The Bond and Money Markets:
Strategy, Trading, Analysis

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The Bond and Money Markets:
Strategy, Trading, Analysis

Moorad Choudhry

OXFORD AUCKLAND BOSTON JOHANNESBURG MELBOURNE NEW DELHI

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Butterworth-Heinemann
Linacre House, Jordan Hill, Oxford OX2 8DP
225 Wildwood Avenue, Woburn, MA 01801-2041
A division of Reed Educational and Professional Publishing Ltd

A

A member of the Reed Elsevier plc group

First published 2001
© Moorad Choudhry 2001
All rights reserved. No part of this publication may be reproduced in any material form (including photocopying or storing in any

medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the
written permission of the copyright holder except in accordance with the provisions of the Copyright, Designs and Patents Act
1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England
W1P OLP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be
addressed to the publishers

The views, thoughts and opinions expressed in this book are those of the author in his individual capacity and should not in any
way be attributed to JPMorgan Chase & Co, or to Moorad Choudhry as a representative, officer, or employee of JPMorgan Chase
& Co

British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library

Library of Congress Cataloguing in Publication Data
A catalogue record for this book is available from the Library of Congress

ISBN 0 7506 4677 2

Produced by ReadyText Publishing Services, Bath, Great Britain
Printed and bound in Great Britain by the Bath Press

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For my Mum and Dad

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Butterworth-Heinemann –The Securities Institute

A publishing partnership
About The Securities Institute
Formed in 1992 with the support of the Bank of England, the London Stock Exchange, the Financial
Services Authority, LIFFE and other leading financial organizations, the Securities Institute is the professional body for practitioners working in securities, investment management, corporate finance, derivatives and related businesses. Their purpose is to set and maintain professional standards through
membership, qualifications, training and continuing learning and publications. The Institute promotes
excellence in matters of integrity, ethics and competence.

About the series
Butterworth-Heinemann is pleased to be the official Publishing Partner of the Securities Institute with
the development of professional level books for: Brokers/Traders; Actuaries; Consultants; Asset Managers; Regulators; Central Bankers; Treasury Officials; Compliance Officers; Legal Departments; Corporate
Treasurers; Operations Managers; Portfolio Managers; Investment Bankers; Hedge Fund Managers;
Investment Managers; Analysts and Internal Auditors, in the areas of: Portfolio Management; Advanced
Investment Management; Investment Management Models; Financial Analysis; Risk Analysis and
Management; Capital Markets; Bonds; Gilts; Swaps; Repos; Futures; Options; Foreign Exchange; Treasury
Operations.

Series titles
■

Professional Reference Series
The Bond and Money Markets: Strategy, Trading, Analysis

■

Global Capital Markets Series
The REPO Handbook
The Gilt-Edged Market
Foreign Exchange and Money Markets: theory, practice and risk management

For more information

For more information on The Securities Institute please visit their Web site:
www.securities-institute.org.uk
and for details of all Butterworth-Heinemann Finance titles please visit Butterworth-Heinemann:
www.bh.com

vi

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Contents
Foreword
Preface
About the author

xix
xxi
xxviii

Part I

Introduction to the Bond Markets

1

Chapter 1

The Debt Capital Markets

3


1.1
1.2
1.3
1.4
1.5
1.6

Chapter 2

Chapter 3

Chapter 4

Chapter 5

Description
Bond issuers
Capital market participants
World bond markets
Overview of the main bond markets
Financial engineering in the bond markets

4
5
6
8
10
12


Financial Markets Arithmetic

17

2.1
2.2
2.3
2.4
2.5
2.6
2.7

17
20
24
29
31
32
34

Simple and compound interest
The time value of money
Multiple cash flows
Corporate finance project appraisal
Interpolation and extrapolation
Measuring the rate of return
Indices

Traditional Bond Pricing


41

3.1
3.2
3.3
3.4

41
45
46
48

Pricing a conventional bond
Pricing zero-coupon bonds
Clean and dirty bond prices
Bond price and yield relationship

Bond Yield Measurement

53

4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9

4.10
4.11
4.12
4.13
4.14

54
55
56
60
61
62
64
65
65
71
75
76
80
80

Current yield
Simple yield to maturity
Yield to maturity
Yield on a zero-coupon bond
Modifying bond yields
Converting bond yields
Assumptions of the redemption yield calculation
Holding-period yield
Bonds with embedded options

Index-linked bonds
Yields on floating-rate bonds
Measuring yield for a bond portfolio
The price/yield relationship
Summary

Review of Bond Market Instruments

86

5.1
5.2

86
89

Floating Rate Notes
Inverse/Reverse floating-rate bonds

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The Bond and Money Markets: Strategy, Trading, Analysis

viii
5.3
5.4
5.5
5.6


Chapter 6

The Yield Curve
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
6.10
6.11
6.12
6.13
6.14

Chapter 7

Basis point value
Yield value of price change
Hedging using basis point value
Volatility weighting for hedging

Price, Yield and Interest Rate Risk III
9.1
9.2
9.3


Chapter 10

Revisiting the bond price/yield relationship
Duration
A summary of the duration measure
Duration for other securities

Price, Yield and Interest Rate Risk II
8.1
8.2
8.3
8.4

Chapter 9

Using the yield curve
Yield-to-maturity yield curve
The coupon yield curve
The par yield curve
The zero-coupon (or spot) yield curve
The forward yield curve
The annuity yield curve
Analysing and interpreting the yield curve
Interpreting the yield curve
Fitting the yield curve
Spot and forward rates in the market
Examples, exercises and calculations
Case Study: Deriving a discount function
Case Study exercise: Deriving the theoretical zero-coupon (spot) rate curve


Price, Yield and Interest Rate Risk I
7.1
7.2
7.3
7.4

Chapter 8

Asset-backed bonds
PIBS
Callable bonds
Index-linked bonds

Convexity
Summarising the properties of convexity
Dispersion

Price, Yield and Interest Rate Risk IV
10.1
10.2
10.3

Yield curve changes
Portfolio duration and changes in the yield curve
Hedging strategy and duration

90
93
94
98


102
102
103
104
104
105
110
114
114
124
126
130
137
140
144

155
155
158
171
172

175
175
177
178
179

182

182
188
189

194
194
195
197

Part II

Government Bond Markets

201

Chapter 11

The United Kingdom Gilt Market

203

11.1
11.2
11.3
11.4
11.5
11.6

Introduction and history
Market instruments

Taxation
Market structure
Market makers and brokers
Issuing gilts

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203
206
215
216
216
218


Contents

ix
11.7
11.8
11.9
11.10
11.11
11.12
11.13
11.14
11.15
11.16
11.17
11.18

11.19

Chapter 12

The US Treasury Bond Market
12.1
12.2
12.3
12.4
12.5
12.6
12.7
12.8
12.9
12.10
12.11

Chapter 13

The DMO and secondary market trading
Settlement
Index-linked gilts analytics
Gilt strips
Zero-coupon bond trading and strategy
Strips market anomalies
Trading strategy
Illustration: Yield and cash flow analysis
Future developments in strips
HM Treasury and the remit of the Debt Management Office
Gilt derivatives and repo markets

The Minimum Funding Requirement
Developments in electronic trading

The US Treasury
The Federal Reserve
Market convention
The Primary Market
The Secondary Market
Treasury strips
Inflation-protected Treasury bonds
Treasury repo market
Federal Agency bonds
Derivatives markets
Historical long-bond yields

International Bond Markets
13.1
13.2
13.3
13.4
13.5
13.6
13.7
13.8
13.9
13.10
13.11

Overview of government markets
Germany

Italy
France
Japan
Australia
New Zealand
Canada
Hungary
South Africa
Egypt

220
221
223
228
233
235
235
240
242
243
244
246
247

257
257
258
258
261
262

264
265
266
267
269
271

277
279
282
284
287
292
294
297
298
301
301
303

Part III

Corporate Debt Markets

317

Chapter 14

Corporate Debt Markets


319

14.1
14.2
14.3
14.4
14.5
14.6
14.7
14.8
14.9
14.10

Introduction
Determinants of the development of a corporate market
The primary market
The secondary market
Fundamentals of corporate bonds
Bond security
Redemption provisions
Corporate bond risks
High-yield corporate bonds
Corporate bond offering circular

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320
322
322
323

324
326
328
329
332
332


The Bond and Money Markets: Strategy, Trading, Analysis

x

Chapter 15

Analysis of Bonds With Embedded Options
15.1
15.2
15.3
15.4
15.5
15.6

Chapter 16

Convertible Bonds I
16.1
16.2

Chapter 17


Legal and tax issues
The secondary market
Eurobonds and swap transactions

Warrants
20.1
20.2
20.3
20.4

Chapter 21

Eurobonds
Foreign bonds
Eurobond instruments
The issuing process: market participants
Fees, expenses and pricing
Issuing the bond
Covenants
Trust services
Form of the bond
Clearing systems
Market associations
Secondary market
Settlement

Eurobonds II
19.1
19.2
19.3


Chapter 20

Traditional valuation methodology
Fair value of a convertible bond
Further issues in valuing convertible bonds
Convertible bond default risk

The Eurobond Market I
18.1
18.2
18.3
18.4
18.5
18.6
18.7
18.8
18.9
18.10
18.11
18.12
18.13

Chapter 19

Basic description
Advantages of issuing and holding convertibles

Convertible Bonds II
17.1

17.2
17.3
17.4

Chapter 18

Understanding embedded option elements in a bond
The Binomial tree of short-term interest rates
Pricing callable bonds
Price and yield sensitivity
Price volatility of bonds with embedded options
Sinking funds

Introduction
Analysis
Bond warrants
Comparison of warrants and convertibles

Medium-term Notes
21.1
21.2
21.3
21.4
21.5
21.6

Introduction
The primary market
MTNs and corporate bonds
Issue mechanism

The secondary market
The Euro-MTN market

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339
339
341
345
347
349
350

357
357
362

364
364
365
371
372

378
378
379
380
382
385
386

388
388
390
391
392
393
393

394
394
394
395

396
396
396
397
398

400
401
401
403
405
406
408


Contents


xi
21.7

Chapter 22

Commercial Paper
22.1
22.2

Chapter 23

Preference Shares and Preferred Stock

418

Basic concepts
Pricing and modelling techniques
Interest rate risk
Portfolio performance

Asset-backed Securities III
Collateralised mortgage securities
Non-agency CMO bonds
Commercial mortgage-backed securities
Motor-car-backed securities
Credit card asset-backed securities
Static spread analysis of asset-backed bonds
Conclusion

Collateralised Debt Obligations

28.1
28.2
28.3

Chapter 29

Mortgage-backed securities
Cash flow patterns
Evaluation and analysis of mortgage-backed bonds

Mortgage-backed Bonds II

27.1
27.2
27.3
27.4
27.5
27.6
27.7

Chapter 28

Description of municipal bonds
The municipal bond market
Municipal bonds credit ratings
Bond insurance
Taxation issues
Exotic municipal bonds
Municipal money market instruments


Asset-Backed Bonds I: Mortgage-backed Securities

26.1
26.2
26.3
26.4

Chapter 27

The size of the market
Description and definition of preference shares
Cost of preference share capital
The preference share market
Auction market preferred stock (Amps)

The US Municipal Bond Market

25.1
25.2
25.3

Chapter 26

414
415
416

24.1
24.2
24.3

24.4
24.5
24.6
24.7

Chapter 25

408

Commercial Paper programmes
Commercial paper yields

23.1
23.2
23.3
23.4
23.5

Chapter 24

Structured MTNs

An overview of CDOs
Relative value analysis
Credit derivatives

High-yield Bonds
29.1
29.2
29.3


Growth of the market
High-yield securities
High-yield bond performance

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418
419
422
423
423

427
427
429
430
431
431
431
432

434
434
440
444

452
452
452

455
457

459
459
465
467
468
470
473
475

478
478
484
485

489
489
490
492


The Bond and Money Markets: Strategy, Trading, Analysis

xii

Chapter 30

Corporate Bonds and Credit Analysis

30.1
30.2
30.3
30.4

Credit ratings
Credit analysis
Industry-specific analysis
The art of credit analysis

496
496
498
502
503

Part IV

The Money Markets

505

Chapter 31

The Money Markets

507

31.1
31.2

31.3
31.4

Chapter 32

Introduction
Securities quoted on a yield basis
Securities quoted on a discount basis
Foreign exchange

507
508
512
517

Banking Regulatory Capital Requirements

526

32.1
32.2
32.3

Chapter 33

Regulatory issues
Capital adequacy requirements
Proposed changes to Basle rules

526

527
529

Asset and Liability Management

532

33.1
33.2
33.3
33.4
33.5

Chapter 34

Introduction
The ALM desk
Liquidity and interest-rate risk
Critique of the traditional approach
Securitisation

The Repo Markets
34.1
34.2
34.3
34.4
34.5
34.6
34.7
34.8

34.9
34.10
34.11
34.12
34.13
34.14
34.15
34.16
34.17
34.18
34.19
34.20
34.21
34.22

Development of the repo market
Introduction to repo
Uses and economic functions of repo
Repo mechanics
Other repo structures
Pricing and margin
Risks in dealing repo
Legal issues
Accounting, Tax and capital issues
Market participants
The United Kingdom gilt repo market
Market structure
Trading patterns
Open market operations
Gilts settlement and the CREST service

Gilt repo Code of Best Practice
Trading approach
Electronic repo trading
Repo netting
The implied repo rate and basis trading
Repo market structures
Central bank repo and overseas markets

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532
534
536
543
544

550
550
551
552
554
556
558
560
562
563
565
565
567
568

570
571
572
572
579
580
582
590
593


Contents

Chapter 35

xiii

Money Markets Derivatives
35.1
35.2
35.3
35.4
35.5

Forward rate agreements
FRA mechanics
Long-dated FRAs
Forward contracts
Short-term interest rate futures


599
599
600
606
607
607

Part V

Risk Management

619

Chapter 36

Risk Management

621

36.1
36.2
36.3

Chapter 37

Bank Risk Exposure and Value-at-Risk
37.1
37.2
37.3
37.4

37.5
37.6
37.7
37.8
37.9

Chapter 38

Introduction
Risk management
Non-VaR measure of risk

621
622
624

625

Value-at-Risk
Explaining Value-at-Risk
Variance-covariance Value-at-Risk
Historical VaR methodology
Simulation methodology
Value-at-risk for fixed interest instruments
Derivative products and Value-at-Risk
Stress testing
Value-at-Risk methodology for credit risk

625
627

628
635
635
636
640
643
645

Interest-rate Risk and a Critique of Value-at-Risk

661

38.1
38.2
38.3

Interest-rate risk
Comparison with traditional duration-based risk measurement
A critique of Value-at-Risk

661
663
663

Part VI

Derivative Instruments

667


Chapter 39

Swaps I

669

39.1
39.2
39.3
39.4
39.5
39.6
39.7
39.8
39.9
39.10

Chapter 40

Introduction
Interest rate swaps
Relationship between interest-rate swaps and FRAs
Generic swap valuation
Zero-coupon swap pricing
Non-vanilla interest-rate swaps
Cancelling a swap
Swaptions
Cross-currency swaps
Credit risk


Swaps II
40.1
40.2
40.3
40.4

Using swaps
Hedging an interest-rate swap
The convexity bias
Swaps netting

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669
672
680
680
681
689
692
692
694
696

705
705
707
711
716



The Bond and Money Markets: Strategy, Trading, Analysis

xiv

Chapter 41

Bond Futures
41.1
41.2
41.3
41.4

Chapter 42

Options I
42.1
42.2
42.3
42.4

Chapter 43

Chapter 45

Chapter 46

The Dynamics of Asset Prices

745


The behaviour of asset prices
Stochastic calculus models: Brownian motion and Itô calculus
Perfect capital markets

745
752
755

Options II: Pricing and Valuation

762

44.1
44.2
44.3
44.4
44.5
44.6
44.7
44.8
44.9
44.10

762
763
770
771
772
773

774
775
778
780

Option pricing
Pricing derivative securities
Simulation methods
Valuation of bond options
Interest-rate options and the Black model
Critique of the Black–Scholes model
The Barone–Adesi and Whaley model
Valuation of American options
Describing stochastic volatilities
A final word on (and summary of) the models

Options III: The Binomial Pricing Model

788

45.1
45.2
45.3

788
790
791

The binomial option pricing model
The binomial approach for interest-rate options

Comparison with B–S model

Options IV: Pricing Models for Bond Options
Introduction
Pricing bond options
Using option models to price corporate bonds

Options V –Managing an Option Book
47.1
47.2
47.3

Chapter 48

734
734
738
739
740

46.1
46.2
46.3

Chapter 47

720
723
726
730


Introduction
Option instruments
Options and payoff profiles
Option pricing parameters

43.1
43.2
43.3

Chapter 44

Introduction
Futures pricing
Hedging using futures
The margin process

720

Behaviour of option prices
Measuring option risk: The Greeks
The option smile

Options VI: Strategies and Uses
48.1
48.2
48.3
48.4
48.5


Introduction
Spreads
Volatility trades
Collars, caps and floors
Using options in bond markets

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794
794
795
797

801
801
802
809

812
812
812
816
820
822


Contents

Chapter 49


xv

Options VII: Exotic Options
49.1
49.2
49.3
49.4
49.5

Options with modified contract terms
Path-dependent options
Multi-asset options
Pricing and hedging exotic options
Using exotic options: case studies

832
832
833
837
838
840

Part VII

Approaches to Trading and Hedging

845

Chapter 50


Approaches to Trading and Hedging

847

50.1
50.2
50.3
50.4
50.5

Futures trading
Yield curves and relative value
Yield spread trades
Hedging bond positions
Introduction to bond analysis using spot rates and
forward rates in continuous time

848
851
855
856
858

Part VIII

Advanced Fixed Income Analytics

865

Chapter 51


Interest-rate Models I

873

51.1
51.2
51.3
51.4
51.5
51.6

Chapter 52

Interest-rate Models II
52.1
52.2
52.3
52.4

Chapter 53

53.5

Introduction
Bond market information
Curve-fitting techniques: parametric
The cubic spline method for estimating and
fitting the yield curve
The Anderson–Sleath evaluation


Advanced Analytics for Index-Linked Bonds
54.1
54.2
54.3

Chapter 55

Introduction
The Heath–Jarrow–Morton model
Multi-factor term structure models
Assessing one-factor and multi-factor models

Estimating and Fitting the Term Structure
53.1
53.2
53.3
53.4

Chapter 54

Introduction
Interest-rate processes
One-factor models
Arbitrage-free models
Fitting the model
Summary

Index-linked bonds and real yields
Duration and index-linked bonds

Estimating the real term structure of interest rates

Analysing the Long Bond Yield
55.1
55.2
55.3
55.4

Theories of long-dated bond yields
Pricing a long bond
Further views on the long-dated bond yield
Analysing the convexity bias in long-bond yields

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873
874
876
880
884
886

888
888
888
892
895

901
901

903
904
907
910

918
918
919
921

926
926
929
931
932


The Bond and Money Markets: Strategy, Trading, Analysis

xvi

Chapter 56

The Default Risk of Corporate Bonds
56.1
56.2

Corporate bond default spread risk
Default risk and default spreads


934
934
935

Part IX

Portfolio Management

939

Chapter 57

Portfolio Management I

941

57.1
57.2

Chapter 58

Portfolio Management II
58.1
58.2
58.3
58.4
58.5

Chapter 59


Portfolio yield
Value-weighted portfolio yield

Bond Indices
61.1
61.2
61.3
61.4
61.5

Chapter 62

Introduction
Performance evaluation

Portfolio Yield Measurement
60.1
60.2

Chapter 61

Overview
Structured portfolio strategies
Immunisation
Extending traditional immunisation theory
Multiple liabilities immunisation

Portfolio Management III
59.1
59.2


Chapter 60

Generic portfolio management
Active bond portfolio management

Overview
Maturity of an index
Responding to events
Composition of the index
Calculation of index value

International Investment
62.1
62.2

Arguments for investing in international bonds
International portfolio management

941
943

948
948
952
955
959
960

966

966
966

969
969
970

972
972
973
974
974
975

978
978
979

Part X

Technical Analysis

981

Chapter 63

Technical Analysis

983


63.1
63.2
63.3
63.4
63.5
63.6
63.7
63.8
63.9
63.10
63.11

983
985
986
987
989
995
1000
1003
1005
1009
1009

Introduction
Trading market profile
Dow theory
Chart construction
Trend analysis
Reversal patterns

Continuation patterns
Point and figure charting
Mathematical approaches
Contrary opinion theory
Volume and open interest

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Contents

xvii
63.12
63.13
63.14
63.15

Candlestick charting
Elliott wave theory
Stop losses
Concluding remarks

Part XI

Introduction to Credit Derivatives

Chapter 64

Introduction to Credit Derivatives
64.1

64.2
64.3

Chapter 65

Credit Derivatives II
65.1
65.2
65.3

Chapter 66

Overview
Pricing
Regulatory issues

Theoretical pricing models
Credit spread options
Default options pricing

Credit Derivatives III: Instruments and Applications
66.1
66.2
66.3
66.4
66.5

Credit default swaps
Total return swap
Credit options

Credit-linked notes
Applications

Part XII

Emerging Bond Markets

Chapter 67

Emerging Bond Markets and Brady Bonds
67.1
67.2
67.3
67.4

Chapter 68

Overview
Key features
Trading in the emerging bond markets
Brady bonds

Emerging Bond Markets II
68.1
68.2

Analysing of relative value
Selected emerging bond markets

Concluding Remarks

Glossary
Index

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1010
1017
1019
1019

1027
1029
1029
1032
1036

1045
1045
1047
1048

1052
1052
1053
1054
1055
1055

1059
1061

1061
1063
1064
1067

1073
1073
1075

1081
1085
1107


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Foreword
The world’s bond markets have a value of more than $30 trillion. They form a vital source of finance both for
governments and companies. For investors they provide an invaluable home for capital, offering a range of risks and
rewards, and yet they are little understood outside the arcane spheres in which bankers and brokers move. Further,
the bond markets have grown enormously both in size and complexity in the last quarter of the twentieth century.
Long gone are the days when Galsworthy’s fictional Forsyte family were content to lodge their fortunes in “Consols”,
earning interest at 3 per cent a year, secure in the belief that both their capital and income was safe.
The development of the international bond markets, the advent of swaps and the arrival of sophisticated computer bond trading programs, are only a few of the changes over the last 25 years which have made the bond markets
more intricate. More volatile interest rates and the abandonment of fixed exchange rates have introduced greater
turbulence into the markets, requiring ever more agility from participants. The relative decline of bond issuance by
governments –for the most part, at least among developed nations, regarded as highly unlikely to default on their
debts –and the expansion of borrowing by corporate entities, has added a greater element of credit risk to the
equation.

Indeed, a recent substantial and authoritative report by the investment bank Merrill Lynch concludes that the
traditional risk-free asset presents challenges to investors and issuers alike. The report1 is a most comprehensive
analysis, which shows that the world bond market has experienced dramatic growth in its size and major shifts in its
structure. The report highlights the extent of change in the current bond market world-wide, the US Fixed Income
market, the divergent trends in government and corporate bonds and emerging market local currency debt securities.
Some of the most significant facts and developments in recent years have included the following:
the global bond market maintains a robust rate of growth, while undergoing a dramatic shift in its composition;
■
the world bond market grew 8.1% in 1999, due to a sharp increase in the non-government debt arena;
■
the size of the world bond market at the end of 1999 was estimated to be US$ 31.1 trillion;
■
government bonds continue to see their share of the world market fall, to a new low of 54% at the end of 1999,
■
while corporate bonds and Eurobonds volumes rose to 42% of the world bond market capitalisation at the same
time;
bonds in the world’s three largest currencies (US$, euro and Japanese yen) account for 88% of the total size of
■
the world bond market;
emerging market local currency debt securities are estimated at $1.2 trillion as of year-end 1999.
■
It is thus a particularly apposite time for the publication of this book. The Bond and Money Markets provides a
wide-ranging and detailed examination of the global markets for debt capital. Starting from first principles, and
proceeding to explain the technicalities of bond valuation and trading strategies, this book will be of particular benefit to
newcomers to the subject as well as to more advanced students, and experienced practitioners.
Moorad Choudhry has the experience of a number of years working in the bond markets, which has given him
the knowledge to write this book. I have known Moorad since 1992, when we worked together at Hoare Govett Securities
Limited. Although initially a sterling bond house, it later became an UK gilt-edged market maker, thus becoming one of
the few houses to cover all sterling bonds. Moorad traded the short-dated gilt-edged market as well as the Treasury
book, a possibly almost unique experience and exposure to money markets, repo, off-balance sheet and bond trading

all at the same time. From there he went on to proprietary trading at Hambros Bank Limited. This background is
evident in the style and accessibility of his book, which has been written from a practitioner viewpoint, with an
emphasis on clarity of approach. Readers will find much of interest and value within the following pages.
Sean Baguley
Director, Merrill Lynch

1

Size and structure of the World Bond Market: The Decline of the Risk-Free Asset, Merrill Lynch, April 2000.

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Preface
This book is about the bond and money markets. This means that it is about the instruments used in the world’s
debt capital markets, because bonds are debt capital market products. One could stock an entire library with books
about the fixed income markets and about how bonds are traded and analysed. In such a library one would also
expect to find related books dealing with derivative instruments, bond portfolio management, technical analysis,
financial market mathematics, yield curve modelling and so on. The subject matter is indeed a large one. In bringing
together all the different strands into one volume one is forced to sacrifice some of the depth afforded by dedicated
texts. However the purpose of this book is to present a fairly comprehensive and in-depth look at all aspects of the
debt capital markets. Therefore while we start right from the beginning we hope, by the book’s conclusion, to have
presented the reader with most of the information required to be fully conversant with bonds and related derivatives, whether this is the terminology, analytical techniques, financial mathematics, or trading strategy.
The bond markets, also known as the fixed interest or fixed income markets, are an important part of the global
financial markets, and a vital conduit through which capital is raised and invested.1 Over the last two decades the

growth in trading volumes has been accompanied by the introduction of ever more sophisticated financial
engineering techniques, such that the bond markets today are made up of a large variety of structures. Banks can
tailor packages to suit the most esoteric of requirements for their customers, so that bond cash flows and the
hedging instruments available for holders of bonds can be far removed from the conventional fixed interest
instruments that originally made up the market. Instruments are now available that will suit the needs of virtually all
users of the financial markets, whether they are investors or borrowers.
The purpose of this book is to provide an introductory description and analysis of the bond markets as a whole.
However we seek to leave the reader with sufficient information and worked examples to enable him or her to be at
ease with all the different aspects of the markets. Hence we begin by considering conventional bonds and elementary
bond mathematics, before looking at the array of different instruments available. This includes an overview of offbalance sheet instruments and their uses. We also consider the analytical techniques used by the markets, valuation
of securities and basic trading and hedging strategy. We then develop the concepts further and look at constructing
and managing portfolios, speculation and arbitrage strategies and hedging strategies. The basic principles apply in
all bond markets around the world, but there are details differences across countries and currencies and so we also
provide brief descriptions of some of the major bond markets. The exception to this is the United Kingdom
government bond market, which is called the Gilt market, and which we look at in some detail.
One of the objectives behind writing this book was to produce something that had a high level of application to
real-world situations, but maintained analytical rigour. We hope this objective has been achieved. There is no
shortage of books in the market that are highly academic, perhaps almost exclusively so. Certain texts are essentially
a collection of advanced mathematics. We have attempted to move seamlessly between academic principles and
actual applications. Hence this book seeks to place every issue in context, and apply the contents to real-world
matter. Where possible this is backed up by worked examples and case studies. Therefore the aim of this book is to
be regarded as both an academic text as well as a practical handbook.

The capital markets
Capital markets is the term used to describe the market for raising and investing finance. The economies of
developed countries and a large number of developing countries are based on financial systems that contain
investors and borrowers, markets and trading arrangements. A market can be one in the traditional sense such as an
exchange where financial instruments are bought and sold on a trading floor, or it may refer to one where
participants deal with each other over the telephone or via electronic screens. The basic principles are the same in
1


The term “fixed income” is something of a misnomer. Originally bonds were referred to as fixed income instruments
because they paid a fixed rate of interest on the nominal value or “face amount” of the bond. In the sterling markets bonds
were called “fixed interest”instruments. For some time now many instruments in the market have not paid a fixed coupon,
for example floating-rate notes and bonds where the pay-off is linked to another reference rate or index. Although the term is
still used, the fixed income markets are in reality the entire debt capital markets, and not just bonds that pay a fixed rate of
interest.

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any type of market. There are two primary users of the capital markets, lenders and borrowers. The source of
lenders’ funds is, to a large extent, the personal sector made up of household savings and those acting as their
investment managers such as life assurance companies and pension funds. The borrowers are made up of the
government, local governments and companies (called corporates). There is a basic conflict in the financial
objectives of borrowers and lenders, in that those who are investing funds wish to remain liquid, which means they
have easy access to their investments. They also wish to maximise the return on their investment. A corporate on the
other hand, will wish to generate maximum net profit on its activities, which will require continuous investment in
plant, equipment, human resources and so on. Such investment will therefore need to be as long-term as possible.
Government borrowing as well is often related to long-term projects such as the construction of schools, hospitals
and roads. So while investors wish to have ready access to their cash and invest short, borrowers desire as long-term
funding as possible. An economist referred to this conflict as the “constitutional weakness” of financial markets
(Hicks 1946), especially when there is no conduit through which to reconcile the needs of lenders and borrowers. To
facilitate the efficient operation of financial markets and the price mechanism, intermediaries exist to bring together

the needs of lenders and borrowers. A bank is the best example of this. Banks accept deposits from investors, which
make up the liability side of their balance sheet, and lend funds to borrowers, which form the assets on their balance
sheet. If a bank builds up a sufficiently large asset and liability base, it will be able to meet the needs of both
investors and borrowers, as it can maintain liquidity to meet investors’ requirements as well as create long-term
assets to meet the needs of borrowers. The bank is exposed to two primary risks in carrying out its operations, one
that a large number of investors decide to withdraw their funds at the same time (a “run” on the bank), or that a
large numbers of borrowers go bankrupt and default on their loans. The bank in acting as a financial intermediary
reduces the risk it is exposed to by spreading and pooling risk across a wide asset and liability base.
Corporate borrowers wishing to finance long-term investment can raise capital in various ways. The main
methods are:
continued re-investment of the profits generated by a company’s current operations;
■
selling shares in the company, known as equity capital, equity securities or equity, which confirm on buyers a
■
share in ownership of the company. The shareholders as owners have the right to vote at general meetings of the
company, as well as the right to share in the company’s profits by receiving dividends;
borrowing money from a bank, via a bank loan. This can be a short-term loan such as an overdraft, or a longer
■
term loan over two, three, five, years or even longer. Bank loans can be at either a fixed or more usually, variable
rate of interest;
borrowing money by issuing debt securities, in the form of bonds that subsequently trade in the debt capital
■
market.
The first method may not generate sufficient funds, especially if a company is seeking to expand by growth or
acquisition of other companies. In any case a proportion of annual after-tax profits will need to be paid out as
dividends to shareholders. Selling further shares is not always popular amongst existing shareholders as it dilutes
the extent of their ownership; there are also a host of other factors to consider including if there is any appetite in the
market for that company’s shares. A bank loan is often inflexible, and the interest rate charged by the bank may be
comparatively high for all but the highest quality companies. We say comparatively, because there is often a cheaper
way for corporates to borrow money: by tapping the bond markets. An issue of bonds will fix the rate of interest

payable by the company for a long-term period, and the chief characteristic of bonds –that they are tradeable –
makes investors more willing to lend a company funds.
Bond markets play a vital and essential role in raising finance for both governments and corporations. In 1998
the market in dollar-denominated bonds alone was worth over $11 trillion, which gives some idea of its importance.
The basic bond instrument, which is a loan of funds by the buyer to the issuer of the bond, in return for regular
interest payments up to the termination date of the loan, is still the most commonly issued instrument in the debt
markets. Nowadays there is a large variety of bond instruments, issued by a variety of institutions. An almost
exclusively corporate instrument, the international bond or Eurobond, is a large and diverse market. In 1998 the size
of the Eurobond market was over $1 trillion.
In every capital market the first financing instrument that was ever developed was the bond; today in certain
developing economies the government bond market is often the only liquid market in existence. Over time as

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xxiii

financial systems develop and corporate debt and equity markets take shape, bond market retain their importance
due to their flexibility and the ease with which (in theory!) transactions can be undertaken. In the advanced financial
markets in place in developed countries today, the introduction of financial engineering techniques has greatly
expanded the range of instruments that can be traded. These products include instruments used for hedging
positions held in bonds and other cash products, as well as meeting the investment and risk management needs of a
whole host of market participants. The debt capital markets have been and continue to be tremendously important
to the economic development of all countries, as they have been the form of intermediation that allowed
governments and corporates to finance their activities. In fact it is difficult to imagine long-term capital intensive
projects such as those undertaken by say, petroleum, construction or aerospace companies, as well as sovereign
governments, taking place without the existence of a debt capital market to allow the raising of vital finance.


Efficient markets
We often come across the term “free market”, and economists refer to “the price mechanism”. The role of the
market in an economy is to allocate resources between competing interests in the most efficient way, and in a way
that results in the resources being used in the most productive way. Where this takes place the market is said to be
allocatively efficient. The term operationally efficient is used to describe a market where the transaction costs
involved in trading are set competitively. Intermediaries in the capital markets do indeed determine their prices in
relation to the competition, and because they depend on profits to survive there is always a cost associated with
transacting business in the market. A market is described as informationally efficient if the price of any asset at any
time fully reflects all available information that is available on the asset. A market that is allocatively, operationally
and informationally efficient at the same time is perfectly efficient.
The concept of the efficient market was first described by Fama (1970). The efficient markets hypothesis is used
to describe a market where asset prices fully reflect all available information. There are three types of the efficient
markets hypothesis, which are:
the weak form, which describes a situation where market prices reflect only historical data on the asset or
■
security in questions;
the semi-strong form, where prices reflect all publicly available information;
■
the strong form, where prices reflect all known information, whether this information is publicly known or not.
■
The weak-form efficient markets hypothesis states that current market prices for assets fully reflects all
information contained in the past history of asset prices. This implies therefore that historical prices provide no
information on future prices of value to an investor seeking to make excess returns over the returns being earned by
the market. Empirical evidence from market trading suggests that markets are indeed weak-form efficient, and that
security prices incorporate virtually instantaneously all information reflected in past prices to enable investors to
acquire any advantage.
The semi-strong efficient markets hypothesis states that current asset prices fully reflect all publicly available
information about markets. If this is correct it means that any new information entering the public domain is
incorporated almost instantaneously into the current price of the relevant security.2 Once the security price has
reacted to the new information there will be no more price changes as a result of that information. If markets are

semi-strong efficient then this means that an investor who waits for the release of data before deciding which way to
trade will be too late to make any gains. The evidence suggests that markets are also semi-strong efficient, and in fact
security prices often change before the official release of information: this is because the markets have anticipated
the content of the new data, through reading, say, media or brokers’ reports, and have “priced in” the information
accordingly. An example of this is where a central bank is expected to move interest rates a certain way; if the
markets anticipate interest rates to be lowered and this view subsequently proves to be correct, the change in asset
prices is much less than if the markets had guessed wrongly or were not expecting any change at all. So markets are
not only weak-form but also semi-strong form efficient, and operating an investment policy of reacting to publicly
available information will not generate returns that exceed those of the market itself.
2

If it is macro-economic information the relevant securities could be all the stocks on the exchange, including the government
bonds. If it is company specific information then it will probably be only that company’s shares, or companies in the same
sector.

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The strong-form efficient markets hypothesis states that securities prices reflect all known information about the
securities and the market, including information that is available only privately. If this is true it implies that market
prices respond so quickly that an investor with private (that is, inside) information would not be able to trade and
generate excess returns above the market rate. This will not usually be the case, since someone armed with inside
information can usually generate excess profits. However insider trading is illegal in most countries, so this suggests
that strong-form inefficiency exists only through illegal activity. In recent years evidence has indicated that markets
may be strong-form efficient as well, in the activities of fund managers. Where a portfolio of assets is actively
managed by a fund manager with the objective of outperforming the market but does not, it indicates that even the

possession of privately held information is insufficient to generate excess returns. We say “private” because fund
managers undertake a large amount of research on companies and markets, the results of which are not available
publicly. Over the years certain “active”fund managers have been much criticised for failing to outperform or even
underperforming, the market. This has resulted in the popularity of “passive”fund managers, who simply structure
their portfolios to replicate the constituents of the market, hoping to match overall market performance.3 So the
growth of passive fund managers would seem to indicate that more and more investors believe markets to be strongform efficient, and that it is impossible, over the long-term, to outperform the market.
We hope that this initial discussion on capital markets and market efficiency has set the scene for the
discussions that follow. It is always worth keeping in mind the context within which the bond markets operate, and
that debt capital trading exists in order to facilitate the efficient allocation of resources.

Intended audience
This book is aimed at a wide readership, from those with little or no previous understanding of or exposure to the
bond markets to experienced practitioners. The subject matter is wide ranging and this makes the book useful for
undergraduate and postgraduate students on finance or business courses. The second half of the book will be
valuable for advanced level students and first-year researchers. Undergraduate students are recommended to tackle
the book after initially studying the principles of finance, however the basic concepts required (such as present and
future value) are covered and serve to make a complete volume. While most of the mathematics assumes a
knowledge of basic algebra, some of the contents, particularly in the chapters dealing with derivatives and fixed
income analytics, will require slightly higher level mathematical ability. It is not necessary to have degree-level or
even A-level maths in order to understand the basic principles; however those with only elementary maths may find
some of the chapters, particularly those on yield curve modelling, somewhat difficult. Complete beginners may wish
to review first an elementary text on financial market mathematics. Nevertheless this book is intended to serve as a
complete text, and takes readers from the first principles to advanced analysis. Note that by this we mean analysis of
the bond and related derivatives markets; the budding rocket scientists among you may wish to consider books
specifically concerned with say, option pricing, stochastic calculus or programme trading. For students wishing to
enter a career in the financial services industry this book has been written to provide sufficient knowledge and
understanding to be useful in their first job and beyond, thus enabling anyone to hit the ground running. It is also
hoped that the book remains useful as a reference handbook.
The book is primarily aimed at people who work in the markets, including front office, middle office and back
office banking and fund management staff who are involved to some extent in fixed interest markets. This includes

traders, salespersons, money markets dealers, fund managers, stockbrokers and research analysts. Others including
corporate and local authority treasurers, risk management personnel and operations staff will also find the contents
useful, as will professionals who work in structured finance and other market sectors, such as accountants, lawyers
and corporate financiers. As a source of reference the book should be valuable reading for management consultants
and financial sector professionals, such as tax, legal and corporate finance advisors, and other professionals such as
financial sector auditors and journalists.
The book is also aimed at postgraduate students and students sitting professional exams, including MBA
students and those specialising in financial markets and financial market economics. Undergraduate students of
business, finance or the securities markets will hopefully find the book to be a useful source of reference, while
practitioners sitting the exams of various professional bodies may observe that there is much useful practical
information that will help them to apply their studies to their daily work.
3

The rise of so-called “tracker”funds.

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xxv

Comments on the text are welcome and should be sent to the author care of Butterworth-Heinneman. We
apologise for any errors that are lurking in the text, and would appreciate being made aware of any that the reader
might find. The author also welcomes constructive suggestions for improvement which we hope to incorporate in a
second edition.

Organisation of the book
This book is organised into 12 parts. Each part introduces and then develops a particular aspect of the debt capital
markets. Part I is the introduction to bonds as a debt market instrument. The ten chapters in Part I cover the basics

of bonds, bond pricing and yield measurement, and interest-rate risk. There is also an initial look at the different
types of bond instruments that trade in the market. For beginners, there is also a chapter on financial markets
mathematics. Part II looks in detail at two government bond markets, the United Kingdom gilt market and the
United States Treasury market. There is also a chapter looking briefly at selected government bond markets around
the world. The type of subjects covered include market structure, the way bonds are issued and specific detail on the
structure of the different markets.
The seventeen chapters in Part III look in some detail at the corporate debt markets. This sector of the bond
markets is extremely diverse, and it is often in corporate markets that the latest and most exciting innovations are
found. Some of the instruments used in the corporate markets demand their own particular type of analysis; to this
end we review the pricing and analytics of callable bonds, asset-backed bonds and convertibles, among others. There
is also a chapter on credit analysis.
In Part IV we review the money markets. The money markets are part of the debt markets and there is a
relationship between the two, although as we shall see the money market yield curve sometimes trades independently of the bond yield curve. We cover in detail some related issues, which would probably be at home more in a
book about banking than bond trading; these includes bank capital requirements, asset and liability management
(ALM) and the bond repurchase or repo market. Derivative instruments such as futures contracts play an important
part in the money markets, and it was decided to include the chapter on money market derivatives in Part IV rather
than in the section on derivatives, as it was felt that this would make Part IV complete in its own right.
In the capital markets and banking generally, risk management is a keenly-debated topic. A book dealing with
capital markets trading would not be complete without a look at this topic, which is considered in Part V. We also
cover one of the main risk management tools used today, the measurement methodology known as value-at-risk.
Part VI is a comprehensive review of derivative instruments. There are separate chapters on futures, swaps and
options. Readers who have had only an introduction to this subject may find some of the chapters a little trying,
particularly those dealing with stochastic processes and option pricing. We recommend perseverance, as the subject
has been reviewed and summarised in a way that should be accessible to most, if not all. The mathematics has been
kept to a minimum, and in most cases proofs and derivations are taken as given and omitted. The interested reader
is directed to relevant texts that supply this detail in a bibliography at the end of each chapter.
Part VII is composed of a single chapter only, which deals with elementary trading and hedging strategy.
Part VIII on advanced fixed income analytics is the author’s favourite and deals with a particularly exciting
subject, interest-rate models and yield curve modelling. The main models that have emerged from leading academic
writers are introduced, explained and summarised. We also cover fitting the yield curve, and there are additional

chapters dealing with advanced analytics regarding index-linked bonds and the pricing of long-dated bonds.
The remainder of the book deals with related topics. In Part IX we consider portfolio management, essentially
only the main strategies and techniques. There is also a chapter on constructing bond indices. Part X is another one
that contains just one chapter; it sits on its own as it deals with technical analysis or “charting”. In Part XI we
introduce credit derivatives, which are relatively new instruments but are rapidly becoming an important part of the
bond markets. The content is introductory however, and in fact there are a number of excellent texts on credit
derivatives appearing in the market. The final part of the book looks at emerging markets and Brady bonds, and the
additional considerations involved in investing across international markets. We conclude with a look at some likely
future developments.

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