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Fixed Income Analysis (CFA Institute Investment Series) [Hardcover]

Martin L. Leibowitz , Frank J. Fabozzi
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Table of Contents

Foreword xiii

Acknowledgments xvii

Introduction xxi

Note on Rounding Differences xxvii

CHAPTER 1 Features of Debt Securities 1

I. Introduction 1

II. Indenture and Covenants 2

III. Maturity 2

IV. Par Value 3

V. Coupon Rate 4

VI. Provisions for Paying Off Bonds 8

VII. Conversion Privilege 13

VIII. Put Provision 13

IX. Currency Denomination 13

X. Embedded Options 14

XI. Borrowing Funds to Purchase Bonds 15

CHAPTER 2 Risks Associated with Investing in Bonds 17

I. Introduction 17

II. Interest Rate Risk 17

III. Yield Curve Risk 23

IV. Call and Prepayment Risk 26

V. Reinvestment Risk 27

VI. Credit Risk 28

VII. Liquidity Risk 32

VIII. Exchange Rate or Currency Risk 33

IX. Inflation or Purchasing Power Risk 34

X. Volatility Risk 34

XI. Event Risk 35

XII. Sovereign Risk 36

CHAPTER 3 Overview of Bond Sectors and Instruments 37

I. Introduction 37

II. Sectors of the Bond Market 37

III. Sovereign Bonds 39

IV. Semi–Government/Agency Bonds 44

V. State and Local Governments 53

VI. Corporate Debt Securities 56

VII. Asset–Backed Securities 67

VIII. Collateralized Debt Obligations 69

IX. Primary Market and Secondary Market for Bonds 70

CHAPTER 4 Understanding Yield Spreads 74

I. Introduction 74

II. Interest Rate Determination 74

III. U.S. Treasury Rates 75

IV. Yields on Non–Treasury Securities 82

V. Non–U.S. Interest Rates 90

VI. Swap Spreads 92

CHAPTER 5 Introduction to the Valuation of Debt Securities 97

I. Introduction 97

II. General Principles of Valuation 97

III. Traditional Approach to Valuation 109

IV. The Arbitrage–Free Valuation Approach 110

V. Valuation Models 117

CHAPTER 6 Yield Measures, Spot Rates, and Forward Rates 119

I. Introduction 119

II. Sources of Return 119

III. Traditional Yield Measures 120

IV. Theoretical Spot Rates 135

V. Forward Rates 147

CHAPTER 7 Introduction to the Measurement of Interest Rate Risk 157

I. Introduction 157

II. The Full Valuation Approach 157

III. Price Volatility Characteristics of Bonds 160

IV. Duration 168

V. Convexity Adjustment 180

VI. Price Value of a Basis Point 182

VII. The Importance of Yield Volatility 183

CHAPTER 8 Term Structure and Volatility of Interest Rates 185

I. Introduction 185

II. Historical Look at the Treasury Yield Curve 186

III. Treasury Returns Resulting from Yield Curve Movements 189

IV. Constructing the Theoretical Spot Rate Curve for Treasuries 190

V. The Swap Curve (LIBOR Curve) 193

VI. Expectations Theories of the Term Structure of Interest Rates 196

VII. Measuring Yield Curve Risk 204

VIII. Yield Volatility and Measurement 207

CHAPTER 9 Valuing Bonds with Embedded Options 215

I. Introduction 215

II. Elements of a Bond Valuation Model 215

III. Overview of the Bond Valuation Process 218

IV. Review of How to Value an Option–Free Bond 225

V. Valuing a Bond with an Embedded Option Using the Binomial Model 226

VI. Valuing and Analyzing a Callable Bond 233

VII. Valuing a Putable Bond 240

VIII. Valuing a Step–Up Callable Note 243

IX. Valuing a Capped Floater 244

X. Analysis of Convertible Bonds 247

CHAPTER 10 Mortgage–Backed Sector of the Bond Market 256

I. Introduction 256

II. Residential Mortgage Loans 257

III. Mortgage Passthrough Securities 260

IV. Collateralized Mortgage Obligations 273

V. Stripped Mortgage–Backed Securities 294

VI. Nonagency Residential Mortgage–Backed Securities 296

VII. Commercial Mortgage–Backed Securities 298

CHAPTER 11 Asset–Backed Sector of the BondMarket 302

I. Introduction 302

II. The Securitization Process and Features of ABS 303

III. Home Equity Loans 313

IV. Manufactured Housing–Backed Securities 317

V. Residential MBS Outside the United States 318

VI. Auto Loan–Backed Securities 320

VII. Student Loan–Backed Securities 322

VIII. SBA Loan–Backed Securities 324

IX. Credit Card Receivable–Backed Securities 325

X. Collateralized Debt Obligations 327

CHAPTER 12 ValuingMortgage–Backed and Asset–Backed Securities 335

I. Introduction 335

II. Cash Flow Yield Analysis 336

III. Zero–Volatility Spread 337

IV. Monte Carlo Simulation Model and OAS 338

V. Measuring Interest Rate Risk 351

VI. Valuing Asset–Backed Securities 358

VII. Valuing Any Security 359

CHAPTER 13 Interest Rate Derivative Instruments 360

I. Introduction 360

II. Interest Rate Futures 360

III. Interest Rate Options 371

IV. Interest Rate Swaps 377

V. Interest Rate Caps and Floors 382

CHAPTER 14 Valuation of Interest Rate Derivative Instruments 386

I. Introduction 386

II. Interest Rate Futures Contracts 386

III. Interest Rate Swaps 392

IV. Options 403

V. Caps and Floors 416

CHAPTER 15 General Principles of Credit Analysis 421

I. Introduction 421

II. Credit Ratings 421

III. Traditional Credit Analysis 424

IV. Credit Scoring Models 453

V. Credit Risk Models 455

Appendix: Case Study 456

CHAPTER 16 Introduction to Bond Portfolio Management 462

I. Introduction 462

II. Setting Investment Objectives for Fixed–Income Investors 463

III. Developing and Implementing a Portfolio Strategy 471

IV. Monitoring the Portfolio 475

V. Adjusting the Portfolio 475

CHAPTER 17 Measuring a Portfolio′s Risk Profile 476

I. Introduction 476

II. Review of Standard Deviation and Downside Risk Measures 476

III. Tracking Error 482

IV. Measuring a Portfolio s Interest Rate Risk 487

V. Measuring Yield Curve Risk 491

VI. Spread Risk 492

VII. Credit Risk 493

VIII. Optionality Risk for Non–MBS 494

IX. Risks of Investing in Mortgage–Backed Securities 495

X. Multi–Factor Risk Models 498

CHAPTER 18 Managing Funds against a Bond Market Index 503

I. Introduction 503

II. Degrees of Active Management 503

III. Strategies 507

IV. Scenario Analysis for Assessing Potential Performance 513

V. Using Multi–Factor Risk Models in Portfolio Construction 525

VI. Performance Evaluation 528

VII. Leveraging Strategies 531

CHAPTER 19 Portfolio Immunization and Cash Flow Matching 541

I. Introduction 541

II. Immunization Strategy for a Single Liability 541

III. Contingent Immunization 551

IV. Immunization for Multiple Liabilities 554

V. Cash Flow Matching for Multiple Liabilities 557

CHAPTER 20 Relative–ValueMethodologies for Global Credit Bond Portfolio Management (by Jack Malvey) 560

I. Introduction 560

II. Credit Relative–Value Analysis 561

III. Total Return Analysis 565

IV. Primary Market Analysis 566

V. Liquidity and Trading Analysis 567

VI. Secondary Trade Rationales 568

VII. Spread Analysis 572

VIII. Structural Analysis 575

IX. Credit Curve Analysis 579

X. Credit Analysis 579

XI. Asset Allocation/Sector Rotation 581

CHAPTER 21 International Bond Portfolio Management (by Christopher B. Steward, J. Hank Lynch, and Frank J. Fabozzi) 583

I. Introduction 583

II. Investment Objectives and Policy Statements 584

III. Developing a Portfolio Strategy 588

IV. Portfolio Construction 595

Appendix 614

CHAPTER 22 Controlling Interest Rate Risk with Derivatives (by Frank J. Fabozzi, Shrikant Ramamurthy, and Mark Pitts) 617

I. Introduction 617

II. Controlling Interest Rate Risk with Futures 617

III. Controlling Interest Rate Risk with Swaps 633

IV. Hedging with Options 637

V. Using Caps and Floors 649

CHAPTER 23 HedgingMortgage Securities to Capture Relative Value (by Kenneth B. Dunn, Roberto M. Sella, and Frank J. Fabozzi) 651

I. Introduction 651

II. The Problem 651

III. Mortgage Security Risks 655

IV. How Interest Rates Change Over Time 660

V. Hedging Methodology 661

VI. Hedging Cuspy–Coupon Mortgage Securities 671

CHAPTER 24 Credit Derivatives in Bond Portfolio Management (by Mark J.P. Anson and Frank J. Fabozzi) 673

I. Introduction 673

II. Market Participants 674

III. Why Credit Risk Is Important 674

IV. Total Return Swap 677

V. Credit Default Products 679

VI. Credit Spread Products 687

VII. Synthetic Collateralized Debt Obligations 691

VIII. Basket Default Swaps 692

About the CFA Program 695

About the Author 697

About the Contributors 699

Index 703

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