Universidad Carlos III de Madrid 9/2/2010

Topic 7-
7- Fixed Income Securities
Outline
PART I PART II

Topic 77-- Fixed Income 1. VALUATION OF FIXED

INCOME SECURITIES
1. FORWARD INTEREST RATES
AND THEORIES THAT
Securities • Valuation of fixed income
securities with periodical coupon
payments
EXPLAIN THE TERM
STRUCTURE
• Valuation of strips • Forward interest rates
David Moreno (Spanish version) • Computation of accrued interest • The expectations hypothesis theory
Beatriz Mariano (English version)
2. THE TERM STRUCTURE OF • The liquidity-preference theory
Universidad Carlos III INTEREST RATES • The inflation premium theory
• Spot interest rates
Financial Economics • The yield curve 2. RISK MANAGEMENT
• Default risk
• Interest rate risk: Duration and
Immunization

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).

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1- VALUATION OF FIXED INCOME SECURITIES 1- VALUATION OF FIXED INCOME SECURITIES

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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1- VALUATION OF FIXED INCOME SECURITIES 1- VALUATION OF FIXED INCOME SECURITIES

BOND VALUATION: B. CONSTANT COUPON AMOUNT (C)

Assume that a fixed income security pays regularly at each period
A. NON
NON--CONSTANT COUPON AMOUNT (at t=1, 2, 3….n) a coupon that is equal to C and the bond is repaid
Assume that a fixed income security pays regularly at each at par. The cash-flows are represented as follows
period ( at t=1, 2, 3….n) predetermined cash-flows that can be
C C … …C C + FV
represented as follows:
CF1 CF2 … CFn-1 CFn
Today (t0) t1 t2 … tn-1 tn
…
Maturity date
Today (t0) t1 t2 … tn-1 tn
Maturity date
 The value of the bond is calculated as follows:
 The value of the bond is equal to the sum of the discounted
cash-flows which are promised at time 0:
C C C+N N
C FV
P0 = + + ... + = +
r1, r2, ..rN are the (1 + r1 ) (1 + r2 ) 2 (1 + rN ) N t =1 (1 + rt ) t (1 + rN ) N
CF1 CF2 CFN
P0 = PV = + + ... + appropriate spot
(1 + r1 ) (1 + r2 ) 2 (1 + rN ) N interest rate for each
period

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1- VALUATION OF FIXED INCOME SECURITIES 1- VALUATION OF FIXED INCOME SECURITIES

Example:: Suppose that today is 2-2-2009, and you are asked to
Example C. ZERO COUPON BONDS
determine the price of a (Spanish) Treasury bond 3.25, 2-2-2014, whose
Fixed income securities that do not pay any coupon over their lifetime,
principal is repaid with a premium of 10%. The interest rates at 1, 2, 3, 4
the only cash-flow that their holders receive is the principal amount at the
and 5 years are equal to 3%, 3.5%, 4%, 4.5% and 5.25% respectively.
maturity date (it has no explicit return).
 Note: The face value of a (Spanish)Treasury bond is 1000€.
If the repayment amount exceeds the amount at which it was issued its
 Solution::
Solution holder has an implicit return.

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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1- VALUATION OF FIXED INCOME SECURITIES 1- VALUATION OF FIXED INCOME SECURITIES

Example: Compute the value of a zero-coupon bond with a

Example: COUPON RATE:
RATE:
face value of 10.000$ issued at 1-1-2004 that matures at 1-1-  The interests payments paid at regular intervals.
2009 if the bond’s amortization is at 120%. Suppose that the  Example
Example:: Suppose that a bond issued by Telefónica pays
spot interest rate at 5 years is equal to 4.5%. an annual coupon of 3.5% and has a face value of 6.000€
 Solution::
Solution  Solution = 3.5%

CURRENT YIELD OR INTEREST YIELD YIELD::

 Annual coupon payment divided by the bond’s market price.

 Example
Example:: Suppose the market price of the Telefónica
bond is 5650€.
• Solution = 3.716%

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1- VALUATION OF FIXED INCOME SECURITIES 1- VALUATION OF FIXED INCOME SECURITIES

YIELD TO MATURITY (IRR or YTM): The Yield to Maturity is a very complex and complete measure of the
 Measures the return obtained by someone that buys the bond today return of an individual security. It is affected by:
and holds it up to maturity. 1. Issue price of the security: at par, below par or above par.

2. Principal Repayment: at par, below par or above par.

 COMPUTATION: It is the single interest rate that equates the
present value of the bond’s cash-flows to its price: it is the IRR or 3. Coupons: coupon amount, payment frequency monthly, semi-
the yield to maturity annually or annually.
Coupon Coupon Coupon + Ppal
Price today = + + ... +
(1 + IRR )1 (1 + IRR ) 2 (1 + IRR ) n Example:: Compute the yield to maturity of a two year bond with face
Example
value of 1.000€ and coupon rate of 4%, whose market price is equal to
 Interpretation: 963.69€. Principal repayment at par.
It is the compounded interest rate that would have been  Solution
Solution::
obtained over the lifetime of the bond under the assumption
that the COUPON PAYMENTS ARE REINVESTED at the
same interest rate and the bond is held until maturity.
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1- VALUATION OF FIXED INCOME SECURITIES 1- VALUATION OF FIXED INCOME SECURITIES

 Solution:
Example using Excel
 We are looking for the discount rate or the “average” interest rate
that equates the price to the PV of the CF:
The function TIR in Excel
40 1040 computes the Internal Rate of
963.69 = +
1 + Y (1 + Y ) 2 Return for the cash-flows paid
40(1 + Y ) 1040 out at regular intervals
963.69 = + (monthly, semi-annually,
(1 + Y ) 2 (1 + Y ) 2 annually)
963.69(1 + Y ) 2 − 40(1 + Y ) − 1040 = 0
This function gives the IRR
Quadratic equation with one unknown expressed in terms of this time
Y = IRR = 5.98% interval.
When the cash-flows are not
paid out at regular intervals use
The IRR can be obtained by trial and error. In the previous case it can
TIR.NO.PER
be solved using the formula for the solution of a quadratic equation.

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1- VALUATION OF FIXED INCOME SECURITIES 1- VALUATION OF FIXED INCOME SECURITIES

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:

Amount of time the seller held the bond

AI = * Coupon(€)
Time between two consecutive coupon payments

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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

Example:: Suppose that the

Example  Bond 2:
Payment Repayment Quoted Price
following zero coupon bonds Schedule
of the (Spanish) Treasury have (years)
current quoted prices as 1 100% 97,561%
follows (face value of the bond
2 105% 98,018% Bond 3:
1.000€) 

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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2- THE TERM STRUCTURE OF INTEREST RATES

FORWARD INTEREST RATE

The forward interest rate at time t0 for the period [t1,t2] needs to
Topic 77-- Fixed Income satisfy the following equation:

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

Buy 1-year bond

Reinvest in another 1-  In an ENVIRONMENT WITH UNCERTAINTY : This
year bond (1+0R1)(1+0F1,2) does not have to be the case
(1+0R1) (1+0F1,2)  Then, the future spot interest rates ( 1R1, 2R1,…)→ are not
known.
 However, the forward interest rates for the same time
 We will see later that the forward interest rates are very important to
explain the term structure of interest rates and the shape of the yield intervals (0F1,2; 0F2,3;… )→ are known today as they are
curve. calculated using the term structure of interest rates.
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2- THE TERM STRUCTURE OF INTEREST RATES 2- THE TERM STRUCTURE OF INTEREST RATES

Example:: Suppose that you read in today’s newspaper that the

Example
1-year and the 2-year spot interest rates are equal to 3% and
4% respectively. Compute the forward interest rate for the
time interval [1,2].
Example:: Suppose that you read in today’s newspaper that the
Example
1-year, 2-year and 3-year spot interest rates are equal to 3%, 4%
and 4.5% respectively. Compute the current forward interest rate
for the period between years 2 and 3?

 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
to explain the shape of the yield curve.
Each theory assumes that the forward interest rate depends
on some variables.
To simplify, assume there are only two periods.
A. THE EXPECTATIONS HYPOTHESIS THEORY
Forward interest rates are a function of the expected
future interest rates by all the agents in the market
0F1,2 = E0[1R1]

 Remember that:  Therefore, according to this theory:

i. If the agents expect interest rates to increase in the
future, then the yield curve is positively sloped.
(1+0R2)2 =(1+0R1)(1+0F1,2)
ii. If the agents expect interest rates to decrease in the
future, then the yield curve is negatively sloped.

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3-THEORIES THAT EXPLAIN THE TERM 3-THEORIES THAT EXPLAIN THE TERM
STRUCTURE STRUCTURE

B. THE LIQUIDITY PREFERENCE THEORY
Assumes that there is a risk premium (L) for bonds with longer
maturity therefore, the forward interest rates depend on the
expected interest rates for the future and of this liquidity premium.
0F1,2 = E0[1R1]+L1
C. THE INFLATION PREMIUM THEORY
There is a premium associated to inflation risk (Π), and the bonds
issuers have to compensate bondholders for this risk.
These theories help us to derive the short term rates expected
by the market for future dates (E0(1R1); E0(2R1);…)
 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
is a liquidity premium of 1.2% and an inflation premium of
0.5%. Compute the one-year interest rate expected for next
year.
 Answer::
Answer

0F1,2 = E0[1R1]+Π1

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4- INTEREST RATE RISK MANAGEMENT 4- INTEREST RATE RISK MANAGEMENT

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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4- INTEREST RATE RISK MANAGEMENT 4- INTEREST RATE RISK MANAGEMENT

The bonds issued with maturities longer than one year receive a rating between Aaa and C: from the highest quality rating
to the lowest quality rating. Intermediate ratings above Baa are known as "investment grade." Those below Ba are known as
"speculative grade."
INTEREST RATE RISK:
These are the possible ratings:
The risk that arises from the possibility that the value of a portfolio of
Aaa
Highest quality and lowest risk bonds. Are known as gilt edged. The
coupon payments, as well as the principal payment, are guaranteed by
AAA
fixed income securities (or of a single security) decreases due to the
a wide and stable margin.
increase of interest rates.
Aa High quality bonds. Together with the Aaa bonds are known as high- AA

grade bonds. They are not as safe as the Aaa-rating bonds.

BOND PRICE-INTEREST RATE RELATIONSHIP.

Standard and Poor’s

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

 The bond price is a decreasing function of the corresponding

adequatly guaranteed at present but there is some uncertainty in the
long run. Have speculative characteristics.

Ba Protection of coupon and principal payments is moderate. Have BB interest rate.

speculative elements and are not safe in the future.

B Bonds which lack investment appeal. The guarantee of coupon and B

principal payment, as well as of not violating other terms of the debt
contract, are small in the long run.
P

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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4- INTEREST RATE RISK MANAGEMENT 4- INTEREST RATE RISK MANAGEMENT

 These changes in the price of a portfolio of bonds (or Which factors affect the sensitivity of the price of a bond to
individual bond) are known as its volatility. We are going to changes in the interest rate?
analyse the factors that affect it.
 Until the 60’s
 It was believed that it was a function of the lifetime of the bond.
We should not forget that interest risk only affects  More sensitive, the farther from maturity.
positively or negatively the holder of a bond that has to  However, people realized that bonds with similar maturity dates
sell it prior to the maturity date. could have different sensitivities to changes in interest rates, for
example, if coupons were different.

 Since the 70’s

 It is known that the sensitivity of the price of a bond to changes in
interest rates depends on the DURATION of the bond.

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4- INTEREST RATE RISK MANAGEMENT 4- INTEREST RATE RISK MANAGEMENT

DURATION::
DURATION
 Hopewell and Kaufmann (1973) ---- They compute the semi-
 It is the average maturity of a security (expressed in years)
elasticity of the value of a fixed income security with respect  It is the weighted average of the maturities of the cash-flows
to its yield to maturity (y) generated by the security, where the weights are the relative weight of
each cash-flow in the total value of the security.
dP 1 1
=− Duration  Bond with constant coupon payments
di P (1 + y )
 Where Duration is defined as: 1T C FV 
D=  s +T 
P  s =1 (1 + y ) s (1 + y )T 

1T C  MACAULAY  Zero coupon bond

D=  (ts − t0 ) (1 + y)s(ts −to ) 
P  s =1 Duration  The duration coincides with the maturity.

D= ts-t0
P is the price of the security, the
Cs are the expected cash-flows  Example: Compute the duration of a strip issued 4 years ago which
Example:
has 9 years and 6 months left to maturity.
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4- INTEREST RATE RISK MANAGEMENT 4- INTEREST RATE RISK MANAGEMENT

FACTORS THAT AFFECT DURATION: Example:
Example:
 Time to maturity (T) 1. Compute the Duration and the Modified Duration of a Spanish
 If the time to matutity increases, duration increases Treasury (face value 1,000€) with a 5% coupon rate which matures
 Coupon amount (C) in 5 years. Assume an yield to maturity of 4%.
 If the coupon amounts paid out increase, duration decreases.
2. Determine the change in the bond’s price if interest rates increase by
 Interest rates (y) 25 basis points.
 If the interest rate or the IRR increases, duration decreases.

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

 Therefore, the bond’s price sensitivity is equal to: ΔP

= −( DM )Δy
P
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4- INTEREST RATE RISK MANAGEMENT 4- INTEREST RATE RISK MANAGEMENT

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.

Portfolio Duration =Investment Horizon

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4- INTEREST RATE RISK MANAGEMENT 4- INTEREST RATE RISK MANAGEMENT

EXAMPLE: Suppose that a family wishes their son to
EXAMPLE:
enroll in a prestigious masters programme in 10 years time.
PRICE RISK REINVESTMENT The cost of such programme is 35,000€.
- If interest rates versus RISK In order to make sure that they will have enough money to
increase, bond price - If interest rates cover for this cost they decide to invest in bonds today such
decreases. increase, you have better that the returns of those bonds during 10 years achieve a
options to reinvest the future value (VT) of 35,000€.
coupon already received.
Let’s show that in this case immunization happens when
the bond’s Duration=10.
 If the familiy invests in bonds that mature in 14 years
(Duration=13.5)
These go in opposite  If during this period interest rates go up
directions and therefore  The family gains (↑VT) because the coupons that are received over time can
allow for be reinvested at an higher interest rate.
 The family losses (↓VT) at time T (in 10 years) when they sell the bonds in
order to obtain the money to pay for the masters, as when the interest rates
IMMUNIZATION in the market go up the bond prices go down.

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4- INTEREST RATE RISK MANAGEMENT USEFUL WEBSITES

If Duration=10 years, both movements (reinvestment of MOODY’S:

coupon payments and bond price at T) would be identical.  http://www.moodys.com

In this case, even if interest rates change FV=35,000€.

DIRECICIÓN GENERAL DEL TESORO:
 http://www.tesoro.es
A very easy example of bonds with duration of 10 years is to
buy zero coupon bonds that mature in 10 years. In this AIAF MARKET:
 http://www.aiaf.es
case, there is no risk related to reinvestment of coupon
payments, and with the sale of the bond before maturity MADRID STOCK EXCHANGE
given that the bond matures exactly when the money for  http://www.bolsamadrid.es
the masters is needed.
But this can also be done with coupon bonds with duration ANALISTAS FINANCIEROS INTERNACIONALES
equal to 10.  http://www.afi.es

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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

Mascareñas Pérez-Iñigo, J. (2002). Gestión de activos financieros de renta fija.

Pirámide.
 Chapters 4, 5 and 6.

Specialized:
Navarro, E. and Nave, J. (2001). Fundamentos de Matemáticas Financieras. Antoni Bosch
Editor, SA.
 Chapters 5 y 6.

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