Bond market

In effect, the cash-based local drug traffic in Hong Kong created a reserve base for offshore lending to finance the drug traffic in the rest of Asia Since 1975, however, the development of the offshore bond market and the influx of foreign capital has led to the reduction of the liquidity ratio to a still-extraordinary 43 percent. 

To summarize, studies of the impact of pharmaceutical investments on returns in the stock and bond markets do not prove, but are consistent with, the finding that R D drives profitability in the industry and has produced returns over reasonably long periods of time that may exceed the cost of capital. 

We show that the application of the EE is admissible leading to accurate results, even in the case of lognormal-distributed random variables. This good-natured behavior of the EE, firstly comes from the fact that the volatility t5 ically occurring in bond markets is rather low, generating more close-to-normal -distributed random variables. Secondly, the series expansion of the (log) characteristic function in terms of the cumulants can be practically applied for M lower than a critical order Me. 

In recent works Collin-Dufresne and Goldstein [18], Heiddari and Wu [36], Jarrow, Li, and Zhao [45] and Li, Zhao [54] have extended the HJM approach to a framework, where either the volatility of forward rates, or the volatility of bond prices is driven by a subordinated stochastic process. One major implication of these new type of models is an additional source of uncertainty driving the volatility. This implies the existence of an additional market price of risk. Intuitively, this market price of risk cannot be hedged only by bonds. As a result of this, we have a new class of models causing incomplete bond markets ... 

The implications of this new model class are in contrast to most term structure models discussed in the literature, which assume that the bond markets are complete and fixed income derivatives are redundant securities. Collin-Dufresne and Goldstein [ 18] and Heiddari and Wu [36] show in an empirical work, using data of swap rates and caps/floors that there is evidence for one additional state variable that drives the volatility of the forward rates. Following from that empirical findings, they conclude that the bond market do not span all risks driving the term structure. This framework is rather similar to the affine models of equity derivatives, where the volatility of the underlying asset price dynamics is driven by a subordinated stochastic volatility process (see e.g. Heston [38], Stein and Stein [71] and Schobel and Zhu [69]). 

Note that the unspanned stochastic volatility models are contradictory to the stochastic volatility models of Fong and Vasicek [31], Longstaff and Schwartz [56] and de Jong and Santa-Clara [24], where the bond market is complete and all fixed-income derivatives can be hedged by a portfolio solely... 

CDG [18] show that no bivariate Markov model of the term structure can generate incomplete bond markets. Furthermore, they show that at least a three-dimensional model is needed to generate incomplete bond markets. 

Making comparison between bonds could be difficult and several aspects must be considered. One of these is the bond s maturity. For instance, we know that the yield for a bond that matures in 10 years is not the same compared to the one that matures in 30 years. Therefore, it is important to have a reference yield curve and smooth that for comparison purposes. However, there are other features that affect the bond s comparison such as coupon size and structure, liquidity, embedded options and others. These other features increase the curve fitting and the bond s comparison analysis. In this case, the swap curve represents an objective tool to understand the richness and cheapness in bond market. According to O Kane and Sen (2005), the asset-swap spread is calculated as the difference between the bond s value on the par swap curve and the bond s market value, divided by the sensitivity of 1 bp over the par swap. 

We selected five bonds rated BBB, similar maturity (around 6 years at maturity), trading in the European bond market. The bonds were issued by companies operating in the utility industry. The bonds are ... 

For these reasons, practitioners may prefer to use an arbitrage-free model if one can be successfully implemented and calibrated. This is not always straightforward, and under certain conditions, it is easier to implement an equilibrium multi-factor model (which we discuss in the next section) than it is to implement a multi-factor arbitrage-free model. Under one particular set of circumstances, however, it is always preferable to use an equilibrium model, and that is when reliable market data is not available. If modelling the term stmcture in a developing or emerging bond market, it will be more efficient to use an equilibrium model. 

Choudhry, M., 2001. Bond Market Securities. FT Prentice Hall, London. 

The two previous chapters introduced and described a fractiOTi of the most important research into interest-rate models that has been carried out since the first model, presented by Oldrich Vasicek, appeared in 1977. These models can be used to price derivative seciuities, and equitibrium models can be used to assess fair value in the bond market. Before this can take place however, a model must be fitted to the yield curve, or calibrated In practice, this is carried out in two ways the most popular approach involves calibrating the model against market interest rates given by instruments such as cash Libor deposits, futures, swaps and bonds. The alternative method is to model the yield curve from the market rates and then calibrate the model to this fitted yield curve. The first approach is common when using, for example extended Vasicek... 

Central banks and market practitioners use interest rates prevailing in the government bond market to extract certain information, the most important of which is implied forward rates. These are an estimate of the market s expectations about the future directirMi of short-term interest rates. They are important because they signify the market s expectafirMis about the future path of interest rates however, they are also used in derivative pricing and to create synthetic bond prices from the extent of credit spreads of corporate bonds. 

In order to calculate the range of implied forward rates, we require the term stmcture of spot rates for all periods along the continuous discount function. This is not possible in practice, because a bond market will only contain a finite number of coupon-bearing bonds maturing on discrete dates. While the coupon yield curve can be observed, we are then required to fit the observed curve to a continuous term structure. Note that in the United Kingdom gilt market, for example there is a zero-coupon bond market, so that it is possible to observe spot rates directly, but for reasons of liquidity, analysts prefer to use a fitted yield curve (the theoretical curve) and compare this to the observed curve. 

Bonds that have part or all of their cash flows linked to an inflation index form an important segment of several government bond markets. In the United Kingdom, the first index-linked bonds were issued in 1981 and at the end of 2012 they accounted for approximately 25% of outstanding nominal value in the gilt market. Index-linked bonds were also introduced in the United States Treasury market but are more established in Australia, Canada,... 

To obtain the price of an inflation-linked bond, it is necessary to determine the value of coupon payments and principal repayment. Inflation-linked bonds can be structured with a different cash flow indexation. As noted above, duration, tax treatment and reinvestment risk, are the main factors that affect the instrument design. For instance, index-aimuity bmids that give to the investor a fixed annuity payment and a variable element to compensate the inflation have the shortest duration and the highest reinvestment risk of aU inflation-linked bonds. Conversely, inflation-linked zero-coupon bonds have the highest duration of all inflation-linked bonds and do not have reinvestment risk. In addition, also the tax treatment affects the cash flow structure. In some bond markets, the inflation adjustment on the principal is treated as current income for tax purpose, while in other markets it is not. 

A common observation in government bond markets is that the longest dated bond trades expensive to the yield curve. It also exhibits other singular features that have been the subject of research, for example, by Pboa (1998), wbicb we review in this chapter. The main feature of long-bond yields is that they reflect a convexity effect. Analysts have attempted to explain the craivexity effects of long-bond yields in a number of ways. These are discussed first. We then consider the volatility and convexity bias that is observed in long-bond yields. 

FIGURE 9.1 Convertibles, equity and bond market. (Data Source UBS Research 2013 and... 

Philips, G.A., 1997. Convertible Bonds Markets. Macmillan Business, Houndmills, Basingstoke, Hampshire. 

In addition, market turmoil has created concern about the volatility in bond markets from the investor s viewpoint. Figure 10.1 shows the yield trend of the main government bonds in recent years. 

A primary distinguishing feature of a bond is its issuer. The nature of the issuer will affect the way the bond is viewed in the market. There are four issuers of bonds sovereign governments and their agencies, local government authorities, supranational bodies such as the World Bank, and corporations. Within the corporate bond market there is a wide... 

As noted, the coupon rate is the interest rate the issuer agrees to pay each year. The coupon rate is used to determine the annual coupon payment which can be delivered to the bondholder once per year or in two or more equal installments. As noted, for bonds issued in European bond markets and the Eurobond markets, coupon payments are made annually. Conversely, in the United Kingdom, United States, and Japan, the usual practice is for the issuer to pay the coupon in two semiannual installments. An important exception is structured products (e.g., asset-backed securities) which often deliver cash flows more frequently (e.g., quarterly, monthly). 

Bonds with embedded call and put options comprise a relatively small percentage of the European bond market. Exhibit 1.6 shows the percentage of the market value of the Euro Corporate Index and Pan-Euro Corporate Index attributable to bullets (i.e., option-free bonds), callable and putable bonds from the late 1990s through 31 May 2003. Accordingly, our discussion of bonds with embedded options in the remainder of the book will be confined to structured products. 

The principles of pricing in the bond market are exactly the same as those in other financial markets, which states that the price of any financial instrument is equal to the net present value today of all the future cash flows from the instrument. In Chapter 3, bond pricing will be explained. In this chapter we will just present the basic elements of bond pricing. 

The date used as the point for calculation is the settlement date for the bond, the date on which a bond will change hands after it is traded. For a new issue of bonds the settlement date is the day when the bond stock is delivered to investors and payment is received by the bond issuer. The settlement date for a bond traded in the secondary market is the day that the buyer transfers payment to the seller of the bond and when the seller transfers the bond to the buyer. Different markets will have different settlement conventions for example, UK gilts normally settle one business day after the trade date (the notation used in bond markets is T+ 1) whereas Eurobonds settle on T + 3. The term value date is sometimes used in place of settlement date, however the two terms are not strictly synonymous. A settlement date can only fall on a business date, so that a gilt traded on a Friday will settle on a Monday. However a value date can sometimes fall on a nonbusiness day. 

In all major bond markets the convention is to quote price as a clean price. This is the price of the bond as given by the present value of its cash flows, but excluding coupon interest that has accrued on the bond since the last dividend payment. As all bonds accrne interest on a daily basis, even if a bond is held for only one day, interest will have been earned by the bondholder. However, we have referred already to a bond s all-in price, which is the price that is actually paid for the bond in the market. This is also known as the dirty price (or gross price), which is the clean price of a bond plus accrued interest. In other words, the accrued interest must be added to the quoted price to get the total consideration for the bond. 

Exhibit 1.8 shows the conventions (coupon frequency, Day count basis, and ex-dividend period) for the the government bond market of major European countries. 

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