AIMR Suggested Fixed-Income Readings

Section I: Perspectives on Interest Rates and the Pricing of Traditional Fixed-Income Securities, Yield
Curve Behavior, and Monetary Policy
 Section II: Valuation of Bonds and Derivatives
 Section III: Tax and Accounting Issues
 Section IV: Risk Measurement and Risk Management
 Section V: International Fixed-Income Analysis and Portfolio Management
I. Perspectives on Interest Rates and Pricing of Traditional Fixed-Income Securities, Yield Curve Behavior,
and Monetary Policy
Section I Study Guides
STUDY SESSION 1
Overview: Institutional Details and Pricing Fundamentals
READING 1: "An Overview of Fixed-Income Securities," Ch. 1, Fixed Income Markets and Their Derivatives,
Suresh M. Sundaresan (South-Western College Publishing, 1997), pp. 3-39. This reading provides a broad
perspective on fixed-income securities markets. The roles of issuer, investor, and intermediary are presented from
both a domestic (U.S.) and global perspective. The chapter provides a framework for pricing fixed-income securities
for each of the security sectors discussed. Sources of risk that must be modeled for pricing purposes for each sector
are laid out. Level of difficulty: Not difficult. Estimated study time: 2 hours.
READING 2: "Organization and Conduct of Debt Markets," Ch. 2, Fixed Income Markets and Their Derivatives,
Suresh M. Sundaresan (South-Western College Publishing, 1997), pp. 41-75. Various forms of financial market
structures, including direct search, brokered markets, dealer markets, and auction markets, are discussed. This
reading introduces transparency and adverse selection (which are properties of market organization relating to
information). It presents the role of the U.S. Federal Reserve System and the mechanisms by which it operates and
attempts to influence financial markets. The reading examines securities dealers in terms of their trading activities,
position management (to reflect interest rate predictions), and leveraging activity in the repo market. The reading
ends with a review of the role of the U.S. federal government in exercising its responsibility for enforcement and
market surveillance. Level of difficulty: Not difficult. Estimated study time: 1.5 hours.
READING 3: "Treasury Auctions and Selling Mechanisms," Ch. 3, Fixed Income Markets and Their Derivatives,
Suresh M. Sundaresan (South-Western College Publishing, 1997), pp. 77-102. The reading presents various auction
mechanisms, provides details of U.S. government security auctions, and introduces the concept of the "winner's
curse" (the possibility of an aggressive bidder paying too much relative to the market consensus) for discriminatory
auctions. Furthermore, this reading is important to readers because of the potential for growth in emerging markets;
developing countries need to choose mechanisms to carry out their bond sales as their economies mature. Level of
difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 4: "Bond Mathematics," Ch. 4, Fixed Income Markets and Their Derivatives, Suresh M. Sundaresan
(South-Western College Publishing, 1997), pp. 103-54. This reading serves as a rigorous review of the basic
concepts of yield calculation and price risk (duration, convexity) for individual instruments and portfolios. Hedging
under conditions of perfect and imperfect correlation is addressed. The actual market mechanisms (e.g., repo
financing) are presented in the context of setting up hedged trading strategies. Level of difficulty: Difficult.
Estimated study time: 3 hours.
READING 5: "Yield-Curve and Term-Structure Analysis," Ch. 5, Fixed Income Markets and Their Derivatives,
Suresh M. Sundaresan (South-Western College Publishing, 1997), pp. 155-205. This reading introduces building
blocks for the analysis of the yield curve and concepts relating to the term structure of interest rates. Stripping and
reconstituting coupon bonds is discussed with an eye toward examining the arbitrage relationships that hold between
zero-coupon and coupon-paying instruments. The reader is cautioned that frictions such as liquidity and coupon
(tax) effects may create the appearance of an arbitrage violation where none exists. Level of difficulty: Moderately
difficult. Estimated study time: 3 hours.
READING 6: "Piecewise Cubics," Appendix 4C, Fixed Income Securities, University Edition, Bruce Tuckman
(John Wiley & Sons, 1996), pp. 60-61. Often when the term structure of interest rates is bootstrapped, observations
are not available at every point along the maturity spectrum to allow a smooth, continuous relationship. As a result,
the nature of the relationship between observed data points must be estimated. The piecewise cubics procedure
permits the estimation of the relationship between two observations so that a smooth relationship between spot rates
and maturity is obtained. Note that this procedure is purely an estimation technique and has no financial foundation.
Level of difficulty: Not difficult. Estimated study time: 0.5 hour.
STUDY SESSION 2
Yield Curve Analysis-Part 1
READING 1: "Overview of Forward Rate Analysis (Available Online)" Part 1, Understanding the Yield Curve,
Antti Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon Brothers, May 1995), pp. 1-19. The yield
curve can be represented either by coupon bond yields (par rates), zero coupon bond yields (spot rates), or forward
rates. The yield curve shape depends on three determinants: the market's rate expectations, the required bond risk
premiums, and the convexity bias. Thus forward rates do not only reflect the market's rate expectations, because
positive bond risk premiums tend to make the yield curve upward sloping, and the convexity bias tends to pull the
curve down at very long durations. Forward rate analysis can be useful both for "view-taking" investors and for
relative-value analysts. Forward rates are not only breakeven rates against which investors can compare their
subjective rate expectations. Forward rates also measure the near-term returns that various zero coupon bonds will
earn if the yield curve remains unchanged. Level of difficulty: Moderately difficult. Estimated study time: 3 hours.
READING 2: "Market's Rate Expectations and Forward Rates (Available Online)," Part 2, Understanding the
Yield Curve, Antti Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon Brothers, June 1995), pp. 121. The market's interest rate expectations may be the most important determinant of the yield curve's shape. The
market's view on the rate direction influences the slope of today's yield curve; the market's view on curve-flattening
or curve-steepening influences the curvature of today's yield curve. However, it is more appropriate to view the
implied forward yield curves as breakeven yield curves than as the market's rate expectations. The implied forward
yield curve shows, by construction, the future yield curve that would make all government bonds earn the same
return over the horizon. In contrast, empirical evidence suggests that the implied forward yield curve is a poor
predictor-somewhat worse than the current yield curve (a no-change prediction)-of the future yield curve. Level of
difficulty: Moderately difficult. Estimated study time: 3 hours.
READING 3: "Does Duration Extension Enhance Long-Term Expected Returns? (Available Online)" Part 3,
Understanding the Yield Curve, Antti Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon
Brothers, July 1995), pp. 1-18. The required bond risk premiums, or the near-term expected return differentials
between longer bonds and the "riskless" short-term bond, tend to make the yield curve upward sloping. Various
theories propose that bond risk premiums should increase with duration, with return volatility, or with sensitivity to
systematic risk factors. In addition to these risk differences, expected return differentials across bonds may reflect
technical factors, such as liquidity differences. If bond risk premiums are constant over time, one can estimate them
by using historical average return differentials. Empirical analysis confirms that average bond risk premiums are
positive; thus, duration extension does enhance long-run expected returns. However, although the average returns
increase very fast at short durations, the incremental reward from duration extension is small after two years. Level
of difficulty: Moderately difficult. Estimated study time: 3 hours.
STUDY SESSION 3
Yield Curve Analysis-Part 2
READING 1: "Forecasting U.S. Bond Returns (Available Online)," Part 4, Understanding the Yield Curve, Antti
Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon Brothers, August 1995), pp. 1-20. If required
bond risk premiums vary over time, historical average bond returns may reflect time-varying risk premiums rather
than changing rate expectations. Changes in risk premiums may be predictable. The main implication for investors,
therefore, is that bond market fluctuations are partly forecastable. Empirical evidence shows that yield curve
steepness can be used to distinguish more opportune from less opportune times to invest in long-duration bonds.
Combining steepness with other predictors can further enhance the bond return forecasts. Historical backtests show
that dynamic strategies that exploit the return predictability would have substantially outperformed passive bond
market strategies over the longer run. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 2: "Convexity Bias and the Yield Curve (Available Online)," Part 5, Understanding the Yield Curve,
Antti Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon Brothers, September 1995), pp. 1-23.
Convexity bias is the least-known influence on the yield curve shape. Positive convexity in a bond's price-yield
curve is a valuable property because it gives "option like" features to straight bonds and thus implies the possibility
of enhancing the bond's performance if large yield changes occur. Because of their convexity advantage, longduration bonds can have lower yields than short-duration bonds and yet offer similar near-term expected returns.
This convexity bias partly explains the Treasury spot rate curve's typical inversion at the long end. The magnitude of
convexity bias depends on the perceived level of yield volatility. Incorporating this effect into relative-value analysis
is especially important for long-duration bonds. Historical analysis shows that the convexity effect influences the
performance of duration-neutral barbell/bullet positions (i.e., buying barbells financed by selling bullets) but tends to
be overwhelmed by the curve-reshaping effect. Level of difficulty: Moderately difficult. Estimated study time: 2
hours.
READING 3: "A Framework for Analyzing Yield Curve Trades (Available Online)," Part 6, Understanding the
Yield Curve, Antti Ilmanen, Portfolio Strategies, U.S. Fixed Income Research (Salomon Brothers, November 1995),
pp. 1-23. Forward rates, and thus the yield curve shape, can be decomposed into three determinants: the market's
rate expectations, the required bond risk premiums, and the convexity bias. Similarly, the near-term expected return
of government bonds can be decomposed into the following simple building blocks: the yield income, the roll-down
return, the value of convexity, and the duration impact of the rate expectation. This framework is useful for
evaluating all types of government bond positions and is closely related to scenario analysis. Comprehensive
expected return measures are likely to produce better relative-value signals than yield spreads do, especially for
barbell/bullet trades. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 4: "The Cyclical Behavior of U.S. Interest Rates: Theory and Evidence (Available Online)," Michael
R. Rosenberg, Currency and Bond Market Trends, Merrill Lynch, Pierce, Fenner, & Smith (August 1, 1991), pp. 6065. This reading describes a framework for identifying cyclical peaks and troughs in U.S. interest rates. The article
introduces a stylized model to describe how short- and long-term interest rates and the yield curve typically behave
in the course of a business cycle. Although the precise movements of short- and long-term interest rates differ from
cycle to cycle, the article identifies a number of recognizable recurring themes. The reader will be able to put
together a list of variables to help identify when cyclical peaks and troughs in U.S. interest rates should occur and
thus be able to determine the optimal structure of actively managed bond portfolios in terms of duration. Level of
difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 5: "Some Lessons from the Yield Curve," John Y. Campbell, Journal of Economic Perspectives,
American Economic Association (Summer 1995), pp. 129-52. This reading summarizes recent research on the term
structure of interest rates and relates the research to recent swings in the U.S. bond market. The reader will gain
valuable insights into how changes in U.S. monetary policy may affect the U.S. bond market in the future. Level of
difficulty: Not difficult. Estimated study time: 2 hours.
STUDY SESSION 4
Monetary Policy, Interest Rates, and Portfolio Strategy
READING 1: "Monetary Policy Actions and Long-Term Interest Rates (Available Online)," V. Vance Roley and
Gordon H. Sellon, Jr., Economic Review, Federal Reserve Bank of Kansas City (Fourth Quarter 1995), pp. 73-89.
This reading examines the relationship between U.S. monetary policy and long-term interest rates, showing that the
relationship is not stable but, instead, varies over the course of a business cycle. The article reviews the empirical
work conducted in this area and shows that the response of long-term interest rates to monetary policy actions will
vary in both direction and magnitude depending on whether the policy actions are expected to be persistent or
transitory. Level of difficulty: Not difficult. Estimated study time: 1 hour.
READING 2: "Interest Rate Policy and the Inflation Scare Problem: 1979-1992 (Available Online)," Marvin
Goodfriend, Economic Quarterly, Federal Reserve Bank of Richmond (Winter 1993), pp. 1-24. This highly readable
article analyzes the roles that Federal Reserve policy and, more importantly, Federal Reserve credibility have played
in the determination of U.S. interest rates. The reading contends that the Fed's credibility is extremely fragile and
that the result is often long lags between changes in U.S. monetary policy and changes in U.S. long-term interest
rates. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 3: "The Investment Implications of an Inverted Yield Curve (Available Online)," Fixed Income
Research, Goldman, Sachs & Co. (January 1989), pp. 1-28. This reading reviews the history of U.S. yield curve
inversions and infers from past behavior what strategies should be undertaken when the yield curve becomes
inverted. Although this paper was written several years ago and refers to the 1989 outlook, it is appropriate for
today's world. The author shows that barbell portfolios will generally outperform intermediate-maturity portfolios
when the yield curve is expected to remain inverted. The author also shows how the corporate and mortgage markets
typically behave during inverted-yield-curve environments. Level of difficulty: Moderately difficult. Estimated
study time: 2 hours.
II. Valuation of Bonds and Derivatives
Section II Study Guides
STUDY SESSION 5
Corporate Bond Pricing and Arbitrage-Free Pricing
READING 1: "Agency and Corporate Debt Securities," Ch. 8., Fixed Income Markets and Their Derivatives,
Suresh M. Sundaresan (South-Western College Publishing, 1997), pp. 313-56. The reading provides perspective on
volume of trade and bond-rating distribution for the agency, corporate, and hybrid fixed-income sectors. The
motivation for issuing various types of debt instruments, such as callable or putable debt, is discussed. The author
presents models for analyzing default spreads and financial distress in the corporate debt market and shows how
they explain observed spreads of corporate bonds over U.S. Treasuries. Level of difficulty: Moderately difficult.
Estimated study time: 3 hours.
READING 2: "Understanding Aggregate Default Rates of High Yield Bonds (Available Online)," Jean Helwege
and Paul Kleiman, Current Issues in Economics and Finance, Federal Reserve Bank of New York (May 1996), pp.
1-6. This reading presents a summary of previous research on predicting high-yield default rates. It uses refined
proxies (relative to past work) for credit ratings, the macroeconomy, and an aging factor to show how default rates
can be predicted with substantial confidence. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 3: "An Introduction to Arbitrage-Free Pricing of Derivatives," Ch. 5, Fixed Income Securities,
University Edition, Bruce Tuckman (John Wiley & Sons, 1995), pp. 67-72. This reading provides an example of the
arbitrage-free pricing of an interest rate option. Given a binomial model of the future and random movement of
interest rates, one can replicate the cash flow of an interest rate option by trading in a portfolio of two zero coupon
bonds. In other words, the replicating portfolio mimics the value of the option at its expiration regardless of what
happens to interest rates. Therefore, the replicating portfolio and the option must have the same value. And because
the value of the portfolio is known from the value of its component zeros, the value of the option is also known.
Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 4: "Risk-Neutral Pricing," Ch. 6, Fixed Income Securities, University Edition, Bruce Tuckman (John
Wiley & Sons, 1995), pp. 73-76. Finding the composition of the portfolio that replicates a particular interest rate
derivative is tedious. Fortunately, as this reading shows, a short-cut to arbitrage-free pricing exists. One can adjust
the assumed interest rate process so that all zero coupon bonds are priced correctly. Then, pricing the derivative by
discounting its expected value in the adjusted interest rate process produces the same result as the more cumbersome
portfolio replication technique. This subtle result of financial economics has an intuitive explanation. Level of
difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 5: "Arbitrage-Free Pricing in a Realistic Setting," Ch. 7, Fixed Income Securities, University Edition,
Bruce Tuckman (John Wiley & Sons, 1995), pp. 77-87. This reading extends the analysis of Chapters 5 and 6 in the
following ways. First, the author shows how to extend the pricing framework to an arbitrary number of dates.
Second, he shows how to allow for time intervals of any length between model dates. Usually, using a small time
interval increases accuracy at the expense of added computational effort. Level of difficulty: Moderately difficult.
Estimated study time: 1 hour.
STUDY SESSION 6
Term Structure Models and General Financial Engineering
READING 1: "The Art of Term-Structure Modeling," Ch. 8, Fixed Income Securities, University Edition, Bruce
Tuckman (John Wiley & Sons, Inc., 1995), pp. 89-109. The art of term structure modeling is choosing a "good"
interest rate process. This reading presents a description of several important term structure models and a review of
their construction. The Ho-Lee model assumes that interest rates are normally distributed with a constant drift and
volatility. The original Salomon Brothers model assumes a lognormal rate process in which the volatility of rates
increases with the level of rates. The Black-Derman-Toy model allows volatility to change over time in such a way
that the term structure of volatilities in the model reflects the fact that volatilities of long-term rates tend to be lower
than volatilities of short-term rates. Finally, the Black-Karasinski model adds mean reversion, the property that rates
tend to fall when very high and rise when very low. Level of difficulty: Difficult. Estimated study time: 2 hours.
READING 2: "The Arithmetic of Financial Engineering," Donald J. Smith, Journal of Applied Corporate Finance,
Stern Stewart & Co. (Winter 1989), pp. 49-58. This reading provides a remarkably straightforward but
comprehensive treatment of how complex derivatives can be engineered by combining simple structures to create an
otherwise unavailable risk-return tradeoff. The article shows how traditional fixed-income bonds and floating-rate
notes and such off-balance-sheet products as swaps, caps, floors, and collars are related and can be combined to
create securities. Level of difficulty: Not difficult. Estimated study time: 1 hour.
READING 3: "The Options Embedded in Corporate Bonds," Ch. 17, Fixed Income Securities, University Edition,
Bruce Tuckman (John Wiley & Sons, 1995), pp. 209-35. Many corporate bonds are callable-that is, the issuer has
the right to buy bonds from the bondholders at a fixed price. The term structure models introduced in earlier
chapters of Tuckman's book can price these embedded call options. This pricing analysis provides insights into the
price and duration behavior of callable bonds relative to their noncallable equivalents. The analysis also reveals that
yield to call is not a satisfactory valuation methodology. In addition, many corporate bonds also contain sinkingfund requirements. Although the reality is not commonly recognized, these "requirements" are, in fact, a set of
valuable call options exercisable by the issuer. In the presence of both a call option and a sinking-fund requirement,
issuers may choose to exercise a partial call, which is equivalent to purchasing only part of an outstanding issue.
Level of difficulty: Moderately difficult. Estimated study time: 3 hours.
READING 4: "Interest Rate Derivatives and the Use of Black's Model," Ch. 16, Options, Futures, and Other
Derivatives, Third Edition, John C. Hull (Prentice-Hall, 1997), pp. 387-411. This reading introduces some of the
securities associated with interest rate derivatives-exchange-traded interest rate options, embedded bond options,
and mortgage-backed securities (MBS). The chapter focuses primarily on using Black's (1976) option-pricing model
for interest rate options. The author uses the model to evaluate bond options, caps, floors, and swaptions. The author
also explains the effects of convexity of adjustments to the price-yield relationship on forward yields and how to
account for convexity. Level of difficulty: Difficult. Estimated study time: 4 hours.
READING 5: "Anatomy of the Structured Note Market," Leland Crabbe and Joseph Argilagos, Journal of Applied
Corporate Finance, Stern Stewart Management Services (Fall 1994), pp. 85-98. The structured-note market offers
investors a tailored investment vehicle and allows issuers to lower their capital costs. The market for structured
notes has grown exponentially in recent years because investors and issuers have recognized the advantages that
these securities offer. A structured note is designed and sold in a way that meets the investor's specific investment
objectives. The issuer of the note then offsets the structure by entering into a derivative arrangement with an
investment bank in such a way that reduces the net capital costs. The market does contain some unique risks and
problems. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
STUDY SESSION 7
Applications: Floaters, Futures, and Swaps-Part 1
READING 1: "Forward and Futures Contracts," Ch. 14, Fixed Income Securities, University Edition, Bruce
Tuckman (John Wiley & Sons, 1995), pp. 171-89. Forward and futures contracts are agreements to trade some asset
in the future at a price fixed today. Forward contracts require no cash flows until maturity; futures contracts require
mark-to-market payments. As a result, forward contracts on fixed-income securities can be priced by arbitrage
arguments whereas the pricing of futures contracts requires a term structure model. Traded futures contracts are
further complicated by delivery and timing options. Level of difficulty: Moderately difficult. Estimated study time: 3
hours.
READING 2: "Floaters and Inverse Floaters," Ch. 15, Fixed Income Securities, University Edition, Bruce Tuckman
(John Wiley & Sons, 1995), pp. 191-95. This reading deals with securities that are called fixed-income securities but
do not make fixed payments. Examples include floaters and inverse floaters, whose payments depend on future
levels of interest rates. Although the nature of these securities seems complicated, many floaters are quite easy to
price. Simple floating-rate bonds, of any maturity, have durations equal to the time until the next coupon payment.
The duration of a typical inverse floater is greater than its maturity. Thus, inverse floaters are very risky relative to
other bonds with similar maturities. Level of difficulty: Not difficult. Estimated study time: 1 hour.
READING 3: "Interest Rate Swaps," Ch. 16, Fixed Income Securities, University Edition, Bruce Tuckman (John
Wiley & Sons, 1995), pp. 197-207. In a typical interest rate swap, Party A agrees to make fixed payments to Party B
and Party B agrees to make floating payments to Party A. Given knowledge of how to value both fixed- and
floating-rate bonds, one can learn relatively easily how to price swaps and calculate their interest rate sensitivities.
Despite many claims to the contrary, swaps are zero-sum agreements with respect to the present value of future cash
flows for the transacting parties. Even so, however, a swap contract may reduce risk for both parties, making the
trade advantageous to both. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
STUDY SESSION 8
Applications: Floaters, Futures, and Swaps-Part 2
READING 1: "Forward Swaps, Swap Options, and the Management of Callable Debt," Keith C. Brown and Donald
J. Smith, Journal of Applied Corporate Finance, Stern Stewart & Co. (Winter 1990), pp. 59-71. This reading
explores alternative methods of using forward swaps and "swaptions" for protecting the value of a bond's call
provision when the call provision cannot be exercised for several years hence. The analysis covers two swap
strategies to manage callable debt. The first preserves the value of an option to call its own debt. The second strategy
entails the immediate capture or "monetization" of the present value of the bond's call option. Other topics include
the relationship between swap and bond spreads, basis risk, and the effectiveness of forward swap and swaption
hedges. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 2: "Interest-Rate Caps and Floors and Compound Options," Ch. 57, Anand K. Bhattacharya, The
Handbook of Fixed Income Securities, Fourth Edition, Frank J. Fabozzi and T. Dessa Fabozzi, eds. (Irwin, 1995),
pp. 1255-74. This reading describes the basic features and cash flow dynamics of caps, floors, and compound
options and discusses how these products are related to one another. Some basic valuation techniques are covered.
The use of these products in asset/liability management is illustrated. Several exhibits illustrate the effective interest
expense of caps, participating caps, floors, collars, and corridors relative to traditional financing vehicles. The
existence of embedded caps in collateralized mortgage obligation (CMO) floaters and adjustable-rate mortgages
(ARMs) is discussed. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 3: "Overview of the Swap Market," Ch. 1, Interest Rate and Currency Swaps: A Tutorial, Keith C.
Brown and Donald J. Smith (Research Foundation of the Institute of Chartered Financial Analysts, September
1995), pp. 1-18. This reading begins with the historical development of the swap market. The basic product design
and market conventions for both interest rate and currency swaps are covered. The reading concludes with a
discussion of recent trends in the use of swap contracts. Level of difficulty: Not difficult. Estimated study time: 1
hour.
READING 4: "Economic Interpretations of a Swap Contract," Ch. 2, Interest Rate and Currency Swaps: A
Tutorial, Keith C. Brown and Donald J. Smith (Research Foundation of the Institute of Chartered Financial
Analysts, September 1995), pp. 19-39. The authors characterize swaps in several economically meaningful ways.
First, swaps can be viewed as a combination of capital market transactions. The reading outlines how swap contracts
have significant advantages over fully replicating transactions in traditional capital market instruments. This
perspective is useful for valuing a swap and determining its duration. Next, swaps can be depicted as a sequence of
forward contracts. This interpretation helps to illustrate the impact of credit risk on swaps. Finally, the authors
provide an option market characterization. This interpretation invites the use of option-pricing analysis to analyze
swaps. The reading concludes with insights on how to value off-market swap contracts. Level of difficulty:
Moderately difficult. Estimated study time: 2 hours.
READING 5: "Swap Applications," Ch. 3, Interest Rate and Currency Swaps: A Tutorial, Keith C. Brown and
Donald J. Smith (Research Foundation of the Institute of Chartered Financial Analysts, September 1995), pp. 41-60.
This reading demonstrates how corporations use swaps to repackage asset and liability cash flows. Applications
considered take one of three forms: risk management, structured finance, or asymmetrical information. Swaps are
shown to facilitate interest rate management by allowing financial managers to match asset and liability durations.
The reading also shows how managers seek to reduce borrowing costs or enhance returns by using swaps in
arbitrage or structured finance. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 6: "Pricing Interest Rate and Currency Swaps," Ch. 4, Interest Rate and Currency Swaps: A Tutorial,
Keith C. Brown and Donald J. Smith (Research Foundation of the Institute of Chartered Financial Analysts,
September 1995), pp. 61-81. This reading discusses the intricacies of swap contracts and the conventions used in
pricing swaps. The distinction is made between swap pricing and swap valuation. The various methods of pricing
swaps off of forward curves are shown. In particular, Chapter 4 covers pricing swaps off of directly observed
forward curves, pricing swaps off of implied forward curves from a cash market, and estimating swap prices when
no futures or cash markets are available. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
STUDY SESSION 9
Applications: Mortgage-Backed and Asset-Backed Securities-Part 1
READING 1: "Mortgage-Backed Securities," Ch. 18., Fixed Income Securities, University Edition, Bruce Tuckman
(John Wiley & Sons, 1995), pp. 237-60. This chapter summarizes models of mortgage security pricing; a binomial
interest rate model is used to explain the value of the prepayment option in a mortgage. The author discusses why
homeowners do not optimally prepay mortgages and summarizes the types of models used to predict homeowners'
actual refinancing behavior and determine the fair value of mortgage securities. Finally, the author explains the
effect that changes in yields have on several types of mortgage securities. Level of difficulty: Moderately difficult.
Estimated study time: 1 hour.
READING 2: "Mortgage Prepayment Modeling: I," Ch. 8, Charles Shorin and Mark S. Gordon, The Handbook of
Mortgage-Backed Securities, Fourth Edition, Frank J. Fabozzi, ed. (Probus, 1995), pp. 127-42. Prepayments are
critical to the analysis of mortgage-backed securities. This reading begins with a review of historical prepayment
behavior. The authors then discuss the seasonal pattern of prepayments and the issue of prepayment burnout. Next,
they discuss the seasoning (or aging) pattern of prepayment rates. The effect of interest rates on refinancing is
reviewed, and the implications of incorporating the various factors that affect prepayments into a model are
described. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 3: "Understanding CMOs, REMICs, and Other Mortgage Derivatives," Andrew S. Carron, Journal of
Fixed Income, Institutional Investor (June 1992), pp. 25-43. This reading provides a description of various types of
mortgage-backed securities and common mortgage derivatives. Mortgage cash flows, prepayments, and
performance considerations are described. The article also provides a lucid description of mortgage derivative
structures. The discussion of collateralized mortgage obligations (CMOs) focuses on how each tranche adds value
by redistributing interest rate, prepayment, and operational risks. Level of difficulty: Moderately difficult. Estimated
study time: 1 hour.
READING 4: "Stripped Mortgage-Backed Securities," Ch. 14, Lakhbir S. Hayre, Errol Mustafa, and Vincent Pica,
The Handbook of Mortgage-Backed Securities, Fourth Edition, Frank J. Fabozzi, ed. (Probus, 1995), pp. 225-48.
The reading provides a description of the various types of stripped mortgage-backed securities and the development
of the market for these securities are described, and it examines the investment characteristics of IO and PO
securities. Valuation of these securities involves examining the effect of prepayments on their value, their optionadjusted spreads, and their effective durations. The reading also demonstrates how to use these instruments for
hedging. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 5: "Asset-Backed Securities," Ch. 26, Tracy Hudson van Eck, The Handbook of Fixed Income
Securities, Fourth edition, Frank J. Fabozzi and T. Dessa Fabozzi, eds. (Irwin, 1995), pp. 583-601. This reading
gives an in-depth overview of asset-backed securities, including such relevant topics as their history, structure, cash
flows, risks, and pricing. The reading also outlines the differences between installment loan and revolving credit
asset-backed securities. Two cases are studied to evaluate the legalities involved when an issuer declares bankruptcy
or enters Federal Deposit Insurance Corporation receivership. Level of difficulty: Not difficult. Estimated study
time: 1 hour.
READING 6: "Asset-Backed Securities: An Attractive Addition to the Low-Duration Sector of the Fixed Income
Market," Ch. 10, William J. Curtin and Stephen H. Deckoff, The Handbook of Asset-Backed Securities, Jess
Lederman, ed. (New York Institute of Finance, 1990), pp. 205-25. This reading examines the price and return
sensitivity of asset-backed securities. It explains the differences between the typical cash flow patterns of
automobile receivable-backed securities and credit card receivable-backed securities. It shows that asset-backed
securities have less prepayment risk than mortgage-backed securities (MBS). As a consequence, ABS usually do not
have the negative convexity of MBS and will outperform many mortgage securities when interest rates are volatile.
Level of difficulty: Not difficult. Estimated study time: 1 hour.
STUDY SESSION 10
Applications: Mortgage-Backed and Asset-Backed Securities-Part 2
READING 1: "Synthetic Mortgage-Backed Securities," Anand K. Bhattacharya and Carol Sze, The Handbook of
Mortgage-Backed Securities, Fourth Edition, Frank J. Fabozzi, ed. (Probus, 1995), pp. 249-59. This reading explores
issues in the creation of synthetic securities using various types of structured mortgage-backed securities. The
authors explain the use of options and futures to create stripped mortgage-backed securities, demonstrate synthetic
combinations using other types of CMO tranches, and provide warnings about the risks associated with creating
synthetic mortgage-backed securities. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 2: "A Comparison of Methods for Analyzing Mortgage-Backed Securities," Ch. 28, Andrew S.
Davidson, Robert Kulason, and Michael Herskovitz, The Handbook of Mortgage-Backed Securities, Fourth Edition,
Frank J. Fabozzi, ed. (Probus, 1995), pp. 587-610. Various methods have been used to value and analyze the price
volatility characteristics of mortgage-backed securities, including the static cash flow yield method, scenario
analysis, the option-adjusted spread Monte Carlo model, and the refinancing threshold pricing model. The reading
describes each method and its required assumptions and concludes with recommendations about valuing and
analyzing MBS. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 3: "Introduction to the Option-Adjusted Spread Method," Ch. 29, Frank J. Fabozzi and Scott F. Richard,
The Handbook of Mortgage-Backed Securities, Fourth Edition, Frank J. Fabozzi, ed. (Probus, 1995), pp. 611-24.
The reading describes the Monte Carlo simulation model for valuing mortgage-backed securities and the meaning of
an option-adjusted spread within the context of the valuation model. The concepts of static spread (or zero-volatility
spread), option-adjusted duration (also called effective duration or OAS duration) and its corresponding convexity
measure, and simulated average life are explained. The chapter presents an analysis of an actual collateralized
mortgage obligation (CMO) deal. Level of difficulty: Moderately difficult. Estimated study time: 1.5 hours.
READING 4: "A Further Look at Option-Adjusted Spread Analysis," Ch. 30, Robert W. Kopprasch, The Handbook
of Mortgage-Backed Securities, Fourth Edition, Frank J. Fabozzi, ed. (Probus, 1995), pp. 625-40. This reading
provides an insightful discussion of the more fundamental problems with OAS analysis. It includes a review of OAS
analysis, suggestions for improving OAS analysis, and several illustrations of actual CMO deals to demonstrate the
key points of the chapter. Level of difficulty: Not difficult. Estimated study time: 1.5 hours.
READING 5: "Consistent, Fair and Robust Methods of Valuing Mortgage Securities," Ch. 31, R. Blaine Roberts,
David Sykes, and Michael L. Winchell, The Handbook of Mortgage-Backed Securities, Fourth Edition, Frank J.
Fabozzi, ed. (Probus, 1995), pp. 641-65. This reading provides a definition of fixed-income securities that results in
logical benchmarks to test all bond valuation models. It also provides insight into the fair value of any fixed-income
security. The OAS model is presented as an example of a valuation technique that is quite necessary in the valuation
of mortgage-backed securities. This model is not without its shortcomings, however, and the reading explains these
shortcomings. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 6: "Mortgage Hedge Ratios: Which One Works Best?" Laurie S. Goodman and Jeffrey Ho, Journal of
Fixed Income, Institutional Investor (December 1997), pp. 23-33. This reading compares the effectiveness of using
hedge ratios based on three measures of effective duration to hedge mortgage pass-throughs. The authors show that
model-based hedges that were constructed from option-adjusted-spread measures of duration do not perform as well
as market-based hedges constructed from either empirical duration or option-implied duration. Level of difficulty:
Moderately difficult. Estimated study time: 2 hours.
STUDY SESSION 11
Applications: Duration Considerations and Bond Refunding Decisions
READING 1: "OAS and Effective Duration," Ch. 30, David Audley, Richard Chin, Shrikant Ramamurthy, and
Susan Volin, The Handbook of Fixed Income Securities, Fourth Edition, Frank J. Fabozzi and T. Dessa Fabozzi, eds.
(Irwin, 1995), pp. 665-81. The reading shows the price-yield relationship for option-free bonds, callable bonds, and
putable bonds. The effect of volatility on putable and callable bond pricing is explained. Effective duration is then
defined, and the effect of volatility on effective duration is demonstrated. Rich-cheap analysis based on a
comparison of the duration and OAS parameters of securities is then illustrated. Level of difficulty: Moderately
difficult. Estimated study time: 2 hours.
READING 2: "Duration and Convexity Drift of CMOs," Ch. 33, David P. Jacob and Sean Gallop, The Handbook of
Mortgage-Backed Securities, Fourth Edition, Frank J. Fabozzi, ed. (Probus, 1995), pp. 677-90. Although duration
and convexity are standard methods for assessing the potential price volatility and value of a mortgage-backed
security, using these measures in total return analysis has a drawback. Specifically, for MBS, projecting the duration
and convexity at the end of some investment horizon is more difficult than for U.S. Treasuries. The degree to which
price sensitivity improves or deteriorates over time is determined by such factors as prepayment assumptions, yield
curve shapes and levels, liquidity, and structural considerations. The reading demonstrates the behavior of price
sensitivity with examples. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 3: "Key Rate Durations," Ch. 13, Fixed Income Securities, Bruce Tuckman (John Wiley & Sons, 1995),
pp. 157-67. Modified duration suffers from the assumption of a flat term structure with parallel shifts. This
assumption implies that all interest rates are perfectly related, an assumption common to all single-variable term
structure models. The key rate duration methodology attempts to remedy this drawback. Key rate durations enable
the user to isolate the sensitivity of a fixed-income security to a particular point on the term structure. By choosing a
few key rates along the term structure, an analyst can evaluate nonparallel shifts in the curve. The key rate duration
has the same interpretation as modified duration but at a certain point along the term structure. Level of difficulty:
Not difficult. Estimated study time: 1 hour.
READING 4: "Effective Duration and Effective Convexity," Ch. 28, Frank J. Fabozzi, Andrew J. Kalotay, and
George O. Williams, The Handbook of Fixed Income Securities, Fourth Edition, Frank J. Fabozzi and T. Dessa
Fabozzi, eds. (Irwin, 1995), pp. 630-32. A major drawback of using modified duration and convexity is that they
both assume that the cash flows of the security do not change when changes in yield occur. As a result, these
concepts are not effective for securities with embedded options. Clearly, in high- or low-interest-rate environments,
the value of bonds with embedded options will be different from the value of comparable bonds without options.
Effective duration and effective convexity take into consideration the changing cash flows of these types of
securities as yields change. Consequently, they are more accurate measures of interest rate sensitivity than the
standard measures. Level of difficulty: Not difficult. Estimated study time: 0.5 hour.
READING 5: "Embedded Call Options and Refunding Efficiency," C. Douglas Howard and Andrew J. Kalotay,
Advances in Futures and Options Research, Frank J. Fabozzi, ed. (JAI Press, 1988), pp. 97-117. This reading
describes the methodology underlying the computation of refunding efficiency and the target refunding rate. The
analysis shows how to analyze embedded options that affect refunding decisions beyond traditional breakeven rate
analysis. The refunding efficiency concept measures the combined impact of the many factors that affect the target
refunding rate. It compares the benefit obtained from refunding with the cost of the forfeited option. Level of
difficulty: Moderately difficult. Estimated study time: 2 hours.
III. Tax and Accounting Issues
Section III Study Guides
STUDY SESSION 12
Tax and Accounting Issues: Tax-Exempt and Mortgage-Backed Securities
READING 1: "Tax-Exempt Debt Securities," Ch. 10, Suresh M. Sundaresan, Fixed Income Markets and Their
Derivatives (South-Western College Publishing, 1997), pp. 409-26. This chapter contains a description of the U.S.
municipal debt market and the securities in that market. The author examines historical spread relationships to
corporate and Treasury debt securities, together with the impact of recent tax reform on these securities. The chapter
also covers varying degrees of tax advantage provided by municipal debt. Level of difficulty: Not difficult.
Estimated study time: 1 hour.
READING 2: "FAS 115 and MBS Portfolio Management," Ch. 38, Brian Lancaster, Ken Spindel, and Andrew
Taddei, The Handbook of Mortgage-Backed Securities, Fourth Edition, Frank J. Fabozzi, ed. (Irwin Professional
Publishing, 1995), pp. 843-65. This chapter provides a description of FAS 115, the required financial accounting
treatment for securities. The focus is on the implications of FAS 115 for the management of MBS portfolios. The
authors describe the systems and technology necessary to implement FAS 115. Level of difficulty: Not difficult.
Estimated study time: 1 hour.
READING 3: "Federal Income Tax Treatment in Mortgage-Backed Securities," Ch. 39, James M. Peaslee and
David Z. Nirenberg, The Handbook of Mortgage-Backed Securities, Fourth Edition, Frank J. Fabozzi, ed. (Irwin
Professional Publishing, 1995), pp. 867--932. This chapter provides an in-depth discussion of the nuances of the
U.S. federal income taxation of mortgage-backed securities. The authors describe the three groups of mortgagebacked securities: those taxable as debt, real estate mortgage investment conduit residual interests and equity
interests in owner trusts that are not taxable mortgage pools, and equity interests in taxable mortgage pools that are
treated as stock in a corporation. Level of difficulty: Moderately difficult. Estimated study time: 2.5 hours.
IV. Risk Measurement and Risk Management
Section IV Study Guides
STUDY SESSION 13
Risk Measurement
READING 1: "Measuring Value at Risk," Ch. 5, Value at Risk, Philippe Jorion (Irwin Professional Publishing,
1997), pp. 85-102. This reading contains a formal definition of VAR and a discussion of the techniques for verifying
the accuracy of VAR models. Jorion uses simple examples to compare and contrast VAR models for general and
parametric distributions. Model verification based on failure rates illustrates that no known optimal choice of
confidence level currently exists. Parametric methods have the potential to provide more precise measures of VAR
than a general approach based on the empirical distribution and its sample quantile. Level of difficulty: Moderately
difficult. Estimated study time: 1 hour.
READING 2: "VAR: Seductive but Dangerous," Tanya Beder, Financial Analysts Journal, Association for
Investment Management and Research (September/October 1995), pp. 12-23. This reading presents some of the
shortcomings of the VAR approach to risk management. The shortcomings exist because the different parameters,
data, assumptions, and methodologies used generate significant differences among VAR calculations. Level of
difficulty: Moderately difficult. Estimated study time: 2 hours.
READING 3: "The Risks in Swap Contracting," Ch. 5, Interest Rate and Currency Swaps: A Tutorial, Keith C.
Brown and Donald J. Smith (Research Foundation of the Institute of Chartered Financial Analysts, 1995), pp. 83102. Swap risk is composed primarily of market risk and credit risk. Enterprise, accounting, and tax risks are also
sources of uncertainty. Market makers face additional risk exposure in managing a swap book because of their need
to hedge. Level of difficulty: Difficult. Estimated study time: 2 hours.
READING 4: "A New Tool for Portfolio Managers: Level, Slope, and Curvature Durations," Ram Willner, Journal
of Fixed Income, Institutional Investor (June 1996), pp. 48-59. Duration assumes parallel shifts of a flat yield curve.
Complex fixed-income securities, however, have exposure to various points on the yield curve. This reading shows
that it is useful to decompose yield curve behavior into three duration measures-level, slope, and curvature. The
sensitivity of a security or portfolio to each of these independent parameters can be computed either analytically or
empirically. For large moves in interest rates, the sum of these sensitivities gives a much more accurate estimation
of price change than either a single-point duration or the duration of a replicating portfolio of T-notes. Empirical
evidence suggests that this approach accurately estimates both security prices and yields. Level of difficulty:
Moderately difficult. Estimated study time: 1.5 hours.
READING 5: "Convexity and Empirical Option Costs of Mortgage Securities," Douglas T. Breeden, Journal of
Fixed Income, Institutional Investor (March 1997), pp. 64-87. Breeden uses interest-only and principal-only strips
(IOs and POs) to highlight the influence of prepayments on differences in broker forecasts of option costs, optionadjusted durations, and option-adjusted spreads. Comparisons of option theory, broker forecasts, and empirical
evidence illustrate the influence. For both conventional mortgage-backed securities and MBS strips, the option cost
and "whipsaw risk" that arise from the hedging of MBS negative convexity can be significant. Level of difficulty:
Moderately difficult. Estimated study time: 3 hours.
READING 6: "Fixed-Income Risk Modeling in the 1990's," Ronald N. Kahn, Journal of Portfolio Management,
Institutional Investor (Fall 1995), pp. 94-101. Identifying risks of fixed-income securities is an important aspect of a
successful risk-management program. Traditional risk measures such as duration, value at risk, and key rate duration
do not cover all the potential risks faced by today's fixed-income specialist. This reading introduces some of the
other risks that successful fixed-income specialists face and addresses how to incorporate them into risk analysis.
Level of difficulty: Not difficult. Estimated study time: 1 hour]
STUDY SESSION 14
Risk Management
READING 1: "Implementing Risk Management Systems," Ch. 14, Value at Risk, Philippe Jorion (Irwin
Professional Publishing, 1997), pp. 271-98. Jorion illustrates applications of value at risk (VAR) for information
reporting, resource allocation, and performance evaluation. He also discusses how risk-management systems create
a challenge for the information technology departments of firms. The firm can obtain side benefits, however, by
having a central repository for trades, positions, and valuation models. Level of difficulty: Not difficult. Estimated
study time: 2 hours.
READING 2: "Risk Management: Guidelines and Pitfalls," Ch. 15, Value at Risk, Philippe Jorion (Irwin
Professional Publishing, 1997), pp. 299-314. Jorion presents risk-management guidelines that should accompany the
implementation of a VAR system. He also reviews the Group of Thirty (G-30) guidelines for best practices adopted
in July 1993. The emphasis is on the role of senior management in the implementation process. Jorion also discusses
pitfalls in the interpretation of VAR and other risks that users should be aware of. Level of difficulty: Not difficult.
Estimated study time: 1 hour.
READING 3: "Non-Parallel Yield Curve Shifts and Immunization," Robert R. Reitano, Journal of Portfolio
Management, Institutional Investor (Spring 1992), pp. 36-43. Traditional immunization of an asset/liability (A/L)
surplus against changing interest rates is accurate only for small parallel shifts in the yield curve. Specifically,
setting the A/L surplus duration to zero and the A/L surplus convexity to be positive is not effective in reducing
interest rate risk when the yield curve changes in a nonparallel manner. Reitano quantifies the immunization
approach and illustrates its limitations. Reitano also shows that the surplus can be immunized against nonparallel
shifts in the yield curve, but the method will be effective only for the particular yield curve change. Level of
difficulty: Not difficult. Estimated study time: 1 hour.
READING 4: "A Cost-Effective Approach to Hedging MBS Using Treasury Futures and Futures Options," Larry
Langowski, Tae H. Park, and Lorne N. Switzer, Journal of Fixed Income, Institutional Investor (March 1997), pp.
88-97. Duration hedging of mortgage-backed securities is often not an effective risk-reducing methodology because
of the second-order effects that are characteristic of MBS. Adding long positions in options to a futures hedge
greatly improves the hedging scheme. The authors used empirical duration and convexity of MBS to avoid modelto-model variation. To determine the appropriate hedge ratio, they carried out a nonlinear constrained optimization:
minimizing the transactions costs while constraining effective duration to be zero and effective convexity to be
positive. The authors found that MBS portfolios hedged in this manner outperform both unhedged portfolios and
portfolios hedged only with futures. Level of difficulty: Moderately difficult. Estimated study time: 2 hours.
V. International Fixed-Income Analysis and Portfolio Management
Section V Study Guides
STUDY SESSION 15
Fundamentals of International Fixed-Income Investing
READING 1: "Diversification from a U.S.$ Perspective (Available Online)," Walter Gerasimowicz, J.P. Morgan
Securities (March 1995), pp. 1-16. This report presents the case for global fixed-income investing in the context of
recent trends in international investments. The author describes the performance of global bond markets over the
1986-94 period by using a standard mean-variance framework. He also shows how U.S. investors can acquire
exposure to foreign bonds through equity-linked notes or swaps, and he explains the advantages of doing so. Level
of difficulty: Not difficult. Estimated study time: 1 hour.
Reading 2: "When Do Bond Markets Reward Investors for Interest Rate Risk?" Antti Ilmanen, Journal of Portfolio
Management, Institutional Investor (Winter 1996), pp. 52-64. This article addresses the issue of active management
of global bond portfolios. The author shows that international bond returns can be forecasted by using a number of
variables, including business cycle indicators, real bond yields, and term structure spreads. A dynamic trading
strategy appears to add substantial value, which supports the position that the active management of global bonds
has benefits. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 3: "A New Methodology for Analyzing Projected Currency and Bond Returns," Michael Rosenberg,
Journal of International Securities Markets 7, IFR Publishing (Spring 1993), pp. 17-28. This article provides a
simplified methodology for choosing currency and bond markets in a global fixed-income portfolio. The author
shows that the portfolio decision can be substantially simplified when the currency decision can be separated from
the bond decision. In general, the best currency market is the one that provides the largest money market returns; the
best bond market is the one that provides the largest returns in excess of the local money market rate. Level of
difficulty: Not difficult. Estimated study time: 1 hour.
READING 4: "Global and Local Components of Foreign Bond Risk," Steven Dym, Financial Analysts Journal,
Association for Investment Management and Research (March 1992), pp. 83-91. The author provides empirical
evidence on the various sources of risk in foreign bonds. Risk is decomposed into exposure to local interest rate risk,
to movements in local interest rates, and to movements in exchange rates. This decomposition is useful for
positioning in global bond markets because it allows the portfolio manager to identify sources of risk to which the
manager is exposed. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.
READING 5: "Opportunities in Emerging Market Debt," William Nemerever, Investing Worldwide VII
(Association for Investment Management and Research, 1996), pp. 28-40. This presentation provides a good
introduction to the emerging debt market, which consists of Brady bonds, newly issued debt, tradable bonds, and
local-currency debt. The historical record shows that this asset class provides good diversification benefits and
sizable returns. Active management should also add value when yields are abnormally high and pockets of
inefficiencies can be identified in specific sectors. Level of difficulty: Not difficult. Estimated study time: 1 hour.
READING 6: "High Yield Analysis of Emerging Market Debt: Methodology and Observations (Available
Online)," Allen Vine, et. al, Merrill Lynch, Pierce, Fenner, & Smith (August 23, 1995), pp. 1-19. This research
report provides a good survey of emerging market debt. Global investors must be aware of this market for a number
of reasons: sheer size (recently, more than US$500 billion) market maturation, and the future capital needs of
developing countries. The authors argue that the value of emerging market debt is influenced by three factors:
sovereign risk, technical conditions, and issuer fundamentals. Each factor can be analyzed by using the tools
described in the report. Level of difficulty: Not difficult. Estimated study time: 2 hours.
READING 7: "International Interest Rate Convergence: A Survey of the Issues and Evidence (Available Online),"
Charles Pigott, Federal Reserve Bank of New York Quarterly Review 18, Federal Reserve Bank of New York
(Winter 1993), pp. 24-36. As financial markets become more integrated, the question is whether this integration is
creating convergence in international interest rates. Pigott shows that considerable dispersion still exists among
national interest rates. The major exception is within the European Monetary System, where exchange rates are
closely tied and where interest rate differentials have considerably narrowed. Level of difficulty: Moderately
difficult. Estimated study time: 1 hour.
READING 8: "The Determinants of Real Long-Term Interest Rates: 17 Country Pooled Time Series Evidence
(Available Online)," Adrian Orr, Malcom Edey, and Michael Kennedy, OECD Economics Working Paper 155,
OECD Publications (1995), pp. 1-36. Movement in real interest rates can be decomposed into short-run and long-run
components. In the short run, rates are affected by cyclical factors such as monetary and fiscal policy. In the long
run, rates are affected by a different class of factors, such as structural shifts in the rate of return on physical capital
or long-term prospects for savings and investment. Overall, the authors present a fairly complete overview of factors
that, based on recent data, are affecting global interest rates. Level of difficulty: Moderately difficult. Estimated
study time: 2 hours.
STUDY SESSION 16
The Management of Foreign Currency Risk
READING 1: "Currency Hedging Rules for Plan Sponsors," Stephen Nesbitt, Financial Analysts Journal,
Association for Investment Management and Research (March 1991), pp. 73-81. This article is a good introduction
to currency hedging in the context of strategic, long-term asset allocation. The issue facing plan sponsors is how to
deal with the currency risk of their foreign investments. Nesbitt shows that the hedging decision depends on the
proportion of the portfolio invested abroad, the expected cost from hedging, and the plan sponsor's risk aversion.
Level of difficulty: Not difficult. Estimated study time: 1 hour.
READING 2: Currency Management: Concepts and Practices, Roger Clarke and Mark Kritzman (The Research
Foundation of the Institute of Chartered Financial Analysts, 1996), pp. 1-128. This excellent monograph provides a
comprehensive review of the management of currency risk in global portfolios. The authors describe the instruments
used to hedge currency risk and explain why currency risk should be hedged. Active currency management is also
covered in some detail. This reading will give the reader the tools to make decisions in managing foreign exchange
exposure in an integrated and consistent manner. Level of difficulty: Moderately difficult. Estimated study time: 5
hours.
READING 3: "Currency Forecasting: Theory and Practice (Available Online)," Michael Rosenberg, Merrill
Lynch, Pierce, Fenner, & Smith (August 1996), pp. 1-24. This publication provides a broad overview of the current
thinking about exchange rate models. It first describes fundamental-based approaches to exchange rate forecasting,
including purchasing power parity, balance of payments, and portfolio-balance models, that may be useful for
medium- and long-term predictions. Technical analysis, which has become popular among market participants for
short-term prediction, is also covered in some detail. Level of difficulty: Moderately difficult. Estimated study time:
2 hours.
READING 4: "Currency Crashes in Emerging Markets: An Empirical Treatment (Available Online)," Jeffrey
Frankel and Andrew Rose, International Finance Discussion Paper 534, Board of Governors of the Federal Reserve
System (January 1996), pp. 1-26.
With the increased focus on emerging markets, understanding of currency risk in emerging markets is becoming
essential. Frankel and Rose offer a large-scale empirical analysis of 117 currency crashes in emerging markets. They
note a series of empirical regularities that should be useful in helping investors prevent losses caused by unexpected
devaluations in emerging markets. Level of difficulty: Moderately difficult. Estimated study time: 1 hour.