ALEXANDER DÜRING is Adviser in the Bond Markets and International Operations division of the European Central Bank, working on the implementation of the ECB's Asset Purchase Programme and market analytics. Before joining the ECB, he was Managing Director in Fixed Income Research at Deutsche Bank where he worked in London, Frankfurt and Tokyo. He holds a Doctor of Philosophy in Theoretical Physics and is a CFA^® charterholder.

I Preliminaries 15

1 Introduction 17

2 Money, credit and banking 25

2.1 Abstract properties of money 25

2.2 Early forms of money 27

2.2.1 Paper money and bank notes 31

2.3 Fiat money 32

2.3.1 Fiat money and trade 33

3 Banks 35

3.1 Banks and bank money creation 35

3.2 Categories of banks 36

4 Bank money creation 39

4.1 Single-bank introduction 39

4.2 Extension to multiple banks 42

4.3 Transfer settlement in central bank money 46

4.4 Trade and non-bank credit 50

4.4.1 Non-cash trading instruments 51

4.4.2 Discounting 52

4.4.3 Delineating payment instruments from money 52

4.5 Digital token monies and cryptocurrencies 53

4.6 The money multiplier 54

5 The role of central banks 57

5.1 Introduction 57

5.2 Monetary financing 63

6 Monetary policy 65

6.1 Objectives of monetary policy 65

6.2 Monetary policy under inflation targeting 68

6.3 Central bank operational frameworks 72

6.3.1 Symmetric interest rate corridors 74

6.3.2 Asymmetric lending corridors 76

7 Operational frameworks 77

7.1 Control of the money supply 77

7.2 Liquidity provision: Rediscounting, outright purchases and Lombard lending 78

7.3 Liquidity absorption: Asset sales and reverse repos 79

7.4 The impact of FX operations 80

8 Interaction between frameworks and policy 83

8.1 Volatility 83

8.2 Collateral 84

9 Non-standard monetary policy 87

9.1 Quantitative easing 87

9.1.1 The monetary effect of large-scale asset purchases 92

9.1.2 Market liquidity and central bank asset purchases 93

9.1.3 Helicopter money 95

9.1.4 Choice of methods and assets 96

9.2 Practical experience 99

9.2.1 QE, money multipliers and FX 99

9.2.2 Bank of Japan 2013 QE experience 104

9.2.3 Lessons from the initial BoJ quantitative easing 106

9.3 Negative interest rates 108

9.4 The specific situation of the ECB 109

II Cash instruments 113

10 Contract and instrument types 115

10.1 Securities and bilateral contracts 115

10.2 Security identifiers 118

10.2.1 ISIN codes 118

10.2.2 CUSIP codes 120

11 Trading and settlement 123

11.1 Trading 123

11.1.1 Trading and price formation 123

11.1.2 Trading venues 124

11.1.3 The OTC trade lifecycle 126

11.1.4 The exchange trade cycle 137

11.1.5 Trading in competition versus single dealer inquiries and orders 137

11.2 Settlement 139

11.2.1 Settlement mechanisms 139

11.2.2 Settlement conventions 140

12 Central clearing 143

12.1 Direct clearing 143

12.2 Indirect clearing 149

12.2.1 Agency clearing 149

12.2.2 Principal clearing 150

12.2.3 Hybrid clearing models 150

12.3 Contract value adjustments (xVA) 151

12.3.1 Credit Value Adjustment 152

12.3.2 Funding Value Adjustment 152

12.3.3 Debit Value Adjustment 153

13 The money market 155

13.1 Money market instruments 155

13.2 Discount factors 157

13.3 Daycount conventions 158

13.4 Money market interest rates 160

13.5 Compounding 161

13.6 LIBOR, Euribor, and friends 162

13.7 Overnight benchmarks 164

13.8 Benchmark reform 165

13.9 Money market futures and futures trading 167

13.9.1 Money market futures 167

13.9.2 Identification of futures contracts 168

13.9.3 Futures trading basics 169

13.9.4 Convexity adjustment 170

14 The repo market 173

14.1 The repurchase market 173

14.2 Haircut 175

14.3 Variations of repurchase transactions 176

14.4 Rehypothecation 178

15 Spot and forward rates 179

15.1 Forward rates 179

15.2 No-arbitrage calculations 179

15.3 Official rates versus term rates 181

15.3.1 The turn premium 182

15.3.2 Matching policy expectations to market rates 183

16 Bond market 187

16.1 Introduction 187

16.2 Cashflow types 188

16.2.1 Bullet bonds 188

16.2.2 Zero coupon bonds, perpetuals and annuities 190

16.3 Issuer types 194

16.3.1 Joint issuance 196

16.3.2 Supranationals 199

16.4 Governing law and contractual clauses 200

16.5 Bond markets 203

16.5.1 The primary market 206

16.5.2 The secondary market I: (interdealer market) 211

16.5.3 The secondary market II: (customer-facing market) 212

16.6 Accrued interest 212

16.7 Yield 214

16.7.1 Running yield 214

16.7.2 Simple yield 214

16.7.3 Compound yield 215

16.7.4 Bond-equivalent yield 216

16.8 Interest rate risk 217

16.9 Convexity 219

16.10Bond value decomposition 220

16.11Carry 223

17 Floating-rate notes 225

17.1 Coupon reset mechanics 226

17.2 Libor and OIS-linked notes 227

17.3 Discount margin 229

17.4 CMS and CMT floaters 231

18 Asset markets and liquidity 233

18.1 Concepts 233

18.2 Liquidity measurement 237

18.2.1 Taxonomy of liquidity measures 239

18.3 Examples 241

18.4 Liquidity premium 244

18.5 Liquidity and volatility 246

19 Curves and curve models 249

19.1 Models 250

19.2 Yield curve representation and interpretations 251

19.2.1 Discount factors versus par curves 251

19.3 Market-based curve representations 254

19.3.1 Bootstrapping 254

19.3.2 Reverse bootstrapping 256

19.4 Parametric curve models 257

19.4.1 The Nelson-Siegel and Nelson-Siegel-Svensson spline 258

19.4.2 Polynomial splines 259

19.4.3 The exponential spline 261

19.4.4 The Vasicek spline 261

19.4.5 Composite models 264

19.5 Fitting curve models 265

20 Curve analyis 269

20.1 Expectations 270

20.2 Convexity bias 274

20.3 Term risk premium 276

20.4 Preferred habitat 278

20.4.1 Asset–liability matching 278

20.4.2 Regulatory constraints 279

20.4.3 Passive investing 280

20.4.4 Central bank reserve portfolios 281

20.4.5 Market technicals 281

21 Carry and roll-down 283

22 Curve spreads 287

22.1 Z-spread 287

22.2 Par spread 288

22.3 Swap spreads 289

22.3.1 Asset swap spreads 289

22.3.2 I-spreads 291

22.3.3 The TED spread 292

III Inflation-linked debt 293

23 Inflation-indexed bonds 295

23.1 Introduction 295

23.1.1 Cashflows of inflation-linked bonds 298

23.1.2 Quotation of index-linked bonds 300

23.2 Rebalancing, rebasing and revision of CPI indices 301

23.3 Inflation seasonality 304

23.4 Price formation in inflation-linked markets 308

23.5 Return measures of inflation-linked bonds 310

23.6 Breakeven inflation 312

23.7 Carry on inflation-indexed bonds 315

23.8 Comprehensive inflation modelling 316

23.9 Inflation models and expectations 321

IV Defaultable claims 325

24 Credit risk 327

24.1 Default, insolvency, and bankruptcy 327

24.2 Seniority and subordination 328

24.2.1 Time subordination and acceleration 328

24.2.2 Contractual subordination 329

24.2.3 Statutory subordination 330

24.2.4 Joint liabilities and credit support 331

24.2.5 Sovereign debt 331

24.3 The default process 332

24.3.1 Collective action clauses 334

24.3.2 Debt exchanges and consent solicitations 335

24.3.3 Managed defaults 336

24.3.4 Wind-downs 337

24.4 Credit ratings 337

24.4.1 Rating migration 340

24.4.2 Alternative rating approaches 345

25 Covered bonds 347

25.1 Statutory covered bonds 353

25.2 Danish covered bonds 356

25.3 Structured covered bonds 357

25.4 Covered bond credit risk analysis 359

26 Asset-backed securities 363

26.1 The ABS issuance process 364

26.2 Default risk of ABS 365

26.3 Maturity of ABS 367

27 Residential mortgage-backed securities 369

27.1 Residential mortgage prepayments 370

27.2 Prepayment modelling 373

V Derivatives 381

28 Bond futures 383

28.1 Introduction 383

28.2 Futures trading patterns 386

28.2.1 Open interest and trading volume 386

28.2.2 CFTC data for US futures contracts 390

28.3 Valuation of physically delivered bond futures 394

28.3.1 Basis and implied repo rate 394

28.3.2 Conversion factors and the notional coupon 396

28.3.3 The cash-and-carry arbitrage 399

28.3.4 The quality option 400

28.3.5 Hedging with futures 401

28.4 Futures rolls 407

28.4.1 Roll ratios 410

28.4.2 Advanced futures delivery models 413

28.5 Delivery windows 413

28.6 Interaction between futures and bonds 415

28.7 Futures squeezes 416

28.8 Cash-settled futures 419

28.8.1 Exchange-for-physical transactions 420

28.9 New bond issues 421

29 Swaps 423

29.1 Introduction 423

29.2 Plain vanilla swaps 426

29.3 Trade compression and re-couponing 428

VI Standard trading strategies 431

30 Trading principles 433

30.1 Definitions 433

30.2 Trade identification 436

30.3 Trade portfolios 437

31 Curve trading 439

31.1 Simple curve trades 443

31.1.1 Outright trades 443

31.1.2 Steepeners and flatteners 443

31.1.3 Butterflies 446

31.1.4 Condors 447

31.2 Intrinsic curve movements 448

31.2.1 Alternative specifications 454

32 Bond trading 457

32.1 Bond relative value 457

32.2 Relative value strategies 459

32.2.1 Spread widener/tightener 459

32.2.2 Basis trade 460

32.2.3 Bond spread 461

32.2.4 Bond spread with curve hedge 461

32.2.5 Alternative strategies 462

33 Principal Component Analysis 465

33.1 PCA as generalised regression 468

33.2 Measuring data complexity with PCA 469

34 Bond index mechanics 473

34.1 Bond index principles 473

34.2 Index rebalancing 475

35 Portfolio risk management 477

35.1 Risk-neutral portfolios 477

35.2 Index tracking 480

35.2.1 Friction effects 484

36 Hedging 487

36.1 Introduction 487

36.2 Duration-neutral hedges 488

36.3 Regression hedges 489

36.4 Yield curve model hedges 490

37 Mean-variance optimisation 495

38 Portfolio rebalancing 505

38.1 Passive and semi-passive strategies 506

38.1.1 No reallocation 506

38.1.2 Passive management 506

38.1.3 Index replication 507

38.1.4 Constant asset allocation 508

38.1.5 Trend following 509

38.1.6 Mean reversion 509

38.2 Numerical examples 510

VIII References 513

39 Selected global bond markets 515

39.1 Euro area 515

39.1.1 Austria 517

39.1.2 Belgium 518

39.1.3 Finland 519

39.1.4 France 519

39.1.5 Germany 522

39.1.6 Greece 525

39.1.7 Ireland 526

39.1.8 Italy 527

39.1.9 The Netherlands 529

39.1.10 Portugal 530

39.1.11 Spain 531

39.2 Iceland 532

39.3 Japan 533

39.4 Sweden 536

39.5 United Kingdom 537

39.6 United States of America 539

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