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Topic 7 Fixed Income
Topic 7 Fixed Income
Topic 7-
7- Fixed Income Securities
Outline
PART I PART II
Topic 7-
7- Fixed Income Securities
Objectives
Compute the price of different fixed income securities and
understand how it varies with different variables.
Understand how the interest rate varies with maturity and how
Topic 77-- Fixed Income
this is translated in the term structure of interest rates. Securities
Distinguish between spot and forward rates and learn how to
compute them.
Learn the different theories that explain the term structure of Part I
interest rates.
Learn the types of risk that affect fixed income securities: interest
rate risk and default risk. Learn how to measure interest rate risk
using duration and how to eliminate it (immunization).
Fixed income securities are securities that promise their Other variables that characterize bonds:
holders the future payment of predetermined cashflows up Based on the issue price:
to their maturity date. Par Bond
Discount bond (below par)
Fixed income securities represent a loan that the firm that Premium bond (above par)
issues them receives from the investors that buy them.
Based on repayment value:
Most important elements of fixed income securities: At par
Face value : Principal amount of the loan ( or security) used to calculate the Below par
future regular payments (coupons).
Above par
Coupon: the interests payments paid at regular intervals (month, quarter, year,
etc.) which are set at the time of the issue.
Types of fixed income securities:
Maturity date: Time in the future at which the loan (or security) ceases to exist
and the principal repayment takes place. Bonds Pay a stated coupon at
Inflation-indexed bonds (tips) regular intervals
Principal repayment or amortization: Repayment of the principal at the
maturity date. Pure discount or zero-coupon bonds (strips)
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This are very important securities, which are going to be used to obtain
the spot interest rates and the Yield Curve. C N
….
Today t1 tN-1 tN
(t0)
The value of such bond is calculated as follows:
CN where rN is the spot
P0 = interest rate for the
(1 + rN ) N period between (t0,tN)
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Example
Example:: Suppose the market price of the Telefónica
bond is 5650€.
• Solution = 3.716%
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FLAT PRICE:
PRICE: It is the quoted price of a bond which does not Example:: Today 1-9-2004 you want to buy a (Spanish) Treasury
Example
include the part of the next coupon that is due at a particular bond which matures at 31-12-2009. The bond pays an annual
point in time (accrued interest). coupon of 7%. Moreover, the quoted price of the bond is 946.88
euros. How much do you pay the seller?
The buyer of a bond pays to the seller of the bond
a. 946.88€
Flat price + accrued interest. b. More than 946.88€
This is know as the “full price”
Solution::
Solution
ACCRUED INTEREST
It is calculated as follows:
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2- THE TERM STRUCTURE OF INTEREST RATES 2- THE TERM STRUCTURE OF INTEREST RATES
Next we are going to see the definition and how to construct the term HOW TO INTERPRET THE SPOT INTEREST RATE:
RATE:
structure of interest rates.
if one period=one year
Before doing so we need to define the following concept: The spot interest rate is like an “average” annual interest
SPOT interest rate for the time period [0,t]: ,t]: The internal rate of rate that is obtained between [0,t]
,t]..
return of a bond of the highest credit quality whose repayment
takes place at t.
It is denominated as 0Rt As an average ANNUAL return corresponding to the
Therefore, 0Rt can be obtained using the market prices of strips period [0,t] given that it is an IRR.
(stripped bonds).
Example
Example:: The spot interest rate 0Rt is obtained using the price
of a strip issued at t0 that matures at tt.
1/ t
Ct C
P0 = 0 Rt = t − 1
(1 + 0 Rt ) t 0
P
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2- THE TERM STRUCTURE OF INTEREST RATES 2- THE TERM STRUCTURE OF INTEREST RATES
3 110% 97,790%
Compute the 1-year, 2-year, 3- 4 120% 101,013%
year, 4-year and 5-year spot 5 125% 99,115%
interest rates. Bond 4:
Solution::
Solution
Bond 1
Bond 5:
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2- THE TERM STRUCTURE OF INTEREST RATES 2- THE TERM STRUCTURE OF INTEREST RATES
If we plot in a graph the spot interest rates computed before for the CONCLUSION This relationship between spot interest rates and maturity
CONCLUSION:
corresponding maturities (1, 2, 3, 4 and 5 years), we obtain the yield curve for dates is called yield curve.
this market. The shape of the yield curve as of a particular point in time can be very
diverse and it changes over time.
Yield curve of spot rates
4.75% i i
4.4%
5.0%
4.0%
Spot interest rates
4.5% 3.5%
4.0%
3.5%
2.5%
3.0%
2.5%
2.0%
1.5% Matur. Matur.
1.0%
0.5% i i
0.0%
Maturity (years))
1 2 3 4 5
In the following section we will see why this happens and its
implications but before we need to define forward interest rates. Matur. Matur.
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Securities (1+t 0 Rt2 )(t2 −t0 ) = (1+t Rt1 )(t1 −t0 ) (1+t0 Ft1 ,t2 )(t2 −t1 )
0
Example: For the simple case with two periods the expression used
Example:
Part II to compute the forward interest rate is the following:
(1 + 0 R2 ) 2 = (1 + 0 R1 ) (1 + 0 F1, 2 )
Interpretation of the interest rate 0F1,2:
0F1,2 is the interest rate that should take place between periods 1 and 2,
such that the return from investing in long-term bonds (buying a bond
that matures in 2 years) is equal to the return of buying a short-term
bond (buying a bond that matures in 1 year) and then reinvesting the
money (buying another 1-year bond). 26
2- THE TERM STRUCTURE OF INTEREST RATES 2- THE TERM STRUCTURE OF INTEREST RATES
This can be analyzed graphically. REMEMBER THAT :
The forward interest rate equates the returns of both In an ENVIRONMENT WITH CERTAINTY CERTAINTY:: The
investment strategies: forward interests rate are going to coincide with interest rates
Buy 2-year bond in the future, in order to eliminate arbitrage opportunities.
(1+0R2)2
For example → 0F1,2=1R1
2- THE TERM STRUCTURE OF INTEREST RATES 2- THE TERM STRUCTURE OF INTEREST RATES
Solution::
Solution Solution::
Solution
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3-THEORIES THAT EXPLAIN THE TERM 3-THEORIES THAT EXPLAIN THE TERM
STRUCTURE STRUCTURE
The definition of forward interest rate is going to be used A. THE EXPECTATIONS HYPOTHESIS THEORY
to explain the shape of the yield curve. Forward interest rates are a function of the expected
Each theory assumes that the forward interest rate depends future interest rates by all the agents in the market
on some variables.
To simplify, assume there are only two periods. 0F1,2 = E0[1R1]
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3-THEORIES THAT EXPLAIN THE TERM 3-THEORIES THAT EXPLAIN THE TERM
STRUCTURE STRUCTURE
B. THE LIQUIDITY PREFERENCE THEORY These theories help us to derive the short term rates expected
Assumes that there is a risk premium (L) for bonds with longer by the market for future dates (E0(1R1); E0(2R1);…)
maturity therefore, the forward interest rates depend on the
expected interest rates for the future and of this liquidity premium.
Example: Suppose that current 1-year, 2-year and 3-year
Example:
spot rates are equal to 4.5%, 4% and 3.8% respectively. There
0F1,2 = E0[1R1]+L1 is a liquidity premium of 1.2% and an inflation premium of
0.5%. Compute the one-year interest rate expected for next
year.
C. THE INFLATION PREMIUM THEORY
There is a premium associated to inflation risk (Π), and the bonds Answer::
Answer
issuers have to compensate bondholders for this risk.
0F1,2 = E0[1R1]+Π1
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There is a general impression that there is no risk associated with fixed There is a close relationshp
The credit quality of bonds between the rating and the return
income securities. We are going to see that this is not true. Fixed can be measured by a credit of the bond.
income securities are affected by: Default Risk and Interest Rate rating that is issued by a
Risk.
rating agency, for example:
Moody’s
DEFAULT RISK: RISK: Standard and Poor’s.
It refers to the possibility that the issuer fails to make the payments on
the bond/loan. Moody’s gives a triple A rating to
In other words, that the issuer fails to pay the coupon or fails to repay the highest quality bonds.
the principal at maturity. The bonds with a Baa or more
rating are known as investment
It is obvious that this risk is higher the lower the credit quality of the grade bonds and many institutional
issuer. For this reason, investors demand a higher return for investing investors (banks) can only invest in
in securities issued by entities with a lower credit quality (as can be bonds which have been rated.
observed from the following picture). The bonds with a rating lower than
Baa are known as junk bonds.
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A
A Bonds of medium to high quality. The factors that guarantee the
coupon paymenst and the principal are good enough, but there are
elements that could increase risk.
BBB
Its is an inverse relationship.
Baa Bonds known as medium-grade. The coupon and principal payment are
Caa Poor quality and high risk bonds. Issuers are in danger of defaulting. CCC
CC
Ca Highly speculative bonds Issuers are usually in default.
C Bonds of insolvent issuers unlikely not to fail with their future debt C
obligations.
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VOLATILITY : Solution::
Solution
It is the slope of the curve that relates Pbond and the interest rate.
It is the same as the Modified Duration (DM)
D
DM =
1+ y
IMMUNIZATION STRATEGY:
STRATEGY
THE PROBLEM OF AN INVESTOR WITH A
LIMITED INVESTMENT HORIZON
An investor who does not want to be affected by interest rate risk
can immunize his portfolio of fixed income securities. In other
words, if an investor has a limited investment horizon, and does
not wish that the value of his portfolio changes with interest rates
during this time, he should immunize his portfolio.
The easiest immunization technique is to form a portfolio of
fixed income securities whose duration equals the investor’s
investment horizon.
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READINGS
Basic or general:
Bodie, Z., Kane, A. and Marcus, A. J. (1999). Investments. McGraw Hill
(Fouth Edition)
Chapters 9 and 10.
Brealey, R.A. and Myers, S.C. (2006). Principles of Corporate Finance. McGraw
Hill
Parts of chapters 23 and 24
Specialized:
Navarro, E. and Nave, J. (2001). Fundamentos de Matemáticas Financieras. Antoni Bosch
Editor, SA.
Chapters 5 y 6.
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