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PB = ∑ C t t + ParValue T
(1+ r )
T
t =1 (1+ r )
Ct = 40 (SA)
FV = 1000
T = 20 periods
r = 3% (SA)
Prices and Coupon Rates
Price
Yield
Yield to Maturity
• Interest rate that makes the present value of the
bond’s payments equal to its price.
Solve the bond formula for r
PB = ∑ C t
+
ParValue T
(1+r )
T
t =1 (1+r )
t
Yield to Maturity Example
35 20
1000
950 = ∑ +
(1+r )
T
(1+r )
t
t=1
where
I = interest payment
P1 = price in one period
P0 = purchase price
Holding-Period Example
CR = 8% YTM = 8% N=10 years
Semiannual CompoundingP0 = $1000
In six months the rate falls to 7%
P1 = $1068.55
HPR = [40 + ( 1068.55 - 1000)] / 1000
HPR = 10.85% (semiannual)
Holding-Period Return:
Multiperiod
• Requires actual calculation of reinvestment income
• Solve for the Internal Rate of Return using the
following:
– Future Value: sales price + future value of
coupons
– Investment: purchase price
Default Risk and Ratings
• Rating companies
– Moody’s Investor Service
– Standard & Poor’s
– Duff and Phelps
– Fitch
• Rating Categories
– Investment grade
– Speculative grade
Factors Used by Rating
Companies
• Coverage ratios
• Leverage ratios
• Liquidity ratios
• Profitability ratios
• Cash flow to debt
Protection Against Default
• Sinking funds
• Subordination of future debt
• Dividend restrictions
• Collateral
Default Risk and Yield
• Risk structure of interest rates
• Default premiums
– Yields compared to ratings
– Yield spreads over business cycles
Managing Fixed Income
Securities: Basic Strategies
• Active strategy
– Trade on interest rate predictions
– Trade on market inefficiencies
• Passive strategy
– Control risk
– Balance risk and return
Bond Pricing Relationships
C 3% 30 Years 10%
D 3% 30 Years 6%
Bond Pricing Relationships
A
prices
C
Changes in Yield to Maturity D
Bond Pricing Relationships
• Inverse relationship between price and yield.
• An increase in a bond’s yield to maturity results in a
smaller price decline than the gain associated with a
decrease in yield.
• Long-term bonds tend to be more price sensitive than
short-term bonds.
Bond Pricing Relationships
(1 +y)
Rule 6 The duration of a level annuity is equal to:
y
1+ y T
−
y (1 + y ) T − 1
Rules for Duration (cont’d)
Rule 7 The duration for a corporate bond is equal to:
1 + y (1 + y ) + T (c − y )
−
y c[(1 + y ) T − 1] + y
Duration and Convexity
Price
Pricing Error
from convexity
Duration
Yield
Convexity
• Convexity :
– 1/ P*(1+y)2*∑[CFt/(1+y)t (t2+t)]
Yield Curve
Yield Curve and Term Structure
of Interest Rate
• Yield Curve : If we plot the yield ( observed on a
particular day ) of different securities of different
maturity in Y axis against the corresponding
maturity of the securities in the X axis, we get an
Yield curve. The Yield curve can take the shape of the
following :
– Upward slopping yield curve
– Downward slopping yield curve
– Flat Yield Curve
Yield Curve and Term Structure
of Interest Rate
• The shape of the yield curve is explained with the
help of the term structure of interest rate. The term
structure has three theories :
– Unbiased Expectation Theory
– Liquidity Preference Theory
– Market Segmentation Theory
Yield Curve and Term Structure
of Interest Rate
• Unbiased expectation theory : It holds that the forward rate represents the
average opinion of the expected future spot rate for the period in question.
• The investor could follow a maturity strategy investing the money now for the
two years at two years spot rate of say 8% p.a and at the end , he will get 1.1664.
• Or he can invest in 1 year for 7% to get 1.07 after one year and then to reinvest
after one year.
• Although the investor does not know what the one year spot rate will be one
year from now, the investor has an expectation about what it would be. This is
denoted by es1,2.
• .If the investor thinks that it will be 10% , then his.her investment has an
expected value 1.177(=1*1.07*1.10)
• In this case , the investor would chose a roll over strategy.
• Under this unbiased expectation theory, the equilibrium condition is satisfied by
the following equation :
– (1+s1 ) ( 1+ es1,2 ) = ( 1+ s 2 )2
Yield Curve and Term Structure
of Interest Rate
– (1+s1 ) ( 1+ es1,2 ) = ( 1+ s 2 )2
– The meaning of the above equilibrium equation is
that the expected return from a maturity strategy
must equal the expected return on a rollover
strategy.
– An upward slopping yield curve would be
explained by the fact that es1,2 is to expected to rise
in the future;
– An downward slopping yield curve would be
explained by the fact that es1,2 is to expected to
decline in the future;
Yield Curve and Term Structure
of Interest Rate
• Liquidity Preference Theory : It starts with the
notion that investors are primarily interested in
purchasing short term securities. This is due to price
risk .
• Considering this , the investor must require a
premium for investment in the longer term security.
This is called the liquidity premium.
• This is defined as the difference between the forward
rate and expected spot rate . So
f12 = es12 + L12
Yield Curve and Term Structure
of Interest Rate
• Liquidity Preference Theory : The equation of the Liquidity
Preference theory :
– (1+s1 ) ( 1+ es1,2 ) < ( 1+ s 2 )2
– The above inequality holds as the maturity strategy is more
risky so the return should be more.
Downward slopping Yield Curve : Here s1> s2 . The above
inequality will hold if es1,2 is substantially lower than the s1
implying that the market interest rate is expected to decline
sharply.
Flat Yield Curve : Here s1= s2 The above equation will be true if
es1,2 is less than s1 .
Yield Curve and Term Structure
of Interest Rate
• Liquidity Preference Theory : The equation of the Liquidity
Preference theory :
– (1+s1 ) ( 1+ es1,2 ) < ( 1+ s 2 )2
– The above inequality holds as the maturity strategy is more
risky so the return should be more.
Downward slopping Yield Curve : Here s1> s2 . The above
inequality will hold if es1,2 is substantially lower than the s1
implying that the market interest rate is expected to decline
sharply.
As an example, assume that the one year spot rate (s1) is 7%
and the two year spot rate (s2) is 6%.
This is a situation where the term structure is downward
slopping.
Yield Curve and Term Structure
of Interest Rate
• Liquidity Preference Theory : Now according to the
liquidity preference theory,
(1+0.07)(1+es12) <(1.06)2
Total 14693.28
B .Interest falls to 7 %
1 4 800(1.07)4=1048.64
2 3 800(1.07)3= 980.03
3 2 800(1.07)2= 915.92
4 1 800(1.07)1=856.00
5 0 800(1.07)0=800.00
5 0 10,800/(1.07) =10093.46
Total 14694..05
Immunization
Total 14696.02
Immunization
Accumulated value of
Invested Fund
t* D* Time
Immunization
• As the time passes on the duration of the asset profile changes .
• This brings the importance of rebalancing the portfolio.
• The manager must rebalance the portfolio continuously to keep
the duration of the portfolio equal to the maturity profile of the
liability.
• This is so because duration generally decreases less rapidly than
does maturity.
• So even if the portfolio is immunized at the beginning , the
maturity and duration fall in different rate,necessitating the
rebalancing of the portfolio.
Immunization
• There are many shortcomings in immunization technique :
• It assumes that the portfolio yield curve is flat.
• In the case of an upward sloping yield curve, the appropriate
rate need to be taken from the yield curve.
• Next is the parallel shift in yield curve. In case on non parallel
shift in yield curve immunization technique would not be able
to protect the portfolio from the interest rate risk.
• The immunization does not address the inflation issues at all.
Cash Flow Matching and
Dedication
• In case of cash flow matching, the obligations are first
found out for a particular period and then cash flows
are matched by forming a portfolio.
• Once matching is carried out, the portfolio need not
be immunized.
• When matching is done for the entire investment
horizon, it is called dedication technique.
• But getting bonds to follow the cash flow matching
and dedication technique is very difficult.
Active Bond Management
Technique
• There are two ways for active bond management technique.
– Interest rate forecasting : it tries to anticipate movements
across the entire spectrum of the fixed income markets.
– Identification of relative mis pricing within fixed income
markets
• Both the techniques would generate abnormal returns only if
the analyst’s information or insight is superior to that of the
market.
• Empirical evidences do not support that individual possesses
better knowledge than that of the market.
Bond Swap
• This belong to the active bond management
technique.
• Bond swap means replacement of one types of bonds
with that of another.
• There are fives types of bond swaps :
– The substitution swap
– The intermarket spread swap
– The rate anticipation swap
– The pure yield swap
– The tax swap
Different types of bonds
• The substitution swapSwap
is an exchange of one bond for a nearly
identical substitute. The substituted bonds should be of
essentially equal coupon,maturity, quality,call feature ,sinking
fund provisions etc. This swap would be motivated by a
discrepancy between the prices of the bonds represents a profit
opportunity.
• The Intermarket spread swap is pursued when an investor
believes that the yield spread between two sectors of the bond
markets is out of line. For example if the current spread
between the corporate and government bond market is
considered too wide and is expected to narrow, the investor will
shift from government bond to corporate bond.
Different types of bonds
Swap
• The rate anticipation swap is pegged to interest rate
forecasting.If the investor views that interest rate is
likely to decrease, it would replace shorter duration
bond with longer duration bond .
• The pure yield swap is aimed to earn the higher
yield. This strategy involves replacement of lower
yield bond with higher yield.
• The tax swap is to exploit some tax benefits by
adjusting capital loss from future gains – the facilities
available with some selected securities.
Horizon Analysis
• The analysts using this approach selects a particular
holding period and predicts the yield curve at the
end of the period.
• Then bond’s end of period price is calculated from
the yield curve.
• Then the analysts add the coupon income and the
perspective capital gain of the bond to arrive at the
total return on bond in the horizon period.
•
Horizon Analysis
Suppose a 20 year maturity ,10% coupon bond currently yields
9% and sells at Rs 1092.01.
• An analyst with a 5 year time horizon would be concerned
about the bond’s price and the value of reinvested coupon five
years hence.
• At that time the bond will have 15 years maturity , so the
analyst will predict the yield on 15 years maturity at the end of
5 year period to determine the bond’s expected price .
• If the yield is expected to be 8% , the bond’s end of period price
will be
– 50 * Annuity Factor ( 4% ,30)+1,000 PV Factor ( 4%,30)= Rs
1172.92
Horizon Analysis
• The capital gain on this bond will be Rs 80.91 .
• Meanwhile the coupon paid by the bond will be reinvested over
the five year period.
• The analyst must predict a reinvestment rate at which the
invested coupons can earn interest.
• Suppose the assumed rate is 4% per half year period.
• If all the coupons are reinvested at this rate,the value of the ten
semiannual coupon payments with accumulated interest rate at
the end of the five year will be Rs 600.31.
• The total return proved by the bond over the holding period is
Rs 681.82/Rs 1092.01 i.e. 62.4% .
• The analyst repeats this procedure for many securities and
select the ones promising superior holding period return.
Contingent Immunization
• It is mixed passive –active strategy .
• Suppose that the interest rate at present is 10% per annum and a
manager’s portfolio is worth Rs 10 million right now.
• At current rate the manager can lock in via conventional immunization
techniques, a future portfolio value of Rs 12.1 million after 2 years.
• Now suppose that the manager wants to pursue active management
but is willing to risk losses only to the extent that the terminal value of
the portfolio would not drop lower than Rs 11 million.
• Because only Rs 9.09 million ( Rs 11million/1.102) is required to
achieve this minimum acceptable terminal value , and the portfolio is
currently worth Rs 10 million , the manager can afford to risk some
losses at the outset and might start off with an active strategy rather
than immediately immunizing.
Contingent Immunization
• The key is to calculate the value of the fund required to lock in
via immunization a future value of Rs 11 million at current
rates.
• If T denotes the time left until the horizon date and r is the
market interest rate at any particular point of time , then the
value of the fund necessary to guarantee an ability to reach the
minimum amount of terminal value is Rs 11 million/(1+r)T,
because this size portfolio if immunized will fetch Rs 11 million.
• This value becomes the trigger point.
• When the actual portfolio value dips to the trigger point , active
management will cease.
• Contingent upon reaching the trigger , an immunization
strategy is initiated .
Contingent Immunization
Rs in Million
Portfolio
Value
Trigger Point
t* t
Horizon
Contingent Immunization
Rs in Million
Portfolio
Value
t* t
Horizon
Interest Rate Derivatives
Interest Rate Swap
Interest Rate SWAP
• Consider a three-year swap initiated on March 1,1999 ,in which
company B agrees to pay to company A an interest rate of 5%
per annum on a notional principle of $ 100 million .
• In return company A agrees to pay to Company B the six-
month LIBOR rate on the same notional principal.
• We assume the agreement specifies that payments are to be
exchanged every six months and the 5% interest rate is quoted
with semi annual compounding.
• This is represented diagrammatically in the next slide :
Interest Rate SWAP
5.0%
Company A Company B
LIBOR
Cash Flows to Company B
Date LIBOR rate ( %) Floating Cash Fixed Cash Flow Net Cash Flow
Flow Received Paid
1.3.1999 4.20
1.3.1999 4.20
CDO
Mortgage ABS in a
Backed Narrower
Securities Sense
( MBS) •Credit Card
Residential •Equipment
Mortgage •Student Loan
CLO CBO
Commercial •Music Royalties Loan owned Bonds
Mortgage By Traded in the
Bank Market
Process of securitisation
Credit Originator /
Enhancer Servicer
Provides Credit Receives Loan sale Receives inflow
Enhancement Fund From reference
Transfer
Of Assets Issuer of
Trustee S.P.V. Underwriter
Principal Debt
And Interest Securities
Minus
Servicing Revenues from
Fees Debt Distribution
Securities Of
Disburses
Revenues to Debt Securities
Investors Investors
CDO
• In a Collateralised Debt Obligation ( CDO) structure, the issuer
repackages ( corporate or sovereign ) debt securities or bank
loans in to a reference portfolio ( the collateral) , whose proceeds
are subsequently sold to investors in the form of debt securities
with various levels of senior claim on this collateral.
• The issued securities are structured in so called senioritised credit
tranches, which denote a particular class of debt securities
investor may acquire when they invest in a CDO transaction.
• The tranching can be done by means of various structural
provisioning governing the participations of investors in the
proceeds and losses stemming from the collateral.
CDO
• Subparticipation is one of the most convenient vehicles for
attaching different levels of seniority to categories of issued
securities, so that losses are allocated to the lowest subordinate
tranches before the mezzanine and senior tranches are
considered.
• This process of filling up the tranches with periodic losses bottom
up results in a cascading effect .
• Both interest and losses are allotted according to investor
seniority.
• This prioritisation of claims and losses from the reference
portfolio guarantee that senior tranches carry a high investment
grading ( AAA) , provided sufficient junior tranches have been
issued to shield more senior tranches from credit losses.
Types of CDO
• The classification of CDOs depends on possible variability in the
valuation of the collateral ex post the issuance of the securities.
• In Market value CDO , the allocation of payments to various
tranches depends on the mark to market returns on the reference
portfolio underlying the transactions.
• The market value form of CDO s is generally applied in cases of
distressed reference portfolio of bonds or loans such that the
credit and trading expertise of the originator of these assets might
provide grounds for arbitrage gains from the differences in prices
between the distressed assets on the bank books and their
aggregate valuation when bundled in a reference portfolio
underlying securities.
Various form of structure
enhancement – Waterfall
CDO Tranches
AAA Senior Tranches
Portfolio
Payment A Mezzanine Tranches
X 1000 Made
BB Subordinated Tranches
Y 2000
Equity Tranches
Z 4000
Various form of structure
enhancement
• Over collateralisation : Volume of assets is more than volume of
issued notes.
• Excess Spread: Difference between interest payment from assets
and CDO coupons are collected in an account.
• Guarantee by the originator.
• Insurance by the third party.