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A Guide Guide to to A Fixed Income Income Fixed Analysis Analysis

Andrew R. Young

A Morgan Stanley Guide to Fixed Income Analysis

Andrew R. Young
This chapter is an excerpt from A Morgan Stanley Guide to Fixed Income Analysis by Andrew R. Young, 2003 Morgan Stanley & Co. Incorporated.

This material has been prepared solely for information purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy. It is based on or derived from information generally available to the public from sources believed to be reliable. No representation is made that information or formulae included herein are accurate or complete or that any results obtained therefrom are indicative of actual prices or returns. All pricing and other data herein are derived from Morgan Stanley unless referenced otherwise. Past performance is not necessarily indicative of future results. Additional information is available on request. Copyright 2003 Morgan Stanley & Co. Incorporated

Acknowledgments
This book represents a significant portion of what I have learned in this industry. As such I should start by recognizing Jennifer Carpenter and Stephen Lalli for helping me get started and fostering a sense of curiosity and regard for the details. Particular thanks are also due to Ben Wolkowitz for sparking the development of this book and to Roy Campbell, David Chang, Yoon Chang, Young-Sup Lee, Mike Mendelson, Kelly Thomas, Evan Tick, and Joan Tse for their insight into the approach, additions of material, and cheerful and detailed suggestions as to how to make this more useful. In addition, I offer a warm appreciation for my editor, Sheila York, who spent innumerable hours and applied all her skill and effort to bring this to an (I hope) excellent level of quality and readability. It would have truly been a different outcome without her guidance. Thanks also to Steve Abrahams, Mark Childress, David Depew, Jeff Jennings, Emily Kim, Joe Langsam, Krishna Memani, Louis Scott, Tim Sears, John Scowcroft, Deb Shroyer, Eric Vandercar, and Andrew Waine for their helpful advice, and to the dedicated team at Firm Graphics: Ramona Boston, Bill Devine, Roger Adler, Vance Clarke, Paul Cohen, Sharon Eng, Bryan Fernandez, Steve Feuerborn, Matt Foodim, Lucille Harasti, Sasha Koren, Todd LeBlanc, Carol Murashige, Jane Seguin, Neil Stillman, and Gail Vachon. Finally, I would like to dedicate this book to my wife, Lisa, son, Zachary, and daughter, Michelle, for all their love, support, and forbearance, because I couldnt have done it without them.

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This material has been prepared solely for information purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy. It is based on or derived from information generally available to the public from sources believed to be reliable. No representation is made that information or formulae included herein are accurate or complete or that any results obtained therefrom are indicative of actual prices or returns. All pricing and other data herein are derived from Morgan Stanley unless referenced otherwise. Past performance is not necessarily indicative of future results. Additional information is available on request. 159

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Table of Contents
Chapter One Two Three Zero-Coupon Bonds Coupon Bonds The Yield Curve, a Treasury Pack and Fitted Curve Analysis Sample Treasury Pack Forward Prices Yield Measurement and Total Rate of Return Options Futures Corporate Bonds Swaps Mortgages Portfolio Theory and Market Dynamics Page 1 27 71 101 123 139 159 203 235 259 309 355 389 489 509

Four Five Six Seven Eight Nine Ten Eleven Exercise Solutions Glossary

Equation Reference

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This material has been prepared solely for information purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy. It is based on or derived from information generally available to the public from sources believed to be reliable. No representation is made that information or formulae included herein are accurate or complete or that any results obtained therefrom are indicative of actual prices or returns. All pricing and other data herein are derived from Morgan Stanley unless referenced otherwise. Past performance is not necessarily indicative of future results. Additional information is available on request. 159

Foreword
There is a tremendous amount of debt outstanding, with a wide variety of conventions for pricing and settlement

Fixed income is a business of details. The market is dominated by large transactions and a number of well-capitalized competitors, so spreads in some markets are thin. Accuracy and attention to detail are paramount since the impact of using the wrong convention can easily exceed the bid-ask spread. Each sector of the market has its own conventions, which provide the framework for internal and external communication. This material illustrates some of the important ones. Keep in mind that conventions do change over time, so it is important not to assume that last years still hold. Always clarify your understanding of security pricing or mechanics in markets in which you are not an active or regular participant with sales, product management, research, or trading.

Total Debt Outstanding: $18 Trillion1


1 Source: Federal Reserve Flow of Fundshttp://www.bog.frb.fed.us/releases/Z1 vi
This material has been prepared solely for information purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy. It is based on or derived from information generally available to the public from sources believed to be reliable. No representation is made that information or formulae included herein are accurate or complete or that any results obtained therefrom are indicative of actual prices or returns. All pricing and other data herein are derived from Morgan Stanley unless referenced otherwise. Past performance is not necessarily indicative of future results. Additional information is available on request. 159

Foreword (Continued)
Morgan Stanley seeks to add value by helping customers formulate investment strategy, seek return, and reduce risk, and by providing efficient execution. Methods for doing this often require creative problem-solving, both in identifying a new approach and working through its ramifications. This material aims to provide tools and techniques that are the foundation for that creativity and that will also help you understand markets and market participants. It is fairly mathematical, and requires some difficult algebra, but there are no partial differential equations! Your success depends on your ability to solve problems. At the end of each chapter, you will find exercises that will help drive home concepts. Use this material as an opportunity to enhance your skills. It is a cheap way to gain experience. Better to make a mistake here than on an actual trade. Do not ask for help too soon: struggle with each exercise on your own first. Then, if you are still having trouble mastering a concept, do not be afraid to consult with someone who is more experienced with analytics. Your feedback is important to us. Please let us know what you think of the usefulness of this material and any suggestions you may have.

Andrew Young Morgan Stanley 1585 Broadway New York, NY 10036 Andrew.Young@morganstanley.com

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This material has been prepared solely for information purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy. It is based on or derived from information generally available to the public from sources believed to be reliable. No representation is made that information or formulae included herein are accurate or complete or that any results obtained therefrom are indicative of actual prices or returns. All pricing and other data herein are derived from Morgan Stanley unless referenced otherwise. Past performance is not necessarily indicative of future results. Additional information is available on request. 159