Fixed Income Securities: Valuation, Risk, and Risk Management

Citation

Veronesi, P. (2010). Fixed Income Securities: Valuation, Risk, and Risk Management. John Wiley & Sons.

Chapter Summary

The book has twenty-two chapters (about 790 pages before references) in three parts: Basics (Chapters 1–8), Term Structure Models: Trees (Chapters 9–13) and Term Structure Models: Continuous Time (Chapters 14–22). Most chapters end with a summary and exercises, and many with a case study built on a real episode. The author, writing in 2009, frames the book as a methodology rather than a catalogue of instruments, organized around no arbitrage and the law of one price.

Chapters 1–2: An Introduction to Fixed Income Markets; Basics of Fixed Income Securities

Chapter 1 surveys the government debt, money, repo, mortgage-backed and derivatives markets, and introduces no arbitrage and the law of one price. Chapter 2 supplies the building blocks: discount factors, interest rates and compounding, the term structure, coupon and floating-rate bonds, and methods for extracting discount factors from coupon bond prices (bootstrapping, regression, splines). Its case study decomposes the inverse floaters held by Orange County.

Chapters 3–4: Basics of Interest Rate Risk Management; Basic Refinements in Interest Rate Risk Management

Chapter 3 covers duration, value-at-risk and expected shortfall, immunization and asset-liability management, and revisits the 1994 Orange County bankruptcy. Chapter 4 adds convexity, slope and curvature, factor models and factor-neutral hedging, with principal component analysis in an appendix, and returns to the Orange County portfolio.

Chapters 5–6: Interest Rate Derivatives: Forwards and Swaps; Interest Rate Derivatives: Futures and Options

Chapter 5 values forward rates, forward rate agreements, forward contracts and swaps, with a case study of a swap spread trade. Chapter 6 covers futures (margining, convergence, futures versus forwards) and options, presented as insurance contracts, with strategies and put-call parity.

Chapters 7–8: Inflation, Monetary Policy, and the Federal Funds Rate; Basics of Residential Mortgage Backed Securities

Chapter 7 describes the Federal Reserve and its tools, forecasts of the federal funds rate (including from futures), why the term structure slopes upward on average and the expectations hypothesis, and Treasury inflation-protected securities, ending with a case on monetary policy during 2007–2008. Chapter 8 covers securitization, prepayment, pass-throughs and the TBA market, collateralized mortgage obligations and strips, with a hedging case study.

Chapters 9–10: One Step Binomial Trees; Multi-Step Binomial Trees

Part II begins with one-step trees: replication, risk premia and risk-neutral pricing. Chapter 10 extends the analysis to multi-step trees with dynamic replication, matching the term structure and spot-rate duration.

Chapters 11–13: Risk Neutral Trees and Derivative Pricing; American Options; Monte Carlo Simulations on Trees

Chapter 11 builds the Ho–Lee and simple Black–Derman–Toy trees and prices caps, floors, swaps and swaptions, introducing implied volatility and trees for futures. Chapter 12 prices callable bonds, American swaptions and mortgage-backed securities, showing negative convexity. Chapter 13 uses Monte Carlo on trees for path-dependent products, including a Banc One case and prepayment modelling.

Chapters 14–16: Interest Rate Models in Continuous Time; No Arbitrage and the Pricing of Interest Rate Securities; Dynamic Hedging and Relative Value Trades

Part III starts with Brownian motion, differential equations and Itô's lemma, introduced through the intuition built on trees. Chapter 15 derives the fundamental pricing equation and applies it to the Vasicek and Cox–Ingersoll–Ross models, with parameter estimation and option pricing. Chapter 16 treats rebalancing, relative value trades and the theta–gamma relation.

Chapters 17–18: Risk Neutral Pricing and Monte Carlo Simulations; The Risk and Return of Interest Rate Securities

Chapter 17 presents the Feynman–Kac theorem and Monte Carlo pricing and hedging, with the Procter & Gamble / Bankers Trust leveraged swap as a case. Chapter 18 covers the market price of risk, risk-neutral versus real-world simulation, and a macroeconomic model of the term structure.

Chapters 19–22: No Arbitrage Models and Standard Derivatives; The Market Model and Options' Volatility Dynamics; Forward Risk Neutral Pricing and the LIBOR Market Model; Multifactor Models

Chapter 19 treats the Ho–Lee and Hull–White models, caps, floors and swaptions in "normal" and "lognormal" models. Chapter 20 covers the Black formula for caps, floors and swaptions and flat versus forward volatility; the preface notes it can stand alone as a follow-on to Chapter 11. Chapter 21 introduces change of numeraire, the LIBOR market model and the HJM framework. Chapter 22 extends the models to several factors, including affine and quadratic term-structure models.

Key Concepts

Part I: Basics (Chapters 1–8)

• No arbitrage and the law of one price: the principle linking the markets.
• Discount factors and the term structure: the basic pricing objects.
• Duration, convexity, factor neutrality: risk measures and hedging.
• Value-at-risk and expected shortfall: risk measures in Chapter 3.
• Prepayment and negative convexity: the features of mortgage-backed securities.

Part II: Trees (Chapters 9–13)

• Risk-neutral pricing and dynamic replication.
• Ho–Lee and Black–Derman–Toy trees; implied volatility.
• American options and callable bonds; Monte Carlo on trees.

Part III: Continuous time (Chapters 14–22)

• Itô's lemma and the fundamental pricing equation.
• Vasicek and CIR models; Hull–White; affine models.
• Market price of risk; forward risk-neutral pricing; LIBOR market model and HJM.

Critical Analysis

Strengths

• Data-driven pedagogy. The preface says examples, case studies and most exercises use real data, with spreadsheets (Parts I and II) and code (Part III) provided.
• Case studies on well-known episodes: Orange County, a swap spread trade, Banc One AIRS, Procter & Gamble / Bankers Trust and monetary policy in 2007–2008.
• Honest treatment of models. The author states that parameters must be estimated and that models are "just models", with different models giving different values for the same derivative.
• Staged mathematics. Parts I and II need only basic calculus and cover a full semester; the author states that Part III requires a more analytical background and steps up the mathematics.
• Links to macro finance. A chapter on the Federal Reserve, inflation and evidence on time-varying risk premia connects pricing with monetary policy.

Limitations

• Length. At about 800 pages the book is long, and Part III is a separate course in itself.
• US orientation. Examples, institutions and market data are largely American (Treasuries, Federal Reserve, agency MBS).
• Written in 2009. The preface is set in the middle of the financial crisis, and developments since (for instance in benchmark rates and counterparty valuation) are not covered.
• Instructor-only solutions. The solutions manual is available to instructors only, so self-study readers have no worked answers.

Where It Fits in the Course

Veronesi is the longest of the fixed income texts. Tuckman and Serrat is more compact and tool-oriented; Sundaresan gives more space to institutions, auctions and market organization. Veronesi's distinctive feature is the progression from binomial trees to continuous-time models, which makes it a bridge from a first fixed income course to the derivatives mathematics of Hunt and Kennedy's Financial Derivatives in Theory and Practice and Bingham and Kiesel's Risk-Neutral Valuation. Bodie, Kane and Marcus's Investments covers bonds as one part of a wider survey; Duffie and Singleton's Credit Risk continues into default modelling, which Veronesi does not treat in a dedicated chapter.

How to Use This Book

The preface describes two courses. An introductory course covers Parts I and II, for MBA or undergraduate students who know basic calculus; an advanced course adds Part III.

• Core: Chapters 2–5 for pricing and risk, Chapters 9–11 for trees.
• Select: Chapter 7 for monetary policy and the term structure, Chapters 8 and 12 for mortgage-backed securities, Chapter 13 for Monte Carlo.
• Advanced: Chapters 14–15 and 19–21 for continuous-time models; Chapter 20 can be read directly after Chapter 11.
• Practice: do the data exercises with the spreadsheets, and treat each case study as a worked project.