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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Serie: Wiley Finance Editions
- Sprache: Englisch
A unique, authoritative, and comprehensive treatment of fixed income markets Fixed Income Trading and Risk Management: The Complete Guide delivers a comprehensive and innovative exposition of fixed income markets. Written by European Central Bank portfolio manager Alexander During, this book takes a practical view of how several different national fixed income markets operate in detail. The book presents common theoretical models but adds a lot of information on the actually observed behavior of real markets. You'll benefit from the book's: * Fulsome overview of money, credit, and monetary policy * Description of cash instruments, inflation-linked debt, and credit claims * Analysis of derivative instruments, standard trading strategies, and data analysis * In-depth focus on risk management in fixed income markets Perfect for new and junior staff in financial institutions working in sales and trading, risk management, back office operations, and portfolio management positions, Fixed Income Trading and Risk Management also belongs on the bookshelves of research analysts and postgraduate students in finance, economics, or MBA programs.
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Veröffentlichungsjahr: 2020
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Table of Contents
Cover
Title Page
Copyright
Foreword
PART One: Preliminaries
CHAPTER 1: Introduction
NOTE
CHAPTER 2: Money, Credit and Banking
2.1 ABSTRACT PROPERTIES OF MONEY
2.2 EARLY FORMS OF MONEY
2.3 FIAT MONEY
NOTES
CHAPTER 3: Banks
3.1 BANKS AND BANK MONEY CREATION
3.2 CATEGORIES OF BANKS
CHAPTER 4: Bank Money Creation
4.1 SINGLE‐BANK INTRODUCTION
4.2 EXTENSION TO MULTIPLE BANKS
4.3 TRANSFER SETTLEMENT IN CENTRAL BANK MONEY
4.4 TRADE AND NON‐BANK CREDIT
4.5 DIGITAL TOKEN MONIES AND CRYPTOCURRENCIES
4.6 THE MONEY MULTIPLIER
NOTES
CHAPTER 5: The Role of Central Banks
5.1 INTRODUCTION
5.2 MONETARY FINANCING
NOTES
CHAPTER 6: Monetary Policy
6.1 OBJECTIVES OF MONETARY POLICY
6.2 MONETARY POLICY UNDER INFLATION TARGETING
6.3 CENTRAL BANK OPERATIONAL FRAMEWORKS
NOTES
CHAPTER 7: Operational Frameworks
7.1 CONTROL OF THE MONEY SUPPLY
7.2 LIQUIDITY PROVISION: REDISCOUNTING, OUTRIGHT PURCHASES AND LOMBARD LENDING
7.3 LIQUIDITY ABSORPTION: ASSET SALES AND REVERSE REPOS
7.4 THE IMPACT OF FX OPERATIONS
NOTE
CHAPTER 8: Interaction between Frameworks and Policy
8.1 VOLATILITY
8.2 COLLATERAL
NOTES
CHAPTER 9: Non‐Standard Monetary Policy
9.1 QUANTITATIVE EASING
9.2 PRACTICAL EXPERIENCE
9.3 NEGATIVE INTEREST RATES
9.4 THE SPECIFIC SITUATION OF THE ECB
NOTES
PART Two: Cash Instruments
CHAPTER 10: Contract and Instrument Types
10.1 SECURITIES AND BILATERAL CONTRACTS
10.2 SECURITY IDENTIFIERS
NOTES
CHAPTER 11: Trading and Settlement
11.1 TRADING
11.2 SETTLEMENT
NOTES
CHAPTER 12: Central Clearing
12.1 DIRECT CLEARING
12.2 INDIRECT CLEARING
12.3 CONTRACT VALUE ADJUSTMENTS (XVA)
NOTES
CHAPTER 13: The Money Market
13.1 MONEY MARKET INSTRUMENTS
13.2 DISCOUNT FACTORS
13.3 DAYCOUNT CONVENTIONS
13.4 MONEY MARKET INTEREST RATES
13.5 COMPOUNDING
13.6 LIBOR, EURIBOR, AND FRIENDS
13.7 OVERNIGHT BENCHMARKS
13.8 BENCHMARK REFORM
13.9 MONEY MARKET FUTURES AND FUTURES TRADING
NOTES
CHAPTER 14: The Repo Market
14.1 THE REPURCHASE MARKET
14.2 HAIRCUT
14.3 VARIATIONS OF REPURCHASE TRANSACTIONS
14.4 REHYPOTHECATION
CHAPTER 15: Spot and Forward Rates
15.1 FORWARD RATES
15.2 NO‐ARBITRAGE CALCULATIONS
15.3 OFFICIAL RATES VERSUS TERM RATES
NOTE
CHAPTER 16: The Bond Market
16.1 INTRODUCTION
16.2 CASHFLOW TYPES
16.3 ISSUER TYPES
16.4 GOVERNING LAW AND CONTRACTUAL CLAUSES
16.5 BOND MARKETS
16.6 ACCRUED INTEREST
16.7 YIELD
16.8 INTEREST RATE RISK
16.9 CONVEXITY
16.10 BOND VALUE DECOMPOSITION
16.11 CARRY
NOTES
CHAPTER 17: Floating‐Rate Notes
17.1 COUPON RESET MECHANICS
17.2 LIBOR AND OIS‐LINKED NOTES
17.3 DISCOUNT MARGIN
17.4 CMS AND CMT FLOATERS
NOTES
CHAPTER 18: Asset Markets and Liquidity
18.1 CONCEPTS
18.2 LIQUIDITY MEASUREMENT
18.3 EXAMPLES
18.4 LIQUIDITY PREMIUM
18.5 LIQUIDITY AND VOLATILITY
NOTES
CHAPTER 19: Curves and Curve Models
19.1 MODELS
19.2 YIELD CURVE REPRESENTATION AND INTERPRETATIONS
19.3 MARKET‐BASED CURVE REPRESENTATIONS
19.4 PARAMETRIC CURVE MODELS
19.5 FITTING CURVE MODELS
NOTES
CHAPTER 20: Curve Analysis
20.1 EXPECTATIONS
20.2 CONVEXITY BIAS
20.3 TERM RISK PREMIUM
20.4 PREFERRED HABITAT
NOTES
CHAPTER 21: Carry and Roll‐Down
NOTE
CHAPTER 22: Curve Spreads
22.1 Z‐SPREAD
22.2 PAR SPREAD
22.3 SWAP SPREADS
PART Three: Inflation‐Linked Debt
CHAPTER 23: Inflation‐Indexed Bonds
23.1 INTRODUCTION
23.2 REBALANCING, REBASING AND REVISION OF CPI INDICES
23.3 INFLATION SEASONALITY
23.4 PRICE FORMATION IN INFLATION‐LINKED MARKETS
23.5 RETURN MEASURES OF INFLATION‐LINKED BONDS
23.6 BREAKEVEN INFLATION
23.7 CARRY ON INFLATION‐INDEXED BONDS
23.8 COMPREHENSIVE INFLATION MODELLING
23.9 INFLATION MODELS AND EXPECTATIONS
NOTES
PART Four: Defaultable Claims
CHAPTER 24: Credit Risk
24.1 DEFAULT, INSOLVENCY, AND BANKRUPTCY
24.2 SENIORITY AND SUBORDINATION
24.3 THE DEFAULT PROCESS
24.4 CREDIT RATINGS
NOTES
CHAPTER 25: Covered Bonds
25.1 STATUTORY COVERED BONDS
25.2 DANISH COVERED BONDS
25.3 STRUCTURED COVERED BONDS
25.4 COVERED BOND CREDIT RISK ANALYSIS
NOTES
CHAPTER 26: Asset‐Backed Securities
26.1 THE ABS ISSUANCE PROCESS
26.2 DEFAULT RISK OF ABS
26.3 MATURITY OF ABS
CHAPTER 27: Residential Mortgage‐Backed Securities
27.1 RESIDENTIAL MORTGAGE PREPAYMENTS
27.2 PREPAYMENT MODELLING
NOTES
PART Five: Derivatives
CHAPTER 28: Bond Futures
28.1 INTRODUCTION
28.2 FUTURES TRADING PATTERNS
28.3 VALUATION OF PHYSICALLY DELIVERED BOND FUTURES
28.4 FUTURES ROLLS
28.5 DELIVERY WINDOWS
28.6 INTERACTION BETWEEN FUTURES AND BONDS
28.7 FUTURES SQUEEZES
28.8 CASH‐SETTLED FUTURES
28.9 NEW BOND ISSUES
NOTES
CHAPTER 29: Swaps
29.1 INTRODUCTION
29.2 PLAIN VANILLA SWAPS
29.3 TRADE COMPRESSION AND RE‐COUPONING
NOTES
PART Six: Standard Trading Strategies
CHAPTER 30: Trading Principles
30.1 DEFINITIONS
30.2 TRADE IDENTIFICATION
30.3 TRADE PORTFOLIOS
NOTE
CHAPTER 31: Curve Trading
31.1 SIMPLE CURVE TRADES
31.2 INTRINSIC CURVE MOVEMENTS
NOTES
CHAPTER 32: Bond Trading
32.1 BOND RELATIVE VALUE
32.2 RELATIVE VALUE STRATEGIES
NOTE
PART Seven: Risk Management
CHAPTER 33: Principal Component Analysis
33.1 PCA AS GENERALISED REGRESSION
33.2 MEASURING DATA COMPLEXITY WITH PCA
CHAPTER 34: Bond Index Mechanics
34.1 BOND INDEX PRINCIPLES
34.2 INDEX REBALANCING
NOTE
CHAPTER 35: Portfolio Risk Management
35.1 RISK‐NEUTRAL PORTFOLIOS
35.2 INDEX TRACKING
NOTES
CHAPTER 36: Hedging
36.1 INTRODUCTION
36.2 DURATION‐NEUTRAL HEDGES
36.3 REGRESSION HEDGES
36.4 YIELD CURVE MODEL HEDGES
CHAPTER 37: Mean‐Variance Optimisation
NOTES
CHAPTER 38: Portfolio Rebalancing
38.1 PASSIVE AND SEMI‐PASSIVE STRATEGIES
38.2 NUMERICAL EXAMPLES
NOTE
PART Eight: References
CHAPTER 39: Selected Global Bond Markets
39.1 EURO AREA
39.2 ICELAND
39.3 JAPAN
39.4 SWEDEN
39.5 UNITED KINGDOM
39.6 UNITED STATES OF AMERICA
NOTES
Bibliography
Index
End User License Agreement
List of Tables
Chapter 1
TABLE 1.1 Non‐exclusive list of instrument types
Chapter 4
TABLE 4.1 The main real time gross payments systems.
TABLE 4.2 Example for the effect of transaction ordering on intra‐day cash ba...
Chapter 13
TABLE 13.1 Standard future expiry month codes.
Chapter 18
TABLE 18.1 Liquidity measures by type of information used
Chapter 19
TABLE 19.1 Bootstrapping of the USD swap curve on 5 June 2020. For simplicity...
TABLE 19.2 Reverse bootstrapping of a 6‐year annuity using the USD swap curve...
Chapter 24
TABLE 24.1 Comparable long‐term debt rating scales of five major credit ratin...
TABLE 24.2 Global one‐year corporate average transition rates (1981–2017, in ...
Chapter 25
TABLE 25.1 Simplified comparison of selected features of statutory mortgage c...
TABLE 25.2 Outstanding volumes of covered bonds by country at the end of 2018...
Chapter 28
TABLE 28.1 Sample basis sheet analysing a fictitious bond futures contract mo...
Chapter 29
TABLE 29.1 Natural positions in the plain vanilla swap market for different i...
List of Illustrations
Chapter 2
FIGURE 2.1 Gold price (London fixing) in US dollars divided by the US Urban ...
FIGURE 2.2 Detail of an old five pounds sterling bank note. Because this not...
Chapter 4
FIGURE 4.1 The money creation process. A bank lends money to a customer and ...
FIGURE 4.2 Transfer of a deposit between two customers of the same bank as p...
FIGURE 4.3 Netting across multiple interbank transfers. The final receivable...
FIGURE 4.4 Transfer of a deposit between two customers of two different bank...
FIGURE 4.5 Transfer of a deposit between two customers of two different bank...
Chapter 5
FIGURE 5.1 A Hong Kong Dollar note issued by the Hongkong and Shanghai Banki...
FIGURE 5.2 A US Dollar note bears the seal of the Federal Reserve System but...
Chapter 6
FIGURE 6.1 Example of a Japanese castle wall (Osaka Castle). Source: ALEXAND...
FIGURE 6.2 ECB deposit facility rate and pre‐€STR and €STR. Source: From ECB...
Chapter 9
FIGURE 9.1 Monthly averages of the Japanese yen unsecured overnight (mutan) ...
FIGURE 9.2 Balance sheet effect of large‐scale asset purchases. Correspondin...
FIGURE 9.3 Money multipliers (M2/Base money) in the US, Japan and the Euro a...
FIGURE 9.4 US total reserves and monthy Fedwire Funds transfer values. The r...
FIGURE 9.5 Monthly average current account holdings of Japanese banks at the...
FIGURE 9.6 Long‐run series of the ratio of the Japanese and US money multipl...
FIGURE 9.7 Japanese daily mutan volumes and average rates July 2015–July 201...
Chapter 10
FIGURE 10.1 Security types.
Chapter 11
FIGURE 11.1 The actors and interaction processes in the OTC trade lifecycle ...
Chapter 12
FIGURE 12.1 Clearing relationships with bilateral and central clearing. The ...
FIGURE 12.2 Trade execution with central clearing. After the trade is conclu...
FIGURE 12.3 Standard protection mechanisms for a central counterparty. After...
Chapter 14
FIGURE 14.1 Example of rehypothecation of a single security. Letters designa...
Chapter 15
FIGURE 15.1 Relationship of spot and forward rates.
FIGURE 15.2 Relationship of Libor strip with the spot rate term structure.
FIGURE 15.3 The hierarchy of matching policy rate expectations to observed m...
Chapter 16
FIGURE 16.1 Simple annual fixed rate bullet bond structure. The bond repays ...
FIGURE 16.2 The amortisation payments
of an annuity for different interest...
FIGURE 16.3 Clean and dirty prices of the same bond (3% annual coupon) at tw...
FIGURE 16.4 Clean prices of two bonds (3% and 12% annual coupons) trading at...
FIGURE 16.5 Price–yield relationship for two 10Y bonds with different coupon...
FIGURE 16.6 Yield changes for price changes of two 10Y bonds with different ...
FIGURE 16.7 Price and risk measures for a zero‐coupon bond at 5% yield as a ...
FIGURE 16.8
Graphical representation of convexity
.
FIGURE 16.9 Breakdown of bond present values by coupons and principals for d...
FIGURE 16.10 Breakdown of bond PVBP by coupons and principals for different ...
FIGURE 16.11 Breakdown of bond convexity by coupons and principals for diffe...
FIGURE 16.12 Carry calculated using the exact method of Equation (16.21) and...
Chapter 17
FIGURE 17.1 Simple floating rate note. The bond repays its par amount at the...
Chapter 18
FIGURE 18.1 Multiple aspects of liquidity.
FIGURE 18.2 Bid–offer spreads (in yield basis points) of nominal US Treasuri...
FIGURE 18.3 Average absolute deviations from a Nelson‐Siegel spline for US T...
FIGURE 18.4 Spline liquidity indicators for US Treasuries, German Bunds and ...
FIGURE 18.5 On‐the‐run premium and spline spread deviation measures of US Tr...
FIGURE 18.6 Observed price evolution for an illiquid instrument. As trading ...
Chapter 19
FIGURE 19.1 Curve representations.
FIGURE 19.2 ‘Bootlacing’ representation of the bootstrapping process. Source...
FIGURE 19.3 Sensitivities of zero rates given by a Nelson‐Siegel spline to 2...
FIGURE 19.4 Sensitivities of zero rates to 25% bumps in
and absolute bumps...
FIGURE 19.5 Sensitivities of zero rates to 25% bumps the parameters of the V...
FIGURE 19.6 Scatter plot of the
parameter of a daily Vasicek spline fitted...
FIGURE 19.7 Spread splines (
) calibrated to the 1–10Y bonds issued by the T...
Chapter 20
FIGURE 20.1 VAR model impulse‐response functions of an assumed 1% shock to U...
FIGURE 20.2 Projected par rate responses to a 1% shock to GDP and the GDP de...
FIGURE 20.3 Changes in the impulse‐response functions of the US GDP deflator...
FIGURE 20.4 US Treasury 2–5–10Y butterfly yield pickup as a function of conv...
Chapter 21
FIGURE 21.1 Par, spot and overnight forward curves on a Nelson‐Siegel‐Svenss...
FIGURE 21.2 Carry and roll‐down of German government bonds in August 2014. N...
Chapter 22
FIGURE 22.1 Simple fair‐value asset swap spread model.
Chapter 23
FIGURE 23.1 Reference index interpolation. The index level applied at time
FIGURE 23.2 Difference between the Japanese CPI (all items) changes since Ja...
FIGURE 23.3 German, US and Japanese inflation indices over time. Sources: Da...
FIGURE 23.4 Seasonality factors (percentage deviations from trend developmen...
FIGURE 23.5 Seasonality factors (percentage deviations from trend developmen...
FIGURE 23.6 Seasonal patterns in the clean prices of US TIPS and lagged seas...
FIGURE 23.7 Seasonal patterns in the clean prices of German DBRi and OBLi pr...
FIGURE 23.8 Seasonal patterns in the clean prices of German DBRi and OBLi pr...
FIGURE 23.9 Effect of seasonality on breakeven inflation. Average annual inf...
FIGURE 23.10 Effect of seasonality on breakeven inflation. Average annual in...
FIGURE 23.11 Examples of inflation rate dynamics of the model Equation (23.1...
FIGURE 23.12 Examples of inflation projections for the purpose of modelling ...
FIGURE 23.13 Real 1‐week forward rates in a seasonally adjusted model using ...
FIGURE 23.14 Spline spreads of US TIPS against a naive (not seasonally adjus...
FIGURE 23.15 History of the long‐run inflation obtained from fitting a TIPS ...
FIGURE 23.16 Model‐based long‐run HICP ex‐tobacco estimate from German OBLi/...
Chapter 24
FIGURE 24.1 Comparison between the seven‐year Markov‐implied and actual prob...
FIGURE 24.2 Cumulative probability of losing an investment grade rating over...
FIGURE 24.3 Comparison of cumulative probabilities of losing an investment g...
Chapter 25
FIGURE 25.1 The essential safety features of a covered bond: Security pledge...
FIGURE 25.2 Annual issuance volumes of mortgage Pfandbriefe, public sector P...
FIGURE 25.3 Balance sheet structure of a covered bond issuer.
FIGURE 25.4 Quarterly gross Danish covered bond issuance volumes for fixed‐r...
FIGURE 25.5 General structure of a structured covered bond issuer balance sh...
FIGURE 25.6 Illustration of the three drivers of covered bond default risk f...
Chapter 26
FIGURE 26.1 Standard tranche structure. In reality, the equity and mezzanine...
Chapter 27
FIGURE 27.1 The prepayment model Equation (27.2) and its four parameters: Ba...
FIGURE 27.2 The basic mortality model used in this section. The control para...
FIGURE 27.3 Comparison of the mortalities of three identical bonds with diff...
FIGURE 27.4 Total cashflows (interest, amortisation and prepayment) from the...
FIGURE 27.5 Total cash paid (as a fraction of the remaining principal) by a ...
FIGURE 27.6 Price‐yield (here, price‐spread) relationship of a prepayable mo...
Chapter 28
FIGURE 28.1 Open interest for the front and back contracts during 2017 for t...
FIGURE 28.2 Daily trading volumes for the front and back contracts during 20...
FIGURE 28.3 Daily trading volumes (totals and maximum‐minimum measures) for ...
FIGURE 28.4 Roll progress histories for the Eurex Bund and 10Y BTP and CBOT ...
FIGURE 28.5 CFTC net positions (long minus short) in the CBOT 10Y note futur...
FIGURE 28.6 CFTC net positions (long minus short, in thousands of contracts)...
FIGURE 28.7 SOFR and CFTC positioning (speculator net positions across all U...
FIGURE 28.8 Behaviour of converted bond prices under a parallel downwards yi...
FIGURE 28.9 Net bases (in cents) of the deliverable bonds in a futures baske...
FIGURE 28.10 Spot PVBP of a futures contract for a simple deliverable basket...
FIGURE 28.11 Fair value of the quality option for the standard basket Table ...
FIGURE 28.12 Futures PVBP approximations as a function of yield shifts. The ...
FIGURE 28.13 Spot PVBP of the futures contract from Figure 28.10 but as a fu...
FIGURE 28.14 Futures roll with CTD change (shortest bond drops from the bask...
FIGURE 28.15 Futures roll without CTD switch through time. Essentially the p...
FIGURE 28.16 Sensitivity of the futures roll to parallel yield changes. The ...
FIGURE 28.17 Sensitivity of the futures roll ratio (back contracts per 100 f...
FIGURE 28.18 Difference in contract fair value between a model that assumes ...
FIGURE 28.19 Average spline spreads, including the 1 standard deviation band...
FIGURE 28.20 Average spline spread of the JGB contract CTD on the the JGB cu...
FIGURE 28.21 PVBP of a cash settled future with deliverable baskets as in Ta...
FIGURE 28.22 Fair value of a cash settled future with deliverable baskets as...
Chapter 29
FIGURE 29.1 Cash flows in a 4Y plain vanilla swap in euros (annual fixed aga...
Chapter 30
FIGURE 30.1 Illustration of the use of stop‐loss levels and adjustments. X m...
Chapter 31
FIGURE 31.1 An example of four curve positions on the German spline, shown h...
FIGURE 31.2 Current par curve and implied 6 months forward par curve for the...
FIGURE 31.3 Outright short
FIGURE 31.4 Flattener
FIGURE 31.5 German government curve benchmark spread examples. The arrows ma...
FIGURE 31.6 Japanese 10Y and 30Y rates 2010–2015. Nelson‐Siegel par yields w...
FIGURE 31.7 Butterfly
FIGURE 31.8 Condor
FIGURE 31.9 Normalised PCA factor loadings for the US Treasury Nelson‐Siegel...
FIGURE 31.10
‐factor residuals of the 10Y point on the German Nelson‐Siegel...
FIGURE 31.11 Normalised PCA factor loadings for the German government bond N...
FIGURE 31.12 First PCA factor realisations for the US and Germany. History 2...
FIGURE 31.13 PCA factor realisations for the US Treasury Nelson‐Siegel splin...
FIGURE 31.14 Scatter plot of the PCA factor 3 realisation versus the CBOE VX...
FIGURE 31.15 Scatter plot of the PCA factor 3 realisation against the
para...
FIGURE 31.16 History of the
parameters of the daily ECB AAA Nelson‐Siegel‐...
Chapter 32
FIGURE 32.1 Spread widener
FIGURE 32.2 Short basis trade
FIGURE 32.3 Bond spread trade
FIGURE 32.4 Curve‐hedged bond spread
Chapter 33
FIGURE 33.1 Standard deviations of a highly correlated bivariate normal dist...
FIGURE 33.2 Spline par yields of the US Treasury curve through time. Source:...
FIGURE 33.3 Herfindahl indices calculated from a rolling PCA of the US and G...
FIGURE 33.4 Herfindahl indices calculated from a rolling PCA of Japanese gov...
Chapter 35
FIGURE 35.1 Asset–liability structure of a passive manager.
Chapter 37
FIGURE 37.1 Expected portfolio returns and variances for different asset wei...
FIGURE 37.2 Example of sample mean and standard deviation of a normally dist...
FIGURE 37.3 Simulated risk and return samples for the market portfolio in th...
Chapter 38
FIGURE 38.1 Asset returns for 4 different settings of mean reversion and cov...
FIGURE 38.2 Portfolio performances of 4 different asset allocation strategie...
Guide
Cover Page
Series Page
Title Page
Fixed Income Trading and Risk Management
Foreword
Table of Contents
Begin Reading
Index
WILEY END USER LICENSE AGREEMENT
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Fixed Income Trading and Risk Management
ALEXANDER DÜRING
This edition first published 2021
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Foreword
Source: ALEXANDER DÜRING
This book about fixed income has been inspired by over two decades of work in the market from offices in London, Frankfurt and Tokyo. During this time, the author had the good fortune to be close to, and sometimes involved in, an eclectic mix of events. Although working for a large investment bank and the European Central Bank has made it possible to collect this experience, the book does not represent the views of either. Any opinions about central banking should in particular not be taken as those of the Eurosystem.
This book is also inspired by a building, namely the British Museum in London, a detail of which is pictured above. This inspiration has three aspects. The first is that the architecture of the building cannot be understood by looking only at its historic base, or only at Sir Norman Foster's modern additions. Fixed income markets can similarly not be properly understood by considering only their conventions, or only the modern mathematical apparatus that has been created to analyse them. Although this book will present complex mathematics determining the risk characteristics of various instruments, some design features of these instruments are archaic. These features remain today for no better reason than that there was never a need to change them.
Second, the museum is open to all and free in principle, although a small donation is encouraged. Children can walk in and experience artefacts that once were created for the exclusive use of priests and kings. In the world of fixed income, the efforts of statistics offices, central banks, trade associations and others have made a wealth of data available to the general public. Freely available numerical libraries and advances in computers make it possible for everyone to analyse, and learn from that data. Understanding of markets has thus been democratised in ways that were unimaginable even a decade ago. This book, written at home using only freely available and self‐developed software, is built on these foundations and encourages such exploration.
Third, the British Museum is not uncontroversial, as are some of the exhibits shown there. The ideas of debt, of trading debt, and of banking are similarly the subject of debate and argument. This book gives some space to this debate although the author would not claim to be neutral in it. The financial industry is part of the service sector, however else it may be portrayed in popular culture. People working in it cannot be oblivious to their role in society, and take it as granted that their actions will not be questioned by others.
Books not only require inspiration, but also enablement. In this case, this has been provided by my family who kindly tolerated the amount of time I spent on writing it and whom I thank for their forbearance. Erwin, Reiko and George at Deutsche, and Julian at the ECB helped me to develop a somewhat non‐conformist approach to financial markets. Tamio and Henry at Deutsche Securities Inc. encouraged me to teach, as did Toto, Christophe and Ralph at the ECB. Those who attended these classes and asked questions will hopefully find them answered here. To them, and many not named, go my thanks for making work in financial markets the joy it is.
As this is a textbook, literature references are given here extensively with the aim of encouraging further reading rather than striving for completeness in representing the state of the art.
PART OnePreliminaries
CHAPTER 1Introduction
This book deals with the fixed income markets and the best point to start is to define what this means. The book will follow market usage by defining fixed income instruments as contracts that specify payment obligations that are not linked to the economic situation of the obligor. It also excludes from the scope contracts that establish payments depending on the performance of physical assets, such as commodities or weather. The book will further discuss a range of fixed income derivatives, namely contracts that specify obligations that depend on the performance of fixed income instruments.
Fixed income instruments can be broadly divided in to bilateral contracts and securities. Securities differ from bilateral contracts in that they are transferrable without the consent of all parties. Note that some features of securities may be linked to bilateral contracts. Table 1.1 lists various fixed income instruments in these two categories.
In German, fixed income instruments are referred to as ‘Renten’ and the same word is also used to refer to pensions. In the English vernacular, the scope of the word ‘rent’ to signify income streams has been narrowed down significantly to refer to payments linked to the use of physical assets. The Latin translation of the word ‘rent’, ‘pension’, is now used in English to designate the income stream that accrues to people after a lifetime of work. On the other hand, ‘Pension’ in financial German refers to the renting out of financial assets1. This etymological divergence between otherwise related languages highlights an important point, namely that the notion of fixed income instruments is not new but underwent several changes of connotation over time.
TABLE 1.1 Non‐exclusive list of instrument types
Bilateral contracts
Securities
Deposits
Bonds
Loans
Commercial paper
Swaps
Certificates of deposit
Futures
Asset‐backed securities
Apart from commodity contracts, the definition above rules out common and preferred equity instruments where the issuer has some discretion about the timing and amount of payments. This is a strong restriction because the party to the contract that is obliged to make a payment has no rights versus the payee. The very word ‘equity’ implies an equitable relationship between payer and payee, whereas in the fixed income setting, the obligor usually has limited discretion.
The ancient Greeks despised money lending, as evidenced in Aristotle's Politics:
There are two sorts of wealth‐getting, as I have said; one is part of household management, the other is retail trade: the former necessary and honourable, while that which consists in exchange is justly censured; for it is unnatural, and a mode by which men gain from one another. The most hated sort, and with the greatest reason, is usury, which makes a gain out of money itself, and not from the natural object of it. For money was intended to be used in exchange, but not to increase at interest.
The three book religions, Judaism, Christianity, and Islam, severely restrict the lending of money against interest and hence the majority of fixed income instruments. In scriptural terms, only Judaism permits charging interest at all, and only in the case of Jews charging interest to gentiles according to the usual intepretation of Deuteronomy 23:19–20:
Thou shalt not lend upon usury to thy brother; usury of money, usury of victuals, usury of anything that is lent upon usury. Upon a stranger thou mayest lend upon usury; but unto thy brother thou shalt not lend upon usury; that the LORD thy God may bless thee in all thou settest thine hand to in the land whither thou goest to possess it.
For Christians, the encyclical Vix pervenit [88] issued by Benedict XIV. on 1 November 1745 opened a legal distinction between usury and lending money at interest, although it reaffirmed the general prohibition of usury. Even earlier, the Pax Westphalica [67] in 1648 casually refers to fixed interest obligations. Today, the issue presents no particular problem for Christians. However, many countries retain prohibitions on excessive interest charges that relate back to usury concepts.
In contrast, Islamic law (Shar'iah) has retained its prohibition to lending at interest (riba), or indeed unconditional repayment obligations. Together with gharar (uncertainty) and maysir (gambling), such practices are strictly forbidden by the Qur'an. This rules out investing money for interest (but not the earning of profits from equity investments) and also the concept of pure options. These restrictions present an obstacle for Muslim investors to interact with the western financial system. Accordingly, a system of Islamic finance has developed that allows profitable investments at low risk.
In order to understand why fixed income is apparently such a new concept, it is instructive to study the prohibitions above, setting aside the issue of divine inspiration. For instance, in Exodus 22:25, Jews are instructed:
If thou lend money to any of my people that is poor by thee, thou shalt not be to him as an usurer, neither shalt thou lay upon him usury.
The implication is that a lender of money is somebody with surplus cash while a borrower is in an emergency situation and needs cash to make ends meet. Exploiting such an emergency situation is morally reprehensible and therefore forbidden. Aristotle's aversion to lending is similarly explained in that he abhors the idea of a necessary social process being abused for pecunary gain. Human beings have to trade in order to exist, but the act of trading does, in his eyes, not contribute to the production of goods. Profiting from something that is not actually increasing the store of wealth of humankind is therefore despicable.
These arguments do not sound too unfamiliar today and debts are still viewed negatively in some parts of the political spectrum [43]. The innovation of some newer critical authors is to draw a distinction between social convention of debts that have to be served unconditionally on one hand, and more flexible moral notions of obligations on the other. The latter are alleged by these authors to be more in line with human development. Setting aside the question whether there is indeed an anthropological basis for distinguishing between morals and social convention, there remains a question as to whether lenders are willingly absorbing an ambiguity in their relationship with borrowers, or instead view their claims as legally absolute. An argument made in Henry V [74] (4.1) may be instructive:
KINGHARRY So, if a son is by his father sent about merchandise do sinfully miscarry upon the sea, the imputation of his wickedness, by your rule, should be imposed on his father, that sent him. Or if a servant, under his master's command transporting a sum of money, be assailed by robbers, and die in many irreconciled iniquities, you may call the master the author of the servant's damnation. But this is not so. The King is not bound to answer the particular endings of his soldiers, the father of his son, nor the master of his servant, for they purpose not their deaths when they propose their services.
Similarly, most lenders do not ‘purpose’ inability to repay when they lend money and indeed tend to prefer to lend to borrowers who repay on schedule. A pensioner who has invested in a mortgage does not seek the destitution that may befall the borrower who is dispossessed upon default and would usually prefer not to face the risk of his or her own destitution should the process of liquidating the property faily to reproduce the originally expected income stream.
What has changed in recent times is that lenders are no longer necessarily rich and borrowers are not necessarily poor. People now generally accept that individuals need to put money aside to prepare for their old age and that if they were unable to do so without being paid interest, inflation and credit risk would erode the value of their savings. They also have no reason to enter a relationship based on equity with whoever has use of their money at the time. The association of fixed income with pension in the German word ‘Rente’ is therefore now quite natural. On the borrower side, it is now also common to borrow money for convenience, such as in a mortgage, or to invest in a new business. Many business owners do not want to form equitable partnership with capital providers. They prefer to pay interest on that capital and retain the profits they expect from their venture. In addition, interest payments are tax‐deductible in many jurisdictions. In the times when the great religious books were written, large multigenerational families would have handled equivalent transfers internally, whereas businesses nowadays have to conclude external contracts.
The sometimes shady area of consumer finance shows, however, that inequity is still an issue in money lending. This means that the debate about the moral implications of fixed income liabilities is not likely to end. So‐called predatory lenders, who do seek out borrowers that can be expected not to repay and can therefore be pursued for their assets following default, do exist. Most modern legal codes provide some safeguards against such abuses of the legal system, such as upper limits on interest rates, or know‐your‐client rules.
At the same time, some supposedly new arguments about wealth distribution can be traced to insufficient awareness of what are essentially fixed income assets. Popular studies of wealth disparity tend to focus on traceable forms of assets, such as accumulated income, real estate, etc [68]. However, Mr Darcy is described in ‘Pride and Prejudice’ as having £10,000 a year. Earlier, Sir Toby in ‘Twelfth Night’ justifies the description of Sir Andrew Aguecheek as ‘as tall a man as any in Illyria’ with ‘he has three thousand ducats a year’. This description of a person's assets in terms of the annuity they generate, instead of their current value, was quite common at the time these books were written. Using this approach today can be eye‐opening.
Mayer Amschel Rothschild, founder of the Rothschild banking dynasty and arguably one of the richest men in the world at his time, died on 16 September 1812 of an infection [35]. An affliction of this kind would be trivial to cure today, and that cure would be free of charge to even the poorest British citizen. The National Health Service (NHS) of the United Kingdom had an annual budget of £116.4bn in 2015/16, equivalent to around £1,800 per head of the UK population. The NHS is free of charge at the point of use, so every person registered with the NHS has the right to consume services, if they require, that are worth around £1,800 per year. Assuming for illustration an average remaining life span of 30 years and a discount rate of 1.8% (the long‐term yield at that time), a person wishing to obtain an equivalent income stream would have to invest an amount of about £41,400 using the annuity formula Equation (16.1). Simply by registering with the NHS, an average UK resident therefore in effect acquires an asset that is equivalent to £41,400. This asset is of course only valuable to the extent that illness creates a need to draw on it. The point is, though, that a person outside the NHS would have to accumulate that amount of wealth to be able to purchase the services and goods available to the average NHS user.
Although the NHS‐implied assets are invisible on citizens' balance sheets, their counterpart on the national balance sheet of the United Kingdom is not. The NHS has to be funded either through taxes or government debt. Of the latter, the United Kingdom carried £29,400 per head of the population in 2016.
Germany provides a monthly stipend that in 2017 was €409 and occasional additional payments to single people with no dependants unconditionally on previous earned income. Using current 30 year interest rates, a 30 year annuity of this magnitude had a present value of €127,000. A person with savings of this amount would be considered reasonably well off even though few would consider the equivalent income stream as attractive. Absent this welfare system, one would have to accumulate this very substantial sum to obtain an equivalent income stream. Universal free or subsidised education is another example of a valuable claim on society that is in principle open to all but not valued as an asset.
Classically, wealthy citizens were called upon to fund common expenses and in return earned rights to future distributions of national wealth [57], for instance through the interest on government bonds. Although wealthy persons have been encouraged to provide for the poor by way of charity in many ethical frameworks, this has always been an exhortation rather than an obligation. From the viewpoint of the recipients, such charitable giving was a blessing, not a right. Traditionally, therefore, societies put a lot of value on either income‐earning assets or opportunities for work that would create meaningful income streams. The onus to pay for goods and services, in other words, has traditionally been on the consumer.
Modern societies legislate unconditional claims on society that are not the result of prior contributions, such as welfare or universal health care. Because such liabilities of the national budget ultimatively have to be backed by corresponding tax assets, tax payers, who are the ultimate contingent debtors in this relationship, may at some point feel aggrieved. Claimants on social redistribution in effect have claims on taxpayers and government bond investors that resemble those that creditors have on debtors, namely claims on a fixed income stream.
No extreme point in this virtual creditor–debtor relationship presents an obvious optimum for overall welfare. Denying any form of redistribution would not only create social unrest, but would in most ethical frameworks be considered immoral. It would also be economically ruinous because it would consign potential consumers to destitution, reducing the scope for producers to earn an income. Taken too far, redistribution on the other hand would instead discourage producers from earning (or at least declaring) taxable income. The optimal extent of redistribution is open to debate (known in supply‐side economics as the Laffer curve), but does most certainly depend not only on general measures such as welfare expenditure relative to gross domestic product, but also on the specific form in which redistribution takes place [27].
Islamic finance, which is developing borrowing and lending instruments based on shar'iah notions of equity, could provide interesting lessons in this regard. The pricing of Islamic banking products can generally be translated into terms that would be familiar to Western bankers, but the legal relationships between lenders and borrowers follow different rules. As Muslim nations grow in economic importance and the Islamic finance sector expands, at some point it will perhaps start to influence Western notions of banking. Already at this time, the Ecological and Social Responsibility (ESR) investment trend shares some similar ideas.
This book has been designed as course material and, with the exception of the last chapter, can be read from front to back. Industry practitioners might hopefully find it useful as a general vade mecum afterwards. The chapter arrangement follows a fairly conventional structure. Beginning with money, banking and monetary policy (Chapters 2–9) it then moves to how transactions take place (Chapters 10–12). Having thus covered the infrastructure of financial markets, the next part deals with the money and bond markets (Chapters 13–18). Several ideas linked to valuation follow in Chapters 19–22. The next parts, presented in Chapters 23–27 are detours into more complex parts of the bond market, dealing with inflation, credit risk, and mortgage prepayments. The essential derivatives markets, bond futures and swaps are presented in Chapters 28 and 29. With the complete set of instruments in hand, Chapters 30–32 introduce trading strategies, while Chapters 33–38 address standard portfolio and risk management strategies. Chapter 39 is a reference to various bond markets provided mostly to illustrate the variety of products that exist.
As a general approach, this book does not only present and explain concepts but also critically discusses their shortcomings. Like any human endeavour, fixed income analysis uses imperfect tools. Imperfections do not invalidate tools, but make it incumbent on their user to know when not to trust them.
A quick word on charts
This book uses a particular form of scatter plot, for instance the one shown here.
In this plot, the actual observations are augmented by information about their probability density. When many points fall closely together in the same area, the human eye tends to see them as just one point. This optically overvalues outliers. In the scatter plots here, a two‐dimensional Gaussian is calculated for each individual data points using the observed variance in the and direction of the chart for all data points. These individual Gaussians are then evaluated on a regular grid and added up for all data points. The resulting probability density function is represented in a greyscale behind the usual dots of the scatter plot. In line with topographic maps, isolines are added to give additional flavour to the resulting shape.
NOTE
1
It has to be admitted that few people today use the word Wertpapierpensionsgeschäft.
CHAPTER 2Money, Credit and Banking
Money is ubiquitous in society but the definition of money is still perenially being debated by economists and anthropologists. As this is a finance textbook, a somewhat unconventional approach will be taken here. Starting from abstract properties of money, the concrete items that can be used as money will be explained in a roughly historical order. Starting from the abstract definition has the advantage of being able to focus on essential features before getting side‐tracked by ancillary properties.
2.1 ABSTRACT PROPERTIES OF MONEY
Money is a tool that enables people to trade goods and services against a standard means of exchange. This function makes money an abstract commodity in the sense that is received and given as payment for all other goods or services without necessarily having a material value in itself1. Just what constitues money in this sense in a given society is decided by common agreement because everybody involved in trading needs to accept a particular form of money for it to be effective. There does not have to be a unique money in a given society. Multiple commodities can serve as money in parallel and most modern monetary systems use at least two forms of money.
When transactions involve money on one side, it makes sense to express the value of assets in terms of the amount of money they can be exchanged against. This leads to the use of money as a unit of account.
A concomitant requirement of a means of exchange is that it holds its value, at least over short periods. This requirement means that the rate at which money can be exchanged into goods and services does not fluctuate too much from one day to the next. Sellers of goods or services against money need to have confidence that the money received will purchase a known quantity of other services in the near future. Money can therefore serve as a store of wealth.
The use of money is therefore intrinsically linked to the notion of credit: By accepting money (instead of goods or services) for payment, a seller of goods defers consumption in a way that would not be automatic in barter trade. Money can in this sense be thought of as an obligation of society as a whole to provide goods and services to holders of currency2.
The credit aspect of money implies that money is not in itself wealth but merely a claim on actual goods and services. A society can choose to increase the amount of money in circulation but will not usually find itself richer as a result. Most successful instances of money creation for the purpose of economic stimulus can be traced to increases of credit, i.e., an increase in economic activity not tied to current expenditure. However, the creation of excessive amounts of currency (fiat or specie) can lead to lower economic activity. For instance, inflow of specie from the Americas was argued to have depressed economic activity in the countries that directly benefited from these inflows (Portugal and Spain) (cf. Cantillon in [60]).
Money is therefore a social construct creating an asset that can be used in exchange, as a unit of account, and as a store of value. Among the assets that serve as money, there is generally a subset known as cash that has has crucial specific properties that are sometimes overlooked by classical economists:
Immediate finality of payment
Cash transfers are non‐reversible and therefore final as soon as they occur unless there is an obvious evidence of theft. In contrast, even simple non‐cash transactions such as credit card payments are subject to potential unwind risks related to uncovered obligations.
Anonymity
Two parties can transact in cash without knowing the identity of the other party.
Decentralisation
Cash transactions do not rely on third parties, in particularly not on a bank providing account services.
Indentifiability
Users should be able to readily identify the asset and distinguish it from counterfeits.
Cash transactions incur significant costs related to the safe storage, distribution, collection and counting of cash. Because cash can be transferred quickly and anonymously, there is much more of an incentive to steal cash than any other asset. Stocking cash machines in a remote location of a large country, and returning cash taken in the shops of that location to the central bank requires a lot of transportation in special trucks. Users of the cash usually do not consider such costs which are, however, intimately related to these four properties.
2.2 EARLY FORMS OF MONEY
The oldest form of money is physical and many still think of money in physical terms. As long as there is sufficient stability in the supply of any commodity and its value in terms of other commodities can therefore be reliably assessed, it can be used as money. Money that is based on the value of the commodity of which it is made is known as commodity money. In the larger Asian and Western societies, money used to be associated with precious metals, namely gold and, to a smaller degree, silver. It is therefore common to think of money as something that has value in and of itself, leading to the idea that the ‘gold standard’, gold‐based money, is something inherently desirable. Other cultures used standard commodities, such as rice or grain, to express and settle obligations. However, the exclusive use of commodities as money is neither the historical origin of money, nor is it its apparent direction. Before discussing the basics of modern monies for the purposes of trading in the money market, it is instructive to spend some time on the history of money.
Seen as a tool, cash should be reasonably portable, easily recognisable and difficult to counterfeit. In central Europe, where mining was introduced fairly late, commodities such as salt played the role of money for a long time. Salt was sufficiently scarce to give small amounts of it appreciable value; it can be kept for a long time; and it is difficult to forge. Salt is also an essential food ingredient, so salt obtained in trade could be consumed if it wasn't needed for as a store of wealth. This is only one example for using consumables as money. Islamic law recognises six commodities that must be traded ‘equal for equal, and hand to hand’ (gold, silver, wheat, barley, dates and salt). Islamic law referring to these six commodities is deemed to apply to money in general and therefore governs, for instance FX transactions.
When an item used as money has an idiosyncratic value, for instance under the gold standard, the credit element of money can be obscured. Receivers of money then receive a valuable asset as well as an abstract commodity. However, the production value of gold, or any other form of commodity money, can fluctuate relative to that of other commodities, for instance as a result of advances in mining technology. The historical stability of a commodity as a means of payment is therefore probably at least in part due to its function of money. Users of commodity monies accept the commodity with a view to its future value for purchases, i.e., its monetary value, rather than for its intrinsic value alone. The validity of this argument is difficult to prove conclusively with historical data. It amounts to the statement that stability of prices under a gold standard is not just the result of the value of gold anchoring the value of other goods, but that conversely the value of gold is also anchored by the value of other goods. In the current, post‐metallic currency system, the predominant role of the US dollar as an international trade invoice currency is likely to stabilise its exchange value3.
The volatility of gold prices since the demonetisation of gold in the second half of the 20th century is an illustration, albeit an imperfect one, of this point. Figure 2.1 shows the ratio of the gold price in dollars to the urban consumer price index, which is a measure of the price of a standard basket of goods and services in the US. A stable exchange ratio between gold and goods and services would imply a low volatility of this series. The data appears to bear out the idea that monetary use of gold may have stabilised this ratio before the suspension of dollar convertibility into gold by President Nixon on 15 August 1971 made it more volatile.
FIGURE 2.1 Gold price (London fixing) in US dollars divided by the US Urban Consumer Price index. Data retrieved from FRED.
However, the technical background is more complex. Under the Bretton Woods system, the dollar was pegged to gold which required the active control of gold supply and demand by central banks. The dollar prices of other goods and services meanwhile followed other economic trends, including the policies of the Federal Reserve System. Stability of gold relative to goods and services in the US was therefore due to a common anchor, namely the US dollar. The higher volatility of gold relative to other prices following the suspension of gold convertibility is therefore not only due to changes in market mechanisms but the result of changed government policies. At the same time, gold sometimes outperforms other assets in times of crisis because some investors expect it to become more valuable as a monetary commodity.
Metals, especially precious metals, make the best commodity monies because they are easy to store, count, and transfer. However, at most times in history, commodity monies in practice have traded at a premium or discount to the actual commodity. If money can be made from the metal and turned back into the non‐monetary metal itself (viz. the minting and melting of coins), the cost of minting or melting provides a corridor around the inherent metal value within which the commodity money can trade. Normally, minted money is slightly more expensive than its commodity value because it is more convenient to use as a means of payment. In some cases, minting is restricted to certain workshops operated or licensed by a sovereign and money creation is subject to a special form of tax, known as seigniorage [71]. The value of a coin is then given by the following inequality involving the inherent metal value , minting cost , melting cost and seigniorage :
If a coin is trading below the lower of these boundaries, scrap metal merchants would find it attractive to melt it down, while if coins are trading above the boundary, it would be attractive to mint new coins. The use of coins introduces a number of interesting economic problems, but these are of no interest for the financial markets. The interested reader is referred to the literature, in particular [71].
A legal concept called lex monetae stipulates that each sovereign can legislate what constitutes money in its own jurisdiction. This concept is at the same time trivial and misleading. A sovereign can certainly legislate what types of assets can be used to discharge debts stated in monetary terms, at least as far as court‐enforced payments are concerned. Such assets are referred to as legal tender or forced money. Given that sovereigns are usually able to levy taxes, and therefore command large payment flows, prescribing legal tender can lend significance to assets by legal fiat. While lex monetae in this sense is not written legislation, its operation can be found already in old international treaties. The Pax Westphalica, the peace treaty that in 1648 ended the hostilities of the 30 Years War and set important precedents for international law in Europe, specified restitution payments in the local currency of the respective sovereigns [67]. That being said, those sovereigns were all using gold as the base of their currencies at the time. On this evidence, lex monetae
