Part 2 book “Fixed income analysis” has contents: Valuation of interest rate derivative instruments, general principles of credit analysis, introduction to bond portfolio management, managing funds against a bond market index, portfolio immunization and cash flow matching,… and other contents.
CHAPTER 13 INTEREST RATE DERIVATIVE INSTRUMENTS I INTRODUCTION In this chapter we turn our attention to financial contracts that are popularly referred to as interest rate derivative instruments because they derive their value from some cash market instrument or reference interest rate These instruments include futures, forwards, options, swaps, caps, and floors In this chapter we will discuss the basic features of these instruments and in the next we will see how they are valued Why would a portfolio manager be motivated to use interest rate derivatives rather than the corresponding cash market instruments There are three principal reasons for doing this when there is a well-developed interest rate derivatives market for a particular cash market instrument First, typically it costs less to execute a transaction or a strategy in the interest rate derivatives market in order to alter the interest rate risk exposure of a portfolio than to make the adjustment in the corresponding cash market Second, portfolio adjustments typically can be accomplished faster in the interest rate derivatives market than in the corresponding cash market Finally, interest rate derivative may be able to absorb a greater dollar transaction amount without an adverse effect on the price of the derivative instrument compared to the price effect on the cash market instrument; that is, the interest rate derivative may be more liquid than the cash market To summarize: There are three potential advantages that motivate the use of interest rate derivatives: cost, speed, and liquidity II INTEREST RATE FUTURES A futures contract is an agreement that requires a party to the agreement either to buy or sell something at a designated future date at a predetermined price Futures contracts are products created by exchanges Futures contracts based on a financial instrument or a financial index are known as financial futures Financial futures can be classified as (1) stock index futures, (2) interest rate futures, and (3) currency futures Our focus in this chapter is on interest rate futures A Mechanics of Futures Trading A futures contract is an agreement between a buyer (seller) and an established exchange or its clearinghouse in which the buyer (seller) agrees to take (make) delivery of something (the underlying) at a specified price at the end of a designated period of time The price at which 360 Chapter 13 Interest Rate Derivative Instruments 361 the parties agree to transact in the future is called the futures price The designated date at which the parties must transact is called the settlement date or delivery date Liquidating a Position Most financial futures contracts have settlement dates in the months of March, June, September, and December This means that at a predetermined time in the contract settlement month the contract stops trading, and a price is determined by the exchange for settlement of the contract The contract with the closest settlement date is called the nearby futures contract The next futures contract is the one that settles just after the nearby futures contract The contract farthest away in time from settlement is called the most distant futures contract A party to a futures contract has two choices on liquidation of the position First, the position can be liquidated prior to the settlement date For this purpose, the party must take an offsetting position in the same contract For the buyer of a futures contract, this means selling the same number of the identical futures contracts; for the seller of a futures contract, this means buying the same number of identical futures contracts The alternative is to wait until the settlement date At that time the party purchasing a futures contract accepts delivery of the underlying at the agreed-upon price; the party that sells a futures contract liquidates the position by delivering the underlying at the agreed-upon price For some interest rate futures contracts, settlement is made in cash only Such contracts are referred to as cash settlement contracts The Role of the Clearinghouse Associated with every futures exchange is a clearinghouse, which performs several functions One of these functions is to guarantee that the two parties to the transaction will perform When an investor takes a position in the futures market, the clearinghouse takes the opposite position and agrees to satisfy the terms set forth in the contract Because of the clearinghouse, the investor need not worry about the financial strength and integrity of the party taking the opposite side of the contract After initial execution of an order, the relationship between the two parties ends The clearinghouse interposes itself as the buyer for every sale and the seller for every purchase Thus investors are free to liquidate their positions without involving the other party in the original contract, and without worrying that the other party may default This is the reason that we define a futures contract as an agreement between a party and a clearinghouse associated with an exchange Besides its guarantee function, the clearinghouse makes it simple for parties to a futures contract to unwind their positions prior to the settlement date Margin Requirements When a position is first taken in a futures contract, the investor must deposit a minimum dollar amount per contract as specified by the exchange This amount is called initial margin and is required as deposit for the contract The initial margin may be in the form of an interest-bearing security such as a Treasury bill As the price of the futures contract fluctuates, the value of the margin account changes Marking to market means effectively replacing the initiation price with a current settlement price The contract thus has a new settlement price At the end of each trading day, the exchange determines the current settlement price for the futures contract This price is used to mark to market the investor’s position, so that any gain or loss from the position is reflected in the margin account.1 For a further discussion of margin requirements and illustrations of how the margin account changes as the futures price changes, see Don M Chance, Analysis of Derivatives for the CFA 362 Fixed Income Analysis Maintenance margin is the minimum level (specified by the exchange) to which the margin account may fall to as a result of an unfavorable price movement before the investor is required to deposit additional margin The additional margin deposited is called variation margin, and it is an amount necessary to bring the account back to its initial margin level This amount is determined from the process of marking the position to market Unlike initial margin, variation margin must be in cash, not interest-bearing instruments Any excess margin in the account may be withdrawn by the investor If a party to a futures contract who is required to deposit variation margin fails to so within 24 hours, the futures position is closed out Although there are initial and maintenance margin requirements for buying securities on margin, the concept of margin differs for securities and futures When securities are acquired on margin, the difference between the price of the security and the initial margin is borrowed from the broker The security purchased serves as collateral for the loan, and the investor pays interest For futures contracts, the initial margin, in effect, serves as ‘‘good faith’’ money, an indication that the investor will satisfy the obligation of the contract B Forward Contracts A forward contract, just like a futures contract, is an agreement for the future delivery of something at a specified price at the end of a designated period of time Futures contracts are standardized agreements as to the delivery date (or month) and quality of the deliverable, and are traded on organized exchanges A forward contract differs in that it is usually nonstandardized (that is, the terms of each contract are negotiated individually between buyer and seller), there is no clearinghouse, and secondary markets are often non-existent or extremely thin Unlike a futures contract, which is an exchange-traded product, a forward contract is an over-the-counter instrument Futures contracts are marked to market at the end of each trading day Consequently, futures contracts are subject to interim cash flows as additional margin may be required in the case of adverse price movements, or as cash is withdrawn in the case of favorable price movements A forward contract may or may not be marked to market, depending on the wishes of the two parties For a forward contract that is not marked to market, there are no interim cash flow effects because no additional margin is required Finally, the parties in a forward contract are exposed to credit risk because either party may default on its obligation This risk is called counterparty risk This risk is minimal in the case of futures contracts because the clearinghouse associated with the exchange guarantees the other side of the transaction In the case of a forward contract, both parties face counterparty risk Thus, there exists bilateral counterparty risk Other than these differences, most of what we say about futures contracts applies equally to forward contracts C Risk and Return Characteristics of Futures Contracts When an investor takes a position in the market by buying a futures contract, the investor is said to be in along position or to belong futures The buyer of the futures contract is also Program (Charlottesville, VA: Association for Investment Management and Research, 2003), pp 86–91 Chapter 13 Interest Rate Derivative Instruments 363 referred to as the ‘‘long.’’ If, instead, the investor’s opening position is the sale of a futures contract, the investor is said to be in a short position or to be short futures The seller of the futures contract is also referred to as the ‘‘short.’’ The buyer of a futures contract will realize a profit if the futures price increases; the seller of a futures contract will realize a profit if the futures price decreases When a position is taken in a futures contract, the party need not put up the entire amount of the investment Instead, only initial margin must be put up Consequently, an investor can effectively create a leveraged position by using futures At first, the leverage available in the futures market may suggest that the market benefits only those who want to speculate on price movements This is not true As we shall see, futures markets can be used to control interest rate risk Without the effective leverage possible in futures transactions, the cost of reducing price risk using futures would be too high for many market participants D Exchange-Traded Interest Rate Futures Contracts Interest rate futures contracts can be classified by the maturity of their underlying security Short-term interest rate futures contracts have an underlying security that matures in less than one year Examples of these are futures contracts in which the underlying is a 3month Treasury bill and a 3-month Eurodollar certificate of deposit The maturity of the underlying security of long-term futures contracts exceeds one year Examples of these are futures contracts in which the underlying is a Treasury coupon security, a 10-year agency note, and a municipal bond index Our focus will be on futures contracts in which the underlying is a Treasury coupon security (a Treasury bond or a Treasury note) These contracts are the most widely used by managers of bond portfolios and we begin with the specifications of the Treasury bond futures contract We will also discuss the agency note futures contracts There are futures contracts on non-U.S government securities traded throughout the world Many of them are modeled after the U.S Treasury futures contracts and consequently, the concepts discussed below apply directly to those futures contracts Treasury Bond Futures The Treasury bond futures contract is traded on the Chicago Board of Trade (CBOT) The underlying instrument for a Treasury bond futures contract is $100,000 par value of a hypothetical 20-year coupon bond The coupon rate on the hypothetical bond is called the notional coupon The futures price is quoted in terms of par being 100 Quotes are in 32nds of 1% Thus a quote for a Treasury bond futures contract of 97–16 means 97 and 16/32 or 97.50 So, if a buyer and seller agree on a futures price of 97–16, this means that the buyer agrees to accept delivery of the hypothetical underlying Treasury bond and pay 97.50% of par value and the seller agrees to accept 97.50% of par value Since the par value is $100,000, the futures price that the buyer and seller agree to for this hypothetical Treasury bond is $97,500 The minimum price fluctuation for the Treasury bond futures contract is 1/32 of 1%, which is referred to as ‘‘a 32nd.’’ The dollar value of a 32nd for $100,000 par value (the par value for the underlying Treasury bond) is $31.25 Thus, the minimum price fluctuation is $31.25 for this contract 364 Source: Chicago Board of Trade Conversion factors Issue Mar 2005 Jun 2005 Sep 2005 Dec 2005 Mar 2006 Jun 2006 Sep 2006 Dec 2006 Mar 2007 Jun 2007 1/4 11/15/28 0.9062 0.9065 0.9071 0.9075 0.9081 0.9084 0.9090 0.9095 0.9101 0.9105 1/4 02/15/29 0.9056 0.9062 0.9065 0.9071 0.9075 0.9081 0.9084 0.9090 0.9095 0.9101 3/8 02/15/31 0.9185 0.9189 0.9191 0.9196 0.9198 0.9203 0.9206 0.9210 0.9213 0.9218 08/15/28 0.9376 0.9381 0.9383 0.9387 0.9389 0.9394 0.9396 0.9400 0.9403 0.9407 02/15/26 0.9999 1.0000 0.9999 1.0000 0.9999 1.0000 0.9999 1.0000 0.9999 1.0000 1/8 11/15/27 1.0153 1.0151 1.0152 1.0150 1.0150 1.0148 1.0148 1.0146 1.0146 1.0144 1/8 08/15/29 1.0158 1.0158 1.0156 1.0156 1.0154 1.0155 1.0153 1.0153 1.0151 1.0152 1/4 08/15/23 1.0274 1.0273 1.0270 1.0269 1.0265 1.0264 1.0261 1.0260 1.0256 1.0255 1/4 05/15/30 1.0322 1.0319 1.0319 1.0316 1.0316 1.0313 1.0313 1.0310 1.0310 1.0307 3/8 08/15/27 1.0456 1.0455 1.0451 1.0450 1.0446 1.0444 1.0441 1.0439 1.0435 1.0433 11/15/26 1.0600 1.0595 1.0593 1.0588 1.0585 1.0580 1.0578 1.0573 1.0570 1.0565 5/8 02/15/27 1.0752 1.0749 1.0744 1.0741 1.0735 1.0732 1.0726 1.0722 1.0716 1.0713 3/4 08/15/26 1.0893 1.0889 1.0882 1.0878 1.0871 1.0867 1.0860 1.0855 1.0848 1.0843 7/8 08/15/25 1.1017 1.1011 1.1003 1.0998 1.0990 1.0984 1.0976 1.0970 1.0961 1.0955 1/8 02/15/23 1.1217 1.1209 1.1197 1.1189 1.1177 1.1168 1.1156 1.1147 1.1135 1.1125 1/4 08/15/22 1.1331 1.1321 1.1308 1.1298 1.1285 1.1274 1.1261 1.1250 1.1236 1.1225 11/15/24 1.1711 1.1697 1.1687 1.1673 1.1663 1.1649 1.1637 1.1623 1.1612 1.1597 5/8 11/15/22 1.1746 1.1730 1.1717 1.1701 1.1687 1.1671 1.1657 1.1640 1.1625 1.1607 5/8 02/15/25 1.1864 1.1853 1.1839 1.1828 1.1813 1.1801 1.1786 1.1774 1.1759 1.1746 7/8 02/15/21 1.1892 1.1875 1.1855 1.1838 — — — — — — 11/15/21 1.2077 1.2056 1.2039 1.2018 1.2000 1.1979 1.1960 — — — 1/8 05/15/21 1.2166 1.2144 1.2125 1.2102 1.2083 — — — — — 1/8 08/15/21 1.2185 1.2166 1.2144 1.2125 1.2102 1.2083 — — — — 3/4 05/15/20 1.2695 — — — — — — — — — 3/4 08/15/20 1.2721 1.2695 — — — — — — — — No of Eligible issues 25 24 23 23 22 21 20 19 19 19 Eligible for Delivery as of May 29, 2002 EXHIBIT U.S Treasury Bond Issues Acceptable for Delivery and Conversion Factors Chapter 13 Interest Rate Derivative Instruments 365 We have been referring to the underlying as a hypothetical Treasury bond The seller of a Treasury bond futures contract who decides to make delivery rather than liquidate the position by buying back the contract prior to the settlement date must deliver some Treasury bond issue But what Treasury bond issue? The CBOT allows the seller to deliver one of several Treasury bonds that the CBOT designates as acceptable for delivery The specific issues that the seller may deliver are published by the CBOT for all contracts by settlement date The CBOT makes its determination of the Treasury bond issues that are acceptable for delivery from all outstanding Treasury bond issues that have at least 15 years to maturity from the date of delivery Exhibit shows the Treasury bond issues that the seller could have selected to deliver to the buyer of the CBOT Treasury bond futures contract as of May 29, 2002 Should the U.S Department of the Treasury issue any Treasury bonds that meet the CBOT criteria for eligible delivery, those issues would be added to the list Notice that for the Treasury bond futures contract settling (i.e., maturing) in March 2005, notice that there are 25 eligible issues For contracts settling after March 2005, there are fewer than 25 eligible issues due to the shorter maturity of each previous eligible issue that results in a maturity of less than 15 years Although the underlying Treasury bond for this contract is a hypothetical issue and therefore cannot itself be delivered into the futures contract, the contract is not a cash settlement contract The only way to close out a Treasury bond futures contract is to either initiate an offsetting futures position, or to deliver a Treasury bond issue satisfying the above-mentioned criteria into the futures contract a Conversion Factors The delivery process for the Treasury bond futures contract makes the contract interesting At the settlement date, the seller of a futures contract (the short) is now required to deliver to the buyer (the long) $100,000 par value of a 6% 20-year Treasury bond Since no such bond exists, the seller must choose from one of the acceptable deliverable Treasury bonds that the CBOT has specified Suppose the seller is entitled to deliver $100,000 of a 5% 20-year Treasury bond to settle the futures contract The value of this bond is less than the value of a 6% 20-year bond If the seller delivers the 5% 20-year bond, this would be unfair to the buyer of the futures contract who contracted to receive $100,000 of a 6% 20-year Treasury bond Alternatively, suppose the seller delivers $100,000 of a 7% 20-year Treasury bond The value of a 7% 20-year Treasury bond is greater than that of a 6% 20-year bond, so this would be a disadvantage to the seller How can this problem be resolved? To make delivery equitable to both parties, the CBOT has introduced conversion factors for adjusting the price of each Treasury issue that can be delivered to satisfy the Treasury bond futures contract The conversion factor is determined by the CBOT before a contract with a specific settlement date begins trading.2 The adjusted price is found by multiplying the conversion factor by the futures price The adjusted price is called the converted price Exhibit shows conversion factors as of May 29, 2002 The conversion factors are shown by contract settlement date Note that the conversion factor depends not only on the issue delivered but also on the settlement date of the contract For example, look at the first issue in Exhibit 1, the 1/4% coupon bond maturing 11/15/28 For the Treasury bond futures contract settling (i.e., maturing) in March 2005, the conversion factor is 0.9062 For the December 2005 contract, the conversion factor is 0.9075 The conversion factor is based on the price that a deliverable bond would sell for at the beginning of the delivery month if it were to yield 6% 366 Fixed Income Analysis The price that the buyer must pay the seller when a Treasury bond is delivered is called the invoice price The invoice price is the futures settlement price plus accrued interest However, as just noted, the seller can deliver one of several acceptable Treasury issues and to make delivery fair to both parties, the invoice price must be adjusted based on the actual Treasury issue delivered It is the conversion factors that are used to adjust the invoice price The invoice price is: invoice price = contract size × futures settlement price × conversion factor + accrued interest Suppose the Treasury March 2006 futures contract settles at 105–16 and that the issue delivered is the 8% of 11/15/21 The futures contract settlement price of 105–16 means 105.5% of par value or 1.055 times par value As indicated in Exhibit 1, the conversion factor for this issue for the March 2006 contract is 1.2000 Since the contract size is $100,000, the invoice price the buyer pays the seller is: $100, 000 × 1.055 × 1.2000 + accrued interest = $126, 600 + accrued interest b Cheapest-to-Deliver Issue As can be seen in Exhibit 1, there can be more than one issue that is permitted to be delivered to satisfy a futures contract In fact, for the March 2005 contract, there are 25 deliverable or eligible bond issues It is the short that has the option of selecting which one of the deliverable bond issues if he decides to deliver.3 The decision of which one of the bond issues a short will elect to deliver is not made arbitrarily There is an economic analysis that a short will undertake in order to determine the best bond issue to deliver In fact, as we will see, all of the elements that go into the economic analysis will be the same for all participants in the market who are either electing to deliver or who are anticipating delivery of one of the eligible bond issues In this section, how the best bond issue to deliver is determined will be explained The economic analysis is not complicated The basic principle is as follows Suppose that an investor enters into the following two transactions simultaneously: buys one of the deliverable bond issues today with borrowed money and sells a futures contract The two positions (i.e., the long position in the deliverable bond issue purchased and the short position in the futures contract) will be held to the delivery date At the delivery date, the bond issue purchased will be used to satisfy the short’s obligation to deliver an eligible bond issue The simultaneous transactions above and the delivery of the acceptable bond issue purchased to satisfy the short position in the futures contract is called a cash and carry trade We will discuss this in more detail in the next chapter where the importance of selecting the best bond issue to deliver for the pricing of a futures contract is explained Let’s look at the economics of this cash and carry trade The investor (who by virtue of the fact that he sold a futures contract is the short), has synthetically created a short-term investment vehicle The reason is that the investor has purchased a bond issue (one of the Remember that the short can always unwind his position by buying the same futures contract before the settlement date Chapter 13 Interest Rate Derivative Instruments 367 deliverable bond issues) and at the delivery date delivers that bond issue and receives the futures price So, the investor knows the cost of buying the bond issue and knows how much will be received from the investment The amount received is the coupon interest until the delivery date, any reinvestment income from reinvesting coupon payments, and the futures price at the delivery date (Remember that the futures price at the delivery date for a given deliverable bond issue will be its converted price.) Thus, the investor can calculate the rate of return that will be earned on the investment In the futures market, this rate of return is called the implied repo rate An implied repo rate can be calculated for every deliverable bond issue For example, suppose that there are N deliverable bond issues that can be delivered to satisfy a bond futures contract Market participants who want to know either the best issue to deliver or what issue is likely to be delivered will calculate an implied repo rate for all N eligible bond issues Which would be the best issue to deliver by a short? Since the implied repo rate is the rate of return on an investment, the best bond issue is the one that has the highest implied repo rate (i.e., the highest rate of return) The bond issue with the highest implied repo rate is called the cheapest-to-deliver issue Now that we understand the economic principle for determining the best bond issue to deliver (i.e., the cheapest-to-deliver issue), let’s look more closely at how one calculates the implied repo rate for each deliverable bond issue This rate is computed using the following information for a given deliverable bond issue: the price plus accrued interest at which the Treasury issue could be purchased the converted price plus the accrued interest that will be received upon delivery of that Treasury bond issue to satisfy the short futures position the coupon payments that will be received between today and the date the issue is delivered to satisfy the futures contract the reinvestment income that will be realized on the coupon payments between the time the interim coupon payment is received and the date that the issue is delivered to satisfy the Treasury bond futures contract The first three elements are known The last element will depend on the reinvestment rate that can be earned While the reinvestment rate is unknown, typically this is a small part of the rate of return and not much is lost by assuming that the implied repo rate can be predicted with certainty The general formula for the implied repo rate is as follows: implied repo rate = 360 dollar return × cost of the investment days1 where days1 is equal to the number of days until settlement of the futures contract Below we will explain the other components in the formula for the implied repo rate Let’s begin with the dollar return The dollar return for an issue is the difference between the proceeds received and the cost of the investment The proceeds received are equal to the proceeds received at the settlement date of the futures contract and any interim coupon payment plus interest from reinvesting the interim coupon payment The proceeds received at the settlement date include the converted price (i.e., futures settlement price multiplied by the conversion factor for the issue) and the accrued interest received from delivery of the issue That is, 368 Fixed Income Analysis proceeds received = converted price + accrued interest received + interim coupon payment + interest from reinvesting the interim coupon payment As noted earlier, all of the elements are known except the interest from reinvesting the interim coupon payment This amount is estimated by assuming that the coupon payment can be reinvested at the term repo rate Later, we describe the repo market and the term repo rate The term repo rate is not only a borrowing rate for an investor who wants to borrow in the repo market but also the rate at which an investor can invest proceeds on a short-term basis For how long is the reinvestment of the interim coupon payment? It is the number of days from when the interim coupon payment is received and the actual delivery date to satisfy the futures contract The reinvestment income is then computed as follows: interest from reinvesting the interim coupon payment = interim coupon × term repo rate × (days2 /360) where days2 = number of days between when the interim coupon payment is received and the actual delivery date of the futures contract The reason for dividing days2 by 360 is that the ratio represents the number of days the interim coupon is reinvested as a percentage of the number of days in a year as measured in the money market The cost of the investment is the amount paid to purchase the issue This cost is equal to the purchase price plus accrued interest paid That is, cost of the investment = purchase price + accrued interest paid Thus, the dollar return for the numerator of the formula for the implied repo rate is equal to dollar return = proceeds received − cost of the investment The dollar return is then divided by the cost of the investment.4 So, now we know how to compute the numerator and the denominator in the formula for the implied repo rate The second ratio in the formula for the implied repo rate simply involves annualizing the return using a convention in the money market for the number of days (Recall that in the money market the convention is to use a 360 day year.) Since the investment resulting from the cash and carry trade is a synthetic money market instrument, 360 days are used Let’s compute the implied repo rate for a hypothetical issue that may be delivered to satisfy a hypothetical Treasury bond futures contract Assume the following for the deliverable issue and the futures contract: Actually, the cost of the investment should be adjusted because the amount that the investor ties up in the investment is reduced if there is an interim coupon payment We will ignore this adjustment here 369 Chapter 13 Interest Rate Derivative Instruments Futures contract futures price = 96 days to futures delivery date (days1 ) = 82 days Deliverable issue price of issue = 107 accrued interest paid = 3.8904 coupon rate = 10% days remaining before interim coupon paid = 40 days interim coupon = $5 number of days between when the interim coupon payment is received and the actual delivery date of the futures contract (days2 ) = 42 conversion factor = 1.1111 accrued interest received at futures settlement date = 1.1507 Other information: 42-day term repo rate = 3.8% Let’s begin with the proceeds received We need to compute the converted price and the interest from reinvesting the interim coupon payment The converted price is: converted price = futures price × conversion factor = 96 × 1.1111 = 106.6656 The interest from reinvesting the interim coupon payment depends on the term repo rate The term repo rate is assumed to be 3.8% Therefore, interest from reinvesting the interim coupon payment = $5 × 0.038 × 42 360 = 0.0222 To summarize: converted price accrued interest received at futures settlement date interim coupon payment interest from reinvesting the interim coupon payment proceeds received = 106.6656 = 1.1507 = 5.0000 = 0.0222 = 112.8385 The cost of the investment is the purchase price for the issue plus the accrued interest paid, as shown below: cost of the investment = 107 + 3.8904 = 110.8904 Index Nondollar-denominated issue, 13 Noninvestment-grade bonds (speculative bonds), 29–30 Non-MBSs, optionality risk, 494–495 Nonrecourse loans, 298 Non-systematic risks, 499–500 components, 501–502 Non-term structure risk factors, 500–501 Non-Treasury securities arbitrage-free value calculation, benchmark spot rate curve (usage), 118e valuation See Credit spread yields, 82–86 Non-U.S interest rates, 90–92 Non-U.S residential MBSs, 318–320 Non-U.S sovereign bond issuers, 43–44 Non-U.S WGBI, 586 Normal distribution, 477 Normal yield curve (positively sloped yield curve), 77, 187 Notes See Reference notes; Step-up notes; U.S Treasury notes Notice day, 370 Notional coupon, 363 Notional IO, 283 tranche, creation, 284e Notional principal (notional amount), 92, 193, 283, 377 Nth-to-default swaps, 692 O OAS See Option-adjusted spread Obligation acceleration, 681–682 Obligation Assimilable du Tr´esor (OATS), 43 Obligation debt See Limited tax obligation debt; Unlimited tax obligation debt Observations, number (determination), 210 OECD See Organization of Economic Cooperation and Development Offshore bond market, 38 Off-the-run Treasury issues, 192 One-factor models, 216 One-year rating transition matrix, example, 31e On-the-run issue (current issue), 40 721 On-the-run Treasury issues, 192 yield/maturity, relationship, 77e On-the-run yield curve See Issuers Open-end HEL, 314 Operating cash flow, 430 repayment, 442 Operating cycle See Company Operation and maintenance fund, 449 Option-adjusted duration, 487 See also Effective duration Option-adjusted spread (OAS), 145–147, 235–237, 337 See also Government National Mortgage Association; Zero-volatility OAS approach, 358 basis points, 349 benchmark/relative value, relationship, 223–225, 224e computation, 344–345 See also Mortgage-backed securities demonstration See Callable bond explanation, 493 interpretation, 344–345 OAS-total return, 517 relationship See Monte Carlo simulation model return, accrual, 531 risk premium, 655 terms, 572–573 Optional clean-up call provision, 313 Optionality risk, 494 See also Non-MBSs Option-based valuation approach, 252–254 Option cost, 146–147, 345 increase, 346 Option delta analysis, 495 Option-free bonds price/discount rate relationship, 100e price volatility characteristics, 160–164 price/yield relationship, 161e, 165e, 168e properties, graphical illustration, 163e tangent line (inclusion), price/yield relationship, 172e valuation binomial interest rate tree, usage, 232–233 maturity/coupon rate, 232e process, 225–226 722 Options, 371, 403–416 contracts, number, 644 calculation, 643–644 coupon interest payment, 405 coupon payments, 406 delta, 414 expected interest rate volatility, 406 futures contracts, contrast, 372–374 gamma, 415 hedging, steps, 641 intrinsic value, 404 positions, payoff See Basic option positions premium, 371, 403 price, 371, 376, 403 components, 404–405 sensitivity, 414–416 pricing models, 407–414 risk/return characteristics, 372 short-term risk-free interest rates, 405 short-term risk-free rate, 406 strike price, 405 time to expiration, 405, 406 time value, 404–405 value, 413 Organization of Economic Cooperation and Development (OECD), 437 Originator, 303 Out-of-the-money option, 404 Outperformance methodologies, 581e Outside directors, 434 Overcollateralization, 311 Overnight repo, 16, 536 Over-the-counter (OTC) options, 376–377 contrast See Exchange-traded options Ownership structure, 440 P PAC See Planned amortization class PaineWebber, empirical duration (usage), 357 Parallel yield curve shift, assumption, 522e Par bond, movement, 103e Par call problem, 12 Parental Loans for Undergraduate Students (PLUS), 323 Index Parent company support agreements, 425 Parity value See Conversion Par value, 3–4, 263, 543 relative price, relationship See Coupon Par yield curve See U.S Treasury Passive portfolio, construction (rebalancing), 525–527 Passive strategies, 472 Passthrough monthly cash flow, 268e, 270e price/mortgage rates, relationship, 295e rate, 261 structure, 325 Passthrough security See Agency passthrough securities; Conventional passthrough securities; Mortgage passthrough securities creation, 50e Payment capacity, analysis, 424–432 obligation, determination, 681 structure See Asset-backed securities; Non-agency MBSs Percentage price change See Interest rate risk approximation, duration (usage), 170–171 Percent of bond call See Bonds Percent of collateral call See Collateral Percent yield spread analysis, 575 Performance attribution analysis, 529 impact, 530–531 summary, 533e attribution example, 532e evaluation, 475 See also Bonds measurement, 475 See also Return risk, 468 Period forward rate, 398, 402e Personal property, 59 Physical delivery, 680 Planned amortization class (PAC) See Busted PAC bonds, 284 collar/band See Initial PAC collar IO, 293 level I/II/III tranches, 292 PAC II tranches, 348 Index structure, 348–351 tranche, 52, 284–292, 316–317 average life, 287e, 289e series, creation, 287–289 Planned amortization class (PAC) window, 289 PLUS See Parental Loans for Undergraduate Students PO See Principal-only Pool factor, 263 Pool-level analysis, 308–309 Portfolio See Barbell portfolio; Bullet portfolio; Ladder portfolio adjustment, 475 assessment, 520–523 constraints, 571 construction, 474, 595–614 inputs, formulation, 473–474 multi-factor risk models, usage, 525–528 credit risk, 493–494 dollar duration, 619 duration, 178–179, 487–489 contribution, 490, 490e immunization, 541 application considerations, 548 interest rate risk, measurement, 487–491 monitoring, 475 risk profile, measurement, 476 strategy development, 471–474, 588–595 implementation, 471–474 variance, 481–482 yield See Gross portfolio yield; Net portfolio yield increase, 578 Position day, 370 liquidation, 361 Positive butterfly, 188 Positive carry, 390 Positive convexity, 166 adjustment, 181 duration changes, 654e price changes, 653e Positively sloped yield curve See Normal yield curve PO strips See Principal-only strips 723 Potential performance (assessment), scenario analysis (usage), 513–525 PPC See Prospectus prepayment curve Predicted tracking error, 486 contrast See Actual tracking error Preferred habitat theory, 81, 204 Preferred stock, Prefinancing cash flow, 431 Premium See Trading at a premium leg, 680 movement, 103e Premium payback period (break-even time), 251 Prepayment, 12, 48 See also Home equity loans; Involuntary prepayment behavior, factors, 271–272 cash flow uncertainty, 260 curve See Prospectus prepayment curve lockout, 300 measurement, 321–322 model, 350e options, 12 penalty points, 300 projection, 340 protection See Two-sided prepayment protection ramp, 314 rate/speed, 130 See also Conditional prepayment rate measurement, 263–269 risk, 26–27, 48, 496–498, 659 sensitivity, 496 tranching (time tranching), 306 Prerefunded bonds, 55–56 Prerefunded municipal bonds, 55 Present value, 99 See also Cash flow; Maturity calculation See Floating-rate payments; Interest rate paths properties, 99–100 Present value of cash flow (PVCF), 551 Present value of liabilities (PVL), 555 Price See Clean price; Dirty price; Full price changes (estimation), duration (usage), 171–173 compression, 27 724 Price See Clean price; Dirty price; Full price (contd.) estimation, tangent line (usage), 173e volatility See Bonds yield level, impact, 184e Price value of basis point (PVBP), 182–183, 618 Price-yield relationship, 651 Primary market See Bonds analysis, 512 impact, 566–567 Prime borrowers, 297 See also Subprime borrowers Prime grade, meaning, 29 Principal, 435 Principal amortization period, 308 Principal cash flow, distribution, 331 Principal-only (PO) class, 294 key rate duration profiles, 658e mortgage strips, 294, 657 strips, 294–295 Principal pay down window (principal window), 275–276 Principal payment See Scheduled principal payment distribution, 273 Principal strips, 42 Principal value, Principal window, 309 Priority-of-revenue claims, 450 Private Export Funding Corporation, 44 Probability distribution, 478e properties, 477 Proceeds received, 367 Product structure, effect, 567 Profitability ratios, 425–426 Pro rata basis, Prospectus prepayment curve (PPC), 314–315 Protection end-buyers, 674 end-sellers, 674 leg, 680 Protective put buying strategy, 638–639 futures options, usage, 641–646 strike prices, inclusion, 539e Index Proxy hedged expected return, 603 usage, 615–616 Proxy hedged strategy, excess currency, 607 Proxy hedging, 602, 603 PSA See Public Securities Association Public credit enhancement programs, support See Debt obligations Public Securities Association (PSA) graphical depiction, 266e prepayment benchmark, 265–267, 496 speed, 275 Purchasing power risk, 34 Pure bond index strategy, 504–505 Pure expectations theory, 79–80, 197–203 drawbacks, 198 interpretations, 198–203 local expectations form, 199–202 Put, 371 option, 371, 384e price, 13 provision, 13 Putable bond nodes, highlighting, 241e price/yield relationship, 168e valuation, 240–243 maturity/coupon rate, inclusion, 241e Putable/callable issue, valuation, 242e Putables, 578–579 PVBP See Price value of basis point PVCF See Present value of cash flow PVL See Present value of liabilities Q Quality analysis, 494e Quality option, 370 Quality spread, 84 Quality-spread analysis, 575 Quality tests, 332 Quarterly swap premium payment, 684 Quick ratio, 427 Quoted margin, R Range notes, 64 Rapid amortization provision See Early amortization Rate basis, 626 Rate covenants, 450 Index Rate duration, 26, 204 See also Key rate duration Rate shocks, 173–175 duration estimates, 174e Rating agencies, 29 factors, 445–447 outlook, 422 process, 422 Rating transition matrix, 31 example See One-year rating transition matrix Ratios, 425–432 See also Debt and coverage ratios; Profitability ratios Real estate ABSs, 302 Real property, 59 Real return bonds, 43 Real yield, 594–595 Receivables, portfolio (performance), 326 Reconstitution, arbitrage-free valuation (relationship), 114–115 Recovery rate, 28, 60–62 Redemption price, 9–11 See also Make-whole redemption price contrast See Regular redemption prices value, Reduced form models, 455–456 See also Credit risk Reference asset, 332 Reference bonds, 45 Reference entity, 679 Reference notes, 45 See also Callable Reference Notes Reference obligation credit spread, 688–690 Reference obligation, 679 Reference rate, 194, 393 Refinancing, 442 burnout, 271 incentive, 271 Refunding provision, 9–12 Regular auction cycle/multiple-price method, 39 Regular auction cycle/single-price method, 39 Regular redemption prices, special redemption prices (contrast), 12 725 Regulatory environment, 425 Regulatory risk, 36 Reinvestment income, 120, 543e change, 544e, 547e total dollar return, percentage See Bonds Reinvestment rate, 514 Reinvestment risk, 27–28, 126 factors, 126–127 Relative value, 564 See also Securities analysis, 564 See also Classic relative value analysis relationship See Benchmark application, interpretation, 344–345 assessment See Securities capture, 651 problem, 651–655 methodologies, 564–565 relationship See Option-adjusted spread strategies, 507 Relative yield spread, 82 Renewal and replacement fund, 449 Reorganization See Liquidation Repo margin, 538 Repo rate, 16, 536 determinants, 539 Repudiation/moratorium, 682 Repurchase agreement, 16 date, 536 price, 16, 536 Reserve funds, 310 Reserve maintenance fund, 449 Reset notes, 441 Residential MBSs, 256 See also Non-U.S residential MBSs; United Kingdom Residential mortgage loans, 257–260 Residual error, 530 Residual loss, 435 Restricted subsidiaries, 433 Restructuring, 682 Return achievement See Immunization attribution analysis, 475 components, 596–601 objectives, 463–468 performance measurement, 529–530 sources, 119–120 variance, 477 726 Revenue bonds, 53, 55 basic security , limits, 449 flow of funds structure, 449–450 issuance, 449 Revenue fund, 449 Reverse cash/carry trade, 387e, 388 Reverse floaters See Inverse floaters Revolving period See Lockout period Revolving structure, 308 Risk factor, 688–689 Risk-free return, 531 RiskMetrics (J.P Morgan), 479 R-squared (R2 ), 190 Rural Electrification Administration, 44 Rural Telephone Bank, 44 S Safety net level return, 551 SBA See Small Business Administration Scarcity value, 567 Scenario analysis, 157 illustration, 518e, 519e performance, comparison, 524e usage, 518–519 See also Potential performance Scheduled amortization, 258 Scheduled principal payment, 46 Scheduled tranche, 292 Seasonality, 572 Seasoned security, 314 Seasoning, 272 Secondary market See Bonds Secondary trade rationales, 568–572 Second-to-default basket swap, 692 Sector/credit/security selection, 592 Sector rotation See Asset allocation/sector rotation Sector-rotation trades, 569 Secured debt, 59–60 Securities See Amortizing securities; Federal agency securities; Floating-rate securities; Seasoned security; U.S Treasury; Variable-rate securities cash flows, 97 issuer, market price, 405 price, strike price/intrinsic value (relationship), 405e Index private placement, 71–72 relative value, 474 assessment, 219 risk See U.S Treasury selection, 614 strategies See Individual security selection strategies universe, acceptance, 556 valuation, 359 Securitization, 302 illustration, 304e parties, 304–305 transaction, 303–304 Securitized mortgage, 49, 260 Seller, 371 quality, 446 Sell hedge, 621 Selling short, 522 Semiannual bonds, annual-pay bonds (comparison), 127–128 Semiannual cash flows, valuation, 104–106 Semiannual coupon payment, 105 Semiannual-pay bonds, 515 Semiannual total return, computation, 515 Semi-government bonds, 44–52 Semivariance, 480 See also Target semivariance Senior basket credit default swaps, 692–693 Senior basket default swaps, 693 Senior debts, 441 Senior prepayment percentage, 312 Senior subordinated debt, 441 Senior-subordinate structure, 306, 311–312 Senior tranches See Non-accelerating senior tranches Separate Trading of Registered Interest and Principal Securities (STRIPS), 42 See also Treasury STRIPs Sequential-pay CMOs, 273 Sequential-pay tranches, 273–277 Servicer, quality, 446 Servicing, 303 fee, 259–260 Settlement date, 361 methods, 680–681 Shareholder rights, 440 Shifting interest mechanism, 312 Index Shortfall risk, 480–481 Short futures, 363 Short hedge, 621 Short position, 363 Short-term forward rates curve, 150, 200e graph, 151e relationship See Spot rate Short-term interest rate (financing rate), 390–391 increase, 613 relationships, recasting, 604–605 Short-term risk-free interest rates, 595 See also Options Short-term solvency ratios, 426–427 Short-term trading strategies, 507 Simple margin, 132 Single call price, call date (irrelevance), 9–10 Single-index performance evaluation measures, 530 Single liability, immunization strategy, 541–551 illustration, 542–547 Single monthly mortgage (SMM) rate, 264–265, 321 Single-name credit default swap, 679 illustration, 683–684 Single step-up noncallable note, valuation, 243e, 244e Single step-up note, Sinking fund, 449, 578 provision, 8, 12–13 See also Accelerated sinking fund provision requirement, 12 Skewed distributions, 478 SLABS See Student loan-backed securities SLS See Supplemental Loans to Students Small Business Administration (SBA), 44 loan-backed securities, 324 SMM See Single monthly mortgage Soft bullet, 309, 326 Soft put, 249 Sovereign bonds, 39–44 reference, 451 Sovereign ratings, 39 Sovereign risk, 36 Special bond structures, 55–56 Special collateral, 539 727 Special event risk, 425 Specialized U.S bond market indexes, 467 Special purpose vehicle (SPV) (special purpose corporation), 68–69, 303 Special redemption price, contrast See Regular redemption prices Speculative bonds See Noninvestment-grade bonds Speculative grade, meaning, 29 Spot exchange rate, 597 Spot rate, 82, 119 See also Theoretical spot rates; U.S Treasury curve See Benchmark spot rate curve construction See London Interbank Offered Rate yield spread measure, relationship, 140–147 hypothetical curves, 144e shift, 206 short-term forward rates, relationship, 151–152 usage, 154e Spread, 463 See also Yield spread analysis, 572–575 call risk, impact, 512–513 change return, 531 credit risk, impact, 512 measures interpretation, 220–221 summary, 147 prepayment risk, impact, 512–513 products, 82 risk, 492–493, 655–656 sectors, 82 tools, 574–575 widening, 612 Spread duration See Bond portfolio contribution, 510 corporate sector recommendation, 511e MBS sector recommendation, 511e measures, types, 492–493 Spread for life, 132 SPV See Special purpose vehicle Stakeholders, 436 corporate governance, relationship, 436 relations, 440 728 Standard deviation, 477–479 annualizing, 210–211 calculation See Daily standard deviation measures, review, 476–482 usage, yield estimation (usage), 212 Standard & Poor’s Corporation, 29 analysis, 429 Governance Metrics/Score, 439 observations, 448 sovereign ratings methodology profile, 452e Stated conversion price, 248 State/local governments, entities, 53–56 Statement of cash flows See Cash flow Static return, 531 Static spread, 142, 337 explanation, 493 Step-up callable note, valuation, 243–244 Step-up notes, 4–5 See also Multiple step-up note; Single step-up note Story disagreement, 571–572 Straight value (investment value), 249 Strategic allocation, 593 Strategic strategies, 507 Stratified sampling, 505, 506 technique, 506 Stress testing, 160 Strike price, 371, 406 See also Federal National Mortgage Association bond relationship See Securities selection, 642–643 Strike rate, 382 Stripped MBSs, 294–296 trading/settlement procedures, 296 Stripping, arbitrage-free valuation (relationship), 113–114 STRIPS See Separate Trading of Registered Interest and Principal Securities Structural analysis, 575–579 Structural models See Credit risk Structural protection, 301 Structured credit products, 691 Structured financial products, 256 Structured interest-only tranches (structured IOs), 282–284 Structured MTNs, 63–64 Structured portfolio strategies, 472 Index Structure trades, 513 involvement, 570 Student loan-backed securities (SLABS), 322–324 cash flow, 323–324 issuers, 323 Student Loan Marketing Association, 44 Subordinate basket default swaps, 693 Subordinate credit default swaps, 692–693 Subordinated debenture bonds, 59 Subordinated debt, 441 Subordinate interest, 312 Subordination, level, 312 Subprime borrowers, 297 Subsidiaries See Restricted subsidiaries; Unrestricted subsidiaries Substitution swap, 513 Supplemental Loans to Students (SLS), 323 Support tranche (companion tranche), 52, 284, 292 average life, 287e structure, 348–351 Supranation, l38 Surplus fund, 449 Surveillance, 422 Swap curve (LIBOR curve), 193–196 advantages See Government bond yield curve elements, 183–185 usage increase, reasons, 195–196 Swap rate, 92, 377 calculation, 397–401 determination, 400–401 formula, denominator (calculation), 401e Swaps agreement, counterparty description, 381–382 counterparty, 330 dealer, 379 dollar duration, 636–637 elements, 193–195 entering, 378–379 fixed rate, 193 initiation, 393 nomenclature, option nomenclature (contrast), 685 notional amount, 393 option, 370 Index payment, computation, 392–397 position, interpretation, 379–381 term, 393 valuation, 378e, 403e calculation, 401–403 Swap spreads, 92–96, 194, 377, 401 credit spreads, trailing correlation, 95e curve, 96 See also Germany; Japan; United Kingdom; United States determinants, 95–96 examination, 573–574 relationship See Interest rate swaps Synthetic CDOs, 328, 332–334, 691–692 elements, 332–334 Systematic risks, 499–500 components, 500–501 T Tactical allocation, 593 Tactical strategies, 507 Tangent line inclusion See Option-free bonds usage See Price Target amortization class (TAC) tranches, 293–294 Target dollar duration, 618–619 Target duration, 618 Target price, 622 basis, 627 Target rate, 622 Target rate basis, 626 Target return, 479 Target semivariance, 480 Taxable-equivalent yield, 88–89 Tax-backed debt, 53–55 See also Municipal bonds issues See U.S municipal securities market Tax-equivalent yield, 89 Tax-exempt securities, 53 TBA trade See To-be-announced trade TCL See The Corporate Library Technical analysis, 595 Technical factors, 89 Technical indicators, 594–595 Technicals, 595 Temporal definitions, impact, 178 Tennessee Valley Authority (TVA), 44 729 Terminal value, 552 Term repo, 16, 536 rate, 368 Term structure risk, 500 Term to maturity, The Corporate Library (TCL), 440–441 Then-current futures price, 375 Theoretical futures price arbitrage model, usage, 389–390 examination, 390–392 Theoretical spot rates, 135–147 construction See U.S Treasury curve, 140 Treasury yield curve, relationship, 141e Theoretical value, determination, 342–343 Theta, calculation, 415 Third-party guarantee, 60 TIIS See Treasury Inflation Indexed Securities Time tranching See Prepayment Time value, 404–405 See also Options Timing option, 370 TIPS See Treasury Inflation Protection Securities To-be-announced (TBA) trade, 262 Top-down approach, 564 Top down value added strategies, 507 Total accumulated value, 543e–546e Total debt to capitalization ratio, 428 Total dollar return, 122 receiving, 125 Total future dollars, 122 receiving, 125 Total return, 543e–546e See also Investment horizon analysis, 565–566 calculation, graphical depiction, 515e computation, 514–519 illustration, 516 index swap, 677 payer, 677 receiver, 677 swap, 677–679 benefits, 679 illustration, 677–678 Total-return oriented investor, 584 730 Total tangible assets, 454 Tracking error, 469, 482–486 calculation, 483e contrast See Actual tracking error measurement, 482–485 minimization, 505, 506 prediction, 528e Traded flat See Bonds Traders, experience See Experienced trader Trades assessment, 514–523 interest rate risk, control, 519–520 Trading constraints, 571–572 reasons, 568–571 return, 531 strategy, performance, 522e, 523e Trading at a discount, Trading at a premium, Tranches, 51 See also Non-accelerating senior tranches; Planned amortization class; Scheduled tranche; Support tranche average life, 278 C/D, 351 creation See Notional IO monthly cash flow, 279e usage, 355 Transaction structure, classification, 307–308 Transition matrix, example See One-year rating transition matrix Transparency disclosure, 440 Treasury Inflation Indexed Securities (TIIS), 41 Treasury Inflation Protection Securities (TIPS), 6, 41, 76 Treasury securities See Fixed-principal Treasury securities; Inflation-indexed Treasury securities; U.S Treasury securities creation See Zero-coupon Treasury securities Treasury STRIPs, 42–43 Trigger point, 553 Trinomial models, 217 Index Trustee (trustee agent), 305 TVA See Tennessee Valley Authority Two-bond hedge, 662 computation, 662–664 contrast See Duration finding, 665–667 illustrations, 664–671 long position, inclusion, 665–668 short position, inclusion, 665–668 illustration, 668–670 Two-factor models, 216 Two-sided prepayment protection, 284 Type-III liability, 465 Type-II liability, 465 Type-I liability, 464–465 Type-IV liability, 465 U Underlying, delivery, 361 Underlying bond call option price, 414–415 price, 414–415 Underwriting standards, 303 Unhedged expected return, 602, 604 usage, 614 Unhedged international bond portfolios, risk-return, 587e Unhedged returns, 587e Unhedged strategy, excess currency return, 606 United Kingdom (UK) gilt yield curve, 91e residential MBSs, 318–319 swap spread curves, 96e United States (US) daily swap spreads, 96e swap spread curves, 96e Unleveraged strategy, 533 Unlimited tax obligation debt, 54 Unrestricted active management, 507 Unrestricted subsidiaries, 433 Unsecured debt, 59–60 Upgrade, 30 Upper medium grade, meaning, 29 Upward sloping yield curve, 77 731 Index U.S agency debentures/discount notes, 45–46 U.S agency MBSs, 46–52 U.S aggregate core portfolio, portfolio recommendation, 508e U.S bond market indexes See Broad-based U.S bond market indexes; Specialized U.S bond market indexes U.S credit rolling Sharpe Ratio, 563e U.S federal agency securities, overview, 45e U.S investment-grade credit index excess returns, 562e U.S investment-grade credit markets, composition (change), 576e U.S investment-grade curves, illustration, 580e U.S investors, perspective, 586 U.S municipal securities market, tax-backed debt issues, 53e U.S Treasury arbitrage-free value, determination, 112e, 113e bills, 75 yield, 133–135 coupon securities/bills, 192–193 coupon strips, 191–192 debt instruments, overview, 40e equivalent position, 662 hypothetical yields, 137e issue hedge held to delivery, 624e issues See Off-the-run Treasury issues; On-the-run Treasury issues market benchmark, 221 notes, 41, 75 futures, 371 par yield curve, 138e, 200e portfolios, key rate duration profile, 208e price, discount rate valuation, 115e, 116e rates, 75–82 returns, yield curve movements (impact), 189–190 securities, 521e spot rate, 82, 111 usage See Valuation usage reason, 113–115 stripping, arbitrage profit, 116e strips, 81–82 theoretical spot rate, construction, 190–193 yield curve, 77–81 changes, 518e, 519e examination, 186–189 illustration, 78e Zero, daily yield change (moving average), 213e U.S Treasury bonds, 41, 75 futures, 363–370 issues, delivery/conversion factors (acceptance), 364e market value, 623 valuation, 412e U.S Treasury securities, 40–43 cash flows, 110e risks, 76–77 stripping, 81 valuation, traditional approach/arbitrage-free approach (comparison), 111e User-charge covenants, 450 V Valuation approach See Arbitrage-free valuation approach forward rates, usage, 152–155 models, 117–118, 145–146 multiple discount rates, usage, 102–104 principles, 97–109 traditional approach, 109–110 comparison See U.S Treasury securities Treasury spot rates, usage, 112–113 valuation Value added strategies, 507 Value-at-Risk (VaR), 481 framework, 184 Value indicators, 594–595 732 Variable-rate securities, Variance, 477 See also Return Variation margin, 362 Vega, calculation, 416 Volatility See Yield volatility arbitrage-free value, relationship, 234–235 assumption, 339 contrast See Historical volatility reduction, 348 risk, 34–35, 659 sectors, 572 Voluntary bankruptcy, 57 W WAC See Weighted average coupon WAM See Weighted average maturity Washington Metropolitan Area Transit Authority, 44 Weighted average coupon (WAC) rate, 261, 267, 274 Weighted average life (average life), 269–270, 309 Weighted average maturity (WAM), 261, 267, 274, 309 WGBI See Citigroup World Government Bond Index Whole-loan CMOs, 297 Wild card option, 370 Working capital maintenance provisions, 433 World bond indexes, 467 Writer, 371 W.T Grant, financial statements, 429 Y Yield See After-tax yield; Cash flow yield; Current yield; Non-Treasury securities; Taxable-equivalent yield beta, 632 curve-adjustment trades, 570 estimation, usage See Standard deviation maintenance charge, 300 maturity, relationship See On-the-run Treasury issues measures, 119 limitations, 608 Index ratio, 83 traditional measures, 120–135 Yield curve, 3, 23 See also Flat yield curve; Humped yield curve; Inverted yield curve; Normal yield curve; Upward sloping yield curve; U.S Treasury butterfly shift, 189e flattening, 188 movements, impact See U.S Treasury nonparallel shift, 25e, 26e, 188, 189e parallel shift, 25e, 188, 189e risk, 23–26, 656–659 composition, example, 24e measurement, 204–207, 491–492 shape, 186–188 illustration, 186e shifts, 188–189 impact, 657 types, 189e slope, twist, 188 steepening, 188 assumption, 523e strategies, 509–510 twists, 189e Yield level, impact, 20 Yield spread, 29 See also Absolute yield spread; Government National Mortgage Association; Relative yield spread change, refinement, 631–632 measures, relationship See Spot rate understanding, 74 Yield/spread pickup trades, 568 Yield to call, 128–129 Yield to first par call, 128 Yield to maturity, 121–128 measure, limitations, 122–126 Yield to next call, 128 Yield to put, 129–130 Yield to refunding, 128 Yield to worst, 130 Yield volatility forecasting, 212–214 importance, 183–184 measurement, 207–214 See also Historical yield volatility 733 Index Z Z bond See Accrual tranches Zero-coupon bonds, valuation, 106 Zero-coupon Treasury securities, creation, 42e Zero-volatility OAS, 146 Zero-volatility spread (Z-spread), 141–145, 337–338 approach, 358 determination, 143e explanation, 493 illustration, 144e increase, 346 nominal spread, divergence, 143–145 relationship See Benchmark Zeta model, 454 ... days/ 360 × notional 24 ,749,4 12 24,764,618 24 ,748,981 24 ,454,011 23 ,6 32, 899 23 ,595,477 23 ,544,891 23 ,23 3,179 22 , 425 ,368 22 ,363, 622 22 ,28 7,568 21 ,964 ,25 5 28 1,764 ,28 1 Let’s apply the formula to... 1/8 05/15 /21 1 .21 66 1 .21 44 1 .21 25 1 .21 02 1 .20 83 — — — — — 1/8 08/15 /21 1 .21 85 1 .21 66 1 .21 44 1 .21 25 1 .21 02 1 .20 83 — — — — 3/4 05/15 /20 1 .26 95 — — — — — — — — — 3/4 08/15 /20 1 .27 21 1 .26 95 — — —... 1, 027 ,7 32 1, 126 ,079 1,154 ,22 9 1,158,0 12 1,186,8 52 1 ,21 2,5 62 1 ,21 9,7 42 1 ,21 0,970 1 ,22 9,999 1 ,25 9 ,24 8 1 ,26 5,141 14,0 52, 917 400 Fixed Income Analysis Determination of the Swap Rate The fixed- rate payer will