FNCE 450: Fixed Income Securities

Spring 2011 Term 1 Professor Michael W. Brandt Fuqua School of Business Duke University Course description: Effective risk management is essential in todays uncertain business environment. Derivatives and especially fixed income derivatives are standard instruments for managing financial risk. More than 90% of the Worlds largest 500 companies use fixed income derivatives to manage interest rate risk exposure. While vanilla fixedfor-floating swap contacts are by far the most common fixed income derivative, financial engineers keep inventing new fixed income derivatives to help firms transfer risks more effectively and selectively. It is critical for anyone involved in corporate or financial risk management to have a deep-rooted understanding of interest rate risk and fixed income securities. This course explores key issues in fixed income. It develops tools for valuing and modeling the risk exposures of fixed income securities and their derivatives, with the ultimate goal of deploying these instruments in a corporate or financial risk management setting. The course is divided into two parts, covering (1) basic fixed income securities and (2) fixed income derivatives with a focus on popular interest rate models used to value them. To make the material broadly accessible, concepts are, whenever possible, explained through hands-on applications and examples, rather than through advanced mathematics. The course also develops a basic command of the Bloomberg Professional data terminal. Prerequisites and preassigment: The only prerequisite for FNCE 450 is FNCE 350 (Global Financial Management). For some topics, however, it will be very useful to have taken FNCE 353 (Derivatives). Those of you without this course may require additional time reviewing the material and/or working on the assignments. I recommend that you join a group in which at least one person has taken Derivatives. There is no formal preassignment, but I assume basic understanding of valuation and derivatives (at the level of FNCE 350) as well as of probability and regression (at the level of Whaleys appendices A and B available on the course website).

Required readings: Course notes will be distributed in class prior to the discussion session. Please bring your notes to class each day to follow along the lecture presentation. All course notes are/will be available on the course website: http://www.duke.edu/~mbrandt/fnce450.html Most lectures are supplemented with required readings from the book: Bruce Tuckman, 2002, Fixed Income Securities: Tools for Today's Markets (2nd edition), John Wiley & Sons, Inc.

This book is available at the bookstore and at www.amazon.com. Additional readings (both required and optional) may also be distributed in class. Finally, please read Section C of The Wall Street Journal each day. Articles from the Journal frequently serve as the basis for class discussions. If you are interested in having another fixed income or risk management textbook, I recommend the following: Fixed Income Frank J. Fabozzi, 2007, Fixed Income Analysis (2nd edition), McGraw-Hill Companies, Inc. Frank J. Fabozzi, 2005, Fixed Income Mathematics: Analytical and Statistical Techniques (4th edition), McGraw-Hill Companies, Inc. Frank J. Fabozzi, 2001, The Handbook of Fixed Income Securities (6th edition), McGraw-Hill Companies, Inc.

Risk Management Linda Allen, Jacob Boudhoukh, and Anthony Saunders, 2004, Understanding Market, Credit, and Operational Risk, Blackwell Publishing. Michel Crouhy, Dan Galai, and Robert Mark, 2001, Risk Management, McGraw-Hill Companies, Inc. Philippe Jorion, 2006, Value at Risk (3rd edition), McGraw-Hill Companies, Inc.

Requirements and grading: There will be two fairly lengthy homework assignments, a midterm exam, and a final exam. The homework assignments are group work, with each group working independently of all other groups. The assignments consist of a mix of exam-style problems, Excel-based modeling exercises, and case-type discussion questions. Groups can have no more than five members, and each group is responsible for submitting to me a list of its members by Friday, January 28th. Your group's assignment solutions are due at the end of the second class on the due date. No late homework will be accepted. The midterm exam is scheduled for Friday, February 11th, during regular class time. The final exam will be scheduled sometime during March 3rd-5th. Both exams are closed-book. A one- or two-sided formula sheet will be provided for the midterm or final exams, respectively. The format and content of the exams will be very similar to the assignment problems. In fact, 20% of the exam questions will be adapted from the assignments. Assuming your course work is completed, your final course grade will be based 30% on your assignments and 70% on your exams (equally weighted). I will follow Fuquas recommended grade distribution for elective courses (nor more than 30% SP, 45% HP, and at least 25% P, LP, and F). Office hours and reviews: Unless announced otherwise, I will be available in my office (W411) from 1pm to 2:00pm every Friday. In addition, I have an open door policy the remainder of the week. Feel free to drop in if the door is open and if I am not talking with someone else or on the phone. Alternatively, we can schedule a time to meet by email. There will be at least two review sessions, tentatively scheduled for: Midterm review: Tuesday, February 8th, 7-9pm, location TBA Final review: Tuesday, March 1st, 7-9pm, location TBA

Communication: Email The quickest way to contact me is by e-mail at mbrandt@duke.edu. I will usually respond within a few hours.

Course website I will maintain a website for FNCE 450. The URL of the website is: http://www.duke.edu/~mbrandt/fnce450.html. I will use the website to distribute course readings, assignments, solutions, practice exams, software, and data. Please check it each day. Most materials on my web site are password protected. The login and password will be given out in the first class meeting.

Faculty assistant My faculty assistant is Tara Bowens. Her desk location is W401C (right outside my office) and her phone number is 660-7775.

Honor Code: The Fuqua School of Business Honor Code is enforced in FNCE 450. By accepting admission to the school, you have agreed to abide by the Honor Code. If you are convicted of an Honor Code violation for cheating, lying, or stealing, which is related to your performance in this course, you will earn an F in this course and will be reported to the Judicial Board. The Honor Code requires that I define the manner in which assignments are to be completed. If you believe the following is ambiguous or incomplete, please let me know. Group assignments must be the original and complete work of only the students in that group, all of whose names must appear on the write-up. You may not use any materials containing solutions or partial solutions of the assignments, which includes solutions prepared by current and former students at Fuqua and elsewhere. You may not discuss the assignment with anyone other than the members of your group prior to handing in your solution. Substantial contributions by each group member on each assignment are expected Midterm and final exams must be the original work of the student whose name appears on the exams. No assistance, other than that detailed above, may be given, received, or used during the exams. You may not communicate with any other individual regarding the exams. Calculators, but not personal computers, PDAs, or cell phones are permitted.

Preliminary course outline: Part 1: Basic fixed income securities Date Jan. 21st Jan. 25th Jan. 28th Feb. 1st Feb. 4th Feb. 8th Lecture topic Course introduction Bond markets Bond valuation Term structure of interest rates Term structure of interest rates (cont) Price sensitivity and hedging Price sensitivity and hedging (cont) Tuckman, ch. 5-8 Readings Tuckman, ch. 1,15 Tuckman, ch. 2-3 Tuckman, ch. 3-4

Midterm exam review (Feb. 8th) Midterm exam (Feb. 11th, in-class) Part 2: Fixed income derivatives Date Feb. 15th Feb. 18th Feb. 22nd Feb. 25th Mar. 1st Lecture topic Euro currency markets Interest rate swaps Review of risk neutral pricing Interest rate models Interest rate models (cont) Readings Tuckman, ch. 16-17 Tuckman, ch. 18 McDonald, ch. 10-11 Tuckman, ch. 9-14

Final exam review (Mar. 1st) Final exam (Mar. 3rd-5th, details TBA)