Finance 544. Interest Rate Models; Spring, 2015.

Professor Lamoureux

This class meets on Tuesdays from 3:30 - 6:20 pm in McClelland Hall, Room 129.

Office hours: M: 2:30 - 6:00; T: 9:00 - 12:00
The TA for this class is Danjue Shang. She resides in the PhD student carrels in Room 315. Her e-mail address is dshang@email.arizona.edu.

Her office hours are M 12:00 - 2:00 and F 10:00 - 12:00 + appt. in Room 316.

Required Materials:

• Books:
  • Fixed Income Securities: Valuation, Risk, and Risk Management , by Pietro Veronesi.
• I expect you to subscribe to The Wall Street Journal and read it daily.
• The Economist is also recommended reading.

Recommended Books:

• Financial Modeling Using Excel and VBA, by Chandan Sengupta. (Available electronically through the library.)
• Advanced Modeling in Finance using Excel and VBA, by Mary Jackson and Mike Staunton.

Institutional and Intellectual Context of the course:

This class is concerned with building an understanding of why the yield curve is shaped the way it is and why the yield curve changes over time. The underlying (or primitive) state variable in term structure models is the instantaneous rate of interest (the yield to maturity on a hypothetical claim to $1 to be paid in a nanosecond). In turn this instantaneous interest rate may itself depend on different underlying factors. Interest rate models then are specifications of the dynamics of these primitives. Term Structure Models use tools from modern finance to solve for the prices of bonds, options, futures, etc., for a given interest rate model. One of the most important tools in this context is switching to the equivalent risk-neutral world. In this world, the price of any security is simply the expectation of the future cash flows, discounted at the risk-free rate. By construction, today's prices are the same in the actual world and the equivalent risk-neutral world.

A tool that is used in pricing as well as in building intuition is Monte Carlo simulation. It is virtually impossible to do Monte Carlo analysis in Excel, so it is necessary to use a programming language. Since it is embedded in Excel and has a general syntax, we will use Visual Basic. As such, a learning objective of this course is to be able to write code in VBA to simulate different interest rate processes.

As we move through the course, we will look at instruments, trading strategies, and models. You will master:

• Institutional Features:
  1. Details of the contract or instrument.
  2. Details of the market(s) in which it trades.
  3. Who trades this and why.
• Computing Holding Period Returns in positions involving this contract or instrument.
• Valuation.
  1. Absence of Arbitrage.
  2. Needed Assumptions.
  3. Model Details.
  4. Apply the model.
• The Veronesi text has a very nice applied orientation. We will start off the semester reviewing some of the basic concepts from last semester within the framework of the cases in the text.

Context of the course within the curriculum:

This course assumes that you have taken FIN 542 -- ``Fixed Income.''

This course is complementary to several other courses in our Finance curriculum. Specifically:

• FIN 542 Introduction to Fixed Income. This is a pre-requisite, as it provides a foundation of understanding of instruments and markets in the fixed income milieu.
• FIN 523A and 523B -- Applied Portfolio Management. FIN 523 entails the management of a ``balanced fund'' that has a benchmark that includes both fixed income and equity. Students involved with the fixed income component must take this class. In Applied Portfolio Management, you put to work the skills and tools developed in this class.
• FIN 521 -- Investment Analysis. FIN 521 provides a framework for understanding risk and return in financial markets.
• FIN 522 -- Derivatives. FIN 522 develops more deeply students' ability to evaluate derivative securities. The emphasis in FIN 522 is on equity derivatives. There is overlap in terms of the mathematical tools used in modeling financial securities.
• FIN 525 -- Empirical Modeling. FIN 525 is concerned with estmating model parameters from financial data. So, in this class we will take parameters as given, and learn about the properties of models, in FIN 525 you estimate those parameters. Also, many of the important properties of interest rates are manifest in empirical models such as GARCH.
• FIN 545 -- Credit Risk Models. Our focus is on the properties of treasury securities and their derivatives. These securities do not have any default risk. If we think about corporate bonds, a natural way to proceed is to view them as a treasury plus a default piece--that depends on the fortunes of the issuer. Modeling this default piece is one of the most interesting and active areas for research in Finance, and is the focus of FIN 545.

Conduct of Course and Grading:

Each class will start with a 20-minute quiz that relates to the either in-class activities from the previous class or readings. The remainder of the class time will be divided between working in-class problems and interactive lecture. There will be 14 quizzes, and you may drop your lowest one--with the exception of the last quiz. Your class grade will be the average of your top 13 quiz scores.