Handbook of Fixed-Income Securities

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