Advanced Fixed Income Analysis, Second Edition

252 Pages·2015·11.24 MB·English

by  Choudhry, Moorad, Lizzio, Michele

Advanced Fixed Income Analysis

Advanced Fixed Income
Analysis
2nd Edition
Moorad Choudhry
Michele Lizzio
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individualprivatecapacities,andshouldnotinanywaybeattributedtoHabibBankZurichplc,the
HabibBankAGZurichGroup,orDeloitteFinancialAdvisoryS.r.l,ortoMooradChoudhryasa
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Dedication
Moorad Choudhry
For my grandfather, Mr Abdul Hakim
(c. 1898–1983), Advocate
Citizen of Noakhali, Bangladesh
and
Michele Lizzio
For my mum and dad
About the Authors
Moorad Choudhry is CEO of Habib Bank
Zurich plc in London, and Visiting Professor
at the Department of Mathematical Sciences,
BrunelUniversity.HeisFounderofTheCer-
tificate of Bank Treasury Risk Management
(BTRM).
Moorad has over 25 years experience in
bankingintheCityofLondonandwasprevi-
souly IPO Treasurer at the Royal Bank of
Scotland,HeadofTreasuryatRBSCorporate
Banking, Head of Treasury at Europe Arab
Bank, Head of Treasury at KBC Financial
Products and vice-president in structured
finance servicesat JPMorgan Chase Bank.
Moorad is a Fellow of the Chartered Institute for Securities & Investment
and a Fellow of IFS-University College. He is Editor of Review of Financial
Markets, and the author of The Principles of Banking (John Wiley & Sons
2012).
Michele Lizzio is Senior Analyst at Deloitte
Financial Advisory, Valuation Services in
Milan. He has experience in equity valuation
andisinvolvedinthedevelopmentandimple-
mentationoffixedincomeandderivatebased
modelsinDeloitte.
HegraduatedcumlaudeinMScCorporate
FinancefromUniversityofBrescia.Hebegan
his career collaborating with Alberto Falini,
Professor of Corporate Finance at University
of Brescia.
xiii
Preface
Everythinginlifeisrelative.Oneperson’ssimpleisanotherperson’sdifficult.
Comparisonsareoftenproblematictoundertake,becauseofthedifficultieswith
ensuringthatoneismeasuringlikeagainstlike.SowebegintheSecondEdition
of Advanced Fixed Income Analysis with the caveat that while it may be
“advanced” to some it may well not be to others. But nevertheless it is worth
updatingthebooksimplytoreflectchangesinthinkingandapproachthathave
occurred since the First Edition was published.
Whatisworthythenofafurtherinvestmentofcashtopurchasethissecond
edition?Hopefullythenewchaptersonassetswapspreadrelativevalue,con-
vertiblebonds,callable/putablebondsandfloating-ratenoteswillbesufficient
justification; additionally wehave updated thepreviouschaptersoninflation-
linkedbondsandriskycorporatebondsvaluation.WehavealsoincludedExcel
spreadsheetsthatenablethereadertoapplytheanalysisdescribedinthechap-
ters right away tobonds thathe orshe selects.
We have deleted the chapters on cubic spline (a technique now very well
knownandwithplentyofmaterialaboutitoutthereontheinternet)andBrady
bonds.Wehavealsoremovedtheearlieredition’schaptersonrisk-freesover-
eignbondstrading,onthegroundsthatthelogicofanalysisemployedforsuch
investmentshasnotchangedsince2003,andalsomoreindirectlybecausethere
are sofew genuinely risk-free sovereign issuers left inthe world!
Iamgratefultomynewco-authorforthisSecondEdition,MicheleLizzio,
for his tireless and energetic input.
Asalwaysreadersarewelcometosendfeedbackdirect,pleaseemailmeat
[email protected]
We hope youenjoy the book.
xv
xvi Preface
MooradChoudhry
Surrey, England
February2015
MicheleLizzio
Milan, Italy
February2015
Preface to the First Edition
(published 2004)
THE DYNAMICS OF THE YIELD CURVE
Inchapter2ofthecompanionvolumetothisbookintheboxed-setlibrary,Cor-
porateBondsandStructuredFinancialProducts,weintroducedtheconceptof
the yield curve, and reviewed some preliminary issues concerning both the
shapeofthecurveandtowhatextentthecurvecouldbeusedtoinfertheshape
andleveloftheyieldcurveinthefuture.Wedonotknowwhatinterestrateswill
beinthefuture,butgivenasetofzero-coupon(spot)ratestodaywecanesti-
matethefuturelevelofforwardratesusingayieldcurvemodel.Inmanycases
howeverwedonothaveazero-couponcurvetobeginwith,soitthenbecomes
necessarytoderivethespotyieldcurvefromtheyieldsofcouponbonds,which
onecanobservereadilyinthemarket.Ifamarketonlytradesshort-dateddebt
instruments, then it willbe possibleto constructashort-dated spot curve.
Itisimportantforazero-couponyieldcurvetobeconstructedasaccurately
aspossible.Thisbecausethecurveisusedinthevaluationofawiderangeof
instruments, not only conventional cash market coupon bonds, which we can
valueusingtheappropriatespotrateforeachcashflow,butotherinterest-rate
productssuch asswaps.
Ifusingaspotratecurveforvaluationpurposes,banksusewhatareknown
asarbitrage-freeyieldcurvemodels,wherethederivedcurvehasbeenmatched
tothecurrentspotyieldcurve.Theconceptofarbitrage-free,alsoknownasno-
arbitragepricingor“thelawofoneprice”isthatifoneisvaluingthesameprod-
uct or cash flow in two different ways, the same result will be obtained from
either method. So as we demonstrated in chapter 6, if one was valuing a
two-yearbondthatwasput-ablebytheholderatparinoneyear’stime,itcould
beanalysedasaone-yearbondthatentitledtheholdertoreinvestitforanother
year. The rule of no-arbitrage pricing states that an identical price will be
obtained whichever way one chooses to analyse the bond. When matching
derivedyieldcurvestherefore,correctlymatchedcurveswillgeneratethesame
pricewhenvaluingabond,whetheraderivedspotcurveisusedorthecurrent
term structure ofspot rates.
Fromourunderstandingofderivatives,weknowthatoptionpricingmodels
suchasBlack-Scholesassumethatassetpricereturnsfollowalognormaldis-
tribution.Thedynamicsofinterestratesandthetermstructureisthesubjectof
xvii
xviii PrefacetotheFirstEdition
somedebate,andthemaindifferencesbetweenthemaininterest-ratemodelsis
inthe way that they choose to capture the change inrates over a time period.
However although volatility ofthe yield curve isindeed the main areaof dif-
ference, certain models are easier to implement than others, and this is a key
factorabankconsiderswhendecidingwhichmodeltouse.Theprocessofcal-
ibratingthe model,thatis, settingit uptoestimatethe spot andforwardterm
structure using current interest rates that are input to the model, is almost as
important as deriving the model itself. So the availability of data for a range
of products, including cash money markets, cash bonds, futures and swaps,
isvital tothe successfulimplementation ofthe model.
Asonemightexpecttheyieldsonbondsarecorrelated,inmostcasesvery
closely positively correlated. This enables us to analyse interest-rate risk in a
portfolio for example, but also to model the term structure in a systematic
way.Muchofthetraditionalapproachtobondportfoliomanagementassumed
aparallelshiftintheyieldcurve,sothatifthe5-yearbondyieldmovedupwards
by10basispoints,thenthe30-yearbondyieldwouldalsomoveupby10basis
points.Thisunderpinstraditionaldurationandmodifieddurationanalysis,and
theconceptofimmunisation.Toanalysebondsinthisway,weassumetherefore
thatbondyieldvolatilitiesareidenticalandcorrelationsareperfectlypositive.
Althoughbothtypesofanalysisarestillcommon,itisclearthatbondyieldsdo
notmoveinthisfashion,andsowemustenhanceourapproachinordertoper-
formmoreaccurateanalysis.
FACTORS INFLUENCING THE YIELD CURVE
Fromthediscussioninchapterweareawarethattherearerangeoffactorsthat
impact onthe shape andlevel oftheyieldcurve.Acombinationofeconomic
andnon-economicfactorsareinvolved.Akeyfactor isinvestorexpectations,
with respect to the level of inflation, and the level of real interest rates in the
future. In the real world the market does not assume that either of these two
factorsisconstant,howevergiventhatthereisahighleveluncertaintyoverany-
thing longer than the short-term, generally there is an assumption about both
inflation and interest rates to move towards some form of equilibrium in the
long-term.
Itispossibletoinfermarketexpectationsaboutthelevelofrealinterestrates
going forward by observing yields in government index-linked bonds, which
trade in a number of countries including the US and UK. The market’s view
onthefuturelevelofinterestratesmayalsobeinferredfromtheshapeandlevel
ofthecurrentyieldcurve.Againfrom chapter6,wesawthattheslopeofthe
yieldcurvealsohasaninformationcontent.Thereismorethanonewaytointer-
pretany given slopehowever, and thisdebateisstill open.
Thefactthatthereareanumberoffactorsthatinfluencechangesininterest
rates and the shape of the yield curve means that it is not straightforward to