FixIncomeOverview

FixIncomeOverview - Overview
of
Fixed
Income
 Markets
 Importance
of
Markets
 • 

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Unformatted text preview: Overview
of
Fixed
Income
 Markets
 Importance
of
Markets
 •  Market
structure
is
important
to
risk
managers
 mainly
through
its
impact
on
liquidity.
 •  A
successful
market
brings
together
many
 buyers
and
sellers,
reduces
transacBons
costs.
 •  Market
structure
can
impact
risk:

 –  OTC
trades
have
greater
credit
risk
but
lower
basis
 risk.
 2
 Liquidity
 •  Liquidity
is
the
ability
to
transact
quickly
without
affecBng
 prices.
 •  Liquidity
is
enhanced
when:

 –  contracts
are
homogeneous
 –  markets
are
effecBvely
linked
together
 –  posiBons
are
small
 •  Liquidity
is
a
potenBal
problem
when:

 –  products
are
diverse
 –  markets
are
fragmented
 –  posiBons
are
large
 3
 Financial
Exchanges
vs.
OTC
Markets
 •  Financial
Exchanges:
 –  right
to
trade
limited
to
members
 –  detailed
and
explicit
rules
regarding
conduct
of
trade
 –  contracts
are
standardized
 –  exchanges
provide
price
informaBon,
facilitate
trade
 seLlement
 •  OTC:
Any
non‐exchange
trade
is
called
OTC
(Over‐the‐counter)
 –  Buyer
and
seller
can
negoBate
trade
details
 –  
Investors
do
not
have
protecBon
of
exchange
rules
and

 procedures.
 4
 Services
Offered
by
Exchanges
vs.
OTC
 Equivalents
 1.  SeTng
standards
for
traded
financial
products.
(OTC
markets
 oVen
use
ISDA
master
agreements
as
templates).
 2.  Providing
price
informaBon.
(On
OTC
markets,
must
get
price
 quotes
from
different
dealers).
 3.  ProtecBng
against
counterparty
risk.
(Clearinghouse
is
 counterparty
for
all
transacBons).
(OTC
markets
reduce
 counterparty
risk
by
restricBng
parBcipaBon
to
high
credit
 quality
investors,
e.g.
AA
or
above).
 4.  Matching
buyers
and
sellers
(electronic
on
all
exchanges
 except
NYSE).
(OTC
markets
compete
with
independent
 Electronic
Crossing
Networks,
which
neither
set
prices
nor
 carry
inventory,

to
match
buyers
and
sellers).
 5
 OTC
vs.
Exchange
Markets
 •  Tradeoff:
Increased
liquidity
offered
by
 standardized
contracts
on
exchanges.
Basis
 risk
is
also
increased.
 •  Basis
risk
is
the
mismatch
between
the
hedge
 and
the
posiBon
being
hedged.
 6
 OTC
Markets:
TradiBonal
 Structure
 •  Dealers
quote
bid
and
ask
prices
to
prospecBve
 buyers
and
sellers.
 •  Normal market size
is
the
maximum
size
of
 transacBon
at
which
a
dealer
is
prepared
to
 transact
at
the
stated
bid/ask
prices.
 •  Dealers
make
profit
from
order
flow,
both
 through
bid‐ask
spread
and
from
anBcipaBng
 short‐term
price
moves
based
on
their
 privileged
access
to
orders.
 •  Dealers
also
bear
risk
from
holding
inventory,
 and
from
the
possibility
of
being
"picked
off"
 by
investors
with
superior
informaBon.
 •  Major
OTC
markets
include
those
for
debt,
 FOREX,
some
derivaBves,
and
the
NASDAQ.

 7
 Measures
of
Liquidity
in
a
Dealer
Market
 Stock Market Cap $mill. 1 NMS Bid $thous. 200.0 1 9.43 2.50 Ask Spread % 0.21 33% A - liquid 10,000 Billiquid 9.45 3.50 Bid
is
the
amount
the
dealer
is
willing
to
pay
for
the
stock.
 Ask
is
the
price
for
which
the
dealer
will
sell
the
stock.
 Normal Market Size is
the
transacBon
size
for
these
prices. 8
 Funding
and
Liquidity
 •  Many
derivaBve
securiBes
(e.g.
swaps,
forwards)
 require
no
exchange
of
principal
and
therefore
no
 (or
liLle)
money
upfront
(nothing
beyond
an
 iniBal
margin).
 •  Taking
an
equivalent
posiBon
in
a
cash
market
 would
require
a
large
amount
of
funding.

 •  This
tends
to
push
trading
acBvity
and
price
 formaBon
onto
derivaBves
markets.

 9
 Financial
Markets
 •  Commonly
divided
into
the
following
two
 components.
 •  Money
Markets:
Maturity
<
1
year.
 •  Capital
Markets
 –  Equity
Market
 –  Debt
Market
(Fixed
Income
Instruments)
 –  DerivaBve
SecuriBes
 Bonds
 •  A
bond
is
a
financial
claim
by
which
the
issuer
 (borrower)
is
commiLed
to
paying
back
to
the
 bondholder
(lender)
the
cash
amount
 borrowed
(principal)
plus
periodic
interest
 calculated
on
that
amount
over
a
period
of
 Bme.
 11
 Basic
Terminology
 •  •  •  •  •  •  •  •  Term:
period
of
Bme
over
which
borrowing
occurs.
End
of
the
term
is
called
 the
maturity
date.
 Principal:
Amount
repaid
on
maturity
date.
Principal=Face
Value=Par
Value
 Interest
Rate:
Amount
borrower
pays
the
lender
for
the
use
of
the
money,
 usually
expressed
as
an
annual
percentage.
 Yield:
effecBve
interest
rate
of
the
bond
 Issuer:
government,
local
government,
corporaBons,
supranaBonal
 organizaBon
 Marketability:
Whether
or
not
ownership
can
be
transferred.
 Security:
Collateral
that
can
be
seized
in
the
event
of
failure
to
pay.
 Call
or
Put
Features:
Provisions
that
allow
the
borrower
to
repay
(call)
or
the
 lender
to
demand
payment
(put)
before
maturity.
 12
 Some
types
of
bonds
 Bullet
bonds:
pay
regular
interest
at
fixed
rate
 Zero
coupon
bonds:
don’t
pay
regular
interest
 FloaBng‐Rate
notes:
interest
rate
linked
to
an
external
reference
 Index‐Linked
bonds:
coupon
payments
(and
possibly
principal
 repayment)
linked
to
an
external
reference
as
inflaBon,
prices…
 •  SecuriBzed
bonds

 •  Bonds
with
embedded
opBons
 •  •  •  •  13
 Example
of
a
Bond
and
its
Associated
Cash
 Flows
 •  Consider
an
Eurobond
of
face
value
1
million
USD
with
 maturity
in
5
years
paying
4%
at
the
end
of
each
year,
its
cash
 flow
is:
 Cash flow (mill. us $) Issuer receives bond price ($1m if issued at par) Time (years) 0 $40000 (each year) Holder receives 1m 3 4 5 (maturity time) 1 2 Bond
CharacterisBcs
 Issuer's
name,
type,
country
of
origin.
 Bond
market,
denominaBon.
 Collateral
(bonds
vs.
debentures).
 Coupon
rate,
type,
frequency.
 Yield,
Price
(issuance
or
aVer),
RaBng
 (Moody's,
S&P).

 •  Price
quoBng
method
(clean
vs.
dirty).
 •  Announcement
date,
interest
accrual
 date,
seLlement
date.
 •  •  •  •  •  15
 Risks
Associated
with
Bonds
 •  •  •  •  •  •  Credit
Risk
 Liquidity
Risk
 Currency
Risk
 Reinvestment
Risk
 Call
Risk
 PoliBcal/Legal
Risk
 16
 Markets
 •  Money
Market:
short‐term
borrowing
and
 lending
(maturiBes
≤
1
year).
 •  Capital
Market:
Maturity
>
1
year.
 •  Primary
Market:
IniBal
issue
of
the
bond
(for
 corporates,
typically
by
an
investment
bank
 underwriBng
the
issue
for
the
borrower).
 •  Secondary
Market:
Trading
aVer
iniBal
issue.
 17
 Money
Market
Instruments
 Deposits
 •  DemandDeposits:
No
prior
noBce
need
be
 given
before
funds
are
withdrawn.
Very
low
 interest.
 •  NoBce
Deposit:
NoBficaBon
must
be
given
 before
funds
are
withdrawn
(this
provision
 rarely
enforced).
Very
low
floaBng
rate
 interest.
 •  Fixed‐Term
Deposits:
Fixed
or
floaBng.
 19
 Credit
FaciliBes
 •  Credit
lines
made
available
to
corporate
clients,
methods
of
 borrowing
tailored
to
suit
client
needs.

 •  Amount
borrowed
is
flexible
(below
some
preset
limit),
but
 corporaBon
pays
a
small
commitment
fee
on
unused
porBon
 of
funds.
 •  Other
methods
of
short
term
corporate
borrowing:

 –  –  –  –  20
 one‐off
loans
 syndicated
loans
 commercial
paper
(marketable)
 bankers'
acceptances
(marketable)
 Repo
Markets
 •  "Repo"
is
short
for
a
sale
and
repurchase
agreement.

 •  It
is
a
useful
way
of
removing
credit
risk
from
short
term
 funding.

 •  One
party
sells
a
security
(e.g.
a
gov't
bond)
to
another
 party,
with
an
agreement
to
buy
it
back
in
the
near
future
 at
a
slightly
higher
price.

 •  The
deal
has
liLle
credit
risk
because
if
there
is
a
default,
 the
lender
simply
keeps
the
securiBes.

 •  Because
of
the
eliminaBon
of
credit
risk,
the
interest
rate
 charged
is
close
to
the
risk
free
rate.
 21
 Repo
Markets:
Terminology
 •  If
you
borrow
$100,
and
pledge
securiBes
with
a
 current
market
price
of
$110,
your
"haircut"
is
10%.
 •  The
opposite
side
of
a
Repo
contract
is
called
a
reverse repo. In
this
case,
you
buy
a
parBcular
security,
and
sell
 it
back
in
the
very
near
future
for
a
higher
price.
 •  Overnight
repo:
term
of
one
day
 •  Term
repo:
Term
>
1
day.
 22
 Example
 •  A
company
needs
to
borrow
$10,000.
The
bank
 quotes
them
a
3%
haircut.
What
is
value
of
liquid
 securiBes
(e.g.
government
bonds)
must
the
 company
provide
to
the
bank
as
security
on
the
 loan?
 •  Answer:

 
Amount
Pledged
=
Amount
Borrowed
(1+Haircut)

 



 






























=
10,000(1.03)
 































=
10,300
 23
 T‐Bills
 •  Short
term
zero
coupon
bonds
issued
by
 (naBonal)
governments.
 •  Credit
risk
is
typically
very
low,
and
liquidity
in
 the
secondary
market
is
typically
very
high.
 •  Owing
to
market
convenBons,
there
are
 different
ways
of
expressing
the
yield
on
T‐ Bills.
 24
 U.S.
Gov’t
T‐Bills
 •  Issued
in
weekly
aucBons
 •  3
maturiBes:
4,
13
and
26
weeks
 •  Price
quoBng
convenBon:
%
of
par
(in
32nds
 of
a
percent).
 •  Yield
quoBng
convenBon:
discount
yields
 based
on
a
360
day
year.
 U.S.
Gov’t
T‐Bills
 •  General
formula
for
bond
price
with
a
given
 quoted
yield:
 n P = F × 1 − y × 360 •  F:
Face
Value
 € •  y: Quoted
yield
 •  n:
Time
to
maturity
(in
days). Example
 •  A
U.S.
gov’t
T‐Bill
quoted
at
5.25%
yield
with
 61
days
unBl
maturity
and
a
face
value
of
 100,000

has
the
following
price:

 61 P = 100, 000 × 1 − 0.0527 × = 99,107 360 € EffecBve
Annual
Yield
 •  The
yield
that
would
be
obtained
over
a
year
if
 the
return
obtained
over
the
holding
period
 would
conBnue
(and
be
compounded)
over
a
 whole
year.
 •  It
is
the
value
of
r
such
that:

 F 365 / n = 1+ r P € Canadian
Gov’t
T‐Bills
 •  MaturiBes
1,3,6,12
months.
 •  Uses
simple
interest
and
a
365
day
year
for
 quoBng
yields.

 •  QuoBng
convenBon
for
yields
is
different:
 P= F n 1 + y × 365 € Example
 •  A
Canadian
gov’t
T‐Bill
quoted
at
5.25%
yield
 with
61
days
unBl
maturity
and
a
face
value
of
 100,000

has
the
following
price:

 P= 100, 000 61 1 + 0.0527 × 360 = 99,127 € Bankers'
Acceptances
 •  Short
term
debt
issued
by
a
corporaBon
and
 guaranteed
by
a
bank.
 •  The
bank
is
paid
a
stamping
fee
(in
advance)
 for
assuming
the
credit
risk.
 31
 Bonds
 Bond
Issuers
 •  Public
Issuers:
Sovereigns,
agencies,
 provinces/municipaliBes
 •  Corporate
Bonds:
DomesBc,
internaBonal,
 foreign.
 33
 Sovereign
Bonds
 •  •  •  •  Issued
by
naBonal
governments.
 Usually
in
regular
aucBons.
 U.S.
Treasuries
are
by
far
the
most
liquid.
 On‐the‐run
vs.
Off‐the‐run:
Recently
issued
 bonds
are
referred
to
as
"on‐the‐run"
(tend
to
 be
more
liquid,
trade
at
a
premium),
other
 bonds
are
"off‐the‐run".
 34
 US
Agency
Bonds
 •  Federal
NaBonal
Mortgage
AssociaBon
(Fannie
Mae)
 •  Federal
Home
Loan
Bank
System
 •  Federal
Home
Loan
Mortgage
CorporaBon
(Freddie
 Mac)
 •  Farm
Credit
System
 •  ResoluBon
Funding
CorporaBon
 •  Student
Loan
MarkeBng
AssociaBon
(Sallie
Mae)
 •  Tennessee
Valley
Authority
 •  Debt
is
not
necessarily
guaranteed
by
the
government.
 Contains
a
credit
premium.
 35
 Municipal
Bonds
 •  Issued
by
municipaliBes.
 •  OVen
tax‐exempt
in
the
US.

 •  General
ObligaBon
Bonds:
Backed
by
the
full
 faith
and
credit
of
the
issuing
government.

 •  Revenue
Bonds:
Backed
by
the
revenues
 generated
by
the
operaBng
projects
financed
 with
the
proceeds
of
the
bond
issue.
 36
 Pricing
QuotaBons
 •  Bonds
can
be
quoted
by:

 •  Price:

 •  
 Clean
Price:
Dirty
Price
‐
Accrued
Interest
 •  
 Usually
quoted
in
terms
of
%
of
par
value.

 •  
 US
Treasury
bonds
and
some
other
bonds
 quoted
in
32nds
of
cents.
 •  Yield:
Interest
rate
at
which
all
cash
flows
should
 be
present
valued
to
produce
current
price.
 •  Spread:
Bond
Yield
=
Benchmark
Rate
+
Spread
 37
 Example
 •  How
much
would
you
pay
for
US‐Treasury
 bonds
with
total
noBonal
$100,000
quoted
at
 99‐14?
 •  Answer: •  99‐14
means
99
+
14/32
=
99.4375.
 •  Total
price
=
$100,000(99.4375)
=
$994,375.00
 38
 STRIPS
 •  STRIPS
(Separate
Trading
of
Registered
Interest
 and
Principal)
 •  SeparaBon
of
the
interest
and
principal
 repayment
of
a
bond
that
typically
pays
coupons
 (i.e.
US
government
bonds).
 •  Can
buy
either
the
interest
component
(principal
 strips)
or
the
principal
repayment
(coupon
strips).
 •  Not
as
liquid
as
coupon‐bearing
bonds.
 39
 Corporate
Bonds
 •  Four
Major
Markets:
US,
UK,
EURO,
JP
 •  Sectors:
Financial,
UBliBes,
Industrial •  US
is
by
far
the
most
mature,
largest,
and
 most
diversified
(both
in
terms
of
sectors
and
 credit
quality).
 40
 Corporate
Bonds
 •  Typically
<
20
years
in
length.
 •  Corporate
borrowers
tend
to
prefer
longer
borrowing
 periods.
 •  Shorter
bonds
are
oVen
preferred
by
investors.

 •  Longer
bonds
have
higher
interest
rate
price
sensiBvity
 than
do
otherwise
idenBcal
shorter‐term
bonds.
 •  Most
corporate
bonds
have
call/put
features
which
 mean
that
they
may
'expire'
before
the
maturity
date.
 41
 Sinking
Funds
 •  High
credit‐quality
borrowers
may
not
need
to
specify
how
a
bond
issue
 will
be
repaid.

 •  Lower
quality
borrowers
may
make
explicit
provisions.
 •  A
sinking
fund
is
a
ring‐fenced
amount
of
cash
used
to
buy
back
a
 proporBon
of
the
bond
issue
each
year.

 •  It
tends
to
reduce
credit
risk,
because
funds
have
been
put
aside
for
 repayment
of
the
debt.
 •  Typically,
bonds
are
redeemed
by
loLery,
and
at
par
(i.e.
face
value).
 •  Sinking
fund
also:
 –  Creates
liquidity
in
secondary
market
 –  Reduces
credit
risk
(smaller
payment
at
bond
maturity)
 42
 Call
Provision
 •  In
many
corporate
bonds,
the
issuer
has
the
right
to
'call'
the
bond,
 exchanging
the
bond
for
a
fixed
redempBon
price.
 •  Frequently,
the
bonds
can
be
called
aVer
a
fixed
cooling
off
period
(say
 5‐10
years),
on
a
fixed
set
of
dates.

 •  Call
Schedule:
Gives
the
call
price
at
each
date
(oVen
the
call
price
is
the
 par
value).

 •  This
might
enable
the
company
to
refinance
at
cheaper
rates.

 •  It
represents
a
negaBve
feature
for
the
bondholder.
 43
 Other
Embedded
OpBons
 •  Putable
bonds:
investor
has
the
right
to
sell
back
 the
bond
to
the
issuer
at
par
at
specified
dates.
 •  ConverBble
Bonds:
Can
be
exchanged
for
a
fixed
 number
of
shares
of
the
bond
issuer.
 –  Conversion
raBo:
number
of
shares
the
bond
can
be
 exchanged
for.
 –  Conversion
price:
Face
Value
/
Conversion
RaBo
 –  Represents
an
advantage
to
investors
if
rates
rise.
 •  Exchangeable
bond:
Can
be
exchanged
for
the
 common
stock
of
a
company
other
than
the
bond
 issuer.
 FloaBng
Rate
Notes
 •  Coupon
payments
depend
on
a
floaBng
interest
rate.
 •  FloaBng‐Rate
Bonds:
Indexed
to
a
short‐term
reference
 with
maturity
less
than
one
year.
 •  Variable‐Rate
Bonds
(Adjustable‐Rate
Bonds):
Indexed
 to
a
longer
term
reference
(e.g.
yield
on
10‐year
US
 Treasury
Bonds).
 •  Usually,
reset
frequency
=
coupon
payment
frequency.
 •  Inverse
Floaters:
Coupon
moves
in
the
opposite
 direcBon
of
the
reference
index.
 45
 LIBOR
 •  •  •  •  •  LONDON

 INTER
 BANK
 OFFER

 RATE
 •  At
11am,
BriBsh
Bankers'
AssociaBon
surveys
the
rates
offered
by
≥
8
 banks
in
the
London
market.
Drops
lowest
and
highest
25%,
and
takes
 average
of
remaining
50%.
The
result
is
the
BBA
LIBOR
for
the
given
 maturity
and
currency.
 •  LIBOR
is
the
primary
benchmark
rate
for
floaBng
rate
loans
(parBcularly
 USD).
 46
 Example
 •  An
investor
buys
an
inverse
floater
the
enBtles
 him
to
receive
max(18%
‐
2*LIBOR,0)
on
a
 $100,000
noBonal
every
year.
If
LIBOR
is
 currently
5%,
how
much
does
he
receive?
 •  Answer: Rate = max(0.18‐2(0.05),0) = 0.08 •  $100,000(0.08) = $80,000. 47
 InflaBon
Indexed‐Bonds
 •  Issued
by
governments
typically
targeBng
low
 inflaBon
rates.
 •  Useful
for:

 •  
 Hedges
against
inflaBon
rates.
 •  
 DiversificaBon
of

por}olios
(index
linked
bonds
 tend
to
be
weakly
correlated
with
other
assets
 such
as
stocks,
fixed
coupon
bonds
and
cash).
 •  
 Insurance
companies
and
pension
funds
wishing
 to
hedge
inflaBon
linked
liabiliBes.
 48
 Yield
 •  The
yield
(to
maturity)
of
a
bond
is
the
interest
rate
 that
will
make
the
present
value
of
the
cash
flows
 from
the
bond
equal
to
its
current
price.
 •  It
is
determined
by:

 –  gov't
yields
 –  credit
spread
 –  liquidity
 –  supply
and
demand
factors
 49
 Pricing
Bullet
Bonds
 On
a
coupon
date:
 1 F P = cF ∑ + k (1 + y ) (1 + y ) n k =1 P:
Price
 c:
coupon
rate
 y:
yield
 F:
Face
value
 n:
number
of
periods

 n € 50
 Pricing
Bullet
Bonds,
cont
 • AlternaBve
formula:
 51
 Example
 •  


Price
a
treasury
bond
with
face
value
 $1000
which
pays
a
10%
coupon,
 redempBon
in
10
years
from
now,
which
 pays
semi‐annual
coupons.
Assume
the

 interest
rate
with
semi‐annual
 compounding
is
equal
to
5%
per
annum.
 52
 Example
 •  SoluBon:
Coupon
payments
are
$50
every
6
 months.
There
are
20
of
them.
The
interest
 rate
per
period
is
2.5%.
 53
 Pricing
Bonds
in
Between
Coupon
Dates
 •  The
previous
formula
assumed
the
bond
was
 being
priced
on
a
coupon
date.
 i= Days from value date to next coupon date d = Days in the interest period D € 1 F P = cF ∑ + k− i n− i (1 + y ) (1 + y ) k =1 n 54
 € Clean
and
Dirty
Prices
 •  Clean
Price:
Without
accrued
interest.
Normal
 method
for
quoBng
bond
prices
in
most
 markets.
 •  Dirty
Price:
Gross
price
paid
for
the
bond.
 Includes
accrued
interest.
 55
 Clean
vs.
Dirty
Prices
 •  For
a
bond
between
coupon
dates,
(Face
value
F,
per
period
coupon
 rate
c)
 •  y:
yield
(expressed
as
a
per‐period
rate
 •  D:
#
of
days
between
coupon
payments
 •  d:
#
of
days
since
last
coupon
payment
 •  n:
number
of
remaining
coupon
payments •  Dirty
Price:
 n cF F d PD = (1 + y ) D ∑ + k (1 + y ) (1 + y ) n k =1 •  Dirty
Price:
 € PC = PD − AI = PD − d cF D •  Clean
price
quotes
are
oVen
preferred
as
they
are
more
stable
 € More
Terminology
 •  Trading/Priced
at
a
discount:
Price
<
Par
 •  Trading/Priced
at
a
premium:
Price
>
Par
 •  •  •  •  57
 For
coupon
bearing
bonds:
 If
Yield
<
Coupon
Rate,
Priced
at
a
Premium
 If
Yield
>
Coupon
Rate,
Priced
at
a
Discount
 If
Yield
=
Coupon
Rate,
Priced
at
Par.
 Perpetuals
 •  No
maturity
date,
just
an
infinite
stream
of
 coupon
payments.
Also
called
irredeemable
 bonds.
Examples
include
UK
government
 consols.
 •  From
summing
the
infinite
series:

 •  P
=
C/r
 58
 Example
 •  A
UK
government
consol
provides
coupon
 payments
of
£100
per
annum
in
perpetuity.
If
 the
consol
is
priced
to
yield
10%,
what
is
its
 current
price?

 •  Answer: 100/0.1 = 1000 59
 ...
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This note was uploaded on 01/13/2011 for the course ACTSC 445 taught by Professor Christianelemieux during the Spring '09 term at Waterloo.

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