Fixed Income-I

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Fixed Income Securities I
Mapping to Curriculum
Reading 57: Introduction to the Valuation of Debt Securities Reading 53: Features of Debt Securities Reading 54: Risks Associated with Investing in Bonds Reading 55: Overview of Bond Sectors and Instruments
This files has expired at 30-Jun-13 Expect around 15 questions in the exam from todays lecture
Neev Knowledge Management Pristine
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Key Concepts
Discount, Par, Premium Bond Pricing Yield-Price Relationship Clean Price, Dirty Price Embedded Options Risks Associated With Investing In Bonds Effect of Maturity and Coupon on Duration Types of Government Bonds This files has expired at 30-Jun-13 ABS, MBS,CMO,CDO
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Fixed Income (Introduction)

Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable A bond is simply a promise to pay interest on borrowed money, there is some important terminology used by the fixed-income industry:
The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and pays the interest. The principal of a bond also known as maturity value, face value, par value is the amount that the issuer borrows which must be repaid to the lender. This files has expired at 30-Jun-13 The coupon (of a bond) is the interest that the issuer must pay. The maturity is the end of the bond, the date that the issuer must return the principal. The bond Indenture is the contract that states all of the terms of the bond. It contains the obligations, rights, and any options available to the issuer or buyer of a bonds. A written agreement between the issuer of a bond and his/her bondholders, usually specifying interest rate, maturity date, convertibility.
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Basic Structure Of A Plain Vanilla Bond

150
100
50

0 T0 T1 T2 T3 T4 T5 T6 T7 T8 T9 T10
-50
-100
-150
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Key Issues In Introduction To The Valuation Of Debt Securities
Bond Valuation Process
Problems encountered in Valuation
Computing the value of a bond
Change in value with passage of time
Value of a zero-coupon bond
Arbitrage-free valuation approach This files has expired at 30-Jun-13
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Important Points
When interest rates rise, market prices of bonds fall (and vice versa) The longer the time until maturity, the more sensitive the bond price is to changes in interest rates In practice most bonds pay interest semi-annually, so we have to nd the appropriate semi-annual rate and adjust coupon payments The yield to maturity (YTM)of a bond is the discount rate which equates the price of a bond with the PV of its expected future cash ow Bond valuation is the determination of the fair price of a bond. As with any security or capital investment, The theoretical fair value of a bond is the present value of the of cash flows it is expected to This files has expired atstream 30-Jun-13 generate.
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Bond Valuation
The value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.
If the coupon rate of the security is equal to the market yield then the bond will sell at par Coupon Rate = Market Yield --- Price = Par Value
If the coupon rate of the security is more than the market yield then the bond will sell at premium Coupon Rate>Market Yield - Price> Par Value
If the coupon rate of the security is less than the market yield then the bond will sell at discount Coupon Rate<Market Yield - Price<Par Value
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Example :
Par Bond
Bond value 1000, Interest Rate 10%, Coupon Rate : 10% Term 5 year. Calculate the PV by discounting method. (100)
Premium Bond
This has expired 30-Jun-13 Bond value 1000, Interest Rate files 9 %, Coupon Rate : 10% Termat 5 year. Present Value : 1038.89
Discount Bond
Bond value 1000, Interest Rate 11 %, Coupon Rate : 10% Term 5 year. Present Value : 963.04
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It is a simple three step process: 1. Estimate all the cash flows expected on a security 2. Determine the appropriate discount rate 3. Calculate the present value of the estimated cash flows
Formula for finding value of a bond:

Value of a bond C C C C PAR ...... 2 3 (1 YTM) (1 YTM) (1 YTM) (1 YTM) N
where CP (N) -> coupon payment for year N, YTM -> yield to maturity (interest rate) PAR -> Face Value of teh bond
PV
FV (1 r ) t
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Example: Bond Prices
Consider a 5 year vanilla bond with a face value of $1000 and 10% annually paid coupon. Calculate its price if the interest rates are 9%, 10%, and 11%.
Time T=1 T=2 T=3 T=4 T=5 Total Comment
Cash flow 100 100 100 100 1100
PV @11%
90.09 81.16 73.12 65.87
PV @ 10%
90.91 82.64 75.13 68.30
PV @ 9%
91.74 84.17 77.22 70.84
This 652.80 files has 683.01 expired at 30-Jun-13 714.92

963.04 1,000.00 1,038.90
Bond trading at a Discount
Bond trading at Par
Bond trading at a Premium
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Future Value Of An Ordinary Annuity:
Future value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today.
Future value of an annuity (FVA) is the future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest
Future value is the value of an asset at a specific date. It measures the nominal future sum of money that a given sum of money is "worth" at a specified time in the future assuming a certain interest rate, or more generally, rate of return; it is the present value multiplied by the accumulation function.
FV PV * (1 Rate ) n
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Bonds Where Estimating Cash Flow Is Difficult
Problems Encountered in Valuation: Coupon payments are reset periodically based on some reference rate.
Example: Floating Rate Bonds
Issuer or Investor has the option to change the contractual due date for the payment of the principal.
Example: Callable or Putable Bonds
The principal payments are files not known with surety because the risk of prepayment This has expired atof30-Jun-13
Example: MBSs
The investor has the choice to convert the bond into common sock.
Convertible Bonds
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Computing The Value Of A Bond
Value of a bond is the present value of its cash flows
In the exam you will deal with the following parameters: (Refer the Texas Instrument BA II Plus Professional calculator)
N=?; PMT=?; FV=?; I/Y=?; and then Compute PV. Usually four of the above five terms will be given and the fifth will have to be calculated
Example 1: Calculate the value of a security which has coupon rate of 10%, maturing in 6 years at par value($100). The discount rate is 9%.
Solution: N=6; PMT=10; FV=100; I/Y=9%; Using the Texas Instrument BA II Plus Professional calculator: then PV=104.48.
Example 2: A market value of a security is $ 98.50. Calculate the discount rate if the security has coupon rate of 10%, maturing in 6 years at par value($100). Solution: N=6; PMT=10; FV=100; PV=-98.50; Using the Texas Instrument BA II Plus Professional calculator: then I/Y=10.34%.
Note:Give attention to the sign of the cash flows

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Computing The Value Of A Zero Coupon Bond
Value of a Zero Coupon Bond It is the present value of the face value of the bond. Value = Maturity Value / (1+i)Number of years *2
In the above formula we are using the semi-annual discount rate to value the bond. The annual rate can also be used.
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How Discount Rates And Maturity Date Affect Price
Interest rates and Bond Values are inversly related higher coupon rate compared to the reduced market interest rate
A decrease in the interest rate will result in an increase in the bond price as the bond is giving a
As a result, the price yield curve is a downward sloping curve
Changes in Value with Passage of Time:
Whether the bond is trading at a premium or at a discount,
as a bond approaches maturity, its value converges to the par value.
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Bond Valuation
Pull to Par is the effect in which the price of a bond converges to par value as time passes. At maturity the price of a debt instrument in good standing should equal its par or face value.
Pull to Par is the phenomenon that as time passes, the price of a credit instrument in good standing moves towards its par value. The nearer to maturity the greater the influence because the security will only pay out the stated principal amount
The calculation process of the bond amortization (Pull to Par ) is in the next slide..
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Bond Valuation: Pull To Par Concept

Price of $100 Face Value Bond Yielding 6% versus Years to Maturity At Various Coupons (4% - 8%)
8.00%
$140 $130 $120 $110 $100 $90 $80 $70 $60
7.00%
6.00% 5.00%
4.00%
30 28 26 24 22 20 18 16 14 12 10 8 Years to Maturity
Price pulled to par as bond nears maturity maturity

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Pull To Par
Consider two bonds. One trading at a discount and the other trading at a premium:
Bond-Discount Coupon Tenure YTM Face Value
FY 0 $69.28 $138.61
$160.00 $140.00 $120.00 $100.00 $80.00 $60.00 $40.00 $20.00 $0.00 FY 0
Bond-Premium 5% 10 10% 100 Coupon Tenure YTM Face Value

FY 3 FY 4 FY 5 FY 6 FY 7
10% 10 5% 100
FY 8 $91.32 $109.30 FY 9 $95.45 $104.76 FY
ce Bondcount ce Bondemium
FY 1
$71.20

$73.33 $75.66 $78.22 $81.05 $84.15 $87.57 $132.32 $128.93 $125.38 $121.65 $117.73 $113.62
FY 2
$100
$135.54
$100
Pull to Par
FY 2
FY 4 Price Bond-Discount
FY 6
FY 8 Price Bond-Premium
FY 10
FY 12
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Arbitrage-free Valuation Approach
Discounting all cash flows of a bond with the same discount rate is a flaw in the traditional approach. pertains to the maturity of that cash flows. This discount rate is nothing but the Spot Rate
In the arbitrage free valuation approach, each cash flow is discounted by the discount rate that
We had studied earlier about STRIPS
As per this approach, the value of the Treasury Bond as a whole should be equal to the value of its individual parts
Each part =
Cash flow 1 Spot rate/2periods
If this is not the case, a person can achieve arbitrage-free profits by buying the whole and selling the parts or vice-versa
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Questions
1. If the current yield is 8%, what is the value of a security carrying a annual coupon of 7%, maturing in 8 years, redeemable at par value of $1,000? A. $942.53 B. $1,000 C. $1,059.71 2. If the current value of a bond is $1,065, what is the YTM of the bond carrying a annual coupon of 7%, maturing in 6 years, redeemable at par value of $1,000? A. 5.69% B. 7% This files has expired at 30-Jun-13 C. 6.69% 3. The current price of a bond is $985. An increase in the yield by 50 basis points will most likely result in the price becoming: A. $1,000 B. $1,015 C. $970 4. The value of a $10,000 face value zero-coupon bond with 10 years to maturity and a semi-annual pay yield of 8% is: A. $2,145.48 B. $4,563.95 C. $4,635.67
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Solutions
1. A. $942.53
2. A. 5.69%
3. C. $970. This is a trick question requiring no calculations as the value of a bond will decrease as yields increase.
4. B. $4,563.95 [ = 10000/(1 + 0.08/2)] ^ (10*2)
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Key Issues In Features Of Debt Securities
Bonds Indenture
Basic features of a Bond
Definitions
Redemption and Retirement of Bonds
Embedded Options
Institutional Investors
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Bonds Indenture
A bonds Indenture is the document which specifies the rights and obligations of both the issuer and the buyer of the bond. Contains Affirmative Covenents wich requires the borrower to affirm to certain actions. Examples:
Maintaining minimum financial ratios Pay interest and principal on a timely basis
Contains Negative Covenants which prevent the borrower from doing certain things. This files has expired at 30-Jun-13 Examples:
raising additional amount of debt pledging the same assets
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Example
Company XYZs debt is trading in the market. A covenant in its bond indenture states that further borrowing above $100 million is restricted. This is:
A. An Affirmative Covenant B. A Negative Covenant C. A Positive Covenant
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Basic Features Of A Bond
Basic Features of a Bond: Can be issued in the domestic or foreign currency Make annual or semi-annual payment of interest Bonds that do not pay interest during their tenure are called Zero-coupon bonds Step-up notes are bonds for which the coupon rate increases one or more times during their tenure Deferred-coupon bonds are bonds for which the initial coupon payments are deferred for a certain period Floating-rate securities bonds whose coupon is linked to some benchmark reference rate like the This files has at 30-Jun-13 LIBOR rate. (Varities: Inverse Floaters andexpired Inflation-indexed bonds)
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Optionality: A bond may contain an embedded option; that is, it grants option like features to the buyer or issuer:
Callable BondSome bonds give the issuer the right to repay the bond before the maturity date on the call dates. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds.
Putable BondSome bonds give the bond holder the right to force the issuer to repay the bond before the maturity date on the put dates This files has expired at 30-Jun-13
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Basic Features of a Bond:
Floating-rate securities bonds whose coupon is linked to some benchmark reference rate like the LIBOR rate. (Varities: Inverse Floaters and Inflation-indexed bonds) Cap is the maximum interest that will be paid by the borrower Floor is the minimum interest that will be received by the lender Combination of both is called a Collar
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Questions
1. The price per $1 of a par value bond is $1.2538 when the par value is $10,000. The quoted price and the dollar price is closest to:
Quoted Price A B C 125 3/8 122 1/8 125 1/2 Dollar Price $12,538 $11,438 $14,620
This files has expired at 30-Jun-13 2. If the interest rate falls, the reinvestment income from a Zero-coupon bond will: A. Increase B. Decrease C. Unaffected
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Answers
1. A. Dollar Price = 1.2538 * 10,000 = 12,538 Quoted Price = 12,538/1,000 = 125 3/8 2. C. Unaffected
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Definitions
Accrued interest: Interest accrued on a bond from the last coupon date and the date of sale of the bond Full Price/Dirty Price: Total amount paid by the buyer to the seller for the bond Clean price: Full price less the accrued interest Dirty Price = Clean Price + Accrued Interest
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Questions
1. A person pays $1,050 for a bond. The accrued interest till the date of purchase was $36. The clean price of the bond is:
A. $1,050 B. $1,086 C. $1,014
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Answers
C. $1,014
1.
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Redemption And Retirement Of Bonds
Non amortizing securities pay only interest during the tenure of the bond and the entire principal is repaid on the maturity of the bond
Amortizing securities repay both the the interest and the pricipal amount over the tenure of the bond
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Redemption and Retirement of Bonds
Prepayment option allows the borrower to repay the principal before the due date Call option on a bond is similar to a prepayment option and allows the borrower to call repay the entire or part of the bond outstanding Nonrefundable bonds prohibit the issuer from redeeming a bond by issuing fresh bonds at a lower coupon rate
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Redemption And Retirement Of Bonds
Sinking Fund Provision require the issuer to repay the principal amount over the life of the bond through regular payments.
Accelerated Sinkind Fund Provision allows the Issuer to repay an amount more than that stipulated by the Sinking Fund provisions
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Embedded Options
Options favourable to the Issuer:

Call Provisions: grant the Issuer the right to redeem the bond before the maturity date at a fixed price. Cap: sets the maximum amount of interest that will be paid to the bondholder for a floating rate bond. Prepayment option: allows the Issuer to prepay amount before maturity. Accelerated Sinkind Fund Provision: allowsexpired the Issuer to at reapy an amount more than that stipulated by This files has 30-Jun-13 the Sinking Fund provisions.
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Embedded Options
Options favourable to the Bondholder:

Put Provisions: grant the bondholder the right to demand repayment of the amount before the maturity date at a fixed price. Floor: sets the minimum amount of interest that will be paid to the bondholder for a floating rate bond. Conversion Option: grants the bondholder to convert the bond into a fixed number of shares of the issuer. This files has expired at 30-Jun-13
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Questions
1. Assuming a common issuer and maturity, which of the following bonds will most likely have the lowest yield? A. A plain vanilla bond B. A bond with an embedded call option C. A bond with an embedded put option
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Solutions
B
An embedded call option is favorable to the bond issuer. Further, its price cannot appreciate much in a falling interest rate scenario since the bond since the issuer would chose to exercise its call option. Hence, to compensate, it would trade at a higher yield than the other options.
1.
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Questions
1. Which of the following is true about a bond with a deferred call provision?: A. It could be called at any time after the deferment period B. Principal repayment can be deferred until it reaches maturity C. It could not be called right after the date of issue
2. Which of the following is right: A. A put provision will benefit the buyer in times of rising interest rates B. A put provision will benefit the buyer in times of falling interest rates C. A put provision will benefit seller in times rising interest rates Thisthe files has of expired at 30-Jun-13
3. An mortgage security: A. Repays only the principal amount during the tenure of the security B. Repays the principal and the interest amount during the tenure of the security C. Cannot be retired earlier than the period of the security
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Answers
1. A. A deferred call provision means the issue is initially (say, for the first 5 to 7 years) non-callable, after
which time it becomes freely callable. In other words, there is a deferment period during which time the bond
cannot be called, but after that, it becomes freely callable. A. A put provision will benefit the buyer in times of rising interest rates.
2.
3. B. Repays the principal and the interest amount during the tenure of the security
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Agenda
Features of Debt Securities Risks Associated with Investing in Bonds Overview of Bond Sectors and Instruments Understanding Yield Spreads
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Risks Associated with Investing in Bonds
Interest Rate risk: refers to the effect of change in the market interest rates on the price of the bond. The overall interest rates will change from the levels extant when the security is sold, causing an opportunity cost
Yield Curve risk: results from the change in the yield curve and its impact on the bond fall
Call Risk: is the risk that the Issuer will exercise the call option on a callable bond if the interest rates
Prepayment risk: is the risk to prepayment of the principal amount before its due date
Reinvestment risk: is the risk that the cash flows from the securities will be reinvested at a lower rate
Credit risk: is the risk that the borrower will default on the installment payments
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Currency risk that exchange rates with other currencies will change during the security's term, causing loss of buying power in other countries
Default risk that the issuer will be unable to pay the scheduled interest payments due to financial hardship
Repayment of principal risk that the issuer will be unable to repay the principal due to financial hardship
Soveriegn risk: refers to the risk arising out of change in government policies
Volatility risk: refers to the change in value of securities which have embeded options as a result of interest rate volitality
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Inflation risk: It refers to the risk of errosion of the purchasing power of the returns from the security as a a result of unexpected rise in inflation, that the buying power of the principal will decline during the term of the security .
Liquidity risk: The risk that the security will sell for a amount lower than its fair value due to lack of liquidity. The buyer will require the principal funds for another purpose on short notice, prior to the expiration of the security, and be unable to exchange the security for cash in the required time period without loss of fair value
Exchange rate risk: Is the uncertainity regarding movement in the exchange rates and the consequent impact on the rerurns from the securities
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Discount, Premiuim, At Par
Imp
If the coupon rate of the security is equal to the market yield then the bond will sell at par Coupon Rate = Market Yield --- Price = Par Value
If the coupon rate of the security is more than the market yield then the bond will sell at premium Coupon Rate>Market Yield - Price> Par Value
If the coupon rate of the security is less than the market yield then the bond will sell at discount Coupon Rate<Market Yield - Price<Par Value
If Interest Rates Increase -- Price of a Bond Decreases If Interest Rates Decrease -- Price of a Bond Increases
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Maturity, Coupon, Options, Yield Affect Interest Rate Imp Risk

Duration or Interest Rate Risk
Higher Lower Lower Lower
Variable
Maturity in Longer Coupon Rate is Higher Embedded Call Option Embedded Put Option
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Present Value Of The Cash Flow
Present value of an annuity An annuity is a series of equal payments or receipts that occur at evenly spaced intervals The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. In example Assume the Interest Rate is 5% so the Discounted cash flow is as follows:
FV This files has expired at 30-Jun-13 PV (1 r )t
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Callable Bonds
Bonds which have an embedded call option give the Issuer the right to call the bond before its maturity
Duration is a good measure when the changes in yield are small
However if the yield changes are high then we use the measure of convexity
Convexity is a measure of the curvature of the price/yield relationship
Value of a callable bond = Value of a option-free bond Value of embedded option
As the yield falls, the price of the bond increases
But this increase in the price of a bond is capped in the case of a callable bond at the call price
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Duration And Dollar Duration
Duration of a Bond:
It is the sensitivity of the price of the bond in response to a change in the interest rates/yield Duration = - (Percentage change in bond price/Percentage change in Yield) negative sign is used because of the inverse relation between yield and bond prices Thus, increase in the yield results in a fall in the bond price
Dollar Duration
The approximate dollar price change for a 100bps change in yield.
Given by:
Price if Yield Decline - Price if Yield Rise 2 (Inintial Price) (Change in Yield in decimal)
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Interest Rate Risk Of A Floating Rate Security
Floating rate security: It is one whose coupon rate is reset at each coupon date so that it matched the current market yield. It is typically a reference rate(say, LIBOR) + additional margin
This implies that a floating rate security will always sell at par
However, it is possible for a floating rate security to quote below or above par if there is a change in the market yield in between the reset dates
Example: If a floating rate security which pays interest every six months, is reset in the month of April and the interest rates fall, it will trade at a premium till the next reset date in October
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Yield Curve Risk
Yield Curve: Shows the relationship between Yield and Maturity
Yield curve risk refers to the change in the Yield curve
The risk of experiencing an adverse shift in market interest rates associated with investing in a fixed income instrument.
The risk is associated with either a flattening or steepening of the yield curve, which is a result of changing yields among comparable bonds with different maturities With reference to a Portflolio of bonds: a non parallel shift in the yield curve will result in varying impact on short maturity and long maturity bonds, makes duration a poor measure for Portfolio of bonds
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Reinvestment Risk
Reinvestment Risk lower rate than the security that generated the proceeds.
Reinvestment risk: Interest and Principal payments that are available to be reinvested will be done so at a
A security which is amortising, with higher coupon; a call feature; a prepayment option; will have a higher reinvestment risk
Prepayable securities have a higher reinvestment risk because a reduction in the interest rates results in an
This files expired at 30-Jun-13 increase in prepayments which will have tohas be reinvested at the lower rate
Zero-Coupon bonds eliminate reinvestment risk.
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Credit Risk
A security issued by the U.S. government is considered risk free as it has no credit risk
Default risk premium:

The spread over a risk free asset of similar maturity for bearing the credit risk of the security.
Credit spread risk:

The increase in this default risk premium
Downgrade risk: The risk that a bonds rating maybe downgraded by the credit rating agency which results in an increase the return demanded by the investors for bearing the increased credit risk
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Liquidity Risk
Indicated value: last traded price
Liquidity Risk: The risk that the investor will have to sell a bond below its indicated value.
The primary risk measure The bid/ask spread
The wider the bid-ask spread, the lower the liquidity, the greater the liquidity risk.
Retail Investors
This files has expired 30-Jun-13 For investors who plan to hold the security until maturity, notat need to mark to market and liquidity risk is not a major concern.
Institutional Investors
Need to mark to market, even if they plan to hold until maturity. This is needed to calculate Net Asset Value (NAV)
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Exchange Rate Risk

The risk of receiving less of the domestic currency when investing in a bond that makes payments in a currency other that the managers domestic currency is called exchange rate risk or currency risk.
Exchange Rate Risk:
When you invest in a bond whose payments are not in your domestic currency, the cash flows you receive depend on the exchange rate at the time of the cash inflows.
If the foreign currency depreciates relative to the domestic currency, you receive less units of the domestic currency upon exchange. This files has expired at 30-Jun-13
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Inflation Risk
Inflation risk: refers to the risk of errosion of the purchasing power of the returns from the security as a result of unexpected rise in inflation 3%. That means your purchasing power only increased by (8%-3% = 5%)..
Example: Last year, you purchased a 1 year zero coupon bond with a 8% interest rate and the inflation was
Inflation protection bonds eliminate inflation risk.
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Yield Volatility
Price of a Callable Bond = Price of Option Free Bond Price of Embedded Option
Price of a Putable Bond = Price of Option Free Bond + Price of Embedded Option
Type of Embedded Option

Callable Bonds Putable Bonds
Volatility Risk Due to

An increase in expected yield volatility A decrease in expected yield volatility
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Questions
1. Ted works for a fixed income fund; he wants to buy a bond for his portfolio. Which of the following bonds will have the least sensitivity to interest rate risks A. A 10% coupon bond with a maturity of 15 years B. A zero-coupon bond with a maturity of 20 years C. A 8% coupon bond with a maturity of 15 years
2. A company has to make a balloon loan payment of $5,000,000 in 3 years. Which of the following options is best for the company to make repayment and to minimize reinvestment risk. All bonds are non-callable and are otherwise similar except as noted with face values of $5,000,000. Market rates are at 5.0%. This files has expired at 30-Jun-13 A. 4-year, zero coupon bond priced to yield 5.5% B. 2-year, zero-coupon bond priced to yield 9.0%. C. 3-year, zero coupon bond priced to yield 5.0%.
3. Which of the following has the highest interest rate risk?: A. Zero coupon bond B. Floating rate bond C. Fixed coupon bond
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Questions (Cont...)
A. Higher than the value of an option-free bond. B. Lower than the value of an option-free bond. C. More or less equal to the value of an option-free bond
4. The value of a putable bond will be:
5. On the reset date, the value of a floating rate security will be:
A. Trading at a premium. B. Trading at a discount. C. Trading at par This
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6. Which of the following is least correct?:

A. A Treasury security has no credit risk. B. A floating rate bond protects against inflation risk. C. A AAA bond has no credit risk.
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Solutions
1. A. The longer the maturity the higher the interest rate sensitivity. Lower coupon rates also increase the sensitivity of bond prices to changes in interest rates. A ZCB has the highest sensitivity to interest rate changes 2. C. Since all the choices are non-callable, the treasurer will prefer a zero-coupon to a coupon bond. While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannot eliminate reinvestment risk. One exception is zero-coupon bonds, since these bonds deliver payments in one lump sum at maturity. Although the 3-year coupon bond fulfills the treasurers requirement concerning funds for repayment, it does not minimize reinvestment risk. Among the zero-coupon bonds, the one that best matches the loans maturity will minimize This files has expired 30-Jun-13 reinvestment risk. The treasurer will thus prefer the 3-year,at zero-coupon bond. If he purchased the 4year zero-coupon bond, he would have to sell the bond prior to maturity to payoff the loan and would face price risk. The 2-year zero-coupon bond is attractive because of the higher yield. However, the bond matures one year before the loan is due and would expose the firm to reinvestment risk. 3. A. Zero coupon bond 4. A. Higher than the value of an option-free bond 5. C. Trading at par 6. C. A AAA bond has no credit risk
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Agenda
Features of Debt Securities Risks Associated with Investing in Bonds Overview of Bond Sectors and Instruments Understanding Yield Spreads
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Key Issues In Overview Of Bond Sectors And Instruments
Characteristics of Government Securities
Types of Securities
Stripped Treasury Securities
Securities issued by US Federal Agencies
Mortgage-backed securities
Collateralized Mortgage Obligation This files has expired at 30-Jun-13
Securities issued by Municipalities in US
Securities issued by Corporations
Asset-Backed Security
Collateralized debt Obligation
Issuing bonds in the Primary market
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Characteristics Of Government Securities

Government securities are considered to be free of default risk. It is also known as sovereign debt. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. However for a person in the US, the sovereign debt of another company will have credit risk.
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Types Of Government Securities
Types of Securities
Treasury Securities:
Treasury Bills: Maturity of less than one year and do not make interest payment. Issued at discount to par. Treasury Notes: Pay semiannual interest rates. Maturities of 2, 3, 5, 10 years. Treasury Bonds: Pay semiannual interest rates. Maturities of 20, 30 years. Treasurt Inflation Protected semiannual interest rates. Maturities of 5, 10, 20 years. This Securities( files TIPS): has Pay expired at 30-Jun-13 The par value is adjusted semi annually to account for the change in inflation.
On-the-run Treasury Securities: Most recent auctioned securities.
Off-the-run Treasury Securities: Older issued securities
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Stripped Treasury Securities
Separate Trading of Registered Interest and Principal Securities(STRIPS): Introduced by Treasury in 1985
As the Treasury did not issue and zero-coupon bonds, bankers separated the coupons due on normal securities and sold the coupons and the principal amount as zero-coupon bonds
Coupon STRIPS: STRIPS created from coupon payments
Coupon STRIPS: Acrrued Interest is Taxed every year even though interest is not paid until maturity. Thus, they have negative cash flows until maturity.
Principal STRIPS: STRIPS created from the Principal

For some foreign players, the interest gained on Principal STRIPS are taxed as capital gains tax. They are preferred by those foreign entities.
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Types Of U.S. Federal Agencies Securities

Securities Issued by US Federal Agencies Debt securities issued by various US Federal Agencies are called Agency Bonds. These can be:
Federally related institutions
Export-Import Bank of the United States Goverment National Mortgage Association (Ginnie Mae)
Government sponsered enterprises(GSEs)

Federal National Mortgage Association (Fannie Mae)
Federal Home Loan Mortgage Corportion (Freddie Mac) These two institutions issued CMOs.
Debentures are unsecured securities. Generally issued by GSEs
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Mortgage-backed Securities
MBS is a security which is backed by a pool of loans. These pool of loans act as a collateral for these securities and also provide the regular cash flows to service these securities.
Cash Flows from a mortgage:

Interest payment Scheduled principal repayment Excess Principal repayment
As there is no restriction on the repayment of the principal amount, investors face a high Prepayment risk.
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Mortgage Loans
It is a loan secured by the collateral of some specified real estate. Default -Foreclosure Each payment includes both interest and principal -> Ammortized Prepayment has no penalty and can be: For the entire principal outstanding
This files Partial Amount called Curtailment
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Mortgage Pass-through Security:

Homeowners' payments pass from the original bank through a government agency (like Ginnie Mae, Fannie Mac, Freddie Mac) or investment bank to investors of the securities in proportion of their holding. That is why the name, Pass-through. Prepayments are more predictable based on historical prepayment experience.
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Stripped MBS:
These STRIPS are either Interest-only(IO) of Principal-only(PO) STRIPS. The holder of a IO loses out on interest as a result of prepayment of the principal. The PO gains as a result of prepayment.
Collateralized Mortgage Obligations (CMO)

Created to distribute prepayment risk among different classes of bonds.
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Collateralized Mortgage Obligation
This is complex version of a Mortgage Passthrough security. The payments are not disbursed in the proportion of the holding. Tranches are created out of the passthrough security. These Tranches have varying properties. For ex: A CMO with Tranche I, II and III maybe structured such that Tranche I is repaid first followed by Tranche II and Tranche II.
The reason for creating a CMO is:

To redistribute the prepayment risk. In the above example: Tranche III bears most of the credit risk and Tranche I bears most of the prepayment risk. To create securities with varying maturities. Trance II will have the longest maturity in the above example.
Investors invest in a particular Tranche as per their requirements depending on the risks they are willing to take on of the risk they want to avoid.
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Securities Issued By Corporations
Structured Notes: These are basically debt securities that also contains an embedded derivative component. One example is Equity Linked Notes (ELNs) wherein the return on the debt instrument is linked to the return on the equity.
Commercial Paper: is a short-term, unsecured debt instrument used by corporate to raise funds. Maturities range from 2 days to 270 days.
Directly-placed paper is sold directly to the investors (large investors). Dealer-placed paper is sold to investors through a commercial-paper dealer.
Certificate of Deposit: is issued by banks to raise money from the public. Negotiable CDs can be bought and sold in the secondary market.
Bankers Acceptance: is a bank gaurantee that a loan will be repaid. This is used primarily to facilitate foreign trade.
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Asset-Backed Security
Asset-backed security: It is a security whose value and income payments are backed by a specified pool of underlying assets. These can be auto loans, corporate receivables, etc. Purpose Vehicle(SPV). This ensures that the SPV becomes a bankruptcy remote entity and the securities receive a higher rating resulting in lower borrowing costs
In order to enhance the rating of these securities, the financial assets are transferred to a Special
Apart from the above, the SPV may go for some external credit enhancements to improve the ratings it receives:
Corporate Guarantee Letters of Credit Bond Insurance
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Collateralized Debt Obligations (CDOs)
Collateralized Debt Obligation(CDO): It is a type of structured asset-backed security (ABS) whose value and payments is derived from a underlying pool of debt securities.
The pool can consist of one or more of the following:

US Domestic Investment grade and high yield corporate bonds (CBO) US Domestic Bank Loans (CLO) Emerging market bonds (CBO)
Special Situation loans and distressed debt Foreign bank loans (CLO) Asset backed securities Residential and commercial MBSs other CDOs
The CDO is structure into Tranches, each with its own rating.
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Primary And Secondary Bond Markets
Primary market
The deal is underwritten by investment bankers. This can be by way of:

Firm Commitment (or) Best Efforts basis
In private placements, the issuer must furnish a private placement memorandum. This is similar to a prospectus except it does not contains non-material information and not subject to SEC review.
Secondary market
Fair values are determined
Liquidity
Can be traded
Over the Counter Over Exchanges
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Questions
1. An investor wants to invest in a security with the least prepayment risk. From the following list of securities he is least likely to invest in
A. Mortgage loans B. Mortgage pass throughs C. CMOs A. Improve the credit ratings of the issue. B. Creates a bankruptcy remote entity. C. Reduce the risk associated the securities. This with files has expired
2. Transferring the assets to a Special Purpose Vehicle helps do all of the following except:
at 30-Jun-13
3. A bond has more reinvestment risk when?

A. It is bullet payment bond B. It has an embedded put option C. It has higher coupon rate than currently available market interest rate A. Treasury Bill B. Treasury Bond C. Treasury Note
4. A Treasury Security with a 10 year maturity is called a:
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Questions(Cont...)
5. Which of the following bonds has the highest risk: A. Unlimited tax general obligation bonds B. Prefunded Bonds C. Revenue Bonds
6. Which of the following is not an reason for creating a CMO: A. To reduce the total risk B. To redistribute the prepayment risk C. To create securities with varying maturities This files has expired at
30-Jun-13
7. Which of the following bonds is not an external credit enhancement for a SPV :
A. Letters of Credit B. Over Collateralization C. Bond Insurance
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Solutions
1. A. Mortgage pass throughs have lower prepayment risks as compared to individual mortgages as the prepayment risk is spread over the entire portfolio of loans pooled in the pass through. CMOs or Collateralized Mortgage Obligations are a type of mortgage pass throughs.
2. C. By converting the assets to liquid cash the originating agency can improve its liquidity ratios. The liquid cash can then be reused in the business. By improving its capital adequacy ratio it can improve its credit ratings. Also a SPE can be structured in such a manner that it is bankruptcy remote. However the risk associated the securities is not removed. This with files has expired at 30-Jun-13 Higher the coupon rate, greater the reinvestment risk.
3. C. The correct answer is It has higher coupon rate than currently available market interest rate.
4. C. Treasury Note
5. C. Revenue Bonds
6. A. To reduce the total risk
7. B. Over Collateralization
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Extra-Quiz Questions
1. A floating rate issue has the following provision in which the coupon rate is calculated as 6-month LIBOR 80 basis points. The issue has a floor at 5.5%. If the 6-month LIBOR on the reset date is 5.8%, the coupon rate is closest to
A. 4.5% B. 5.5% C. 5.0%
2. A $100 par value bond has duration of 12.7 If the price rises to 104.57 when the yield declines by 50 basis points, the price when the yield drops by 50 basis points is closest to
A. 95.7 B. 91.8 C. 92.5
3. Carl and Karen are CFA Level I candidates. Carl says that a zero coupon bond has higher interest rate risk than a coupon bond of the same maturity. While Karen says that a callable bond has higher volatility risk than an option-free bond. Which of the two statements are most likely correct
Carl A B C No Yes Yes Karen Yes No Yes
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4. For a 100 basis points downward shift in the yield curve which of the following bonds will have the lowest percentage price change
A. An option-free bond B. A callable bond C. A putable bond
106% 104% 102% 100%
5. A $ 10mn par value bond can be redeemed at the following prices 2001- 2003 Suppose the investor decides to redeem the $10 mn 2003-2005 bond on 31st December 2005. 2005-2007 2007 onwards This hasto expired at 30-Jun-13 The price that the investor will files get is closest
A. $10.4 mn B. $12mn C. $16mn
6. Value of a 15-year, 8.5% annual coupon bond callable in five years is at 94.4 (prices are stated as a percentage of par). A straight bond that is similar in all other aspects as the callable bond is priced at 100.0. Which of the following is closest to the value of the call option?
A. 2.8 B. 4.4 C. 5.6
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7. Carl an analyst with a fixed income hedge fund states that investments in high yield securities from emerging economies carries a number of risk factors. Which of the following is least likely to be listed as a risk when investing in high yield securities from emerging markets
A. Sovereign risk B. Exchange rate risk C. Downgrade risk
8. What is least likely to be accurate regarding Interest rate risk?

A. It is a risk of having This to reinvest at rateshas that are lower than what investor is currently receiving files expired at an 30-Jun-13 B. Interest rate risk is commonly measured by the bond's duration C. Can be reduced by buying bonds with longer duration
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Solutions
Coupon rate = ref rate + quoted margin = 5.8% - 80 basis points = 5.0%. Since the floater has a floor at 5.5%. The coupon is set to 5.5% on the reset date.
1. B.
2. B.
Duration = Price if yield declines price if yield rises 2 * (initial price) * (change in yield in decimals) Price if yield declines = 104.57 12.7*2*100*0.005 = 91.8 Callable options have lower volatility thanexpired option-free bond of the embedded call option in This filesrisk has at because 30-Jun-13 the bond. Zero-coupon bonds have a higher interest rate risk and their prices can change significantly if the yields change. The value of a callable bond does not rise as much as a comparable option-free bond. Price of a putable bond = price of an option-free bond + price of the embedded put. So when the yield curve is shifted downwards the price of a putable bond will change more than a comparable option-free bond. The redemption price is calculated as $10mn * 104% = %10.4 mn.
3. B.
4. B.
5. A.
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Solutions
The bond rated as B+ has low credit worth and hence is highly speculative. Since the objectives of the fund allow them to invest in only investment grade securities. Sally cannot invest in the 16% 10-year coupon bond. A high yield bond has generally a low-credit and is of speculative nature. Investments in foreign currency bonds carry exchange rate risks. The bonds also have sovereign risk due to the risk of actions of the foreign government in case of default. Interest rate risk can be reduced by buying bonds with a longer duration.
6. C.
7. C.
8. B
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Five Minute Recap

Variable Maturity in Longer Coupon Rate is Higher Embedded Call Option Embedded Put Option Duration or Interest Rate Risk Higher Lower Lower Lower Special Purpose Vehicle(SPV). Used to enhance the rating of ABS SPV becomes a bankruptcy remote entity Dirty Price = Clean Price + Accrued Interest
isks associated with vesting in Bonds: Interest Rate risk Yield Curve risk Call Risk Prepayment risk Reinvestment risk Credit risk Currency risk Default risk Repayment of principal risk Soveriegn risk Volatility risk Inflation risk Liquidity risk Exchange rate risk
The following features of a security is subject to higher Reinvestment Risk: Amortising Higher coupon This files has expired Call feature Prepayment option
After Tax Yield Taxable Yield * 1 Marginal tax rate
at 30-Jun-13
Expanding economy, credit spreads become narrow Contracting economy, credit spreads widen.
terest rate tools used to mplement the Feds monetary olicy: Discount rate Open Market Operations Bank Reserve requirements Pursuation
Agency Bonds are issued by various US Federal Agencies Federally related institutions Export-Import Bank of the United States Goverment National Mortgage Association (Ginnie Mae) Government sponsered enterprises(GSEs) Federal National Mortgage Association (Fannie Mae) Federal Home Loan Mortgage Corportion (Freddie Mac)
Price of a Callable Bond = Price of Option Free Bond Price of Embedded Option Price of a Putable Bond = Price of Option Free Bond + Price of Embedded Option
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Fixed Income-I

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Fixed Income Securities I

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Fixed Income (Introduction)

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Basic Structure Of A Plain Vanilla Bond

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Key Issues In Introduction To The Valuation Of Debt Securities

Bond Valuation Process

Problems encountered in Valuation

Computing the value of a bond

Change in value with passage of time

Value of a zero-coupon bond

Arbitrage-free valuation approach This files has expired at 30-Jun-13

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Neev Knowledge Management Pristine

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Bond Valuation Process

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Bond Valuation Process

Formula for finding value of a bond:

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Example: Bond Prices

Time T=1 T=2 T=3 T=4 T=5 Total Comment

Cash flow 100 100 100 100 1100

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Bond trading at a Discount

Bond trading at Par

Bond trading at a Premium

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Future Value Of An Ordinary Annuity:

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Bonds Where Estimating Cash Flow Is Difficult

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Computing The Value Of A Bond

Value of a bond is the present value of its cash flows

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Note:Give attention to the sign of the cash flows

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Computing The Value Of A Zero Coupon Bond

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How Discount Rates And Maturity Date Affect Price

As a result, the price yield curve is a downward sloping curve

Changes in Value with Passage of Time:

Whether the bond is trading at a premium or at a discount,

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as a bond approaches maturity, its value converges to the par value.

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Bond Valuation: Pull To Par Concept

$140 $130 $120 $110 $100 $90 $80 $70 $60

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Price pulled to par as bond nears maturity maturity

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Bond-Premium 5% 10 10% 100 Coupon Tenure YTM Face Value

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