Curve Construction

In Chapter 1 we illustrated the structure of a financial institution and we gave a high-level introduction to the fundamental activities that an investment or development bank carries out. We shall now undertake the process of gaining a deeper understanding of what we have introduced.

We mentioned in the introduction that our two goals are an understanding of credit and how credit manifests itself through the valuation of financial instruments. The starting point must be the understanding of how to assess the present value of a future cash flow: this is crucial in pricing an instrument and it will also become apparent how this is closely linked to the concept of credit. In this chapter we will learn how to combine the information given by the rates markets into constructing an index curve to predict future cash flows and a discount curve to assess their present value.

As our prime focus is debt and therefore credit, we should view the exposition that follows as an incremental involvement of credit in the way we discount cash flows. To assess the present value of a future cash flow is, by admitting that a promise is worth less than the immediate possession, to pass an implicit judgment on credit. By gradually presenting the instruments that contribute to the construction of an interest rate curve from the simplest to the most complex, we will show how historically the market has become more and more sophisticated in the treatment of credit when building a discount curve. From including the impact of borrowing in different currencies, to the impact of rates with different tenors, to finally the inclusion of collateral, the market has let credit play an increasingly important role in refining the simple concept of the time value of money.

The concepts and tools learned in this chapter will result in the pricing of bonds presented in Chapter 5 as we will see that overall discounting is the main driver of a bond price.

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