We have spent several chapters building interest rate models. Vasicek, CIR, Hull and White, Ho and Lee, Black-Derman-Toy. Each one chosen for its nice mathematical properties, clean closed-form solutions, and easy calibration. But here is the uncomfortable question Wilmott asks in Chapter 36: do any of these models actually match what interest rates do in the real world?
In the last chapter, we saw one-factor models for interest rates. You pick a model, choose some parameters, and out comes a theoretical yield curve. But here is the problem: that theoretical yield curve almost certainly does not match the actual yield curve you see in the market. And if your model gives wrong prices for plain vanilla bonds, how can you trust it to price anything more complex?
We are leaving the world of options for a bit and entering the world of fixed income. This is the world of bonds, interest rates, and cashflows. Chapter 13 of Wilmott’s book is a self-contained introduction that does not require anything from earlier chapters. If you have ever wondered what a yield curve is or why bond traders care about something called “duration,” this is the post for you.
So you want to pick government bonds. Not just any bonds. You want to pick the right ones, from the right countries, at the right part of the yield curve. Chapter 5 of Richardson’s book shows you how to do that systematically.
Chapter 5 brings us to the classic fixed income question: which bonds are cheap and which are rich? But the authors remind us right away that cheap-rich analysis is just one part of relative value. The bigger question remains: what is the best way to express a particular view?
Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2
Chapter 2 explained why the general level of interest rates changes. Chapter 3 answers a different question: why do different securities pay different yields at the same point in time? A Treasury bond and a corporate bond with the same maturity do not offer the same return. This chapter explains why.
This is Part 1 of our retelling of Chapter 2 from “Trading the Fixed Income, Inflation and Credit Markets: A Relative Value Guide” by Neil C. Schofield and Troy Bowler (Wiley, 2011, ISBN: 978-0-470-74229-7).
Chapter 6 is where the book gets into the real meat of EM rates trading. And the first thing it tells you might be surprising: before you can trade EM rates, you need to understand US rates. Because the Fed drives everything.
Book: Systematic Fixed Income: An Investor’s Guide Author: Scott A. Richardson, Ph.D. ISBN: 9781119900139 Publisher: John Wiley & Sons, 2022