Introduction to Bond Markets

Dr Moorad Choudhry is the former Head of Treasury at Europe Arab Bank plc in London. He is Visiting Professor at the Department of Economics, London Metropolitan University, a Visiting Research Fellow at the ICMA Centre, University of Reading, a Fellow of the ifs-School of Finance and a Fellow of the Chartered Institute for Securities and Investment.

• Foreword xviiPreface xixPreface to the First Edition xxiiiAbout the author xxv1 Introduction to Bonds 1Description 4Outline of market participants 6Bond analysis 8Financial arithmetic: the time value of money 8Present value and discounting 9Discount factors and boot-strapping the discount function 15Bond pricing and yield: the traditional approach 18Bond pricing 18Bond yield 23Accrued interest 30Clean and dirty bond prices 30Day-count conventions 32Illustrating bond yield using Excel spreadsheets 33Bibliography 382 The Yield Curve, Spot and Forward Yields 41The yield curve 42Yield-to-maturity yield curve 42The par yield curve 44The zero-coupon (or spot) yield curve 45The forward yield curve 49Theories of the yield curve 50Spot rates 54Discount factors and the discount function 55The boot-strapping method: deriving the theoretical zero-coupon (spot) rate curve 56Mathematical relationship 60Implied forward rates 62Understanding forward rates 69The term structure of interest rates 70Bibliography 733 Bond Instruments and Interest-rate Risk 75Duration, modified duration and convexity 76Duration 77Properties of Macaulay duration 81Modified duration 81Convexity 87Bibliography 914 Floating-rate Notes and other Bond Instruments 93Floating-rate notes 94Synthetic convertible note 98Description 98Investor benefits 99Interest differential notes 99Example of IDN 99Benefits to investors 100Convertible quanto note 101Example of Japanese equity note 102Bibliography 1055 The Money Markets 107Introduction 109Securities quoted on a yield basis 111Money market deposits 111Certificates of deposit 113cd yields 114Securities quoted on a discount basis 118Treasury bills 120Banker’s acceptances 121Eligible banker’s acceptance 122Commercial paper 123Commercial paper programmes 124Commercial paper yields 126Asset-backed commercial paper 127Repo 132Definition 133The classic repo 134Examples of classic repo 136The sell/buy-back 141Examples of sell/buy-back 142Repo collateral 144Legal treatment 146Margin 146Variation margin 1485.A Currencies using money market year base of 365 days 1486 the Eurobond Market 151Eurobonds 152Foreign bonds 155Eurobond instruments 155Conventional bonds 155Floating rate notes 156Zero-coupon bonds 157Convertible bonds 157The issue process: market participants 159The borrowing parties 160The underwriting lead manager 162The co-lead manager 163Investors 164Fees, expenses and pricing 164Fees 164Expenses 165Pricing 165Issuing the bond 166The grey market 168Alternative issue procedures 168Covenants 169Trust services 170Depositary 170Paying agent 171Registrar 172Trustee 172Custodian 173Form of the bond 173Temporary global form 173Permanent global bond 174Definitive form 174Registered bonds 175Fiscal agent 176Listing agent 176Clearing systems 176Market associations 178International Capital Market Association 178Bloomberg screens 178Secondary market 180Settlement 180Bibliography 1817 CONVERTIBLE BONDS, MTNs AND WARRANTS 183Description 184Analysis 184Value and premium issues 187Zero-coupon convertibles 188Warrants 189Medium-term notes 190MTN programme 191Shelf registration 192Credit rating 192Secondary market 192Issuers and investors 193MTNs and corporate bonds 1938 Credit Ratings 197Credit ratings 199Purpose of credit ratings 199Formal credit ratings 200Credit rating agencies and the 2007–2008 financial market crash 2019 Inflation-linked Bonds 209Basic concepts 210Choice of index 210Indexation lag 211Coupon frequency 213Type of indexation 213Index-linked bond cash flows and yields 215TIPS cash flow calculations 216TIPS price and yield calculations 217Assessing yields on index-linked bonds 220Which to hold: indexed or conventional bonds? 221Inflation-indexed derivatives 222Market instruments 223Applications 227Bibliography 22810 An Introduction to Asset-backed Securities 229The concept of securitisation 232Reasons for undertaking securitisation 233Benefits of securitisation to investors 236The process of securitisation 237Securitisation process 237SPV structures 239Credit enhancement 240Impact on balance sheet 242Credit rating 243Redemption mechanism 245Average life 245Illustrating the process of securitisation 246Securitisation post-credit crunch 250Bloomberg screens 253Bibliography 25911 Introduction to Derivative Instruments 261Interest-rate swaps 262Characteristics of IR swaps 264Swap spreads and the swap yield curve 267Swap duration 270Summary of IR swap 271Non-standard swaps 271Using swaps 273Cancelling a swap 276Zero-coupon swap pricing 276Hedging using bonds and swaps 278Swaptions 282Cross-currency swaps 283Bloomberg screens 284Futures contracts 288Description 288Bond futures contracts 290Futures pricing 293Arbitrage-free futures pricing 297Hedging using futures 299The hedge ratio 301Interest-rate options 302Introduction 302Definition 303Option terminology 305Option premium 306Pricing options 307Behaviour of option prices 311Using options in bond markets 312Hedging using bond options 314Exotic options 315Bibliography 31712 Introduction to Credit Derivatives 319Introduction 321Why use credit derivatives? 323Classification of credit derivative instruments 325Definition of a credit event 326Asset swaps 327Credit default swaps 330Impact of the 2007–2008 credit crunch: new CDS contracts and the CDS ‘Big Bang’ 334Credit-linked notes 338Total return swaps 341Synthetic repo 345Reduction in credit risk 346Capital structure arbitrage 347The TRS as a funding instrument 347Credit options 349The CDS iTraxx index 350General applications of credit derivatives 355Use of credit derivatives by portfolio managers 355The credit default swap basis 358A negative basis 358The basis as market indicator 361Bibliography 36413 Approaches to Government Bond Trading And Yield Analysis 365Introduction 366The determinants of yield 366Spread trade risk weighting 367Identifying yield spread trades 373Coupon spreads 374Butterfly trades 376Basic concepts 376Putting on the trade 377Yield gain 379Convexity gain 380Bloomberg screens 384Bond spreads and relative value 386Bond spreads 388Summary of a fund manager’s approach to value creation 393Bibliography 39614 Risk Management and Value-at-risk 397Characterising risk 398Risk management 400The risk management function 401Interest-rate risk 402Value-at-Risk 403Definition 403Calculation methods 404Validity of the variance–covariance (correlation) VaR estimate 406Assessment of VaR tool 407VaR methodology for credit risk 408Modelling VaR for credit risk 409Time horizon 411Applications of credit VaR 412Bibliography 412Glossary 413List of abbreviations 421Index 425