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Low Latency Interest Rate Markets - Theory, Pricing and Practice

Interest Rate Markets
The primary function of interest rate markets is to bring together borrowers and lenders to facilitate the financing of government and corporate projects. It is a market that facilitates more than USD 370 trillion of funding solutions globally. Large scale government and corporate projects carry considerable risk for which interest rate markets provide a wide variety of solutions. Interest rate swaps fix borrowing costs and protect domestic investors from interest rate risk, whilst cross currency swaps protect foreign investors from FX risk. The market provides credit default swaps to protect against counterparty payment defaults and asset swaps provide a fund raising solution to invest in bonds.

Why the need for speed and low latency?
The interest rate market is primarily an USD 81 trillion electronic market. It is a highly liquid market where transactions take place in real-time with high precision and tight bid-offer spreads of typically 1/10th of a basis point. Consequently, financial service providers, market makers and high frequency traders must compete accurately and at high speed.

Why purchase this book?
This book shares my insights as an experienced and successful Quant and market practitioner. The analytics I have built at several major financial institutions has been of the highest quality, accuracy and speed. If on a standard desktop in Excel I have been able to compete in interest rate markets and perform calculations in micro-seconds, imagine how my analaytical solutions perform on a server with sophisticated hardware or on the cloud (certainly nano-seconds or better).

Brute force hardware or cloud solutions may provide speed, but at high financial cost and often miss signifnificant optimizations. The secret sauce and key ingredient to low latency lies in having a detailed understanding of the markets and products on a micro-level to heavily optimize calculations before applying hardware solutions. The majority of pricing and risk calculations can be fundamentally reduced to trival calculations. This is achieved by understanding how to reduce model, portfolio pricing and risk calculations into a state where we can precompute and store the majority of the calculation as static data that does not require continuous recomputation to track the market.

To compete and succeed in interest rate markets, one must pay attention to the details, which on the surface appear straight forward and trivial, but few look deeper into how to bypass the majority of the calculation. My book demonstrates these techniques and provides examples. I have succeeded in applying these concepts for major financial institutions. Not only do my solutions offer precision and low latency, but they are also low cost and acccessable to all. The world-class analytics I build outperforms competitors who overlook these details as trivia and often insist pricing and risk systems have no state and a low memory footprint.

Author Biography

Nicholas Burgess has a breadth of practitioner experience accumulated from having worked on trading floors internationally as a Quant for many large investment banks, hedge funds and financial institutions including Citigroup, UBS, Credit Suisse, Bank of America, CQS Hedge Fund, Deutsche Bank, Commerzbank, Société Générale, ANZ, MUFG, Mizuho, HSBC and currently XP Investments. This has allowed the author to gain broad insight and exposure to the trading, pricing and risk management of interest rates, fixed income, equities, credit, commodities, FX, hybrids & exotics, inflation and XVA. Recently he worked as the Head of Quant Research and Analytics for Mizuho specializing in electronic swaps trading, low latency pricing and risk analytics. Currently he manages the core Quant teams covering at XP Inc in Brazil.

He is well‐qualified having read financial strategy at Saïd Business School, University of Oxford with post‐graduate research in machine learning and algorithmic trading strategies. He also read quant finance at Henley Business School and Mathematics at the University of Manchester. Over the course of his professional and academic career the author has written and published many quantitative and finance research papers.

Book Reviews

In today’s interest rate derivatives markets, there is a rising urgency to provide timely, accurate computations to adequately support for electronic pricing, trading and risk management. The construction of low latency interest rate systems is a challenging task at the leading edge of quantitative and practical applications. For readers with a need to understand the theoretical and practical content of such systems there is no other source needed except this one book. With great clarity of text and its emphasis on pragmatic applications, all written by an industry practitioner, this book sets the standard for low latency practice in today’s interest rate derivatives markets.
Ronald T. Slivka, Ph.D., Adjunct Professor, NYU Tandon School of Engineering

The world of quantitative finance is constantly evolving to meet the requirements of an ever-changing market, new regulations, improvements in technology and the greater need for real-time calculations. This book addresses these challenges and is the result of years of experience at leading financial institutions. It is remarkable in the wide-ranging topics it covers, and the level of mathematical detail it contains while remaining accessible. This book is a worthy reference on every quant bookshelf.
Ian Castleton, Director of Quantitative Analytics, Mizuho International

Nicholas is a world-class Quant and thinker, who capably traverses academic theory for market practitioners to integrate into their investment and risk processes. This book is poised to be a critical compendium on rates markets for years to come.
Karim Henide, Portfolio Manager, Record Currency Management

CONTENTS

Low Latency Interest Rate Markets
Preface
Acknowledgements
Introduction
Excel Support Materials
List of Symbols and Abbreviations

PART ONE: THEORY – PRODUCTS AND MODELS

Chapter 1 Introduction to Low Latency Interest Rate Markets

1.1 Project Finance, Risk Management & Hedge Instruments
1.2 Low Latency Market Requirements & Techniques
1.3 Interest Rate Benchmarks
1.4 Impact of Benchmark Rate Reform
      1.4.1 Structural Interest Rate Changes
      1.4.2 Fall-Back Rates
      1.4.3 Yield Curve Changes
      1.4.4 New Interest Rate Products
1.5 Market Terminology
1.6 Interest Rate Market Changes

Chapter 2 Introduction to Interest Rate Swaps

2.1 Swap Quotation as an NPV or Par Rate
2.2 Swap Quotation as a Spread Over US Treasury Yields
2.3 Swap Positions Terminology
2.4 Swap Trading & Execution
2.5 Swap Trade Specification
2.6 Swap Schedule Parameters
2.7 Swap Schedule Generation
2.8 Swap Schedules & Pricing
2.9 LIBOR Trading Conventions
2.10 RFR Trading Conventions

Chapter 3 Interest Rate Products & Pricing

3.1 Interest Rate Swaps (IRS)
3.2 Overnight Indexed Swaps (OIS)
3.3 Risk-Free Rate Swaps (RFR)
3.4 Tenor Basis Swaps (TBS)
3.5 Cross Currency Swaps (XCCY)
      3.5.1 Funding Example
      3.5.2 Cross Currency Swap Risks
      3.5.3 Cross Currency Swap Features
      3.5.4 Example: Trading Book & Cash Flow Schedule
      3.5.5 Fixed or Floating Interest
      3.5.6 CSA Collateral Posting
      3.5.7 FX Forward Rates & CSA Adjustments
      3.5.8 Marked-to-Market (MTM)
      3.5.9 Notional FX Resets
      3.5.10 Notional Scaling Factor
      3.5.11 Cross Currency Swap Pricing
3.6 Credit Default Swaps (CDS)
      3.6.1 CDS Standardization
      3.6.2 CDS Specifications & Terminology
      3.6.3 CDS Events & Triggers
      3.6.4 CDS Default Swap Pricing
3.7 Asset Swaps (ASW)
      3.7.1 Credit Risk
      3.7.2 Asset Swap Spreads
      3.7.3 Yield-Yield Asset Swap Spread
      3.7.4 Par-Par Asset Swap Spread
      3.7.5 Par-Par Asset Swap Spreads with Accrued Interest
      3.7.6 Asset Swap Spread Example
3.8 Forward Rate Agreements (FRA)
3.9 Interest Rate Futures (FUT)
      3.9.1 What is an Interest Rate Future?
      3.9.2 Differences between Futures and FRAs
      3.9.3 Futures Contract Specifications
      3.9.4 Futures Quotes & Pricing
      3.9.5 Hedging with Futures
      3.9.6 Futures Trading, Initial & Variation Margin
      3.9.7 Yield Curve Calibration Using Futures
      3.9.8 Futures Conve