Interest Rate

Markets
A Practical Approach to
Fixed Income

SIDDHARTHA JHA

WILEY
John Wiley & Sons, Inc.

Contents
Acknowledgments

xiii

Introduction
CHAPTER 1 Tools of the Trade

xv
''

Basic Statistics
Regression: The Fundamentals
Regression: How Good a Fit? }
Principal Components Analysis
Scaling through Time
Backtesting Strategies
Summary

2
6
11
14
15
16
17

CHAPTER 2 Bonds

19

Basics of Bonds
Risks Embedded in Fixed Income Instruments
Discounting i
Bond Pricing
Yield Curve
Duration
Convexity
Repo Markets
Bid Offer
Calculating Profit/Loss of a Bond
Carry

19
22
27
28
32
34
37
42
44
45
45

Vill

Forward Rates
Roildown/Slide
Curves and Spreads
Butterfly Trades
Summary

CONTENTS

47
51
53
55
56

.
.
i

if

CHAPTER 3 Fixed Income Markets 1

Federal Reserve
Treasuries
STRIPS
TIPS
Mortgages
Agency Debt
Corporate Bonds
Municipal Bonds
Summary

59
60
67
70
71
73
77
; 79
82
84

CHAPTER 4 Interest Rate Futures

85

Basics of Futures Transactions

Eurodollar Futures
Convexity (or Financing) Bias
Creating Longer-Dated Assets Using
Eurodollar Futures
Treasury Futures
Fed Funds Futures
Futures Positioning Data
Summary

86
89
92
93
94
101
104
105

CHAPTER 5 Interest Rate Swaps

107

Basic Principles
Duration and Convexity
Uses of Swaps
Counterparty Risk
Other Types of Swaps
Summary

108
111
112
115
115
124

Contents

ix

CHAPTER 6 Understanding Drivers of

Interest Rates
_.

125

Supply and Demand for Borrowing

'
Components of Fixed Income Supply and Demand
Treasury Supply
,
'
Other Sources of Fixed Income Supply
Fixed Income Demand
-,Short-Term Yield Drivers
Summary

126
141
141
145
148
157
172

CHAPTER 7 Carry and Relative Value Trades

173

Carry Trades
Carry Trade Setup and Evaluation
Pitfalls of the Carry Trade
Carry-Efficient Directional Trades
Relative Value Trades
Setting Up Relative Value Trades
Treasury Bond Relative ValuePar Curve
Other Treasury Relative Value Trades
Summary

173
175
178
182
183
185
191
193
194

CHAPTER 8 Hedging Risks- in Interest

' Rate Products

197

Principles of Hedging
Choices of Instruments for Hedging
Calculating Hedge Ratios
Yield Betas
Convexity Hedging
Summary

198
202
210
215
218
223

CHAPTER 9

Trading Swap Spreads

How Swap Spreads Work

Why Trade Swap Spreads?
Directionality of Swap Spreads to Yields
Futures Asset Swaps

225
225
230
240
241

CONTENTS

Spread Curve Trades

243

Summary

245

CHAPTER 10 Interest Rate Options and

Trading Volatility

247

Option Pricing and Fundamentals

249

Modifications for the Interest Rate Markets

254

Quoting Volatility

256

Measuring Risks in Option Positions

257

Put/Call Parity

266

Implied and Realized Volatility

268

Skew

270

Delta Hedging

270

Interest Rate Options

275

Embedded Options and Hedging

280

More Exotic Structures

283

Yield Curve Spread Options

284

Forward Volatility

285

Volatility Trading

286

Interest Rate Skew

293

Volatility Spread Trades

Caps versus Swaptions

294
,

297

Summary '

298

CHAPTER 11 Treasury Futures Basis

and Rolls

299

The Futures Delivery Option

299

Calculating the Delivery Option Value

309

Option-Adjusted and Empirical Duration

311

Treasury Futures Rolls

313

Summary

318

Contents

xi

CHAPTER 12 Conditional Trades

Conditional Curve Trades
Conditional Spread Trades
Summary

References

319
320
324
328

329

About the Author

331

About the Web Site

333

Index

335