A Practical Guide to Interest Rate Derivative Modelling/Fundamentals

(work in progress)

In this part we cover the following:

Part I. Market fundamentals

Chapter 1. Demand and Supply of Funds - Borrowers of funds, funding cost - Lenders of funds, investment yield - Where borrowers meet lenders -- banks, primary market and secondary market - market segmentation - product format - example products - Three dimensions (to analyze the price of money a.k.a. interest rate): - credit worthiness (name, collateral) - currency - term - This book focuses on "macro" factors

Chapter 2. Derivatives - doesn't bring funds / provide yield in itself - serve as hedging / transformation / etc purpose - (trading venues?) - example products: - in currency dimension: fxswap, ccs - in term dimension: interest rate swap

Chapter 3. Market Making, Hedging and Arbitrage * liquidity provider * economy of scale * law of one price * risk-free and risky arbitrage * arbitrage in term, currency, market access * potato

Chapter 4. Regulatory constraints

Part II. Modelling fundamentals (maybe merge with Part I)

Chapter 5. What a Model Does * Banking book (accrual accounting) vs trading book (mark-to-market accounting) * price and avoid arbitrage * pricing on unseen point / hedging * q-quant vs p-quant * q-quant: key is hedging and replication * p-quant: statistical hedging and arbitrage (cross-sectional or in time a.k.a carry) * Non-parametric approach * provide benchmark for potato price * mark-to-market vs mark-to-model: potato * price/pricing vs value/valuation

Chapter 6. Recipe to price/value a product - "know your problem" phase * (why) understand the purpose of its existence (how does it help demand and supply) * (what) understand payoff (termsheet, master agreement; link to spec and/or open source code) * (how) roughly go through the front-to-back workflow - Modelling phase * replicate with traded instruments with known price (model-free, q-quant) * price the residual payoff using a model (model-dependent, p-quant) * check the hidden costs (regulatory charges, VAs, tax, etc)

Part III. Modelling Funding Transactions

Chapter 7. Single-Currency Funding and Yield Curves - non-collateralized funding - deposit (non-tradable); deposit curve (discount curve) - bond (tradable); yield curve - collateralized funding - repo (non-tradable); repo "curve" (not "macro"?) - mbs/abs (just mention)

Chapter 8. Cross-Currency Funding and Yield Differentials - fx swap - interest rate parity

Part IV. Modelling Derivative Transactions

Chapter 9. Interest Rate Swap and Forward Curves - why what how - short-model way - "market model" way (potatoes) - which is better?

Chapter 10. Basis Swap and Basis Curves - why what how - irs is not funding / LIBOR is *not* funding / no "unique" funding curve!

Chapter 11. Overnight Index Swap (and the Reunion of Short-rate Model and Market Model) - why what how - major ois indices - moving from LIBOR to OIS - again, OIS is not unique (e.g. fed-fund v sofr) - reunion of short-rate and market model (from a model perspective)

Chapter 12. Cross-Currency Swap - CCS, CBS, MTM-CCS, MTM-CBS - not exactly replicable!

Chapter 13. OTC Particularities - bilateral trading - collateral, csa - not linked to the payoff but affects valuation on a trade basis - 2nd order effect in nature (funding rate is 1st order effect) - central clearing - types of margins - not linked to the payoff and affects valuation on an aggregate basis - how do we price them?

Chapter 14. Futures - trading venue (exchange), margin process, settlement / fixing - interest rate futures and convexity adjustment - bond futures, delivery basket, cheapest to deliver, options - fx futures (??)

(??) optional content: credit default swap and survival curve (more important); inflation product (?? less important); structured product (doesn't quite fit here)

Part V. Calibration

In the previous chapters we have assumed the interest rate term structure to be given by a black-box which fits all market traded instruments. In this chapter we consider how the black-box works. - parametric Interpolation - non-parametric optimization - reference to books and open source libraries