Bond Evaluation, Selection, and Management, + Website, 2nd Edition

Preface xvii

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