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Fixed Income Securities Dr. Rong Chen The Department of Finance Xiamen University.

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1 Fixed Income Securities Dr. Rong Chen The Department of Finance Xiamen University

2 Fixed income ? Fixed cash flow / interest rate sensitive Major types — traditional fixed-income securities —Interest rate derivatives —Bonds with embedded options Copyright © Rong Chen, 2007, Finance Department, XMU2

3 Syllabus Part I basic knowledge: Fixed-income instruments, prices and yields Part II Term structure: Empirical properties and classical theories of the term structure & Deriving the zero-coupon yield curve Part III Hedging interest-rate risk with duration, convexity and other ways Part IV Investment strategies: passive, active and performance measurement. Part V: Interest rate swaps, forwards and futures Part VI: Dynamic term structure modeling Part VII: Interest-rate derivatives Part VIII: Securitization Copyright © Rong Chen, 2007, Finance Department, XMU3

4 Reference Lionel 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 Publishing John Hull, 2006, options, futures and other derivatives, Prentice Hall Moorad Choudhry, 2005, Fixed-income securities and derivatives handbook, Bloomberg Bond 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 Copyright © Rong Chen, 2007, Finance Department, XMU4

5 Internet resources ndex.jsp ndex.jsp 中国债券信息网 ew/zaxiang/shouye/index.jsp ew/zaxiang/shouye/index.jsp 中国货币网 和讯债券 Copyright © Rong Chen, 2007, Finance Department, XMU5

6 Chapter 1 Introduction


8 Issuers the issuer’s name the issuer’s type the issuer’s domicile Copyright © Rong Chen, 2007, Finance Department, XMU8

9 Time The maturity date Short/ medium/ long term/ Consols Callable, puttable…. —The issuance date —the interest accrual date —the settlement date —Day-count conventions Copyright © Rong Chen, 2007, Finance Department, XMU9

10 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 Copyright © Rong Chen, 2007, Finance Department, XMU10

11 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) Copyright © Rong Chen, 2007, Finance Department, XMU11

12 Other characteristics Amortization Feature Embedded options Issuance market (Domestic, Eurodollar…) Copyright © Rong Chen, 2007, Finance Department, XMU12

13 Bond Markets A US T-Bond Description on Bloomberg yield pricecoupon rate maturity date


15 BONDS 1.2.1

16 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 Copyright © Rong Chen, 2007, Finance Department, XMU16

17 Inflation-indexed bonds Inflation-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

18 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 Copyright © Rong Chen, 2007, Finance Department, XMU18

19 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 International Governments and Corporations Copyright © Rong Chen, 2007, Finance Department, XMU19

20 Government Securities Treasury 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- linked Copyright © Rong Chen, 2007, Finance Department, XMU20

21 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 Copyright © Rong Chen, 2007, Finance Department, XMU21

22 Agency Securities Issued 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 Copyright © Rong Chen, 2007, Finance Department, XMU22

23 Municipal Bonds Issued by state and local governments —Exempt from federal income tax —Exempt from (issuing) state local tax Not necessarily high credit ranking Types 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.)

24 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%

25 Markets of government securities The primary market The secondary market: market maker/ OTC When-issued market The repo market — the general-collateral repo rate (GC) —The special repo rate (on-the-run or cheapest-to-deliver securities) Copyright © Rong Chen, 2007, Finance Department, XMU25

26 Corporate bonds Bonds issued by a corporation Typically pay semi-annual coupons 3 Sources of Risk —Interest Rate Risk —Default Risk —Liquidity Risk Bond indenture contracts stipulate collateral and specify terms Different “seniority” classes —Secured Bonds —Subordinated debentures —Debentures Preferred stocks —‘Promises’ fixed dividend = coupon rate —Cannot force bankruptcy if no dividend paid

27 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?

28 Corporate bonds Lower liquidity Credit market Default or credit risk —Bankruptcy, recovery rate —Reorganization —Negotiation between shareholders and creditors: a package of cash and newly issued securities Copyright © Rong Chen, 2007, Finance Department, XMU28


30 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

31 T-Bills Treasury bills: short term gov. debt Discounted securities Quotes : Money-market yield : Copyright © Rong Chen, 2007, Finance Department, XMU31

32 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.

33 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

34 An example A 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

35 Types of repos Repo and reverse repo general repo and special repo Copyright © Rong Chen, 2007, Finance Department, XMU35


37 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…

38 Questions The structure and development of Chinese bonds markets? Copyright © Rong Chen, 2007, Finance Department, XMU38

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