Lecture notes in fixed income fundamentals, volume 2

Lecture Notes in Fixed Income Fundamentals www.ebook3000.com 10271_9789813149755_TP.indd 10/2/17 3:12 PM World Scientific Lecture Notes in Finance ISSN: 2424-9955 Series Editor: Professor Itzhak Venezia Published: Vol Lecture Notes in Introduction to Corporate Finance by Ivan E Brick (Rutgers Business School at Newark and New Brunswick, USA) Vol Lecture Notes in Fixed Income Fundamentals by Eliezer Z Prisman (York University, Canada) Forthcoming Titles: Lecture Notes in Behavioral Finance by Itzhak Venezia (The Hebrew University of Jerusalem, Israel) Lecture Notes in Market Microstructure and Trading by Peter Joakim Westerholm (The University of Sydney, Australia) Lecture Notes in Risk Management by Zvi Wiener and Yevgeny Mugerman (The Hebrew University of Jerusalem, Israel) Shreya - Lecture Notes in Fixed Income.indd 16-02-17 3:40:57 PM World Scientific Lecture Notes in Finance – Vol Lecture Notes in Fixed Income Fundamentals Eliezer Z Prisman Schulich School of Business York University, Canada World Scientific NEW JERSEY • LONDON • SINGAPORE • BEIJING • SHANGHAI • HONG KONG • TAIPEI • CHENNAI • TOKYO www.ebook3000.com 10271_9789813149755_TP.indd 10/2/17 3:12 PM Published by World Scientific Publishing Co Pte Ltd Toh Tuck Link, Singapore 596224 USA office: 27 Warren Street, Suite 401-402, Hackensack, NJ 07601 UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE Library of Congress Cataloging-in-Publication Data Names: Prisman, Eliezer Z., author Title: Lecture notes in fixed income fundamentals / Eliezer Z Prisman (York University, Canada) Description: New Jersey : World Scientific, [2016] | Series: World scientific lecture notes in finance | Includes index Identifiers: LCCN 2016035725| ISBN 9789813149755 | ISBN 9789813149762 (pbk) Subjects: LCSH: Fixed-income securities Classification: LCC HG4650 P75 2016 | DDC 332.63/2044 dc23 LC record available at https://lccn.loc.gov/2016035725 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Copyright © 2017 by World Scientific Publishing Co Pte Ltd All rights reserved This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the publisher For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA In this case permission to photocopy is not required from the publisher Desk Editor: Shreya Gopi Typeset by Stallion Press Email: enquiries@stallionpress.com Printed in Singapore Shreya - Lecture Notes in Fixed Income.indd 16-02-17 3:40:57 PM February 23, 2017 11:27 ws-book9x6 Fixed Income Fundamentals 10271-main Preface This book is the hard copy version of the eBook Fixed Income Fundamentals: An interactive e-book powered by Maple, see http://www.yorku.ca/eprisman As such, it contains all the Maple commands that are used to calculate the examples The Maple programming language is very intuitive and at the level used in this book is very much like a pseudo code The commands are self-explanatory, so that the purpose of each calculation is apparent, even to a reader not familiar with Maple Where there was a need to use a more complicated calculation/algorithm a procedure was written The procedure’s name, the input parameters, the output and the goal of the procedure are all explained in the body of the text Hence again the reader of the hardcopy version will find the material very intuitive To distinguish the text from the Maple commands, lines containing Maple commands start with > The hard copy version is thus equivalent to the eBook and therefore the rest of the preface that was written for the eBook applies as well to the hardcopy version The only exception is that the eBook allows interactive interaction as explained henceforth The topic of fixed income securities has advanced tremendously in the last decade or so Simultaneously, the use of sophisticated Mathematics needed to fully grasp this material has grown exponentially The term “fixed income securities”, historically a synonym for bonds (as they promise deterministic fixed cash flows to be paid at fixed deterministic times), no longer accurately describes this field Bonds that now incorporate many options-like features and financial contracts that are contingent on interest rates are very popular, thereby rendering the “term fixed income securities” obsolete v www.ebook3000.com page v February 23, 2017 11:27 vi ws-book9x6 Fixed Income Fundamentals 10271-main Fixed Income Fundamentals Bonds and the behavior of interest rates are not as detached as they were, a few years ago, from the topics of valuation and derivative securities In fact the topic of interest rate derivative securities (contingent claims) is more complex than equity derivatives Yet many books, maybe even most books in this area, try to teach students the basics of fixed income securities together with interest rate derivative securities The complexity of the quantitative methods needed in this field stemmed mostly from the need to model the evolution of the term structure of interest rates (TS) Modern books in this area tend to attempt (and they may be justified in doing so) to encompass the frontier of the field and thus speak about options, interest rate contingent claims, the evolution of the TS and thereby present a very daunting task to beginners in this field The result could be an overwhelming amount of material for a beginner and consequently the student may fail to grasp a deep understanding of fixed income securities At the same time they may not fully comprehend the derivative securities aspect Yet, there is a lot that can be done in this field without modelling the evolution of the TS by using only the “yield curve” or the current realization of the TS The basic understanding of the no arbitrage condition (NA), its relation to the existence and estimation of the TS and to valuation of various instruments (swapes, forward rate agreements etc.) can be mastered and well explained without reference to the evolution of the TS Such an approach would allow the student to grasp the philosophy behind the NA and its use This is exactly what this book aims to achieve It is meant to equip novices to this area with a solid and intuitive understanding of the NA, its link to the existence and estimation of the term structure of interest rates and to valuation of financial contracts The book uses the modern approach of arbitrage arguments and addresses only positions and contracts that not require the knowledge of the evolution of the TS As such, the book removes a barrier to entry to this field (at the cost of being only an introduction to this subject) We believe that this trade off is well justified and will provide the readers of this book with good intuition for the TS, the NA, the bond market and certain financial contracts This book concentrates on understanding and explaining the pillars of fixed income markets using the modern finance approach as stipulated and page vi February 23, 2017 11:27 ws-book9x6 Fixed Income Fundamentals Preface 10271-main vii implied by the ‘no free lunch condition’ The book focuses on a conceptual understanding so that the readers will be familiar with the tools needed to analyze bond markets Institutional information is covered only to the extent that such is needed to get a full appreciation of the concepts It follows the philosophy that institutional details are much easier to understand and are readily available from different sources unlike the core ideas and ways of thinking about fixed income markets Furthermore these institutional details might be slightly different from country to country, thus concentrating on conceptual issues will help to maintain a universal book that can be used anywhere The book is written for an undergraduate first course in fixed income securities, bonds, interest rates and related financial contracts It assumes that readers are familiar with the concept of “time value of money”, even though it is reviewed in the first chapter The book assumes a certain mathematical maturity but not much above what is sometimes referred to as “finite mathematics” Calculus or optimization is used in a very small fraction of the material Its use however is hidden (in appendixes or suppressed) and readers lacking this knowledge can read the complete book without difficulties Thus the book will also be of interest to anybody who seeks an introduction to the subjects of bonds, interest rates and financial contracts the valuation of which depends on interest rates The book is tailored for beginners in this area and as such it does not attempt to teach students about fixed income derivative securities and the evaluation of the term structure of interest rates Rather it focuses on cementing the core and fundamental points of fixed income securities The valuation of different positions and financial contracts is covered as long as it can be done by using only the current term structure of interest rates (and not its evolution) Thereby we believe that we will expose the student to the way of thinking and analyzing situations utilizing the NA condition (without the complicated issues of the evolution of the term structure) The book starts by reviewing the concept of time value of money It continues by underlying the basic framework of government bond markets, the role of the NA (no free lunch condition), and its relation to the TS and discount factors Next the estimation of the TS is addressed followed by the valuations of swaps and futures (forwards) in a one-period setting A variety of instruments, the valuation of which depends on the TS (in a www.ebook3000.com page vii February 23, 2017 11:27 viii ws-book9x6 Fixed Income Fundamentals 10271-main Fixed Income Fundamentals multi-period framework), are explored The book also covers interest rate risk management, immunization strategies, and matched cash flow It also touches on interest rate options (mainly utilizing a binomial-based model) and credit derivatives This book is tailored to an introductory (undergraduate) course spanning 12–15 weeks of lectures or a short graduate course of about weeks After taking a course based on this book, the students will know how to value different financial contracts that require the current realization of the TS (“yield curve”) as an input However we believe they will appreciate and acquire a full understanding of the implications and applications of the NA in bond markets The book presents a universal view of bond markets which could be applied anywhere We believe that our goals can be accomplished requiring only the very basic course of introduction to finance that exists in almost all business schools and most economics departments After completing a course based on this book students will be ready to obtain the needed mathematical modelling of the evolution of the TS and move to this next step The e-book presents an interactive and dynamic friendly environment allowing readers to learn through hands-on experience The book can only be read with the Maple software We have chosen Maple because of its symbolic computation ability as well as its visualization capability and the structure of its files that allows embedding commands within the text This e-book is a series of Maple worksheets connected by hyperlinks and a Table of Contents which has links to each worksheet It presents an Interactive Dynamic Environment for Advanced Learning (IDEAL) which is supported by a collection of procedures — a Maple package A reader who follows the book on-screen, will find the commands are already typed in the appropriate files The reader should merely re-execute the printed commands while reading The technology allows readers to learn through immediate application of theory and concepts, while avoiding the frustration of tedious calculations Readers can use the prepared Maple files, follow the text on-screen, and explore different numerical examples with no prior programming knowledge In fact, readers can keep generating their own examples, verifying and investigating different situations not addressed in the book Learning is enhanced by altering the parameters of the commands, varying them at will, in order to experiment page viii February 23, 2017 11:27 ws-book9x6 Fixed Income Fundamentals Preface 10271-main ix with applications of the concepts and different (reader-generated) examples, in addition to the ones already in the prepared file It is this interaction and experimentation, making use of Maple together with the ability to bring to life on the screen the theoretical material of the chapter, which provides a unique, powerful, and entertaining way to be introduced to the fundamentals of fixed income securities Copyright and Disclaimer The copyright holder retains ownership of the Maple code included with this e-book U.S Copyright law prohibits you from mailing (making) a copy of this e-book for any reason without written permission, only copying files for personal research, teaching, and communication excepted The author makes no warranties or representations, either expressed or implied, concerning the information contained in the copyright material including its quality, merchantability, or fitness for a particular use, and will not be liable for damages of any kind whatsoever arising out of the use or inability to use the e-book The author makes no warranty or representation, either expressed or implied, with respect to this e-book, including its quality, merchantability, or fitness for particular purpose In no event will the author be liable for direct, indirect, special, incidental, or consequential damages arising out of the use or inability to use the e-book, even if the author has been advised of the possibility of such damages To the extent permissible under applicable laws, no responsibility is assumed by the author for any injury and/or damage to persons or property as a result of any actual or alleged libellous statements, infringement of intellectual property or privacy rights, or products liability, whether resulting from negligence or otherwise, or from any use or operation of any ideas, instructions, procedures, products or methods contained in the material therein Suggested Settings Verify the following the first time you open Maple: From the Tools menu, select Options (On an Apple computer click Maple 2016 on the top left and go to ‘Preferences’) www.ebook3000.com page ix February 23, 2017 11:27 x ws-book9x6 Fixed Income Fundamentals 10271-main Fixed Income Fundamentals In the Options dialog, click the Display tab Ensure that: the ‘Input display’ shows Maple Notation, the ‘Output display’ shows 2-D Math Notation, and the ‘Show equation labels’ feature is not selected Save your settings globally so they will be set for every session, not just the current one Otherwise make sure you reset it every time you read the book page x ... - Lecture Notes in Fixed Income. indd 16- 02- 17 3:40:57 PM World Scientific Lecture Notes in Finance – Vol Lecture Notes in Fixed Income Fundamentals Eliezer Z Prisman Schulich School of Business... enquiries@stallionpress.com Printed in Singapore Shreya - Lecture Notes in Fixed Income. indd 16- 02- 17 3:40:57 PM February 23 , 20 17 11 :27 ws-book9x6 Fixed Income Fundamentals 1 027 1-main Preface This book... 194 198 20 1 21 1 21 2 21 7 21 7 22 3 22 6 23 7 24 1 24 5 24 7 24 8 25 1 Index www.ebook3000.com page xiii b2530   International