Lecture3 All 2017-18 Upload

Lecture 3: Fixed-income securities I
BEAM047A Fundamentals of Financial

Management
Lecture 3: Fixed-income securities
Panagiotis Couzo↵
Autumn Term, 2017/18

Outline
Introduction to fixed-income securities
Bond valuation
Yield to maturity
Term structure of interest rates
Forward rates
Bond characteristics and prices
Interest rate risk
Managing interest rate risk
Reinvestment risk
Outline
Bond valuation
Yield to maturity
Forward rates
Interest rate risk
Reinvestment risk
What is a fixed-income security?
I Fixed-income securities are instruments that allow entities to borrow

money from investors.
I The promised payments on fixed-income securities are contractual
obligations of the issuer to the investor.
I These payments have therefore a prior claim on the company’s
earnings and assets compared with the claim of shareholders.
I Hence, a company’s fixed-income securities carry, in theory, lower
risk than the same company’s common shares.
How important are bonds?
I The importance of the market is probably best summarized by (2016

data):
Bonds NYSE stocks
Market
$40.7tn $19.3tn
Capitalization
Daily
$739.9bn $44.2bn
Trading Volume
Basic features of bonds
I Some basic features of bonds:

1. The issuer
2. The maturity
3. The par value
4. The coupon rate and frequency
5. The currency denomination
Basic features of bonds (cont’d)
1. Types of issuers:
I Supranational organizations (e.g. World Bank)
I Sovereign governments (e.g. the US)
I Non-sovereign governments (e.g. the state of Louisiana)
I Quasi-government agencies (e.g. La Poste in France)
I Companies (e.g. General Motors)
2. Maturity: date by which the issuer is obligated to redeem the bond
by paying the outstanding amount.
I Money market, capital market, perpetual bonds
Size of bond market (by issuer)
Source: Securities Industry and Financial Markets Association (SIFMA)

3. Par Value (or Principal, Face Value): the amount that the issuer
agrees to repay on maturity date.
I The nominal values of bonds are typically £100 and $1,000, but can
theoretically take any value.
I In practice, bond prices are quoted as a percentage of their par
value. For convenience, we will assume that bonds have a face value
of 100, such that the bond’s price can be also interpreted as such.
I Bonds can be traded
I below par (at a discount),
I at par (the price equals the face value), or
I above par (at a premium).
4. Coupon rate and Frequency

I The coupon rate is the interest rate that the issuer agrees to pay
each year.
I Coupon payments may have di↵erent frequencies (annually,
semi-annually, quarterly, or monthly).
I The annual amount of interest payments made is called the coupon,
which is equal to the product of the bond’s coupon rate and its par
value.
I The interest on the par value can be either fixed (plain vanilla
bonds) or floating (floating-rate notes). FRNs are usually quoted
as the sum of a reference rate (e.g the Libor) plus a spread.
I Bonds that do not pay coupons are called zero-coupon bonds.
5. Currency denomination
I Mainly in e and US$, dual-currency bonds, currency option bonds
Examples of coupon rates and frequencies

I Cash flows of a zero-coupon bond with three years to maturity
Time 1 2 3
Cash flow 0 0 100
I Cash flows of a 6% coupon bond with annual coupons and two years
to maturity
Time 1 2
Cash flow 6 106
I Cash flows of a 4% coupon bond with semiannual coupons and five

semesters to maturity
Time 0.5 1 1.5 2 2.5

Cash flow 2 2 2 2 102
Default risk
I Fixed-income securities generally involve default risk, i.e. the risk

that the issuer does not meet his obligations.
I An issuer’s creditworthiness is assessed by credit rating agencies,
such as Standard and Poor’s, Moody’s and Fitch.
I Issuers may take provisions to retire some of the principal amount
outstanding in order to reduce credit risk:
I Fully or partially amortized bonds vs bullet bonds
I Sinking fund arrangements
Riskless securities
I The only fixed-income securities that involve virtually no default risk

are US Treasury securities.
I The US Treasury issues three types of securities:
I Treasury Bills (T-Bills): Maturities up to one year, no coupon.
I Treasury Notes (T-Notes): Maturities between one and ten years,
semiannual coupons.
I Treasury Bonds (T-Bonds): Maturities greater than ten years,
semiannual coupons.
I The US Treasury allows buyers of T-Notes and T-Bonds to exchange
them for a portfolio of zeros o↵ering the same cash flows as the
individual coupons and face value. These zero-coupon bonds are
called Treasury STRIPS (T-Strips).
Bonds with contingency provisions
I A contingency refers to some future event or circumstance that is

possible, but not certain.
I Contingency provisions are clauses in a legal document that allow for
some action if the event or circumstance occurs.
I They provide the issuer or the holders the right, but not the
obligation, to take some action.
I These rights are generally called options, but in the case of bonds,
the more accurate term is embedded options as they are part of
the contract and cannot be traded separately.
Bonds with contingency provisions (types)
I The most common types of bonds with embedded options are

1. Callable bonds: they give the issuer the right to redeem all or part
of the bond before the maturity date.
2. Putable bonds: they give bondholders the right to sell the bond
back to the issuer at a pre-determined price on specified dates.
3. Convertible bonds: they give bondholders the right to exchange the
bond for a specified number of common shares in the issuing
company.
Bond valuation
Outline
Bond valuation
Yield to maturity
Forward rates
Interest rate risk
Reinvestment risk
Bond valuation
Methodology
I Bond prices depend on the coupon rate, the current interest rate,
the par value, the maturity and the issuer.
I The general principle is to calculate the present values of a bond’s
cash flows, the sum of which yields a fair price of the bond.
I Hence, there are three steps in valuing a bond:
I Determine the bond’s cash flows (coupons and principal)
I Determine the appropriate discount rate (a single one for all cash
flows – YTM – or a series of them, one for each cash flow)
I Calculate the PV of each cash flow and add them up
Bond valuation
Term structure of spot rates
I Remember that the PV of $1 received t years from now is

1
dt = t
(1 + rt )
where rt is the annualized interest rate until year t (this is called the
t-year spot rate).
I Knowing the spot rate for each maturity is essential for the valuation
of fixed-income securities.
I The term structure of spot rates (or yield curve) represents the
spot rates as a function of maturity.
Bond valuation
Valuation of zero-coupon bonds

I Consider a zero-coupon bond with T years to maturity.
I The PV of the bond’s cash flow is simply
100
PV = T
= 100 dT
(1 + rT )
where rT is the T -year spot rate. This PV is the price of the bond.
I Example: The 3-year spot rate is 4%. Compute the price of a zero
with 3 years to maturity.
100
Price = 3 = 88.90
(1 + 0.04)
I Under normal circumstances, zero-coupon bonds sell below par (at
a “discount”).
Bond valuation
Valuation of coupon bonds

I Consider a bond with annual coupon rate c% and T years to
maturity.
I The PV of the bond’s cash flows is
c c 100 + c
PV = + 2 + ... + T
1 + r1 (1 + r2 ) (1 + rT )
= c d1 + c d2 + . . . + (100 + c) dT
I Example: The 1-, 2-, and 3-year spot rates are 3.1%, 3.6% and 4%
respectively. Compute the price of a bond with annual coupon rate
5% and 3 years to maturity
5 5 105
Price = + 2 + 3 = 102.85
1 + 0.031 (1 + 0.036) (1 + 0.04)
I Coupon bonds may sell below par (at a discount), at par (at face
value), or above par (at a premium).
Bond valuation
Semiannual coupon payments

I Consider a bond with semiannual coupon rate c% and T years to
maturity.
I Assume that spot rates are quoted as semiannual APRs.
I The PV of the bond’s cash flows (and its price) is
c/2 c/2 100 + c/2

PV = + + ... +
r0.5 r1 2 rT 2T
1+ 2 1+ 2 1+ 2
I Example: Suppose r0.5 = 8%, r1 = 8.2%, r1.5 = 8.6% and r2 = 9%.

Compute the price of a bond with semiannual coupon rate 8% and 2
years to maturity
4 4 4 104
Price = + 2+ 3+ 4 = 98.27
1 + 0.04 (1 + 0.041) (1 + 0.043) (1 + 0.045)
Yield to maturity
Outline
Bond valuation
Yield to maturity
Forward rates
Interest rate risk
Reinvestment risk
Yield to maturity
Yield to maturity
I The yield to maturity (YTM) of a bond is the single discount rate

that equates the PV of the bond’s cash flows to the bond’s price.
I For a bond with annual coupon rate c% and T years to maturity,
the YTM (y ) is given by
c c 100 + c
Price = + 2 + ... + T
1+y (1 + y ) (1 + y )
I Example: For c = 10, T = 3, and a price of £98, then
10 10 110
98 = + 2 + 3
1+y (1 + y ) (1 + y )
Solving numerically yields y = 10.82%.

Yield to maturity
Yield to maturity and coupon rates
I The relation between a bond’s YTM and coupon rate tells us how
the bond’s price compares to the face value:
I If the YTM is greater than the coupon rate, then the bond sells at a
discount (below par).
I If the YTM is equal than the coupon rate, then the bond sells at
face value (at par).
I If the YTM is lower than the coupon rate, then the bond sells at a
premium (above par).
Yield to maturity
Yield to maturity and spot rates
I Consider the pricing equations using spot rates and YTM for an c%
annual coupon paying bond with T years to maturity:
c c 100 + c
Price = + 2 + ... + T
1 + r1 (1 + r2 ) (1 + rT )
c c 100 + c
Price = + 2 + ... + T
1+y (1 + y ) (1 + y )
I Comparing the two equations:
I YTM is a complicated average of the spot rates corresponding to the
years 1 to T .
I YTM can be easily calculated if:
I the bond is zero-coupon (c = 0); in this case y = rT , or
I Price = FV ; in this case, y = c%.
Yield to maturity
Uses and abuses of the YTM
I Main use of the YTM:

I Alternative way to quote the price of a bond.
I Abuses of the YTM:
I Measure of the bond’s return
I Tool for choosing among di↵erent bonds
Yield to maturity
YTM and return: zero-coupon bonds
I The YTM of a zero-coupon bond (also called spot yield) is the spot
rate for the bond’s time to maturity (rT ).
I This is the return from investing in the bond and holding it until
maturity.
I It is not the return for any other investment horizon.
I Example: Consider a zero-coupon bond with 3 years to maturity and
YTM 6%.
I The return from investing in and holding the bond for 3 years is 6%.
I However, the return from investing in the bond and selling it after
one year is unknown today.
I The return will depend on the selling price (its PV in one year)
I The latter will depend on the 2-year spot rate prevailing in the
market in one year. This rate is unknown today.
Yield to maturity
YTM and return: coupon bonds
I The YTM of a coupon bond is the return from investing in the

bond, holding it until maturity, and reinvesting the coupons at a rate
equal to the YTM.
I Issues:
1. Similar for zeros, this is not the return for any other investment
horizon other than T .
2. The YTM might not even be the return for an investment horizon
equal to maturity T . This is because the future spot rates at which
the coupons will be reinvested may be di↵erent than the YTM.
Yield to maturity
YTM and comparing bonds
I Using the YTM for comparing bonds is correct only when the bonds
have the same coupon and time to maturity.
I In all other cases, it can be very misleading.
I Consider, for example, two bonds with di↵erent times to maturity:
1. The YTM is at best the return of investing until maturity
2. Therefore, comparing YTMs is equivalent to comparing returns for
di↵erent time horizons!
I The correct way to compare bonds is simply to compute the PV of
their cash flows and compare it to their prices.
Outline
Bond valuation
Yield to maturity
Forward rates
Interest rate risk
Reinvestment risk
Term structure and YTM
I The yields-to-maturity of two bonds might di↵er for various reasons:

I Currency, credit risk, liquidity, frequency of coupons, etc.
I Fundamentally, they might di↵er due to di↵erent times to maturity
(tenors).
I Consider for example two zero-coupon bonds, one with three years
to maturity and one with four years to maturity. For their
yields-to-maturity to be the same, r3 = r4 needs to hold.
I Obviously, this is not always the case.
Some term structures

I US Treasury yield curves on the first trading day of the year.
Yield curves
I The term structure of interest rates plays an important role in the

valuation of fixed-income securities.
I To analyze the term (also called maturity) structure, one needs to
look at the population of spot rates, defined as the YTM of
zero-coupon government bonds, across di↵erent maturities.
I The resulting dataset forms a curve, called the spot curve (also
zero curve or “strip” curve).
I Another way to assess the maturity structure is by drawing a par
curve, i.e. the coupon rate that would make a bond to be valued at
par for di↵erent maturities.
Some facts about the term structure
I The term structure can have many shapes, but generally slopes up.
This means that spot rates for long maturities are generally higher
than short maturities.
I There are many theories trying to explain the positive slope of the
term structure of interest rates (Expectations Hypothesis, Liquidity
Preference Theory, Market Segmentation Hypothesis, Preferred
Habitat Theory), the analysis of which is beyond the scope of this
module.
I Spot rates, both for short and long maturities, can move
substantially over time.
Predictability of bond returns
I Long maturity bonds return more, on average, than short maturity

bonds.
I 5-year bonds have yielded 0.5% higher return per year than 1-year
bonds during 1953-1997 period in the US.
I The excess return of long-maturity bonds is positively related to the
slope of the term structure.
I The variance in the predicted excess return of 5-year bonds over
1-year bonds is 1.5% per year.
I Therefore, bond returns exhibit some predictability.
Forward rates
Outline
Bond valuation
Yield to maturity
Forward rates
Interest rate risk
Reinvestment risk
Forward rates
Forward rates
I If an investor wants to invest in fixed-income securities, today’s spot

rates are the most relevant for valuation.
I But, what if an investor wants (or knows they will want) to invest
next year?
I They can wait until next year, and invest in next year’s spot rates; or
I They can lock future prices in by using forward rates.
I Forward rates are interest rates on fixed-income securities that are
traded in a forward market, i.e. they are rates that can be
guaranteed today for investing in the future.
Forward rates
Obtaining forward rates from spot rates

I Implied forward rates can be derived from today’s spot rates.
I Consider two ways in which you can invest $1 for t + T years:
a) Invest at the t + T -year spot rate and get
(1 + rt+T )t+T
b) Invest at the t-year spot rate, and reinvest at the forward rate t fT
between years t and T
(1 + rt )t (1 +t fT )T
I Given that both amounts are guaranteed today, these two quantities
have to be equal, i.e.
t+T
T (1 + rt+T )
(1 + t fT ) = t
(1 + rt )
I If they are not, there is an arbitrage opportunity!
Forward rates
An example
I Suppose that the 1-year spot rate is 5%, the 2-year spot rate is
4.5%, and the 3-year spot rate is 4%. Which forward rates can you
compute based on this information?
I The forward rate between years 1 and 2 is
2
(1 + r2 )
1 + 1 f1 = =) 1 f1 = 4%
1 + r1
3
(1 + r3 )
1 + 2 f1 = 2 =) 2 f1 = 3%
(1 + r2 )
3
2 (1 + r3 )
(1 +1 f2 ) = =) 1 f2 = 3.5%
1 + r1
Forward rates
Use of forward rates
I According to Expectations Theory, the forward rate t fT coincides

with the expected t-year spot rate that will prevail in t years’ time.
t fT = E0 [t rT ]
I As such, forward rates can be thus interpreted as incremental

returns for extending the time-to-maturity for an additional period,
or breakeven reinvestment rates.
I While these are only an approximation, forward rates can give us an
idea of expected future rates.
I They can also be depicted graphically by a forward curve, i.e. a
series of forward rates with the same time frame.
Forward rates
The forward curve

Outline
Bond valuation
Yield to maturity
Forward rates
Interest rate risk
Reinvestment risk
How is the price of a bond expected to change over time?
The constant-yield price trajectory is the plot of the price of a bond over
time if the discount rate remains unchanged.
I As time passes, the price “pulls to

par”, i.e. comes closer to the bond’s
face value.
I Prices of discount bonds are expected
to increase.
I Prices of premium bonds are expected
to drop.
Price-yield curve
The price-yield curve is the plot of the price of a bond against its YTM.
I There is a negative relationship
between the price of a bond and its
yield.
I The price-yield curve is convex.
I The intercept is the total
undiscounted value of all the bond’s
cash flows (y = 0). The example to
the right is a 7% annual coupon bond
with 10 years to maturity.
I The price of a bond approaches to
zero as the yield to maturity goes to
infinity.
First basic fact
I Bond prices are sensitive to interest rate movements. They go down

when interest rates go up and vice-versa.
I Bond prices are negatively related to interest rates.
I Intuition:
I Prices are the PV of the bonds’ cash flows. If interest rates go up,
cash flows are discounted more heavily, and the PV goes down.
I Suppose that interest rates go up. This means that the newer bonds
in the market o↵er higher interest rates. Existing bond prices will
decrease as the opportunity cost is higher!
Second basic fact
I The percentage price change is greater (in absolute terms) when the
discount rate decreases than when it increases.
I Bond prices are convex in interest rates.
I Intuition:
I The convexity of the price-yield curve reflects the e↵ect of
compounding.
I A decrease in interest rates does not reduce only the interest on the
capital, but also the interest on interest!
Price-yield curve and maturity
I For a given coupon rate and a given

YTM, the longer the maturity, the
steeper the price-yield curve, i.e. a
change in the yield has a larger e↵ect
on the price of bonds with longer
maturities.
I The price-yield curves for di↵erent
maturities intersect at their par value,
at a YTM that is equal to their
coupon rate (still 7% in the graph on
the right).
Third basic fact
I Prices of long-term bonds are more interest rate sensitive than prices
of intermediate term bonds.
I In general, the interest rate sensitivity of bond prices increases
with maturity.
I Intuition:
I The cash flows of long term bonds are farther in the future, and are
more heavily discounted than the cash flows of shorter term bonds.
I Therefore, the PV of the cash flows is more interest rate sensitive for
long term bonds than for shorter term bonds.
Price-yield curve and coupon
I For a given maturity and a given

YTM, the lower the coupon rate, the
steeper the price-yield curve, i.e. a
change in the yield has a larger e↵ect
on the price of bonds with lower
coupons.
Fourth basic fact
I Prices of low coupon bonds are more interest rate sensitive than
prices of high coupon bonds.
I The interest rate sensitivity of bond prices decreases with the
coupon rate.
I Intuition:
I If the coupon rate is low, the majority of total cash flows comes from
the final (principal) payment. Given that this is the farthest payment
in the future, it is the most a↵ected by interest rate changes.
I On the other hand, a high coupon rate means that a higher
proportion of cash flows comes early in the life of the bond and is
thus more immune to interest rate changes.
I Therefore, the PV of the cash flows is more interest rate sensitive for
low coupon bonds than for higher coupon bonds.
Interest rate risk
Outline
Bond valuation
Yield to maturity
Forward rates
Interest rate risk
Reinvestment risk
Interest rate risk
Interest rate risk
I The sensitivity of the price of a bond to the interest rate is known as

interest rate risk and is captured by the slope of the price-yield
curve.
I Aggregating the conclusions from the previous section:
I Bonds with long maturities have greater interest rate risk than bonds
with short maturities.
I Similarly (but to a much lower extent), bonds with low coupons have
greater interest rate risk than bonds with high coupons.
I Finally, bonds with lower yield-to-maturity have greater interest rate
risk than the ones with larger yield-to-maturity.
Interest rate risk
Duration
I The interest rate risk of a bond is determined by how long you have
to “wait” on average to receive the bond’s cash flows.
I This concept is captured by duration:
I It’s the weighted average of the years in which the bond pays cash
flows.
I It can basically be interpreted as a “center of gravity”, i.e. the year
around which the bond’s discounted cash flows are “balanced”.
Interest rate risk
Duration (cont’d)
I Consider a bond with annual coupon rate c% and T years to
maturity.
I The Macaulay duration (D) of the bond is
T
X
D= wt t
t=1
where
c 1
wt = t for t < T
(1 + r ) P
100 + c 1
wT = T
(1 + r ) P
and P is the bond price.

I The weight of a given year is the PV of that year’s cash flow divided
by the PV of all cash flows, i.e. the price of the bond.
Interest rate risk
Duration (cont’d)
I The interpretation of duration hints that it should be related to the
slope of the price-yield curve.
I Indeed, the modified duration (D ⇤ ) is the semi-elasticity of the
bond’s price with respect to the YTM, i.e. the proportional change
in price in terms of a change in YTM:
1 @P
D⇤ =
P @y
and
D
D⇤ =
1+r
I For small changes in the yield to maturity, the change in an asset’s
price is closely approximated by (minus) the product of its price, the
modified duration (both evaluated at the initial yield to maturity),
and the change in YTM:
P⇡ P D⇤ y
Interest rate risk
Why is duration expressed in years?
I Note that duration is expressed in units of time, and can be

interpreted as follows: The price of an asset i with Macaulay
duration Di is as sensitive to YTM changes as the present value of
one dollar to be received in Di from today.
I For bonds, it is also referred to as the “e↵ective maturity” since a
bond with Macaulay duration Dj is as sensitive to interest rate
changes as a zero-coupon bond maturing in Dj !
Interest rate risk
An example
I Consider a 3 year bond, paying 10% coupon annually, with a YTM

of 12%. What is the price of the bond today?
10 10 110
P= + 2
+ = 8.93 + 7.97 + 78.30 = 95.20
1.12 1.12 1.123
I Now suppose the yield to maturity increases by 0.5%. What will be
the new price of the bond?
10 10 110
P= + + = 8.89 + 7.90 + 77.26 = 94.05
1.125 1.1252 1.1253
Interest rate risk
An example (cont’d)
I A very similar result can be reached using duration.
I The duration of the bond before the change in its YTM is equal to
8.93 7.97 78.3
D= ⇤1+ ⇤2+ ⇤ 3 = 2.73
95.20 95.20 95.20
I The modified duration is thus
D 2.73
D⇤ = = = 2.4375
1+y 1.12
I The change in the price by an 0.5% increase in the YTM is
approximately
Pnew = Pold + P ⇡ Pold P D⇤ y

= 95.20 95.20 ⇤ 2.4375 ⇤ 0.005 = 94.04
Interest rate risk
When is it safe to use duration?
I For small shifts in the term structure, duration provides a good

approximation to the actual change.
I However, duration is merely a linear approximation, and, as such, it
works less and less well as the shifts increase.
I Approximating the change using duration:
I Understates the capital gain if interest rates go down;
I Overstates the capital loss if interest rates go up.
I The size of the approximation error depends on the curvature of the
price-yield curve.
Interest rate risk
Approximation with duration

Interest rate risk
Convexity
I In order to better approximate the change in an investment’s value,
one can use convexity (in addition to duration).
I Convexity relates to the curvature of the price-yield curve at the
current YTM y .
I The convexity ( ) of a bond with annual coupon rate c% and T
years of maturity is
T
X
1
= 2 wt t (t + 1)
(1 + y ) t=1
where the weights wt are the same as with in the definition of the
Macaulay duration.
I For a small movement y in the YTM, the change in the value of
an investment is approximately
1 2
P⇡ P D⇤ y+ P ( y)
2
Interest rate risk
Approximation with duration and convexity

Outline
Bond valuation
Yield to maturity
Forward rates
Interest rate risk
Reinvestment risk
Covering for liabilities
I Duration is important for the immunisation of a firm’s exposure to

interest rate risk.
I Consider a firm that has a number of liabilities that will arise on
future dates.
I In order to cover for these, the firm can hold a portfolio of bonds
that have the same present value; if interest rates remain
unchanged, the value of the bond portfolio will exactly match the
value of the liabilities.
Covering for liabilities (cont’d)
I However, if interest rates change, both the liabilities’ and the bond
portfolio’s values are going to change.
I If the sensitivity to interest rate is ignored, these will change by
di↵erent amounts and liabilities will be either over-funded or worse
under-funded.
I By investing in a portfolio of bonds that has the same present value
and duration as the liabilities, the firm can immunise against interest
rate changes more e↵ectively.
Immunisation: an example
I To illustrate the use of immunisation, consider the following

example.
I You are the CFO of an insurance company. Your liabilities consist of
four payments of $20M in 14, 15, 17, and 18 years. Your assets
consist of $35M.
I You are uncertain about future interest rates and you would like to
immunise your net worth (i.e. make it insensitive to interest rate
movements). What should you do?
A dangerous choice
I Suppose you decide to keep the $35M in cash.
I Assume that the term structure of interest rates is flat at 6%.
I The PV of your liabilities is
20 20 20 20
L= + + + = 31.63
(1.06)14 (1.06)15 (1.06)17 (1.06)18
I Your net worth is
A L = 35 31.63 = 3.37
I Suppose that interest rates drop to 5%.
I The PV of your liabilities becomes
20 20 20 20
L= + + + = 36.76
(1.05)14 (1.05)15 (1.05)17 (1.05)18
I Your net worth is now
A L = 35 36.76 = 1.76
Immunisation using duration
I Suppose you can invest in zero-coupon bonds with 10 and 20 years

maturity.
I Can you choose investments such that your net worth is insensitive
to small interest rate movements?
I The approach consists of matching the changes in assets and
liabilities by an interest rate movement, using duration.
Immunisation using duration (cont’d)
I Let’s start with the liability side.

I Similar to the duration of a bond, you can calculate the duration of a
portfolio of fixed-income securities:
D = w14 14 + w15 15 + w17 17 + w18 18
where
20 1
wt = t
(1.06) 31.63
I This yields D = 15.85 and D ⇤ = 14.96.
I The approximate change in the value of liabilities is
L⇡ L D⇤ r= 473.03 r
I Let’s now turn to the asset side.

I The price of the 10-year bond is P10 = $55.84, and that of the
20-year bond is P20 = $31.18.
I The Macaulay durations are 10 and 20, and the modified durations
are 9.43 and 18.87 respectively.
I Denoting by x10 and x20 the quantities of the two bonds, the value of
assets is
A = x10 P10 + x20 P20
I The approximate change in the value of assets is
⇤ ⇤
A⇡ x10 P10 D10 r x20 P20 D20 r
I To find a unique solution to this problem, we need to make a

decision on how much of our cash is going to be invested in the
bonds.
I Assuming that we decide to invest all $35M, the problem is then
summarised by a system of two equations with two unknowns:
55.84x10 + 31.18x20 = 35
526.79x10 + 588.31x20 = 473.03
I The solution of this system is x10 = 0.3556 and x20 = 0.4856 (in
million units).
A safer choice
I Suppose you decide to buy 0.3556M 10-year bonds and 0.4856M

20-year bonds, and that interest rates drop to 5%.
I Recall that the PV of your liabilities is $36.76M.
I The value of your assets is
100 100
A = 0.3556 + 0.4856 = 40.13
(1.05)10 (1.05)20
I Your net worth is now
A L = 40.13 36.76 = 3.37

I Much better than -$1.76M!
Uses of immunisation
I The net worth of many market participants is sensitive to interest

rate movements:
I Bond Mutual Funds
I Banks
I Pension funds
I Insurance companies
I As illustrated by the previous example, they can control (or manage)
the sensitivity of their net worth by changing the composition of
their assets and liabilities.
I Duration is a useful tool used by risk managers of such institutions
to control the downside of their interest rate exposure.
Reinvestment risk
Outline
Bond valuation
Yield to maturity
Forward rates
Interest rate risk
Reinvestment risk
Reinvestment risk
Reinvestment risk
I Interest rate risk reflects the fall in the value of a bond when interest
rates rise.
I Reinvestment risk on the other hand reflects the fall in the income
from a bond when interest rates fall.
I When interest rates fall, as payment of coupons occur or the bonds
in a portfolio mature, they must be replaced with bonds with a lower
coupon rate, representing a lower income to a bond holder.
I While long term bonds have more interest rate risk than short term
bonds, they have lower reinvestment risk.
Reinvestment risk
Reinvestment risk
I Ultimately, the risk of a bond depends on the investment horizon

and circumstances of the investor.
I For an investor who wants to save for one year, a one-year bond
would be low risk:
I There is no interest rate risk since the bond’s value in one year’s
time is certain and
I Reinvestment risk is not important for the short-term investor
I For an investor who wants to provide an income for the next twenty
years, a long term bond would be low risk (there is low reinvestment
risk as the coupons are used for consumption) and interest rate risk
is not important for this long-term investor
I So, do zero-coupon bonds eliminate reinvestment risk? Is the
principal itself subject to reinvestment risk?
I It basically depends on the investment horizon.

Lecture3 All 2017-18 Upload

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecture3 All 2017-18 Upload

Uploaded by

Copyright:

Available Formats

Lecture 3: Fixed-income securities I

BEAM047A Fundamentals of Financial

Autumn Term, 2017/18

Term structure of interest rates

Bond characteristics and prices

Interest rate risk

Managing interest rate risk

Term structure of interest rates

Bond characteristics and prices

Interest rate risk

Managing interest rate risk

What is a fixed-income security?

I Fixed-income securities are instruments that allow entities to borrow

How important are bonds?

I The importance of the market is probably best summarized by (2016

Basic features of bonds

I Some basic features of bonds:

Basic features of bonds (cont’d)

Size of bond market (by issuer)

Source: Securities Industry and Financial Markets Association (SIFMA)

Basic features of bonds (cont’d)

Basic features of bonds (cont’d)

4. Coupon rate and Frequency

Examples of coupon rates and frequencies

I Cash flows of a 4% coupon bond with semiannual coupons and five

Time 0.5 1 1.5 2 2.5

I Fixed-income securities generally involve default risk, i.e. the risk

I The only fixed-income securities that involve virtually no default risk

Bonds with contingency provisions

I A contingency refers to some future event or circumstance that is

Bonds with contingency provisions (types)

I The most common types of bonds with embedded options are

Term structure of interest rates

Bond characteristics and prices

Interest rate risk

Managing interest rate risk

Term structure of spot rates

I Remember that the PV of $1 received t years from now is

Valuation of zero-coupon bonds

Valuation of coupon bonds

Semiannual coupon payments

c/2 c/2 100 + c/2

I Example: Suppose r0.5 = 8%, r1 = 8.2%, r1.5 = 8.6% and r2 = 9%.

Term structure of interest rates

Bond characteristics and prices

Interest rate risk

Managing interest rate risk

I The yield to maturity (YTM) of a bond is the single discount rate

Solving numerically yields y = 10.82%.

Yield to maturity and coupon rates

Yield to maturity and spot rates

Uses and abuses of the YTM

I Main use of the YTM:

YTM and return: zero-coupon bonds

YTM and return: coupon bonds

I The YTM of a coupon bond is the return from investing in the

YTM and comparing bonds

Term structure of interest rates

Bond characteristics and prices

Interest rate risk

Managing interest rate risk

Term structure and YTM