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An Introduction to Derivative Securities, Financial Markets, and Risk ManagementAdvanced Financial Risk Management, 2nd ed.

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Corporate bond trading activity on October 21 was led by Morgan Stanley (MS), the most heavily traded bond issuer on the day. Petrobras International Finance Company S.A. (PBR) had the two most actively traded bond issues. Alpha Natural Resources (ANR) led the credit spread ranking at 2156 basis points. Cliffs Natural Resources (CLF) (CLV) bonds dominated the lowest priced bond rankings. Credit spreads continue to be squeezed at maturities beyond 12 years, giving long-maturity minded corporate treasurers a unique opportunity to go long. The credit spread to default probability ratio generally declines as default risk rises, so high quality bond issuers dominate “best value” bond trades by this criterion. Finally, substantially all fixed rate corporate bond trading is taking place at the lowest default probability levels. As default probabilities rise, trading actively drops off dramatically. We present the analysis behind these findings in what follows.

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Last Friday, the Federal Reserve decried banks’ reliance on poor risk models as one of the major problems that has been exposed by the stress testing process under the Fed’s Comprehensive Capital Analysis and Review programs. The Fed’s comments were contained in the final rules for CCAR stress testing in 2015 and beyond in a document released Friday, October 17, 2014.

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Forward 1 month T-bill rates fell again this week, dropping sharply at all but the very shortest maturities. The fall in implied forward 1 month Treasury bill rates stems from a decrease of 0.11% to 0.20% in current U.S. Treasury yields in the 2 to 30 year maturities. Forward 1 month T-bill rates now rise steadily until reaching a peak at 3.11% in February, 2022, a peak 0.17% lower and eight months later than last week. The implied forecast also shows forward 10 year U.S. Treasury yields rising to 3.32% in 2024, down 0.13% from last week.

We also present three potential scenarios consistent with the implied forecast that represent alternative paths for interest rates. This kind of multi-factor scenario generation is essential for comprehensive asset and liability management at banks, insurance firms, pension funds, and endowments.

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Kamakura Corporation projections for U.S. Treasuries and fixed rate mortgages this week reflected the 0.06% fall in current 15 year and 30 year fixed rate mortgage all-in yields. This week’s projections show that the implied forward yields for 15 year fixed rate mortgages rise from a current effective yield of 3.372% (down 0.06% from last week) to 5.359% in 10 years, down 0.06% from last week. The all-in yield on 30 year fixed rate mortgages was down 0.061% at 4.162%, after the fall in long term Treasury yields of 0.07% to 0.12% at maturities from 2 to 30 years. The value of net servicing for 30 year fixed rate mortgages rose 0.06% this week.

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The dramatic announcement on October 5 that Hewlett-Packard Company (HPQ) would split in two has very important implications for both common shareholders and bond holders. We update our assessment of the risk and return on Hewlett-Packard Company bonds in light of the October 5 announcement. Hewlett-Packard Company ranks number 31 on the Forbes list of the world’s most valuable brands. We have seen often in this series of notes that there can be brand premium in bond prices that often keeps brand name companies from being “good value” for bond investors. In this note, we examine that question for Hewlett-Packard Company.

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