A securitization is a financial transaction in which assets are pooled and securities representing interests in the pool are issued. An example would be a financing company that has issued a large number of auto loans and wants to raise cash so it can issue more loans. One solution would be to sell off its […]

Efficient Frontier

The efficient frontier was first defined by Harry Markowitz in his groundbreaking (1952) paper that launched portfolio theory. That theory considers a universe of risky investments and explores what might be an optimal portfolio based upon those possible investments. Consider an interval of time. It starts today. It can be any length, but one-year is typically assumed. Today’s […]


Callable Bond

A callable bond (or redeemable bond) is a bond whose indenture includes one or more call provisions providing for the early retirement (“call” or “redemption”) of the bond. Call provisions may provide for optional redemption, extraordinary redemption or sinking fund redemption. When included in a bond’s indenture, extraordinary and sinking fund redemption are “boiler plate” provisions that usually afford the issuer little opportunity to benefit at investors’ expense. Form […]

Asset-Liability Management

Asset-liability management (ALM) is a term whose meaning has evolved. It is used in slightly different ways in different contexts. Asset-liability management was pioneered by financial institutions, but corporations now also apply asset-liability management techniques. This article describes asset-liability management as a general concept, starting with more traditional usage. Motivation Traditionally, banks and insurance companies […]

Bankers Acceptance

A bankers acceptance (BA) is a money market instrument: a short-term discount instrument that usually arises in the course of international trade. Before we explain BAs, let’s introduce some more basic concepts. A draft is a legally binding order by one party (the drawer) to a second party (the drawee) to make payment to a third party (the payee). A simple example […]

Barings Brothers

Barings Debacle

The collapse of Britain’s Barings Bank in February 1995 is a quintessential tale of financial risk management gone wrong. The failure was unexpected. Over a course of days, the bank went from apparent strength to bankruptcy. Barings was Britain’s oldest merchant bank. It had financed the Napoleonic wars, the Louisiana purchase, and the Erie Canal. Barings was the Queen’s bank. […]

Bond Accrued Interest

In fixed income markets, professionals speak of a bond’s clean price or dirty price. These are two quoting conventions that differ in whether or not they include accrued interest in a bond’s quoted price. Exhibit 1 indicates the evolution of the market value of a 3% nominal yield 20-year bond during its first four years. In the evolution of the market […]

Futures Contract

A futures contract (or future) is an exchange-traded derivative which is similar to a forward. Both futures and forwards represent—or emulate financial consequences of—an agreement to buy/sell a notional amount of some underlying asset on some future date, for an agreed-upon price. Both can be for physical settlement or cash settlement. Both offer a convenient […]

<strong>Exhibit 2:</strong> Cash flows—servicing fees, principal and interest—are illustrated for a mortgage pass-through at PSAs 50%, 100% and 150%. Collateral is 30-year fixed-rate mortgages paying an average mortgage rate of 9.5%. Service fees are 0.5%.


Many forms of consumer debt, such as home mortgages, credit card debt and auto loans, permit the borrower to pay down the indebtedness at an accelerated rate or to retire the debt early with a single payment. If a homeowner decides to sell her home, she will use the proceeds of the sale to retire […]

Exhibit 2: Possible cash flows for a pass-through are illustrated. Principal and interest are paid to investors. Servicing fees are deducted from interest payments and are paid to whomever services the pooled mortgages—usually the originator.

Mortgage-Backed Security

A mortgage-backed security (MBS) is a securitized interest in a pool of mortgages. It is a bond. Instead of paying investors fixed coupons and principal, it pays out the cash flows from the pool of mortgages. The simplest form of mortgage-backed security is a mortgage pass-through. With this structure, all principal and interest payments (less […]

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