Market Risk Analysis Volume III: Pricing, Hedging and Trading Financial Instruments

III.1

Bonds and Swaps

III.1.1 INTRODUCTION

A financial security is a tradable legal claim on a firm's assets or income that is traded in an organized market, such as an exchange or a broker's market. There are two main classes of securities: primitive securities and derivative securities. A primitive security is a financial claim that has its own intrinsic price. In other words, the price of a primitive security is not a function of the prices of other primitive securities. A derivative security is a financial claim with a pay-off that is a function of the prices of one or more primitive securities.

This chapter focuses on interest rate sensitive securities that are traded in the debt markets, and on bonds and swaps in particular. We are not concerned here with the very short term debt markets, or money markets which trade in numerous interest rate sensitive instruments with maturities typically up to 1 year.¹ Our focus is on the market risk analysis of bonds and swaps, and at the time of issue most swaps have maturities of 2 years or more.

Virtually all bonds are primitive securities that are listed on exchanges but are traded by brokers in over-the-counter (OTC) markets. The exception is private placements which are like transferable loans. Since there is no secondary market, private placements are usually accounted for in the banking book, whereas most other interest rate sensitive securities are marked to market in the trading book. Forward rate agreements and swaps are derivative ...