Book Review: Bond Pricing and Yield Curve Modeling

Bond Pricing and Yield Curve Modeling: A Structural Approach. 2018. Riccardo Rebonato. Cambridge University Press.

In Bond Pricing and Yield Curve Modeling: A Structural Strategy, Riccardo Rebonato, professor of finance on the EDHEC Enterprise Faculty and the EDHEC-Threat Institute, combines principle with present empirical proof to construct a sturdy understanding of what drives the federal government bond market. The ebook offers the theoretical foundations (no-arbitrage, convexity, expectations, and affine modeling) for a remedy of presidency bond markets, presents and discusses the huge quantity of empirical findings which have appeared within the finance literature prior to now 10 years, and introduces the “structural” fashions utilized by central banks, institutional traders, lecturers, and practitioners to, amongst different issues, mannequin the yield curve, reply coverage questions, gauge market expectations, and assess funding alternatives.

The ebook is organized into seven components. Half I presents the foundations of the ebook, together with an inexpensive taxonomy that describes 4 several types of fashions. Two are statistical and structural no-arbitrage fashions that Rebonato explores extensively. Statistical fashions intention to explain how the yield curve strikes. They match noticed market yield curves effectively and have good predictive energy however lack a powerful theoretical basis, as a result of they can’t assure the absence of arbitrage among the many predicted yields. Structural no-arbitrage fashions make assumptions about how a handful of vital driving components behave, be certain that the no-arbitrage situation is glad, and derive how the three elements that drive the yield curve (expectations, danger premiums, and convexity) ought to have an effect on the yield curve form. The no-arbitrage situations be certain that the derived value of bonds doesn’t translate right into a free lunch. One of many underlying themes the writer develops is the try to mix the predictive and becoming virtues of statistical fashions with the theoretical solidity of the no-arbitrage fashions.

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Half II is dedicated to presenting two of the three constructing blocks of term-structure constructing: expectations and convexity. Half III introduces the glue that holds the three constructing blocks collectively — particularly, the situations of no-arbitrage. With the three constructing blocks and the situations of arbitrage absolutely defined, the writer focuses on the Vasicek model in Half IV, offering a easy derivation of its salient outcomes, together with a deeper dialogue of its strengths and weaknesses. The Vasicek mannequin explains the evolution of rates of interest. A one-factor, short-rate mannequin, it describes rate of interest actions as pushed by just one supply of market danger. Half V returns to the subject of convexity, and Half VI offers with extra returns by presenting the bridge between the actual world and the risk-neutral description. Lastly, in Half VII, the writer discusses plenty of fashions that try to beat the restrictions of the straightforward Vasicek-like fashions mentioned in Components I–VI.

The writer analyzes affine yield curve modeling from a structural perspective and begins through the use of a easy Vasicek mannequin to construct his instinct in regards to the workings of more-complex affine fashions. Regardless of the magnificence and great thing about the Vasicek mannequin, Rebonato features a substantial extension of it primarily based on latest empirical knowledge about extra returns and time period premiums. He argues that for a mannequin to have predictive capacity, it should have a nonconstant market value of danger that’s state dependent and should seize the dependence of the anticipated extra returns on the slope of the yield curve. The writer analyzes new fashions he has constructed that incorporate this key perception and compares their predictions about time period premiums and fee expectations with what has been discovered empirically prior to now decade.

Rebonato finds that after a substantial funding of time and vitality, the more-complex structural fashions predict danger premiums and expectations which might be similar to these produced by purely statistical fashions. Regardless of these comparable outcomes, the writer explores 5 causes structural fashions may be helpful and why relying solely on statistical info is unsatisfactory. One cause is that fashions are enforcers of parsimony: They’re helpful as a result of they inform us not solely what the phenomenon at hand is determined by but additionally which variables it doesn’t rely upon. Absent a mannequin, the econometrician is confronted with a really giant variety of state variables, in addition to their lags, as doubtlessly “vital regressors.” A mannequin, with its simplified depiction of the workings of the financial system, can reinforce some drastic and principled pruning. One of many virtues of a structural mannequin is the flexibility it affords to scale back the variety of parameters that require estimation and to constrain the indicators and relative magnitudes of the parameters that stay.

Structural fashions are additionally enforcers of cross-sectional restrictions, revealers of forward-looking info, and integrators. The models-as-statistical-regularizers view may be seen as a particular case of statistical shrinkage in a course reflecting prior views. Fashions which might be fitted to right this moment’s yield curve and right this moment’s covariance matrix account for the forward-looking info embedded within the costs of the related devices. Fashions present related built-in info as a result of costs are expectations of exponential capabilities of the trail of the state variables, whereas yields are instantly obtainable from costs.

The writer makes the strongest argument for why structural fashions are essential, nevertheless, when explaining that they’re “enhancers of understanding.” Structural fashions afford an understanding of what drives the yield curve that’s tough for a purely statistical evaluation to supply. As a result of statistical info is associative, it doesn’t lend itself to a causal interpretation. The human thoughts works in a causal mode however usually fails when introduced with association-based info. The principle advantage of fashions is the ability they confer on their customers to have interaction in a crucial evaluation of what the mannequin could also be missing and the way it needs to be improved.

In Bond Pricing and Yield Curve Modeling: A Structural Strategy, Rebonato takes readers on a thought-provoking journey that can elevate their desirous about term-structure modeling. On this journey, they’ll possible develop into more and more acquainted and comfy with some easy mathematical methods which might be new to them.

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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.

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Mark K. Bhasin, CFA

Mark Okay. Bhasin, CFA, is senior vp of Foundation Funding Group, LLC, New York Metropolis.

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