Fixed Income

Felix Matthys

Lecture 1: Course Outline &

Introduction to Fixed Income Markets
Course Outline

1 Organization of the course

2 Fixed Income Markets: An Overview

Sovereign Debt Markets
Money Market
Repo Market

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Course Content and Prerequisites

Course Description
The objective of this course is to undertake a rigorous study of various fixed income
securities and their derivatives. After a brief overview of the market for fixed income
securities we will discuss basic pricing of various types of bonds, interest rate risk
management of bonds and their portfolios. We also discuss the green fixed income
market. Furthermore, we will encounter various types of interest rate derivatives.
Additionally will also discuss the role of the central bank and inflation when pricing
bonds.

Prerequisites
The course is quantitatively oriented and requires some knowledge about basic
(multivariate) calculus, statistics and probability theory.

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Content of this Course

(1) Overview of Fixed Income Markets

(2) Basic Fixed Income Analysis
(3) Interest Rate Risk Management
(4) Interest Rate Derivatives: Forwards, futures, swaps and options
(5) Inflation, Monetary Policy and the Federal Funds Rate

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Organization
• About 20 min. of each class will be devoted to solving exercises.
• Bring a calculator (non-programmable) or Excel to class since we will be solving
practical problems.
• Tentative review sessions before midterm and final exam.
• There will be a mandatory exercises, a Take-home exam, mid - term exam, a
group presentation and a final exam. Details about format and deadlines will be
announced in class.
• Bi - weekly voluntary 90 min. exercise sessions on Friday
• Teaching Assistant (TA) for this class is David Chesman: Dvaldovi@itam.mx

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Grading
Your final grad will be based on the following weighted average
• Class participation and bi-weekly (every 14 days) exercises: Weight 10%
Maximum 3 people per group and turn in one answer only per group. Your solutions have
to be uploaded to Canvas (we will provide you with a template).
• In class mid - term exam (in class otherwise online). Weight 15%
You need a calculator for some questions. Date will be announced by ITAM
• Group presentation of up to 3 members on a topic related to fixed income. Weight 10%
Tentative Date: After Dia de la Independencia. Duration will be about 15-20 min.
• Take Home exam that can be solved in groups of up to 3 members. Weight 15%
Tentative Hand-in date: One or two weeks before the semester ends
• End of term exam will be closed book, if in class, but you can bring non-programmable
calculator & cheat sheet (size A4, both sides). Weight 50%
• Your final score (=total number of points) will be a weighted average:
Your Final Score = 0.1 · CE + 0.1 · GP + 0.15 · THE + 0.15 · M + 0.5 · E
where CP is your score on class participation and exercises, GP is the score for your group
presentation, THE is the score on your take home exam, M is your score on the mid term
exam and E is your score on the end of term exam.
• Very important: Your final score will then be compared to the weighted - average of your
class mates. This implies that your final grade will take into account how your fellow
students have performed (see also ”Grading on a Curve”).
: Example: If the exam was very tough and you scored 40/100, while the average of the group was 20, you will get a very
high grade. Likewise, if you score 40/100 and the group average was 80, your grade will be very low.
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Reading Material

The course will to a large extend follow the text book of Prof. Pietro Veronesi:

Pietro Veronesi, Fixed Income Securities: Valuation, Risk, and Risk Management,
Wiley, 2010.1

However, further material, which we also cover in class, are covered in:
• John Hull, Options, futures and other derivatives, 8th Edition, 2012
• Bruce Tuckman, Fixed Income Securities: Tools for Today’s Markets, Second
Edition, Wiley, 2002.
• Damir Filipovic, Term-Structure Models: A Graduate Course, Springer, 2009

1
This slide set is based on lecture notes, slides and further teaching material that was
kindly provided by Prof. Pietro Veronesi and Wiley
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1 Organization of the course

2 Fixed Income Markets: An Overview

Sovereign Debt Markets
Money Market
Repo Market

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Yield Curve of US Government Bonds

Figure: Source: U.S. Department of the Treasury

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Classification of Debt Securities
Treasury Interest bearing marketable coupon public debt.

Asset-Backed Includes auto, credit card, home equity, manufacturing,

student loans and other; USD-denominated CDOs are also included.

Money Markets Includes commercial paper, bankers acceptances, and large time deposits.

Mortgage-Related Includes Government National Mortgage Association (GNMA),

Federal National Mortgage Ass. (FNMA), and FHLMC mortgage-backed

securities and CMOs and private-label MBS/CMOs.

Corporate Debt Incl. all non-convertible debt, MTNs (medium term notes) both

investment grade and non-investment grade bonds.

Federal Agency Contains agency debt of Fannie Mae, Freddie Mac, Farmer Mac,

Federal Home Loan Banks (FHLB), the Farm Credit System, and

federal budget agencies (e.g., Tennessee Valley Authority, TVA).

Municipal issues Debt securities issued by state governments and municipalities.

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Size of Fixed Income Markets

Figure: Debt Securities by residence of Issuer. Source: Bank for international Settlements,
August 2022
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Figure: Outstanding U.S. Bond Market Debt by category as of August 2022. Source: SIFMA

Remark: Yearly nominal US GDP is 24,851 Trillion $ (2021), less than half of the market value
of outstanding US Bonds.
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Monthly Issuance per type of Fixed Income Security

Figure: Issuance of US Fixed Income Securities in %, August 2022. Source: SIFMA

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By Instrument Notional amounts outstanding Gross Market Value

H2 2017 H1 2018 H2 2018 H1 2019 H2 2017 H1 2018 H2 2018 H1 2019

FRAs 68,334 84,131 67,636 88,984 112 107 134 232

Swaps 318,870 349,762 326,681 389,337 6,747 5,914 5,686 7,793

Options 39,112 46,833 42,159 45,298 719 623 581 782

Other Products 332 361 357 340 ... ... ... ...

By Currency Notional amounts outstanding Gross Market Value

H2 2017 H1 2018 H2 2018 H1 2019 H2 2017 H1 2018 H2 2018 H1 2019

USD 156,506 192,510 169,163 199,190 1,434 1,326 1,183 1,745

EUR 121,890 129,417 114,010 135,431 3,561 3,140 3,134 4,352

JPY 38,772 37,215 36,166 39,156 491 443 464 568

GBP 37,570 44,522 39,454 46,971 1,292 1,067 924 1,118

CHF 4,107 4,398 3,467 3,861 62 52 50 65

CAD 10,944 12,494 14,225 13,720 135 104 95 118

SEK 5,985 6,052 5,931 5,213 65 60 52 53

Other curr 50,874 54,478 54,416 80,417 539 452 498 786

Table: Global OTC derivatives market in billions of US Dollars.

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Complexity of Fixed Income Markets

• Federal funds rate quotes and futures at various maturities

• U.S Treasury bill and bond prices and yields for various maturities
• U.S Treasury note futures
• Mortgage-backed securities
• Swap rates for various maturities
• Eurodollar deposit rates at various maturities
• Repo and reverse Repo rates
• Commercial paper quotes
• Eurodollar futures for various maturities
• LIBOR fixes
• Foreign exchange rates

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Government (Sovereign) Debt Markets

Definition: Government Bond

A government bond is a bond issued by a national government, usually denominated in its own
currency and with a promise to pay periodic interest payments and to repay the face value on
the maturity date.

• Usage: Countries issue bonds to finance their operations.

• Generally considered as ’safe’, in the sense of almost default-free, as those bonds are
backed by the governments ability to levy taxes on its citizens to repay back the debt.
• However, investment is not ’safe’, over a short period of time.
• Valuation of government bond varies with changes in interest rates.
→ Interest rate risk
• Since payments of coupons and the final principal amount are given in nominal
terms, a rise (decline) of the future price during the investment period will decrease
(increase) the amount of consumer goods an investor can buy.
→ Inflation risk

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Government (Sovereign) Debt Markets cont.

Figure: Price evolution of 10 year maturity bond over time.

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Bond Price Evolution: Last 15 years

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Bond Price Evolution: This year 2018

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Bond Details: Mexican Bond

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Bond Details: Mexican Bond Price Evolution

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Government (Sovereign) Debt Markets cont.

Name Maturity Coupon Rate Principal

Treasury Bills 4,13,26,52 weeks None Fixed

Treasury Notes 2,5,10 years Fixed - semi-annual Fixed

Treasury Bonds 30 Years Fixed - semi-annual Fixed

TIPS 5,10,20 years Fixed - semi-annual Adjusted for inflation

Table: U.S Treasury Debt Securities

• Treasury bills are zero-coupon bonds, those securities do not pay any coupons during the
lifetime of the bond but only pay the principal at maturity.
• Treasury Inflation Protected Securities (TIPS) offer protection against a rise in inflation,
as the principal of the bond is adjusted for inflation which translates to higher a final
payoff at maturity, and thus higher coupon payments, as they are a fixed percentage of
the principal which increases with inflation.
• Note: Whereas the US does only issue fixed coupon bonds, other countries, such as Italy
for instance, also issue floating rate bonds which are indexed to the country’s LIBOR rate.

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Zero Coupon Bonds
Maturity Bid Ask Chg Yield

2016 Feb 15 99.982 99.983 0.003 0.18

2016 May 15 99.856 99.860 0.003 0.41

2016 Aug 15 99.626 99.632 0.004 0.62

2016 Nov 15 99.364 99.372 0.025 0.75

2017 May 15 98.883 98.897 0.034 0.83

2017 May 15 98.958 98.971 0.018 0.77

2017 Aug 15 98.695 98.711 0.041 0.82

2018 May 15 97.749 97.772 0.049 0.96

2018 Nov 15 96.907 96.935 0.034 1.10

2019 Feb 15 96.475 96.504 0.042 1.15

Table: U.S. zero-coupon STRIPS as of Monday, 12th of January 2016. Source: Wall Street
Journal.
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Discount Curve

Figure: Mid price of Treasury Notes for various maturities on January 7th, 2016 Source: Wall
Street Journal
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The Money Market
When we speak of the money market, we refer to the market for short-term borrowing and
lending.
• The federal funds rate is the interest rate at which financial institutions lend reserve
balances to other financial institutions overnight, on an uncollateralized basis. Reserve
balances are dollar denominated accounts held at the Federal Reserve to maintain
depository institutions’ reserve requirements. Financial Institutions are obligated by law to
hold certain levels of reserves either directly at the Fed or as cash in a vault. The level of
these reserves is determined by the banks’ outstanding assets and liabilities of each
depository institution and by the Fed itself an is usually around 10% of the total value of
the bank’s demand accounts.
• The Eurodollar rate is the interest rate on deposits denominated in U.S. dollars at
financial institutions not only in Europe, but also for all other financial institutions outside
the US. Therefore, they are not under the jurisdiction of the Federal Reserve.
• The London Interbank Offered Rate LIBOR is an average, unsecured interbank rate,
published daily by the British Bankers Association at 11 am, at which banks with very
good credit ratings (usually AA) offer each other short-term uncollateralized borrowing.
The LIBOR rate is one of the most important benchmark rates as it is the reference rate
for many over-the-counter (OTC) derivatives.
• Other money market instruments include Commercial Paper (unsecured notes with
maturity up to 270 days), Certificates of Deposit (CD is a certified document issued by
the bank to an investor who chooses to deposit his funds in the bank for a specific
amount of time and is insured by the Federal Deposit Insurance Corporation (FDIC)).

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The Future of LIBOR: A short Digression

• Two fundamental features:

1 LIBOR is not anchored in observable transactions as it is solely based on
submissions of interest rates by major banks (no market transaction prices
available)
2 LIBOR is an unsecured rate (no collateral)
Some problems with the LIBOR:
• LIBOR scandal: Several banks have been accused of misreporting LIBOR-rates
▶ either inflating or deflating the rates to design profitable trading strategies or
▶ manipulating their own creditworthiness
• Recall: LIBOR is THE benchmark rate for numerous derivatives!
→ Approximate Market size $ 350 Trillions (for comparison: US nominal GDP is
$19,2 Trillions)

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The Future of LIBOR: A short Digression cont.

New regulation aims at replacing LIBOR with an alternative reference rate, which is
based on actual transaction data from all relevant market participants.
• Some existing examples include:
1 The euro’s overnight rate EONIA (not collateralized),
2 Swiss SARON (collaterized, is based on repo transactions),
3 and Japan’s TONAR (not collateralized)
Time line:
• Panel bank supports to introduce new alternative rates by end of 2021

The message is clear:

• New interest rates should be solely based on transaction prices and not on expert
opinion.

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 Figure: Source: St. Louis Fed, Fred Database

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The Repo Market

Definition: Repurchase Agreement (Repo)

Repurchase Agreement is a secured short term loan (overnight up to 30 days or even
more), where the seller of a security agrees to buy them back at a predetermined date
and price. Since the price at which the seller buys those securities back is higher than
the initial selling price, the difference is a positive interest rate and called the repo rate.

• Important usage of Repos: Central bank controlling the money supply. In order
to expand the money supply, the central bank decreases repo rates, by buying
Treasury bills or other government papers and selling the paper back at a later
date. In other words, banks can more easily swap their holdings of government
securities for cash as there is more liquidity in the market. To contract the money
supply it increases the repo rates.

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The Repo Market cont.
• Repo transactions are collateralized, i.e. borrowing and lending occurs against a
delivery of a collateral (for instance US treasury notes). Since borrowing is
secured, it is considered to be a safer way to lend cash, as in the case of default,
the lender could sell the security in order to get his money back.
However, there is still credit risk involved! Consider the following example:
• Suppose a trader enters a repo agreement with a dealer on a notional of 10 Mio.
USD.
• As a collateral, the dealer delivers 10 Mio USD worth of a T-Note.
• Suppose that the trader is forced into bankruptcy and can’t repurchase the T-Note.
Then the dealer has to sell the T-Note on the market to get his money back.
• When the market is down, the T-Note might sell at a considerable discount which
causes a large loss to the dealer.
Two ways to reduce credit risk
1 Margin (Hair cut). Lenders require a margin, i.e. if the security price is Pt they
will only lend (1 − hc )Pt to the borrower, with hc being around 1-3% for high
grade (very liquid) collateral.
2 Market - to - Market Margins: If the collateral value changes by too much,
collateral levels or loan balances are adjusted.
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Repo transaction: Example
Consider a trader who wants to take a long position today at time t on U.S. 30 year
bond with current price Pt .
At time t:
• The trader pays Pt for the bond and enters simultaneously a repurchase agreement
with the dealer.
• Thus, the trader uses the bond as collateral to finance the purchase.
• Repo dealer usually gives less than the market price to the trader, the difference is
called hair cut hc .
• At time t the trader and the dealer agree that the trader will pay back the amount
borrowed Pt (1 − hc ) plus the repo rate rr for n days.

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Repo transaction: Example
Consider a trader who wants to take a long position today at time t on U.S. 30 year
bond with current price Pt .
At time t:
• The trader pays Pt for the bond and enters simultaneously a repurchase agreement
with the dealer.
• Thus, the trader uses the bond as collateral to finance the purchase.
• Repo dealer usually gives less than the market price to the trader, the difference is
called hair cut hc .
• At time t the trader and the dealer agree that the trader will pay back the amount
borrowed Pt (1 − hc ) plus the repo rate rr for n days.
At time T = t + n:
• The trader gets back the bond from the dealer, sells it in the market at price PT
and pays Pt (1 − hc ) plus the repo rate rr .
n
• The Repo interest is RI = rr × 360
× Pt × (1 − hc )
• Profit of the trader is PT − Pt − RI
• Return on capital RoC = PT −Pt −RI .
Pt ×hc

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Repo Transaction: Schematic Example
time t

buy bond at Pt deliver bond

=⇒ =⇒
MARKET TRADER REPO DEALER
⇐= ⇐=

pay Pt get Pt − haircut

time T = t + n days

sell bond at PT get the bond

⇐= ⇐=
MARKET TRADER REPO DEALER
=⇒ =⇒

get PT pay RI

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Why use Repo?
For traders:
1 Borrowing cash to fund long positions in securities (Repo).
2 Borrowing securities to cover short positions in securities (Reverse repo).
Advantages of using Repos:
• Cash lenders receive a collateral for lending money which reduces credit risk. If
the trader does not pay back, the lender could simply sell the collateral at time T
and earning a profit/loss of −(Pt − hc ) + PT .
• Loans issued by lender are subject to lower regulatory capital requirements than
unsecured lending, which improves the return on their cash.
• If the repo dealer is short on liquidity, he can reuse the collateral obtained from
the dealer to enter an other repo with a third party to increase his cash holdings.
(This can not be done in lending markets with unsecured and non-transferable
instruments like deposits.)
• Lower credit risk and lower regulatory capital requirements also decreases the
funding costs as investors are not only more willing to lend, but do so at lower
interest rates. This makes the repo market especially interesting for highly
leveraged firms (i.e. hedge funds, brokerage firms) who will have more difficulties
in finding funding in unsecured securities markets.

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The Repo Market cont.

Definition: Reverse Repo

A Reverse Repo is the opposite transaction of a Repo. In other words, it is an
agreement where one party agrees to purchase securities for cash and will sell it back to
the original owner at a predetermined date and price. The spread between the initial
purchase price and the price at redemption of the security is called the reverse repo
rate.

• Important usage of reverse Repos: Central bank controlling the money supply.
In order to contract the money supply, the central bank increases the repo rates by
selling securities (for instance Treasury Notes or Bonds) to all the depository
banks, so that the cash balance of the depository banks effectively decrease. Since
there is less money in circulation, the interest rate, in this case the reverse repo
rate increases.

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Reverse Repo: Example

Consider a trader that thinks a 30 year treasury bond is overpriced and wants to take a
short position in this security.
At time t:
• The trader borrows the security from the dealer and sells the treasury bond in the
market at a price Pt .
• The trader and dealer agree that the trader will deliver the borrowed security in
T = t + n and he will receive the repo rate. Note: trader might be happy to forgo
the repo just to get hold of the security.
At time T = t + n:
• The trader buys the bond at the current market price PT and gives it back to the
repo dealer.
n
• The repo dealer pays Pt + RI to the trader, where RI = 360
× rr × Pt .
• The trader makes a profit if Pt + RI − PT > 0, i.e. the price of the bond has
declined sufficiently much.

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 time t

sell bond at Pt borrow bond

⇐= ⇐=
MARKET TRADER REPO DEALER
=⇒ =⇒

get Pt use Pt as cash collateral

time T = t + n days

buy bond at PT give bond back

=⇒ =⇒
MARKET TRADER REPO DEALER
⇐= ⇐=

pay PT n )
get back Pt ×(1+ repo rate × 360

• Profit of this trade:

n
Profit = (Pt − PT ) + Pt × rr ×
360

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Fixed Income and their Derivatives

Some examples include:

• Forwards and futures on stocks, interest rate bearing securities, currencies,
commodities.
• Swaps, like interest rate swaps, currency swaps or credit default swaps
• Options on stocks, indexes, bonds, commodities, currencies or employee stock
options and exotic options.
Hybrid products:
• Options on futures.
• Swaption, which is an option to enter a swap, typically refers to options on interest
rate swaps.
• Convertible bonds which is a bond that can be converted to a company’s equity at
certain times during its lifetime of the bond.

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Arbitrage and the Law of one Price cont.

Definition: Arbitrage Opportunity

An arbitrage opportunity is a riskless trading strategy that costs no initial investment
and yields a positive positive profit/cashflow with certainty.

An other way to interpret this strategy:

The trading strategy generates a positive stream of cash flows at inception and it has a
sure nonnegative payoff at a known future date.
Note: We say the market is arbitrage free if there exists no arbitrage opportunities.
Two examples:
1 Company Z’s stock trades at $ 5 per share on the New York Stock Exchange and
$ 5.1 on the Chicago Stock Exchange, then an arbitrageur could buy the Company
Z’s stock on the New York Stock Exchange and sell it immediately on the Chicago
Stock Exchange locking in a profit of $ 0.1 per share

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No Arbitrage and the Law of one Price cont.

2 Two securities that have the same payoff on the same future date T = t + n,
where n is one year. Suppose today there are two zero coupon bonds with prices
P1 = $95 and P2 = $96, that each pay 100 in one year. Short-sell N = 1′ 000 units
of the $96 bond and buy the cheaper $95 bond, which results in a profit of
1′ 000 × (96 − 95) = $1′ 000 today.
The trader is now perfectly hedged as in one year he obtains exactly N × 100 from
the long position in the cheaper P1 bond which he can use to pay the N × 100 he
owes from selling the more expensive P2 bond.

The law of one price

The law of one price establishes that two securities with identical payoff characteristics
must have the same price.

Note: If the law of one price does not hold, then there exists an arbitrage opportunity.

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Summary
Key concepts:
✓ Term Structure of Interest Rates (or yield curve): The term structure of
interest rates shows the relationship between interest rates (yield) and maturity. In
general, the term structure of interest rates is usually upward sloping indicating
that the yield on longer term bonds is higher than on shorter term bonds.
✓ U.S. Treasury market: The US government issues four types of securities:
Short-term T-bills (or strips) with no coupon, medium maturity T-Notes (with
coupon), long-term maturity T-Bonds (with coupon) as well as TIPS, i.e.
inflation-protected securities.
✓ Money Market and Money Market Rates: This market is the source of short
term borrowing. The most important short term rates are the Fed Funds Rate,
ECF discount rate, the LIBOR as well as commercial paper rate.
✓ Repurchase Agreement and the repo rate: Collaterized borrowing between two
counterparties. The repo rate is the interest rate earned/paid within a repurchase
agreement.
✓ Arbitrage Strategies: Those strategies cost nothing to set up but yield a positive
profit. In well-functioning markets, there should not exist any arbitrage
opportunities. The rule of no arbitrage determines the relative pricing between
assets.
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