Fixed Income Markets and Their Derivatives

Citation

Sundaresan, S. (2009). Fixed Income Markets and Their Derivatives (3rd ed.). Academic Press.

Chapter Summary

The third edition has nineteen chapters in four parts. According to the publisher, the organization emphasizes institutions first, analytics second, selected segments of fixed income markets third and fixed income derivatives fourth, so that instructors can tailor the material to their course and to students' mathematical ability. The edition adds material on credit default swaps and collateralized debt obligations and an integrated discussion of the credit crisis, and it ends with a glossary of key financial terms.

Part 1, Chapters 1–2: Overview of Fixed Income Markets; Price-Yield Conventions

Chapter 1 introduces debt securities, their markets and the main participants, and the risks they carry (interest rate, credit, liquidity and others), contrasting the risk profiles of US Treasury and corporate debt. Chapter 2 covers compounding, discounting and yield to maturity, and the price-yield conventions for bills, notes and bonds.

Part 1, Chapters 3–4: Federal Reserve (Central Bank) & Fixed Income Markets; Organization and Transparency of Fixed Income Markets

Chapter 3 describes the role of the Federal Reserve and its tools, such as open market operations and the discount window, and the Fed's actions in the 2007–2008 credit crisis. Chapter 4 looks at the structure of primary and secondary markets, interdealer brokers and measures of market transparency.

Part 1, Chapters 5–6: Financing Debt Securities: Repurchase (Repo) Agreements; Auctions of Treasury Debt Securities

Chapter 5 explains repo and reverse repo as secured lending and as a way of financing long and short positions, including general and special collateral. Chapter 6 covers how Treasury securities are auctioned: the mechanics, uniform-price and discriminatory formats, auction theory and empirical evidence.

Part 2, Chapters 7–8: Bond Mathematics: DV01, Duration and Convexity; Yield Curve and the Term Structure

Chapter 7 introduces DV01 (PVBP), duration and convexity and applies them to hedging and trading strategies such as spread and butterfly trades, including effective duration and convexity. Chapter 8 analyses the yield curve: principal components, volatility, the effect of economic news, bootstrapping and forward rates.

Part 2, Chapters 9–10: Models of Yield Curve and the Term Structure; Modeling Credit Risk and Corporate Debt Securities

Chapter 9 reviews one-factor term-structure models such as Vasicek and Cox–Ingersoll–Ross and their calibration to market data. Chapter 10 turns to credit: defaults, business cycles and rating agencies, structural models including the KMV approach, the costs of financial distress, and reduced-form models of corporate debt.

Part 3, Chapters 11–13: Mortgages, Federal Agencies & Agency Debt; Mortgage-Backed Securities (MBS); Inflation-Linked Debt: Treasury Inflation Protected Securities (TIPS)

Chapter 11 reviews mortgage contracts and risks, and federal agencies and their debt. Chapter 12 covers securitization, prepayment risk and its determinants, and valuation frameworks for pass-throughs and REMIC structures. Chapter 13 describes TIPS: design, cash flows, risks, real and nominal yields and break-even inflation.

Part 4, Chapters 14–17: Derivatives on Overnight Interest Rates; Eurodollar Futures Contracts; Interest-Rate Swaps; Treasury Futures Contracts

Chapter 14 covers Fed funds futures and overnight index swaps; Chapter 15 Eurodollar futures, LIBOR and options on the futures; Chapter 16 swap valuation, forward swaps, swap spreads and bid–offer spreads; Chapter 17 forward and futures contracts, delivery options, conversion factors and hedging with Treasury futures.

Part 4, Chapters 18–19: Credit Default Swaps: Single Name, Portfolio and Indexes; Structured Credit Products: Collateralized Debt Obligations

Chapter 18 reviews credit default swaps, valuation, credit-linked notes and credit default indexes. Chapter 19 describes CDO structures, players and types, market growth, valuation and CDX tranches.

Key Concepts

Part 1: Institutions and conventions (Chapters 1–6)

• Debt securities and their risks: interest rate, credit, liquidity and other risks.
• Yield to maturity and price-yield conventions.
• Central bank operations and repo financing.
• Treasury auctions: uniform-price and discriminatory formats.

Part 2: Analytics (Chapters 7–10)

• DV01, duration, convexity.
• Term structure, bootstrapping and forward rates.
• One-factor models: Vasicek and Cox–Ingersoll–Ross.
• Structural and reduced-form credit models.

Parts 3–4: Segments and derivatives (Chapters 11–19)

• Prepayment risk and pass-through MBS; TIPS and break-even inflation.
• Overnight index swaps, Eurodollar futures, interest rate swaps, Treasury futures.
• Credit default swaps and collateralized debt obligations.

Critical Analysis

Strengths

• Modular design. The publisher presents the four-part structure as allowing instructors to choose material by course and by students' mathematical level.
• Institutions as well as models. Central-bank policy, market organization, repo financing and Treasury auctions have their own chapters.
• Credit crisis coverage. The third edition adds credit default swaps, collateralized debt obligations and a discussion of the crisis, and the Fed's 2007–2008 actions appear in Chapter 3.
• Endorsements. The publisher quotes Paul Calello, Darrell Duffie, Andrew Lo, Francis Longstaff and Stephen Schaefer, praising the balance between theory and institutional material and the coverage of credit-risky bonds, credit derivatives and mortgages.
• Reference aids. A glossary of financial terms, and worked-example resources for instructors on a password-protected site.

Limitations

• Date of the edition. The 2009 edition describes the market as the credit crisis was unfolding; later developments such as the end of LIBOR are outside its scope.
• US focus. The chapter titles centre on US Treasuries, the Federal Reserve, agency debt and TIPS.
• Worked solutions not public. The additional examples are for instructors only.
• Limited model depth. Term-structure models are treated in one chapter (Chapter 9), so readers who need derivations will need a more mathematical text.

Where It Fits in the Course

Of the three fixed income texts in the course, this one gives the most space to institutions. Tuckman and Serrat are more compact and quantitative, moving quickly from discount factors to hedging and instruments; Veronesi is the longest, with binomial trees, continuous-time models and data-driven case studies. Sundaresan suits a course that wants market structure, conventions and instruments, with the analytics adjustable to the students' mathematical level, and it covers credit-risky debt, credit default swaps and CDOs in chapters that can precede Duffie and Singleton's Credit Risk.

Bodie, Kane and Marcus's Investments is the broader survey in which fixed income is one part; Hunt and Kennedy's Financial Derivatives in Theory and Practice and Bingham and Kiesel's Risk-Neutral Valuation supply the stochastic-calculus pricing theory that Sundaresan keeps light.

How to Use This Book

The publisher names students in MBA and master's programmes in finance, and professionals who want an authoritative explanation of fixed income methods, as the readership.

• Institutions-first course: Chapters 1–6, then 11–13 for mortgages, agencies and TIPS.
• Analytics: Chapters 7–8 for everyone; Chapters 9–10 where models and credit are in the syllabus.
• Derivatives: Chapters 14–17 for rates derivatives; Chapters 18–19 as a bridge to credit risk.
• Glossary: use it for terminology while reading.