Understanding
Fixed Income Instruments
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Understanding Fixed Income Instruments
Welcome To The
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rather Lower Risk
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that safety
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Isn’t It?
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Understanding Fixed Income Instruments
Conventions
Debt securities – Issued by borrowers to
obtain liquidity or capital for their short term
or long term needs
Promised payment events – Interest
payment & Repayment of fixed amount
Secured & Unsecured
Risk prone – Not absolute risk free
Mid 2009 Debt market valued at $30 Trillion
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Understanding Fixed Income Instruments
Types Of Bonds
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Understanding Fixed Income Instruments
Features Of Bonds
Coupon Rate
“6s of 12/10/2009” – 6% Coupon maturing @...
Monthly (MBS & ABS), Semi-Annually
Zero-Coupon Bonds
Accrual Securities
Deferred Coupon Bonds
Floating Rate Securities
Reference Rate + Quoted Margin
1-month LIBOR+100 basis points
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Understanding Fixed Income Instruments
Accrual Securities
Par Value of $100 - Semi Annual Interest Of 5%
Buyer Seller
Jan 09 $ 5 Jun 09 $ 5 Jan 10 $ 5 Jun 10 $ 5 Jan 11 $ 5 Jun 11
Accrued Interest
Dirty Price – Trading Cum-Coupon Clean Price – Trading Ex-Coupon
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Understanding Fixed Income Instruments
Calculating Accrued Interest
Three pieces info needed:
No of days in the accrued interest period
No Of days in the coupon period
Dollar amount of the coupon payment
AI is calculated as
Day count conventions
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Understanding Fixed Income Instruments
Features Of Bonds – Contd’
Maturity Date
Time period over receipt of interest payments
Yield on a Bond
Price Of the Bond
Price Of the Bond is calculated as
C = coupon payment
n = number of payments
i = interest rate, or required yield
M = value at maturity, or par value
Sum Of the Present values of all expected
coupon payments & Principal @ Par
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Understanding Fixed Income Instruments
Features Of Bonds – Contd’
Yield – returns which investor gets by holding
the bond till maturity
Current Yield Vs Adjusted Current Yield
A bond with a par value of $100 for $95.92 and it paid a
coupon rate of 5%
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Understanding Fixed Income Instruments
Price Vs Yield
Price of a Bond & Yield of a Bond are
inversely related
When the Coupon rate is less than the
required Yield, the price is less than the par
value
When price is greater than the par value, the
coupon rate is greater than the required yield
YTM - The discount rate that equates a
bond’s price with the present value of its
future cash flows.
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Understanding Fixed Income Instruments
Risk Associated With Bonds
Interest Rate Risk
Price Of a bond falls when interest rates rise
Floating Rate Securities
Credit Risk
Default, Downgrade
Contractual Risk
Callable Bonds
Inflation Risk
Increase in inflation – Purchasing power
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Understanding Fixed Income Instruments
Types Of Bonds
Callable Bonds - A bond that can be redeemed by
the issuer prior to its maturity.
main cause of a call is a decline in interest rates
Convertible Bonds – A bond that can be converted
into a predetermined amount of the company's
equity at certain times during its life
Eurodollar Bonds - U.S.-dollar denominated bond
issued by an overseas company and held in a
foreign institution outside both the U.S. and the
issuer's home nation
Chinese bank held dollar-denominated bonds issued by a
Japanese company, this would be considered a eurodollar
bond.
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Understanding Fixed Income Instruments
Types Of Bonds
Eurobond is an international bond that is
denominated in a currency not native to
the country where it is issued
Yankee Bond - A bond denominated in U.S.
dollars that is publicly issued in the U.S. by
foreign banks and corporations
Bulldog Bond - A sterling denominated bond
that is issued in London by a company that
is not British
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Understanding Fixed Income Instruments
Types Of Bonds
Maple Bond - A bond denominated in
Canadian dollars that is sold in Canada by
foreign financial institutions
Matilda/Kangaroo Bond - An bond
denominated in the Australian dollar
and issued on the Australian market by a
foreign entity
Samurai Bond - Yen-denominated bond
issued in Tokyo by a non-Japanese
company
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Understanding Fixed Income Instruments
Fixed Income Products
Treasury Bills – Maturities with 6,12 & 18
months duration
Issued by the Treasury of the state
Always issued at discount
Government Bonds - Medium & long term
bonds – known as bonos & obligaciones
Maturities of 10, 15 & 30 Years
Fixed Interest rate through annual coupons
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Understanding Fixed Income Instruments
Fixed Income Products
Commercial Paper - An unsecured, short-term debt
instrument issued by a corporation, typically
for the financing of accounts receivable, inventories
and meeting short-term liabilities.
Maturities on commercial paper rarely range any
longer than 270 days
Certificate of deposit or CD is a time deposit, a
financial product commonly offered to consumers
by banks, thrift institutions, and credit unions
Held until maturity
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Understanding Fixed Income Instruments
Fixed Income Products
Repo – Repurchase
Agreements (Not
necessarily FI product)
Is a contract in which
a security is sold with
an agreement to
repurchase the
security at a higher
price
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Understanding Fixed Income Instruments
Fixed Income Products
Repo
Reverse Repo is a
contract in which a
security is borrowed
with an agreement
to replace the
security at a higher
price
Secured lending and
borrowing
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Understanding Fixed Income Instruments
Fixed Income Products
Commercial Paper – Zero Coupon bonds
issued at discount
Short term with maturities 1,3,6,12 & 18 months
Placed in the primary market through
competitive auctions
Convertible/Exchangeable Bonds
Enables a financial asset to be transformed
into other
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Understanding Fixed
Income Instruments
Fixed Income Derivatives
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Understanding Fixed Income Instruments
MBS
A mortgage-backed security (MBS) is an
asset-backed security or debt obligation
that represents a claim on the cash flows
from mortgage loans, most commonly on
residential property.
Residential mortgage-backed security (RMBS)
Commercial mortgage-backed security
Collateralized mortgage obligation
Stripped mortgage-backed securities
Interest-only stripped mortgage-backed securities
Principal-only stripped mortgage-backed securities
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Understanding Fixed
Income Instruments
Weapons Of Financial Destruction
Collateralized Debt Obligation Process Of Securitization
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Understanding Fixed Income Instruments
Interest Rate Swap
Interest rate swap is a derivative in which
one party exchanges a stream of interest
payments for another party's stream of cash
flows
Fixed for floating/Vanilla Interest Rate Swaps
Often use LIBOR as reference rates
Hedging/Speculation on interest & FX rates
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Understanding Fixed Income Instruments
Interest Swaps – Illustrated
Time 6-Month Fixed Rate Floating Rate Swap
0 2.80% –100.0 –100.0 0
Cash Flows During 0.5 3.40% 2.3 1.4 0.9
the Life of a 1 4.40% 2.3 1.7 0.6
Hypothetical USD
1.5 4.20% 2.3 2.2 0.1
100MM 4.6% Four-
Year Swap 2 5.00% 2.3 2.1 0.2
2.5 5.60% 2.3 2.5 –0.2
3 5.20% 2.3 2.8 –0.5
3.5 4.40% 2.3 2.6 –0.3
4 3.80% 102.3 102.2 0.1
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Understanding Fixed Income Instruments
Interest Rate Caps
An interest-rate cap is an OTC derivative in
which the buyer receives payments at the
end of each period in which the interest
rate (reference rate/LIBOR) exceeds the
agreed strike rate (Cap rate)
3-year, USD 200MM notional cap
6-month Libor - index rate,
struck at 7.5%.
Protects from int. rate rises
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Understanding Fixed Income Instruments
Interest Rate Floors
An interest rate floor is a derivative in which
the buyer of the floor receives money if on
the maturity the reference rate fixed is
below the agreed strike price of the floor
Protects holder from declines in short-term interest
3-year, USD 200MM notional cap
6-month Libor - index rate,
struck at 7.5%.
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Understanding Fixed Income Instruments
Swaption
A swaption is an option granting its owner
the right but not the obligation to enter into
an underlying swap
the term "swaption" typically refers to
options on interest rate swaps
A payer swaption gives the owner of the swaption the right
to enter into a swap where they pay the fixed leg and
receive the floating leg.
A receiver swaption gives the owner of the swaption the
right to enter into a swap where they will receive the fixed
leg, and pay the floating leg.
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Understanding Fixed Income Instruments
Swaption
designed to give the holder the benefit of
the agreed-upon strike rate if the market
rates are higher
American swaption, in which the owner is allowed to enter
the swap on any day that falls within a range of two dates.
European swaption, in which the owner is allowed to enter
the swap only on the maturity date.
Bermudan swaption, in which the owner is allowed to enter
the swap only on certain dates that fall within a range of
the start (roll) date and end date.
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