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© CFA Institute. For candidate use only. Not for distribution. FIXED INCOME AND DERIVATIVES CFA® Program Curriculum 2020 • LEVEL II • VOLUME 5 © CFA Institute. For candidate use only. Not for distribution. © 2019, 2018, 2017, 2016, 2015, 2014, 2013, 2012, 2011, 2010, 2009, 2008, 2007, 2006 by CFA Institute. All rights reserved. This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself. It does not cover the individual selections herein that first appeared elsewhere. Permission to reprint these has been obtained by CFA Institute for this edition only. Further reproductions by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval systems, must be arranged with the individual copyright holders noted. CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute. To view a list of CFA Institute trademarks and the Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only. ISBN 978-1-946442-86-4 (paper) ISBN 978-1-950157-10-5 (ebk) 10 9 8 7 6 5 4 3 2 1 © CFA Institute. For candidate use only. Not for distribution. CONTENTS How to Use the CFA Program Curriculum Background on the CBOK Organization of the Curriculum Features of the Curriculum Designing Your Personal Study Program Feedback v v vi vi viii ix Fixed Income Study Session 12 Fixed Income (1) 3 Reading 32 The Term Structure and Interest Rate Dynamics Introduction Spot Rates and Forward Rates The Forward Rate Model Yield to Maturity in Relation to Spot Rates and Expected and Realized Returns on Bonds Yield Curve Movement and the Forward Curve Active Bond Portfolio Management The Swap Rate Curve The Swap Rate Curve Why Do Market Participants Use Swap Rates When Valuing Bonds? How Do Market Participants Use the Swap Curve in Valuation? The Swap Spread Spreads as a Price Quotation Convention Traditional Theories of the Term Structure of Interest Rates Local Expectations Theory Liquidity Preference Theory Segmented Markets Theory Preferred Habitat Theory Modern Term Structure Models Equilibrium Term Structure Models Arbitrage-Free Models: The Ho–Lee Model Yield Curve Factor Models A Bond’s Exposure to Yield Curve Movement Factors Affecting the Shape of the Yield Curve The Maturity Structure of Yield Curve Volatilities Managing Yield Curve Risks Summary Practice Problems Solutions 5 6 6 8 indicates an optional segment 16 19 20 24 24 25 26 29 31 33 33 34 35 35 38 38 42 45 45 47 50 51 54 56 67 © CFA Institute. For candidate use only. Not for distribution. ii Contents Reading 33 The Arbitrage-Free Valuation Framework Introduction The Meaning of Arbitrage-Free Valuation The Law of One Price Arbitrage Opportunity Implications of Arbitrage-Free Valuation for Fixed-Income Securities Interest Rate Trees and Arbitrage-Free Valuation The Binomial Interest Rate Tree What Is Volatility and How Is It Estimated? Determining the Value of a Bond at a Node Constructing the Binomial Interest Rate Tree Valuing an Option-Free Bond with the Tree Pathwise Valuation Monte Carlo Method Summary Practice Problems Solutions 7