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Fixed Income
Mathematics
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Fixed Income
Mathematics
Analytical and Statistical
Techniques
Fifth Edition
FRANK J. FABOZZI
FRANCESCO A. FABOZZI
New York Chicago San Francisco Athens London

Madrid Mexico City Milan New Delhi
Singapore Sydney Toronto

Copyright © 2023, 2006, 1997, 1993 by Frank J. Fabozzi. All rights reserved. Except as permitted
under the United States Copyright Act of 1976, no part of this publication may be reproduced or
distributed in any form or by any means, or stored in a database or retrieval system, without the prior
written permission of the publisher.
ISBN: 978-1-26-425828-4
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To my wife, Donna
—Frank J. Fabozzi
To my Princeton wrestling teammates

—Francesco A. Fabozzi


C o n t e n t s
Preface ix
Fifth Versus Fourth Edition xi
Acknowledgments xv
Chapter 1: Introduction 1
Part One
Time Value Of Money

Chapter 2: Future Value 11
Chapter 3: Present Value 21
Chapter 4: Yield (Internal Rate of Return) 35
PART Two
Bond Pricing For Option-Free Bonds And

Conventional Yield Measures
Chapter 5: The Price of a Bond 45
Chapter 6: Bond Yield Measures 63
Chapter 7: The Yield Curve, Spot-Rate Curve, and Forward Rates 77
Part Three
Return Analysis AND RETURN MEASURES

Chapter 8: Potential Sources of Dollar Return 99
Chapter 9: Total Return 107
Chapter 10: Historical Return Measures 119
Chapter 11: Risk-Adjusted Returns/Reward-Risk Ratios 131
PART Four
Price Volatility For Option-Free Bonds

Chapter 12: Price Volatility Properties of Option-Free Bonds 143
Chapter 13: Duration as a Measure of Price Volatility 159
Chapter 14: Combining Duration and Convexity to Measure Price Volatility 191
vii

viii Contents
Chapter 15: Duration and the Yield Curve 209

Chapter 16: Empirical Duration 221
Part Five
Historical Return And Yield Volatility

Chapter 17: Measuring Historical Return Volatility 231
Chapter 18: Measuring and Forecasting Yield Volatility 241
PART Six
ANALYZING BONDS WITH EMBEDDED OPTIONS

Chapter 19: Interest-Rate Modeling 251
Chapter 20: Call Options: Investment and Price Characteristics 277
Chapter 21: Valuation and Price Volatility of Bonds with Embedded Options 293
Chapter 22: Analysis of Floating-Rate Securities 319
Part Seven
CREDIT AND LIQUIDITY CONCEPTS

Chapter 23: Credit Risk Concepts and Measures 341
Chapter 24: Measuring Bond Liquidity 357
PART Eight
Analyzing Securitized Products

Chapter 25: Cash-Flow Characteristics of Fixed-Rate Amortizing
Mortgage Loans 375
Chapter 26: Cash-Flow Characteristics of Mortgage-Backed Securities 387
Chapter 27: Analysis of Agency Mortgage-Backed Securities 411
PART Nine
PERFORMANCE ANALYSIS
Chapter 28: Holdings-Based Performance Attribution Analysis 427
Chapter 29: Returns-Based Style Attribution Analysis 445
PART Ten
STATISTICAL AND OPTIMIZATION TECHNIQUES

Chapter 30: Probability Distributions and Statistics 457
Chapter 31: Regression and Principal Component Analysis 475
Chapter 32: Multifactor Risk Models and Their Application to Portfolio
Construction 497
Chapter 33: Monte Carlo Simulation 527
Chapter 34: Optimization Models 541
Chapter 35: Machine Learning 565
Index 579

P r e f a c e
In the past four decades, participants in the fixed-income markets have been
introduced to new analytical frameworks for analyzing fixed-income securities
and formulating fixed-income portfolio strategies. In discussing fixed-income
securities and strategies, we often hear terms such as model duration, empiri-
cal duration, effective duration, spread duration, positive and negative convexity,
option-adjusted spread, duration times spread, prepayment rates, spot rates, for-
ward rates, yield volatility, lattice model, value-at-risk, factor models, optimiza-
tion, simulation, machine learning, fat tails, and default correlation, and the list
goes on. What do these concepts mean? Why are these concepts useful in the
analysis of fixed-income securities and the formulation of fixed-income strate-
gies? Moreover, what are the dangers of using these concepts without a complete
understanding of what they mean and their limitations?
Fixed Income Mathematics: Analytical and Statistical Techniques not only
explains these and many other important concepts that players in the bond market
need to know, but also sets forth the foundation needed to understand them, their
computation, their limitations, and their application to fixed-income analysis and
portfolio management. It begins with the basic concepts of the mathematics of
finance (the time value of money) and systematically builds on these, taking you
through the state-of-the-art methodologies for evaluating fixed-income securities
with embedded options: mortgage-backed securities (mortgage pass-through
securities, collateralized mortgage obligations, and stripped mortgage-backed secu-
rities). The concepts are illustrated with numerical examples and graphs. The mate-
rial is self-contained and requires only a basic knowledge of elementary algebra
to understand.
Frank J. Fabozzi
Francesco A. Fabozzi
ix


Fifth Versus Fourth Edition
The fourth edition of the book contained eight parts and 31 chapters as shown in the table
following:
Chapter 1 Introduction
Chapter 2 Overview of Fixed-Income Securities and Derivatives
PART ONE TIME VALUE OF MONEY

Chapter 3 Future Value
Chapter 4 Present Value
Chapter 5 Yield (Internal Rate of Return)
PART TWO BOND PRICING FOR OPTION-FREE BONDS AND CONVENTIONAL

YIELD MEASURES
Chapter 6 The Price of a Bond
Chapter 7 Conventional Yield and Spread Measures for Bonds
Chapter 8 The Yield Curve, Spot Rate Curve, and Forward Rates
PART THREE RETURN ANALYSIS

Chapter 9 Potential Sources of Dollar Return
Chapter 10 Total Return
Chapter 11 Measuring Historical Performance
PART FOUR PRICE VOLATILITY FOR OPTION-FREE BONDS

Chapter 12 Price Volatility of Properties of Option-Free Bonds
Chapter 13 Duration as a Measure of Price Volatility
Chapter 14 Combining Duration and Convexity to Measure Price Volatility
Chapter 15 Duration and the Yield Curve
PART FIVE ANALYZING BONDS WITH EMBEDDED OPTIONS

Chapter 16 Interest-Rate Models
Chapter 17 Call Options: Investment and Price Characteristics
Chapter 18 Valuation and Price Volatility of Bonds with Embedded Options
PART SIX CREDIT RISK

Chapter 19 Credit Risk Concepts and Measures for Corporate Bonds
PART SEVEN ANALYZING SECURITIZED PRODUCTS

Chapter 20 Measures Used for Securitized
Chapter 21 Cash Flow Characteristics of Amortizing Loans
xi

xii Fifth Versus Fourth Edition
Chapter 22 Cash Flow Characteristics of Mortgage-Backed Securities

Chapter 23 Prepayment Models for Mortgage-Backed Securities
Chapter 24 Basics of MBS Structuring
Chapter 25 Analysis of Agency Mortgage-Backed Securities
PART EIGHT STATISTICAL AND OPTIMIZATION TECHNIQUES

Chapter 26 Basics of Probability Theory and Statistics
Chapter 27 Regression Analysis
Chapter 28 Statistical Techniques for Credit Scoring and Risk Factor Identification
Chapter 29 Tracking Error and Multifactor Risk Models
Chapter 30 Simulation
Chapter 31 Optimization Models
The fifth edition has 10 parts and 35 chapters. The 15 chapters that are almost identical
to the chapters in the fourth edition (shown in parentheses is the chapter number in the fourth
edition) are:
2 Future Value (3)

3 Present Value (4)
4 Yield (Internal Rate of Return) (5)
5 The Price of a Bond (6)
6 Bond Yield Measures (7)
7 The Yield Curve, Spot-Rate Curve, and Forward Rates (8)
8 Potential Sources of Dollar Return (9)
9 Total Return (10)
12 Price Volatility of Properties of Option-Free Bonds (12)
14 Combining Duration and Convexity to Measure Price Volatility (14)
15 Duration and the Yield Curve (15)
20 Call Options: Investment and Price Characteristics (17)
21 Valuation and Price Volatility of Bonds with Embedded Options (18)
25 Cash-Flow Characteristics of Fixed-Rate Amortizing Mortgage Loans (21)
26 Cash-Flow Characteristics of Mortgage-Backed Securities (22)
The 11 new chapters in the fifth edition are
10 Historical Return Measures

11 Risk-Adjusted Returns/ Reward-Risk Ratios
16 Empirical Duration
17 Measuring Historical Return Volatility
18 Measuring and Forecasting Yield Volatility
22 Analysis of Floating-Rate Securities
24 Measuring Bond Liquidity

Fifth Versus Fourth Edition xiii
28 Holdings-Based Performance Attribution Analysis

29 Returns-Based Style Attribution Analysis
32 Multifactor Risk Models and Their Application to Portfolio Construction
35 Machine Learning
The 9 substantially revised chapters are (shown in parentheses is the chapter number
in the fourth edition):
Ch. Chapter title Change

1 Introduction (1) Completely revised to explain the importance of the
topics in the book and the new organization of the book.
13 Duration as a Measure of Differentiating between model and empirical duration,
Price Volatility (13) and a discussion of the interpretation of duration.
19 Interest-Rate Modeling (16) Completely revised to describe the different arbitrage-
free interest rate models and their implementation using
the lattice method.
23 Credit Risk Concepts and Completely revised to introduce new analytical
Measures (23 and 25) concepts.
27 Analysis of Agency Revised to include prepayment modeling in this chapter
Mortgage-Backed rather than having a separate chapter on prepayment
Securities (25) modeling.
30 Probability Distributions and Previous chapter title: Basics of Probability Theory and
Statistics (26) Statistics. Expanded to include hypothesis testing and
types of errors in hypothesis testing.
31 Regression and Principal Significantly revised to include the steps in applying
Component Analysis (27) regression analysis and to include principal component
analysis.
33 Monte Carlo Simulation (30) Revised to include the application to backtesting
investment strategies.
34 Optimization Models (31) Completely revised to discuss convex optimization
problems and optimization under uncertainty.
The following four chapters, which provide background material that appeared in
the fourth edition, have been removed and are available online:
Overview of Fixed-Income Securities and Derivatives (Chapter 2, now online supplement A)

Basics of Agency CMO Structuring (from Chapter 24, now online supplement B)
Measures Used for Securitized Products (Chapter 20, now online supplement E)
Basic Concepts in Probability Theory (from Chapter 26, now online supplement F)
Two new online supplements are also available:
Online Supplement C. Illustration of Holdings-Based Performance Attribtion Analysis

Online Supplement D. Econometric Issues Associated with the Regression Model Used for
Returns-Based Style Attribution Analysis


A c k n o w l e d g m e n t s
The first edition of this book was published in 1993. Several individuals assisted
in various ways in subsequent editions of the book, and we acknowledge them
below:
• Jan Mayle and Dragomir Krgin provided information on the day count
conventions discussed in Chapter 5.
• Chapter 19 on interest rate modeling is coauthored with Gerald W.
Buetow, Jr. (BFRC Services), Bernd Hanke (BFRC Services), and
Brian J. Henderson (School of Business, The George Washington
University).
• Parts of Chapter 21 on valuing bonds with embedded options draws
from the work of Frank Fabozzi with Andrew Kalotay (Andrew Kalotay
Associates) and George Williams.
• Chapter 24 benefitted from discussions and feedback about liquidity
measures provided by Stefano Pasquale (BlackRock) and Harshdeep
Singh Ahluwalia (Vanguard).
• The illustration of the Campisi Attribution Model in Chapter 28 was
provided by Bruce J. Feibel (State Street).
• The illustration of attribution analysis of a hypothetical UK corporate
bond/credit portfolio in the online supplement C was prepared by René
Alby (Insight Investment).
• Chapter 29 was coauthored with Gueorgui S. Konstantinov (LBBW
Asset Management).
• In Chapter 32, the illustration of the Axioma Factor-Based Fixed
Income Risk Model developed by Qontigo’s Analytics Research group
was provided by Bill Morokoff (Qontigo).
• Amundi Asset Management fixed-income multifactor risk model
described and illustrated in Chapter 32, was provided by Amina Cherief
and Mohamed Ben Slimane (Amundi Asset Management).
• In Chapters 17 and 34 we used the software by Portfolio Visualizer
(https://www.portfoliovisualizer.com/).
xv


CHAPTER
1
INTRODUCTION
Before the 1980s, the analysis of fixed-income securities was relatively simple. In
an economic environment that exhibited relatively stable interest rates, investors
purchased fixed-income securities intending to hold them to maturity. Yield to
maturity was used as a proxy measure of their relative value. Risk was gauged in
terms of default risk based on the credit rating assigned by the major credit-rating
agencies. When a fixed-income security was callable, a second measure—yield to
call—was used to assess its relative value. For a callable bond, the long-standing
rule of thumb for a conservative investor at the time was to select the lower of the
yield to maturity and the yield to call as the potential return. Moreover, prior to the
1980s, there was little trading of fixed-income securities. The strategy was simply
a buy-and-hold strategy.
Those days of reliance on simple analytics to manage a fixed-income port-
folio are gone. This is because fixed-income portfolios are actively traded, requir-
ing the use of analytics that draw from the fields of statistics, data science,
mathematics, and operations research. Moreover, prior to the 1970s, corporate
bond issuers were primarily those with an investment-grade rating. Non-investment-
grade corporate bonds that were traded were those of one-time investment-grade
bond issues that were subsequently downgraded, referred to as fallen angels. In
1977, Bear Stearns underwrote non-investment-grade corporate bonds, popularly
referred to as junk bonds and high-yield bonds, with bond market participants
seeing opportunities to enhance returns by constructing a diversified portfolios of
such issues despite higher default risk. Other market participants developed credit
analytics to identify junk bond issuers that were candidates for an upgraded rating,
thereby enhancing returns. In fact, 6 years after the Bear Stearns underwriting of
the first junk bond, roughly a third of all corporate bonds were non-investment
grade.1 Investing in non-investment-grade corporate bonds made investors recog-
nize the need to forecast default rates for a diversified portfolio of such bonds and
recovery rates.
The need for more rigorous analytics became clear with the development of
the mortgage-backed securities (MBS) market. When the first MBS were issued
in 1968, these securities were acquired primarily because of their greater offered
yield than Treasury securities, and they were not traded actively. Purchasing MBS
based purely on a potential higher yield than Treasury securities was clearly naive.
1. Jared Cummans, “A Brief History of Bond Investing,” BondFunds.com, October 1, 2014. Available
at http://bondfunds.com/education/a-brief-history-of-bond-investing/.
Fabozzi_ch01.indd 1 22/07/22 6:16 PM

2 C h a p t e r 1 Introduction
Once the concept of prepayment risk was understood and that different MBS issues
backed by different pools of mortgages paid at different prepayment speeds, the
importance of prepayment modeling in the selection of the specific MBS to include
in a portfolio made investors realize the need to bring in statistical modeling and
ushered in the individuals trained in mathematics, statistics, and physics. The
modeling of prepayments became even more important with the development of
mortgage-derivative products (collateralized mortgage obligations and mortgage
strips) where the pricing of some of these products is highly sensitive to changes
in prepayment rates and interest rates. Although the initial MBS issues were viewed
as having the same credit risk as U.S. Treasuries, in the late 1980s, MBS issued
by private entities, referred to a nonagency MBS, began to appear. The pricing of
nonagency MBS made investors realize the need for not only modeling prepay-
ments but also forecasting default rates and recovery rates.
A look at the history of interest rates and the properties of a bond’s price
volatility provides insights into the need for analytics beyond those used in tradi-
tional fixed-income analytics. Let’s look at 30-year Treasury yields in the follow-
ing 3 years:
1977: 7.8%
1981: 15.21% (historical high)
2021: 1.90%
Let’s suppose that a 30-year Treasury bond was purchased in each year with a
coupon rate equal to the yield. As explained in Chapter 5, each bond would trade
at par value or 100. Suppose that after the bond is purchased, interest rates increase
by 50 basis points.2 The new market price, the change in the price, and the percent-
age price change are shown below:
Percentage
Yield/Coupon Initial New Yield New Price Price
Year Rate (%) Price ($) (%) Price ($) Change ($) Change (%)
1977 7.80 100 8.30 94.50 –5.50 –5.50

1981 15.21 100 15.71 96.85 –3.15 –3.15
2021 1.90 100 2.40 89.35 –10.65 –10.65
Look at the price sensitivity of the three bonds. In the historical high interest-
rate environment of 1981, a 50 basis point change would have resulted in a percent-
age price change of only about half of 1977, about a third of that of 2021, and
almost triple that of the lowest of the three yields in this illustration. This follows
from a property of the price sensitivity of a bond described in Chapter 13: for a
given maturity, the lower the market yield, the greater is the price volatility. As
interest rates decline, bond portfolio managers focused increasingly on measures
of interest-rate sensitivity, the two most popular measures being duration and
convexity (the subject of Chapters 13 and 14).
2. One basis point is equal to 0.01%.

C h a p t e r 1 Introduction 3
With the complexity of fixed-income products—debt instruments with

embedded options, callable/putable bonds and MBS, and certain types of
asset-backed securities—traditional analytical techniques for valuing these prod-
ucts had severe limitations. The new army of market researchers that dealer firms
recruited from academia brought tools not previously used in the bond market.
These included models and techniques for valuing embedded options. Market
researchers drew from the fields of option theory and operations research (e.g.,
Monte Carlo simulation) not only to value these complex products but also to
quantify how sensitive the products were to changes in interest rates (concepts such
as effective duration and effective convexity were introduced). But it became
apparent that even measures such as duration had their limitations using analytical
models, leading to the use of regression analysis to estimate the price sensitivity
of securities to changes in interest rates for some complex fixed-income products.
The resulting interest-rate sensitivity measure is empirical duration, the subject of
Chapter 16.
Because a greater understanding of interest-rate sensitivity of a portfolio
(duration and convexity) was used in structuring a portfolio compared with the
same exposure for a bond market benchmark, the limitations of these measures
became apparent. Although duration and convexity offered portfolio managers a
means to quantify a portfolio’s exposure to changes in interest rates, they were for
only one type of an interest-rate change: a parallel shift in the yield curve. Thus
market researchers developed frameworks for quantifying exposure to changes in
the shape of the yield curve, more specifically changes in the slope of the yield
curve (key rate duration and yield-curve duration), the subject of Chapter 15.
Returning to the valuation of complex fixed-income products, models for
doing so required the modeling of how interest rates might change over a security’s
life. Along with valuation modeling came the need to model how interest rates can
vary randomly over a security’s life. To do so, researchers introduced the notion
of stochastic interest-rate models, drawing on an advanced statistical technique
called stochastic differential equations.3
In equity portfolio management, at one time the key and sole driver of returns
was assumed to be the market as proxied by the concept of beta. As more studies
demonstrated that there are multiple factors that drive equity returns, quantitative
(systematic) approaches to equity portfolio management began to identify those
other systematic factors These studies have led to the quantitative strategy of factor
investing and the construction of equity portfolios based on those factors. Similarly
in the fixed-income market, empirical studies have investigated the drivers of bond
returns. Early studies empirically demonstrated that changes in the level and shape
of the yield curve were major drivers of bond returns. Further studies identified
other factors that should be considered in constructing a bond portfolio. Since the
3. As one well-known bond markets analytics guru once remarked: “At one time we hired salespeople
based on their ability to drink with clients. Now we hire them based on their ability to solve dif-
ferential equations.”

turn of the century, increasingly research has investigated whether the same factors
that drive equity returns also drive corporate bond returns.
Clearly, to be successful as a fixed-income portfolio manager, one needs an
understanding of the fundamentals of bond analytics, probability theory, statistics
(including financial econometrics and machine learning), and operations research
(optimization and Monte Carlo simulation).
ORGANIZATION OF THIS BOOK

There are 34 chapters divided into 10 parts. Part One covers the time value of
money with three chapters covering future value (Chapter 2), present value
(Chapter 3), and yield measures (Chapter 4). Part Two covers how option-free
bonds are priced and conventional yield measures. Option-free bonds are bonds
that do not have any embedded options. That is, option-free bonds are not callable
or putable. Chapter 5 explains and illustrates how option-free bonds are priced.
(The pricing of bonds with embedded options such as callable bonds, MBS, and
floating-rate securities is covered in Part Six.) Chapter 6 covers conventional yield
measures such as yield to maturity, several yield-to-call measures, yield to put, and
yield to worst. The limitations of these measures, as well as the limitation of port-
folio yield measures, are described in this chapter. The yield curve, spot-rate curve,
and forward rates are covered in Chapter 7.
The four chapters in Part Three cover return analysis and return measures.
The performance of a bond portfolio is measured by its total return. To understand
total return, which is the subject of Chapter 9, the potential sources of a bond’s
return are covered in Chapter 8. It may sound simple to calculate a bond portfolio’s
historical return. However, as explained in Chapter 10, that is not the case. Typically,
returns are computed for subperiods and then averaged. There are three measures
of averaging subperiod returns: arithmetic average rate of return, time-weighted
rate of return, and dollar-weighted rate of return. These measures are described in
Chapter 10, along with the advantages and disadvantages of each measure. Also
explained in that chapter is how to calculate trailing returns, rolling returns,
contribution of a bond to a portfolio’s return, and relative return measures (e.g.,
excess return, active return, abnormal return, and residual return). The final chap-
ter in Part Three, Chapter 11, covers how to adjust returns for risk. Risk-adjusted
returns are basically reward/risk measures where the numerator is a measure of
return and the denominator is some measure of risk. The three risk-adjusted return
measures covered in this chapter are the Sharpe ratio, the Sortino ratio, and the
information ratio.
The measurement of price volatility for option-free bonds is the subject of
Part Four. The first of the five chapters in this part of the book, Chapter 12, describes
the price volatility properties of option-free bonds when interest rates change.
Chapter 13 then explains the most popular measure used to estimate a bond’s price
and a portfolio’s value sensitivity to a parallel shift in interest rates (i.e., the yield
for all maturities changes by the same number of basis points), duration. We begin

by distinguishing between model duration and empirical duration. Model duration

for a bond is based on prices generated from a bond pricing model when interest
rates change, whereas empirical duration is based on observed market prices when
interest rates change. Chapter 13 covers model duration, which includes Macaulay
duration, modified duration, and effective duration. Duration, model or empirical,
is the first approximation as to how a bond’s price or a portfolio’s value will change
when interest rates change in a parallel fashion. A second approximation is mea-
sured by a bond’s convexity, the subject of Chapter 14. Because duration is a
measure that assumes a parallel shift in the yield curve, a measure or measures are
needed to assess the impact on the value of a portfolio for a nonparallel shift in the
yield curve. Such measures are the subject of Chapter 15, which covers key rate
durations, level-slope-curvature durations, and yield-curve-reshaping durations.
Empirical duration is the subject of Chapter 16. As noted earlier, empirical duration
is based on observed market prices and prices estimated using regression analysis.
The two chapters in Part Five explain how to measure historical return vola-
tility and yield volatility. In Chapter 17, where we explain how to measure his-
torical return volatility, we begin with describing the measures of dispersion
commonly used in bond analytics (i.e., range, interquartile range, mean absolute
deviation, variance/standard deviation, semivariance/semi–standard deviation, and
lower partial moment). We then describe skewness and kurtosis measures. In this
chapter, we introduce the concept of tracking error. More specifically, we discuss
backward-looking tracking error. Chapter 18 covers how to measure historical yield
volatility and the difference between historical and implied yield volatility. Implied
volatility is a by-product of option pricing models. We explain the observed vola-
tility smile and implied volatility surface. After describing these basic concepts,
we discuss the methods used to forecast yield volatility (i.e., moving averages and
autoregressive conditional heteroscedasticity).
While we explained the valuation of option-free bonds in Part Two, the four
chapters in Part Six describe how to value and analyze bonds with embedded
options. Because the value of a bond depends on the expected cash flows, and in
the case of a bond with an embedded option, the cash flow depends on the level of
interest rates, modeling the path of future interest rates is critical in valuing a bond
with an embedded option. Therefore, we start Part Six with a discussion of interest-
rate modeling (Chapter 19). More specifically, we explain no-arbitrage interest-rate
modeling and commonly used models (e.g., Ho–Lee model, Kalotay–Williams–
Fabozzi model, Black–Derman–Toy model, Hull–White model, and Black–
Karasinski model) and their implementation using the lattice method. We also
explain the impact of these models on effective duration, effective convexity, and
option-adjusted spread. Because a commonly embedded option is a call option,
Chapter 20 is devoted to describing the investment and price characteristics of call
options. The valuation of bonds with options and the price volatility of such bonds
are the subjects of Chapter 21. We demonstrate how to value bonds with embedded
options using the lattice model and introduce the concept of an option-adjusted
spread. We postpone discussion of the valuation of MBS (which have an embedded
call option because of the borrower’s right to prepay a mortgage) until Chapter 27

in Part Eight. We conclude Part Six with an explanation of how to value floating-
rate securities (Chapter 22). These securities often have call and put provisions, as
well as caps and floors. We begin with a description of spread measures for floating-
rate securities (e.g., spread for life, adjusted simple margin, adjusted total margin,
and discount margin) and then explain their price-volatility characteristics. The
lattice method described in Chapter 21 is then applied to value three complex float-
ing-rate securities (a range note, a step-up callable note, and a callable capped
floating-rate bond). We also explain how to analyze an inverse-floating-rate security.
Part Seven covers measures of credit risk and liquidity risk. Credit-risk con-
cepts and measures are covered in Chapter 23. The measures include credit default
risk and credit spread risk. Statistical models for predicting corporate bankruptcy
(e.g., multiple discriminant analysis, linear probability model, probit regression
model, and logit regression model) are explained. Other important concepts cov-
ered in Chapter 23 include the statistical concepts of default correlation and copula
and the analytical concepts of credit spread duration and duration times spread.
The deteriorating liquidity in the bond market due to dealers withdrawing capital
commitments to this market has heightened the concern about liquidity risk. In
Chapter 24 we first define (or at least provide the general properties) of liquidity
and then explain the relationship between liquidity and transaction costs (i.e.,
investment delay cost, opportunity cost, and market [price] impact cost). We then
describe the challenges to measuring liquidity and metrics proposed by market
professionals and academics for measuring the liquidity of individual financial
instruments and portfolios.
The analysis of securitized products is the subject of the three chapters in
Part Eight. Chapter 25 explains the cash-flow characteristics of fixed-rate level-
payment mortgage loans. In Chapter 26 we show how to estimate the cash flow for
the largest sector in the securitized market, residential mortgage-backed securities
(RMBS). The pool of residential mortgage loans is used as collateral for the cre-
ation of these securities. How to analyze agency MBS, explaining the traditional
analysis of this product versus the Monte Carlo method for doing so, is the subject
of Chapter 27.
Although the risk-adjusted return measures described in Chapter 11 provide
a starting point for assessing the performance of a bond portfolio manager, these
measures fail to identify the reasons why a portfolio manager may have matched,
outperformed, or underperformed a benchmark. The decomposition of perfor-
mance results to explain why the results were achieved is called performance
attribution analysis. The two most common approaches to performance attribution
models are the holdings-based attribution approach and the returns-based style
attribution approach. The two chapters in Part Nine describe these two approaches,
Chapter 28 covering holdings-based attribution and Chapter 29 returns-based attri-
bution.
The last part of the book, Part Ten, explains statistical and optimizations
techniques. This part begins by describing probability distributions (Chapter 30).
Regression analysis, the major statistical tool employed in bond analysis, as well
as the steps in applying regressions analysis (i.e., model selection, model estimation,

and model testing), is the subject of Chapter 31. Also covered in this chapter is
principal component analysis and its application to explaining yield-curve dynam-
ics and identifying bond risk factors. A description of multifactor risk models and
an illustration of how these models are used in portfolio construction are covered
in Chapter 32. Two tools from the field of operations research, Monte Carlo simu-
lation and optimization models, are the subjects of Chapters 33 and 34, respec-
tively. In Chapter 33 we describe the various methodologies for backtesting bond
portfolio strategies and explain why Monte Carlo simulation has several advantages
over other methodologies. The final chapter in the book, Chapter 35, describes
machine learning and how machine-learning algorithms provide bond portfolio
managers with the opportunity to use modern nonlinear and highly dimensional
techniques needed to build predictive models regarding information that contains
complex patterns that when properly analyzed can be used in formulating bond
investment strategies so as to enhance portfolio returns. To accomplish this, mem-
bers of the portfolio management team must be capable of analyzing both struc-
tured and unstructured data. Machine learning, which is a subfield of artificial
intelligence, provides the analytical tools for extracting insights from a wide range
of data sets.


part
one
TIME VALUE OF MONEY


CHAPTER
2
FUTURE VALUE
The notion that money has a time value is one of the most basic concepts in finan-
cial analysis. Money has a time value because of the opportunities for investing
money at some interest rate. In the three chapters of Part One of this book, we
review the three fundamental concepts involved in understanding the time value
of money. First, we explain how to determine the future value of an investment.
In the next chapter, we explain the procedure for determining how much money
must be invested today (called the present value) in order to realize a specific
amount in the future. In the last section of this chapter we explain the special case
where continuous compounding is assumed. In Chapter 4 we show how to compute
the yield on any investment.
FUTURE VALUE OF AN INVESTMENT

Suppose that an investor places $1,000 in a bank account and the bank agrees to
pay interest of 7% a year. At the end of 1 year, the account will contain $1,070,
that is, $1,000 of the original principal plus $70 of interest. Suppose that the inves-
tor decides to let the $1,070 remain in the bank account for another year and that
the bank continues paying interest of 7% a year. The amount in the bank account
at the end of the second year will equal $1,144.90, determined as follows:
Principal at beginning of year 2 $1,070.00

Interest for year 2 ($1,070 × 0.07) 74.90
Total in bank account $1,144.90
In terms of our original $1,000 investment, the $1,144.90 represents the fol-
lowing:
Original investment at beginning of year 1 $1,000.00

Interest for year 1 ($1,000 × 0.07) 70.00
Interest for year 2 based on the original investment 70.00
Interest for year 2 earned on the interest from year 1 ($70 × 0.07) 4.90
Total $1,144.90
The interest of $4.90 in year 2 above the $70 interest earned on the original prin-
cipal of $1,000 is interest earned on interest.
11

12 PART One Time Value of Money
After 8 years, the $1,000 investment—if allowed to accumulate tax free at

an annual interest rate of 7%—will be $1,718.19, as shown below:
Original investment at beginning of year 1 $1,000.00
At the end of year 1 ($1,000.00 × 1.07) $1,070.00
At the end of year 2 ($1,070.00 × 1.07) $1,144.90
At the end of year 3 ($1,144.90 × 1.07) $1,225.04
At the end of year 4 ($1,225.04 × 1.07) $1,310.79
At the end of year 5 ($1,310.79 × 1.07) $1,402.55
At the end of year 6 ($1,402.55 × 1.07) $1,500.73
At the end of year 7 ($1,500.73 × 1.07) $1,605.78
At the end of year 8 ($1,605.78 × 1.07) $1,718.19
After 8 years, $1,000 will grow to $1,718.19 if allowed to accumulate tax free at
an annual interest rate of 7%. We refer to the amount at the end of 8 years as the
future value.
Notice that the total interest at the end of 8 years is $718.19. The total inter-
est represents $560 of interest earned on the original principal ($70 × 8) plus
$158.19 ($718.19 – $560) earned by the reinvestment of the interest.
Computing the Future Value of an Investment

To compute the amount that $1,000 will grow to at the end of 8 years if interest is earned
at an annual rate of 7%, $1,000 can be multiplied by 1.07 eight times, as shown below:
$1,000(1.07)(1.07)(1.07)(1.07)(1.07)(1.07)(1.07)(1.07) = $1,718.19.
A shorthand notation for this calculation is
$1,000(1.07)8 = $1,718.19.
To generalize the formula, suppose that $1,000 is invested for N periods at
an annual interest rate of i (expressed as a decimal). Then, the future value N years
from now can be expressed as follows:
$1,000(1 + i)N.
For example, if $1,000 is invested for 4 years at an annual interest rate of 10%
(i = 0.10), then the future value will be $1,464.10:
$1,000(1.10)4 = $1,000(1.4641) = $1,464.10.
The expression (1 + i)N is the amount to which $1 will grow at the end of N years
if an annual interest rate of i is earned. This expression is called the future value
of $1. The future value of $1 multiplied by the original principal yields the future
value of the original principal.
For example, we just demonstrated that the future value of $1,000 invested
for 4 years at an annual interest rate of 10% would be $1,464.10. The future value

C h apt e r 2 Future Value 13
of $1 is $1.4641. Therefore, if instead of $1,000, $50,000 is invested, the future

value would be
$50,000(1.4641) = $73,205.
We can generalize the formula for the future value as follows:
FV = P(1 + i)N,
where
FV = future value ($);
P = original principal ($);
i = interest rate (in decimal form);
N = number of years.
The following five illustrations show how to apply the future value formula.
Illustration 2–1. A pension fund manager invests $10 million in a financial

instrument that promises to pay 8.7% per year for 5 years. The future value of the
$10 million investment is $15,175,665, as shown below:
P = $10,000,000; i = 0.087; N = 5.
FV = $10,000,000(1.087)5
= $10,000,000(1.5175665) = $15,175,665.
Illustration 2–2. A life insurance company receives a premium of $10 million,

which it invests for 5 years. The investment promises to pay an annual interest
rate of 9.25%. The future value of $10 million at the end of 5 years is $15,563,500,
as shown below:
P = $10,000,000; i = 0.0925; N = 5.
FV = $10,000,000(1.0925)5
= $10,000,000(1.5563500) = $15,563,500.
Illustration 2–3. Suppose that a life insurance company has guaranteed a pay-
ment of $14 million to a pension fund 4 years from now. If the life insurance
company receives a premium of $11 million and can invest the entire premium
for 4 years at an annual interest rate of 6.5%, will it have sufficient funds from
this investment to meet the $14 million obligation?
The future value of the $11 million investment at the end of 4 years is
$14,151,130, as shown below:
P = $11,000,000; i = 0.065; N = 4.
FV = $11,000,000(1.065)4
= $11,000,000(1.2864664) = $14,151,130.

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No. 55. No. 56.
1733–42. Barth. Dandridge. 1733–37. Coston Aston.
1746–48. [263]Lady Dinely Goodyer. 1740–44. Madame Bowne.
1751–58. Chas. Hoare. 1744. [263]Chas. Leivez.
1758–61. Lord Halton. 1745. —— Pritchard.

1761–65. Chas. Hoare. 1746–50. Chas. Leivez.
1766. Widow Hoare. 1750–61. Ben Wilson.
1767–70. [264]Godfrey Kneller. 1761–68. Jno. Palmer.
1770–82. Coach Office. 1768–69. W. Brereton.
1782–90. Jas. McGee. 1770–74. Ed. Taylor.
1790–99. Jas. Wilson. 1775–78. Wm. Mattingnon.
1799– [264]J. Kneller. 1779. Miss Lavell.
1780–82. —— Bowen.
1782–86. John Hoole.
1786–88. Jas. Boswell.
1788–89. Ed. Jones.
1791– W. Chippendale.
Bartholomew Dandridge obtained a considerable practice in the

reign of George II. as a painter of portraits; he also painted small
conversation-pieces.[265]
Benjamin Wilson was born at Leeds in 1721. His father, Major
Wilson, a wealthy clothier, lost his money while Benjamin was still a youth,
and the latter came to London to earn a living. If his statements are true, the
frugality which he exercised must have been extraordinary. At all events, he
managed to save, and obtaining after a time a position with some little
leisure, he resumed the artistic studies which he had been compelled to
renounce. By degrees his perseverance and ability made him known, and
from 1748 to 1750 he was in Ireland executing commissions for portraits.
On his return he settled at No. 56, Great Queen Street. While here his
reputation steadily increased, and 1761 he moved to Nos. 57–58, a larger
house.[266] In 1771 he again removed, this time to Great Russell Street,
Bloomsbury. In 1767 he was appointed painter to the Board of Ordnance.
Wilson was also a student of chemistry, and had a reputation for his
knowledge of electricity, receiving in 1760 the gold medal of the Royal
Society for his electrical experiments. He died at his house in Great Russell
Street[267] in 1788.
John Hoole, translator, was born in Moorfields in 1727, the son of a
watchmaker and inventive mechanician. He obtained a position in the
accomptant’s office of the East India Company, and rose to be successively
auditor of Indian accompts and principal auditor. He resigned about the
end of 1785. His residence in Great Queen Street seems to have commenced
in 1782, and it lasted to April, 1786, when he retired to the parsonage at
Abinger, Surrey. He died at Dorking in 1803. His chief works are the
translations of Tasso and Ariosto. He also wrote the life of John Scott of
Amwell, which, as it was published in 1785, was probably composed in the
house in Great Queen Street, and three plays.
James Boswell, biographer, son of Alexander Boswell, Lord
Auchinleck, was born in Edinburgh in 1740. In 1760 he first visited London,
and in 1762, with much difficulty, prevailed upon his father to let him return
there. On 7th May, 1763, he was introduced by Davies the actor to Dr.
Johnson. From August, 1763, to February, 1766, he was on the Continent
studying law at Utrecht, travelling in Italy, and consorting with Paoli in
Corsica, and returned with his head full of the latter. The result was the
publication in 1768 of An Account of Corsica; the Journal of a Tour to that
Island. He now commenced work in earnest as an advocate at the Scottish
bar, and for some years visited London but seldom. In November, 1769, he
married his cousin, Margaret Montgomery. In 1773 he accompanied
Johnson on the journey which is described in the Journal of a Tour in the
Hebrides; the indiscretions of the narrative produced a rapid sale when it
was printed some years afterwards. In June 1784, he met Johnson for the
last time. In 1786 he was called to the English Bar, and moved to London. In
a letter, dated May, 1786, to Mickle, the translator of the Lusiad, he
writes[268] that he has the house of his friend Hoole (who, as has been seen
above, left No. 56, Great Queen Street in April, 1786), and a later letter,[269]
dated 9th February, 1788, to Bishop Percy, is headed “London, Great Queen
Street, Lincoln’s Inn Fields.” In 1789 he removed to Queen Anne Street
West, and subsequently to No. 122 (formerly 47), Great Portland Street,
where he died in May, 1795. His fame rests upon his biography of Dr.
Johnson, one of the greatest books ever written. There can be no doubt that
a portion of the book was composed in No. 56, Great Queen Street. In 1905
the London County Council affixed to the house a tablet of blue encaustic
ware, commemorative of Boswell’s residence.[270]
In Wheatley and Cunningham’s London, Past and Present[271] it is
stated that after the occupation of Hoole (whose residence is wrongly
identified with that of Worlidge, see p. 77) the house “was rented by
Chippendale, the cabinet-maker, whose furniture has during the last few
years been so eagerly sought after and imitated.” Inasmuch, however, as
Chippendale died in 1779, and Hoole’s residence did not terminate until
1786, this is impossible. The statement probably originated in the fact that a
person of the same name is shown in the ratebooks as an occupant of this
house (see above). But it is William Chippendale, not Thomas; the period of
his occupation is from 1791 onwards; and he was not a furniture maker, but
an attorney.[272]
In the Council’s collection are:—
[273] Ground, first and second floor plans (measured drawing).
Attic floor plan (measured drawing).
Elevation of houses in Great Queen Street by Sir J. Soane, preserved
in the Soane Museum (photograph).
[721] Sketch, by J. Nash in 1840 (print).
[721] “House called Queen Anne’s Wardrobe,” drawn by J. W. Archer,
1846 (photograph).
[721] “House of the Sardinia Ambassador,” drawn by J. W. Archer,
1858 (photograph).
Elevation measured by J. Cooke (print).
[721] The exterior, May, 1906 (photograph).
The exterior, June, 1906 (photograph).

Staircase in No. 55—
[721]Ground to first floor (photograph).
First floor level (photograph).

[721] Archway from passageway to staircase in No. 55.
[721] Staircases in Nos. 55 and 56, details (measured drawing).
XXXVIII.—FREEMASONS’ HALL.
Ground landlords.
The United Grand Lodge of Antient Free and Accepted
Masons of England.
General description and date of
structure.
The present Freemasons’ Hall and buildings connected
therewith occupy the sites of two original houses and parts of two
others. These were reckoning from west to east: (i.) the eastern half
of Bristol House; (ii.) Rivers House; (iii.) the house on which the
statue of the Queen was placed; (iv.) the western half of Conway
House.
The origin of (i.) has already been described.[274] It was, in its
turn, divided into two in 1812 or 1813,[275] and seems to have been
demolished between 1840 and 1846.
(ii.) The house to the east of Bristol House is easily identifiable
with that which is described in a deed[276] dated 31st July, 1641, as
abutting on the west “upon another mesuage of the same building
now in the occupacion of the Earle of St. Albans [i.e., Clanricarde].”
The premises had a frontage of 44 feet upon Queen Street, and the
ground extended southward 200 feet or “neere thereabout” to the
garden of Humfrey Weld. The eastern boundary was “a new
messuage where the statue of the Queenes Majestie is placed.” It is
mentioned that the Countess Rivers then had tenure of the house,
which had previously been in the occupation of “the ledger
Embassador of the King of Spaine.” As the house is mentioned as
being in existence and in fact occupied by the Spanish Ambassador
on 22nd January, 1637–8,[277] its erection may be assigned with
certainty to the year 1637.
The original house was pulled down in 1739, and on the site
two houses were built fronting Great Queen Street, and a number of
others on the ground behind.[278] In the centre of the Great Queen
Street frontage was an archway leading to the premises in the rear,
and known as Queen’s Court.[279] Whether this simply reproduced a
feature of the old mansion (there were similar archways on the west
side of Bristol House and the east side of Conway House), or whether
it was consequent on the necessity for communication between the
street and the new houses behind, is uncertain.
(iii.) It has been seen above that the next house eastwards was
“a new messuage where the statue of the Queenes Majestie is
placed.” This, therefore, is the house referred to in an indenture[280]
of 20 May, 1674, as “fronting upon the streete called Queene Street,
wherein is made a nichy or place for a statue to be placed in.” The
property is said to contain 44 feet frontage, to extend southwards
200 feet, and to have belonged originally to Anthony Wither. It may
thus be identified with the messuage and garden in St. Giles-in-the-
Fields referred to as having been sold in 1637 by William Newton to
Anthony Wyther,[281] so that in this case also 1637 was the date of
erection. The statue of the Queen, which was gilt, was pulled down in
1651,[282] which accounts for the fact that the deed of 1674 could only
record the existence of a niche, with no statue. At some time between
1702 and 1709 the premises were divided, not lengthwise but
breadthwise, a passage being formed to lead from the street to that
house which was in the rear. In 1774 the houses were purchased by
the Grand Lodge of Free and Accepted Masons.
(iv.) The fourth house is mentioned in a deed[283] of 20th
December, 1641, as “all that capitall messuage or tenement with one
yard, one court and one garden plott, stable, coachhouses and
outhouses, as they are now erected, built and inclosed with brick wall
to the same belonging or therewithal now used or enjoyed, scituate
and being in Queene Street ... now being in the tenure or occupation
of Edward, Lord Viscount Conway and Killultagh which ...
conteyneth in front towards Queene Street 88 feet ... and the said
messuage, yard, court and garden plott doe extend from the said
streete backward towards the south unto the garden of Humfrey
Weld, Esq., 199 feet or thereabouts, scituate lying and being between
the messuage, yard and garden plote of Anthony Wither, Esq., now
in the tenure ... of the Lord Awbyney on the west, and the messuage
of Peter Mills, bricklayer, now in the tenure of the Countess of Essex.
And also all those greate gates and gateway[284] over which some part
of Peter Mills messuage is erected, leading out of Queene Street into
the courtyard and garden, with liberty of way by a dore made or to be
made out of the south-east corner of the said garden in by and
through a way and passage of 8 feet in breadth intended to be made
by William Newton over the sewer ... and to lead into ... Princes
Street.”
In 1696 the house was in a dangerous condition, and an Act of
Parliament was obtained authorising its repair and letting on lease
for 51 years[285]. The house was still in existence in May, 1743[286]. By
November of the same year, however, it had been demolished, and
on its site four houses, each 22 feet wide, had been erected, or were
then in course of erection on the Great Queen Street frontage.
Having thus dealt with the history of the earlier buildings on
the site, it remains to describe the various processes by which the
existing premises came to be erected. We will therefore return to the
purchase, in 1774, by the Grand Lodge of Free and Accepted Masons,
of the house on which the statue of Queen Henrietta Maria had
formerly stood.
This site is now occupied by the eastern half of the main block,
including the Temple. The premises (as shown on the plan and
elevation Plate 22) consisted of a house facing the street and a small
house at the back adjoining the garden, which was probably used
subsequently as a museum. The former was let on a short lease to a
Mr. Brooks, paper stainer, and the latter became the original
Freemasons’ Coffee House or Tavern, a portion being fitted up as
offices (with Committee Room) for the use of the Grand Lodge. The
front house was in design similar to Nos. 55 and 56, except that the
elevation showed a parapet, added in 1779, and the front of the
ground floor storey had also been considerably altered.
“Notwithstanding the large expenditure in repairs and
alterations of the old premises ... it was found that, as the business
increased, they were ill adapted for tavern purposes; the Grand
Lodge therefore, on the advice of Thomas Sandby, Esq., R.A., Grand
Architect, and William Tyler, Esq., P. G. Steward, another eminent
architect, decided to demolish the old buildings and erect instead a
large tavern connected with the Hall, with suitable accommodation
for the Grand Secretary and the meetings of Lodges and other
Societies. This was a serious undertaking in view of the fact that the
Hall was not yet paid for and the amount received for its use was
barely enough for working expenses—still it was, no doubt, the right
thing to do, considering the great age of the structure.”[287]
The Hall (or Temple) was built in 1775 by Thomas Sandby,
and was opened on 23rd May, 1776. The tavern was built in 1786 by
William Tyler, and a view of the front is preserved in the Grand
Lodge Library (Plate 23).
THE DISASTROUS FIRE AT FREEMASONS’ HALL, GREAT

QUEEN STREET—THE SCENE OF THE CONFLAGRATION
The Temple is the only remaining structure of this period. It is

rectangular in shape, 78 feet long, 38 feet wide, and about 58 feet
high. It was designed to represent the interior of a Roman Doric
Temple. The side walls are enriched with pilasters, and the ends with
attached columns. A gallery is placed over the vestibule at the
entrance end. It is fitted with an ornamental balustrade stretching
between the columns, which here rise clear and support the main
entablature. Opposite is a small apse which contains a statue of the
Duke of Sussex, executed by E. H. Bailey in 1839. In the original
design a small gallery was placed in either angle of this end of the
Temple, but these were not replaced after the fire of 1883.
Illustrations of the Temple before and after the fire are preserved in
the Grand Lodge Library. The ceiling is flat, with an enriched
modelled ornament somewhat out of keeping with the rest of the
design. It is connected with the cornice of the order by a deep cove
pierced with semi-circular windows, but those originally existing on
the east side have been lately filled in. The decorations are in
excellent taste, and treated with soft colouring, the mouldings and
enrichments being picked out in gold, the whole generally
harmonising with the portraits and other paintings and panels on the
walls.
The vestibule to the Temple (see Plate 28) is paved with
mosaic brought by Mr. W. H. Mordsley from Jerusalem, and laid in
position in 1873, the inscription on the floor being as follows:—
“THIS PAVEMENT FORMED OF ANTIQUE TESSERÆ
COLLECTED AT JERUSALEM BY THE W. HENRY MORDSLEY, P.G.D.,
AND PRESENTED BY HIM TO THE GRAND LODGE WAS LAID IN THE
FOURTH YEAR OF THE GRAND MASTERSHIP OF H.R.H. ALBERT
EDWARD, PRINCE OF WALES, A.L., 5877.
F. P. COCKERELL, GD. SUPT. OF WORKS.”
In 1815 the two houses comprising the western half of Conway
House were acquired by the aid of Sir John Soane. These were
connected by openings, and used by the Grand Lodge. Shortly
afterwards, Soane commenced the designing of additional premises
at the rear of these two houses. In 1828 building operations were
begun, and in the following year the works were completed. The
Grand Lodge in 1832 thanked Sir John Soane for his completion of
the work and for his donation of £500.[288]
Plate 27 is a reproduction of a pen and ink drawing in the
Soane Museum, probably by Soane himself, showing his design for
the new Hall of the Tavern. It is evidently the original sketch for the
elaborate water colour drawing, in the Hogarth Room, executed by
either J. M. Gandy, A.R.A., or C. J. Richardson. This hall did not long
exist. In 1863 the two houses on the site of Rivers House were
demolished, together with all the Tavern and Grand Lodge premises,
excepting Sandby’s Temple, and preparations were made for the
erection of a new building after designs by F. P. Cockerell, son of
Professor C. R. Cockerell, R.A. The foundation stone was laid on 27th
April, 1864, and the building was finished in 1866. The exterior is
shown on Plate 24 and the principal features of the interior not
already mentioned, are the staircase (Plate 28) and the first floor
corridor.[289]
In 1899 a western wing on the site of the eastern half of Bristol
[290]
House was added, from the designs of Henry L. Florence, to
provide more accommodation for the Grand Lodge, including a
Library and Museum. The most recent alterations and additions to
the Tavern were made in 1910, when these premises were named
“The Connaught Rooms.” These works were carried out by Messrs.
Brown and Barrow. Very little of Cockerell’s work in the Banqueting
Hall has been retained.
FREEMASONS HALL GREAT QUEEN STREET W.C.

PLAN OF FIRST FLOOR
BEFORE THE ALTERATIONS IN 1899.
Condition of repair.
The premises are in excellent condition.
Biographical notes.
Bristol House, Eastern Half.
After the division of Bristol House into two about 1684, the first four
occupants of the eastern half (Nos. 57–58) were[291] the Earl of Wiltshire,
the Earl of Stamford, Henry, Viscount Montagu, and the Portuguese Envoy.
Charles Powlett, afterwards second Duke of Bolton, second and
eldest surviving son of the first Duke, was born in 1661. During the lifetime
of his father he was known as the Earl of Wiltshire. He accompanied the
Prince of Orange on his expedition in 1688, having a few months previously
gone over to Holland, and was one of the advanced guard who entered
Exeter with him. He seems to have stood high in William’s favour. He
succeeded his father in the dukedom in 1699, and was made Lord-
Lieutenant of Ireland in 1717. He continued to occupy a fairly prominent
place about the court until his death in 1722. His residence in Great Queen
Street began in 1684, or a little later, and he was still in occupation of the
house on 22nd April, 1689.[291]
Thomas Grey, second Earl of Stamford, born in 1654, was the
only son of Thomas Grey, Lord Grey of Groby. He succeeded his
grandfather in the earldom in 1673. In 1681 he was arrested on a
charge of complicity in the Rye House plot, and remained in the
Tower until March, 1686. On the landing of the Prince of Orange he
took up arms in his favour, and afterwards was appointed to
numerous official positions, becoming Lord Lieutenant of
Grey. Devonshire, Chancellor of the Duchy of Lancaster, and President of
the Board of Trade and Foreign Plantations. On the accession of
Anne, he was dismissed from all his offices, but afterwards regained his
position at the head of the Board of Trade. He died in 1720. His residence in
Great Queen Street must have terminated some time before 1703, at which
date “Henry Browne” is shown in occupation.
Henry Browne, fifth Viscount Montagu, was born some time before
1641.[292] He succeeded his brother Francis in the title in June, 1708. His
residence at the house in Great Queen Street commenced some time,
probably not long, before 1703,[293] and lasted at least until 1715,[294]
possibly until his death, which occurred in 1717 at Epsom.[295] He was
succeeded in the title by his son, Anthony, who three years later married
Barbara Webb, to whose mother, Lady Barbara Webb, daughter of Lord
Belasyse, the eastern half of Bristol House had come by way of bequest.
After the occupation by Lord Montagu the house was
used as the residence of the Portuguese Envoy.[296] The
earliest mention of him as occupying the house is dated 5th
March, 1718–9. How long the Embassy was situated here is
uncertain. The house is referred to in Sir Godfrey Kneller’s
will,[297] dated 27th April, 1723, as “now in the possession of
the Portugal Envoy.” In a codicil, dated 18th July, in the
same year, it is described as “now or late in the occupation of Browne.
the Portugal Envoy,” and Kneller states that the premises are
much out of repair, and that he proposes to spend a sum of £200 in works.
It would almost seem therefore that the envoy left the house between April
and July, 1723, and some confirmation of this suggestion is found in the fact
that in the Westminster sewer ratebook, dated 18th July, 1723, the name,
not of the Portuguese Envoy, but of Sir Godfrey Kneller, the owner, appears
for the house.
After the departure of the Portuguese Envoy, the house was used for
the purposes of the Great Wardrobe.[298] The parish ratebooks from 1730
(the earliest extant) until 1748 show “Thos. Dummer, Esq.,” the deputy[299]
of John, Duke of Montagu, keeper of the Great Wardrobe, as in occupation.
The occupants of Nos. 57–58 from the time of the Great Wardrobe
were as follows:—
1750–60. John Jackson.

1761–71. Benjamin Wilson.
1771–72. —— Salvadore.
1772–76. John Henderson.
1777–82. Richard Brinsley Sheridan.
1782–90. A. and E. Boak.
1791– Boak and Banson.
For particulars as to Benjamin Wilson, see under Nos. 55–56, Great

Queen Street (p. 57).
Richard Brinsley Sheridan, son of Thomas Sheridan, actor and
“orthoepist,” was born in Dublin in 1751. When he was nineteen years of
age, his father settled at Bath. In the winter of 1773, soon after his marriage
with Miss Linley, the couple came to live in London,[300] and Sheridan
essayed to earn his living by writing. In January, 1775, The Rivals appeared,
and by the end of the year Sheridan had become a favourite with playgoers.
Next year he became manager and part-proprietor of Drury Lane Theatre.
In 1791–4 the theatre was pulled down and rebuilt, and the expenditure
greatly exceeding the estimate, Sheridan undertook to pay the liabilities
thus incurred. The destruction of the new theatre by fire, however, in 1809,
involved him in financial troubles which continued until his death. As a
dramatic writer he far excelled all his contemporaries. His chief plays were:
The Rivals, St. Patrick’s Day, The Duenna, A Trip to Scarborough, The
School for Scandal, The Critic, Pizarro. From 1780 he was no less
prominent in political than in literary life. In September of that year he
entered the House of Commons as member for Stafford, and soon became
noted as an orator. For two periods of short duration in 1782–3 he was
respectively under-secretary for foreign affairs and secretary to the
Treasury, and in 1806–7 was treasurer to the Navy. Among his most
noteworthy oratorical achievements must be placed his speeches in
connection with the trial of Warren Hastings. His last speech in Parliament
was made in June, 1812. Soon after his entry into Parliament he had become
personally acquainted with the Prince of Wales, and ever after acted as his
confidential adviser. Sheridan died in Savile Row in July, 1816, and was
awarded a public funeral in Westminster Abbey.
His occupation of the house in Great Queen Street is shown by the
parish ratebooks to have lasted from 1777 to 1782.[301] The former date is
confirmed by a letter from W. Windham, dated 5th January, 1778, directed
to “Ric. Brinsley Sheridan, Esq.,” at “Queen Street, Lincoln’s Inn
Fields.”[302] It is said that on the day of Garrick’s funeral (1779), after the
ceremony was over, Sheridan “spent the remainder of the day in silence,
with a few select friends, at his residence in Great Queen Street.”[303]
Rivers House.
The first occupant of the house immediately to the east of Bristol

House, occupying the site of what were afterwards Nos. 59 and 60, Great
Queen Street, was the Spanish Ambassador, who has been shown above[304]
to have been in residence on 22nd January, 1637–8. A reference to his
occupation of the house occurs in the following: “May 10, 1638. The Spanish
Ambassador, the Conde de Oniate, accompanied with an Irish gentleman of
the order of Calatrava, in the Holy Week, came to Denmark House to do his
devotions in the Queen’s Chapel there. He went off thence about 10 o’clock,
a dozen torches carried before him by his servants, and some behind him.
He and the Irish gentleman were in the front with their beads in their
hands, which hung at a cross, some English also were among them; so that
with their own company and many who followed after, they appeared a
great troop. They walk from Denmark House down the Strand in great
formality, turn into the Covent Garden, thence to Seignior Con’s house in
Long Acre, so to his own house in Queen’s Street.”[305] Writing to Sir John
Pennington from the Earl of Northumberland’s residence [i.e., probably
next door] on 21st November, 1638, Thomas Smith says: “The Spanish
Ambassador was robbed here last night of all his church plate. The thieves
are not heard of.”[306]
In July, 1641, the Countess Rivers purchased the house, being
already in occupation of the premises.[307] This was Elizabeth, eldest
daughter and co-heir of Thomas Darcy, Baron Darcy of Chich, afterwards
created Viscount Colchester and (on 4th November, 1626) Earl Rivers. She
married, in 1602, Sir Thos. Savage, Bt., of Rock Savage, Chester, who was
created Viscount Savage on the same day that his father-in-law was raised
to the earldom. He died in 1635, and in April, 1641, about fifteen months
after her father’s death, his widow was created Countess Rivers for life. She
died in March, 1651.
The Subsidy Roll for 1646 contains among the few items
relating to the south side of Great Queen Street, one, “The Lady
Savige her house,” which undoubtedly refers to the Countess Rivers.
That she was resident at the house that year appears from the fact
that in April, 1646, she petitioned[308] the House of Lords, stating
that her houses in Suffolk and Essex, with all her personal estate,
had been utterly wasted and destroyed, so that if she and her family
Elizabeth, were forced to leave their present residence they must be exposed to
Countess a misery not to be expressed. She pointed out that both she and her
Rivers. servants had taken the negative oath, and therefore she prayed for a
licence for herself and family to remain in her house in Queen
Street.
On the Countess’s death the house presumably came into the
possession of her son, the second Earl Rivers. John Savage, born before
1610, succeeded his father as Viscount Savage in 1635, and his maternal
grandfather as Earl Rivers in 1640. He died in 1654, and was succeeded by
his son Thomas, third Earl Rivers, born before 1626.[309] The third Earl’s
residence at the house in Great Queen Street was divided into two periods,
the house having apparently been let for some time circ. 1670–80. That the
Savage family were in occupation in 1658 is clear from the terms of a
letter[310] dated 24th September in that year from Sir William Persall:
“Our Queen Street news is ill; my Lady Rivers[311] is in a very ill
condition of health.” The Hearth Tax Rolls for 1665 and 1666[312] give the
name of the Earl in connection with the house, and to this period is
apparently to be assigned the further letter[313] dated 3rd October, in an
unknown year, by Sir William Persall, in the following terms: “Give me
leave to render you the history of our Queen Street family, and the reason of
the bill on the door which found at my coming up. They had intelligence
that the constables were to come and present the names of all church
absentees popishly affected;[314] so they consulted in my absence and
resolved to set the bill on the door, and give it out my Lady Rivers was in the
country, Sir Francis Petre[315] in common garden[316] out of the parish, Sir
Will. Persall gone to live at his house in the country, none but servants left;
when everyday half-a-dozen coaches come to visit us, and the baskets of
meat as full as ever, and two or three brewers still carrying in ale and beer;
and all for Tom Browne, who, poor man, is already half damn’d with telling
of lies to all that come to inquire of us, as well friends as others. But they
have given us in, as Tom Brown reported that we were all gone except my
Lady Mary,[317] who is but fifteen, and so incapable to take the oath, and yet
I hear they have taken our names again.”
In the Hearth Tax Roll for 1673 Col. Thos. Howard is shown as
occupying the house. He was succeeded by “Lord Obryant” (Hearth Tax
Roll for 1675). This is undoubtedly Lord O’Brien, afterwards the second Earl
of Inchiquin.
William O’Brien, son of Murrough O’Brien, sixth
Baron and first Earl of Inchiquin, was born about 1638. He
was brought up in London at the house of Sir Philip Perceval,
and afterwards saw much military service with his father in
France and Spain. In 1660 they were both captured by an
Algerian corsair, and carried into Algiers, but were
subsequently ransomed by the English Government. His
O’Brien.
residence in the house in Great Queen Street seems to have
begun about November, 1673. Writing to Williamson on the
28th of that month,[318] he says: “I rejoice at nothing more in my remove to
Queen Street than to be able to assure you that besides a hearty welcome,
there is a couple of good rooms at your command.” Again, on 20th
February, 1673–4,[319] he writes to Williamson with reference to the latter’s
German voyage, adding that “your poor friends in Queen Street wish you
really as well as any of those that contrive this voyage for you.” A few weeks
afterwards he was appointed captain general of the forces in Africa and
governor and vice-admiral of Tangier, a position which he held for six years.
He succeeded his father in the title on 9th September, 1674. On the
Revolution he supported William III. and in 1690 was appointed captain
general and governor of Jamaica, where his troubles with the French and
negroes, increased by his want of tact, undoubtedly shortened his life. He
died in January, 1691–2.
The ratebook for 1683 shows the house again in the occupation of
Earl Rivers. He died in 1694 at the house in Great Queen Street.[320]
The Jury Presentment Roll for 1698 shows “Lady Rivers” at the
house, but whether this refers to the widow of the third Earl[321] or the
second wife of the fourth Earl[322] is not known.
In the ratebook for 1700 no name appears against the house, but in
those for 1703 and 1709 Earl Rivers is shown in occupation. Richard, the
fourth Earl (“Tyburn Dick”) was handsome, brave, and a most notorious
rake. As Lord Colchester (a title he obtained after his elder brother’s death),
he had been the first nobleman to welcome the Prince of Orange on his
landing. During William’s reign he saw a great deal of military service in
Ireland and on the Continent. Being strongly recommended by
Marlborough, he was in 1706 appointed to the command of a force
originally intended for a descent on France, but afterwards diverted to
Portugal. Rivers was, however, superseded within a few weeks after his
landing and returned home. He owed much to Marlborough’s influence, but
being unable, in 1709, to induce him to support his candidature for the
position of constable of the Tower, he paid court to the other side, and the
grant to him of the appointment on the recommendation of Harley was the
first sign of the coming fall of the Whigs. High in favour, he was in 1710 sent
on a delicate political mission to Hanover, and in 1711 was created master of
the ordnance. He died in August, 1712, at his house at Ealing Grove.
In his will[323] he left to Mrs. Elizabeth Colleton alias Johnson,[324]
“all my mansion house called Rivers House, scituate in Great Queen Street,”
and in the ratebook for 1715 the occupant of the house is given as “Mrs. Eliz.
Collington,” with a note “an ambassador’s house and gone away.”
The next occupant of the house was apparently William, sixth Baron
North. [325] He was son of Charles, fifth Baron North, who had on his
marriage with Catherine, only daughter of William, Lord Grey of Wark,
taken the title of Lord Grey. He succeeded to the titles in 1691. He served
with Marlborough throughout the war of the Spanish Succession, at the end
of which he held the rank of lieutenant-general. During the latter part of
Anne’s reign his Jacobite sympathies became more and more pronounced.
On the accession of the Hanoverian dynasty he therefore became an object
of suspicion, and on 28th September, 1722, was committed to the Tower for
complicity in Atterbury’s plot.[326] He escaped and was re-arrested, but
subsequently was admitted to heavy bail. Shortly afterwards he left the
country and never returned, dying at Madrid in October, 1734. His
residence at Rivers House must have been short, commencing some time
between 1715 and 1720, and terminating either at or before his committal to
the Tower in 1722.
In the will of Richard, fourth Earl Rivers, there is mention of “Miss
Bessy Savage,” to whom the Earl left £10,000 on condition that she married
with the consent of Mrs. Colleton. “Bessy” was the Earl’s illegitimate
daughter by the latter, and in August, 1714, when she was fifteen years old,
she married “with consent of her mother”[327] the third Earl of Rochford. As
Rivers House is found in her possession, she evidently obtained it, either by
gift or bequest, from her mother, to whom Lord Rivers had left it.
Frederick Nassau de Zuylestein, third Earl of Rochford, was born in
1683, and succeeded to the title in 1710. His occupation of Rivers House
began some time before 1723, the ratebook for the latter date giving his
name in connection with the house, which continued to be his town
residence[328] until the end of his life. He died on 14th June, 1738, at his
house in Great Queen Street,[327] and his wife, with but little delay, married
again,[329] her second husband being the Rev. Philip Carter. Early in the
following year Rivers House was sold[330] and demolished, two
houses being erected on the frontage to Great Queen Street.
The names of the occupiers of these two houses (Nos. 59 and
60) up to 1800 were as follows:—
Frederick
Nassau de
Zuylestein,
Earl of
Rochford.
No. 59. No. 60.

1743–46. Mrs. Clive. 1743–46. Matthew Hone.
1747. Cath. Clive. 1747–52. Edw. Borrett.
1748–53. Eliz. Hill. 1753. W. G. Freeman.
1754–57. —— Cheeke. 1754–60. Joseph Blisset.
1758. Mrs. Pont. 1760–74. John Twelves.
1758–62. Thos. Webb. 1775. John Cooper.
1763–68. Augustin Noverre. 1776–79. Thos. Cooper.
1768–79. Thos. Vaughan. 1780–81. —— Plowden.
1779–82. Miss Savill. 1781–84. —— Burnett.
1782–84. —— Hughes. 1784–95. Miss Ride.
1784–85. —— Garnault. 1795–99. Wm. Byrn.
1785–99. John Hughes. 1799– John Crace.
1799– —— Jackson.
The Catherine Clive, who is shown by the ratebooks of 1743 to 1747

as the occupier of No. 59, Great Queen Street, is almost certainly the famous
singer and actress usually known as Kitty Clive, but apart from
Heckethorn’s statement,[331] for which no authority is quoted, that about
the year 1733 she was probably living at No. 56, no evidence to confirm the
fact of her residence in the street has been found. She was born in 1711, her
father, William Raftor, being an Irish lawyer, who supported James II. at
the battle of the Boyne, and afterwards settled in London. Kitty’s lack of
refinement and even of the rudiments of education suggests that her
training as a child was neglected, but the story that while engaged in
cleaning the steps of a lodging-house she attracted the notice of some actors
under whose auspices she was introduced to the stage is open to
considerable doubt. Her marriage to George Clive, a barrister, was a
mistake, and the parties agreed to separate. They were living together in
1734 when Fielding wrote of her in the preface to the Intriguing
Chambermaid. “Great favourite as you ... are with your audience you would
be much more so ... did they see you ... acting in real life the part of the best
wife, the best daughter, the best sister, and the best friend.” She acted
generally at Drury Lane, being almost entirely in Garrick’s company from
1746 until her retirement in 1769. Although she excelled in comedy and
character parts of middle and low life, she occasionally essayed work of a
higher character, as, for instance, when she sang the music of “Delilah” at
the first production in 1742, of Handel’s Samson. On her retirement she
withdrew to a house at Strawberry Hill, which Horace Walpole had given
her some years before,[332] and here she died in 1785. Johnson had a high
opinion of her acting, and his opinion of her as a woman is shown by his
remarks to Boswell. “Clive, sir, is a good thing to sit by; she always
understands what you say.... In the sprightliness of humour I have never
seen her equalled.”[333]
Thomas Vaughan, nicknamed “Dapper” by Colman, was a mediocre
dramatist of the latter part of the eighteenth and the beginning of the
nineteenth centuries. One of his chief plays, The Hotel; or the Double Valet,
has the preface dated: “Great Queen Street, 2nd December, 1776.” Vaughan
is said to have been the original of Dangle in Sheridan’s Critic.

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Fixed Income Mathematics: Analytical

and Statistical Techniques, 5th Edition

The Handbook of Fixed Income Securities, Ninth Edition

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New York Chicago San Francisco Athens London

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eBook conversion by codeMantra

To my Princeton wrestling teammates

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Time Value Of Money

Bond Pricing For Option-Free Bonds And

Return Analysis AND RETURN MEASURES

Price Volatility For Option-Free Bonds

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Chapter 15: Duration and the Yield Curve 209

Historical Return And Yield Volatility

ANALYZING BONDS WITH EMBEDDED OPTIONS

CREDIT AND LIQUIDITY CONCEPTS

Analyzing Securitized Products

STATISTICAL AND OPTIMIZATION TECHNIQUES

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PART ONE TIME VALUE OF MONEY

PART TWO BOND PRICING FOR OPTION-FREE BONDS AND CONVENTIONAL

PART THREE RETURN ANALYSIS

PART FOUR PRICE VOLATILITY FOR OPTION-FREE BONDS

PART FIVE ANALYZING BONDS WITH EMBEDDED OPTIONS

PART SIX CREDIT RISK

PART SEVEN ANALYZING SECURITIZED PRODUCTS

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Chapter 22 Cash Flow Characteristics of Mortgage-Backed Securities

PART EIGHT STATISTICAL AND OPTIMIZATION TECHNIQUES

2 Future Value (3)

The 11 new chapters in the fifth edition are

10 Historical Return Measures

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28 Holdings-Based Performance Attribution Analysis

Ch. Chapter title Change

Overview of Fixed-Income Securities and Derivatives (Chapter 2, now online supplement A)

Two new online supplements are also available:

Online Supplement C. Illustration of Holdings-Based Performance Attribtion Analysis

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1977 7.80 100 8.30 94.50 –5.50 –5.50

2. One basis point is equal to 0.01%.

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With the complexity of fixed-income products—debt instruments with

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ORGANIZATION OF THIS BOOK

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by distinguishing between model duration and empirical duration. Model duration