Handbook of Fixed-Income Securities

A comprehensive guide to the current theories and methodologies intrinsic to fixed-income securitiesWritten by well-known experts from a cross section of academia and finance, Handbook of Fixed-Income Securities features a compilation of the most up-to-date fixed-income securities techniques and methods. The book presents crucial topics of fixed income in an accessible and logical format. Emphasizing empirical research and real-life applications, the book explores a wide range of topics from the risk and return of fixed-income investments, to the impact of monetary policy on interest rates, to the post-crisis new regulatory landscape. Well organized to cover critical topics in fixed income, Handbook of Fixed-Income Securities is divided into eight main sections that feature:* An introduction to fixed-income markets such as Treasury bonds, inflation-protected securities, money markets, mortgage-backed securities, and the basic analytics that characterize them* Monetary policy and fixed-income markets, which highlight the recent empirical evidence on the central banks' influence on interest rates, including the recent quantitative easing experiments* Interest rate risk measurement and management with a special focus on the most recent techniques and methodologies for asset-liability management under regulatory constraints* The predictability of bond returns with a critical discussion of the empirical evidence on time-varying bond risk premia, both in the United States and abroad, and their sources, such as liquidity and volatility* Advanced topics, with a focus on the most recent research on term structure models and econometrics, the dynamics of bond illiquidity, and the puzzling dynamics of stocks and bonds* Derivatives markets, including a detailed discussion of the new regulatory landscape after the financial crisis and an introduction to no-arbitrage derivatives pricing* Further topics on derivatives pricing that cover modern valuation techniques, such as Monte Carlo simulations, volatility surfaces, and no-arbitrage pricing with regulatory constraints* Corporate and sovereign bonds with a detailed discussion of the tools required to analyze default risk, the relevant empirical evidence, and a special focus on the recent sovereign crisesA complete reference for practitioners in the fields of finance, business, applied statistics, econometrics, and engineeringHandbook of Fixed-Income Securities is also a useful supplementary textbook for graduate and MBA-level courses on fixed-income securities, risk management, volatility, bonds, derivatives, and financial markets.Pietro Veronesi, PhD, is Roman Family Professor of Finance at the University of Chicago Booth School of Business, where he teaches Masters and PhD-level courses in fixed income, risk management, and asset pricing. Published in leading academic journals and honored by numerous awards, his research focuses on stock and bond valuation, return predictability, bubbles and crashes, and the relation between asset prices and government policies.

Notes on Contributors xixPreface xxvPART I FIXED INCOME MARKETS 11 Fixed Income Markets: An Introduction 31.1 Introduction 31.2 U.S. Treasury Bills, Notes, and Bonds 71.3 Interest Rates, Yields, and Discounting 81.4 The Term Structure of Interest Rates 91.5 Pricing Coupon Notes and Bonds 171.6 Inflation-Protected Securities 191.7 Floating Rate Notes 221.8 Conclusion 24References 242 Money Market Instruments 252.1 Overview of the Money Market 252.2 U.S. Treasury Bills 262.3 Commercial Paper 272.4 Discount Window 292.5 Eurodollars 292.6 Repurchase Agreements 322.7 Interbank Loans 352.8 Conclusion 40References 403 Inflation-Adjusted Bonds and the Inflation Risk Premium 413.1 Inflation-Indexed Bonds 413.2 Inflation Derivatives 423.3 No-Arbitrage Pricing 433.4 Inflation Risk Premium 433.5 A Look at the Data 453.6 Conclusion 503.7 Appendix 503.8 Data Appendix 51References 524 Mortgage-Related Securities (MRSs) 534.1 Purpose of the Chapter 534.2 Introduction to MRSs 544.3 Valuation Overview 574.4 Analyzing an MRS 624.5 Summary 72References 73PART II MONETARY POLICY AND FIXED INCOME MARKETS 755 Bond Markets and Monetary Policy 775.1 Introduction 775.2 High-Frequency Identification of Monetary Policy Shocks 785.3 Target Versus Path Shocks 845.4 Conclusions 90References 916 Bond Markets and Unconventional Monetary Policy 936.1 Introduction 936.2 Unconventional Policies: The Fed, ECB, and BOE 946.3 Unconventional Policies: A Theoretical Framework 1016.4 Unconventional Policies: The Empirical Evidence 1046.5 Conclusions 115References 116PART III INTEREST RATE RISK MANAGEMENT 1177 Interest Rate Risk Management and Asset Liability Management 1197.1 Introduction 1197.2 Literature Review 1207.3 Interest Rate Risk Measures 1207.4 Application to Asset Liability Management 1277.5 Backtesting ALM Strategies 1417.6 Liability Hedging and Portfolio Construction 1427.7 Conclusions 1447.8 Appendix: The Implementation of Principal Component Analysis 145References 1468 Optimal Asset Allocation in Asset Liability Management 1478.1 Introduction 1478.2 Yield Smoothing 1508.3 ALM Problem 1518.4 Method 1558.5 Single-Period Portfolio Choice 1568.6 Dynamic Portfolio Choice 1608.7 Conclusion 1648.8 Appendix: Return Model Parameter Estimates 1658.9 Appendix: Benchmark Without Liabilities 165References 166PART IV THE PREDICTABILITY OF BOND RETURNS 1699 International Bond Risk Premia 1719.1 Introduction 1719.2 Literature Review 1729.3 Notation and International Bond Market Data 1749.4 Unconditional Risk Premia 1749.5 Conditional Risk Premia 1779.6 Understanding Bond Risk Premia 1859.7 Conclusion and Outlook 187References 18910 Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity 19110.1 Introduction 19110.2 Brief Literature Review 19210.3 Bond Data and Definitions 19310.4 Estimating the Liquidity Differential Between Inflation-Indexed and Nominal Bond Yields 19410.5 Bond Excess Return Predictability 20110.6 Conclusion 206References 20811 U.S. Treasury Market: The High-Frequency Evidence 21011.1 Introduction 21011.2 The U.S. Treasury Markets During the Financial Crisis 21111.3 The Reaction of Bond Prices and Interest Rates to Macroeconomic News 21711.4 Market-Microstructure Effects 22811.5 Bond Risk Premia 23211.6 The Impact of High-Frequency Trading 23411.7 Conclusions 236References 236PART V ADVANCED TOPICS ON TERM STRUCTURE MODELS AND THEIR ESTIMATION 23912 Structural Affine Models for Yield Curve Modeling 24112.1 Purpose and Structure of This Chapter 24112.2 Structural Models 24212.3 A Simple Taxonomy 24212.4 Why do we Need No-Arbitrage Models After All? 24312.5 Affine Models and the Drivers of The Yield Curve 24412.6 Introducing No-Arbitrage 24712.7 Which Variables Should One use? 24712.8 Risk Premia Implied by Affine Models with Constant Market Price of Risk 24912.9 Testable Predictions: Constant Market Price of Risk 25112.10 What Do We Know About Excess Returns? 25112.11 Understanding the Empirical Results on term Premia 25212.12 Enriching the First-Generation Affine Models 25412.13 Latent Variables: The D'Amico, Kim, and Wei Model 25412.14 From Linear Regressors to Affine Models: the ACM Approach 25512.15 Affine Models using Principal Components as Factors 25612.16 The Predictions from the "Modern" Models 25812.17 Conclusions 261References 26313 The Econometrics of Fixed-Income Markets 26513.1 Introduction 26513.2 Different Types of Term Structure Models 26613.3 Parametric Estimation Methods 26913.4 Maximum Likelihood Estimation 27213.5 Constructing the Likelihood Function: Expansion of the Transition Density 27513.6 Concluding Remarks 278References 27914 Recent Advances in Old Fixed-Income Topics: Liquidity, Learning, and the Lower Bound 28214.1 Introduction 28214.2 Liquidity 28314.3 Learning 29114.4 Lower Bound 30114.5 Conclusion 30914.6 Appendix: Moments of Truncated Bivariate Distribution 310References 31115 The Economics of the Comovement of Stocks and Bonds 31315.1 Introduction 31315.2 A Brief Literature Survey 31315.3 The Stock-Bond Covariance and Learning about Fundamentals 31515.4 Beliefs from Surveys and from the Model 31915.5 Survey and Model Beliefs and the Stock-Bond Covariance 31915.6 Some International Evidence 32215.7 Summary 325References 325PART VI DERIVATIVES: MARKETS AND PRICING 32716 Interest Rate Derivatives Products and Recent Market Activity in the New Regulatory Framework 32916.1 Introduction 32916.2 Background on the New Derivatives Regulatory Framework 33116.3 Exchange-Traded Derivatives 33516.4 Noncleared Swaps 34116.5 Cleared Swaps 35416.6 Comparative Market Activity Across Execution Venues 36016.7 Liquidity Fragmentation in Nondollar Swaps 36616.8 Prospects for the Future 36816.9 Appendix: The New Regulatory Framework for Interest Rate Derivatives in the United States and EuropeanUnion 371References 38517 Risk-Neutral Pricing: Trees 38917.1 Introduction 38917.2 Binomial Trees 38917.3 Risk-Neutral Pricing on Multistep Trees 39417.4 From Diffusion Models to Binomial Trees 40317.5 Trinomial Trees 406References 41318 Discounting and Derivative Pricing Before and After the Financial Crisis: An Introduction 41418.1 Introduction 41418.2 Forward Rate Agreements (FRAs) 41518.3 Overnight Index Swaps (OISs) 42218.4.1 LIBOR Discount Curve with Single-Curve Pricing 42618.5 The Crisis and the Double-Curve Pricing of LIBOR-Based Swaps 42618.6 The Pricing of LIBOR-Based Interest Rate Options 43018.7 Conclusions 433References 433PART VII ADVANCED TOPICS IN DERIVATIVES PRICING 43519 Risk-Neutral Pricing: Monte Carlo Simulations 43719.1 Introduction 43719.2 Risk-Neutral Pricing 43719.3 Risk-Neutral Pricing: Monte Carlo Simulations 44619.4 Valuation by Monte Carlo Simulation 45119.5 Monte Carlo Simulations in Multifactor Models 46119.6 Conclusion 467References 46720 Interest Rate Derivatives and Volatility 46920.1 Introduction 46920.2 Markets and the Institutional Context 46920.3 Dissecting the Instruments 47320.4 Evaluation Paradigms 47920.5 Pricing and Trading Volatility 48720.6 Conclusions 50720.7 Appendix 508References 51221 Nonlinear Valuation under Margining and Funding Costs with Residual Credit Risk: A Unified Approach 51421.1 Introduction 51421.2 Collateralized Credit and Funding Valuation Adjustments 51621.3 General Pricing Equation Under Credit, Collateral, and Funding 52221.4 Numerical Results: Extending the Black-Scholes Analysis 52721.5 Extensions 53521.6 Conclusions: Bilateral Prices or Nonlinear Values? 536References 537PART VIII CORPORATE AND SOVEREIGN BONDS 53922 Corporate Bonds 54122.1 Introduction 54122.2 Market and Data 54222.3 A Very Simple Model 54422.4 Structural Models 54622.5 Reduced-form Models 55022.6 Risk Premia in Intensity Models 55422.7 Dealing with Portfolios 55622.8 Illiquidity as a Source of Spreads 55722.9 Some Additional Readings 55822.10 Conclusion 559References 55923 Sovereign Credit Risk 56123.1 Introduction 56123.2 Literature Review 56323.3 Modeling Sovereign Default 56423.4 Credit Risk Premia 56823.5 Estimating Intensity Models 56923.6 Application to Emerging Markets 57023.7 Application to the European Debt Crisis 57523.8 Conclusion 58023.9 Appendix: No Arbitrage Pricing 58023.9.1 The Risk-Neutral Default Intensity 583References 584Index 587