all about fixed income instruments

Understanding Fixed Income Instruments

Welcome To The World Of Risk Free rather Lower Risk and moderate returns

You are safe but no assurance on that safety

Quite a pickle – Isn’t It?

We see why?????

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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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Types Of Bonds

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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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Accrual Securities

Buyer Seller

Jan 09 Jan 10 Jun 10 Jan 11 Jun 11Jun 09$ 5 $ 5

$ 5 $ 5

$ 5

Accrued Interest

Par Value of $100 - Semi Annual Interest Of 5%

Dirty Price – Trading Cum-Coupon

Clean Price – Trading Ex-Coupon

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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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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

Sum Of the Present values of all expected coupon payments & Principal @ Par

C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value

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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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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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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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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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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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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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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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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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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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Fixed Income Products

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

Repo

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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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Fixed Income Derivatives

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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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Weapons Of Financial Destruction

Collateralized Debt Obligation Process Of Securitization

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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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Interest Swaps – Illustrated

Time 6-Month Fixed Rate Floating Rate Swap

0 2.80% –100.0 –100.0 00.5 3.40% 2.3 1.4 0.91 4.40% 2.3 1.7 0.6

1.5 4.20% 2.3 2.2 0.12 5.00% 2.3 2.1 0.2

2.5 5.60% 2.3 2.5 –0.23 5.20% 2.3 2.8 –0.5

3.5 4.40% 2.3 2.6 –0.34 3.80% 102.3 102.2 0.1

Cash Flows During the Life of

a Hypothetical USD 100MM 4.6% Four-Year Swap

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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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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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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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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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all about fixed income instruments

Economy & Finance

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rate risk price

features of bonds coupon

bond yield

types of bonds callable

price vs yield price

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