Interest Rate Markets: A Practical Approach to Fixed Income

Acknowledgments xiii

Introduction xv

CHAPTER 1 Tools of the Trade 1

Basic Statistics 2

Regression: The Fundamentals 6

Regression: How Good a Fit? 11

Principal Components Analysis 14

Scaling through Time 15

Backtesting Strategies 16

Summary 17

CHAPTER 2 Bonds 19

Basics of Bonds 19

Risks Embedded in Fixed Income Instruments 22

Discounting 27

Bond Pricing 28

Yield Curve 32

Duration 34

Convexity 37

Repo Markets 42

Bid Offer 44

Calculating Profit/Loss of a Bond 45

Carry 45

Forward Rates 47

Rolldown/Slide 51

Curves and Spreads 53

Butterfly Trades 55

Summary 56

CHAPTER 3 Fixed Income Markets 59

Federal Reserve 60

Treasuries 67

Strips 70

Tips 71

Mortgages 73

Agency Debt 77

Corporate Bonds 79

Municipal Bonds 82

Summary 84

CHAPTER 4 Interest Rate Futures 85

Basics of Futures Transactions 86

Eurodollar Futures 89

Convexity (or Financing) Bias 92

Creating Longer-Dated Assets Using Eurodollar Futures 93

Treasury Futures 94

Fed Funds Futures 101

Futures Positioning Data 104

Summary 105

CHAPTER 5 Interest Rate Swaps 107

Basic Principles 108

Duration and Convexity 111

Uses of Swaps 112

Counterparty Risk 115

Other Types of Swaps 115

Summary 124

CHAPTER 6 Understanding Drivers of Interest Rates 125

Supply and Demand for Borrowing 126

Components of Fixed Income Supply and Demand 141

Treasury Supply 141

Other Sources of Fixed Income Supply 145

Fixed Income Demand 148

Short-Term Yield Drivers 157

Summary 172

CHAPTER 7 Carry and Relative Value Trades 173

Carry Trades 173

Carry Trade Setup and Evaluation 175

Pitfalls of the Carry Trade 178

Carry-Efficient Directional Trades 182

Relative Value Trades 183

Setting Up Relative Value Trades 185

Treasury Bond Relative Value—Par Curve 191

Other Treasury Relative Value Trades 193

Summary 194

CHAPTER 8 Hedging Risks in Interest Rate Products 197

Principles of Hedging 198

Choices of Instruments for Hedging 202

Calculating Hedge Ratios 210

Yield Betas 215

Convexity Hedging 218

Summary 223

CHAPTER 9 Trading Swap Spreads 225

How Swap Spreads Work 225

Why Trade Swap Spreads? 230

Directionality of Swap Spreads to Yields 240

Futures Asset Swaps 241

Spread Curve Trades 243

Summary 245

CHAPTER 10 Interest Rate Options and Trading Volatility 247

Option Pricing and Fundamentals 249

Modifications for the Interest Rate Markets 254

Quoting Volatility 256

Measuring Risks in Option Positions 257

Put/Call Parity 266

Implied and Realized Volatility 268

Skew 270

Delta Hedging 270

Interest Rate Options 275

Embedded Options and Hedging 280

More Exotic Structures 283

Yield Curve Spread Options 284

Forward Volatility 285

Volatility Trading 286

Interest Rate Skew 293

Volatility Spread Trades 294

Caps versus Swaptions 297

Summary 298

CHAPTER 11 Treasury Futures Basis and Rolls 299

The Futures Delivery Option 299

Calculating the Delivery Option Value 309

Option-Adjusted and Empirical Duration 311

Treasury Futures Rolls 313

Summary 318

CHAPTER 12 Conditional Trades 319

Conditional Curve Trades 320

Conditional Spread Trades 324

Summary 328

References 329

About the Author 331

About the Web Site 333

Index 335