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Fixed Income Analysis

Fixed Income Analysis

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Fixed Income Analysis:
Securities, Pricing, and Risk Management
Claus Munk\u2217
This version: January 23, 2003
\u2217Department of Accounting and Finance, University of Southern Denmark, Campusvej 55, DK-5230
Odense M, Denmark. Phone: 6550 3257. Fax: 6593 0726. E-mail:cmu@sam.sdu.dk. Internet homepage:
http://www.sam.sdu.dk/\u02dccmu
Contents
Preface
viii
1 Basic interest rate markets, concepts, and relations
1
1.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1
1.2 Markets for bonds and interest rates. . . . . . . . . . . . . . . . . . . . . . . . . .
1
1.3 Discount factors and zero-coupon bonds. . . . . . . . . . . . . . . . . . . . . . . .
5
1.4 Zero-coupon rates and forward rates. . . . . . . . . . . . . . . . . . . . . . . . . .
6
1.4.1 Annualcompounding. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7
1.4.2 Compounding over other discrete periods \u2013 LIBOR rates. . . . . . . . . .
8
1.4.3 Continuouscompounding. . . . . . . . . . . . . . . . . . . . . . . . . . . .
8
1.4.4 Di\ufb00erent ways to represent the term structure of interest rates. . . . . . . 10
1.5 Determining the zero-coupon yield curve: Bootstrapping. . . . . . . . . . . . . . . 10

1.6 Determining the zero-coupon yield curve: Parameterized forms. . . . . . . . . . . 14 1.6.1 Cubicsplines. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 1.6.2 The Nelson-Siegel parameterization. . . . . . . . . . . . . . . . . . . . . . . 18 1.6.3 Additional remarks on yield curve estimation. . . . . . . . . . . . . . . . . 19

1.7 Exercises. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2 Fixed income securities
22
2.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

2.2 Floating rate bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.3 Forwards on bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.4 Interest rate forwards \u2013 forward rate agreements. . . . . . . . . . . . . . . . . . . 25
2.5 Futures on bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
2.6 Interest rate futures \u2013 Eurodollar futures. . . . . . . . . . . . . . . . . . . . . . . . 26
2.7 Options on bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
2.7.1 Options on zero-coupon bonds. . . . . . . . . . . . . . . . . . . . . . . . . 29
2.7.2 Options on coupon bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
2.8 Caps, \ufb02oors, and collars. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

2.8.1 Caps. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 2.8.2 Floors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 2.8.3 Collars. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 2.8.4 Exotic caps and \ufb02oors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

2.9 Swaps and swaptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
i
Contents
ii

2.9.1 Swaps. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 2.9.2 Swaptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 2.9.3 Exotic swap instruments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

2.10 Exercises. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
3 Stochastic processes and stochastic calculus
43
3.1 Probabilityspaces. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

3.2 Stochasticprocesses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 3.2.1 Di\ufb00erent types of stochastic processes. . . . . . . . . . . . . . . . . . . . . 44 3.2.2 Basicconcepts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 3.2.3 Markov processes and martingales. . . . . . . . . . . . . . . . . . . . . . . 46 3.2.4 Continuous or discontinuous paths. . . . . . . . . . . . . . . . . . . . . . . 46

3.3 Brownianmotions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 3.4 Di\ufb00usionprocesses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 3.5 It\u02c6

o processes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

3.6 Stochasticintegrals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 3.6.1 De\ufb01nition and properties of stochastic integrals. . . . . . . . . . . . . . . . 53 3.6.2 Leibnitz\u2019 rule for stochastic integrals. . . . . . . . . . . . . . . . . . . . . . 54

3.7 It\u02c6
o\u2019s Lemma. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

3.8 Important di\ufb00usion processes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 3.8.1 Geometric Brownian motions. . . . . . . . . . . . . . . . . . . . . . . . . . 57 3.8.2 Ornstein-Uhlenbeckprocesses. . . . . . . . . . . . . . . . . . . . . . . . . . 59 3.8.3 Square root processes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

3.9 Multi-dimensionalprocesses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 3.10 Change of probability measure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 3.11 Exercises. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70

4 Asset pricing and term structures: discrete-time models
71
4.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

4.2 A one-period model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 4.2.1 Assets, portfolios, and arbitrage. . . . . . . . . . . . . . . . . . . . . . . . 72 4.2.2 Investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 4.2.3 State-price vectors and de\ufb02ators. . . . . . . . . . . . . . . . . . . . . . . . 75 4.2.4 Risk-neutralprobabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 4.2.5 Redundantassets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 4.2.6 Completemarkets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 4.2.7 Equilibrium and representative agents in complete markets. . . . . . . . . 82

4.3 A multi-period, discrete-time model. . . . . . . . . . . . . . . . . . . . . . . . . . 84 4.3.1 Assets, trading strategies, and arbitrage. . . . . . . . . . . . . . . . . . . . 85 4.3.2 Investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 4.3.3 State-price vectors and de\ufb02ators. . . . . . . . . . . . . . . . . . . . . . . . 87 4.3.4 Risk-neutral probability measures. . . . . . . . . . . . . . . . . . . . . . . 89 4.3.5 Redundantassets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 4.3.6 Completemarkets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

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