FIN 4120- Fixed Income Securities Analysis

Lecture Notes

Professor Yizhou Xiao

CUHK Business School
Department of Finance

Spring 2020

FINA 4120 – Fixed Income 1

 Instructor and TA

• PROFESSOR: Yizhou Xiao

• Office: Room 1238, 12/F, Cheng Yu Tung Building
• E-mail: [email protected]
• Office Hour: By appointment

• TA: Jie (Jessica) XU

• PhD Student (CUHK)
• Office: Room 1239, 12/F, Cheng Yu Tung Building
• E-mail: [email protected]
• Office Hour: By appointment
FINA 4120 – Fixed Income 2
 Topic 1

Course Overview

FINA 4120 – Fixed Income 3

 Topic 1 - Outline

• Course overview and logistics

– Why fixed income/what will we cover?
– Course style
– Class logistics

• Review
– Interest rate quotations and conversions
– Basic PV calculation (annuity, car loan, mortgage)
– Basic bond valuation
– Basic yield curve
FINA 4120 – Fixed Income 4
Course Overview and Logistics

FINA 4120 – Fixed Income 5

 Where are we?

Investment Analysis & Portfolio Management

( FINA 3080 )

Derivatives
Others
FINA 4150
…
Options & Futures Fixed Income
FINA 4110 FINA 4120

FINA 4120 – Fixed Income 6

 Why Fixed Income?

• Equity Market: Cash flow is uncertain

• Fixed income: Cash flow fixed…
• So simple so boring…

FINA 4120 – Fixed Income 7

 Simple is Power (1)

• Simple is good if there is asymmetric information

• Townsend (1979)
• It is costly to verify information
• Example: Gangs

FINA 4120 – Fixed Income 8

 Costly Information Verification

• Why gangs extort fixed contribution fees?

• The income flows of local shops are owner’s
private information
• Owner does not
want to tell the
truth
• It is costly for
gangs to verify

FINA 4120 – Fixed Income 9

 Simple is Power (2)

• No uncertainty
• Accepted and preferred by people without
financial knowledge or underdeveloped financial
system
• Example 1: The Code of Hammurabi
• Example 2: Real estate firms in China mainland

FINA 4120 – Fixed Income 10

 Simple is Power (3)

• No uncertainty
• Idea Policy tool
• Central bank monetary market operation
• HKD:

FINA 4120 – Fixed Income 11

 1997 Asian Financial Crisis

• Soros Fund:

1. Borrow money from banks in country A

2. Sell it for USD
3. Central Bank does not have enough USD
4. Currency A depreciates
5. Repay loans at much cheaper price

FINA 4120 – Fixed Income 12

 1997 Asian Financial Crisis

Exchange rate
Currency (per US$1) Change
June 1997 July 1998
Thai baht 24.5 41 40.2%
Indonesian rupiah 2,380 14,150 83.2%
Philippine peso 26.3 42 37.4%
Malaysian ringgit 2.48 4.88 45.0%
South Korean won 850 1,290 34.1%

FINA 4120 – Fixed Income 13

 1997 Asian Financial Crisis

GNP (US$1 billion)

Country Change
June 1997 July 1998
Thailand 170 102 -40.0%
Indonesia 205 34 -83.4%
Philippines 75 47 -37.3%
Malaysia 90 55 -38.9%
South Korea 430 283 -34.2%

FINA 4120 – Fixed Income 14

 1997 Asian Financial Crisis

• One solution: increase interest rate

• Too costly
• Housing price, loans rates, stock market etc.
• HK 300% overnight rate
• HS stock index: -50%
• “任一招”

FINA 4120 – Fixed Income 15

 1997 Asian Financial Crisis

• Another way: Trade against speculators

• No benefit from lending
• Need huge reserved money (USD)
• In the final trading day for HS stock:
• 3 billion HKD in first 5 mins
• 79 billion HKD for the whole day
• HK gov used 120 billion HKD
• Averaged trading volume in 1997: 2 billion HKD
FINA 4120 – Fixed Income 16
 US Fixed Income Market
• Very large!
– The U.S. bond market is more than twice the size of the combined
market capitalization of all U.S. stock markets
– It amounts to almost $41.0 trillion (as of Q4, 2017)—making it by far
the largest securities marketplace in the world
– Current Amount: http://www.usdebtclock.org/index.html

Asset-Backed, 3%
Money Markets,
6%
Federal Agency
Municipal
Securities, 5%
, 9%

Corporate Debt, Treasury, 33%

21%

Mortgage Related,
22%

FINA 4120 – Fixed Income 17

US Fixed Income Market

FINA 4120 – Fixed Income 18

 This class is useful to students who are
interested in
• Sales and Trading

• Portfolio Management

• Commercial and Investment Banking

• Corporate Treasury

• Planning to take the CFA exams

FINA 4120 – Fixed Income 19

 We will cover

• Basic Bond Math

– Pricing
– Hedging
– Arbitrage
• Various Debt Instruments
– Convertible, ARS, MBS, ABS, CDS, CMO, CDO…
• Current Market Development

FINA 4120 – Fixed Income 20

 Examples of questions that will be answered

• What are PIK / TIPS / Reverse Convertible / Yankee /

Bulldog / Dim sum bonds?
• What do Janet Yellen and Ben Roethlisberger have in
common?
• Is there free lunch in fixed income market?
• Are yield curves better than tea leaves in predicting the future?
• Why do firms issue convertible bonds?
• How do I protect my bond investments from future interest
rate movements?
• What fixed income investment strategies do IBs recommend to
their clients and why?
FINA 4120 – Fixed Income 21
 Course Logistics

• Class
– Attendance will NOT be taken
– Show up on time
– Check Blackboard for supplementary materials
– Self-test questions are provided
– Print slides beforehand

FINA 4120 – Fixed Income 22

 Course Logistics
• Homework
– Can be solved in groups of no more than THREE students
– 2 in total

• Exams
– Two in-class: mid-term and Final

• Grade
– Class participation: 10%, HW: 20%, Mid-term: 20%, Final: 50%

FINA 4120 – Fixed Income 23

 Course Logistics
• Suggested Textbook (Not Required):
– Fixed Income Analysis, 3rd Edition
– Good practice and end-of-chapter questions
– WSJ/Economists
• Reference:
– Handbook of Fixed Income Securities

• Computation
– A financial calculator is needed for taking exams
• TI BA II Plus is preferred
– Students are allowed (and in fact are most encouraged) to use MS
Excel to solve homework questions

FINA 4120 – Fixed Income 24

 Mid Raw Scores

60 57

50

40
35
32
29
30

20

12
10

0
[0,60) [60,70) [70,80) [80,90) [90,100]
 Final Raw Scores

45
41
40
36
35

30

25 23
21
20 19

15

10
7
6
5
5
2
0
0
[0,10) [10,20) [20,30) [30,40) [40,50) [50,60) [60,70) [70,80) [80,90) [90,100]

FINA 4120 – Fixed Income 26

 Grades
Count of Grades
90

80

70

60

50

40

30

20

10

0
F C+ B+ A- A

FINA 4120 – Fixed Income 27

 Course Style

• Not technically challenging

– We won’t touch fancy stuff like stochastic processes,
simulations and numerical solutions
– Almost all contents are based on basic financial
concepts and calculations
• It is indeed quite challenging
– Lots of application and modifications
– Emphasis on the ability to apply basic concepts to new
products (out of your comfort zone!)

FINA 4120 – Fixed Income 28

 Course Style

• We focus on US market and mainland market

• US market:
– The most efficient market, good to understand basic
facts/concepts
– The largest market, and most new products debug here
• Mainland market:
– Dynamic and growing fast
– Major customers/competitors
• We will also take a look at HK market as well
FINA 4120 – Fixed Income 29
 Course Style

• Class note
– You still need to take MANY notes
– Commitment device to force you to digest and
reorganize by yourself
• Emphasis on analysis rather than computation
• Emphasis on why instead of how
– Why we need the product/feature?
– Implicit assumption? When it works?
– Pros and Cons?
FINA 4120 – Fixed Income 30
 Course Style

• Emphasis on applying fundamental ideas

– Not repeating homework/basic questions
– Not to screw you by complicated computations
– Mainly new products/issues haven’t touched in class
– Applying what we learnt to understand them
• May have more in-depth analysis that beyond the
scope of the class
– Curiosity
– A little bit disorganized…
FINA 4120 – Fixed Income 31
 Course Style

• Polarized teaching evaluations

– Love/hate “no pain no gain” style
– Love/hate touching non-standard products and apply
the basic concepts to understand them
– Love/hate the emphasis on application of basic stuff
and very little technical discussions
– Mid/Final non-standard questions
– Very fast face and (maybe) too much coverage
– Not interested in mainland market

FINA 4120 – Fixed Income 32

 Negative Comments

• Flat tone;
• Speak too fast;
• Need more practice questions;
• Need more information on mid/final
• Stop holding coffee cups!
• Too much/little coverage.

FINA 4120 – Fixed Income 33

• Next, Let’s review some basic concepts:
– Different interest rate quotations
– Annuity valuation
– Basic bond valuation
– Yield curve

FINA 4120 – Fixed Income 34

 Interest Rate Quotations
• Effect interest rate vs. Annual Percentage Rate
• Effective n-month interest rate is the actual rate of return over n months
– If the effective n-month interest rate is x%, what is the effective one-month
interest rate?
– Answer: (1 + x%)1/n -1
– Effective 12-month interest rate is also known as EAY (effective annual
yield)

• Annual Percentage Rate (APR) is a way of quoting the effective interest

rate
– APR with monthly compounding of y% implies the effective monthly
interest rate is y%/12
– APR with quarterly compounding of y% implies the effective quarterly
interest rate is y%/4
– APR with semi-annual compounding of y% implies the effective semi-
annual interest rate is y%/2

FINA 4120 – Fixed Income 35

 Continuously Compounded Return

• Defined as ln(1+effective interest rate)

• Why bother?
– Recall to go from n-month effective interest rate (Rn) to m-
month effective interest rate (Rm), we use
Rm+1 = (1 + Rn)m/n
– Now take logs on both sides and use cont. comp. returns (r)
rm = m/n×rn
– Much simpler expression!

FINA 4120 – Fixed Income 36

 Exercise: Interest rate conversion
• If APR with quarterly compounding is 8%, what is the effective 7-
month interest rate?

• If effective 4-month interest rate is 4%, what is the corresponding APR

with semi-annual compounding?

• If APR with monthly compounding is 12%, what is the EAY?

• If APR with monthly compounding is 12%, what is the corresponding

APR with semi-annual compounding?

• If effective 5-month interest rate is 5%, what is the effective 11-month

interest rate?

• If the EAY is 10%, what is the corresponding continuously

compounded return?

FINA 4120 – Fixed Income 37

 Rule of 72

• If you were to invest $100 with compounding

interest at a rate of 9% EAY, how many years
does it take to double your investment
• Approximately, 72/9 = 8 years.
• What happens, if interest rate becomes 2%, 3%,
8%, or 12%?

FINA 4120 – Fixed Income 38

 Simple Annuity

• An annuity is a stream of cash flows C received at the

end of each period for n periods

• Cash flows are the same over time

• There is no cash flow today (i.e. the first cash flow is

received one period from now)

FINA 4120 – Fixed Income 39

 Valuing a Simple Annuity

The PV of an annuity for n years is:

r is the one-period effective interest rate

FINA 4120 – Fixed Income 40

 Car Loan
You need to buy a $20,000 car but you have only
$4,000. You have two options:
a) You can borrow from a bank at 9% A.P.R
compounded monthly with a rebate of $1,000
b) “South Bend Dealers” offers financing at 6% A.P.R.
compounded monthly but then you forego a $1,000
rebate.
Both loans are for 30 months. What should you do?

FINA 4120 – Fixed Income 41

monthly payment bank:
X  1 
$15,000  1    X  $560
30 
0.09/12  (1  0.09/12) 

monthly payment dealer:

X  1 
$16,000  1    X  $576
30 
0.06/12  (1  0.06/12) 

FINA 4120 – Fixed Income 42

 Mortgage

You have managed to save $50,000 and are buying

your first house for $250,000. You are offered a 9%
APR (compounded monthly) 30 year mortgage.

a) What is your monthly payment?

b) How long would it take you to pay back the
mortgage if you are willing to cut back on your
monthly expenses and increase the monthly payment
by $200?

FINA 4120 – Fixed Income 43

a) Monthly payment
monthly interest rate 9%/12=0.75%
 1 1 

$200,000  X *     X *124.28
3012 
 0.75% 0.75%(1  0.75%) 
 X  $1,609
b) New monthly payment: $1,809
 1 1 
$200,000  1,809 *   
n 
 0.75% 0.75%(1  0.75%) 
200,000 * 0.75% 1
  1
1,809 (1  0.75%) n
200,000 * 0.75%
 (1  0.75%)  n  1   0.1708
1,809
ln( 0.1708)
n  236.5months  19 years8.5mohts
ln (1  0.75%)
FINA 4120 – Fixed Income 44
 Mortgage: Composition of mortgage
payments
• Break the monthly payments into “interest” and “principal”.
time Loan outstanding Payment Interest Principal
(beginning month) (end (end month) (end month)
month)
1 200,000 1,609 200,000(0.09/12)=1,500 109

2 200,000-109 = 1,609 199,891(0.09/12)=1,499 110

199,891
3 199,781 1,609 199,791(0.09/12)=1,498 111

… … … … …

360 1,597 1,609 12 1,597

FINA 4120 – Fixed Income 45

 Mortgage: Composition of mortgage
payments
$1,800

$1,600
Interest
$1,400

$1,200

$1,000

$800

$600

$400
principal
$200

$0
1 37 73 109 145 181 217 253 289 325

FINA 4120 – Fixed Income 46

 Coupon Bond
$50 $50
New Issue March 1, 2010 $50 $50
$50 $50
$50 $50
$1000 $50 $50
$50 $50
$50 $50
ABC Corporation $50 $50
$50
$50
$50 $50
10% Subordinated Note due 2030 $50 $50
$50 $50
$50 $50
$50 $50
$50 $50
(Coupons Redeemed Semiannually) $50 $50
$50 $50
$50 $50
$50 $50
$50 $50
FINA 4120 – Fixed Income 47
 ABC Corp Bond

• This simple bond is characterized by:

– Maturity, "T" --- 20 years
– Face value, "F" (also called par value) --- $1000
– Coupon rate, "c" --- $100 or 10% per year
– Payment frequency --- semi-annual
• Valuing the bond is easier than valuing equity
– It has a maturity date
– Cash flows are fixed and paid at pre-determined dates
(hence the name fixed income security)

FINA 4120 – Fixed Income 48

 Pricing --- Discounted Cash Flow

C1 C2 C3 CT 1 CT
P  "Value"  "Price"      
1  r1 (1  r2 ) 2 (1  r3 )3 (1  rT 1 )T 1 (1  rT )T
T
Ct

t 1 (1  rt )
t

where:

P  present value or price

T  time to maturity
Ct  periodic cash payment (coupon/interest)
r  discount rate or spot rate
t  time period when a payment is received
FINA 4120 – Fixed Income 49
 Yield to Maturity (YTM)

• A bond’s yield answers the question: “What is the

constant rate of return that makes the bond price equal
to the present value of promised future payments?” –
recall Internal Rate of Return (IRR)
C1 C2 C3 CT 1 CT
P  "Value"  "Price"      
1  y (1  y )2 (1  y )3 (1  y )T 1 (1  y )T
T
Ct

t 1 (1  y )
t

• Given the other information, you can solve for the yield
using a financial calculator or spreadsheet program

FINA 4120 – Fixed Income 50

 ABC Corporation Bond Example (1)

• Assume price P = $919.77, what is the YTM?

 40 50  1000
919.77    t 

 t 1 (1  y )  (1  y )
40

y  5.5%  semi  annual YTM

or, with calculator:
PMT  50, PV  919.77, N  40, FV  1000, I  ?
I  5.5%

FINA 4120 – Fixed Income 51

 ABC Corporation Bond Example (2)

• Assume a semi-annual YTM of 4.5%, what’s the Price?

 40 50  1000
P   t 
 40
 t 1 (1.045)  (1.045)
 1092.01
or, with calculator:
PMT  50, I  4.5%, N  40, FV  1000, PV  ?
PV  1092.01

FINA 4120 – Fixed Income 52

 Price-YTM Graph
Price

YTM

FINA 4120 – Fixed Income 53

 Price-YTM Relationship
• Price  YTM
– Given one, you can get the other
• Premiums, discounts and yield
– coupon rate < YTM => price < face (discount)
– coupon rate = YTM => price = face (par)
– coupon rate > YTM => price > face (premium)

FINA 4120 – Fixed Income 54

 Practice Question

Issue Coupon (%) Maturity Yield (%) Price

(year)
A 7 3/8 16 6 114.02
B 6 3/4 4 7 99.14
C 0 10 5 102.1
D 5 1/2 20 5.9 104.15
E 8 1/2 18 8.5 100.00
F 4 1/2 6 4 96.5
G 6 1/4 25 6.25 103.45

Which prices are wrong?

FINA 4120 – Fixed Income 55

 Answer

C, D, F and G

FINA 4120 – Fixed Income 56

 Quotation Conventions

• Bond yields are quoted in many different ways. To turn a yield quotation
into a price or vice versa, you have to know which convention you are
working with!

• To compare the yields on alternative investments quoted differently, you

need to convert all of the yields to the same convention or “basis”.

• You do not need to memorize the myriad bond market quotation

conventions for this class. But you do need to learn to work with several
common conventions.

FINA 4120 – Fixed Income 57

 Bond Equivalent Yield (BEY) --- Coupon Bond

• Similar to YTM but assumes semi-annual compounding:

C1 C2 C3 CT 1 CT
P     
y y 2 y 3 y y
1 (1  ) (1  ) (1  )T 1 (1  )T
2 2 2 2 2
T
Ct

y
t 1 (1  )t
2
– In the previous example, BEY = 2 ∙ semi-annual YTM = 11%
– Basically, it is the annual percentage rate (APR) with
semiannual compounding
• BEY is the most common way coupon bond yields are
quoted in financial press

FINA 4120 – Fixed Income 58

 Effective Annual Yields
• EAY is the effective 12-month interest rate

• If “Y” is the quoted BEY, investors earn Y/2 every six months. The
equivalent effective annual yield is:

(1 + Y/2)2 – 1

• Comprehension Check Question:

A bond equivalent yield is 10.5%

What is the effective annual rate?

.105 2
(1  )  1  10.776%
2
What is the effective 6- month rate?
10.5%/2 = 5.25%

FINA 4120 – Fixed Income 59

 Key Points

• It is important to understand fixed income

instruments

• Bond price is determined by discounted cash

flows and is therefore a function of two things:
– Cash Flows
– Discount Rates

FINA 4120 – Fixed Income 60