Choudhry. Fixed Income Securities Derivatives Handbook
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13 Hybrid Securities 227
Floating-Rate Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
Inverse Floating-Rate Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
Hedging Inverse Floaters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233
Indexed Amortizing Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234
Advantages for Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236
Synthetic Convertible Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
Investor Benets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
Interest Differential Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
Benets for Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
14 Securitization and Mortgage-Backed Securities 241
Reasons for Undertaking Securitization . . . . . . . . . . . . . . . . . . . . . . . . . . 242
Market Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
Securitizing Mortgages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
Growth of the Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
Types of Mortgages and Their Cash Flows . . . . . . . . . . . . . . . . . . . . . . . 245
Mortgage Bond Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
Types of Mortgage-Backed Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
Cash Flow Patterns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
Prepayment Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
Prepayment Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
Collateralized Mortgage Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
Sequential Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
Planned Amortization Class . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
Targeted Amortization Class . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
Z-Class Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
Interest-Only and Principal-Only Classes . . . . . . . . . . . . . . . . . . . . . . . . 261
Nonagency CMO Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
Credit Enhancements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
Commercial Mortgage-Backed Securities . . . . . . . . . . . . . . . . . . . . . . . . 265
Issuing a CMBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
Types of CMBS Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
Evaluation and Analysis of Mortgage-Backed Bonds . . . . . . . . . . . . . . . 267
Term to Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
Calculating Yield and Price: Static Cash Flow Model . . . . . . . . . . . . . . . 268
Bond Price and Option-Adjusted Spread . . . . . . . . . . . . . . . . . . . . . . . . 270
Effective Duration and Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
Total Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
Price-Yield Curves of Mortgage Pass-Through, PO, and IO Securities . . 274
15 Collateralized Debt Obligations 279
CDO Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Conventional CDO Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Synthetic CDO Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
Motivation Behind CDO Issuance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
Balance Sheet–Driven Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
Investor-Driven Arbitrage Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . 285
Analysis and Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
Portfolio Characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
Cash Flow Analysis and Stress Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
Originator’s Credit Quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
Operational Aspects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
Review of Credit-Enhancement Mechanisms . . . . . . . . . . . . . . . . . . . . . 288
Legal Structure of the Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
Expected Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
PART THREE SELECTED MARKET TRADING CONSIDERATIONS
16 The Yield Curve, Bond Yield, and Spot Rates 293
Practical Uses of Redemption Yield and Duration . . . . . . . . . . . . . . . . . 293
The Concept of Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
Yield Comparisons in the Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
Measuring a Bond’s True Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
Implied Spot Rates and Market Zero-Coupon Yields . . . . . . . . . . . . . . 300
Spot Yields and Coupon-Bond Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Implied Spot Yields and Zero-Coupon Bond Yields . . . . . . . . . . . . . . . 304
Determining Strip Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
Strips Market Anomalies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
Strips Trading Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
Case Study: Treasury Strip Yields and Cash Flow Analysis . . . . . . . . . . 311
17 Approaches to Trading 315
Futures Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316
Yield Curves and Relative Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
Determinants of Government Bond Yields . . . . . . . . . . . . . . . . . . . . . . . 320
Characterizing the Complete Term Structure . . . . . . . . . . . . . . . . . . . . . 323
Identifying Relative Value in Government Bonds . . . . . . . . . . . . . . . . . . 323
Hedging Bond Positions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Simple Hedging Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Hedge Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
Summary of the Derivation of the Optimum-Hedge Equation . . . . . . 329
Appendix: The Black-Scholes Model in Microsoft Excel . . . . . . . . . . . 331
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
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F O R E W O R D
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F O R E W O R D
I
think it’s customary when writing a foreword to say “I couldn’t put
the book down.” While one can’t necessarily say that about Fixed-
Income Securities and Derivatives Handbook, this is certainly not a
book to read once and then leave to gather dust in the attic. The only
tting place for it is within arms’ reach. Given the volume of accessible
material about the market, it takes something special for a single book to
nd a permanent home at the desk and become a rst point of reference
for both practitioners and students alike.
This book reects the emerging role of securitization within the bond
markets. For instance, the Collateralized Debt Obligation (CDO) market
is a constant source of innovation. The low interest rate environment of
the past few years and increasing number of downgrades in the corporate
bond market has made the rating-resilient securitization issuance an at-
tractive source of investment for investors. Virtually everyone who buys
xed-income products is looking at CDOs.
There is clear evidence of a growing comfort with structured prod-
ucts from an increasing number of asset managers and investors. Spread
tightening in the cash bond market has helped draw these parties toward
CDOs, but even existing participants are looking for higher yields than
those offered by traditional structures. We are now seeing CDO
2
, CDOs
with other CDOs as the underlying thus increasing leverage, and even be-
ginning to see CDO
3
. Further, margins on synthetic CDOs are dependent
on the underlying portfolio spread, and so have been fueling demand for
the associated credit default swaps. The result is signicant product devel-
opment, of the kind described in this ne book.
The author’s refreshingly straightforward style enables him to uniquely
bridge the gap between mathematical theory and its current application
in the bond markets today. Moreover, given the dynamic, evolutionary
nature of structured credit products, Choudhry’s comprehensive work on
bond market fundamentals is up to date with the most recent structural
and product innovations.
Suleman Baig
Research Partner, YieldCurve.com
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xv
P R E F A C E
T
he market in bond market securities, also known as the xed-
income market, is incredibly large and diverse, and one that plays
an irreplaceable part in global economic development. The vast
majority of securities in the world today are debt instruments, with out-
standing volume estimated at more than $10 trillion.
Fixed-Income Securities and Derivatives Handbook provides a concise
and accessible description of the main elements of the markets, concen-
trating on the instruments used and their applications. As it has been
designed to be both succinct and concise, the major issues are intro-
duced and described, and where appropriate certain applications are also
analyzed.
Part One, “Introduction to Bonds,” includes a detailed treatment of
bond mathematics, including pricing and yield analytics. This includes
modied duration and convexity. Chapters also cover the concept of spot
(zero-coupon) and forward rates, and the rates implied by market bond
prices and yields; yield-curve tting techniques; an account of spline t-
ting using regression techniques; and an introductory discussion of term
structure models.
Part Two, “Selected Cash and Derivative Instruments,” has an analysis
of various instruments including callable bonds that feature embedded op-
tions. There is also a discussion of mortgage-backed securities, techniques
used in the analysis of U.S. Treasury TIPS securities, and a section on
the use and applications of credit derivatives by participants in the xed-
income markets.
Finally, Part Three, “Selected Market Trading Considerations,” covers
the practical uses of redemption yield and duration as well as trading tech-
niques based on the author’s personal experience.
This book is designed to be a good starting place for those with little or
no previous understanding of or exposure to the bond markets; however,
it also investigates the markets to sufcient depth to be of use to the more
experienced practitioner. Readers who are part of a front ofce, middle of-
ce, or back ofce banking and fund management staff involved to some
extent with xed-income securities will also nd value here. Corporate
xvi Preface
and local authority treasurers, bank auditors and consultants, risk manag-
ers, and legal department staff may also nd the book useful.
Fixed-Income Securities and Derivatives Handbook builds on the con-
tent of the author’s earlier book, Bond Market Securities (FT Prentice
Hall, 2001), and includes an updated treatment of credit derivatives and
synthetic structured products, a detailed analysis of bond futures, and case
studies specic to the U.S. market. A very detailed treatment of specic
markets, exchanges, or trading conventions is left out, as that would result
in a very large book; interested readers can access the References section
at the back of the book. Where possible these references are indicated for
their level of analysis and technical treatment.
Comments on the text are most welcome and should be sent to the
author care of Bloomberg Press.
A Word on the Mathematics
Financial subjects such as the debt capital markets are essentially quan-
titative disciplines, and as such it is not possible to describe them, let
alone analyze them, without a certain amount of numerical input. To
maintain accessibility of this book, the level of mathematics used has
been limited; as a result many topics could not be reviewed in full detail.
There are very few derivations, for example, and fewer proofs. This has
not, in the author’s opinion, impaired the analysis as the reader is still
left with an understanding of the techniques required in the context of
market instruments.
Website and Further Market Research
For the latest market research on xed-income securities from Moorad
Choudhry visit www.YieldCurve.com, which also contains conference
presentations and educational teaching aids written by the author and
other YieldCurve.com associates.
Acknowledgments
The author thanks the following for their help during the writing of this
book: Serj Walia and Maj Haque at KBC Financial Products and Paul
Kerlogue and Andrew Lipton at Moody’s.
Thanks also to Suleman Baig for writing the Foreword.
FIXED-INCOME
SECURITIES AND DERIVATIVES
HANDBOOK
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1
Introduction to Bonds
PART ONE
Part One describes fi xed-income market analysis and the basic
concepts relating to bond instruments. The analytic building
blocks are generic and thus applicable to any market. The analy-
sis is simplest when applied to plain vanilla default-free bonds;
as the instruments analyzed become more complex, additional
techniques and assumptions are required.
The fi rst two chapters of this section discuss bond pricing and
yields, moving on to an explanation of such traditional interest
rate risk measures as modifi ed duration and convexity. Chapter 3
looks at spot and forward rates, the derivation of such rates from
market yields, and the yield curve. Yield-curve analysis and the
modeling of the term structure of interest rates are among the
most heavily researched areas of fi nancial economics. The treat-
ment here has been kept as concise as possible. The References
section at the end of the book directs interested readers to acces-
sible and readable resources that provide more detail.
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