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Fixed Income Relative Value Analysis: A Practitioners Guide to the Theory, Tools, and Trades

Book Description

As western governments issue increasing amounts of debt, the fixed income markets have never been more important. Yet the methods for analyzing these markets have failed to keep pace with recent developments, including the deterioration in the credit quality of many sovereign issuers. In Fixed Income Relative Value Analysis, Doug Huggins and Christian Schaller address this gap with a set of analytic tools for assessing value in the markets for government bonds, interest rate swaps, and related basis swaps, as well as associated futures and options.

Taking a practitioner's point of view, the book presents the theory behind market analysis in connection with tools for finding and expressing trade ideas. The extensive use of actual market examples illustrates the ways these analytic tools can be applied in practice.

The book covers:

  • Statistical models for quantitative market analysis, in particular mean reversion models and principal component analysis.

  • An in-depth approach to understanding swap spreads in theory and in practice.

  • A comprehensive discussion of the various basis swaps and their combinations.

  • The incorporation of credit default swaps in yield curve analysis.

  • A classification of option trades, with appropriate analysis tools for each category.

  • Fitted curve techniques for identifying relative value among different bonds.

  • A multi-factor delivery option model for bond future contracts.

Fixed Income Relative Value Analysis provides an insightful presentation of the relevant statistical and financial theories, a detailed set of statistical and financial tools derived from these theories, and a multitude of actual trades resulting from the application of these tools to the fixed income markets. As such, it's an indispensable guide for relative value analysts, relative value traders, and portfolio managers for whom security selection and hedging are part of the investment process.

Table of Contents

  1. Cover
  2. Contents
  3. Title
  4. Copyright
  5. Foreword
  6. Chapter 1: Relative Value
    1. The Concept of Relative Value
    2. The Sources of Relative Value Opportunities
    3. The Insights from Relative Value Analysis
    4. The Applications of Relative Value Analysis
    5. The Craft of Relative Value Analysis
    6. Summary of Contents
  7. Part I: Statistical Models
    1. Chapter 2: Mean Reversion
      1. What Is Mean Reversion and How Does It Help Us?
      2. Diagnostics for Model Selection
      3. Model Estimation
      4. Calculating Conditional Expectations and Probability Densities
      5. Calculating Conditional, Ex Ante Risk-Adjusted Returns
      6. First Passage Times
      7. A Practical Example Incorporating all the Ideas
      8. Conclusion
    2. Chapter 3: Principal Component Analysis
      1. Introduction: Goal and Method
      2. An Intuitive Approach toward PCA
      3. Factor Models: General Structure and Definitions
      4. PCA: Mathematics
      5. PCA as Factor Model
      6. Insight into Market Mechanisms through Interpretation of the Eigenvectors
      7. Applying Eigenvector Interpretation in Different Markets
      8. Decomposing Markets into Uncorrelated Factors
      9. Embedding PCA in Trade Ideas
      10. Appropriate Hedging
      11. Analyzing the Exposure of Trading Positions and Investment Portfolios
      12. Market Reconstruction and Forecasting
      13. A Yield Curve Model Based on PCA
      14. PCA as a Tool for Screening the Market for Trade Ideas
      15. PCA as a Tool for Asset Selection
      16. Example of a PCA-based Trade Idea
      17. Problems and Pitfalls of PCA 1: Correlation between Factors during Subperiods
      18. Problems and Pitfalls of PCA 2: Instability of Eigenvectors over Time
      19. PCA as a Tool to Construct New Types of Trades
  8. Part II: Financial Models
    1. Chapter 4: Some Comments on Yield, Duration, and Convexity
      1. Introduction
      2. Some Brief Comments on the Yield of a Coupon-Paying Bond
      3. A Brief Comment on Duration
      4. A Common Misapplication of Convexity
    2. Chapter 5: Bond Futures Contracts
      1. Futures Price and Delivery Option
      2. One-Factor Delivery Option Models
      3. The Need for Multi-Factor Delivery Option Models
      4. A Flexible Multi-Factor Delivery Option Model
    3. Chapter 6: LIBOR, OIS Rates, and Repo Rates
      1. Introduction
      2. Brief Definitions
      3. Differences between LIBOR and OIS Rates
      4. Repo Rates in Greater Detail
      5. Capital Treatment for Secured and Unsecured Loans
      6. A Model Relating LIBOR and Repo Rates
      7. Conclusions
    4. Chapter 7: Intra-Currency Basis Swaps
      1. Definition
      2. Factors that Determine Pricing
      3. Role as Building Blocks
      4. Conclusion
    5. Chapter 8: Theoretical Determinants of Swap Spreads
      1. Old Approach: Looking at Default Risk of Swap Counterparties
      2. The Modern Approach
      3. Viewing the Swap as a Derivative
      4. Insurance Properties of LIBOR–Repo Spreads
      5. Other Practical Modeling Issues
      6. The Subprime Crisis as a Brief Case Study
      7. Conclusions
    6. Chapter 9: Swap Spreads from an Empirical Perspective
      1. Empirical Analysis of Swap Spreads
      2. Conclusions
    7. Chapter 10: Swap Spreads as Relative Value Indicators for Government Bonds
      1. Introduction
      2. Typical Use of Swap Spreads as a Relative Value Indicator for Government Bonds
      3. Problems with the Use of Swap Spreads as Relative Value Indicators for Government Bonds
      4. Attempts to Solve these Problems
      5. Conclusions
    8. Chapter 11: Fitted Bond Curves
      1. Introduction
      2. Framework of Analysis
      3. Specifying a Function for Discount Factors
      4. Weights
      5. Example: Fitting the German Bund Curve
      6. Statistical Analysis of Rich/Cheap Figures
      7. Applications
      8. Conclusions
    9. Chapter 12: A Brief Comment on Interpolated Swap Spreads
    10. Chapter 13: Cross-Currency Basis Swaps
      1. Introduction
      2. Definitions
      3. Economic Functions
      4. Pricing the CCBS
      5. Conclusion
    11. Chapter 14: Relative Values of Bonds Denominated in Different Currencies
      1. Introduction
      2. Calculating USD LIBOR Swap Spreads for Foreign Bonds
      3. Rich/Cheap Analysis through Fitted Curves for Bonds Denominated in Different Currencies
      4. Separate Yield Curves in Respective Currencies
      5. The Equilibrium between ASW and CCBS Markets
      6. The Equilibrium for Bunds (Low-Risk Bonds)
      7. The ASW Model Revisited
      8. The Equilibrium in Case of JGBs (Risky Bonds)
      9. Conclusion
    12. Chapter 15: Credit Default Swaps
      1. Introduction
      2. Structure of a CDS
      3. Two Different Pricing Approaches toward CDS: Pricing of CDS versus Other CDS or versus Bonds
      4. A PCA on the CDS Curve
      5. A PCA on the EUR Sovereign CDS Universe
      6. A PCA on CDS-Adjusted Bond Yields
      7. Pitfalls
      8. Conclusion
    13. Chapter 16: USD Asset Swap Spreads versus Credit Default Swaps
      1. Introduction
      2. General Concept of No-Arbitrage Models
      3. Credit Information in the CDS
      4. Credit Information in the (USD) ASW of Bonds
      5. The No-Arbitrage Relationship in Practice
      6. The ASW Model Revisited Once More
      7. Applying the General Concept to an EMU Model
      8. Conclusions
    14. Chapter 17: Options
      1. Introduction
      2. A Brief Review of Option Pricing Theory
      3. Classification of Option Trades
      4. Option Trade Type 1: Single Underlying
      5. Option Trade Type 1: Two or More Underlyings
      6. Option Trade Type 2: Single Underlying
      7. Option Trade Type 2: Two or More Underlyings
      8. Option Trade Type 3: Factor Model for the Vega Sector
      9. Pitfalls of Option Trades of Type 3
      10. Conclusion: Summary of Option Trade Types and Their Different Exposure
  9. Chapter 18: Relative Value in a Broader Perspective
    1. Introduction
    2. The Macroeconomic Role of Relative Value Analysis and Trading
    3. Arbitrageurs and Politicians
    4. The Misrepresentation of Arbitrage by Politicians
    5. Conclusion: Political Implications of Relative Value
  10. Bibliography
  11. Index