Interest Rate Swaps and Their Derivatives: A Practitioner's Guide

Overview

Interest rate swaps and their derivatives have become an integralpart of the fixed income market, but many of the pricing and riskmanagement issues for these now mainstream products can only belearned on a trading floor. While there are many books on fixedincome and interest rate derivatives, they generally suffer frombeing either too elementary and bond-centric, mentioning swaps inpassing, or too technical and focused on exotics and the myriadimplementation issues and ...

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Overview

Interest rate swaps and their derivatives have become an integralpart of the fixed income market, but many of the pricing and riskmanagement issues for these now mainstream products can only belearned on a trading floor. While there are many books on fixedincome and interest rate derivatives, they generally suffer frombeing either too elementary and bond-centric, mentioning swaps inpassing, or too technical and focused on exotics and the myriadimplementation issues and algorithms used to tackle them.

Rather than focusing on exotics, Interest Rate Swaps andTheir Derivatives thoroughly covers the mainstreamproducts—swaps, flow options, Bermudans,semi-exotics—showing the common pricing techniques while alsoexplaining how to generalize the concepts to more nuancedproducts.

Author Amir Sadr, experienced as a quant, trader, financialsoftware developer, and academic in the fixed income field, beginsby presenting plain-vanilla swaps as an extension of fixed ratebonds—revealing how techniques for pricing these instrumentsare a generalization of similar methods used for pricing bonds andrepos, and for the most part involve the concepts of financingcost, discount factors, and projection of forward curves. He thenmoves on to cover the options markets for flow products, includingoptions on futures, caps and floors, and Europeanswaptions—with detailed attention to the actual tradingpractice of these products. Sadr explains how, as with any optionproduct, the pricing and risk management of these requires dealingwith volatility as the main risk factor—and he shows that onedoes not need to have a PhD in math to understand options. Sadrpresents risk-neutral valuation as the fundamental pricing paradigmfor derivatives, and illustrates the core idea of dynamicreplication in a simple binomial setting. This unified framework isused to derive industry-standard Black formula for flow products,and is developed into short-rate and full term-structure models formore complex interest rate exotics including Bermudans.

For current or aspiring practitioners in interest rate products,Interest Rate Swaps and Their Derivatives provides a soundworking knowledge and appreciation of the main features of theseproducts and their pricing and risk management issues.

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Product Details

  • ISBN-13: 9780470443941
  • Publisher: Wiley
  • Publication date: 9/8/2009
  • Series: Wiley Finance Series, #510
  • Edition number: 1
  • Pages: 247
  • Sales rank: 1,254,092
  • Product dimensions: 6.20 (w) x 9.00 (h) x 1.00 (d)

Meet the Author

AMIR SADR, PhD, has experience as a quant, trader, financial software developer, and academic in fixed income markets. He traded options and exotics at HSBC in New York from 2005 to 2006 and traded at the proprietary desk for Greenwich Capital Markets (GCM) for four years prior to that. Sadr also has experience at Morgan Stanley as a vice president in the derivatives products group where he traded interest rate derivatives and exotics. Since 1996, Sadr has served as an adjunct professor at New York University in the Department of Finance and Accounting.

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Table of Contents

Preface.

"Rates" Market.

Background.

Book Structure.

Acknowledgments.

About the Author.

List of Symbols and Abbreviations.

PART ONE Cash, Repo, and Swap Markets.

CHAPTER 1 Bonds: It's All About Discounting.

Time Value of Money: Future Value, Present Value.

Price-Yield Formula.

PV01, PVBP, Convexity.

Repo, Reverse Repo.

Forward Price/Yield, Carry, Roll-Down.

CHAPTER 2 Swaps: It's Still About Discounting.

Discount Factor Curve, Zero Curve.

Forward Rate Curve.

Par-Swap Curve.

Construction of the Swap/Libor Curve.

CHAPTER 3 Interest Rate Swaps in Practice.

Market Instruments.

Swap Trading—Rates or Spreads.

Swap Spreads.

Risk, PV01, Gamma Ladder.

Calendar Rules, Date Minutiae.

CHAPTER 4 Separating Forward Curve from DiscountCurve.

Forward Curves for Assets.

Implied Forward Rates.

Float/Float Swaps.

Libor/Libor Basis Swaps.

Overnight Indexed Swaps (OIS).

PART TWO Interest-Rate Flow Options.

CHAPTER 5 Derivatives Pricing: Risk-NeutralValuation.

European-Style Contingent Claims.

One-Step Binomial Model.

From One Time-Step to Two.

From Two Time-Steps to . . .

Relative Prices.

Risk-Neutral Valuation: All Relative Prices Must beMartingales.

Interest-Rate Options Are Inherently Difficult to Value.

From Binomial Model to Equivalent Martingale Measures.

CHAPTER 6 Black's World.

A Little Bit of Randomness.

Modeling Asset Changes.

Black-Scholes-Merton/Black Formulae.

Greeks.

Digitals.

Call Is All You Need.

Calendar/Business Days, Event Vols.

CHAPTER 7 European-Style Interest-Rate Derivatives.

Market Practice.

Interest-Rate Option Trades.

Caplets/Floorlets: Options on Forward Rates.

European-Style Swaptions.

Skews, Smiles.

CMS Products.

Bond Options.

PART THREE Interest-Rate Exotics.

CHAPTER 8 Short-Rate Models.

A Quick Tour.

Dynamics to Implementation.

Lattice/Tree Implementation.

BDT Lattice Model.

Hull-White, Black-Karasinski Models.

Simulation Implementation.

CHAPTER 9 Bermudan-Style Options.

Bellman's Equation—Backward Induction.

Bermudan Swaptions.

Bermudan Cancelable Swaps, Callable/Puttable Bonds.

Bermudan-Style Options in Simulation Implementation.

CHAPTER 10 Full Term-Structure Interest-Rate Models.

Shifting Focus from Short Rate to Full Curve: Ho-Lee Model.

Heath-Jarrow-Morton (HJM) Full Term-Structure Framework.

Discrete-Time, Discrete-Tenor HJM Framework.

Forward-Forward Volatility.

Multifactor Models.

HJM Framework Typically Leads to Nonrecombining Trees.

CHAPTER 11 Forward-Measure Lens.

Numeraires Are Arbitrary.

Forward Measures.

BGM/Jamshidian Results.

Different Measures for Different Rates.

"Classic" or "New Improved": Pick Your Poison!.

CHAPTER 12 In Search of "The" Model.

Migration to Full-Term Structure Models.

Implementation Era.

Model versus Market: Liquidity and Concentration Risk.

Complexity Risk.

Remaining Challenges.

APPENDIX A Taylor Series Expansion.

Function of One Variable.

Function of Several Variables.

Ito's Lemma: Taylor Series for Diffusions.

APPENDIX B Mean-Reverting Processes.

Normal Dynamics.

Log-Normal Dynamics.

APPENDIX C Girsanov's Theorem and Change ofNumeraire.

Continuous-Time, Instantaneous-Forwards HJM Framework.

BGM Result.

Notes.

Index.

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