Faculty
Professor Richard J. Rendleman
Objectives
This course will focus on the valuation of fixed income securities, fixed income derivatives and investment techniques employed in the hedging and management of fixed income portfolio risks. We will review the basic concepts of fixed income instruments, such as yield-to-maturity, the term structure of interest rates, the zero-coupon yield curve, duration, and convexity. Next, we will focus on the use of stochastic (random) interest rate models as tools for pricing and managing the risks of interest-sensitive portfolios with complex option and default features. Although much of course will focus on default-free securities and related derivatives, we will also study conforming and subprime mortgage CDO structures and the combined role of interest rate risk and credit risk in fixed income security pricing.
The course should be of interest to any student who plans to work in the area of fixed income portfolio management, equity portfolio management (since modern portfolio management involves a tradeoff between equity and fixed-income investment), commercial banking, corporate treasury, or debt underwriting including real estate finance. Many of the course topics are covered on the CFA exam.
Requirements
Materials
Richard J. Rendleman, Jr., Fixed Income Teaching Notes, 2009, including chapters 11 and 15 from Applied Derivatives: Options, Futures and Swaps, revised edition.
David Backus, Manuscript: Debt Instruments and Markets, August 27, 1998.
Frank J. Fabozzi, Bond Markets, Analysis and Strategies, 2007, sixth edition, Prentice Hall, chapters 10-12.
Tuck Honor Code
Students are not allowed to use old lecture notes, tests, test solutions, homework solutions, project solutions or any other material from prior classes that I have taught at Tuck, UNC, or the Helsinki School of Economics that have not been made available to all members of the class. Use of such materials in connection with this class will be considered a violation of the Honor Code.
Homework
A number of optional homework problems will be assigned throughout the term. These problems should not be turned in. Solutions for Q&P from my teaching notes will be made available in the course folder. Solutions to the Backus Q&P are provided in Appendix A. The Backus manuscript also contains several practice tests and solutions.
Projects
Five group projects will be assigned during the term and must be turned in at the beginning of class on the day they are assigned. Each project can count up to 10 percent of your course grade using the "H-Credit" system explained in "PROJECT GRADING.pdf" contained in the GENERAL DOCUMENTS section of the course folder. The projects may be done individually or in a group that does not exceed three students. You should keep a copy of each project and bring it to class for reference during class discussion.
Computer Usage in Class
Computer usage in class is strictly prohibited, unless I have assigned a specific computer-related project for a particular class. In such cases, students will be notified in advance to bring their computers to class..
Cell Phones and Other Communications Devices
The use of cell phones and other communications devices in class for any reason other than to stay in touch with family due to a potentially impending emergency is strictly prohibited.
E-mail
Whenever you send me e-mail, please put "DM:" as the first four characters in the subject line.
Grading
Projects 0-50%.
Five group projects will be assigned during the term and must be turned in at the beginning of class on the day they are assigned. Each project has the potential to give you a grade of H (100) for up to 10 percent of your course grade. Projects may be done individually or in a group that does not exceed three students. More detail on group projects and the "H-Credit" grading system is provided in "PROJECT GRADING.pdf" contained in the GENERAL DOCUMENTS section of the course folder.
Class Participation 10%
Final Exam 40-90%
(Don't panic about the 90%. See the final exam section of the "PROJECT GRADING.pdf" document.) The final exam will be a closed book (and closed notes) take-home exam. I will provide a set of formula sheets approximately one week from the end of the term that you can use when taking the final exam. The exam will be comprehensive (covering the entire term), and you will have four hours to complete the exam during the exam week. Most of the more challenging questions and problems from the Rendleman text came from old exams and are representative of questions of average to above-average difficulty that you can expect to see.
Schedule
Thu 03/26/2009
Review of Bond Pricing and Term Structure
Rendleman, Chapter 1.
Rendleman, Chapter 3, sections 3.1-3.5.
Backus, Chapter 2.
See reading guide in the March 26 assignment folder.
Prepare the triplets assignment contained in the March 26 assignment folder. This assignment will not be graded, but I will "cold call" students or ask for volunteers to provide their answers to questions in the assignment. Students may work in groups of any size to prepare this assignment, but each student, if called upon, should be prepared to defend his/her solution. Yes, I realize that this is the first class and that it may be difficult to prepare the assignment along with all the readings. Therefore, I will not penalize students who have not done the assignment but, obviously, I will be happier if you are prepared.
Optional: Backus Practice Exams.
B.1 Midterm, Spring 1998, problem 2.
B.2 Midterm, Fall 1995, problems 1 and 2.
B.3 Midterm, Fall 1995, problems 1, 2 and 3.
Fri 03/27/2009
Project 1: More Realistic Bond Math, Zero-Coupon and Par Yield Curves
(Instructions in PROJECTS folder.) This is an important project, and given the structure of the course, it doesn't make sense to do it at any other time. Please make sure you are familiar with my project and grading method. (See "PROJECT GRADING.pdf" in the GENERAL DOCUMENTS folder.) If you are unable to complete the project, it will not count against you. Instead, it will just put more weight on your final exam.
Wed 04/01/2009
Review of Duration and Convexity
Rendleman, chapters 2 and 4.
Backus, chapter 4.
(The Backus chapter will be more in line with the way you learned about duration and convexity in Debt Markets.)
Thu 04/02/2009
Duration and Convexity (continued)
Reading assignments continued.
Duration/convexity assignment in assignment folder.
Prepare for class discussion and cold calls.
Rendleman Q&P, 1-5.
Backus Practice Problems 4, 5a-5c.
Optional: Backus Practice Exams.
B.1 Spring 1998, problem 4. (Note, we haven't studied swaps yet, but based on how we have developed the theory of duration, you should be able to answer this question.)
Wed 04/08/2009
Introduction to Swap Markets
Rendleman, chapter 5, sections 5.1-5.4.
Note, I will not test you on the material in section 5.4, but you should still read it.
Backus, chapter 5, sections 5.1-5.2, 5.5-5.6.
Don't worry about the material at the top of page 79.
Thu 04/09/2009
Project 2: Swap Valuation: Upper Valley National Bank
Instructions in PROJECTS folder.
Thu 04/09/2009
Duration-Based Interest Rate Risk Management using Swaps
Rendleman, chapter 5, sections 5.5-5.7.
Backus, pages 76 and 80.
Rendleman, Q&P 2 and 3.
Backus, Practice Problem 1.
Prepare all for class discussion and volunteers. (Yes, I realize that there is a lot to prepare for this class. Therefore, no cold calls for this assignment, but Kudos if you can get it done.)
Optional: Backus Practice Problems, 5-7.
Optional: Backus Practice Exams.
B.1 Midterm, Spring 1998, problem 4 (assigned previously).
B.2 Midterm, Fall 1995, problem 4.
B.3 Midterm, Fall 1995, problems 4, 5a and 5b.
Wed 04/15/2009
Introduction to Stochastic (Random) Interest Rate Models
In this class we will use stochastic (random) interest rate models to dispel several "myths" associated with term structure, "the magic of convexity" and parallel shifts in the yield curve. Later, we will expand on this valuation framework to deal with the pricing and risk management of fixed income portfolios that contain securities with option features.
Rendleman, chapter 6.
Backus, chapter 7 (VERY optional).
In general, most of the Rendleman and Backus readings reinforce each other and give you a slightly different way of looking at the same thing. In this case, however, the Rendleman and Backus chapters appear to be much different. (In fact, they are not, but it would probably look that way to a student seeing this material for the first time.) A lot more is covered in the Backus chapter than in the Rendleman chapter, although we will get to some of the additional topics later in Rendleman, chapter 11. And unlike his other chapters, Backus chapter 7 is closer to Ph.D. level than MBA level. Unfortunately, I cannot come up with a good way to guide you through the topics of the Backus chapter that parallel Rendleman, chapter 6. So, if nothing else, just look at the Backus chapter as confirmation that I'm not just making all this stuff up! At a minimum, read the very last paragraph on page 121.
Rendleman Q&P 1-3.
These problems parallel what I will be doing in my lecture, so I probably will not be going over the problems in class.
Wed 04/15/2009
Pricing Interest Rate-Dependent Financial Claims with Option Features
Rendleman chapter 11, sections 11.1 and 11.2.
Optional: Rendleman Q&P 2, 3, 5.
Optional: Backus Practice Exams.
(Throughout, assume pi = 0.5).
B.4 Final, Spring 1998, problems 4a-4c.
B.5 Final, Fall 1996, problem 4.
B.6 Final, Fall 1995, problem 2.
Thu 04/16/2009
Arbitrage-Free Stochastic (Random) Term Structure Models
Rendleman, chapter 11, sections 11.3-11.4.
Optional: Rendleman, Q&P 1, 6 and 7.
Wed 04/22/2009
Interest Rate Futures
Rendleman, chapter 15, sections 15.3-15.8.
Backus, chapter 8, section 8.1-8.2.
Rendleman, Q&P 1-3. Also prepare problem 4, knowing in advance that the 17-year 9% bond will be cheapest to deliver.
For class discussion and cold calls.
Optional: Improving the Design of Treasury Bond Futures Contracts
Wed 04/22/2009
Project 3: Simple Mortgage Pricing Using Binomial-Based Stochastic Interest Rate Models
Instructions in project folder.
Thu 04/23/2009
More on Treasury Bond and Note Futures
Richard J. Rendleman, Jr., "Delivery Options in the Pricing
and Hedging of Treasury Bond and Note Futures," Journal of Fixed Income (September 2004), in course pack. Also read SUPPLEMENT.pdf in DM\COURSE PACK\RENDLEMAN T-BOND FUTURES for corrections and clarifying comments.
Wed 04/29/2009
More on Treasury Bond and Note Futures (continued)
Wed 04/29/2009
Interest Rate Risk Management Using Arbitrage-Free Stochastic Term Structure Models
Richard J. Rendleman, Jr., "First Derivatives National Bank: A Case Problem in the Management of Interest Rate Risk," Journal of Risk (1999), in GENERAL DOCUMENTS FOLDER (FDNB_WRITEUP_TYPOS_FIXED.pdf).
Thu 04/30/2009
Interest Rate Risk Management Using Arbitrage-Free Stochastic Term Structure Models (continued)
Wed 05/06/2009
Interest Rate Risk Management Using Arbitrage-Free Stochastic Term Structure Models (continued)
Wed 05/06/2009
Project 4: Interest Rate Risk Management Using Treasury Note Futures
Thu 05/07/2009
Introduction to Mortgage Markets and Mortgage-Backed Securities
Fabozzi, chapters 10 and 11.
Thu 05/07/2009
Project 5: Calculating Projected Cash Flows for Mortgage-Backed Security with Prepayments
Will be used in class discussion. Prepare for cold calls.
Wed 05/13/2009
Collateralized Mortgage Obligations (CMOs)
Fabozzi, chapter 12.
Practice problems from two of my old exams are contained May 13 assignments folder. We probably will not have time to go over these in class.
Thu 05/14/2009
Subprime Mortgage Market and CDO Structures
For most of this session and the next, I will be going over my notes, "Anatomy of a Subprime Deal," GSAMP 2006-NC2. The prospectus for this deal is contained in DM\GENERAL DOCUMENTS\SUBPRIME along with a representative monthly servicer report. The document SUPPLEMENT_TO_SUBPRIME_DEAL.pdf, in the same folder, is an integral part of the notes to be used in both subprime sessions. Much of my presentation draws from the paper by Adam Ashcraft and Til Schuermann, "Understanding the Securitization of Subprime Mortgage Credit," also in the same folder. I have also included the transcript of Bob Hansen's interview with Mike Stockman. None of this should be considered as required reading, other than the supplement document. I have many more articles and papers relating to the subprime crisis if you are interested.
Case: Subprime Meltdown: American Housing and
Global Financial Turmoil.
This is an excellent summary of the subprime crisis. Just read the case as background material. We will not "do" the case in class, and there is nothing to write up.
Wed 05/20/2009
Subprime Mortgage Market and CDO Structures (continued)
See previous assignment.
Thu 05/21/2009
Speaker
Neil Baron
Retired Vice Chairman & General Counsel
Fitch Ratings
