Bond Evaluation, Selection, and Management
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Acknowledgments xxi
PART ONE Bond Evaluation 1
CHAPTER 1 Overview of the Financial System 3
1.1 Real and Financial Assets 3
1.2 Types of Debt Claims 4
1.3 Financial Market 6
1.4 Types of Financial Markets 7
1.5 Regulations 15
1.6 Efficient Financial Markets 17
1.7 Characteristics of Assets 20
1.8 Conclusion 23
CHAPTER 2 Bond Value and Return 29
2.1 Introduction 29
2.2 Bond Valuation 29
2.3 The Yield to Maturity and Other Rates of Return Measures 43
2.4 Rates on Zero-Coupon Bonds 49
2.5 Total Return 51
2.6 Spot Rates and Equilibrium Prices 57
2.7 Geometric Mean 60
2.8 Conclusion 64
CHAPTER 3 The Level and Structure of Interest Rates 75
3.1 Introduction 75
3.2 Level of Interest Rates 77
3.3 The Structure of Interest Rates 91
3.4 Conclusion 99
CHAPTER 4 The Term Structure of Interest Rates 105
4.1 Introduction 105
4.2 Market Segmentation Theory 107
4.3 Preferred Habitat Theory 118
4.4 Pure Expectations Theory 120
4.5 Liquidity Premium Theory 132
4.6 Summary of Term Structure Theories 132
4.7 Constructing the Benchmark Yield Curve 133
4.8 Conclusion 138
CHAPTER 5 Bond Risk 147
5.1 Introduction 147
5.2 Default Risk 147
5.3 Call Risk 159
5.4 Market Risk 162
5.5 Duration and Convexity 169
5.6 Conclusion 182
PART TWO Debt Markets 191
CHAPTER 6 Corporate Debt Securities 193
6.1 Introduction 193
6.2 Corporate Bonds 194
6.3 Bankruptcy 207
6.4 The Markets for Corporate Bonds 209
6.5 Medium-Term Notes 214
6.6 Commercial Paper 215
6.7 Conclusion 217
CHAPTER 7 Treasury and Agency Securities 225
7.1 Introduction 225
7.2 Treasury Instruments 225
7.3 Repurchase Agreements 240
7.4 Federal Agency Securities 243
7.5 Conclusion 252
CHAPTER 8 Municipal Securities 259
8.1 Introduction 259
8.2 Municipal Financing 259
8.3 Tax-Exempt Status 260
8.4 Types of Municipals 261
8.5 Special Features of Municipals 266
8.6 Credit Risk, Quality Ratings, and Credit Spreads 267
8.7 Municipal Bond Markets 274
8.8 Conclusion 276
CHAPTER 9 Intermediary Debt Securities 283
9.1 Introduction 283
9.2 Bank Securities 283
9.3 Banker's Acceptances 287
9.4 Mortgage-Backed and Asset-Backed Securities 288
9.5 Investment Funds 289
9.6 Insurance Companies and Pension Funds 303
9.7 Conclusion 309
CHAPTER 10 International Debt Securities 317
10.1 Introduction 317
10.2 International Debt Securities 317
10.3 The Foreign Bond Market 318
10.4 The Eurobond Market 318
10.5 Non-U.S. Domestic Bonds 321
10.6 Emerging Market Debt 323
10.7 Global Fixed-Income Mutual Funds and ETFs 324
10.8 Foreign Bond Risk and Sovereign Bond Ratings 324
10.9 Eurocurrency Market 326
10.10 The Foreign Currency Market and Exchange-Rate Risk 333
10.11 Conclusion 336
CHAPTER 11 Residential Mortgages and Mortgage-Backed Securities 343
11.1 Introduction 343
11.2 Residential Mortgage Loans 344
11.3 Mortgage Portfolio 351
11.4 Mortgage-Backed Securities 360
11.5 Features of Mortgage-Backed Securities 361
11.6 Collateralized Mortgage Obligations and Strips 365
11.7 Evaluating Mortgage-Backed Securities 376
11.8 Conclusion 377
CHAPTER 12 Nonagency Residential MBSs, Commercial MBSs, and Other Asset-Backed Securities 391
12.1 Introduction 391
12.2 Nonagency Mortgage-Backed Securities 391
12.3 Commercial Mortgage-Backed Securities 394
12.4 Asset-Backed Securities 396
12.5 Collateralized Debt Obligations 400
12.6 Conclusion 404
PART THREE Bond Strategies and the Evaluation of Bonds with Embedded Options 411
CHAPTER 13 Bond Investment Strategies 413
13.1 Introduction 413
13.2 Active Investment Strategies 414
13.3 Passive Bond Management Strategies 423
13.4 Bond Immunization Strategies 428
13.5 Conclusion 437
CHAPTER 14 Binomial Interest Rate Trees and the Valuation of Bonds with Embedded Options 451
14.1 Introduction 451
14.2 Binomial Interest Rate Model 452
14.3 Valuing Bonds with Other Option Features 461
14.4 Convertible Bond 466
14.5 Valuing Mortgage-Backed Securities 473
14.6 Conclusion 480
CHAPTER 15 Estimating the Binomial Tree 487
15.1 Introduction 487
15.2 Subdividing the Binomial Tree 487
15.3 Estimating the Binomial Tree 488
15.4 u and d Estimation Approach 492
15.5 Calibration Model 496
15.6 Option-Adjusted Spread 503
15.7 Duration and Convexity 505
15.8 A Note on the Black-Scholes Option Pricing Model 506
15.9 Conclusion 508
PART FOUR Debt Derivatives: Futures and Options 515
CHAPTER 16 Futures Contracts on Debt Securities: Fundamentals 517
16.1 Introduction 517
16.2 The Market and Characteristics of Futures on Debt Securities 520
16.3 The Nature of Futures Trading and the Role of the Clearinghouse and Margins 526
16.4 Futures Hedging 531
16.5 Futures Pricing 536
16.6 Conclusion 541
CHAPTER 17 Interest Rate Options Contracts: Fundamentals 549
17.1 Introduction 549
17.2 Options Terminology 550
17.3 Markets and Types of Interest Rate Options 552
17.4 Option Positions 556
17.5 Options Trading-Microstructure 566
17.6 Option Price Relationships 571
17.7 Conclusion 576
CHAPTER 18 Managing Fixed-Income Positions with Interest Rate Derivatives 583
18.1 Introduction 583
18.2 Hedging Fixed-Income Positions 583
18.3 Cross Hedging 590
18.4 Speculating with Interest Rate Derivatives 593
18.5 Synthetic Debt and Investment Positions 596
18.6 Using Options to Set a Cap or Floor on a Cash Flow 599
18.7 Conclusion 599
CHAPTER 19 Managing Fixed-Income Positions with OTC Derivatives 607
19.1 Introduction 607
19.2 Hedging with OTC Derivatives 607
19.3 Hedging a Series of Cash Flows: OTC Caps and Floors 612
19.4 Financing Caps and Floors: Collars and Corridors 615
19.5 Other Interest Rate Products 620
19.6 Hedging Currency Positions with Foreign Currency Options 624
19.7 Conclusion 627
PART FIVE Swaps 635
CHAPTER 20 Interest Rate Swaps 637
20.1 Introduction 637
20.2 Generic Interest Rate Swaps 637
20.3 Swap Market 644
20.4 Swap Valuation 648
20.5 Comparative Advantage and the Hidden Option 650
20.6 Swaps Applications 653
20.7 Credit Risk 657
20.8 Conclusion 658
CHAPTER 21 Swap Derivatives: Forward Swaps and Swaptions 667
21.1 Introduction 667
21.2 Forward Swaps 667
21.3 Swaptions 670
21.4 Cancelable and Extendable Swaps 677
21.5 Nongeneric Swaps 678
21.6 Conclusion 678
CHAPTER 22 Currency and Credit Default Swaps 685
22.1 Introduction 685
22.2 Currency Swaps 685
22.3 Credit Default Swaps 691
22.4 Conclusion 705
Key Terms 705
APPENDIX A Uses of Exponents and Logarithms 713
APPENDIX B Mathematical Statistical Concepts 719
APPENDIX C Primer on Return, Present Value, and Future Value 727
APPENDIX D Web Site Information and Examples 737
APPENDIX E Global Investments and Exchange Rates 745
APPENDIX F Arbitrage Features of the Calibration Model 747
APPENDIX G T-Bond Delivery Procedure and Equilibrium Pricing 749
APPENDIX H Pricing Interest Rate Options with a Binomial Interest Tree 753
APPENDIX I Pricing Interest Rate Options with the Black Futures Option Model 763
What's on the Companion Web Site 769
Answers and Solutions to Select End-of-Chapter Problems 771
Glossary of Terms 831
Index 855
