An Introduction to Financial Markets

Chapter Five Fixed-Income Markets

We have introduced the fundamental concepts related to interest rates and fixed–income assets in Chapter 3. Then, in Chapter 4, we have introduced simple interest rate derivatives that may be used, among other things, to manage interest rate risk, as we shall illustrate in Chapter 6. In this chapter, we take a short break to deal with some topics that are quite relevant for the profession. Mathematically inclined readers may not be interested in certain nasty details of real markets, and indeed they can skip this chapter if they are only interested in the intellectual pleasure of quantitative models. However, there is little value in overly sophisticated and fragile models, without any understanding of the pitfalls and issues that are so pervasive in financial markets, especially in the fixed-income case. Due to space constraints, we will not be able to present an extensive picture, but it is important to get at least a feeling for some issues that do play an important role in practice. The choice of topics is somewhat arbitrary, and it has been made to illustrate just a few among the most essential issues.

• When calculating interest in elementary treatments, we deal with time measured in years or months. For the sake of simplicity, we pretend that every month is just the same and consists of 30 days, but this is not really the case. We have to consider the difference between months consisting of 30 or 31 days, and possibly 28 (or 29 in leap ...