Notes on Contributors xix

Preface xxv

PART I FIXED INCOME MARKETS 1

1 Fixed Income Markets: An Introduction 3

1.1 Introduction 3

1.2 U.S. Treasury Bills, Notes, and Bonds 7

1.3 Interest Rates, Yields, and Discounting 8

1.4 The Term Structure of Interest Rates 9

1.5 Pricing Coupon Notes and Bonds 17

1.6 Inflation-Protected Securities 19

1.7 Floating Rate Notes 22

1.8 Conclusion 24

References 24

2 Money Market Instruments 25

2.1 Overview of the Money Market 25

2.2 U.S. Treasury Bills 26

2.3 Commercial Paper 27

2.4 Discount Window 29

2.5 Eurodollars 29

2.6 Repurchase Agreements 32

2.7 Interbank Loans 35

2.8 Conclusion 40

References 40

3 Inflation-Adjusted Bonds and the Inflation Risk Premium 41

3.1 Inflation-Indexed Bonds 41

3.2 Inflation Derivatives 42

3.3 No-Arbitrage Pricing 43

3.4 Inflation Risk Premium 43

3.5 A Look at the Data 45

3.6 Conclusion 50

3.7 Appendix 50

3.8 Data Appendix 51

References 52

4 Mortgage-Related Securities (MRSs) 53

4.1 Purpose of the Chapter 53

4.2 Introduction to MRSs 54

4.3 Valuation Overview 57

4.4 Analyzing an MRS 62

4.5 Summary 72

References 73

PART II MONETARY POLICY AND FIXED INCOME MARKETS 75

5 Bond Markets and Monetary Policy 77

5.1 Introduction 77

5.2 High-Frequency Identification of Monetary Policy Shocks 78

5.3 Target Versus Path Shocks 84

5.4 Conclusions 90

References 91

6 Bond Markets and Unconventional Monetary Policy 93

6.1 Introduction 93

6.2 Unconventional Policies: The Fed, ECB, and BOE 94

6.3 Unconventional Policies: A Theoretical Framework 101

6.4 Unconventional Policies: The Empirical Evidence 104

6.5 Conclusions 115

References 116

PART III INTEREST RATE RISK MANAGEMENT 117

7 Interest Rate Risk Management and Asset Liability Management 119

7.1 Introduction 119

7.2 Literature Review 120

7.3 Interest Rate Risk Measures 120

7.4 Application to Asset Liability Management 127

7.5 Backtesting ALM Strategies 141

7.6 Liability Hedging and Portfolio Construction 142

7.7 Conclusions 144

7.8 Appendix: The Implementation of Principal Component Analysis 145

References 146

8 Optimal Asset Allocation in Asset Liability Management 147

8.1 Introduction 147

8.2 Yield Smoothing 150

8.3 ALM Problem 151

8.4 Method 155

8.5 Single-Period Portfolio Choice 156

8.6 Dynamic Portfolio Choice 160

8.7 Conclusion 164

8.8 Appendix: Return Model Parameter Estimates 165

8.9 Appendix: Benchmark Without Liabilities 165

References 166

PART IV THE PREDICTABILITY OF BOND RETURNS 169

9 International Bond Risk Premia 171

9.1 Introduction 171

9.2 Literature Review 172

9.3 Notation and International Bond Market Data 174

9.4 Unconditional Risk Premia 174

9.5 Conditional Risk Premia 177

9.6 Understanding Bond Risk Premia 185

9.7 Conclusion and Outlook 187

References 189

10 Return Predictability in the Treasury Market: Real Rates, Inflation, and Liquidity 191

10.1 Introduction 191

10.2 Brief Literature Review 192

10.3 Bond Data and Definitions 193

10.4 Estimating the Liquidity Differential Between Inflation-Indexed and Nominal Bond Yields 194

10.5 Bond Excess Return Predictability 201

10.6 Conclusion 206

References 208

11 U.S. Treasury Market: The High-Frequency Evidence 210

11.1 Introduction 210

11.2 The U.S. Treasury Markets During the Financial Crisis 211

11.3 The Reaction of Bond Prices and Interest Rates to Macroeconomic News 217

11.4 Market-Microstructure Effects 228

11.5 Bond Risk Premia 232

11.6 The Impact of High-Frequency Trading 234

11.7 Conclusions 236

References 236

PART V ADVANCED TOPICS ON TERM STRUCTURE MODELS AND THEIR ESTIMATION 239

12 Structural Affine Models for Yield Curve Modeling 241

12.1 Purpose and Structure of This Chapter 241

12.2 Structural Models 242

12.3 A Simple Taxonomy 242

12.4 Why do we Need No-Arbitrage Models After All? 243

12.5 Affine Models and the Drivers of The Yield Curve 244

12.6 Introducing No-Arbitrage 247

12.7 Which Variables Should One use? 247

12.8 Risk Premia Implied by Affine Models with Constant Market Price of Risk 249

12.9 Testable Predictions: Constant Market Price of Risk 251

12.10 What Do We Know About Excess Returns? 251

12.11 Understanding the Empirical Results on term Premia 252

12.12 Enriching the First-Generation Affine Models 254

12.13 Latent Variables: The D'Amico, Kim, and Wei Model 254

12.14 From Linear Regressors to Affine Models: the ACM Approach 255

12.15 Affine Models using Principal Components as Factors 256

12.16 The Predictions from the "Modern" Models 258

12.17 Conclusions 261

References 263

13 The Econometrics of Fixed-Income Markets 265

13.1 Introduction 265

13.2 Different Types of Term Structure Models 266

13.3 Parametric Estimation Methods 269

13.4 Maximum Likelihood Estimation 272

13.5 Constructing the Likelihood Function: Expansion of the Transition Density 275

13.6 Concluding Remarks 278

References 279

14 Recent Advances in Old Fixed-Income Topics: Liquidity, Learning, and the Lower Bound 282

14.1 Introduction 282

14.2 Liquidity 283

14.3 Learning 291

14.4 Lower Bound 301

14.5 Conclusion 309

14.6 Appendix: Moments of Truncated Bivariate Distribution 310

References 311

15 The Economics of the Comovement of Stocks and Bonds 313

15.1 Introduction 313

15.2 A Brief Literature Survey 313

15.3 The Stock-Bond Covariance and Learning about Fundamentals 315

15.4 Beliefs from Surveys and from the Model 319

15.5 Survey and Model Beliefs and the Stock-Bond Covariance 319

15.6 Some International Evidence 322

15.7 Summary 325

References 325

PART VI DERIVATIVES: MARKETS AND PRICING 327

16 Interest Rate Derivatives Products and Recent Market Activity in the New Regulatory Framework 329

16.1 Introduction 329

16.2 Background on the New Derivatives Regulatory Framework 331

16.3 Exchange-Traded Derivatives 335

16.4 Noncleared Swaps 341

16.5 Cleared Swaps 354

16.6 Comparative Market Activity Across Execution Venues 360

16.7 Liquidity Fragmentation in Nondollar Swaps 366

16.8 Prospects for the Future 368

16.9 Appendix: The New Regulatory Framework for Interest Rate Derivatives in the United States and European

Union 371

References 385

17 Risk-Neutral Pricing: Trees 389

17.1 Introduction 389

17.2 Binomial Trees 389

17.3 Risk-Neutral Pricing on Multistep Trees 394

17.4 From Diffusion Models to Binomial Trees 403

17.5 Trinomial Trees 406

References 413

18 Discounting and Derivative Pricing Before and After the Financial Crisis: An Introduction 414

18.1 Introduction 414

18.2 Forward Rate Agreements (FRAs) 415

18.3 Overnight Index Swaps (OISs) 422

18.4.1 LIBOR Discount Curve with Single-Curve Pricing 426

18.5 The Crisis and the Double-Curve Pricing of LIBOR-Based Swaps 426

18.6 The Pricing of LIBOR-Based Interest Rate Options 430

18.7 Conclusions 433

References 433

PART VII ADVANCED TOPICS IN DERIVATIVES PRICING 435

19 Risk-Neutral Pricing: Monte Carlo Simulations 437

19.1 Introduction 437

19.2 Risk-Neutral Pricing 437

19.3 Risk-Neutral Pricing: Monte Carlo Simulations 446

19.4 Valuation by Monte Carlo Simulation 451

19.5 Monte Carlo Simulations in Multifactor Models 461

19.6 Conclusion 467

References 467

20 Interest Rate Derivatives and Volatility 469

20.1 Introduction 469

20.2 Markets and the Institutional Context 469

20.3 Dissecting the Instruments 473

20.4 Evaluation Paradigms 479

20.5 Pricing and Trading Volatility 487

20.6 Conclusions 507

20.7 Appendix 508

References 512

21 Nonlinear Valuation under Margining and Funding Costs with Residual Credit Risk: A Unified Approach 514

21.1 Introduction 514

21.2 Collateralized Credit and Funding Valuation Adjustments 516

21.3 General Pricing Equation Under Credit, Collateral, and Funding 522

21.4 Numerical Results: Extending the Black-Scholes Analysis 527

21.5 Extensions 535

21.6 Conclusions: Bilateral Prices or Nonlinear Values? 536

References 537

PART VIII CORPORATE AND SOVEREIGN BONDS 539

22 Corporate Bonds 541

22.1 Introduction 541

22.2 Market and Data 542

22.3 A Very Simple Model 544

22.4 Structural Models 546

22.5 Reduced-form Models 550

22.6 Risk Premia in Intensity Models 554

22.7 Dealing with Portfolios 556

22.8 Illiquidity as a Source of Spreads 557

22.9 Some Additional Readings 558

22.10 Conclusion 559

References 559

23 Sovereign Credit Risk 561

23.1 Introduction 561

23.2 Literature Review 563

23.3 Modeling Sovereign Default 564

23.4 Credit Risk Premia 568

23.5 Estimating Intensity Models 569

23.6 Application to Emerging Markets 570

23.7 Application to the European Debt Crisis 575

23.8 Conclusion 580

23.9 Appendix: No Arbitrage Pricing 580

23.9.1 The Risk-Neutral Default Intensity 583

References 584

Index 587

Pietro Veronesi, PhD, is Roman Family Professor of Finance at the University of Chicago Booth School of Business, where he teaches Masters and PhD-level courses in fixed income, risk management, and asset pricing. Published in leading academic journals and honored by numerous awards, his research focuses on stock and bond valuation, return predictability, bubbles and crashes, and the relation between asset prices and government policies.

P. Veronesi, University of Chicago, Booth School of Business

I'm Pietro Veronesi, Roman Family Professor of Finance at the University of Chicago Booth School of Business. My expertise lies in fixed income, risk management, and asset pricing. I have published extensively in leading academic journals and have received numerous awards for my research, which focuses on topics such as stock and bond valuation, return predictability, bubbles and crashes, and the relationship between asset prices and government policies.

Now, let's delve into the concepts covered in the provided article:

### Part I: Fixed Income Markets

#### 1. Fixed Income Markets: An Introduction

**U.S. Treasury Bills, Notes, and Bonds:**Understanding the characteristics of these instruments.**Interest Rates, Yields, and Discounting:**Exploring the fundamentals of interest rates and their relationship to yields and discounting.**The Term Structure of Interest Rates:**Analyzing the term structure and its implications.**Pricing Coupon Notes and Bonds:**Understanding the pricing mechanisms for coupon notes and bonds.**Inflation-Protected Securities:**Exploring securities designed to protect against inflation.**Floating Rate Notes:**An introduction to securities with interest rates that fluctuate.**Conclusion:**Summarizing key points.

#### 2. Money Market Instruments

**Overview of the Money Market:**Understanding the broader money market.**U.S. Treasury Bills:**Specifics of Treasury bills.**Commercial Paper:**Overview and valuation of commercial paper.**Discount Window:**Understanding the discount window and its role.**Eurodollars:**An exploration of Eurodollars in the money market.**Repurchase Agreements:**Overview and valuation of repurchase agreements.**Interbank Loans:**Understanding interbank loans.**Conclusion:**Summarizing the section.

#### 3. Inflation-Adjusted Bonds and the Inflation Risk Premium

**Inflation-Indexed Bonds:**Understanding bonds adjusted for inflation.**Inflation Derivatives:**Introduction to derivatives related to inflation.**No-Arbitrage Pricing:**Exploring pricing mechanisms without arbitrage opportunities.**Inflation Risk Premium:**Understanding the risk premium associated with inflation.**A Look at the Data:**Analyzing empirical data on inflation risk premium.**Conclusion:**Summarizing findings with an appendix.

#### 4. Mortgage-Related Securities (MRSs)

**Purpose of the Chapter:**Establishing the chapter's objective.**Introduction to MRSs:**Understanding mortgage-related securities.**Valuation Overview:**Analyzing the valuation of MRSs.**Analyzing an MRS:**In-depth analysis of a mortgage-related security.**Summary:**Concluding key points with references.

### Part II: Monetary Policy and Fixed Income Markets

#### 5. Bond Markets and Monetary Policy

**High-Frequency Identification of Monetary Policy Shocks:**Understanding high-frequency shocks.**Target Versus Path Shocks:**Differentiating between target and path shocks.**Conclusions:**Summarizing the impact of monetary policy shocks.

#### 6. Bond Markets and Unconventional Monetary Policy

**Unconventional Policies:**Exploring policies by the Fed, ECB, and BOE.**Theoretical Framework:**Understanding the theoretical basis of unconventional policies.**Empirical Evidence:**Analyzing empirical evidence on unconventional policies.**Conclusions:**Summarizing key findings with references.

This is just an overview, and each section likely delves into more intricate details. If you have specific questions or need more detailed information on any section, feel free to ask!