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Preface to the Second Edition

I am pleased to present the second edition of Bond Math. I'm sure my editors at Wiley will disagree but I'm more impressed with who reads the book rather than how many. I've been very happy with reader responses to the first edition. Best of all, based on the book, I was invited by CFA Institute to write two new readings on Fixed-Income Valuation and Risk and Return for the Chartered Financial Analyst® Level I curriculum. I was joined in that endeavor by James Adams, with whom I've been writing a series of articles on corporate finance applications of derivatives to hedge interest rate risk. One of the changes to the second edition of this book is to align the notation and terminology used in Bond Math with the CFA Institute readings. Also, I have added the simple model to value floating-rate notes that is used in the Fixed-Income Valuation reading.

One of my objectives is to explain the math behind numbers presented on commonly used Bloomberg pages, primarily the Yield and Spread Analysis page for bonds. Bloomberg has changed the format of this page since the first edition, so it is timely to update the examples. I like the new format – the page is less “busy,” as a graphic designer might say. In Chapters 3 and 61 show the formulas that generate the various risk and return statistics for fixed-income bonds, that is, yield to maturity, modified duration, and convexity, included on that page. But still there are some Bloomberg numbers that I think are misleading and unreliable. You see in Chapter 4 that Bloomberg makes a curious assumption for some bonds to get the projected after-tax rate of return, namely, that current U.S. tax law does not apply to the investor. Also, you see in Chapter 7 that Bloomberg shows some hard-to-understand (and therefore use) modified duration results for a floating-rate note.

Chapter 8 is significantly revised from the first edition. I now include discussion of how the financial crisis of 2007 to 2009 has changed derivatives valuation. The traditional method to value interest rate swaps, which I use in the first edition, is called LIBOR discounting. The idea is that LIBOR is a workable and reasonable proxy for the interbank “risk-free” interest rate. The financial crisis revealed the flaws in that assumption. Nowadays, OIS discounting is the standard. Rates on overnight indexed swaps are now used to generate the discount factors to value derivatives. You see that with

OIS discounting, care must be taken in valuing a swap as a combination of fixed-rate and floating-rate bonds, as you might have learned in a derivatives textbook.

A second edition of Bond Math has been on my wish list. Next on the list is to have it translated from American to British financial English and use examples of U.K. gilts instead of U.S. Treasuries. The title of the translation would have to be Bond Maths.

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