Dr.

Maddah ENMG 602 Intro to Financial Eng’g 01/13/09

Fixed-Income Securities (Chapter 3, Luenberger)

• Financial instruments and securities

¾ Money is the most popular of traded commodities.
¾ Interest rate is a price for money.
¾ Vast assortments of bills, notes, bonds, annuities, futures
contracts, and mortgages are part of the market for money.
¾ These items are not real goods. They are traded based on the
promises they represent.
¾ These items are called financial instruments (products).
¾ A financial instrument that has a well-developed market so
that it can be traded freely and easily is called a security.
¾ A fixed-income security is a financial instrument that
promises a fixed (deterministic) income to the holder (e.g.
bonds, mortgages).1

• Examples of fixed-income securities

¾ Saving deposits are offered by commercial banks and
savings and loan institutions.
o Demand deposit pays interest that varies with market condition.
o Time deposit account pays a guaranteed interest but the deposit
must be maintained for a length of time (or penalties apply).

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Certain fixed-income securities may generate income that varies with an interest rate index or a stock
price.

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 o A certificate of deposit (CD) is similar to a time deposit. CDs
with large denominations can be sold in the market.
¾ Money market is the market for short-term loans (≤ 1 year)
by corporations and financial intermediaries (e.g. banks).
o A commercial paper is an unsecured loan to a corporation.
o A banker’s acceptance is a promise by a bank to pay an amount
to a company at a future date. The company can sell this promise
at a discount.
o Eurodollar deposits are deposits in dollars held in a bank
outside the U.S.
o Eurodollar CDs are CDs in dollars issued by a bank outside the
U.S. This allows escaping U.S. regulations.
¾ The U.S. government obtains loans by issuing fixed-income
securities.
o U.S. Treasury bills are issued with a fixed maturity date of 13,
26, or 52 weeks, and are sold at a discount from the face value.
o U.S. Treasury notes are issued with maturities of 1-10 years and
offer the holder coupon payments every six months. At maturity,
the holder receives the last coupon payment and the face value.
o U.S. Treasury bonds are issued with maturities > 10 years. They
are similar to Treasury notes but some are callable.
o U.S. Treasury strips are bonds where the coupon payments and
the principle are issued in strips. Each strip can be traded
independently as a zero-coupon bond.

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¾ Bonds are also issued by other entities.
o Municipal bonds are issued by agencies of state and local
governments. Their interest income is exempt from tax.
o Corporate bonds are issued by corporations. They vary in
quality.
¾ For a homeowner a mortgage looks like the opposite of a
bond.
¾ A homeowner will sell a mortgage in order to obtain cash to
buy a home. In return, the homeowner makes periodic
(usually monthly) payments to the mortgage holder.
¾ Mortgages are typically bundled into large packages and
traded among financial institutions. These packages are
called mortgage-backed securities.
¾ An annuity is a contract that pays the holder (the annuitant)
money periodically. E.g., pension benefits.
¾ Annuity sometimes depends on the age of the annuitant at the
time the annuity is purchased.
¾ A perpetual annuity, or perpetuity, is an annuity that pays
fixed income periodically forever.
¾ Annuities are not real securities since they are not traded.
But they provide investment opportunities.

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• Value formulas
¾ The present value of an annuity which pays an amount A per
period for n period at an interest rate of r per period is
A⎡ 1 ⎤
P= −
r ⎢⎣ (1 + r ) n ⎥⎦
1 .

¾ The present value of a perpetual annuity which pays an

amount A per period at an interest rate of r per period is
A⎡ 1 ⎤ A
P = lim 1− = .
n →∞ r ⎣ (1 + r ) n ⎥⎦ r
⎢

¾ Amortization is the process of substituting a current payment

P for periodic payments of A per period. (E.g. a car loan,
home mortgage.)
¾ At an interest rate of r per period, the periodic payment is
⎡ r (1 + r ) n ⎤
A= P⎢ ⎥ .
⎣ (1 + r ) n
− 1 ⎦
• Running amortization
¾ One can view each amortization payment (A) as composed
of two parts: (i) interest on running (outstanding) balance and
(ii) partial repayment of principal.
¾ This procedure is equivalent to re-amortizing the running
balance every period over the remaining time horizon.
¾ This is consistent with accounting practice.

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¾ E.g., consider a loan of $1,000 issued on Jan 1, 2006, to be
paid back in equal monthly payments over 5 years at an
interest rate of 12% per year compounded monthly.
¾ The monthly payment is
⎡ (0.01)(1 + 0.01)60 ⎤
A = 1000 ⎢ ⎥ = $22.24 .
⎣ (1 + 0.01) 60
− 1 ⎦
¾ Then, the outstanding balance on Feb 1, 2006 is $1,000
minus the monthly payment ($22.24) plus the monthly
interest (0.01×1,000=$10), which gives $987.76.
¾ The (running) amortization of the $987.76 on Feb 1, 2006
over the remaining 59 months is
⎡ (0.01)(1 + 0.01)59 ⎤
A = 987.67 ⎢ ⎥ = $22.24 .
⎣ (1 + 0.01) 59
− 1 ⎦
¾ The (running) amortization of the $975.39 on Mar 1, 2006
over the remaining 58 months is also $22.24, and so on.

Previous Payment New

Date Interest
balance Received Balance
1-Jan-06 $1,000
1-Feb-06 $1,000 $10.00 $22.24 $987.76
1-Mar-06 $987.76 $9.88 $22.24 $975.39
1-Apr-06 $975.39 $9.75 $22.24 $962.90
1-May-06 $962.90 $9.63 $22.24 $950.28
. . . . .
. . . . .
1-Dec-10 $43.83 $0.44 $22.24 $22.02
1-Jan-11 $22.02 $0.22 $22.24 $0.00

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• Annual worth
¾ The amortization formula provides a main for evaluating a
cash flow stream on the basis of annual worth.
¾ Specifically, a stream x = (x0, x1, …, xn) is transformed into
an equivalent stream (0, A, …, A). The larger A the better the
stream is. Also, A > 0 is equivalent to PV > 0.

• Bond details (see also Chapter 12 in Antle’s book)

¾ Bonds represent the greatest monetary values of fixed income
securities.
¾ A bond is an obligation by the bond issuer to pay money to
the bond holder (buyer).
¾ A bond pays its face value or par value at its maturity date.
¾ In addition, bonds usually pay periodic coupon payments. In
the U.S., coupon payments are made every 6 months.
¾ The coupon amount is described in percent of face value.
¾ Usually coupon rates are close to the prevailing interest rate.
¾ A bond can be traded freely in the market place. Its price
varies continuously.
¾ The bid price of a bond is the price dealers are willing to pay
for a bond. The ask price is the price at which dealers are
willing to sell the bond.

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• Bond accrued interest
¾ When buying a bond, one must pay the accrued interest to
the seller in addition to the ask price.
¾ This is the interest accrued since the last coupon payment till
the sale date. The accrued interest (AI) is given by

AI = × coupon amount .
number of days since last coupon
number of days in coupon period

• Bond quality ratings

¾ Bonds are subject to the risk of default if the issuer faces
financial difficulties or falls into bankruptcy.
¾ To characterize this risk bonds are rated by rating
organizations. U.S. treasury securities are not rated because
they are considered risk-free.
¾ A bond with low rating will have a lower price than a similar
bond with high rating.
¾ The two main rating organizations are Moody’s and Standard
& Poor’s. Their classification is as follows:

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 Bond Grade Moody’s Standard & Common
Rating Poor’s Rating Bond Name
High Grade Aaa AAA Investment
Grade
Aa AA “
Medium A A “
Grade
Baa BBB “
Speculative Ba BB Junk Bond
Grade
B B “
Default Caa CCC “
Danger
Ca CC “
C C “
D “

• Bond yield
¾ Yield to maturity (YTM) is the IRR of the bond.
¾ Specifically, for a bond with a price of P and a face value F
making m coupon payments per year of C/m (with a total of n
payments), the YTM is the value of λ such that

P= +∑
n

(1 + λ / m) k =1 [1 + (λ / m)]
F C/m
n k .

¾ This formula assumes that the interest is compounded every

payment period.

¾ Upon simplification,
C⎛ ⎞
P= + ⎜1 − n ⎟ .
[1 + (λ / m)] λ ⎝ [1 + (λ / m)] ⎠
F 1
n

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• Price-yield curves
¾ These give the price, P, as a function of yield to maturity λ .
¾ Nature of price-yield curves.
o P is decreasing in λ (also λ decreases with P).
o At λ = 0, P = F+ n(C/m), this is the undiscounted price.
o P tends to zero as λ increases.
o The yield curve is convex (P is decreasing in λ at a
decreasing rate).
o As the coupon payment, C, increases, P increases.
o At λ = C/F, P = F, for all n. This is the price of a par bond.
o As time to maturity, n, increases, the price-yield curve
becomes steeper.
o That is, long-maturity bonds are very sensitive to interest
rate.
¾ The following figure shows price-yield curves for a 30-year
bond having a coupon value C = 5%, 10%, and 15%.
600

P( λ , C) := + ⋅ ⎡⎢ 1 − ⎤⎥
100 C 1

⎛1 + λ ⎞
λ ⎢ ⎛ λ⎞ ⎥
⎜ ⎟ ⎢ ⎜1 + ⎟ ⎥
60 60

⎝ 2⎠ ⎣ ⎝ 2⎠ ⎦
P ( λ , 15)
400

P ( λ , 10)

P ( λ , 5)
200

0
0 0.05 0.1 0.15 0.2
λ

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 ¾ The following figure shows different price-yield curves for
a 10% coupon bond with maturity n = 3, 10, and 30 years.

P( λ , n ) := ⋅ ⎡⎢ 1 − ⎤⎥
400

+
⎡⎛ n⋅ 2⎤ ⎥
100 10 1

⎛ λ⎞
n⋅ 2 λ ⎢
⎜1 + ⎟ ⎢ ⎢⎜ 1 + λ ⎞⎟ ⎥ ⎥
300 ⎝ 2⎠ ⎣ ⎣⎝ 2⎠ ⎦⎦
P ( λ , 30)

P ( λ , 10) 200

P ( λ , 3)

100

0
0 0.05 0.1 0.15 0.2
λ

• E.g., Lebanese treasury bills yield on Jan 13, 2010 (source:

Bank Audi)

Lebanese T-Bills 91 days 182 364 728 1092

Maturity 08/04/2010 08/07/2010 06/01/2011 05/01/2012 03/01/2013
Treasury Bills Primary
4.55% 5.63% 5.73% 6.32% 7.10%
Yields

• E.g.: U.S. treasury bills yield (source: Wall Street Journal)

4:05 a.m. EST 01/13/10Treasurys

Price Yield
Chg (%)
1-Month Bill -0/32 0.005
3-Month Bill -1/32 0.030
6-Month Bill 0/32 0.141
1-Year Note 1/32 0.342
2-Year Note -2/32 0.936
3-Year Note -1/32 1.514
5-Year Note -4/32 2.504
10-Year Note -9/32 3.752
30-Year Bond -16/32 4.654
* at close

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