Lec 15

Fixed income
S Sial
Dept of Mathematics
LUMS
Spring 2022
S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Outline
Outline
1 Fixed-income products
Zero-coupon bond
Coupon-bearing bond
Floating rate bond
Money market account
Forward rate agreement
Repos
2 International bond market
3 Interest
4 Measures of yield Fixed income
S Sial (LUMS) MATH 449 Spring 2021-2022
Fixed-income products

Fixed-income products Zero-coupon bond
Fixed-income products:
Zero-coupon bond
Zero-coupon bond

Zero-coupon bond
Zero-coupon bond
A zero-coupon bond pays interest (a coupon)
but is traded at a discount, giving profit at
maturity T when the bond is redeemed for its
full face value.

Example
Example
A zero-coupon bond pays nothing for 10 years
and then pays $1 at maturity.
How much should we pay for such a bond?

Fixed-income products Coupon-bearing bond
Fixed-income products:
Coupon-bearing bond
Fixed-income products: Coupon-bearing bond

Coupon-bearing bond
Coupon-bearing bond
Pays the principal at maturity, AND it pays
smaller quantities, the coupons, at intervals up
to and including the maturity date T .

Example
Example
Coupon-bearing bond pays $1 in ten years. Also,
every six months it pays 4% or 4 cents. This
would be called an 8% coupon.

Example contd
Compare to previous example

The bond in this example is worth more than the
bond in the previous example.

Coupon-bearing bonds in terms of

zero-coupon bonds
Think of coupon-bearing bond as a portfolio of

zero-coupon bonds
We can construct a coupon-bearing bond as a
portfolio of zero-coupon bonds.

Example contd
Previous coupon-bearing bond as a portfolio of
zero-coupon bonds
Portfolio of zero-coupon bond expiry in 6
months with principle 4 cents, plus another with
expiry in one year with principle 4 cents, ... 4
cents in 10 years, finally zero-coupon bond
giving $1 in ten years.

Example contd
Cashflow of actual coupon-bearing and portfolio

Equivalent cash flow to the coupon-bearing bond
example.

Fixed-income products Floating rate bond
Fixed-income products: Floating

rate bond
Fixed-income products: Floating rate bond

Fixed-income products Floating rate bond
Floating rate bond
Floating rate bond

A floating interest rate is the amount that you
get on your bank account. This amount varies
from time to time.

Fixed-income products Money market account
Fixed-income products: Money

market account
Fixed-income products: Money market account

Fixed-income products Money market account

Account accumulates interest compounded at a
rate that varies from time to time. The rate is
usually short-term and unpredictable.

Fixed-income products Forward rate agreement
Fixed-income products: Forward

rate agreement
Fixed-income products: Forward rate agreement


Two parties agree that a prescribed interest rate
will apply to a prescribed principal over some
specified period in the future.

Motivation
Why do we have these?

A borrower wants to lock in an interest rate. A
lender thinks that rates might go down, so will
be lending at a higher than market rate.

Fixed-income products Repos
Fixed-income products:Repos
Fixed-income products:Repos

Repos
Repos
A repo is a repurchase agreement to sell some
security to another party and then buy it back at
a fixed date for a fixed amount.

Repos contd
The price at which the security is bought back is
greater than the selling price and the difference
implies an interest rate called the repo rate.

Example
I need $100 right now. I sell you a security for
$100. The next day I buy it back at $100.01,
effectively repaying a loan of $100 with some
interest.

Amortization
The principal can amortize or decrease during
the life of the contract. The principal is thus
paid back gradually and interest is paid on the
amount of the principal outstanding.


International bond market
International bond markets

USA
Bills: Bonds with maturity less than one year,
zero-coupon bonds

USA
Notes: Bonds with maturity 2-10 years, coupon
bearing bonds

USA
Bonds: Maturity more than 10 years

UK
Gilts: Bonds issued by the UK government are
called gilts.

UK
Some gilts are callable, irredeemable, and
convertible.


Interest
Interest
Interest

Interest
Interest
Continuously compounded interest

The present value of $1 paid at time T in the
future is e −rT × $1.

Interest
Interest
Discretely compounded interest

The present value is
1
× $1
(1 + r )T

Interest

Measures of yield
Measures of yield
Measures of yield

Measures of yield
Measures of yield
Current yield
annual coupon income / bond price

Measures of yield
Measures of yield
Example
10-year bond pays 4 cents every six months, and
$1 at maturity. Suppose that the bond currently
costs $8. Then the current yield is 0.08/8 =
0.01 = 1%.

Measures of yield
Measures of yield
Yield to maturity/internal rate of return

We have a coupon-bearing bond. Discount all
coupons and the principal to the present by
using some interest rate y .

Measures of yield
Measures of yield

The present value of the bond at time t
X
−y (T −t)
V = Pe + Ci e −y (T −ti )

Measures of yield
Measures of yield

P = Principal, i = 1, ..., N (no. of coupon
payments), Ci is the coupon paid on date ti .

Measures of yield
Measures of yield
Duration
The Macaulay duration is a measure of how
sensitive a bond’s price is to changes in interest
rates.

Measures of yield
Measures of yield
Duration contd
1 dV
−
V dy

Measures of yield
Measures of yield
Convexity
1 d 2V
V dy 2

Measures of yield

Hedging
Hedging
Hedging

Hedging
Hedging
Recall
We balanced options and assets to create risk
free portfolio.

Hedging
Hedging
For a portfolio of bonds

Hedge movements in one bond with movements
in another.

Hedging
Hedging
Portfolio
Assume that a move of x% in bond A’s yield is
accompanied by a move of x% in B’s yield.

Hedging
Hedging
Portfolio
P = VA(yA) − ∆VB (yB )

Hedging
Hedging
Portfolio
Choose delta to eliminate the leading order risk

Hedging

Time dependent interest rates

Interest rate considered function of time

Implies the bond price is a function of time and
a function of maturity T .

Example
Consider a zero coupon bond at pays 1 at time
t = T.

Example contd
Then V (T ) = 1.

Example contd
Change in value over time interval dt.
dV
dV = dt
dt

Example contd
Arbitrage considerations implies
dV
= r (t)V
dt

Example contd
Solving the eqn gives
− tT r (t) dt
R
V (t; T ) = e

What about for coupon bearing bonds?

Hint

dV
dV = + K (t) dt
dt


Forward rates
Forward rates
Forward Rates

Forward rates
Forward rates
Problem with yield to maturity

Not consistent across instruments

Forward rates
Forward rates
Forward rates
Interest rates that are assumed to apply over
given periods in the future for all instruments

Forward rates
Forward rates
Assumption
We have a continuous distribution of
zero-coupon bonds with all maturities T

Forward rates
Forward rates
Forward rate
The implied forward rate is the curve of a time-
dependent spot interest rate that is consistent
with the market price of instruments

Forward rates
Forward rates
Formula
If this rate is r (s) at time s then
− tT r (s)ds
R
Z (t; T ) = e

Forward rates
Forward rates
Rate
d
r (T ) = − log Z (t; T )
dT

Forward rates
Forward rates
Rate
This is the forward rates at time t applying at
time T in the future, denote it by F (t, T )

Forward rates
Forward rates
Rate
Use Z (t; T ) = e −y (t,T )(T −t) to derive a
relationship between yield and forward rates.

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Fixed income

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

How much should we pay for such a bond?

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Fixed-income products: Coupon-bearing bond

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Compare to previous example

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Coupon-bearing bonds in terms of

Think of coupon-bearing bond as a portfolio of

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Cashflow of actual coupon-bearing and portfolio

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Fixed-income products: Floating

Fixed-income products: Floating rate bond

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Floating rate bond

Floating rate bond

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Fixed-income products: Money

Fixed-income products: Money market account

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Money market account

Money market account

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Fixed-income products: Forward

Fixed-income products: Forward rate agreement

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Forward rate agreement

Forward rate agreement

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

Why do we have these?

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

International bond markets

International bond markets

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

International bond markets

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

International bond markets

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

International bond markets

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

International bond markets

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022

International bond markets

S Sial (LUMS) Fixed income MATH 449 Spring 2021-2022