Analysis of Interest Rates and Debt Markets

Catalog description

The course starts off with a review of the time value of money concepts and the pricing of standard cash flows such as annuities, perpetuities. Next, an overview of the Treasury markets is provided with emphasis on both the primary and the secondary markets. In particular, the economics of the Treasury auctions, on-the-run/off-the-run liquidity issues, the presence of the zero lower bound, the economics of inflation-protected bonds, and other topics will be discussed at length. Students will also learn how to interpret the shapes of the nominal and the real yield curves, how to forecast short/long term future directions of rates as well as how to forecast future inflations based on nominal-real rate differentials. The course then moves on to non-Treasury segments of the fixed income markets: forward contracts, repurchasing agreements, floating rate notes, swaps, single stock futures, corporate bonds. For each topic, standard pricing techniques and relevant practical issues will be discussed. For example, how can a fixed income investor price a bond newly issued by a corporation based on their past equity market performance, using techniques typically employed by Moody's KMV? How does an investor gauge the potential illiquidity of a bond when transaction data are sparse? Or how one can extract a measure of the London Inter-bank Offered Rate (LIBOR) from the single stock futures markets? Or how a Chief Financial Officer (CFO) could hedge interest rate risks using standard duration and convexity hedging techniques even in a quick moving environment when assumptions underlying these techniques are likely, to varying degrees, violated. The final third of the course deals with relatively more advanced topics. Students are introduced to the use of risk-neutral probability measures in pricing fixedincome derivative products (callable bonds, treasury futures, swaptions) in the context of a binomial tree. For example, students learn how to use calibrated binomial trees of interest rates to accommodate bonds¿ callable features, how to compute/interpret the options-adjusted spreads, how to account for various institutional features of the Treasury bonds futures markets and why futures and forward prices may differ when bonds are the underlying assets. The class finishes with a topic on Collateralized Debt Obligations (CDOs) and the economics of their mispricing prior to the Great Recession.