Preface
Participants in today's fixed income markets need to know not only details of
particular instruments such as Treasury bonds, corporate bonds, mortgages,
swaps, etc. but also the analytical framework and techniques required for
pricing and hedging. Although many good descriptions of particular instruments and market conventions are readily available, the explosive growth in
analytical methods in recent years has meant that many analytical results
are only available in journals or working papers. Many of these articles are
written at a very high level of mathematical abstraction, resulting in many
analytical tools being unavailable to the general reader.
The central thesis of this text is that the fundamentals of fixed income
and interest rate derivative analysis are simple and can be easily understood
not as high-powered mathematical formulas, but as a small number of simple
economic concepts. From these simple principles a wide range of fixed income
instruments and derivatives can be valued and hedged:
9 Fixed cash flows can be valued using the principle of static replication.
The underlying concept is no more difficult than the notion of pricing
a basket of shopping goods given the prices of the individual goods.
9 More complex cashflows such as FRAs, inverse floaters, futures, and
simple swaps can be understood, valued, and hedged using the concept
of simple dynamic replication.
9 Generalized interest-rate-sensitive cash flows such as caps and floors,
bond options, and callable bonds can also be valued and hedged using
the concept of replication. However, replication now takes place within
the context of a specific model, and the merits and drawbacks of various
types of model are discussed.
The simplicity of the underlying economic principles provides a unifying
theme to the text. In general, these concepts are reinforced and amplified not
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PREFACE
with high-powered mathematics, but with actual examples of various market
instruments. In this manner a large number of instruments is covered without
sacrificing the analysis essential to a true understanding of the instruments.
A second theme is the incorporation of real world frictions such as transactions costs and short-selling constraints into the analytical framework.
Though often ignored, such considerations are vital when making choices in
the market.