Pricing and Hedging Interest Rate and Credit Risk Sensitive Instruments

The training "Pricing and Hedging Interest Rate and Credit Risk Sensitive Instruments" covers the following topics:

  • Discounted Cash Flow (DCF) Analysis
  • One-Factor Interest Rate Risk Metrics
  • Multi-Factor Interest Rate Risk Metrics
  • Hedging Interest Rate Risk
  • Risk Neutral Pricing and Binomial Models
  • Implementing the Black-Derman-Toy Model
  • Duration, Convexity and OAS with Binomial Pricing
  • Pricing Interest Rate Derivatives
  • Pricing Defaultable Bonds
  • Credit Risk Metrics
  • Pricing Credit Derivatives
  • Hedging Credit Risk
  • Asset-Backed Securities

The training aims to meet the practical needs of risk managers and portfolio managers. The approach is intuitive and mathematically simple (e.g. no continuous time stochastic differential equations); it emphasizes models implementation with applications to representative sample financial instruments, with both Excel spreadsheets and R code examples. The training's philosophy can be summarized as "keep it simple and practical".

1. Discounted Cash Flow (DCF) Analysis

1.1 DCF Analysis

Fixed, floating and inflation-linked bonds DCF pricing; interest rate swaps DCF pricing; par, spot and forward rates; yield to maturity and par yield; discount margin; z-spread.

Part 1 Appendices

1.A Perpetual Bonds Pricing

1.B Principal Protected Notes Pricing

2. One-Factor Interest Rate Risk Metrics

2.1 One-Factor Interest Rate Risk Metrics

Curve/yield duration and convexity measures; interest rate PV01; credit spread PV01 (CS01); portfolio duration and convexity; approximate bond price/portfolio value changes; classical immunization; yield volatility.

Part 2 Appendices

2.A Bond Classifications

2.B Useful Bloomberg Functions

2.C Bond Market Indices

3. Multi-Factor Interest Rate Risk Metrics

3.1 Multi-Factor Interest Rate Risk Metrics

Key Rate Analysis, Key Rate Duration and Key Rate PV01 (KR01); PCA Analysis and Principal Component Durations.

Part 3 Appendices

3.A Cubic Spline Interpolation

3.B The ECB Term Structure Model

3.C Foundations of Return Attribution

4. Hedging Interest Rate Risk

4.1 Hedging Interest Rate Risk

Hedging strategies and basis risk; practical hedging with derivatives; hedging effectiveness.

Part 4 Appendices

4.A Case Study: Metallgesellschaft AG Hedging Program

4.B Currency Hedging

4.C Linear Algebra Review

5. Bond Pricing with Binomial Models

5.1 Risk Neutral Pricing and Binomial Models

State prices and risk neutral probabilities; approaches to build a binomial tree; model calibration.

5.2 Implementing the Black-Derman-Toy Model

Black-Derman-Toy short rate tree and bond price tree; Black-Derman-Toy calibration.

5.3 Duration, Convexity and OAS with Binomial Pricing

Computing effective duration, effective convexity and OAS with binomial models.

6. Pricing Interest Rate Derivatives and Defaultable Bonds

6.1 Pricing Interest Rate Derivatives

Risk-neutral pricing framework; pricing interest rate derivatives with binomial models.

6.2 Pricing Defaultable Bonds

Binomial and DCF defaultable bonds pricing.

Part 6 Appendices

6.A Binomial Pricing vs Monte Carlo Pricing

6.B Black’s Option Pricing Formulas

7. Credit Related Instruments and Credit Risk Metrics

7.1 Credit Default Swaps

Single-name CDS; multi-name CDS; CDS market developments, conventions and activity.

7.2 Other Credit Related Instruments

Asset swaps; credit-linked notes; total return swaps.

7.3 Credit Risk Metrics

Credit ratings; credit spreads; default probability; recovery rates; default correlation.

Part 7 Appendices

7.A CDS case studies

7bis. Pricing and Hedging Credit Risk

7bis.1 Pricing Credit Derivatives

Risk neutral hazard rates; CDS implied survival probabilities; single-name CDS pricing; index CDS pricing; forward-starting CDS pricing; Black’s default swaptions pricing formula.

7bis.2 Hedging Credit Risk

CDS sensitivities; hedging with single-name CDS; hedging with index CDS.

7bis.3 Real World Default Probabilities

Merton model; estimating default probabilities with logistic regression.

8. Asset-Backed Securities

8.1 Asset-Backed Securities

Types of asset-backed securities; securitisation and tranching; single mortgages; prepayment risk; pass-through MBS; sequential-pay CMO; traditional and synthetic CDOs; CLOs now vs CDOs in 2008.

Part 8 Appendices

8.A The Financial Crisis of 2007-2008

References

M. J. Anson, F. J. Fabozzi, M. Choudhry and R. Chen, Credit Derivatives Instruments, Applications, and Pricing. Wiley, 2004.

M. Baxter and A. Rennie, Financial Calculus. Cambridge University Press, 1996.

S. Benninga and Zvi Wiener, Binomial Term Structure Models. Mathematica in Education and Research, 1998.

P. Bjerksund and G. Stensland, Implementation of the Black-Derman-Toy Interest Rate Model. The Journal of Fixed Income, 1996.

F. Black, E. Derman and W. Toy, A One-Factor Model of Interest Rates and Its Application to Treasury Bond Options. Financial Analysts Journal, 1990.

A. Bomfim, Understanding Credit Derivatives and Related Instruments. 2nd ed. Academic Press, 2015.

P. P. Boyle, K. S. Tan and W. Tian, Calibrating the Black–Derman–Toy model: some theoretical results. Applied Mathematical Finance, 2001.

M. Britten-Jones, Fixed Income and Interest Rate Derivative Analysis. Butterworth-Heinemann, 1998.

G. W. Buetow Jr., B. Hanke and F. J. Fabozzi, Impact of Different Interest Rate Models on Bond Value Measures. The Journal of Fixed Income, 2001.

J. Carpenter, Debt Instruments and Markets Lecture Notes, 2011.

D. N. Chorafas, Introduction to Derivative Financial Instruments. McGraw-Hill, 2008.

L. Clewlow and C. Strickland, Implementing Derivative Models. Wiley, 1998.

J. Cox, S. Ross and M. Rubinstein, Option Pricing: a Simplified Approach. Journal of Financial Economics, 1979.

M. Choudhry, Advanced Fixed Income Analysis. Elsevier, 2004.

M. Choudhry, Fixed-Income Securities and Derivatives Handbook. Bloomberg Press, 2005.

M. Deacon, A. Derry and D. Mirfendereski, Inflation-indexed Securities. 2nd ed. Wiley, 2004.

Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report. US Government, 2011.

F. J. Fabozzi, Fixed Income Mathematics: Analytical & Statistical Techniques. 4th ed. McGraw-Hill, 2006.

F. J. Fabozzi, Measuring and Forecasting Yield Volatility. Appendix to Institutional Investment Management: Equity and Bond Portfolio Strategies and Applications. Wiley, 2009.

F. J. Fabozzi, Bond Markets, Analysis, and Strategies. 6th ed. Pearson Prentice Hall, 2007.

F. J. Fabozzi and Steven V. Mann, The Handbook of Fixed Income Securities. 8th ed. Irwin, 2012.

E. Falkenstein and J. Hanweck, Minimizing Basis Risk from Nonparallel Shifts in the Yield Curve. Journal of Fixed Income, 1996.

E. Falkenstein and J. Hanweck, Minimizing Basis Risk from Nonparallel Shifts in the Yield Curve Part II. Journal of Fixed Income, 1997.

L. Giordano and G. Siciliano, Real-world and risk-neutral probabilities in the regulation on the transparency of structured products. Quaderni di Finanza CONSOB, 2013.

N. Gisiger, Risk-Neutral Probabilities Explained. Research paper, 2010.

R. Hauswald, Note on Floaters and Swaps. Technical Note, 2010.

D. G. Luenberger, Investment Science. Oxford University Press, 1998.

J. Hull, Options, Futures and Other Derivatives. 8th ed. Prentice Hall, 2012.

J. Hull, Risk Management and Financial Institutions. 4th ed. Wiley, 2015.

M. Jackson and M. Staunton, Advanced Modelling in Finance using Excel and VBA. Wiley, 2001.

R. Jarrow, Modeling Fixed-Income Securities and Interest Rate Options. 2nd ed. Stanford University Press, 2002.

R. Jarrow and S. Turnbull, Derivative Securities. 2nd ed. South-Western, 1999.

C. Lee, Metallgesellschaft AG and Its Hedging Program. Case study, 2011.

Z. Lei, A Java Applet for pricing Bonds and Bond Options using the Black-Derman-Toy model. Master thesis, 2005.

J. London, Modeling Derivatives in C++. Wiley Finance, 2007.

L. Martellini, P. Priaulet and S. Priaulet, Fixed-Income Securities: Valuation, Risk Management and Portfolio Strategies. Wiley, 2003.

A. Mello and J. Parsons, Maturity Structure of a Hedge Matters: Lessons from the Metallgesellschaft Debacle. Journal of Applied Corporate Finance, 1995.

R. L. McDonald, Derivatives Markets. 3rd ed. Pearson Education, 2013.

K. Musaelian, S. Nagarajan and D. Villani, PCA: Invariant Risk Metrics and Representation of Residuals for Bond Returns. Research Paper, 2016.

S. K. Nawalkha and G. M. Soto, Managing Interest Rate Risk: the Next Challenge. Research Paper, 2012.

S. K. Nawalkha, G. M. Soto and N. A. Beliaeva, Interest Rate Risk Modeling. Wiley, 2005.

S. N. Neftci, Principles of Financial Engineering. 2nd ed. Academic Press, 2008.

Permanent Subcommittee on Investigations. JPMorgan Chase Whale Trades: a Case History of Derivatives Risks and Abuses. US Senate, 2013.

B. Petitt, J. Pinto and W. Pirie, Fixed Income Analysis. 3rd ed. Wiley, 2015.

M. Raffaelli, BESA Floating Rate Note (FRN) Pricing Specification. Methodology paper, 2005.

P. Ritchken, Derivative Markets: Theory, Strategy, and Applications. HarperCollins, 1996.

F. Skinner, Pricing and Hedging Interest and Credit Risk Sensitive Instruments. Elsevier, 2005.

S. Shreve, Stochastic Calculus for Finance I: The Binomial Asset Pricing Model. Springer, 2005.

S. M. Sundaresan, Fixed Income Markets and Their Derivatives. 3rd ed. Academic Press, 2009.

N. Taleb, Dynamic Hedging: Managing Vanilla and Exotic Options. Wiley, 1997.

B. Tuckman and A. Serrat, Fixed Income Securities: Tools for Today’s Markets. 3rd ed. Wiley Finance, 2012.

D. Van Deventer, K. Imai and M. Mesler, Advanced Financial Risk Management. 2nd ed. Wiley, 2013.

P. Veronesi, Fixed Income Securities: Valuation, Risk and Risk Management. Wiley, 2010.

N. Wagner, Credit Risk Models, Derivatives, and Management. Chapman & Hall/CRC, 2008.

P. Wilmott, Paul Wilmott on Quantitative Finance. 2nd ed. Wiley, 2006.

Y. Zheng, Liability Driven Investment Optimization. Master Thesis, 2007.