Abstract and Keywords
This article explores the component parts of the global fixed income market and focus on risks arising from interest rates and credit spreads. In fixed income markets including foreign exchange, over-the-counter (OTC) derivatives dwarf exchange-traded derivatives in notional size. An OTC derivative is the contract between two parties where there is counter party credit risk. It is not certain that both parties will honor their contractual obligations. Exchange-traded derivatives have minimal counterparty risk, since exchanges use capital cushions and collateral (margin) collection to avoid defaults. Derivatives' notionals, particularly interest rate derivatives' notionals are many times as large as global fixed income markets. A fixed income instrument consists of a series of future cash flows that may occur at future times. The sources of risk are the sizes of the flows, the timing of the flows, and whether or not the flows will actually occur as agreed. The observations about dimension reduction and interpolation indicate that there isn't a large gap between observable market prices of a discrete number of bonds, and a properly fitted smooth continuous function describing a yield curve. The class of models allows Monte Carlo simulations of complex instruments to be run in order to characterize the distribution of responses to changes in the yield curve.
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