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A Trader’s Guide to Bonds Swaps & IR Instrument:

 

Volume 1 – Products, Pricing, Structuring

Table of Contents

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Table of Contents - CHAPTER Listing

 

0 Foreword and Highlights for the TG2 Series
1 Foreword and Highlights for TG2 Bonds, Swaps, IR Instruments


PART I – IR Markets Basics
 

2 The “IR Business”
3 Loans, Deposits, “Differences”, and IR Markets
4 (Practical) Present Value Theory
5 Certainty and Uncertainty in IR Valuation/Risk – Part I
6 IR Curves: Building and Using
 

PART II – IR Instruments
 

7 Overview of Valuation Basics: Arbitrage Free/Fair Value?
8 Money Market Instruments
9 Notes and Bonds
10 Overview of (non-contingent) Derivatives
11 IR Futures
12 FRAs and Vanilla Swaps
13 Generalised Bonds & Swaps
14 A First Look at Contingent and Structured IR Products
15 IR Risks
16 IR Portfolios and Position Taking – 1
17 Introduction to IR Position Keeping
 

Appendices
References
Subject Index

  

Table of Contents - DETAILED Listing

 

0 Foreword and Highlights for the TG2 Series 1
0.1 Why the TG2 Series of Books? 1
0.2 What is, and is not, important, and who is this for anyway? 2
0.2.1 Who is this Series for? 2
0.2.2 Pedagogical Issues 3
0.2.3 Notation, Grammar, Spelling 4
0.2.4 About Accompanying Software, and Commercial Software. 5
0.2.5 About these books and relationship to ARTSchool 6
0.3 Future Direction & Road Map for the Series 7
0.4 About the Authors 8
0.4.1 Invitation for Contribution 8

1 Foreword and Highlights for TG2 Bonds, Swaps, IR Instruments 9
1.1 Objectives 10
1.2 IR Trading is a Business: Pricing and Usage vs. P&L and Trading 12

PART I – IR Markets Basics

2 The “IR Business” 15
2.1 Business Objectives 15
2.2 Market Basics 17
2.2.1 Overview of Interest Rate and Capital Markets 17
2.2.2 Economic Needs and Principles (Where’s the Greed?) 20
2.2.3 The Supply/Demand Process and the Market Mechanism 20
2.2.4 The Arbitrage “Process” 21
2.2.5 Arbitrage-Free/Fair-Value Valuation 23
2.2.6 Cash is King 27
2.2.7 Lending/Investment Risk & Categorising Risk/Return Management 27
2.2.8 (Market) Risk/Return and the Market Price of Risk 29
2.2.9 (Credit/Default) Risk/Return Profile and Measurement 37
2.2.10 Risk/Return vs. Holding Period Risk/Return and “real” P&L 39
2.2.11 Summary and Basic Rules of Thumb 41
2.3 Capital Markets & Economic Need (Who & Why – “The Buy Side”) 42
2.3.1 Why Capital Markets Exist (Where is the Greed?) 43
2.3.2 Examples of “Types” of Loans 43
2.3.3 Example of a “Very Safe” Loan 44
2.3.4 Example of a “Safe-ish” Loan 46
2.3.5 Example of a “Risky” Loan 48
2.3.6 Example of a “Very Risky” Loan 48
2.3.7 Example of a “Pure Punt” Loan and “Clever Punt” Loan 49
2.3.8 Examples of Hedgers 50
2.3.9 Example of a “Spread” or “Difference” Loan-Hedge 51
2.3.10 Example of an “Expected” Loan or Protection 52
2.3.11 Examples of Investors 52
2.3.12 Lending/Investment Risk (Again) 54
2.3.13 Interim Summary 55
2.4 A Brief History of “Loans” 56
2.4.1 Babylon, the Knights Templar, and the Renaissance 56
2.4.2 The Gold standard, War Reparations, and Petroleum 58
2.4.3 EuroDeposits and Euro/Petro-Dollars 60
2.4.4 Floating of the US Dollar 62
2.4.5 Telecoms, Computers, and Quantitative Finance 64
2.4.6 Central Banks, Monetary Policies, and Fiscal Policies 67
2.5 Loans/Deposits and Securities/Investments 69
2.5.1 Loans and Deposits 69
2.5.2 Investments 69
2.5.3 Securities 70
2.6 Interest Rates: The “Price” of Loans and Credit 71
2.6.1 Rates vs. Yields vs. Returns 71
2.6.2 Cost of Capital vs. Yield/IRR 74
2.6.3 Negative Interest Rates 74
2.6.4 Default Risk and Credit (Ratings and “ratings”) 75
2.6.5 Rates “Spread Over” vs. “All-in” 76
2.7 Making Money with IR Instruments 77
2.7.1 Deposits/Loans: Savings, Insurance, and Pensions 77
2.7.2 Deposits/Loans: NIM – What Banks Do 78
2.7.3 Bid/Offer Spread – What Market Makers Do 80
2.7.4 Capital Raising/Hedging 81
2.7.5 Investing 82
2.7.6 Arbitrage 82
2.8 Funding, Funding, and More Funding … oh, and Liquidity 84
2.8.1 Funding: Tied for the Most Important Ignored Element 84
2.8.2 Funding: Repo’s, Rho, Rebalancing, etc 84
2.8.3 What is Liquidity? (Tied for the Most Important Ignored Element) 86
2.8.4 No Contracts/No Trading Liquidity 86
2.8.5 Bid/Offer Spread Liquidity 86
2.8.6 One-Way Markets (Bid without/Offered without) 87
2.9 Characteristics of Interest Rate Markets 88
2.9.1 Term and Term Structure 88
2.9.2 Term Structure Theory vs. Term-Structure Models 89
2.9.3 IR Indices 90
2.9.4 Credit and Supply/Demand vs. Credit 91
2.9.5 (Thousands of) Conventions 92
2.10 Loans vs. Investments & Bonds vs. Shares & Contract Definitions 93
2.10.1 Bonds vs. Shares 93
2.10.2 Contracts (ISDA, Exchanges, etc.) 94
2.11 (A few words about) Capital Budgeting and Finance 96
2.11.1 Debt Re-Financing vs. Investor/Lender Returns 97
2.11.2 Debt vs. Equity and the Debt/Equity Ratio 99
2.11.3 Taxation 100
2.11.4 Agency Theory 101

3 Loans, Deposits, “Differences”, and IR Markets 103
3.1 Overview of Financial Products and Cash Flows 106
3.1.1 Cash Flows and Cash Flow Schedules 107
3.1.2 Fixed Rate Coupons vs. Floating Rate Coupons and “Fixing” 110
3.1.3 Coupon Bearing vs. Zero-Coupon/Discount Instruments 111
3.2 Loans and Securities (Who and Why – “The Sell Side”) 112
3.2.1 Government Loans and Securities 113
3.2.2 Corporate Loans and Securities 120
3.2.3 Retail Loans and Securities 138
3.2.4 Mortgages 144
3.2.5 Securitisation 148
3.3 Forwards and Contracts for Differences 150
3.3.1 Forward Delivery Contracts: EFP vs. Cash and “Differences” 151
3.3.2 When is a Loan not a Loan (Deposit Futures/FRAs/Swaps)? 153
3.3.3 Options … 156
3.3.4 Abuses – When is a Hedge a Loan/Investment (Banking vs. Hedging, and Market Risk vs. Credit Risk)? 157
3.4 Primary and Secondary Markets 159
3.4.1 The Primary Markets (Issuance, Syndication, Auctions, and WI’s) 160
3.4.2 Central Bank Interventions (“Fed Watching”) 170
3.4.3 The Secondary Markets (OTC, Listed, and “others”) 175
3.4.4 The Inter-Bank Market 177
3.4.5 The Broker Market 179
3.4.6 Infrastructure, Communications, and Transactions Mechanisms 181
3.5 Determinants of Issuance Volumes 186
3.5.1 What Determines Ease of Issuance? 186
3.5.2 Historical Volumes as a Function of Interest Rates 187
3.5.3 Yield Enhancement, Risk Reduction, and Other Factors 188
3.6 Introduction to Regulatory and Capital Requirements 191
3.6.1 BIS/Basle, ISDA, etc, and Regulators/Agreements 194
3.7 Loans/Deposits, Securities, and Derivatives Summary 197

4 (Practical) Present Value Theory 199
4.1 Overview of Present Value Theory 200
4.2 Review of Usual Discounting Measures 201
4.2.1 Discount Factors 201
4.2.2 (Spot) Interest Rates 202
4.2.3 Present Value vs. Future Value 205
4.2.4 Doubling Your Money 206
4.2.5 Frequency Conversion 207
4.2.6 Compounding Frequency vs. Cash flow Frequency 208
4.2.7 Forward Rates 209
4.3 IR Curves and Discounting Multiple Cash Flows 212
4.3.1 The Internal Rate of Return 213
4.3.2 IRR and Swap Rates 216
4.3.3 Annuities and Annutisation 218
4.4 Price to Yield (IRR) Conversion 221
4.4.1 Price/Yield Conversion Mechanics/Illustration 222
4.5 Market Conventions and “Basis” 226
4.5.1 Interest Basis 227
4.5.2 Business Day (or Calendar) Basis 229
4.5.3 Settlement Conventions 230
4.5.4 Holidays 230
4.6 IRs, PV, Foreign Exchange, and (Financial) Economics 232
4.6.1 Spot Foreign Exchange 232
4.6.2 Forward FX 232
4.6.3 Interest Rate Parity 233
4.6.4 Purchasing Power and “Other” Parities, and “Financial Economics” 235

5 Certainty and Uncertainty in IR Valuation/Risk – Part I 239
5.1 Yields vs. Prices 239
5.2 Certainty vs. Uncertainty and Prices vs. P&L’s 239
5.2.1 Why/When Non-Contingent IR Instruments Can be “Treated” with Certainty – Liquidity 240
5.2.2 Why/When Non-Contingent IR Instruments Can be “Treated” with Certainty – Linearity 240
5.3 Valuation Under Uncertainty, Risk-Adjusted P&L’s, and Simulation 241
5.3.1 Expectations, and Position Taking 241
5.3.2 Market Modelling and Strategy Simulation 242

6 IR Curves: Building and Using 243
6.1 (Usually) Much More than just PV’ing/Curve Fitting 244
6.2 Curves vs. Term-Structure 246
6.3 IR Curves: Purpose and Practice 249
6.3.1 Curves: The Zero-coupon and IRR curve 250
6.3.2 Government, LIBOR, Corporate, etc – Curves 251
6.4 IR Curve Generation Basics (via Market Convention) 254
6.4.1 Curve Building Mechanics Overview 254
6.4.2 Admissible instruments 254
6.4.3 Market Data 256
6.4.4 Blending 257
6.4.5 Curve Building: “Boot-Strapping” (vs. Implicit Curves) 258
6.4.6 Curve Interpolation: “Boot-Strapping/Linear” (vs. Implicit Curves) 262
6.5 IR Curve Building Demonstration (Market Convention) 263
6.5.1 A Treasury/Bond Curve (Idealised & Real) 264
6.5.2 A LIBOR/Swap Curve ... and More Reality 271
6.5.3 Interpolation and Resulting Curves – Market Convention 283
6.5.4 Curve/Data “Accuracy/Type Adjustment” 285
6.5.5 LIBOR vs. Gov. Curves (vs. “anything” curves) 286
6.6 Basic Curve Usage Issues 288
6.6.1 Discount Factors vs. Rates (and Exponential vs. Linear) 289
6.6.2 Curve Validation 292
6.6.3 Obtaining Forwards from (spot) Curves 293
6.7 Advanced Curve Methods – Part 1 297
6.7.1 “Fancy Curve Fitting” 297
6.7.2 Splined Curves, Forwards, and Adaptive Corrective Methods 299
6.7.3 Implicit Curve Fitting (c.f. Boot-strapping) and Accounting for Other Effects 305
6.7.4 Curve Trading and “Curve Arbitrage” 307
6.7.5 Curve Trading and “Curve Arbitrage” 308

PART II – IR Instruments

7 Overview of Valuation Basics: Arbitrage Free/Fair Value? 311
7.1 Pricing and Risk management of Interest Rate Securities and Derivatives 312
7.1.1 Securities & Derivatives Pricing vs. Delivery Valuation 313
7.1.2 Risk Neutral Delivery of Loans and Bonds 315
7.1.3 Risk Neutral Delivery of Four Fundamental Derivatives 316
7.1.4 Delivery of a Contract vs. Delivery of “Performance” 319
7.1.5 Delivery/Replication Valuation – The Story so Far 320
7.2 Classical Arbitrage in IR Securities/Derivatives Valuation 321
7.2.1 The Arbitrage Concept and “Fair Value” for IR Instruments 322
7.2.2 Cash and Carry Arbitrage – Idealised 323
7.2.3 Arbitrage and Fair Value – Real World 327
7.2.4 Cash and Carry Arbitrage – Real World 331
7.2.5 Cash-and-Carry Arbitrage – Breach of Risk-Neutrality: Dynamic Replication, and Default 333
7.2.6 A “Cash & Carry” Arbitrage – As a Trading Strategy/Business 335
7.2.7 Arbitrage and Fair Value for IR Forwards/Futures 337
7.2.8 Index/Futures/Forwards/Basket Arbitrage 341
7.2.9 Interest Rate Parity Arbitrage 342
7.2.10 Implications of Arbitrate/Fair Value for Valuation/Pricing and Risk Management 343

8 Money Market Instruments 345
8.1 Economic Need and Usage 346
8.1.1 Treasury Bills 346
8.1.2 Certificates of Deposit 347
8.1.3 Commercial Paper 348
8.1.4 Bankers Acceptances 349
8.1.5 LIBOR and LIBOR-like Instruments 350
8.2 Valuation of Money Market Loans and Deposit 356
8.2.1 Valuing a Loan or Deposit 356
8.3 Pricing Money Market Instruments 357
8.3.1 US Treasury Bills (T-Bills) 357
8.3.2 LIBOR Deposits and LIBID Loans 359
8.3.3 Money Market Yield vs. Bond Equivalent Yield 361
8.4 Additional/On-line references 365

9 Notes and Bonds 367
9.1 Bond and Note Preliminaries 368
9.1.1 The Transaction Mechanism 369
9.1.2 Floating vs. Fixed Income vs. Cash Flow Schedule 370
9.1.3 Bond “Legals”, Covenants, etc 371
9.1.4 Price From Yield – Is This Circular? 372
9.1.5 Economic Need and Usage 372
9.2 Fixed Income/Fixed Interest Bonds & Notes 373
9.2.1 Vanilla Bonds 373
9.2.2 Pricing a Zero-Coupon Bond (IRR Based) 375
9.2.3 Price to Yield: Zero-Coupon Bond 377
9.2.4 Pricing a Coupon Bearing Bond (IRR Based) 378
9.2.5 Pricing a Bond: Accrued Interest 379
9.2.6 Price to Yield: Coupon Bearing Bonds and Newton’s Method 384
9.2.7 Pricing a Bond (Zero Coupon Curve) 387
9.2.8 Bond Quotations and Terminology 391
9.2.9 A Bond Transaction: Price vs. P&L 399
9.3 Floating Rate Bonds & Notes 402
9.3.1 Vanilla FRN’s 402
9.3.2 Economic Need and Usage 405
9.3.3 Pricing Vanilla FRN’s (Rolling/IRR basis) 406
9.3.4 Accrued Interest, Fixing, and Market Rates 407
9.3.5 Vanilla FRN’s (Zero Coupon/Forwards basis) 408
9.3.6 Vanilla FRN’s Contract Sample 412
9.4 Basic Bond Value Characteristics 416
9.5 Variations on Vanilla Bonds 418
9.5.1 Premium/Discount Coupon Bonds 418
9.5.2 Step-Up/Uneven Coupon Bonds 419
9.5.3 Odd-date Bonds and Stub Periods 421
9.5.4 Consol/Long Dated Bonds 424
9.5.5 Inverse Floaters 425
9.6 Sundry IR Trading Items 427
9.6.1 Price to Yield and Quotation Conventions and Terminology 427
9.6.2 “Mutation of Risk” 428
9.7 Repos, Securities Lending, and Funding/Hedging 430
9.7.1 Repo Basics 430
9.7.2 Types of Repo’s 432
9.7.3 Uses of Repo’s 432
9.7.4 Bond Repo’s: Pricing vs. Valuation 434

10 Overview of (non-contingent) Derivatives 439
10.1 Qualitative Description of Derivative instruments 439
10.2 Generic Forwards Pricing (Fair Value and Arbitrage) 440
10.3 Classes of Forwards 442
10.3.1 “Short” Positions 442
10.3.2 OTC Forwards 443
10.3.3 Futures 443
10.3.4 Repos and securities lending 444
10.3.5 Serial Forward 444
10.3.6 Contingent/Option Based Contracts 445

11 IR Futures 447
11.1 Deposit Futures 449
11.1.1 Deposit Futures – Example: EuroDollar Futures 450
11.1.2 “LIBOR” or “Not LIBOR” 451
11.2 Margining Futures (or Anything) 455
11.2.1 Margining – The Basic Idea 455
11.2.2 Margining Futures 456
11.3 The Futures “Calendar” 460
11.3.1 The IMM (and related) Calendar(s) 460
11.3.2 Calendar Notation/Terminology 462
11.3.3 Serial Futures (vs. Serial Derivatives) Calendar 464
11.3.4 Calendars vs. EFP/Delivery Cycles 465
11.4 Futures Quotations and Terminology 467
11.4.1 (Some) Quotation Terminology 467
11.4.2 (Some) Position Taking Terminology 470
11.5 Brokers and Execution vs. Clearing 473
11.6 Pricing/Valuation Considerations for Deposit Futures 474
11.6.1 Futures Pricing vs. Futures Prices 474
11.6.2 Tick Value and Curvature (One Kind of “Convexity”) 477
11.6.3 Futures Convexity/Tailing 481
11.6.4 Price Volatility vs. Yield Volatility 484
11.6.5 Can’t be less than zero (or can it?): 485
11.6.6 Leverage and Futures Risk 486
11.7 Deposit Futures “Strips” & “Spreads” 487
11.7.1 Calendar Spreads and Basis 487
11.7.2 IMM Strips 488
11.7.3 Cross-Instrument Spreads – The TED Spread 491
11.8 Bond Futures 492
11.8.1 Bond Futures Overview 492
11.8.2 Delivery vs. Futures Trading 495
11.8.3 Pricing a Bond Future 498
11.8.4 CTD: Conversion Factor, Net/Gross Basis, and Rules 500
11.8.5 Bond Futures Quotation and Terminology 517
11.9 (Some) Bond Futures Specific Trading Matters 518
11.9.1 Basis and Basis Trading 518
11.9.2 The “Delivery Option” and CTD Trading 520
11.9.3 “Double/Triple Convexity” 521
11.9.4 Continuity Implications 522
11.10 Example Transaction with Position Profile (M2M, P&L, Risk, etc) 523

12 FRAs and Vanilla Swaps 525
12.1 Introduction to FRAs 526
12.1.1 Economic Need 527
12.1.2 Example of a FRA Structure 528
12.1.3 FRA Quotations and Terminology 529
12.1.4 Pricing a FRA 533
12.1.5 FRA “Convexity” 538
12.1.6 Connection to FXA’s etc 542
12.1.7 Credit spread/locks 542
12.2 (Vanilla) IR Swaps 543
12.2.1 The Basic Swap Concept 544
12.2.2 Economic Needs and “Market Insight” 548
12.2.3 The Mechanics of an IR Swap – A Sequence of Cash flows 551
12.2.4 Market Terminology and Swap Specification 554
12.2.5 Example Swap Ticket Specification 555
12.2.6 IR Swaps Quotation Examples 557
12.2.7 Settlement, Extra Considerations and Contract Elements 560
12.2.8 Swap Pricing Preliminaries 561
12.2.9 Interest Rate Swap Pricing: Fixed/Floating - Bond Method 562
12.2.10 Interest Rate Swap Pricing: Fixed/Floating – Zero-Coupon Method 565
12.2.11 Accuracy and Some Reasons for Non-zero Swap Values 570
12.2.12 Accrued Interest 574
12.2.13 Price to Yield “trick” for Vanilla Swaps 575
12.3 Common Variations of Vanilla IR Swaps 577
12.3.1 IMM Swaps 577
12.3.2 Odd-date Swaps 579
12.3.3 Spread to LIBOR Swaps 581
12.3.4 LIBOR Step-Up Swaps 583
12.3.5 Amortising/Accreting Swaps 584
12.3.6 Forward Start Swaps and Swap Futures 587
12.4 Contracts, Lines, Limits, and ISDA 591
12.4.1 Exiting a Swap Position 591
12.4.2 Counterparty “Lines” and Credit/Ratings 592
12.4.3 Accrual vs. M2M etc 594
12.4.4 (ISDA) Master Agreements 596
12.4.5 Sample Swap Confirm/Contract 597
12.5 Swaps with Repos, Money Markets, Bonds, & Futures 618
12.6 Example Transaction with Position Profile (M2M, P&L, Risk, etc) 619

13 Generalised Bonds & Swaps 625
13.1 Generalised Variations 626
13.1.1 Cash Flow Management: Coupons, Principal, and Timing 626
13.1.2 Performance Management: Yield Enhancement vs. Risk Reduction 628
13.2 Variations on the Basic Bond Theme 629
13.2.1 IO’s, PO’s, and Tranches 629
13.2.2 Mortgages (Vanilla) 632
13.2.3 Constant Maturity Treasuries 637
13.2.4 Inflation-Indexed Bonds 648
13.2.5 Basket and Index Structures 651
13.2.6 Callable/Putable Bonds 655
13.2.7 Consol/Perpetual Bonds 657
13.2.8 FX’d and Foreign Bonds 660
13.3 Variations on the Basic Swap Theme 664
13.3.1 Overview 664
13.3.2 (Mixed) Interest Rate Swaps 665
13.3.3 Interest Rate Swaps as Structured Products 667
13.4 (Single Currency) Basis Swaps 668
13.4.1 Basis Swap Example: Prime Rate vs. LIBOR Hedge. 669
13.5 Cross Currency Swaps 671
13.5.1 XC Swap vs. FX Swap 671
13.5.2 (Cross-currency) Basis Swaps 672
13.5.3 Mechanics and Valuation of XC Basis Swaps 673
13.5.4 Basis Swaps Valuation: Reality vs. Interest Rate Parity 673
13.5.5 (Cross-currency) Basis Swaps Quotation/Terminology 675
13.5.6 Vanilla Cross-currency Swaps: Fixed-Fixed 678
13.5.7 Vanilla Cross-currency Swaps: Fixed-Fixed – Examples 680
13.5.8 Cross-currency Swaps: Position Keeping Considerations 684
13.6 Asset/Liability and Debt Swaps 687
13.6.1 (Traditional) Asset/Liability Swaps 688
13.6.2 Some Notes on Terminology and Contracts 690
13.6.3 Traditional Valuation of Asset Swaps 691
13.6.4 (“Balance Sheet/Corporate Finance”) Asset/“Debt” Swaps 692
13.6.5 Uses of Asset/Debt Swaps 693
13.6.6 Uses: Bond structuring 693
13.6.7 Uses: Policy and Management Structuring 695
13.6.8 Uses: Tax/Legal implications 697
13.7 Selected Special Cases and Advanced Swaps 698
13.7.1 Advanced Swaps vs. Contingent Swaps 698
13.7.2 Constant Maturity Swaps 699
13.7.3 Fixed In Arrears/Paid in Arrears Swaps 703
13.7.4 Total Return Swaps 706
13.8 Equity Swaps (vs. IR Swaps) 714
13.8.1 Generic Equity Swaps vs. IR Swaps 715
13.8.2 An S&P/LIBOR Swap 716
13.9 Commodity Swaps (vs. IR Swaps) 720
13.9.1 Generic Commodity Swaps vs. IR swaps 720
13.9.2 A Gold/LIBOR Swap 721
13.10 Credit and Credit Ratings in Valuation 723
13.10.1 Traditional Valuation of Default & Recovery Rates 724
13.10.2 Default vs. Migration Risk 726
13.10.3 Recovery Ratios 727
13.10.4 Credit Analysis Reliability 728
13.10.5 Credit spreads vs. Swap Spreads 728
13.10.6 Credit Arbitrage: FRA’s/Futures & Swaps/Futures 730
13.10.7 Credit Arbitrage: Funding/Regulatory 730

14 A First Look at Contingent and Structured IR Products 733
14.1 Yield Enhancement vs. Risk Reduction 733
14.1.1 Supply Push vs. Demand Pull & Hype vs. Value 734
14.1.2 Contingent Products vs. Options 735
14.1.3 Cost Reduction vs. Increased Leveraged 735
14.2 Introduction to Options 737
14.3 Overview of IR Options 741
14.3.1 How IR Options Differ from “Non-term/IR Options” 741
14.3.2 Price Based vs. Yield Based 745
14.3.3 Listed vs. OTC IR Options 747
14.3.4 Bond options 747
14.3.5 Interest Rate Guarantees (IRGs) 748
14.3.6 Swaptions 749
14.3.7 Caps, Floors, and Collars 751
14.3.8 Options on Deposit Futures 753
14.3.9 Options on Bond Futures 754
14.3.10 Exotic Options 756
14.3.11 Risk associated with IR options 760
14.4 Overview of Structured and Hybrid IR Products 761
14.4.1 Structured & Hybrid Products 761
14.4.2 Legal/Contractual Issues 763
14.4.3 Diff-Swaps, Quanto Swaps, Quanto’d Structures 764
14.4.4 Index Amortising Swaps 766
14.4.5 Callable/Putable, Extendable/Retractable 768
14.4.6 Accrual Notes/Bonds 770
14.4.7 Participating & Capital Protected Notes and Products 771
14.4.8 Convertible Bonds 772
14.4.9 Mortgages (again) 773
14.4.10 Securitisation 775
14.5 Credit Derivatives 776
14.5.1 Babylon, Regulators, and Traditional vs. Modern Credit Derivatives 776
14.5.2 Traditional Products: Repo’s, Assets Swaps, Rolling FRNs, Bond Options, etc. 777
14.5.3 Modern Products: Credit Default Swaps and Baskets 779
14.5.4 CDx Valuation “Hype” vs. “Practice” 781
14.5.5 CDx Structures: TotRS’s, CLN’s, CDO’s, etc 783

15 IR Risks 785
15.1 Risk & Types of Risk 786
15.1.1 Types of Risk 786
15.1.2 Types of Risk Measures 788
15.2 Types of Hedging 799
15.3 Position Keeping vs. Risk Management 800
15.4 Overview of Risk Measurement and Hedging Basics 801
15.4.1 Risk Assessment & Control Objectives 802
15.4.2 Valuation Under Certainty vs. Valuation Under UnCertainty 803
15.5 Sensitivity Based Risk Measures & Hedging 804
15.5.1 Sensitivity Matching and Hedging - The Basic Idea 804
15.5.2 Properties of IR Position Values 807
15.5.3 Position Sensitivity Measures 810
15.5.4 Empirical (Numerical) Sensitivities (V01) 811
15.5.5 Instantaneous Sensitivities: Tangent slope, Elasticity, & Duration 815
15.5.6 Macaulay vs. Modified Duration 819
15.5.7 Duration vs. V01 Risk 821
15.5.8 Properties of 1st Order Sensitivities: Measures vs. P&L 824
15.5.9 Curvature, Convexity, and Sensitivity of Sensitivity 828
15.5.10 Properties of 2nd Order Sensitivity: Curvature and Convexity 832
15.5.11 Sensitivities and Taylor Series 835
15.5.12 Multi-Dimensional Sensitivities: Theta, Accruals, etc 836
15.6 Sensitivity Measures: IRR vs. Yield Curve 837
15.7 Sensitivity Hedging and Hedge Ratios 838
15.7.1 Sensitivity Hedge: Bond/Bond and Bond/Futures 839
15.7.2 Sensitivity Hedge: Structured Strategies, Rotation, etc. 848
15.7.3 Cash/FRA/Depo Futures 854
15.7.4 Convexity and Curvature Hedging 855
15.7.5 Sensitivity Hedges and (2-types of) Time 857
15.7.6 Sensitivity Hedge: Swaps (at least 2-legs to hedge) 858
15.8 Term-Structure, Portfolios, Curves, and Risk 863
15.8.1 Parallel Curve Shifts 864
15.8.2 Bucket Curve Shifts and Rotation 866
15.8.3 Choosing Buckets and Shifts 869
15.8.4 Bucket Curve Shifts, Specific Risk, and Homogeneity 870
15.8.5 Many Shifts, and Scenarios of Sensitivities/Risks 873
15.9 Sensitivities Summary 874
15.10 Immunisation and Profile Matching 876
15.10.1 Pension Fund Cash Flow Matching & Immunisation 877
15.10.2 Provisioning: Valuation/Hedge Strategy for Credit Default Swaps 882
15.11 VaR Based Risk Reporting (and Hedging?) 883
15.11.1 Illustration of the Basic VaR Idea 884
15.11.2 Introduction to Types of VaR Measurement 890
15.11.3 Historical Methods: HVaR 893
15.11.4 Covariance VaR Methods: CVaR 900
15.11.5 Monte Carlo methods: MCVaR 906
15.11.6 Backtesting and Verification of VaR 907
15.11.7 Credit VaR based methods 908
15.11.8 Economic Capital based methods 909
15.11.9 VaR and Term-Structure 910
15.11.10 Basic VaR Summary 910
15.11.11 Reality Impact and Future Considerations 911
15.12 Provisioning 915
15.13 Profit-at-Risk (PaR) and Holding Period Optimal Methods 915

16 IR Portfolios and Position Taking – 1 917
16.1 Trading/Mandate Specific Issues 917
16.1.1 Position Taking and the “Trading Cycle” 917
16.1.2 Trade Idea Generation vs. Market Making/Hedging 919
16.2 Examples of Common Trades (Why, How, and P&L) 920
16.2.1 An Outright Bond Trade 920
16.2.2 A Deposit Futures “Calendar Spread/Rotation” Trade 925
16.2.3 The TED Spread: A credit play 930
16.2.4 The BED Spread: A cross currency credit play 931
16.2.5 A Bond/Curve Spread: The NoB 933
16.2.6 A Curve + Credit Spread: EuroDollar/Notes or Bonds 936
16.2.7 A Swap Spread Trade: Hedge or Punt 937
16.2.8 Curvature, Curve Arbitrage, and Butterflies 941
16.2.9 Cheap/Dear Analysis (of Anything) 944
16.3 Portfolio Considerations 949
16.3.1 Homogeneity 949
16.3.2 How Many Curves? 950
16.3.3 Portfolio Concentration 951

17 Introduction to IR Position Keeping 953
17.1 Position Keeping and the “Trading Cycle” 954
17.2 Position Keeping vs. Risk Management 955
17.2.1 Does the Risk Management Department Exist Purely for “Show”? 956
17.2.2 (Qualitative) Examples of Position Keeping 958
17.3 Position-Keeping and “Slippage”/”Hidden Risk” 960
17.4 Proactive vs. Reactive Approaches 963
17.4.1 Heuristic and Informal Proactive Processes 964
17.4.2 Forecast-free Proactive Methods: Surfaces, Scenarios, etc 965
17.5 Static Position Keeping 968
17.6 Dynamic Position Keeping 969
17.7 Holding Period vs. Instantaneous Risk Methods, and PaR 970
17.7.1 Holding Period Position Keeping – Parameter Selection 970
17.7.2 Holding Period Position Keeping – Strategy Selection 971
17.7.3 Holding Period Risk Management - Strategy Switching 972
17.8 Profit-at-Risk (PaR) 974
17.8.1 Trading, Hedging, Selling, Managing, and Real World P&L 974
17.8.2 Trading, Hedging, Selling, Managing, and Simulated P&L 975
17.8.3 Comments on Software and Programming Issues 976
17.8.4 Forward Testing vs. Back Testing 978
17.8.5 Back Testing with Historical Market Data 981
17.8.6 Elements of a PaR Simulator 983
17.8.7 A Simple Forward/Backward PaR Example: Bonds/Bond Futures 988
17.8.8 Forward Testing (with a 1-factor Model) 989
17.8.9 Back Testing the Hedging Strategy and the (1-factor) model 991
17.9 The Management of Risk/P&L – “The Business” 994
17.9.1 The Big Picture, and Risk 994
17.9.2 Extended Risk Reports, and (other) Complications 995
17.9.3 Operational Issues Trade Booking & Risk Reporting/Management 996
17.9.4 Operational Matters 997
17.9.5 Other Managerial Matters 998
17.9.6 Management, Risk Management, and Compensation 998

Appendices i
Appendix A: Notation/Abbreviations i
Abbreviations i
Currencies i
Greek Letters ii
Alphanumeric Letters ii
Mathematical Operators ii
Appendix B: ARTicles 3
B1: ARTicles: Arb 101 Part 1 – Release Notes 3
B2: ARTicles: Credit Default Swaps 3
B3: ARTicles: How much to pay a trader? 3
Appendix C: Basis 5
References 7
Subject Index 14


 

 
 

 

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