Interest Rate Markets E-Book

Siddhartha Jha

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Trading Series
• Sprache: Englisch

Seitenzahl: 692

Veröffentlichungsjahr: 2011

Beschreibung

How to build a framework for forecasting interest rate market movements With trillions of dollars worth of trades conducted every year in everything from U.S. Treasury bonds to mortgage-backed securities, the U.S. interest rate market is one of the largest fixed income markets in the world. Interest Rate Markets: A Practical Approach to Fixed Income details the typical quantitative tools used to analyze rates markets; the range of fixed income products on the cash side; interest rate movements; and, the derivatives side of the business. * Emphasizes the importance of hedging and quantitatively managing risks inherent in interest rate trades * Details the common trades which can be used by investors to take views on interest rates in an efficient manner, the methods used to accurately set up these trades, as well as common pitfalls and risks?providing examples from previous market stress events such as 2008 * Includes exclusive access to the Interest Rate Markets Web site which includes commonly used calculations and trade construction methods Interest Rate Markets helps readers to understand the structural nature of the rates markets and to develop a framework for thinking about these markets intuitively, rather than focusing on mathematical models

Leseprobe

Contents

Cover

Series

Title Page

Copyright

Dedication

Acknowledgments

Introduction

Chapter 1: Tools of the Trade

BASIC STATISTICS

REGRESSION: THE FUNDAMENTALS

REGRESSION: HOW GOOD A FIT?

PRINCIPAL COMPONENTS ANALYSIS

SCALING THROUGH TIME

BACKTESTING STRATEGIES

SUMMARY

Chapter 2: Bonds

BASICS OF BONDS

RISKS EMBEDDED IN FIXED INCOME INSTRUMENTS

DISCOUNTING

BOND PRICING

YIELD CURVE

DURATION

CONVEXITY

REPO MARKETS

BID OFFER

CALCULATING PROFIT/LOSS OF A BOND

CARRY

FORWARD RATES

ROLLDOWN/SLIDE

CURVES AND SPREADS

BUTTERFLY TRADES

SUMMARY

Chapter 3: Fixed Income Markets

FEDERAL RESERVE

TREASURIES

STRIPS

TIPS

MORTGAGES

AGENCY DEBT

CORPORATE BONDS

MUNICIPAL BONDS

SUMMARY

Chapter 4: Interest Rate Futures

BASICS OF FUTURES TRANSACTIONS

EURODOLLAR FUTURES

CONVEXITY (OR FINANCING) BIAS

CREATING LONGER-DATED ASSETS USING EURODOLLAR FUTURES

TREASURY FUTURES

FED FUNDS FUTURES

FUTURES POSITIONING DATA

SUMMARY

Chapter 5: Interest Rate Swaps

BASIC PRINCIPLES

DURATION AND CONVEXITY

USES OF SWAPS

COUNTERPARTY RISK

OTHER TYPES OF SWAPS

SUMMARY

Chapter 6: Understanding Drivers of Interest Rates

SUPPLY AND DEMAND FOR BORROWING

COMPONENTS OF FIXED INCOME SUPPLY AND DEMAND

TREASURY SUPPLY

OTHER SOURCES OF FIXED INCOME SUPPLY

FIXED INCOME DEMAND

SHORT-TERM YIELD DRIVERS

SUMMARY

Chapter 7: Carry and Relative Value Trades

CARRY TRADES

CARRY TRADE SETUP AND EVALUATION

PITFALLS OF THE CARRY TRADE

CARRY-EFFICIENT DIRECTIONAL TRADES

RELATIVE VALUE TRADES

SETTING UP RELATIVE VALUE TRADES

TREASURY BOND RELATIVE VALUE—PAR CURVE

OTHER TREASURY RELATIVE VALUE TRADES

SUMMARY

Chapter 8: Hedging Risks in Interest Rate Products

PRINCIPLES OF HEDGING

CHOICES OF INSTRUMENTS FOR HEDGING

CALCULATING HEDGE RATIOS

YIELD BETAS

CONVEXITY HEDGING

SUMMARY

Chapter 9: Trading Swap Spreads

HOW SWAP SPREADS WORK

WHY TRADE SWAP SPREADS?

DIRECTIONALITY OF SWAP SPREADS TO YIELDS

FUTURES ASSET SWAPS

SPREAD CURVE TRADES

SUMMARY

Chapter 10: Interest Rate Options and Trading Volatility

OPTION PRICING AND FUNDAMENTALS

MODIFICATIONS FOR THE INTEREST RATE MARKETS

QUOTING VOLATILITY

MEASURING RISKS IN OPTION POSITIONS

PUT/CALL PARITY

IMPLIED AND REALIZED VOLATILITY

SKEW

DELTA HEDGING

INTEREST RATE OPTIONS

EMBEDDED OPTIONS AND HEDGING

MORE EXOTIC STRUCTURES

YIELD CURVE SPREAD OPTIONS

FORWARD VOLATILITY

VOLATILITY TRADING

INTEREST RATE SKEW

VOLATILITY SPREAD TRADES

CAPS VERSUS SWAPTIONS

SUMMARY

Chapter 11: Treasury Futures Basis and Rolls

THE FUTURES DELIVERY OPTION

CALCULATING THE DELIVERY OPTION VALUE

OPTION-ADJUSTED AND EMPIRICAL DURATION

TREASURY FUTURES ROLLS

SUMMARY

Chapter 12: Conditional Trades

CONDITIONAL CURVE TRADES

CONDITIONAL SPREAD TRADES

SUMMARY

References

About the Author

About the Web Site

Index

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Copyright © 2011 by Siddhartha Jha. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Jha, Siddhartha, 1984– Interest rate markets : a practical approach to fixed income / Siddhartha Jha. p. cm. – (Wiley trading series) Includes bibliographical references and index. ISBN 978-0-470-93220-9 (cloth); ISBN 978-1-118-01777-7 (ebk); ISBN 978-1-118-01778-4 (ebk); ISBN 978-1-118-01779-1 (ebk) 1. Interest rates. 2. Fixed-income securities. 3. Bonds. I. Title. HG1621.J43 2011 332.63′2044–dc22 2010043312

To my parents

Acknowledgments

This work is the outcome of inspiration, training, and support I received from so many colleagues, friends, and family. Much as I am deeply indebted to them, I cannot possibly mention them all in the short space here. To name just a few, Pavan Wadhwa and Srini Ramaswamy helped me understand markets in a thorough and logical manner throughout my career. I would like to thank Ross Jackman and Russ Mannis for their encouragement at the start of my career in municipals. My discussions about finance with colleagues such as Manas Baveja and Anthony Heading over the years have been instrumental in addressing any doubts in my thought process. I also want to acknowledge Kelly for her unwavering support.

A number of individuals took the time to perform the arduous task of editing and offered advice on content. Specifically, I want to express my gratitude to my dad and to Hitomi Kimura for their assistance.

Last, but definitely not least, I would like to thank the editing staff at Wiley who took the time to thoroughly edit my manuscripts. In particular, I thank Laura Walsh, Judy Howarth, and Laura Cherkas for their assistance with the whole publication process.

Introduction

The U.S. fixed income market, with securities worth trillions of dollars traded yearly, is one of the largest in the world. It attracts a wide variety of borrowers and investors, from individuals and corporations to governments. The market offers an array of instruments such as bonds, swaps, futures, and options for trading or managing risk. As the size and sophistication of the U.S. fixed income market have increased over the past two decades, so have the challenges and opportunities that come along with these instruments. Managing interest rate risk has become a crucial task for portfolio managers. Indeed, the various crises that punctuated the financial markets over the past two decades have underscored the importance of this task. Therefore, given the complexity of interest rate products and the range of macroeconomic factors that affect them, participants in the fixed income markets need to have frameworks for logical and in-depth analysis of trades and embedded risks.

Such a framework needs to be based on the principles of mathematical modeling as well as an intuitive grasp of the economy and monetary policy. Mathematical models are important because the contemporary fixed income market has numerous complex products that require quantitative foundations. Likewise, the knowledge of fundamentals is indispensable because markets are more integrated than ever before. However, the current literature on the U.S. fixed income market lacks the balance of these essential elements. Some works rely on a qualitative approach, whereas others exaggerate the significance of quantitative models. The overemphasis on models, as is well known, was a part of the problem in recent financial crises.

This book breaks a new, middle ground. It begins with the essential mathematical tools needed to objectively analyze data and financial instruments. These instruments can be thought of as packages of different types of risks that on one hand provide opportunity to trade, and on the other hand involve careful management. Such management requires both mathematical skills and an intuitive grasp of the economy and financial markets. To this end, this book analyzes fundamentals and financial flows and identifies the optimal instruments for a trade using quantitative tools.

This book is meant for both newcomers and experienced professionals in fixed income markets. For newcomers, it builds an understanding of bonds and more complex products such as interest rate swaps, futures, and options. Subsequently, it describes the driving factors behind fixed income markets and explains how to use these products to express views on interest rates and their spreads. For experienced professionals, the book describes economic fundamentals and the behavior of market participants in order to explain short-term as well as long-term drivers of interest rates. As an important companion to trading, the book discusses hedging. The details include its general principles as well as the choice of instrument for a hedge. The information is meant to enable effective risk management and construction of market indicators. Finally, the limitations and pitfalls of each type of trade are discussed; the lessons of past financial crises show there is no such thing as a safe trade.

To summarize, the framework of the book includes:

Quantitative tools that form the foundations of market analysisMechanics of interest rate products, both bonds and derivatives, including swaps, options, and futuresThought processes for forming a view on interest rates and related variables, such as swap spreadsTypes of trades commonly done by professionals in the market to express views and detailed discussions of methods to accurately set up the tradesThe importance of quantitatively managing risks inherent in interest rate tradesCommon pitfalls and risks facing popular interest rate trades

Chapter 2

Bonds

Bonds are the starting point for understanding the fixed income market. They represent a standardized form of loan between investors and debt holders and form the foundation of the fixed income market. Although bonds are traded in massive volume daily, they are less known to the general public than the stock market. Unlike stocks, which have indefinite maturity and uncertain dividends that can be withdrawn at will by the issuer, bonds have a fixed maturity and fixed interest at inception (or interest that changes according to an agreed-on formula). Furthermore, while stocks are issued mainly by corporations, bonds have a tremendous variety of issuers, including governments, corporations, and homeowners. This chapter introduces the basic characteristics of bonds, their valuation, and the risks of investing in them. Even if the borrower of the debt is sure to repay the loan, there are other risks to consider if bonds are bought and sold in the market. We quantify and attempt to control them, especially when initiating trades beyond simply buying or selling a single bond.

BASICS OF BONDS

To understand the details of bonds, first consider a simple case where you lend your friend $5 for a week. In the case of such micro-loans, most of the time the $5 is returned after a week with no adjustment made for interest. However, let's take the example to a larger scale. Assume that you have lent money not to a good friend, but to an institution, such as the government. Also, instead of $5, suppose you have lent $1 million. Finally, instead of a week, suppose the term of the loan is 10 years. In this case, the government promises to return your $1 million after 10 years, probably using it for purposes like defense or social welfare in the meantime. Although lending without interest was okay with the $5 to your friend for a week, this case is obviously very different. With the government, you are unlikely to just hand over $1 million today and be satisfied with getting it back after 10 years. To see why this is so, consider what else could have been done with the $1 million. To be sure, you could choose to consume it now rather than wait 10 years. Or you could invest the money in a stock and, perhaps, realize large gains if the stock market rises. Finally, if choosing a safe route, you could have saved it in a bank and earned interest in a savings account. Given all these different choices, it is then not unreasonable for the investor to demand that interest be given in return for lending the $1 million to the government.

A bond can be thought of as a loan with standardized terms regarding repayment and interest. This standardization allows larger institutions to borrow from a diverse pool of lenders without having to renegotiate terms with each one. However, standardization generally extends to a particular issue; it does not hold for bonds across markets and sometimes even for different bonds issued by the same institution. For example, bonds issued by some companies may have interest payments that change with market conditions (known as floating rate bonds), while bonds of other institutions may pay their principal over time instead of all at once. Even if the interest rate is fixed, the interest could be paid in different ways: It could be given out at fixed intervals, or the “fixed” interest rate could be zero and an amount larger than $1 million could be given at the end of 10 years with no payments in the interim. We consider the different features in this chapter. To avoid confusion, we first consider examples from the Treasury bond market, which is the debt market for the U.S. government. This is one of the world's largest bond markets and also has straightforward terms that serve as a good starting point. Afterward we consider exceptions and differences across markets.

To understand bonds, consider the $1 million loan to the government for 10 years just mentioned. The $1 million here would be known as the notional. Given the government's massive borrowing needs, it would not be feasible for it to negotiate a loan with every investor. Instead, the government sells bonds, which investors buy with cash. The cash is sent to the Treasury, and, as with any other loan, the Treasury uses the cash for the purposes deemed necessary. At the end of the term of the bond, in this case 10 years, the Treasury is supposed to return the $1 million. There are three initial attributes to keep in mind when considering a bond: coupon rate, maturity, and price. Coupon rate refers to the interest rate of payments made by the issuing entity (in this case, a Treasury bond) and is expressed as a percentage. While the government has the $1 million it was lent, it will pay interest every six months. Treasury bonds are fixed rate bonds, which, as the name implies, means that the coupon payments stay constant through the life of the bond. If the coupon rate of our bond was 3%, the yearly payment of interest would be $3 per $100 of the bond, or in the case of $1 million, $30,000 per year. As the interest is paid out every six months, it means a payment of $15,000 every six months. These payments are made until the term of the bond, at which time the principal is also returned. In our example, the bond is supposed to last for 10 years, which is referred to as the maturity of the bond, listed in MM-YY format as a date. This is an important distinction between bonds and equities: In bonds, there is a fixed date after which the bond no longer exists. The fixed maturity date in turn prompts considerations that an investor in equities does not have to consider; for example, when the bond is bought, it is 10 years in maturity, but after a year, it is only a 9-year bond. If interest rates for 10-year loans differ from interest rates for 9-year loans, the investor may realize profit or loss just from the aging effect, which is known as rolldown (discussed in more detail later in this chapter).

The $1 million here is known as the face value of the bond, which can be thought of as the amount of the loan to the government. However, even if the face value is $1 million, the value or price of the bond may not be equal to the face value. Indeed, bonds get traded between investors all the time, and if you are purchasing a bond from another investor, you are essentially taking on the loan. In that case, since the interest payments by the Treasury remain fixed during the life of the bond, in different circumstances, the interest rate may be more or less attractive. For example, if other, similar Treasury bonds are offering 5%, the 3% bond looks much worse, while if other Treasury bonds are offering 1%, the 3% bond would be a great coupon. Therefore, given changes in interest rates, you may want to pay more or less than the face value for the bond, and this amount is known as the price of the bond. Since face value can differ across bonds, price is generally quoted in per-$100 terms. For example, a bond priced at $99 implies that the bond trades at 99% of its face value. Therefore, to lend $100 to the issuing institution, you only have to pay $99. This would generally be the case if the fixed interest rate being offered by this bond is worse than that of similar new bonds in the market.

The bond market is full of terminology that can confuse a newcomer. Given the usual movement in rates, the common unit of change is basis points (bps), which represent 1/100 of 1%. Therefore, a change in interest rate on a bond from 3.53% to 3.54% represents a change of 0.01%, or 1 bp. Numerous units in the fixed income market quote changes and even levels in basis points. In the bond space, changes in yield require a bit of care. When a change in a 5-year bond yield is mentioned, the change may not be referring to the same 5-year bond. This is because new bonds are issued at regular intervals, and essentially a new 5-year bond exists as soon as it is auctioned. A fresh 5-year bond in this case is called an on-the-run bond, while the older bond is an off-the-run bond. For example, if a 5-year bond is issued monthly, in January 2010, the on-the-run bond would be the January 2015 maturity bond, while the December 2014 maturity bond would be the off-the-run bond. The November 2014 maturity bond would be the double off-the-run, and so on. In February 2010, when the February 2015 bond is issued, it becomes the on-the-run bond while the January 2015 becomes the off-the-run.

RISKS EMBEDDED IN FIXED INCOME INSTRUMENTS

Bonds can be thought of as a package of fixed cash flows for a certain period of time and then repayment of initial principal. In financial settings, it is generally equally, if not more, constructive to think of securities and contracts as packages of risks rather than just as cash flows. These risks can range from the mundane to minute hidden ones, and each deserves time and management—sometimes the smallest source of risk can expand to cause catastrophic losses when stress periods arrive. Any fixed income instrument can also be decomposed into a set of standard types of risk exposure. For any given instrument, some risks may be especially important. Other instruments may exist solely to offset certain classes of risks. These classes of risks include:

Interest rate riskCredit riskInflation riskFinancing/liquidity riskTax riskRegulatory risk

Interest Rate Risk

This is perhaps the starting point when considering the risk embedded in any fixed income instrument. Any security—such as a bond, loan, or any other contract with fixed