QE, money multipliers and FX 67

9.2.2 Bank of Japan 2013 QE experience 71

9.2.3 Lessons from the initial BoJ quantitative easing 72

9.3 Negative interest rates 73

9.4 The specific situation of the ECB 74

Part Two Cash Instruments

Chapter 10 Contract and Instrument Types 79

10.1 Securities and bilateral contracts 79

10.2 Security identifiers 81

10.2.1 ISIN codes 81

10.2.2 CUSIP codes 83

Chapter 11 Trading and Settlement 85

11.1 Trading 85

11.1.1 Trading and price formation 85

11.1.2 Trading venues 86

11.1.3 The OTC trade lifecycle 87

The trade inquiry 89

Negotiation 89

Agreement 90

Recording 91

Enrichment 92

Reporting 92

Pre-confirmation 93

Allocation 93

Confirmation 94

Settlement instructions 94

Fails 95

Reconciliation 96

11.1.4 The exchange trade cycle 96

11.1.5 Trading in competition versus single dealer inquiries and orders 97

Mistrades 98

11.2 Settlement 98

11.2.1 Settlement mechanisms 99

11.2.2 Settlement conventions 99

Chapter 12 Central Clearing 101

12.1 Direct clearing 101

12.2 Indirect clearing 106

12.2.1 Agency clearing 106

12.2.2 Principal clearing 107

12.2.3 Hybrid clearing models 107

12.3 Contract value adjustments (xVA) 108

12.3.1 Credit Value Adjustment 108

12.3.2 Funding Value Adjustment 109

12.3.3 Debit Value Adjustment 110

Chapter 13 The Money Market 111

13.1 Money market instruments 111

13.2 Discount factors 112

13.3 Daycount conventions 114

13.4 Money market interest rates 115

13.5 Compounding 116

13.6 LIBOR, Euribor, and friends 117

13.7 Overnight benchmarks 119

13.8 Benchmark reform 120

13.9 Money market futures and futures trading 121

13.9.1 Money market futures 121

13.9.2 Identification of futures contracts 122

13.9.3 Futures trading basics 124

13.9.4 Convexity adjustment 124

Chapter 14 The Repo Market 126

14.1 The repurchase market 126

14.2 Haircut 128

14.3 Variations of repurchase transactions 128

14.4 Rehypothecation 130

Chapter 15 Spot and Forward Rates 131

15.1 Forward rates 131

15.2 No-arbitrage calculations 131

15.3 Official rates versus term rates 133

15.3.1 The turn premium 133

15.3.2 Matching policy expectations to market rates 134

Chapter 16 The Bond Market 137

16.1 Introduction 137

16.2 Cashflow types 138

16.2.1 Bullet bonds 138

16.2.2 Zero coupon bonds, perpetuals and annuities 139

16.3 Issuer types 142

16.3.1 Joint issuance 144

16.3.2 Supranationals 146

16.4 Governing law and contractual clauses 147

16.5 Bond markets 151

16.5.1 The primary market 153

16.5.2 The secondary market I: (interdealer market) 157

16.5.3 The secondary market II: (customer-facing market) 158

16.6 Accrued interest 158

16.7 Yield 159

16.7.1 Running yield 160

16.7.2 Simple yield 160

16.7.3 Compound yield 160

16.7.4 Bond-equivalent yield 161

16.8 Interest rate risk 163

16.9 Convexity 164

16.10 Bond value decomposition 165

16.11 Carry 167

Chapter 17 Floating-Rate Notes 169

17.1 Coupon reset mechanics 170

17.2 Libor and OIS-linked notes 171

17.3 Discount margin 173

17.4 CMS and CMT floaters 174

Chapter 18 Asset Markets and Liquidity 176

18.1 Concepts 176

18.2 Liquidity measurement 180

18.2.1 Taxonomy of liquidity measures 181

18.3 Examples 183

18.4 Liquidity premium 185

18.5 Liquidity and volatility 187

Chapter 19 Curves and Curve Models 189

19.1 Models 190

19.2 Yield curve representation and interpretations 191

19.2.1 Discount factors versus par curves 191

19.3 Market-based curve representations 193

19.3.1 Bootstrapping 193

19.3.2 Reverse bootstrapping 195

19.4 Parametric curve models 196

19.4.1 The Nelson-Siegel and Nelson-Siegel-Svensson splines 197

19.4.2 Polynomial splines 198

19.4.3 The exponential spline 199

19.4.4 The Vasicek spline 200

19.4.5 Composite models 202

19.5 Fitting curve models 203

Chapter 20 Curve Analysis 205

20.1 Expectations 205

20.2 Convexity bias 209

20.3 Term risk premium 211

20.4 Preferred habitat 212

20.4.1 Asset-liability matching 212

20.4.2 Regulatory constraints 213

20.4.3 Passive investing 214

20.4.4 Central bank reserve portfolios 215

20.4.5 Market technicals 215

Chapter 21 Carry and Roll-Down 217

Chapter 22 Curve Spreads 220

22.1 Z-spread 220

22.2 Par spread 221

22.3 Swap spreads 222

22.3.1 Asset swap spreads 222

22.3.2 I-spreads 223

22.3.3 The TED spread 224

Part Three Inflation-Linked Debt

Chapter 23 Inflation-Indexed Bonds 227

23.1 Introduction 227

23.1.1 Cashflows of inflation-linked bonds 230

23.1.2 Quotation of index-linked bonds 232

23.2 Rebalancing, rebasing and revision of CPI indices 232

23.3 Inflation seasonality 234

23.4 Price formation in inflation-linked markets 238

23.5 Return measures of inflation-linked bonds 240

23.6 Breakeven inflation 241

23.7 Carry on inflation-indexed bonds 244

23.8 Comprehensive inflation modelling 245

23.9 Inflation models and expectations 249

Part Four Defaultable Claims

Chapter 24 Credit Risk 255

24.1 Default, insolvency, and bankruptcy 255

24.2 Seniority and subordination 256

24.2.1 Time subordination and acceleration 256

24.2.2 Contractual subordination 256

24.2.3 Statutory subordination 257

24.2.4 Joint liabilities and credit support 258

24.2.5 Sovereign debt 259

24.3 The default process 259

24.3.1 Collective action clauses 261

24.3.2 Debt exchanges and consent solicitations 262

24.3.3 Managed defaults 263

24.3.4 Wind-downs 263

24.4 Credit ratings 264

24.4.1 Rating migration 266

24.4.2 Alternative rating approaches 270

Chapter 25 Covered Bonds 272

25.1 Statutory covered bonds 277

25.2 Danish covered bonds 279

25.3 Structured covered bonds 281

25.4 Covered bond credit risk analysis 282

Chapter 26 Asset-Backed Securities 284

26.1 The ABS issuance process 285

26.2 Default risk of ABS 286

26.3 Maturity of ABS 287

Chapter 27 Residential Mortgage-Backed Securities 289

27.1 Residential mortgage prepayments 290

27.2 Prepayment modelling 292

Part Five Derivatives

Chapter 28 Bond Futures 301

28.1 Introduction 301

28.2 Futures trading patterns 303

28.2.1 Open interest and trading volume 303

28.2.2 CFTC data for US futures contracts 307

28.3 Valuation of physically delivered bond futures 310

28.3.1 Basis and implied repo rate 310

28.3.2 Conversion factors and the notional coupon 312

28.3.3 The cash-and-carry arbitrage 314

28.3.4 The quality option 315

28.3.5 Hedging with futures 316

28.4 Futures rolls 321

28.4.1 Roll ratios 324

28.4.2 Advanced futures delivery models 325

28.5 Delivery windows 326

28.6 Interaction between futures and bonds 327

28.7 Futures squeezes 329

28.8 Cash-settled futures 331

28.8.1 Exchange-for-physical transactions 332

28.9 New bond issues 332

Chapter 29 Swaps 334

29.1 Introduction 334

29.2 Plain vanilla swaps 336

29.3 Trade compression and re-couponing 338

Part Six Standard Trading Strategies

Chapter 30 Trading Principles 343

30.1 Definitions 343

30.2 Trade identification 345

30.3 Trade portfolios 346

Chapter 31 Curve Trading 347

31.1 Simple curve trades 350

31.1.1 Outright Trades 350

31.1.2 Steepeners and Flatteners 350

31.1.3 Butterflies 353

31.1.4 Condors 354

31.2 Intrinsic curve movements 354

31.2.1 Alternative specifications 360

Chapter 32 Bond Trading 362

32.1 Bond relative value 362

32.2 Relative value strategies 363

32.2.1 Spread widener/tightener 363

32.2.2 Basis trade 364

32.2.3 Bond spread 365

32.2.4 Bond spread with curve hedge 365

32.2.5 Alternative strategies 366

Part Seven Risk Management

Chapter 33 Principal Component Analysis 371

33.1 PCA as generalised regression 373

33.2 Measuring data complexity with PCA 375

Chapter 34 Bond Index Mechanics 378

34.1 Bond index principles 378

34.2 Index rebalancing 380

Chapter 35 Portfolio Risk Management 381

35.1 Risk-neutral portfolios 381

35.2 Index tracking 383

35.2.1 Factor analysis and spanning sets 385

35.2.2 Friction effects 387

Chapter 36 Hedging 389

36.1 Introduction 389

36.2 Duration-neutral hedges 390

36.3 Regression hedges 391

36.4 Yield curve model hedges 392

Chapter 37 Mean-Variance Optimisation 395

Chapter 38 Portfolio Rebalancing 403

38.1 Passive and semi-passive strategies 404

38.1.1 No reallocation 404

38.1.2 Passive management 404

38.1.3 Index replication 405

38.1.4 Constant asset allocation 405

38.1.5 Trend-Following 406

38.1.6 Mean reversion 406

38.2 Numerical examples 407

Part Eight References

Chapter 39 Selected Global Bond Markets 413

39.1 Euro area 413

39.1.1 Austria 414

39.1.2 Belgium 415

39.1.3 Finland 416

39.1.4 France 416

39.1.5 Germany 418

39.1.6 Greece 421

39.1.7 Ireland 422

39.1.8 Italy 423

39.1.9 The Netherlands 424

39.1.10 Portugal 425

39.1.11 Spain 426

39.2 Iceland 427

39.3 Japan 428

39.4 Sweden 430

39.5 United Kingdom 431

39.6 United States of America 433

Bibliography 435

Index 439

Authors

Alexander During