Fixed income ?
Fixed cash flow / interest rate sensitiveMajor types— traditional fixed-income securities—Interest rate derivatives—Bonds with embedded options
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SyllabusPart I basic knowledge: Fixed-income instruments, prices and yieldsPart II Term structure: Empirical properties and classical theories of the term structure & Deriving the zero-coupon yield curvePart III Hedging interest-rate risk with duration, convexity and other waysPart IV Investment strategies: passive, active and performance measurement.
Part V: Interest rate swaps, forwards and futuresPart VI: Dynamic term structure modelingPart VII: Interest-rate derivativesPart VIII: Securitization
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ReferenceLionel Martellini, Philippe Priaulet, Stephane Priaulet, 2003, Fixed-income securities: valuation, risk management and portfolio strategies, Wiley.Suresh M. Sundaresan, 1997, Fixed income markets and their derivatives, South-Western College PublishingJohn Hull, 2006, options, futures and other derivatives, Prentice HallMoorad Choudhry, 2005, Fixed-income securities and derivatives handbook, BloombergBond markets, analysis and strategies, Frank J. Fabozzi ,4th edition, NJ :Prentice Hall,2000 固定收益证券 , ( 美 ) 布鲁斯 ·塔克曼 (Bruce Tuckman) 著 , 黄嘉斌译;北京:宇航出版社, 1999固定收益证券:对利率风险进行定价和套期保值的动态方法 , 李奥奈尔 ·马特里尼 , 菲利普 ·普里奥兰德著;肖军译 , 北京:机械工业出版社, 2002谢剑平, 2003 , 固定收益证券:投资与创新,人民大学出版社薛立言 刘亚秋, 2006 , 债券市场,东华书局林清泉, 2005 ,固定收益证券 , 武汉大学出版社姚长辉 , 2006 ,固定收益证券 : 定价与利率风险管理 , 北京大学出版社
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Internet resources
http://www.chinabond.com.cn/chinabond/index.jsp中国债券信息网http://www.chinamoney.com.cn/databas/new/zaxiang/shouye/index.jsp中国货币网http://bond.homeway.com.cn/和讯债券
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Issuers
the issuer’s name
the issuer’s type
the issuer’s domicile
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Time
The maturity date Short/ medium/ long term/ ConsolsCallable, puttable….
—The issuance date—the interest accrual date—the settlement date—Day-count conventions
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Face value
—par amount/ nominal amount/ principal amount
—The total issued amount—The outstanding amount—The minimum amount and minimum
increment that can be purchased—The redemption value—The issuance price—Currency denomination
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Interest rate
Interest rates— The coupon type ( zero, fixed, floating,
multicoupon, step-up coupon…)—The coupon rate —The coupon frequency
Mortgage/ government guarantee…The rating (Moody’s and S&P)
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Other characteristics
Amortization Feature
Embedded options
Issuance market (Domestic , Eurodollar…)
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Interest rates types
Zero Coupon bonds
Fixed-rate bonds
Floating-rate notes (FRN) :—reference index *k +margin—floating-rate bonds—Variable-rate bonds or adjustable-rate
bonds—Inverse floater
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Inflation-indexed bondsInflation-indexed bonds deliver coupons and principal that are indexed on the future inflation rates
They are mainly issued by governments to make it clear they are willing to maintain a low inflation level
An inflation-indexed bond can be used to — hedge a portfolio against a rise in the inflation rate— diversify a portfolio based on low correlation with stocks,
fixed-coupon bonds and cash
Strips
Initially created by investment banks( trademark zeros)
Coupons are detached and principal and coupons sold individually
—It used to imply a tax break—Not anymore, the law has changed—Even after the law changed, great success
The government has its own program
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Issuer’s types
US Treasury
—T-Bill (maturity < 1 year)—T-Notes (maturity 2, 3, 5, 7 and 10 year) —T-Bonds (>10 years)
Municipalities
Corporations
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Government SecuritiesTreasury Bills
—Pure discount securities placed through auction—Maturity 13, 26 and 52 weeks
Treasury Notes and Bonds
—Half coupon paid semi-annually—Maturity 2, 3, 5, 7, 10 (notes) and 30 years
(bonds)—Sold in denominations of $1,000—Bonds may be callable or term securities—Bullet bonds/ amortization—Nominal coupon-bearing securities/ inflation-
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Government Securities
—Full faith and credit of the US government
—The most active, liquid and efficient market
—On-the-run/off-the-run
—2 year/5 year/10year/30 year : benchmark securities, market indicator, overliquid
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Agency SecuritiesIssued by different organizations—Federal National Mortgage Association (Fannie Mae)—Federal Home Loan Bank System (FHLBS),—Federal Home Loan Mortgage Corporation (Freddie Mac) —Farm Credit System (FCS)—Student Loan Marketing association (Sallie Mae) —Resolution Funding Corporation (REFCO)—Tennessee Valley Authority (TVA)
Agencies have at least two common features—First, they were created to fulfill a public purpose.—Second, the debt of most agencies is not guaranteed by
the US government—the organizations are different
High credit ranking
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Municipal Bonds
Issued by state and local governments
—Exempt from federal income tax—Exempt from (issuing) state local tax
Not necessarily high credit rankingTypes of ‘munis’
—General obligation bonds: baked by the ‘full faith of credit’ of the issuer (taxing power)
—Revenue bonds (riskier): issued to finance specific projects (airports, hospital, etc.)
Municipal Bonds
Who purchases municipal bonds?
—T-bond pays 5% and municipal bond 3.8%—If (marginal) tax rate is 20%? 35%?
After-tax return
—MTR = 20%: (.05)x(.8) = .04 > .038—MTR = 35%: (.05)x(.65) = .0325 < .038
What MTR is indifferent (‘cutoff rate’)?
(.05)x(1 - t) = .038 => t = .24 = 24%
Markets of government securities
The primary marketThe secondary market: market maker/ OTCWhen-issued marketThe repo market— the general-collateral repo rate (GC)—The special repo rate (on-the-run or
cheapest-to-deliver securities)
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Corporate bondsBonds issued by a corporation Typically pay semi-annual coupons3 Sources of Risk
— Interest Rate Risk— Default Risk— Liquidity Risk
Bond indenture contracts stipulate collateral and specify termsDifferent “seniority” classes— Secured Bonds— Subordinated debentures— Debentures
Preferred stocks— ‘Promises’ fixed dividend = coupon rate — Cannot force bankruptcy if no dividend paid
Corporate bonds
Standard & Poor, Moody’s and other firms score ‘the probability of continued & uninterrupted streams of interest & principal payments to investors’
Classes of grades
—Moody’s Investment Grades: Aaa,Aa,A,Baa—Moody’s Speculative Grades: Ba, B, Caa,
Ca, C—Moody’s Default Class: D
Are ratings agencies better able to discern default risk or simply react to events?
Corporate bonds
Lower liquidityCredit marketDefault or credit risk— Bankruptcy, recovery rate—Reorganization—Negotiation between shareholders and
creditors: a package of cash and newly issued securities
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Money Markets Instruments
Markets for short term debt
Highly marketable (liquid)
Low risk
Very large denominations
MM mutual funds accessible
Very sensitive to the central bank’s policy — open market operations— key interest rate
T-Bills
Treasury bills: short term gov. debt
Discounted securitiesQuotes :
Money-market yield :
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*q
F P By
F n
* *
*
*
q
q
q
F P B Fy y
P n PB y
B n y
CDs and CPs
Certificate of Deposit (CD)— Time deposit (penalty for early withdrawal)— Bearing coupons
Commercial Paper— Short term, unsecured— A way of raising short-term funds or as bridge financing
Banker’s Acceptances— Bank guarantees payment— No interest rate: calculated in the same manner as the price of a
T-bill
Interbank Deposit— LIBID/ LIBOR: the average of the rates quoted by the major banks
of a market place.
Repurchase Agreements
Repurchase Agreements (Repo’s)— Effectively an overnight, collateralized loan— Sell government securities, with promise to repurchase at slightly higher
price tomorrow
A repo is a way for an investor to borrow money— A commitment by the seller of a security (usually gvt security) to buy it back
from the buyer at a specified price and at a given future date— Can be viewed as a collateralized loan, the collateral being the security
Repo maturity— When repo maturity is one day, called overnight repo— When repo maturity exceeds one day, called term repo
A reverse repo is a way for an investor to lend money— A reverse repo agreement is the same transaction viewed from the buyer's
perspective
The repo rate is computed on an Actual/360 day-count basis
An exampleA German investor needs money—He lends € 1 million …—… of the 10-year Bund benchmark bond (i.e., the Bund 5%
07/04/2011 with a quoted price of 104.11, on 10/29/2001) …—… over 1 month at a repo rate of 4%—There is 160 days' accrued interest as of the starting date of the
transaction
Cash payments—At the beginning of the transaction, investor receives an amount
of cash equal to the gross price of the bond times the nominal of the loan, that is
(104.11+5x160/360)x1,000,000/100= € 1,063,322
—At the end of the transaction, in order to repurchase the securities he will pay the amount of cash borrowed plus the repo interest due over the period, that is
1,063,322 + 1,063,322 x 4 x 30/360= € 1,066,866
Types of repos
Repo and reverse repo
general repo and special repo
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Other Fixed-Income Securities
Swaps (Chapter 10)Futures and forwards (Chapter 11)Bonds with embedded options (Chapter 14)Swaptions (Chapter 15)Caps, floors, collars (Chapter 15)Exotic options (Chapter 16)Credit derivatives (Chapter 16)Mortgage-Backed Securities (Chapter 17)etc…