Siddhartha Jha - Interest Rate Markets

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Copyright 2011 by Siddhartha Jha. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Jha, Siddhartha, 1984
Interest rate markets : a practical approach to fixed income / Siddhartha Jha.
p. cm. (Wiley trading series)
Includes bibliographical references and index.
ISBN 978-0-470-93220-9 (cloth); ISBN 978-1-118-01777-7 (ebk);
ISBN 978-1-118-01778-4 (ebk); ISBN 978-1-118-01779-1 (ebk)
1. Interest rates. 2. Fixed-income securities. 3. Bonds. I. Title.
HG1621.J43 2011
332.632044dc22
2010043312

To my parents

Acknowledgments

This work is the outcome of inspiration, training, and support I received from so many colleagues, friends, and family. Much as I am deeply indebted to them, I cannot possibly mention them all in the short space here. To name just a few, Pavan Wadhwa and Srini Ramaswamy helped me understand markets in a thorough and logical manner throughout my career. I would like to thank Ross Jackman and Russ Mannis for their encouragement at the start of my career in municipals. My discussions about finance with colleagues such as Manas Baveja and Anthony Heading over the years have been instrumental in addressing any doubts in my thought process. I also want to acknowledge Kelly for her unwavering support.

A number of individuals took the time to perform the arduous task of editing and offered advice on content. Specifically, I want to express my gratitude to my dad and to Hitomi Kimura for their assistance.

Last, but definitely not least, I would like to thank the editing staff at Wiley who took the time to thoroughly edit my manuscripts. In particular, I thank Laura Walsh, Judy Howarth, and Laura Cherkas for their assistance with the whole publication process.

Introduction

The U.S. fixed income market, with securities worth trillions of dollars traded yearly, is one of the largest in the world. It attracts a wide variety of borrowers and investors, from individuals and corporations to governments. The market offers an array of instruments such as bonds, swaps, futures, and options for trading or managing risk. As the size and sophistication of the U.S. fixed income market has increased over the past two decades, so have the challenges and opportunities that come along with these instruments. Managing interest rate risk has become a crucial task for portfolio managers. Indeed, the various crises that punctuated the financial markets over the past two decades have underscored the importance of this task. Therefore, given the complexity of interest rate products and the range of macroeconomic factors that affect them, participants in the fixed income markets need to have frameworks for logical and in-depth analysis of trades and embedded risks.

Such a framework needs to be based on the principles of mathematical modeling as well as an intuitive grasp of the economy and monetary policy. Mathematical models are important because the contemporary fixed income market has numerous complex products that require quantitative foundations. Likewise, the knowledge of fundamentals is indispensable because markets are more integrated than ever before. However, the current literature on the U.S. fixed income market lacks the balance of these essential elements. Some works rely on a qualitative approach, whereas others exaggerate the significance of quantitative models. The overemphasis on models, as is well known, was a part of the problem in recent financial crises.

This book breaks a new, middle ground. It begins with the essential mathematical tools needed to objectively analyze data and financial instruments. These instruments can be thought of as packages of different types of risks that on one hand provide opportunity to trade, and on the other hand involve careful management. Such management requires both mathematical skills and an intuitive grasp of the economy and financial markets. To this end, this book analyzes fundamentals and financial flows and identifies the optimal instruments for a trade using quantitative tools.

This book is meant for both newcomers and experienced professionals in fixed income markets. For newcomers, it builds an understanding of bonds and more complex products such as interest rate swaps, futures, and options. Subsequently, it describes the driving factors behind fixed income markets and explains how to use these products to express views on interest rates and their spreads. For experienced professionals, the book describes economic fundamentals and the behavior of market participants in order to explain short-term as well as long-term drivers of interest rates. As an important companion to trading, the book discusses hedging. The details include its general principles as well as the choice of instrument for a hedge. The information is meant to enable effective risk management and construction of market indicators. Finally, the limitations and pitfalls of each type of trade are discussed; the lessons of past financial crises show there is no such thing as a safe trade.