Fixed Income Analysis
The CFA Institute treatment of valuation and risk measures.
Summary
Fabozzi and Petitt produced this as the fixed income text within the CFA Institute investment series, aimed at candidates and at practitioners who need the analytical framework rather than instrument description alone.
The coverage moves from features and pricing to risk measurement to portfolio application. Early chapters treat bond features, cash flow structures and the arbitrage-free valuation framework using spot rates. The interest rate risk chapters develop duration in its several forms, including Macaulay, modified, effective and key rate duration, and convexity, with attention to why effective duration is required for bonds with embedded options. The term structure chapters cover spot and forward rate relationships and the theories offered to explain the shape of the curve. Valuation of bonds with options uses binomial interest rate trees and option-adjusted spread, and there is treatment of Monte Carlo methods for mortgage securities where the cash flows are path dependent.
Credit chapters cover traditional credit analysis, structural and reduced-form models, and credit derivatives. Later chapters address portfolio management including benchmark selection, active strategies, liability-driven approaches and performance measurement.
The book is a teaching text rather than an argument, and its purpose is to convey the standard framework accurately. Readers should note that it presents professional practice rather than criticising it, and the treatment of structured products and rating agency methodology reflects the industry view. Editions differ substantially and the post-crisis revisions changed the structured product and credit chapters considerably.
Key takeaways 7
- Arbitrage-free valuation requires discounting each cash flow at its own spot rate rather than at a single yield.
- Effective duration rather than modified duration must be used for bonds with embedded options, because the cash flows change with rates.
- Key rate durations decompose interest rate exposure across points on the curve, which parallel-shift measures cannot capture.
- Option-adjusted spread separates compensation for credit and liquidity from the value of any embedded option.
- Mortgage securities require path-dependent valuation because prepayment behaviour depends on the history of rates, not only the current level.
- Liability-driven investing matches asset and liability sensitivities rather than maximising return against a market benchmark.
- Credit risk can be modelled structurally from the firm's asset value or reduced-form from observed default intensities, and the two give different answers.
Who should read it
Candidates and practitioners who need the standard analytical framework for fixed income valuation and risk measurement in one text.
About Frank J. Fabozzi
Finance professor and longtime editor of the Journal of Portfolio Management, who writes and edits the standard fixed-income handbooks.
The handbooks define how bond, mortgage and preferred-stock markets are measured: cash-flow mechanics, duration and convexity, credit structures, and the pricing conventions desks actually use. Practitioners and CFA candidates work through these volumes to value and hedge the instruments the equity literature skips.
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