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