Principles of Financial Engineering, 2nd Edition

CHAPTER 13

Fixed-Income Engineering

1. Introduction

This chapter extends the discussion of swap type instruments and outlines a simple framework for fixed-income security pricing. Term structure modeling is treated within this framework. The chapter also introduces the recent models that are becoming a benchmark in this sector.

Until recently, short-rate modeling was the most common approach in pricing and risk-managing fixed-income securities. The publication in 1992 of the Heath-Jarrow-Merton (HJM) approach enabled arbitrage-free modeling of multifactor-driven term structure models, but markets continued to use short-rate modeling. Today the situation is changing. The Forward Libor or Brace-Gatarek-Musiela (BGM) model is becoming the market ...