Description: This is an advanced course on applied fixed income and speculative strategies. This course will cover the three major fixed income markets—U.S. Government Treasury notes and bonds, corporate bonds, and mortgages. We will start with duration, convexity and price volatility in Treasury bonds, as well as an analysis of the term structure of interest rates. Next, we will examine corporate bonds and bank loans in the context of the credit option, demonstrating the nonlinearities and skewness in risky corporate bond returns. Then we will cover mortgage securities and the prepayment option, examining their negative convexities and skewness characteristics as well. Following that, we will demonstrate how dynamic trading can create nonlinear payoffs, such as call and put options, and then show how to use those techniques to hedge mortgages and corporate bonds. Mortgage derivatives, such as interest only and principal only strips, will be examined and the difficulties of risk estimation for such derivatives will be made clear.
Common speculative strategies that “hedge and lever” the returns of mortgages and corporate bonds will be examined next. The strategies and fall of Long Term Capital Management in 1998 and the fall of many more “smart money players” in the Financial Panic of 2008-2009 (Bear Stearns, Lehman, Fannie Mae, Freddie Mac, myself and others) are examined in vivid detail. Nonlinearities, skewness and option effects are demonstrated in nonagency mortgages with credit risk and with corporate bonds. Challenges of risk management with shifting correlations are explored, as well as the major changes of correlations in extreme markets. The allures and risks of leverage are made clear by examining real cases. Finally, behavioral finance is discussed for its help in understanding the errors made in speculative strategies and for thinking about better methods of risk management, given what we have learned.
Course #: 15.S05
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