Handbook of Fixed–Income Securities

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 U.S. and abroad, and its sources, such as liquidity and volatility Advanced topics, which focuses 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, which includes a detailed discussion of the new regulatory landscape after the financial crisis as well as an introduction to no–arbitrage derivatives pricing Further topics on derivatives pricing that covers 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, equities, 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. 

 

Preface xvii

Part I Fixed Income Markets

1 Fixed Income Markets: An Introduction 1

1.1 Introduction 1

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 10

1.4.1 The Economics of the Nominal Yield Curve 10

1.4.2 The Expectations Hypothesis 16

1.4.3 Forward Rates as Expectation of Future Interest Rates? 20

1.4.4 Interpreting a Steepening of the Yield Curve 22

1.5 Pricing Coupon Notes and Bonds 23

1.5.1 Estimating the Zero–Coupon Discount Function 23

1.5.2 Data and Bond Illiquidity 25

1.6 Inflation–Protected Securities 27

1.7 Floating Rate Notes 29

1.8 Conclusion 31

2 Money Market Instruments 35

2.1 Overview of the Money Market 35

2.2 U.S. Treasury Bills 37

2.3 Commercial Paper 38

2.3.1 General Facts About Commercial Paper 38

2.3.2 Non–Asset Backed Commercial Paper 39

2.3.3 Asset–Backed Commercial Paper 40

2.4 Discount Window 42

2.5 Eurodollars 43

2.5.1 Eurodollar Futures 45

2.6 Repurchase Agreements 45

2.6.1 Types of Repos and Haircuts 45

2.6.2 Basic Forms of Repo Collateral 47

2.6.3 Repo Rates and Collateral Value Risks 48

2.6.4 The Run on Repo During the Financial Crisis 49

2.7 Interbank Loans 51

2.7.1 Federal Funds 51

2.7.2 LIBOR 54

2.7.3 Overnight Index Swaps and LIBOR–OIS Spreads 55

2.7.4 A Model of LIBOR–OIS Spreads 56

2.8 Conclusion 59

3 Inflation–Adjusted Bonds and the Inflation Risk Premium 61

3.1 Inflation–Indexed Bonds 61

3.1.1 Mechanics of TIPS 62

3.1.2 Valuing an Inflation–Indexed Bond 63

3.2 Inflation Derivatives 63

3.2.1 Constructing a Synthetic Nominal Treasury Bond with Inflation Swaps 64

3.3 No Arbitrage Pricing 64

3.3.1 Zero–Coupon Bonds 64

3.4 Inflation Risk Premium 65

3.4.1 Determinants of the Inflation Risk Premium 67

3.5 A look at the Data 68

3.5.1 Break–even rates 68

3.5.2 Inflation Swap Rates 69

3.5.3 Inflation Risk Premium 74

3.6 Conclusion 76

3.7 Appendix 76

3.7.1 Breeden–Lucas–Rubinstein example 76

3.7.2 Disaster Risk 77

3.8 Data Appendix 78

4 Mortgage Related Securities 81

4.1 Purpose of the Chapter 81

4.2 Introduction to MRSs 83

4.2.1 Mortgage and Securitization 83

4.2.2 The cash flows of Mortgage Pools 84

4.3 Valuation Overview 89

4.3.1 OAS, OAD, and Negative Convexity 90

4.3.2 Modeling prepayment and default 93

4.4 Analyzing a MRS 97

4.4.1 Modeling prepayment and default 97

4.4.2 Freddie Mac s STACR 106

4.4.3 Analyzing the STACR Series 2013–DN1 111

4.5 Summary 115

Part II Monetary Policy and Fixed Income Markets

5 Bond Markets and Monetary Policy 119

5.1 Introduction 119

5.2 High Frequency Identification of Monetary Policy Shocks 122

5.2.1 Learning About Monetary Policy Surprises 123

5.2.2 The Impact on Treasury Bond Yields 126

5.2.3 The Timing of Expected Fed Interventions 128

5.3 Target versus Path shocks 129

5.3.1 The Economics of FOMC Meetings and Bond Yields 134

5.4 Conclusions 142

6 Bond Markets and Unconventional Monetary Policy 147

6.1 Introduction 147

6.2 Unconventional Policies: The Fed, ECB, and BoE 149

6.2.1 Federal Reserve Operations 149

6.2.2 Bank of England Operations 153

6.2.3 European Central Bank Operations 154

6.3 Unconventional Policies: A Theoretical Framework 161

6.4 Unconventional Policies: The Empirical Evidence 166

6.4.1 The Treasury Bond Market 166

6.4.2 The MBS Market 180

6.4.3 How Persistent is the Effect? 184

6.5 Conclusions 185

Part III Interest Rate Risk Management

7 Interest Rate Risk Management and ALM 191

7.1 Introduction 191

7.2 Literature Review 192

7.3 Interest Rate Risk Measures 194

7.3.1 Duration 194

7.3.2 Convexity 195

7.3.3 Key Rate Duration 198

7.3.4 Principal Component Analysis and Factor Duration 199

7.4 Application to Asset Liability Management 204

7.4.1 Nature of Liabilities 204

7.4.2 Cash Flow Matching 207

7.4.3 Classic Immunization and Duration Matching 209

7.4.4 Key Rate Duration Matching 214

7.4.5 Factor Duration Matching 220

7.5 Backtesting ALM Strategies 226

7.6 Liability Hedging and Portfolio Construction 228

7.7 Conclusions 231

7.8 Appendix: The Implementation of Principal Component Analysis 233

8 Optimal Asset Allocation in ALM 237

8.1 Introduction 237

8.2 Yield Smoothing 243

8.3 ALM problem 245

8.3.1 Return and Yield Dynamics 245

8.3.2 Preferences 248

8.3.3 Constraints 250

8.3.4 Data description and estimation 251

8.4 Method 252

8.5 Single Period Portfolio Choice 254

8.5.1 ALM with a VaR constraint 254

8.5.2 ALM with AFCs 257

8.6 Dynamic Portfolio Choice 262

8.6.1 Welfare and portfolio implications of yield smoothing 262

8.6.2 Hedging demands and regulatory constraints 264

8.7 Conclusion 269

8.8 Appendix: Return model parameter estimates 270

8.9 Appendix: Benchmark Without Liabilities 270

Part IV The Predictability of Bond Returns

9 International Bond Risk Premia 277

9.1 Introduction 277

9.2 Literature review 280

9.3 Notation and international bond market data 282

9.3.1 Notation 282

9.3.2 International bond market data 282

9.4 Unconditional risk premia 283

9.4.1 A long–term perspective 284

9.4.2 More recent evidence 287

9.5 Conditional risk premia 289

9.5.1 Local predictors of returns 290

9.5.2 Global predictors of returns 296

9.6 Understanding bond risk premia 302

9.6.1 Links to economic growth 302

9.6.2 State dependency 304

9.7 Conclusion and outlook 306

10 Return Predictability: Real Rates, Inflation, and Liquidity 313

10.1 Introduction 313

10.2 Brief Literature Review 315

10.3 Bond Data and Definitions 317

10.3.1 Bond Notation and Definitions 317

10.3.2 Yield Data 318

10.4 Real Nominal Liquidity Differential 319

10.4.1 Estimation Strategy 322

10.4.2 Data on Liquidity and Inflation Expectation Proxies 323

10.4.3 Estimating Differential Liquidity 327

10.5 Bond Excess Return Predictability 332

10.5.1 Economic Significance of Bond Risk Premia 337

10.6 Conclusion 338

11 U.S. Treasury Market: The high–frequency evidence 345

11.1 Introduction 345

11.2 The U.S. Treasury markets during the financial crisis 347

11.2.1 Yields 347

11.2.2 Volatility 349

11.2.3 Off–the–run/on–the–run yield spread 351

11.2.4 Trading volume and price impact 351

11.2.5 Fails 351

11.2.6 Intra–day evidence on March 18, 2009 354

11.2.7 Summary 355

11.3 The reaction of bond prices and interest rates to macroeconomic news 356

11.3.1 Level effects 356

11.3.2 The impact of monetary policy 358

11.3.3 Realized–volatility patterns 360

11.3.4 Macro news and option–implied volatilities 361

11.3.5 ARCH and GARCH effects 365

11.3.6 Jumps 369

11.3.7 Summary 373

11.4 Market microstructure effects 374

11.4.1 Microstructure effects in the cash market 375

11.4.2 Joint microstructure effects in the cash market and futures markets 380

11.4.3 Summary 381

11.5 Bond risk premia 382

11.5.1 Daily evidence 382

11.5.2 Intra–day evidence 384

11.5.3 Summary 385

11.6 The impact of high–frequency trading 386

11.6.1 The effects of HFT on liquidity, volatility, and risk premia 386

11.6.2 Summary 388

11.7 Conclusions 388

Part V Advanced Topics on Term Structure Models and Their Estimation

12 Structural Affine Models 395

12.1 Purpose and Structure of This Chapter 395

12.2 Structural Models 396

12.3 A Simple Taxonomy 397

12.4 Why Do We Need No–Arbitrage Models After All? 399

12.5 Affine Models and the Drivers of the Yield Curve 401

12.5.1 Expectations 401

12.5.2 Term (Risk) Premia 401

12.5.3 Convexity 404

12.6 Introducing No–Arbitrage 405

12.7 Which Variables Should One Use? 406

12.8 Risk Premia Implied by Affine Models with Constant Market Price of Risk 409

12.9 Testable Predictions: Constant Market Price of Risk 411

12.10What Do We Know About Excess Returns? 412

12.11Understanding the Empirical Results on Term Premia 414

12.12Enriching the First–Generation Affine Models 416

12.13Latent Variables: The D Amico, Kim and Wei Model 417

12.14From Linear Regressors to Affine Models: the ACMApproach 419

12.15Affine Models Using Principal Components as Factors 421

12.16The Predictions from the Modern Models 423

12.17Conclusions 427

12.17.1 Models As Enforcers of Parsimony and Builders of Confidence 428

12.17.2 Models As Enforcers of Cross–Sectional Restrictions 429

12.17.3 Models As Revealers of Forward–Looking Informations 430

12.17.4 Models As Enhancers of Understanding 431

13 The Econometrics of Fixed Income Markets 435

13.1 Introduction 435

13.2 Different Types of Term Structure Models 437

13.2.1 Factor Models 437

13.2.2 Observable Factors 438

13.2.3 Latent Factors: Filtering vs. Indirect Observation 438

13.2.4 Macroeconomic Models 439

13.2.5 Affine Models 440

13.2.6 Yield–based Models 441

13.2.7 Forward–based Models 442

13.3 Parametric Estimation Methods 443

13.3.1 GMM 443

13.3.2 Maximum Likelihood 444

13.3.3 QML 445

13.3.4 Efficient Method of Moments 446

13.3.5 Estimation Bias in Mean Reversion Parameters 447

13.4 Maximum Likelihood Estimation 447

13.4.1 Observed State Variables 448

13.4.2 Latent State Variables 448

13.5 Constructing the Likelihood Function: Expansion of the Transition Density 452

13.5.1 Reducibilty 453

13.5.2 The Irreducible Case 455

13.6 Concluding Remarks 457

14 Recent Advances in Old Fixed–Income Topics 463

14.1 Introduction 463

14.2 Liquidity 465

14.2.1 Bills, Notes and Bonds 465

14.2.2 Market Liquidity and Short–Selling Costs 468

14.2.3 Hedging Demand 470

14.2.4 Risky Arbitrage 471

14.2.5 Segmented Markets and Preferred Habitats 472

14.2.6 Funding Risk 474

14.2.7 Implication for Term Structure Models 477

14.3 Learning 479

14.3.1 Yield Survey Forecasts 479

14.3.2 Affine Term Structure Models 482

14.3.3 Spanning Survey Forecasts 487

14.3.4 Adaptive Learning and Survey Forecasts 491

14.3.5 Equilibrium models of the term structure 492

14.4 Lower Bound 493

14.4.1 Square–Root and Auto–Regressive Gamma Models 494

14.4.2 Black (1995) Tobit 497

14.4.3 No–Dominance Term Structure Models 499

14.4.4 Recent Empirical Results 501

14.5 Conclusion 504

15 The Economics of the Comovement of Stocks and Bonds 513

15.1 Introduction 513

15.2 A Brief Literature Survey 514

15.3 The Stock–Bond Covariance and Learning About Fundamentals 516

15.3.1 Investors Beliefs About Composite Regimes 518

15.3.2 Valuations and the Fed Model 520

15.3.3 Explaining the Time Variation in the Stock–Bond

Covariance 521

15.4 Beliefs from Surveys and from the Model 522

15.5 Survey and Model Beliefs and the Stock–Bond Covariance 525

15.6 Some International Evidence 528

15.7 Summary 533

Part VI Derivatives: Markets and Pricing

16 Interest Rate Derivatives: Market Activity and New Regulation 537

16.1 Introduction 537

16.2 Background on the New Derivatives Regulatory Framework 539

16.2.1 Clearing 540

16.2.2 Execution 543

16.2.3 Reporting 544

16.3 Exchange–Traded Derivatives 547

16.3.1 Major Products 547

16.3.2 Execution 548

16.3.3 Clearing 549

16.3.4 Market Activity 553

16.4 Non–Cleared Swaps 555

16.4.1 Major Products 555

16.4.2 Execution 559

16.4.3 Credit Risk Mitigation 564

16.4.4 Market Activity 574

16.5 Cleared Swaps 580

16.5.1 Major Products 580

16.5.2 Market Activity 580

16.6 Comparative Market Activity Across Execution Venues 591

16.6.1 OTC vs. Exchange–Traded Interest Rate Derivatives 591

16.6.2 Bilateral vs. SEF Execution of OTC Interest Rate Derivatives 596

16.7 Liquidity Fragmentation in Non–Dollar Swaps 601

16.8 Prospects for the Future 606

16.8.1 Cleared Swaps and Exchange–Traded Interest Rate Derivatives 608

16.8.2 Swap Futures 609

16.8.3 Non–Cleared Swaps and End Users 609

16.9 Appendix: The New Regulatory Framework 611

16.9.1 Classifications of Market Participants 612

16.9.2 Clearing 615

16.9.3 Execution 619

16.9.4 Reporting 622

16.9.5 Margin Requirements for Non–Cleared Swaps 623

16.9.6 Capital Requirements for Non–Cleared Swaps 628

16.9.7 Cross–Border and Extra–Territoriality Issues 632

17 Risk–Neutral Pricing: Trees 649

17.1 Introduction 649

17.2 Binomial Trees 650

17.2.1 One Step Binomial Trees 650

17.2.2 The Market Price of Risk 655

17.3 Risk–Neutral Pricing on Multi–Step Trees 657

17.3.1 Calibration of Risk–Neutral Trees to the Yield Curve 658

17.3.2 The Pricing of European Options 661

17.3.3 The Pricing of American Options 668

17.4 From Diffusion Models to Binomial Trees 670

17.4.1 The Hull and White Model 674

17.5 Trinomial Trees 676

17.5.1 Calibration to the Yield Curve 678

17.5.2 Pricing Bermudan contracts using the trinomial tree 682

17.5.3 Calibration to the Volatility Curve 684

18 Derivative Pricing Before and After the Crisis 687

18.1 Introduction 687

18.2 Forward Rate Agreements (FRA) 690

18.2.1 Forward Rates 691

18.2.2 Forward Rates after the Crisis 692

18.2.3 A Simple Explanation for the Arbitrage 695

18.3 Overnight Index Swaps (OIS) 700

18.3.1 OIS Discount Curve 701

18.4 LIBOR–based Swaps 701

18.4.1 LIBOR Discount Curve with Single Curve Pricing 704

18.5 The Crisis and the Double–Curve Pricing of LIBOR–based Swaps 705

18.5.1 Extracting FRA Rates from Swap Quotes 708

18.5.2 Extracting the Discount Curve from FRA Rates 708

18.5.3 Summing Up 709

18.6 The Pricing of LIBOR–based Interest Rate Options 710

18.6.1 Black s Option Pricing Formula 710

18.6.2 Caps and Floors before and after the Crisis 712

18.6.3 Swaptions before and after the Crisis 714

18.7 Conclusions 715

Part VII Advanced Topics in Derivatives Pricing

19 Risk–Neutral Pricing: Monte Carlo Simulations 719

19.1 Introduction 719

19.2 Risk–Neutral Pricing 720

19.2.1 Interest Rate Models 723

19.2.2 The Market Price of Risk 724

19.2.3 Valuation under P and under Q 725

19.2.4 Multifactor Models 726

19.3 Risk–Neutral Pricing: Monte Carlo Simulations 732

19.3.1 Discretization of the Vasicek model 733

19.3.2 Discretization of the Cox Ingersoll Ross model 734

19.3.3 Interest Rate Modeling at the Zero Lower Bound 738

19.4 Valuation by Monte Carlo Simulation 739

19.4.1 Valuation of Securities with Payoff at Fixed Date 740

19.4.2 MC Valuation of Callable Bonds 744

19.4.3 MCValuation of securities with American or Bermudan exercise style 746

19.5 Monte Carlo simulations in multifactor models 755

19.5.1 Discretization procedure of the affine factor models 756

19.5.2 MCsimulations for callable securities in multifactor models 757

19.6 Conclusion 764

20 Interest Rate Derivatives and Volatility 767

20.1 Introduction 767

20.2 Markets 768

20.2.1 Market Size 768

20.2.2 OTC IRD Trading and Volatility 769

20.2.3 Exchange–Listed IRD Trading and Volatility 773

20.2.4 Recent Developments in the IRD Market 773

20.3 Dissecting the Instruments 775

20.3.1 Government bonds 776

20.3.2 Time deposits 778

20.3.3 Forwards rate agreements and interest rate swaps 780

20.3.4 Caps, floors and swaptions 782

20.4 Evaluation Paradigms 783

20.4.1 Models of the short–term rate 784

20.4.2 No arbitrage models 786

20.4.3 Volatility 792

20.5 Pricing and trading volatility 797

20.5.1 Standard volatility trading practice 798

20.5.2 An introduction to interest rate variance swaps 799

20.5.3 Pricing volatility in three markets 811

20.5.4 Current forward looking indexes of IRV 820

20.5.5 Products on IRV indexes 824

20.6 Conclusions 828

20.7 Appendix 829

21 Nonlinear Valuation under Margin and Funding Costs 839

21.1 Introduction 840

21.2 Collateralized Credit and Funding Valuation Adjustments 844

21.2.1 Trading under Collateralization and Close–out Netting 846

21.2.2 Trading under Funding Risk 850

21.3 General Pricing Equation under Credit, Collateral and Funding 855

21.3.1 Discrete–time Solution 856

21.3.2 Continuous–time Solution 858

21.4 Numerical Results: Extending the Black–Scholes Analysis 862

21.4.1 Monte Carlo Algorithm 862

21.4.2 Market, Credit, and Funding Risk Specification 864

21.4.3 Preliminary Analysis without Credit Risk and with Symmetric Funding Rates 866

21.4.4 Full Analysis with Credit Risk, Collateral and Funding Costs 868

21.4.5 Non–linearity Valuation Adjustment 873

21.5 Extensions 875

21.6 Conclusions: Bilateral Prices or Nonlinear Values? 877

Part VIII Corporate and Sovereign Bonds

22 Corporate bonds 883

22.1 Introduction 883

22.2 Market and data 884

22.2.1 Data on bond characteristics 884

22.2.2 Data on market prices 885

22.2.3 Understanding market data from TRACE 887

22.3 A very simple model 889

22.3.1 The credit spread arising from expected loss 890

22.3.2 Adding a risk premium 891

22.4 Structural models 892

22.4.1 Merton s model with beta 892

22.4.2 Bankruptcy costs 896

22.4.3 Early default 898

22.5 Reduced–form models 899

22.5.1 A useful approximation 902

22.5.2 Closed–form solutions 904

22.6 Risk premia in intensity models 906

22.7 Dealing with portfolios 909

22.8 Illiquidity as a source of spreads 910

22.9 Some additional readings 912

22.10Conclusion 913

23 Sovereign Credit Risk 917

23.1 Introduction 917

23.2 Literature Review 920

23.3 Modeling Sovereign Default 922

23.3.1 Risk–Neutral Pricing 922

23.3.2 Pricing Sovereign Credit Default Swaps 927

23.3.3 Pricing in a Log–Normal Model 929

23.4 Credit Risk Premia 930

23.5 Estimating Intensity Models 931

23.6 Application to Emerging Markets 933

23.6.1 Credit Markets of Emerging Economies 936

23.6.2 Credit Risk Premia in Emerging Credit Markets 938

23.7 Application to the European Debt Crisis 941

23.7.1 Credit Risk Premia in the Eurozone 947

23.8 Conclusion 950

23.9 Appendix: No Arbitrage Pricing 950

23.9.1 The risk–neutral default intensity 954

Index 959