Fixed Income Markets

Fully updated with comprehensive coverage of the post-crisis debt markets and their impact on key industry issues, Fixed Income Markets: Management, Trading, and Hedging, Second Edition offers insights into derivative pricing, cross-currency hedging, and new liquidity legislation. Written by Choudhry, Moskovic, and Wong, Fixed Income Markets is an indispensable read for anyone working in bond markets, interest-rate markets, and credit derivatives markets looking to better understand today's debt markets.

This acclaimed book takes a unique look into the leading practices in bond markets as well as post-credit-crunch impacts on pricing that are rarely captured in textbooks. The new edition provides expanded coverage on a wide range of topics within hedging, derivatives, bonds, rebalancing, and global debt capital markets. New topics include:

• Dynamic hedging practices and cross-currency hedging
• Collateralized and uncollateralized derivatives, and their impact on valuation
• Callable bonds, pricing, trading, and regulatory aspects related to liquidity
• Rebalancing as a method for capturing contingencies and other complex imbedded risks

As a bonus, the book includes reference information for statistical concepts and fixed income pricing, as well as a full glossary and index. Written in Choudhry's usual accessible style, Fixed Income Markets is a comprehensive and in-depth account of the global debt capital markets in today's post-crisis world.

Foreword xiii

Preface xvii

About the Authors xix

Part One Introduction to Bonds 1

Chapter 1 The Bond Instrument 3

Chapter 2 Bond Instruments and Interest-Rate Risk 43

Appendix 2.1 Formal Derivation of Modified-Duration Measure 59

Appendix 2.2 Measuring Convexity 59

Appendix 2.3 Taylor Expansion of the Price/Yield Function 61

Chapter 3 Bond Pricing, Spot, and Forward Rates 65

Appendix 3.1 The Integral 83

Appendix 3.2 The Derivation of the Bond Price Equation in Continuous Time 85

Chapter 4 Interest-Rate Modelling 89

Appendix 4.1 Geometric Brownian Motion 101

Chapter 5 Fitting the Yield Curve 105

Appendix 5.1 Linear Regression: Ordinary Least Squares 124

Appendix 5.2 Regression Splines 127

Part Two Selected Market Instruments 133

Chapter 6 The Money Markets 135

Appendix 6.1 179

Chapter 7 Hybrid Securities and Structured Securities 181

Chapter 8 Bonds with Embedded Options and Option-Adjusted Spread Analysis 205

Appendix 8.1 Calculating Interest Rate Paths Using Microsoft Excel 232

Chapter 9 Inflation-Indexed Bonds and Derivatives 235

Appendix 9.1 Current Issuers of Public-Sector Indexed Securities 256

Appendix 9.2 U.S. Treasury Inflation-Indexed Securities (TIPS) 257

Chapter 10 Introduction to Securitisation and Asset-Backed Securities 261

Part Three Derivative Instruments 297

Chapter 11 Forwards and Futures Valuation 299

Chapter 12 Bond Futures Contracts 309

Appendix 12.1 The Conversion Factor for the Long Gilt Future 324

Chapter 13 Swaps 329

Appendix 13.1 Calculating Futures Strip Rates and Implied Swap Rates 370

Chapter 14 Credit Derivatives I: Instruments and Applications 375

Appendix 14.1 Bond Credit Ratings 418

Chapter 15 Credit Derivatives II: Pricing, Valuation, and the Basis 421

Chapter 16 Options I 435

Appendix 16.1 Summary of Basic Statistical Concepts 456

Appendix 16.2 Lognormal Distribution of Returns 457

Appendix 16.3 Black-Scholes Model in Microsoft Excel 458

Chapter 17 Options II 461

Part Four Bond Trading and Hedging 475

Chapter 18 Value-at-Risk and Credit VaR 477

Appendix 18.1 Assumption of Normality 513

Chapter 19 Government Bond Analysis, the Yield Curve, and Relative-Value Trading 517

Chapter 20 Approaches to Trading and Hedging 551

Appendix 20.1 Summary of Derivation of Optimum Hedge Equation 571

Appendix 20.2 Forward-Rate Structure in Conventional Yield-Curve Environment 571

Chapter 21 Derivatives Risk Management: Convexity, Collateral, and Correlation 573

Appendix A Statistical Concepts 621

Appendix B Basic Tools 627

Appendix C Introduction to the Mathematics of Fixed-Income Pricing 633

Appendix D About the Companion Website 639

Glossary 641

Index 669

MOORAD CHOUDHRY works in Group Treasury at The Royal Bank of Scotland, and is a Professor at the Department of Mathematical Sciences, Brunel University. He was a UK government bond trader and money markets trader with ABN Amro Hoare Govett Securities Ltd and a sterling proprietary trader with Hambros Bank Limited. He later traded structured finance bonds and repo at KBC Financial Products. Moorad lives in Surrey, England.

DAVID MOSKOVIC is a hybrid derivatives trader at The Royal Bank of Scotland. Prior to that he worked in market risk and as a quantitative analyst. He qualified as a Chartered Accountant at Ernst & Young before moving to RBS.

MAX WONG is Head of Risk Model Validation at The Royal Bank of Scotland in Singapore. He was previously an index futures trader on the open-outcry floor at SIMEX and a risk quant at Standard Chartered. He is author of Bubble Value at Risk: A Countercyclical Risk Management Approach.

A comprehensive account of the cash and derivative products used in the global debt capital markets, this book provides detailed description of market conventions and trading practices, plus extended coverage of associated instruments such as derivatives and structured products. It extends the analysis to look at every aspect of managing bond positions, including correlation and funding issues. Highlights of this second edition include:

• developments in debt markets trading and hedging, including OIS discounting, CSA curves, and collateral management
• a chapter on convertibles, including the contingent convertible (CoCo)
• hedging, collateral, and correlation issues associated with valuing and managing a portfolio of derivatives
• an updated chapter on value-at-risk
• an overview of relative value trading and investment strategy

The contents are invaluable to everyone with an interest in debt capital markets, including investors, traders, risk managers, and finance consultants.

Praise for Fixed Income Markets
Second Edition

“One of the most comprehensive and detailed books on fixed income securities you will find. A must-read whether you’re new to fixed income or you’re a seasoned investment professional.”
—Patrick Y. Shim, CG Investment Group, Wells Fargo Advisors LLC, Los Angeles

“Another fabulous guide to the fixed income markets from Moorad that will serve readers from all backgrounds very well. The author’s writing style is always entertaining, yet practical for all market participants, focusing and delivering on the latest concepts and strategies in the fixed income space that come from being a seasoned practitioner himself.”
—Stuart Turner, Senior Treasury Dealer, Newedge UK Financial Ltd, London

“The first edition has been widely praised for its clarity and precision, its practical and pragmatic approach and its comprehensive coverage of risk management and trading in fixed income markets. This second edition updates the existing text and contains essential new material, particularly on some of the latest structured credit OTC products. I recommend it without reservation to both practitioners and academics, especially those involved in masters courses on fixed income cash and derivatives markets.”
—Carol Alexander, Professor of Finance and Head of Business and Management Department, University of Sussex and co-editor-in-chief of the Journal of Banking and Finance

“A very welcome new edition of Professor Choudhry’s benchmark bond and fixed income markets textbook. There is excellent coverage of the latest developments in both cash and derivatives products, and very useful detail on the impact of issues such as greater collateral and secured funding requirements. A high-quality reference book written in the author’s trademark accessible style, which will be of great value to those involved in the debt capital markets in any capacity.”
—Mohamoud Barre Dualeh, Head of Product Development, Alizz Islamic Bank, Muscat

“A welcome update with this second edition, and again a very pedagogical contribution from Moorad Choudhry, of immense interest both for students and practitioners. Exactly what you need to master the bond markets.”
—Philippe Priaulet, Head of the Shareholders Network Sales Desk, Natixis, Paris and Associate Professor, University of Evry Val d’Essonne