fixed income-i
DESCRIPTION
CFA 1 Fixed Income Part 1TRANSCRIPT
Fixed Income Securities – I
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Fixed Income Securities – I
Mapping to Curriculum
• Reading 57: Introduction to the Valuation of Debt
Securities
• Reading 53: Features of Debt Securities
• Reading 54: Risks Associated with Investing in Bonds
• Reading 55: Overview of Bond Sectors and Instruments
Expect around 15 questions in the exam from today’s lecture
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Expect around 15 questions in the exam from today’s lecture
• Reading 57: Introduction to the Valuation of Debt
Securities
• Reading 53: Features of Debt Securities
• Reading 54: Risks Associated with Investing in Bonds
• Reading 55: Overview of Bond Sectors and Instruments
Expect around 15 questions in the exam from today’s lecture
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Expect around 15 questions in the exam from today’s lecture
Key Concepts
• Discount, Par, Premium• Bond Pricing• Yield-Price Relationship• Clean Price, Dirty Price• Embedded Options• Risks Associated With Investing In Bonds• Effect of Maturity and Coupon on Duration• Types of Government Bonds• ABS, MBS,CMO,CDO
© Neev Knowledge Management – Pristine
• Discount, Par, Premium• Bond Pricing• Yield-Price Relationship• Clean Price, Dirty Price• Embedded Options• Risks Associated With Investing In Bonds• Effect of Maturity and Coupon on Duration• Types of Government Bonds• ABS, MBS,CMO,CDO
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• Discount, Par, Premium• Bond Pricing• Yield-Price Relationship• Clean Price, Dirty Price• Embedded Options• Risks Associated With Investing In Bonds• Effect of Maturity and Coupon on Duration• Types of Government Bonds• ABS, MBS,CMO,CDO
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• Discount, Par, Premium• Bond Pricing• Yield-Price Relationship• Clean Price, Dirty Price• Embedded Options• Risks Associated With Investing In Bonds• Effect of Maturity and Coupon on Duration• Types of Government Bonds• ABS, MBS,CMO,CDO
3
Fixed Income (Introduction)
Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuerto make payments on a fixed schedule, even if the number of the payments may be variableA bond is simply a promise to pay interest on borrowed money, there is some important terminologyused by the fixed-income industry:
• The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and paysthe interest.
• The principal of a bond – also known as maturity value, face value, par value – is the amount that theissuer borrows which must be repaid to the lender.
• The coupon (of a bond) is the interest that the issuer must pay.• The maturity is the end of the bond, the date that the issuer must return the principal.• The bond Indenture is the contract that states all of the terms of the bond. It contains the obligations,
rights, and any options available to the issuer or buyer of a bonds. A written agreement betweenthe issuer of a bond and his/her bondholders, usually specifying interest rate, maturity date, convertibility.
© Neev Knowledge Management – Pristine
Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuerto make payments on a fixed schedule, even if the number of the payments may be variableA bond is simply a promise to pay interest on borrowed money, there is some important terminologyused by the fixed-income industry:
• The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and paysthe interest.
• The principal of a bond – also known as maturity value, face value, par value – is the amount that theissuer borrows which must be repaid to the lender.
• The coupon (of a bond) is the interest that the issuer must pay.• The maturity is the end of the bond, the date that the issuer must return the principal.• The bond Indenture is the contract that states all of the terms of the bond. It contains the obligations,
rights, and any options available to the issuer or buyer of a bonds. A written agreement betweenthe issuer of a bond and his/her bondholders, usually specifying interest rate, maturity date, convertibility.
4
Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuerto make payments on a fixed schedule, even if the number of the payments may be variableA bond is simply a promise to pay interest on borrowed money, there is some important terminologyused by the fixed-income industry:
• The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and paysthe interest.
• The principal of a bond – also known as maturity value, face value, par value – is the amount that theissuer borrows which must be repaid to the lender.
• The coupon (of a bond) is the interest that the issuer must pay.• The maturity is the end of the bond, the date that the issuer must return the principal.• The bond Indenture is the contract that states all of the terms of the bond. It contains the obligations,
rights, and any options available to the issuer or buyer of a bonds. A written agreement betweenthe issuer of a bond and his/her bondholders, usually specifying interest rate, maturity date, convertibility.
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Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuerto make payments on a fixed schedule, even if the number of the payments may be variableA bond is simply a promise to pay interest on borrowed money, there is some important terminologyused by the fixed-income industry:
• The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and paysthe interest.
• The principal of a bond – also known as maturity value, face value, par value – is the amount that theissuer borrows which must be repaid to the lender.
• The coupon (of a bond) is the interest that the issuer must pay.• The maturity is the end of the bond, the date that the issuer must return the principal.• The bond Indenture is the contract that states all of the terms of the bond. It contains the obligations,
rights, and any options available to the issuer or buyer of a bonds. A written agreement betweenthe issuer of a bond and his/her bondholders, usually specifying interest rate, maturity date, convertibility.
4
Basic Structure Of A Plain Vanilla Bond
50
100
150
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-150
-100
-50
0T0 T1 T2 T3 T4 T5
5
Basic Structure Of A Plain Vanilla Bond
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T5 T6 T7 T8 T9 T10
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Key Issues In Introduction To The Valuation OfDebt Securities
• Bond Valuation Process
• Problems encountered in Valuation
• Computing the value of a bond
• Change in value with passage of time
• Value of a zero-coupon bond
• Arbitrage-free valuation approach
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• Bond Valuation Process
• Problems encountered in Valuation
• Computing the value of a bond
• Change in value with passage of time
• Value of a zero-coupon bond
• Arbitrage-free valuation approach
6
Key Issues In Introduction To The Valuation OfDebt Securities
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Important Points
• When interest rates rise, market prices of bonds fall (and vice versa)• The longer the time until maturity, the more sensitive the bond price is to changes in interest rates• In practice most bonds pay interest semi-annually, so we have to find the appropriate semi-annual
rate and adjust coupon payments• The yield to maturity (YTM)of a bond is the discount rate which equates the price of a bond with the
PV of its expected future cash flow• Bond valuation is the determination of the fair price of a bond. As with any security or capital
investment,• The theoretical fair value of a bond is the present value of the stream of cash flows it is expected to
generate.
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• When interest rates rise, market prices of bonds fall (and vice versa)• The longer the time until maturity, the more sensitive the bond price is to changes in interest rates• In practice most bonds pay interest semi-annually, so we have to find the appropriate semi-annual
rate and adjust coupon payments• The yield to maturity (YTM)of a bond is the discount rate which equates the price of a bond with the
PV of its expected future cash flow• Bond valuation is the determination of the fair price of a bond. As with any security or capital
investment,• The theoretical fair value of a bond is the present value of the stream of cash flows it is expected to
generate.
7
• When interest rates rise, market prices of bonds fall (and vice versa)• The longer the time until maturity, the more sensitive the bond price is to changes in interest rates• In practice most bonds pay interest semi-annually, so we have to find the appropriate semi-annual
rate and adjust coupon payments• The yield to maturity (YTM)of a bond is the discount rate which equates the price of a bond with the
PV of its expected future cash flow• Bond valuation is the determination of the fair price of a bond. As with any security or capital
investment,• The theoretical fair value of a bond is the present value of the stream of cash flows it is expected to
generate.
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• When interest rates rise, market prices of bonds fall (and vice versa)• The longer the time until maturity, the more sensitive the bond price is to changes in interest rates• In practice most bonds pay interest semi-annually, so we have to find the appropriate semi-annual
rate and adjust coupon payments• The yield to maturity (YTM)of a bond is the discount rate which equates the price of a bond with the
PV of its expected future cash flow• Bond valuation is the determination of the fair price of a bond. As with any security or capital
investment,• The theoretical fair value of a bond is the present value of the stream of cash flows it is expected to
generate.
7
Bond Valuation
• The value of a bond is obtained by discounting the bond's expected cash flows to the present usingan appropriate discount rate.
• If the coupon rate of the security is equal to the market yield then the bond will sell at parCoupon Rate = Market Yield --- Price = Par Value
• If the coupon rate of the security is more than the market yield then the bond will sell at premiumCoupon Rate>Market Yield - Price> Par Value
• If the coupon rate of the security is less than the market yield then the bond will sell at discountCoupon Rate<Market Yield - Price<Par Value
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• The value of a bond is obtained by discounting the bond's expected cash flows to the present usingan appropriate discount rate.
• If the coupon rate of the security is equal to the market yield then the bond will sell at parCoupon Rate = Market Yield --- Price = Par Value
• If the coupon rate of the security is more than the market yield then the bond will sell at premiumCoupon Rate>Market Yield - Price> Par Value
• If the coupon rate of the security is less than the market yield then the bond will sell at discountCoupon Rate<Market Yield - Price<Par Value
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• The value of a bond is obtained by discounting the bond's expected cash flows to the present usingan appropriate discount rate.
• If the coupon rate of the security is equal to the market yield then the bond will sell at parCoupon Rate = Market Yield --- Price = Par Value
• If the coupon rate of the security is more than the market yield then the bond will sell at premiumCoupon Rate>Market Yield - Price> Par Value
• If the coupon rate of the security is less than the market yield then the bond will sell at discountCoupon Rate<Market Yield - Price<Par Value
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• The value of a bond is obtained by discounting the bond's expected cash flows to the present usingan appropriate discount rate.
• If the coupon rate of the security is equal to the market yield then the bond will sell at parCoupon Rate = Market Yield --- Price = Par Value
• If the coupon rate of the security is more than the market yield then the bond will sell at premiumCoupon Rate>Market Yield - Price> Par Value
• If the coupon rate of the security is less than the market yield then the bond will sell at discountCoupon Rate<Market Yield - Price<Par Value
8
Bond Valuation Process
Example :
• Par BondBond value 1000, Interest Rate 10%, Coupon Rate : 10% Term 5 year.
Calculate the PV by discounting method…. (100)
• Premium BondBond value 1000, Interest Rate 9 %, Coupon Rate : 10% Term 5 year.
Present Value : 1038.89
• Discount BondBond value 1000, Interest Rate 11 %, Coupon Rate : 10% Term 5 year.Present Value : 963.04
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Example :
• Par BondBond value 1000, Interest Rate 10%, Coupon Rate : 10% Term 5 year.
Calculate the PV by discounting method…. (100)
• Premium BondBond value 1000, Interest Rate 9 %, Coupon Rate : 10% Term 5 year.
Present Value : 1038.89
• Discount BondBond value 1000, Interest Rate 11 %, Coupon Rate : 10% Term 5 year.Present Value : 963.04
9
Example :
• Par BondBond value 1000, Interest Rate 10%, Coupon Rate : 10% Term 5 year.
Calculate the PV by discounting method…. (100)
• Premium BondBond value 1000, Interest Rate 9 %, Coupon Rate : 10% Term 5 year.
Present Value : 1038.89
• Discount BondBond value 1000, Interest Rate 11 %, Coupon Rate : 10% Term 5 year.Present Value : 963.04
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Example :
• Par BondBond value 1000, Interest Rate 10%, Coupon Rate : 10% Term 5 year.
Calculate the PV by discounting method…. (100)
• Premium BondBond value 1000, Interest Rate 9 %, Coupon Rate : 10% Term 5 year.
Present Value : 1038.89
• Discount BondBond value 1000, Interest Rate 11 %, Coupon Rate : 10% Term 5 year.Present Value : 963.04
9
Bond Valuation Process
• It is a simple three step process:1. Estimate all the cash flows expected on a security2. Determine the appropriate discount rate3. Calculate the present value of the estimated cash flows
• Formula for finding value of a bond:
where CP (N) -> coupon payment for year N,YTM -> yield to maturity (interest rate)PAR -> Face Value of teh bond
N32 YTM)(1PARC......
YTM)(1C
YTM)(1C
YTM)(1CbondaofValue
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• It is a simple three step process:1. Estimate all the cash flows expected on a security2. Determine the appropriate discount rate3. Calculate the present value of the estimated cash flows
• Formula for finding value of a bond:
where CP (N) -> coupon payment for year N,YTM -> yield to maturity (interest rate)PAR -> Face Value of teh bond
10
N32 YTM)(1PARC......
YTM)(1C
YTM)(1C
YTM)(1CbondaofValue
trFVPV)1(
• It is a simple three step process:1. Estimate all the cash flows expected on a security2. Determine the appropriate discount rate3. Calculate the present value of the estimated cash flows
• Formula for finding value of a bond:
where CP (N) -> coupon payment for year N,YTM -> yield to maturity (interest rate)PAR -> Face Value of teh bond
N32 YTM)(1PARC......
YTM)(1C
YTM)(1C
YTM)(1CbondaofValue
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• It is a simple three step process:1. Estimate all the cash flows expected on a security2. Determine the appropriate discount rate3. Calculate the present value of the estimated cash flows
• Formula for finding value of a bond:
where CP (N) -> coupon payment for year N,YTM -> yield to maturity (interest rate)PAR -> Face Value of teh bond
10
N32 YTM)(1PARC......
YTM)(1C
YTM)(1C
YTM)(1CbondaofValue
trFVPV)1(
Example: Bond Prices
Consider a 5 year vanilla bond with a face value of $1000 and 10% annually paid coupon. Calculate itsprice if the interest rates are 9%, 10%, and 11%.
Time Cash flow PV @11% PV @ 10%T=1 100 90.09 90.91
T=2 100 81.16 82.64
T=3 100 73.12 75.13
T=4 100 65.87 68.30
652.80 683.01
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T=5 1100 652.80 683.01
Total 963.04 1,000.00
Comment Bond tradingat a Discount
Bond tradingat Par
Consider a 5 year vanilla bond with a face value of $1000 and 10% annually paid coupon. Calculate itsprice if the interest rates are 9%, 10%, and 11%.
PV @ 10% PV @ 9%90.91 91.74
82.64 84.17
75.13 77.22
68.30 70.84
683.01 714.92
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683.01 714.92
1,000.00 1,038.90
Bond tradingat Par
Bond tradingat a Premium
Future Value Of An Ordinary Annuity:
• Future value is the value of an asset or cash at a specified date in the future that is equivalent invalue to a specified sum today.
• Future value of an annuity (FVA) is the future value of a stream of payments (annuity), assumingthe payments are invested at a given rate of interest
• Future value is the value of an asset at a specific date. It measures the nominal future sum of moneythat a given sum of money is "worth" at a specified time in the future assuming a certain interest rate,or more generally, rate of return; it is the present value multiplied by the accumulation function.
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• Future value is the value of an asset or cash at a specified date in the future that is equivalent invalue to a specified sum today.
• Future value of an annuity (FVA) is the future value of a stream of payments (annuity), assumingthe payments are invested at a given rate of interest
• Future value is the value of an asset at a specific date. It measures the nominal future sum of moneythat a given sum of money is "worth" at a specified time in the future assuming a certain interest rate,or more generally, rate of return; it is the present value multiplied by the accumulation function.
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nRatePVFV )1(*
Future Value Of An Ordinary Annuity:
• Future value is the value of an asset or cash at a specified date in the future that is equivalent invalue to a specified sum today.
• Future value of an annuity (FVA) is the future value of a stream of payments (annuity), assumingthe payments are invested at a given rate of interest
• Future value is the value of an asset at a specific date. It measures the nominal future sum of moneythat a given sum of money is "worth" at a specified time in the future assuming a certain interest rate,or more generally, rate of return; it is the present value multiplied by the accumulation function.
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• Future value is the value of an asset or cash at a specified date in the future that is equivalent invalue to a specified sum today.
• Future value of an annuity (FVA) is the future value of a stream of payments (annuity), assumingthe payments are invested at a given rate of interest
• Future value is the value of an asset at a specific date. It measures the nominal future sum of moneythat a given sum of money is "worth" at a specified time in the future assuming a certain interest rate,or more generally, rate of return; it is the present value multiplied by the accumulation function.
12
Bonds Where Estimating Cash Flow Is Difficult
Problems Encountered in Valuation:• Coupon payments are reset periodically based on some reference rate.
− Example: Floating Rate Bonds
• Issuer or Investor has the option to change the contractual due date for the payment of theprincipal.− Example: Callable or Putable Bonds
• The principal payments are not known with surety because of the risk of prepayment− Example: MBS‘s
• The investor has the choice to convert the bond into common sock.− Convertible Bonds
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Problems Encountered in Valuation:• Coupon payments are reset periodically based on some reference rate.
− Example: Floating Rate Bonds
• Issuer or Investor has the option to change the contractual due date for the payment of theprincipal.− Example: Callable or Putable Bonds
• The principal payments are not known with surety because of the risk of prepayment− Example: MBS‘s
• The investor has the choice to convert the bond into common sock.− Convertible Bonds
13
Bonds Where Estimating Cash Flow Is Difficult
Problems Encountered in Valuation:• Coupon payments are reset periodically based on some reference rate.
− Example: Floating Rate Bonds
• Issuer or Investor has the option to change the contractual due date for the payment of theprincipal.− Example: Callable or Putable Bonds
• The principal payments are not known with surety because of the risk of prepayment− Example: MBS‘s
• The investor has the choice to convert the bond into common sock.− Convertible Bonds
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Problems Encountered in Valuation:• Coupon payments are reset periodically based on some reference rate.
− Example: Floating Rate Bonds
• Issuer or Investor has the option to change the contractual due date for the payment of theprincipal.− Example: Callable or Putable Bonds
• The principal payments are not known with surety because of the risk of prepayment− Example: MBS‘s
• The investor has the choice to convert the bond into common sock.− Convertible Bonds
13
Computing The Value Of A Bond
• Value of a bond is the present value of its cash flows
• In the exam you will deal with the following parameters:
(Refer the Texas Instrument BA II Plus Professional calculator)
• N=?; PMT=?; FV=?; I/Y=?; and then Compute PV.
Usually four of the above five terms will be given and the fifth will have to be calculated
• Example 1: Calculate the value of a security which has coupon rate of 10%, maturing in 6 years at par
value($100). The discount rate is 9%.
Solution: N=6; PMT=10; FV=100; I/Y=9%;
Using the Texas Instrument BA II Plus Professional calculator: then PV=104.48.
• Example 2: A market value of a security is $ 98.50. Calculate the discount rate if the security has coupon
rate of 10%, maturing in 6 years at par value($100).
Solution: N=6; PMT=10; FV=100; PV=-98.50;
Using the Texas Instrument BA II Plus Professional calculator: then I/Y=10.34%.
• Note:Give attention to the sign of the cash flows
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• Value of a bond is the present value of its cash flows
• In the exam you will deal with the following parameters:
(Refer the Texas Instrument BA II Plus Professional calculator)
• N=?; PMT=?; FV=?; I/Y=?; and then Compute PV.
Usually four of the above five terms will be given and the fifth will have to be calculated
• Example 1: Calculate the value of a security which has coupon rate of 10%, maturing in 6 years at par
value($100). The discount rate is 9%.
Solution: N=6; PMT=10; FV=100; I/Y=9%;
Using the Texas Instrument BA II Plus Professional calculator: then PV=104.48.
• Example 2: A market value of a security is $ 98.50. Calculate the discount rate if the security has coupon
rate of 10%, maturing in 6 years at par value($100).
Solution: N=6; PMT=10; FV=100; PV=-98.50;
Using the Texas Instrument BA II Plus Professional calculator: then I/Y=10.34%.
• Note:Give attention to the sign of the cash flows
14
• Value of a bond is the present value of its cash flows
• In the exam you will deal with the following parameters:
(Refer the Texas Instrument BA II Plus Professional calculator)
• N=?; PMT=?; FV=?; I/Y=?; and then Compute PV.
Usually four of the above five terms will be given and the fifth will have to be calculated
• Example 1: Calculate the value of a security which has coupon rate of 10%, maturing in 6 years at par
value($100). The discount rate is 9%.
Solution: N=6; PMT=10; FV=100; I/Y=9%;
Using the Texas Instrument BA II Plus Professional calculator: then PV=104.48.
• Example 2: A market value of a security is $ 98.50. Calculate the discount rate if the security has coupon
rate of 10%, maturing in 6 years at par value($100).
Solution: N=6; PMT=10; FV=100; PV=-98.50;
Using the Texas Instrument BA II Plus Professional calculator: then I/Y=10.34%.
• Note:Give attention to the sign of the cash flows
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• Value of a bond is the present value of its cash flows
• In the exam you will deal with the following parameters:
(Refer the Texas Instrument BA II Plus Professional calculator)
• N=?; PMT=?; FV=?; I/Y=?; and then Compute PV.
Usually four of the above five terms will be given and the fifth will have to be calculated
• Example 1: Calculate the value of a security which has coupon rate of 10%, maturing in 6 years at par
value($100). The discount rate is 9%.
Solution: N=6; PMT=10; FV=100; I/Y=9%;
Using the Texas Instrument BA II Plus Professional calculator: then PV=104.48.
• Example 2: A market value of a security is $ 98.50. Calculate the discount rate if the security has coupon
rate of 10%, maturing in 6 years at par value($100).
Solution: N=6; PMT=10; FV=100; PV=-98.50;
Using the Texas Instrument BA II Plus Professional calculator: then I/Y=10.34%.
• Note:Give attention to the sign of the cash flows
14
Computing The Value Of A Zero Coupon Bond
• Value of a Zero Coupon Bond• It is the present value of the face value of the bond.
Value = Maturity Value / (1+i)Number of years *2
• In the above formula we are using the semi-annual discount rate to value the bond. The annual ratecan also be used.
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• Value of a Zero Coupon Bond• It is the present value of the face value of the bond.
Value = Maturity Value / (1+i)Number of years *2
• In the above formula we are using the semi-annual discount rate to value the bond. The annual ratecan also be used.
15
Computing The Value Of A Zero Coupon Bond
• Value of a Zero Coupon Bond• It is the present value of the face value of the bond.
Value = Maturity Value / (1+i)Number of years *2
• In the above formula we are using the semi-annual discount rate to value the bond. The annual ratecan also be used.
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• Value of a Zero Coupon Bond• It is the present value of the face value of the bond.
Value = Maturity Value / (1+i)Number of years *2
• In the above formula we are using the semi-annual discount rate to value the bond. The annual ratecan also be used.
15
How Discount Rates And Maturity Date Affect Price
• Interest rates and Bond Values are inversly related
• A decrease in the interest rate will result in an increase in the bond price as the bond is giving a
higher coupon rate compared to the reduced market interest rate
• As a result, the price yield curve is a downward sloping curve
• Changes in Value with Passage of Time:
• Whether the bond is trading at a premium or at a discount,
as a bond approaches maturity, its value converges to the par value.
© Neev Knowledge Management – Pristine
• Interest rates and Bond Values are inversly related
• A decrease in the interest rate will result in an increase in the bond price as the bond is giving a
higher coupon rate compared to the reduced market interest rate
• As a result, the price yield curve is a downward sloping curve
• Changes in Value with Passage of Time:
• Whether the bond is trading at a premium or at a discount,
as a bond approaches maturity, its value converges to the par value.
16
How Discount Rates And Maturity Date Affect Price
• Interest rates and Bond Values are inversly related
• A decrease in the interest rate will result in an increase in the bond price as the bond is giving a
higher coupon rate compared to the reduced market interest rate
• As a result, the price yield curve is a downward sloping curve
• Changes in Value with Passage of Time:
• Whether the bond is trading at a premium or at a discount,
as a bond approaches maturity, its value converges to the par value.
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• Interest rates and Bond Values are inversly related
• A decrease in the interest rate will result in an increase in the bond price as the bond is giving a
higher coupon rate compared to the reduced market interest rate
• As a result, the price yield curve is a downward sloping curve
• Changes in Value with Passage of Time:
• Whether the bond is trading at a premium or at a discount,
as a bond approaches maturity, its value converges to the par value.
16
Bond Valuation
• Pull to Par is the effect in which the price of a bond converges to par value as time passes.At maturity the price of a debt instrument in good standing should equal its par or face value.
• Pull to Par is the phenomenon that as time passes, the price of a credit instrument in good standingmoves towards its par value. The nearer to maturity the greater the influence because the security willonly pay out the stated principal amount
• The calculation process of the bond amortization (Pull to Par ) is in the next slide..
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• Pull to Par is the effect in which the price of a bond converges to par value as time passes.At maturity the price of a debt instrument in good standing should equal its par or face value.
• Pull to Par is the phenomenon that as time passes, the price of a credit instrument in good standingmoves towards its par value. The nearer to maturity the greater the influence because the security willonly pay out the stated principal amount
• The calculation process of the bond amortization (Pull to Par ) is in the next slide..
17
• Pull to Par is the effect in which the price of a bond converges to par value as time passes.At maturity the price of a debt instrument in good standing should equal its par or face value.
• Pull to Par is the phenomenon that as time passes, the price of a credit instrument in good standingmoves towards its par value. The nearer to maturity the greater the influence because the security willonly pay out the stated principal amount
• The calculation process of the bond amortization (Pull to Par ) is in the next slide..
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• Pull to Par is the effect in which the price of a bond converges to par value as time passes.At maturity the price of a debt instrument in good standing should equal its par or face value.
• Pull to Par is the phenomenon that as time passes, the price of a credit instrument in good standingmoves towards its par value. The nearer to maturity the greater the influence because the security willonly pay out the stated principal amount
• The calculation process of the bond amortization (Pull to Par ) is in the next slide..
17
Bond Valuation: Pull To Par Concept
Price of $100 Face Value Bond Yielding 6%versus Years to Maturity At Various Coupons (4%
- 8%)$140$130
$120
$110
$100
$906.00%
7.00%
8.00%
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Years to Maturity30 121416182022242628
$90
$80
$70
$60 4.00%
5.00%
6.00%
Price “pulled to par” as bond nears maturitymaturity
Bond Valuation: Pull To Par Concept
Price of $100 Face Value Bond Yielding 6%versus Years to Maturity At Various Coupons (4%
- 8%)
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Years to Maturity2468101214 0
Price “pulled to par” as bond nears maturitymaturity
Pull To Par
• Consider two bonds. One trading at a discount and the other trading at a premium:
Bond-Discount
Coupon 5%
Tenure 10
YTM 10%
Face Value 100
FY 0 FY 1 FY 2 FY 3 FY 4Price Bond-Discount
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Price Bond-Discount $69.28 $71.20 $73.33 $75.66 $78.22Price Bond-Premium $138.61 $135.54 $132.32 $128.93 $125.38
$0.00$20.00$40.00$60.00$80.00
$100.00$120.00$140.00$160.00
FY 0 FY 2 FY 4 FY 6
Pull to Par
Price Bond-Discount
• Consider two bonds. One trading at a discount and the other trading at a premium:
Bond-Premium
Coupon 10%
Tenure 10
YTM 5%
Face Value 100
FY 4 FY 5 FY 6 FY 7 FY 8 FY 9 FY 10
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$78.22 $81.05 $84.15 $87.57 $91.32 $95.45 $100.00
$125.38 $121.65 $117.73 $113.62 $109.30 $104.76 $100.00
FY 6 FY 8 FY 10 FY 12
Pull to Par
Price Bond-Discount Price Bond-Premium
Arbitrage-free Valuation Approach
• Discounting all cash flows of a bond with the same discount rate is a flaw in the traditional approach.
• In the arbitrage free valuation approach, each cash flow is discounted by the discount rate that
pertains to the maturity of that cash flows. This discount rate is nothing but the Spot Rate
• We had studied earlier about STRIPS
• As per this approach, the value of the Treasury Bond as a whole should be equal to the value of its
individual parts
• Each part =
• If this is not the case, a person can achieve arbitrage-free profits by buying the whole and selling the
parts or vice-versa
© Neev Knowledge Management – Pristine
• Discounting all cash flows of a bond with the same discount rate is a flaw in the traditional approach.
• In the arbitrage free valuation approach, each cash flow is discounted by the discount rate that
pertains to the maturity of that cash flows. This discount rate is nothing but the Spot Rate
• We had studied earlier about STRIPS
• As per this approach, the value of the Treasury Bond as a whole should be equal to the value of its
individual parts
• Each part =
• If this is not the case, a person can achieve arbitrage-free profits by buying the whole and selling the
parts or vice-versa
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periodsrate/2Spot1flowCash
• Discounting all cash flows of a bond with the same discount rate is a flaw in the traditional approach.
• In the arbitrage free valuation approach, each cash flow is discounted by the discount rate that
pertains to the maturity of that cash flows. This discount rate is nothing but the Spot Rate
• We had studied earlier about STRIPS
• As per this approach, the value of the Treasury Bond as a whole should be equal to the value of its
individual parts
• Each part =
• If this is not the case, a person can achieve arbitrage-free profits by buying the whole and selling the
parts or vice-versa
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• Discounting all cash flows of a bond with the same discount rate is a flaw in the traditional approach.
• In the arbitrage free valuation approach, each cash flow is discounted by the discount rate that
pertains to the maturity of that cash flows. This discount rate is nothing but the Spot Rate
• We had studied earlier about STRIPS
• As per this approach, the value of the Treasury Bond as a whole should be equal to the value of its
individual parts
• Each part =
• If this is not the case, a person can achieve arbitrage-free profits by buying the whole and selling the
parts or vice-versa
20
Questions
1. If the current yield is 8%, what is the value of a security carrying a annual coupon of 7%, maturing in 8years, redeemable at par value of $1,000?
A. $942.53B. $1,000C. $1,059.71
2. If the current value of a bond is $1,065, what is the YTM of the bond carrying a annual coupon of 7%,maturing in 6 years, redeemable at par value of $1,000?
A. 5.69%B. 7%C. 6.69%
3. The current price of a bond is $985. An increase in the yield by 50 basis points will most likely result in theprice becoming:
A. $1,000B. $1,015C. $970
4. The value of a $10,000 face value zero-coupon bond with 10 years to maturity and a semi-annual pay yieldof 8% is:
A. $2,145.48B. $4,563.95C. $4,635.67
© Neev Knowledge Management – Pristine
1. If the current yield is 8%, what is the value of a security carrying a annual coupon of 7%, maturing in 8years, redeemable at par value of $1,000?
A. $942.53B. $1,000C. $1,059.71
2. If the current value of a bond is $1,065, what is the YTM of the bond carrying a annual coupon of 7%,maturing in 6 years, redeemable at par value of $1,000?
A. 5.69%B. 7%C. 6.69%
3. The current price of a bond is $985. An increase in the yield by 50 basis points will most likely result in theprice becoming:
A. $1,000B. $1,015C. $970
4. The value of a $10,000 face value zero-coupon bond with 10 years to maturity and a semi-annual pay yieldof 8% is:
A. $2,145.48B. $4,563.95C. $4,635.67
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1. If the current yield is 8%, what is the value of a security carrying a annual coupon of 7%, maturing in 8years, redeemable at par value of $1,000?
A. $942.53B. $1,000C. $1,059.71
2. If the current value of a bond is $1,065, what is the YTM of the bond carrying a annual coupon of 7%,maturing in 6 years, redeemable at par value of $1,000?
A. 5.69%B. 7%C. 6.69%
3. The current price of a bond is $985. An increase in the yield by 50 basis points will most likely result in theprice becoming:
A. $1,000B. $1,015C. $970
4. The value of a $10,000 face value zero-coupon bond with 10 years to maturity and a semi-annual pay yieldof 8% is:
A. $2,145.48B. $4,563.95C. $4,635.67
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1. If the current yield is 8%, what is the value of a security carrying a annual coupon of 7%, maturing in 8years, redeemable at par value of $1,000?
A. $942.53B. $1,000C. $1,059.71
2. If the current value of a bond is $1,065, what is the YTM of the bond carrying a annual coupon of 7%,maturing in 6 years, redeemable at par value of $1,000?
A. 5.69%B. 7%C. 6.69%
3. The current price of a bond is $985. An increase in the yield by 50 basis points will most likely result in theprice becoming:
A. $1,000B. $1,015C. $970
4. The value of a $10,000 face value zero-coupon bond with 10 years to maturity and a semi-annual pay yieldof 8% is:
A. $2,145.48B. $4,563.95C. $4,635.67
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Solutions
1. A. $942.53
2. A. 5.69%
3. C. $970. This is a trick question requiring no calculations as the value of a bond will decrease asyields increase.
4. B. $4,563.95 [ = 10000/(1 + 0.08/2)] ^ (10*2)
© Neev Knowledge Management – Pristine 22
1. A. $942.53
2. A. 5.69%
3. C. $970. This is a trick question requiring no calculations as the value of a bond will decrease asyields increase.
4. B. $4,563.95 [ = 10000/(1 + 0.08/2)] ^ (10*2)
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Key Issues In Features Of Debt Securities
• Bond‘s Indenture
• Basic features of a Bond
• Definitions
• Redemption and Retirement of Bonds
• Embedded Options
• Institutional Investors
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Key Issues In Features Of Debt Securities
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Bond‘s Indenture
A bond‘s Indenture is the document which specifies the rights and obligations of both the issuer and thebuyer of the bond.
– Contains Affirmative Covenents wich requires the borrower to affirm to certain actions.– Examples:
• Maintaining minimum financial ratios• Pay interest and principal on a timely basis
– Contains Negative Covenants which prevent the borrower from doing certain things.– Examples:
• raising additional amount of debt• pledging the same assets
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A bond‘s Indenture is the document which specifies the rights and obligations of both the issuer and thebuyer of the bond.
– Contains Affirmative Covenents wich requires the borrower to affirm to certain actions.– Examples:
• Maintaining minimum financial ratios• Pay interest and principal on a timely basis
– Contains Negative Covenants which prevent the borrower from doing certain things.– Examples:
• raising additional amount of debt• pledging the same assets
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A bond‘s Indenture is the document which specifies the rights and obligations of both the issuer and thebuyer of the bond.
– Contains Affirmative Covenents wich requires the borrower to affirm to certain actions.– Examples:
• Maintaining minimum financial ratios• Pay interest and principal on a timely basis
– Contains Negative Covenants which prevent the borrower from doing certain things.– Examples:
• raising additional amount of debt• pledging the same assets
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A bond‘s Indenture is the document which specifies the rights and obligations of both the issuer and thebuyer of the bond.
– Contains Affirmative Covenents wich requires the borrower to affirm to certain actions.– Examples:
• Maintaining minimum financial ratios• Pay interest and principal on a timely basis
– Contains Negative Covenants which prevent the borrower from doing certain things.– Examples:
• raising additional amount of debt• pledging the same assets
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Example
• Company XYZ’s debt is trading in the market. A covenant in its bond indenture states that furtherborrowing above $100 million is restricted. This is:A. An Affirmative CovenantB. A Negative CovenantC. A Positive Covenant
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• Company XYZ’s debt is trading in the market. A covenant in its bond indenture states that furtherborrowing above $100 million is restricted. This is:A. An Affirmative CovenantB. A Negative CovenantC. A Positive Covenant
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Basic Features Of A Bond
Basic Features of a Bond:• Can be issued in the domestic or foreign currency• Make annual or semi-annual payment of interest• Bonds that do not pay interest during their tenure are called Zero-coupon bonds• Step-up notes are bonds for which the coupon rate increases one or more times during their tenure• Deferred-coupon bonds are bonds for which the initial coupon payments are deferred for a certain
period• Floating-rate securities bonds whose coupon is linked to some benchmark reference rate like the
LIBOR rate. (Varities: Inverse Floaters and Inflation-indexed bonds)
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Basic Features of a Bond:• Can be issued in the domestic or foreign currency• Make annual or semi-annual payment of interest• Bonds that do not pay interest during their tenure are called Zero-coupon bonds• Step-up notes are bonds for which the coupon rate increases one or more times during their tenure• Deferred-coupon bonds are bonds for which the initial coupon payments are deferred for a certain
period• Floating-rate securities bonds whose coupon is linked to some benchmark reference rate like the
LIBOR rate. (Varities: Inverse Floaters and Inflation-indexed bonds)
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Basic Features of a Bond:• Can be issued in the domestic or foreign currency• Make annual or semi-annual payment of interest• Bonds that do not pay interest during their tenure are called Zero-coupon bonds• Step-up notes are bonds for which the coupon rate increases one or more times during their tenure• Deferred-coupon bonds are bonds for which the initial coupon payments are deferred for a certain
period• Floating-rate securities bonds whose coupon is linked to some benchmark reference rate like the
LIBOR rate. (Varities: Inverse Floaters and Inflation-indexed bonds)
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Basic Features of a Bond:• Can be issued in the domestic or foreign currency• Make annual or semi-annual payment of interest• Bonds that do not pay interest during their tenure are called Zero-coupon bonds• Step-up notes are bonds for which the coupon rate increases one or more times during their tenure• Deferred-coupon bonds are bonds for which the initial coupon payments are deferred for a certain
period• Floating-rate securities bonds whose coupon is linked to some benchmark reference rate like the
LIBOR rate. (Varities: Inverse Floaters and Inflation-indexed bonds)
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Basic Features Of A Bond
• Optionality: A bond may contain an embedded option; that is, it grants option like features to thebuyer or issuer:
• Callable Bond—Some bonds give the issuer the right to repay the bond before the maturity date onthe call dates. With some bonds, the issuer has to pay a premium, the so called call premium. This ismainly the case for high-yield bonds.
• Putable Bond—Some bonds give the bond holder the right to force the issuer to repay the bondbefore the maturity date on the put dates
© Neev Knowledge Management – Pristine
• Optionality: A bond may contain an embedded option; that is, it grants option like features to thebuyer or issuer:
• Callable Bond—Some bonds give the issuer the right to repay the bond before the maturity date onthe call dates. With some bonds, the issuer has to pay a premium, the so called call premium. This ismainly the case for high-yield bonds.
• Putable Bond—Some bonds give the bond holder the right to force the issuer to repay the bondbefore the maturity date on the put dates
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• Optionality: A bond may contain an embedded option; that is, it grants option like features to thebuyer or issuer:
• Callable Bond—Some bonds give the issuer the right to repay the bond before the maturity date onthe call dates. With some bonds, the issuer has to pay a premium, the so called call premium. This ismainly the case for high-yield bonds.
• Putable Bond—Some bonds give the bond holder the right to force the issuer to repay the bondbefore the maturity date on the put dates
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• Optionality: A bond may contain an embedded option; that is, it grants option like features to thebuyer or issuer:
• Callable Bond—Some bonds give the issuer the right to repay the bond before the maturity date onthe call dates. With some bonds, the issuer has to pay a premium, the so called call premium. This ismainly the case for high-yield bonds.
• Putable Bond—Some bonds give the bond holder the right to force the issuer to repay the bondbefore the maturity date on the put dates
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Basic Features Of A Bond
Basic Features of a Bond:• Floating-rate securities bonds whose coupon is linked to some benchmark reference rate like the LIBOR
rate. (Varities: Inverse Floaters and Inflation-indexed bonds)• Cap is the maximum interest that will be paid by the borrower• Floor is the minimum interest that will be received by the lender• Combination of both is called a Collar
© Neev Knowledge Management – Pristine 28
Basic Features of a Bond:• Floating-rate securities bonds whose coupon is linked to some benchmark reference rate like the LIBOR
rate. (Varities: Inverse Floaters and Inflation-indexed bonds)• Cap is the maximum interest that will be paid by the borrower• Floor is the minimum interest that will be received by the lender• Combination of both is called a Collar
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Questions
1. The price per $1 of a par value bond is $1.2538 when the par value is $10,000. The quoted price andthe dollar price is closest to:
2. If the interest rate falls, the reinvestment income from a Zero-coupon bond will:A. IncreaseB. DecreaseC. Unaffected
Quoted Price Dollar Price
A 125 3/8 $12,538
B 122 1/8 $11,438
C 125 1/2 $14,620
© Neev Knowledge Management – Pristine
1. The price per $1 of a par value bond is $1.2538 when the par value is $10,000. The quoted price andthe dollar price is closest to:
2. If the interest rate falls, the reinvestment income from a Zero-coupon bond will:A. IncreaseB. DecreaseC. Unaffected
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1. The price per $1 of a par value bond is $1.2538 when the par value is $10,000. The quoted price andthe dollar price is closest to:
2. If the interest rate falls, the reinvestment income from a Zero-coupon bond will:A. IncreaseB. DecreaseC. Unaffected
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1. The price per $1 of a par value bond is $1.2538 when the par value is $10,000. The quoted price andthe dollar price is closest to:
2. If the interest rate falls, the reinvestment income from a Zero-coupon bond will:A. IncreaseB. DecreaseC. Unaffected
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Answers
1. A. Dollar Price = 1.2538 * 10,000 = 12,538
Quoted Price = 12,538/1,000 = 125 3/8
2. C. Unaffected
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Definitions
• Accrued interest: Interest accrued on a bond from the last coupon date and the date of sale of thebond
• Full Price/Dirty Price: Total amount paid by the buyer to the seller for the bond• Clean price: Full price less the accrued interest
Dirty Price = Clean Price + Accrued Interest
© Neev Knowledge Management – Pristine 31
• Accrued interest: Interest accrued on a bond from the last coupon date and the date of sale of thebond
• Full Price/Dirty Price: Total amount paid by the buyer to the seller for the bond• Clean price: Full price less the accrued interest
Dirty Price = Clean Price + Accrued Interest
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Questions
1. A person pays $1,050 for a bond. The accrued interest till the date of purchase was $36. The cleanprice of the bond is:
A. $1,050B. $1,086C. $1,014
© Neev Knowledge Management – Pristine 32
1. A person pays $1,050 for a bond. The accrued interest till the date of purchase was $36. The cleanprice of the bond is:
A. $1,050B. $1,086C. $1,014
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Answers
1. C. $1,014
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Redemption And Retirement Of Bonds
• Non amortizing securities pay only interest during the tenure of the bond and the entire principal isrepaid on the maturity of the bond
• Amortizing securities repay both the the interest and the pricipal amount over the tenure of the bond
© Neev Knowledge Management – Pristine 34
Redemption And Retirement Of Bonds
• Non amortizing securities pay only interest during the tenure of the bond and the entire principal isrepaid on the maturity of the bond
• Amortizing securities repay both the the interest and the pricipal amount over the tenure of the bond
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Redemption and Retirement of Bonds
• Prepayment option allows the borrower to repay the principal before the due date• Call option on a bond is similar to a prepayment option and allows the borrower to “call“ repay
the entire or part of the bond outstanding• Nonrefundable bonds prohibit the issuer from redeeming a bond by issuing fresh bonds at a
lower coupon rate
© Neev Knowledge Management – Pristine 35
Redemption and Retirement of Bonds
• Prepayment option allows the borrower to repay the principal before the due date• Call option on a bond is similar to a prepayment option and allows the borrower to “call“ repay
the entire or part of the bond outstanding• Nonrefundable bonds prohibit the issuer from redeeming a bond by issuing fresh bonds at a
lower coupon rate
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Redemption And Retirement Of Bonds
• Sinking Fund Provision require the issuer to repay the principal amount over the life of the bondthrough regular payments.
• Accelerated Sinkind Fund Provision allows the Issuer to repay an amount more than that stipulated bythe Sinking Fund provisions
© Neev Knowledge Management – Pristine 36
Redemption And Retirement Of Bonds
• Sinking Fund Provision require the issuer to repay the principal amount over the life of the bondthrough regular payments.
• Accelerated Sinkind Fund Provision allows the Issuer to repay an amount more than that stipulated bythe Sinking Fund provisions
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Embedded Options
• Options favourable to the Issuer:
– Call Provisions: grant the Issuer the right to redeem the bond before the maturity date at a fixed price.
– Cap: sets the maximum amount of interest that will be paid to the bondholder for a floating rate bond.
– Prepayment option: allows the Issuer to prepay amount before maturity.
– Accelerated Sinkind Fund Provision: allows the Issuer to reapy an amount more than that stipulated bythe Sinking Fund provisions.
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• Options favourable to the Issuer:
– Call Provisions: grant the Issuer the right to redeem the bond before the maturity date at a fixed price.
– Cap: sets the maximum amount of interest that will be paid to the bondholder for a floating rate bond.
– Prepayment option: allows the Issuer to prepay amount before maturity.
– Accelerated Sinkind Fund Provision: allows the Issuer to reapy an amount more than that stipulated bythe Sinking Fund provisions.
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• Options favourable to the Issuer:
– Call Provisions: grant the Issuer the right to redeem the bond before the maturity date at a fixed price.
– Cap: sets the maximum amount of interest that will be paid to the bondholder for a floating rate bond.
– Prepayment option: allows the Issuer to prepay amount before maturity.
– Accelerated Sinkind Fund Provision: allows the Issuer to reapy an amount more than that stipulated bythe Sinking Fund provisions.
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• Options favourable to the Issuer:
– Call Provisions: grant the Issuer the right to redeem the bond before the maturity date at a fixed price.
– Cap: sets the maximum amount of interest that will be paid to the bondholder for a floating rate bond.
– Prepayment option: allows the Issuer to prepay amount before maturity.
– Accelerated Sinkind Fund Provision: allows the Issuer to reapy an amount more than that stipulated bythe Sinking Fund provisions.
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Embedded Options
• Options favourable to the Bondholder:
– Put Provisions: grant the bondholder the right to demand repayment of the amount before the maturitydate at a fixed price.
– Floor: sets the minimum amount of interest that will be paid to the bondholder for a floating rate bond.
– Conversion Option: grants the bondholder to convert the bond into a fixed number of shares of theissuer.
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• Options favourable to the Bondholder:
– Put Provisions: grant the bondholder the right to demand repayment of the amount before the maturitydate at a fixed price.
– Floor: sets the minimum amount of interest that will be paid to the bondholder for a floating rate bond.
– Conversion Option: grants the bondholder to convert the bond into a fixed number of shares of theissuer.
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• Options favourable to the Bondholder:
– Put Provisions: grant the bondholder the right to demand repayment of the amount before the maturitydate at a fixed price.
– Floor: sets the minimum amount of interest that will be paid to the bondholder for a floating rate bond.
– Conversion Option: grants the bondholder to convert the bond into a fixed number of shares of theissuer.
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• Options favourable to the Bondholder:
– Put Provisions: grant the bondholder the right to demand repayment of the amount before the maturitydate at a fixed price.
– Floor: sets the minimum amount of interest that will be paid to the bondholder for a floating rate bond.
– Conversion Option: grants the bondholder to convert the bond into a fixed number of shares of theissuer.
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Questions
1. Assuming a common issuer and maturity, which of the following bonds will most likely have the lowestyield?
A. A plain vanilla bondB. A bond with an embedded call optionC. A bond with an embedded put option
© Neev Knowledge Management – Pristine 39
1. Assuming a common issuer and maturity, which of the following bonds will most likely have the lowestyield?
A. A plain vanilla bondB. A bond with an embedded call optionC. A bond with an embedded put option
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Solutions
1. B
– An embedded call option is favorable to the bond issuer. Further, its price cannot appreciate much in a falling
interest rate scenario since the bond since the issuer would chose to exercise its call option. Hence, to
compensate, it would trade at a higher yield than the other options.
© Neev Knowledge Management – Pristine 40
1. B
– An embedded call option is favorable to the bond issuer. Further, its price cannot appreciate much in a falling
interest rate scenario since the bond since the issuer would chose to exercise its call option. Hence, to
compensate, it would trade at a higher yield than the other options.
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Questions
1. Which of the following is true about a bond with a deferred call provision?:A. It could be called at any time after the deferment periodB. Principal repayment can be deferred until it reaches maturityC. It could not be called right after the date of issue
2. Which of the following is right:A. A put provision will benefit the buyer in times of rising interest ratesB. A put provision will benefit the buyer in times of falling interest ratesC. A put provision will benefit the seller in times of rising interest rates
3. An mortgage security:A. Repays only the principal amount during the tenure of the securityB. Repays the principal and the interest amount during the tenure of the securityC. Cannot be retired earlier than the period of the security
© Neev Knowledge Management – Pristine
1. Which of the following is true about a bond with a deferred call provision?:A. It could be called at any time after the deferment periodB. Principal repayment can be deferred until it reaches maturityC. It could not be called right after the date of issue
2. Which of the following is right:A. A put provision will benefit the buyer in times of rising interest ratesB. A put provision will benefit the buyer in times of falling interest ratesC. A put provision will benefit the seller in times of rising interest rates
3. An mortgage security:A. Repays only the principal amount during the tenure of the securityB. Repays the principal and the interest amount during the tenure of the securityC. Cannot be retired earlier than the period of the security
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1. Which of the following is true about a bond with a deferred call provision?:A. It could be called at any time after the deferment periodB. Principal repayment can be deferred until it reaches maturityC. It could not be called right after the date of issue
2. Which of the following is right:A. A put provision will benefit the buyer in times of rising interest ratesB. A put provision will benefit the buyer in times of falling interest ratesC. A put provision will benefit the seller in times of rising interest rates
3. An mortgage security:A. Repays only the principal amount during the tenure of the securityB. Repays the principal and the interest amount during the tenure of the securityC. Cannot be retired earlier than the period of the security
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1. Which of the following is true about a bond with a deferred call provision?:A. It could be called at any time after the deferment periodB. Principal repayment can be deferred until it reaches maturityC. It could not be called right after the date of issue
2. Which of the following is right:A. A put provision will benefit the buyer in times of rising interest ratesB. A put provision will benefit the buyer in times of falling interest ratesC. A put provision will benefit the seller in times of rising interest rates
3. An mortgage security:A. Repays only the principal amount during the tenure of the securityB. Repays the principal and the interest amount during the tenure of the securityC. Cannot be retired earlier than the period of the security
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Answers
1. A. A deferred call provision means the issue is initially (say, for the first 5 to 7 years) non-callable, after
which time it becomes freely callable. In other words, there is a deferment period during which time the bond
cannot be called, but after that, it becomes freely callable.
2. A. A put provision will benefit the buyer in times of rising interest rates.
3. B. Repays the principal and the interest amount during the tenure of the security
© Neev Knowledge Management – Pristine 42
1. A. A deferred call provision means the issue is initially (say, for the first 5 to 7 years) non-callable, after
which time it becomes freely callable. In other words, there is a deferment period during which time the bond
cannot be called, but after that, it becomes freely callable.
2. A. A put provision will benefit the buyer in times of rising interest rates.
3. B. Repays the principal and the interest amount during the tenure of the security
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Agenda
• Features of Debt Securities
• Risks Associated with Investing in Bonds
• Overview of Bond Sectors and Instruments
• Understanding Yield Spreads
© Neev Knowledge Management – Pristine 43
• Features of Debt Securities
• Risks Associated with Investing in Bonds
• Overview of Bond Sectors and Instruments
• Understanding Yield Spreads
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• Interest Rate risk: refers to the effect of change in the market interest rates on the price of the bond.
The overall interest rates will change from the levels extant when the security is sold, causing an
opportunity cost
• Yield Curve risk: results from the change in the yield curve and its impact on the bond
• Call Risk: is the risk that the Issuer will exercise the call option on a callable bond if the interest rates
fall
• Prepayment risk: is the risk to prepayment of the principal amount before its due date
• Reinvestment risk: is the risk that the cash flows from the securities will be reinvested at a lower rate
• Credit risk: is the risk that the borrower will default on the installment payments
Risks Associated with Investing in Bonds
© Neev Knowledge Management – Pristine
• Interest Rate risk: refers to the effect of change in the market interest rates on the price of the bond.
The overall interest rates will change from the levels extant when the security is sold, causing an
opportunity cost
• Yield Curve risk: results from the change in the yield curve and its impact on the bond
• Call Risk: is the risk that the Issuer will exercise the call option on a callable bond if the interest rates
fall
• Prepayment risk: is the risk to prepayment of the principal amount before its due date
• Reinvestment risk: is the risk that the cash flows from the securities will be reinvested at a lower rate
• Credit risk: is the risk that the borrower will default on the installment payments
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• Interest Rate risk: refers to the effect of change in the market interest rates on the price of the bond.
The overall interest rates will change from the levels extant when the security is sold, causing an
opportunity cost
• Yield Curve risk: results from the change in the yield curve and its impact on the bond
• Call Risk: is the risk that the Issuer will exercise the call option on a callable bond if the interest rates
fall
• Prepayment risk: is the risk to prepayment of the principal amount before its due date
• Reinvestment risk: is the risk that the cash flows from the securities will be reinvested at a lower rate
• Credit risk: is the risk that the borrower will default on the installment payments
Risks Associated with Investing in Bonds
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• Interest Rate risk: refers to the effect of change in the market interest rates on the price of the bond.
The overall interest rates will change from the levels extant when the security is sold, causing an
opportunity cost
• Yield Curve risk: results from the change in the yield curve and its impact on the bond
• Call Risk: is the risk that the Issuer will exercise the call option on a callable bond if the interest rates
fall
• Prepayment risk: is the risk to prepayment of the principal amount before its due date
• Reinvestment risk: is the risk that the cash flows from the securities will be reinvested at a lower rate
• Credit risk: is the risk that the borrower will default on the installment payments
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• Currency risk – that exchange rates with other currencies will change during the security's term,causing loss of buying power in other countries
• Default risk – that the issuer will be unable to pay the scheduled interest payments due to financialhardship
• Repayment of principal risk – that the issuer will be unable to repay the principal due to financialhardship
• Soveriegn risk: refers to the risk arising out of change in government policies
• Volatility risk: refers to the change in value of securities which have embeded options as a result of
interest rate volitality
Risks Associated with Investing in Bonds
© Neev Knowledge Management – Pristine
• Currency risk – that exchange rates with other currencies will change during the security's term,causing loss of buying power in other countries
• Default risk – that the issuer will be unable to pay the scheduled interest payments due to financialhardship
• Repayment of principal risk – that the issuer will be unable to repay the principal due to financialhardship
• Soveriegn risk: refers to the risk arising out of change in government policies
• Volatility risk: refers to the change in value of securities which have embeded options as a result of
interest rate volitality
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• Currency risk – that exchange rates with other currencies will change during the security's term,causing loss of buying power in other countries
• Default risk – that the issuer will be unable to pay the scheduled interest payments due to financialhardship
• Repayment of principal risk – that the issuer will be unable to repay the principal due to financialhardship
• Soveriegn risk: refers to the risk arising out of change in government policies
• Volatility risk: refers to the change in value of securities which have embeded options as a result of
interest rate volitality
Risks Associated with Investing in Bonds
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• Currency risk – that exchange rates with other currencies will change during the security's term,causing loss of buying power in other countries
• Default risk – that the issuer will be unable to pay the scheduled interest payments due to financialhardship
• Repayment of principal risk – that the issuer will be unable to repay the principal due to financialhardship
• Soveriegn risk: refers to the risk arising out of change in government policies
• Volatility risk: refers to the change in value of securities which have embeded options as a result of
interest rate volitality
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• Inflation risk: It refers to the risk of errosion of the purchasing power of the returns from the securityas a a result of unexpected rise in inflation, – that the buying power of the principal will decline duringthe term of the security .
• Liquidity risk: The risk that the security will sell for a amount lower than its fair value due to lack ofliquidity. The buyer will require the principal funds for another purpose on short notice, prior to theexpiration of the security, and be unable to exchange the security for cash in the required time periodwithout loss of fair value
• Exchange rate risk: Is the uncertainity regarding movement in the exchange rates and theconsequent impact on the rerurns from the securities
Risks Associated with Investing in Bonds
© Neev Knowledge Management – Pristine
• Inflation risk: It refers to the risk of errosion of the purchasing power of the returns from the securityas a a result of unexpected rise in inflation, – that the buying power of the principal will decline duringthe term of the security .
• Liquidity risk: The risk that the security will sell for a amount lower than its fair value due to lack ofliquidity. The buyer will require the principal funds for another purpose on short notice, prior to theexpiration of the security, and be unable to exchange the security for cash in the required time periodwithout loss of fair value
• Exchange rate risk: Is the uncertainity regarding movement in the exchange rates and theconsequent impact on the rerurns from the securities
46
• Inflation risk: It refers to the risk of errosion of the purchasing power of the returns from the securityas a a result of unexpected rise in inflation, – that the buying power of the principal will decline duringthe term of the security .
• Liquidity risk: The risk that the security will sell for a amount lower than its fair value due to lack ofliquidity. The buyer will require the principal funds for another purpose on short notice, prior to theexpiration of the security, and be unable to exchange the security for cash in the required time periodwithout loss of fair value
• Exchange rate risk: Is the uncertainity regarding movement in the exchange rates and theconsequent impact on the rerurns from the securities
Risks Associated with Investing in Bonds
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• Inflation risk: It refers to the risk of errosion of the purchasing power of the returns from the securityas a a result of unexpected rise in inflation, – that the buying power of the principal will decline duringthe term of the security .
• Liquidity risk: The risk that the security will sell for a amount lower than its fair value due to lack ofliquidity. The buyer will require the principal funds for another purpose on short notice, prior to theexpiration of the security, and be unable to exchange the security for cash in the required time periodwithout loss of fair value
• Exchange rate risk: Is the uncertainity regarding movement in the exchange rates and theconsequent impact on the rerurns from the securities
46
Discount, Premiuim, At Par
• If the coupon rate of the security is equal to the market yield then the bond will sell at par
Coupon Rate = Market Yield --- Price = Par Value
• If the coupon rate of the security is more than the market yield then the bond will sell at premium
Coupon Rate>Market Yield - Price> Par Value
• If the coupon rate of the security is less than the market yield then the bond will sell at discount
Coupon Rate<Market Yield - Price<Par Value
If Interest Rates Increase -- Price of a Bond Decreases
If Interest Rates Decrease -- Price of a Bond Increases
© Neev Knowledge Management – Pristine
• If the coupon rate of the security is equal to the market yield then the bond will sell at par
Coupon Rate = Market Yield --- Price = Par Value
• If the coupon rate of the security is more than the market yield then the bond will sell at premium
Coupon Rate>Market Yield - Price> Par Value
• If the coupon rate of the security is less than the market yield then the bond will sell at discount
Coupon Rate<Market Yield - Price<Par Value
If Interest Rates Increase -- Price of a Bond Decreases
If Interest Rates Decrease -- Price of a Bond Increases
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• If the coupon rate of the security is equal to the market yield then the bond will sell at par
Coupon Rate = Market Yield --- Price = Par Value
• If the coupon rate of the security is more than the market yield then the bond will sell at premium
Coupon Rate>Market Yield - Price> Par Value
• If the coupon rate of the security is less than the market yield then the bond will sell at discount
Coupon Rate<Market Yield - Price<Par Value
If Interest Rates Increase -- Price of a Bond Decreases
If Interest Rates Decrease -- Price of a Bond Increases
Imp
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• If the coupon rate of the security is equal to the market yield then the bond will sell at par
Coupon Rate = Market Yield --- Price = Par Value
• If the coupon rate of the security is more than the market yield then the bond will sell at premium
Coupon Rate>Market Yield - Price> Par Value
• If the coupon rate of the security is less than the market yield then the bond will sell at discount
Coupon Rate<Market Yield - Price<Par Value
If Interest Rates Increase -- Price of a Bond Decreases
If Interest Rates Decrease -- Price of a Bond Increases
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Maturity, Coupon, Options, Yield Affect Interest RateRisk
VariableDuration or Interest
Rate RiskMaturity in Longer Higher
Coupon Rate is Higher LowerEmbedded Call Option LowerEmbedded Put Option Lower
© Neev Knowledge Management – Pristine 48
Maturity, Coupon, Options, Yield Affect Interest RateRisk
Duration or Interest
Rate Risk
Imp
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Present Value Of The Cash Flow
• Present value of an annuity An annuity is a series of equal payments or receipts that occur at evenlyspaced intervals
• The current worth of a future sum of money or stream of cash flows given a specified rate of return.Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower thepresent value of the future cash flows.
• In example Assume the Interest Rate is 5% so the Discounted cash flow is as follows:
© Neev Knowledge Management – Pristine 49
• Present value of an annuity An annuity is a series of equal payments or receipts that occur at evenlyspaced intervals
• The current worth of a future sum of money or stream of cash flows given a specified rate of return.Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower thepresent value of the future cash flows.
• In example Assume the Interest Rate is 5% so the Discounted cash flow is as follows:
trFVPV)1(
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trFVPV)1(
Callable Bonds
• Bonds which have an embedded call option give the Issuer the right to call the bond before its maturity
• Duration is a good measure when the changes in yield are small
• However if the yield changes are high then we use the measure of convexity
• Convexity is a measure of the curvature of the price/yield relationship
• Value of a callable bond = Value of a option-free bond – Value of embedded option
• As the yield falls, the price of the bond increases
• But this increase in the price of a bond is capped in the case of a callable bond at the call price
© Neev Knowledge Management – Pristine
• Bonds which have an embedded call option give the Issuer the right to call the bond before its maturity
• Duration is a good measure when the changes in yield are small
• However if the yield changes are high then we use the measure of convexity
• Convexity is a measure of the curvature of the price/yield relationship
• Value of a callable bond = Value of a option-free bond – Value of embedded option
• As the yield falls, the price of the bond increases
• But this increase in the price of a bond is capped in the case of a callable bond at the call price
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• Bonds which have an embedded call option give the Issuer the right to call the bond before its maturity
• Duration is a good measure when the changes in yield are small
• However if the yield changes are high then we use the measure of convexity
• Convexity is a measure of the curvature of the price/yield relationship
• Value of a callable bond = Value of a option-free bond – Value of embedded option
• As the yield falls, the price of the bond increases
• But this increase in the price of a bond is capped in the case of a callable bond at the call price
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• Bonds which have an embedded call option give the Issuer the right to call the bond before its maturity
• Duration is a good measure when the changes in yield are small
• However if the yield changes are high then we use the measure of convexity
• Convexity is a measure of the curvature of the price/yield relationship
• Value of a callable bond = Value of a option-free bond – Value of embedded option
• As the yield falls, the price of the bond increases
• But this increase in the price of a bond is capped in the case of a callable bond at the call price
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Duration And Dollar Duration
Duration of a Bond:
• It is the sensitivity of the price of the bond in response to a change in the interest rates/yield
Duration = - (Percentage change in bond price/Percentage change in Yield)
negative sign is used because of the inverse relation between yield and bond prices
Thus, increase in the yield results in a fall in the bond price
Dollar Duration
• The approximate dollar price change for a 100bps change in yield.
• Given by:
© Neev Knowledge Management – Pristine
Duration of a Bond:
• It is the sensitivity of the price of the bond in response to a change in the interest rates/yield
Duration = - (Percentage change in bond price/Percentage change in Yield)
negative sign is used because of the inverse relation between yield and bond prices
Thus, increase in the yield results in a fall in the bond price
Dollar Duration
• The approximate dollar price change for a 100bps change in yield.
• Given by:
51
decimal)inYieldin(ChangePrice)(Inintial2RiseYieldifPrice-DeclineYieldifPrice
Duration of a Bond:
• It is the sensitivity of the price of the bond in response to a change in the interest rates/yield
Duration = - (Percentage change in bond price/Percentage change in Yield)
negative sign is used because of the inverse relation between yield and bond prices
Thus, increase in the yield results in a fall in the bond price
Dollar Duration
• The approximate dollar price change for a 100bps change in yield.
• Given by:
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Duration of a Bond:
• It is the sensitivity of the price of the bond in response to a change in the interest rates/yield
Duration = - (Percentage change in bond price/Percentage change in Yield)
negative sign is used because of the inverse relation between yield and bond prices
Thus, increase in the yield results in a fall in the bond price
Dollar Duration
• The approximate dollar price change for a 100bps change in yield.
• Given by:
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decimal)inYieldin(ChangePrice)(Inintial2RiseYieldifPrice-DeclineYieldifPrice
Interest Rate Risk Of A Floating Rate Security
• Floating rate security: It is one whose coupon rate is reset at each coupon date so that it matched the
current market yield. It is typically a reference rate(say, LIBOR) + additional margin
• This implies that a floating rate security will always sell at par
• However, it is possible for a floating rate security to quote below or above par if there is a change in
the market yield in between the reset dates
Example: If a floating rate security which pays interest every six months, is reset in the month of April
and the interest rates fall, it will trade at a premium till the next reset date in October
© Neev Knowledge Management – Pristine
• Floating rate security: It is one whose coupon rate is reset at each coupon date so that it matched the
current market yield. It is typically a reference rate(say, LIBOR) + additional margin
• This implies that a floating rate security will always sell at par
• However, it is possible for a floating rate security to quote below or above par if there is a change in
the market yield in between the reset dates
Example: If a floating rate security which pays interest every six months, is reset in the month of April
and the interest rates fall, it will trade at a premium till the next reset date in October
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Interest Rate Risk Of A Floating Rate Security
• Floating rate security: It is one whose coupon rate is reset at each coupon date so that it matched the
current market yield. It is typically a reference rate(say, LIBOR) + additional margin
• This implies that a floating rate security will always sell at par
• However, it is possible for a floating rate security to quote below or above par if there is a change in
the market yield in between the reset dates
Example: If a floating rate security which pays interest every six months, is reset in the month of April
and the interest rates fall, it will trade at a premium till the next reset date in October
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• Floating rate security: It is one whose coupon rate is reset at each coupon date so that it matched the
current market yield. It is typically a reference rate(say, LIBOR) + additional margin
• This implies that a floating rate security will always sell at par
• However, it is possible for a floating rate security to quote below or above par if there is a change in
the market yield in between the reset dates
Example: If a floating rate security which pays interest every six months, is reset in the month of April
and the interest rates fall, it will trade at a premium till the next reset date in October
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Yield Curve Risk
• Yield Curve: Shows the relationship between Yield and Maturity
• Yield curve risk refers to the change in the Yield curve
• The risk of experiencing an adverse shift in market interest rates associated with investing in a fixed
income instrument.
• The risk is associated with either a flattening or steepening of the yield curve, which is a result of
changing yields among comparable bonds with different maturities
With reference to a Portflolio of bonds: a non parallel shift in the yield curve will result in varying
impact on short maturity and long maturity bonds, makes duration a poor measure for Portfolio of
bonds
© Neev Knowledge Management – Pristine
• Yield Curve: Shows the relationship between Yield and Maturity
• Yield curve risk refers to the change in the Yield curve
• The risk of experiencing an adverse shift in market interest rates associated with investing in a fixed
income instrument.
• The risk is associated with either a flattening or steepening of the yield curve, which is a result of
changing yields among comparable bonds with different maturities
With reference to a Portflolio of bonds: a non parallel shift in the yield curve will result in varying
impact on short maturity and long maturity bonds, makes duration a poor measure for Portfolio of
bonds
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• Yield Curve: Shows the relationship between Yield and Maturity
• Yield curve risk refers to the change in the Yield curve
• The risk of experiencing an adverse shift in market interest rates associated with investing in a fixed
income instrument.
• The risk is associated with either a flattening or steepening of the yield curve, which is a result of
changing yields among comparable bonds with different maturities
With reference to a Portflolio of bonds: a non parallel shift in the yield curve will result in varying
impact on short maturity and long maturity bonds, makes duration a poor measure for Portfolio of
bonds
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• Yield Curve: Shows the relationship between Yield and Maturity
• Yield curve risk refers to the change in the Yield curve
• The risk of experiencing an adverse shift in market interest rates associated with investing in a fixed
income instrument.
• The risk is associated with either a flattening or steepening of the yield curve, which is a result of
changing yields among comparable bonds with different maturities
With reference to a Portflolio of bonds: a non parallel shift in the yield curve will result in varying
impact on short maturity and long maturity bonds, makes duration a poor measure for Portfolio of
bonds
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Reinvestment Risk
Reinvestment Risk
• Reinvestment risk: Interest and Principal payments that are available to be reinvested will be done so at a
lower rate than the security that generated the proceeds.
• A security which is amortising, with higher coupon; a call feature; a prepayment option; will have a higher
reinvestment risk
• Prepayable securities have a higher reinvestment risk because a reduction in the interest rates results in an
increase in prepayments which will have to be reinvested at the lower rate
• Zero-Coupon bonds eliminate reinvestment risk.
© Neev Knowledge Management – Pristine
Reinvestment Risk
• Reinvestment risk: Interest and Principal payments that are available to be reinvested will be done so at a
lower rate than the security that generated the proceeds.
• A security which is amortising, with higher coupon; a call feature; a prepayment option; will have a higher
reinvestment risk
• Prepayable securities have a higher reinvestment risk because a reduction in the interest rates results in an
increase in prepayments which will have to be reinvested at the lower rate
• Zero-Coupon bonds eliminate reinvestment risk.
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Reinvestment Risk
• Reinvestment risk: Interest and Principal payments that are available to be reinvested will be done so at a
lower rate than the security that generated the proceeds.
• A security which is amortising, with higher coupon; a call feature; a prepayment option; will have a higher
reinvestment risk
• Prepayable securities have a higher reinvestment risk because a reduction in the interest rates results in an
increase in prepayments which will have to be reinvested at the lower rate
• Zero-Coupon bonds eliminate reinvestment risk.
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Reinvestment Risk
• Reinvestment risk: Interest and Principal payments that are available to be reinvested will be done so at a
lower rate than the security that generated the proceeds.
• A security which is amortising, with higher coupon; a call feature; a prepayment option; will have a higher
reinvestment risk
• Prepayable securities have a higher reinvestment risk because a reduction in the interest rates results in an
increase in prepayments which will have to be reinvested at the lower rate
• Zero-Coupon bonds eliminate reinvestment risk.
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Credit Risk
• A security issued by the U.S. government is considered risk free as it has no credit risk
• Default risk premium:
– The spread over a risk free asset of similar maturity for bearing the credit risk of the security.
• Credit spread risk:
– The increase in this default risk premium
• Downgrade risk:
– The risk that a bond‘s rating maybe downgraded by the credit rating agency which results in an increase
the return demanded by the investors for bearing the increased credit risk
© Neev Knowledge Management – Pristine
• A security issued by the U.S. government is considered risk free as it has no credit risk
• Default risk premium:
– The spread over a risk free asset of similar maturity for bearing the credit risk of the security.
• Credit spread risk:
– The increase in this default risk premium
• Downgrade risk:
– The risk that a bond‘s rating maybe downgraded by the credit rating agency which results in an increase
the return demanded by the investors for bearing the increased credit risk
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• A security issued by the U.S. government is considered risk free as it has no credit risk
• Default risk premium:
– The spread over a risk free asset of similar maturity for bearing the credit risk of the security.
• Credit spread risk:
– The increase in this default risk premium
• Downgrade risk:
– The risk that a bond‘s rating maybe downgraded by the credit rating agency which results in an increase
the return demanded by the investors for bearing the increased credit risk
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• A security issued by the U.S. government is considered risk free as it has no credit risk
• Default risk premium:
– The spread over a risk free asset of similar maturity for bearing the credit risk of the security.
• Credit spread risk:
– The increase in this default risk premium
• Downgrade risk:
– The risk that a bond‘s rating maybe downgraded by the credit rating agency which results in an increase
the return demanded by the investors for bearing the increased credit risk
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Liquidity Risk
• Liquidity Risk: The risk that the investor will have to sell a bond below its indicated value.– Indicated value: last traded price
• The primary risk measure – The bid/ask spread
• The wider the bid-ask spread, the lower the liquidity, the greater the liquidity risk.
• Retail Investors– For investors who plan to hold the security until maturity, not need to mark to market and liquidity risk is
not a major concern.
• Institutional Investors– Need to mark to market, even if they plan to hold until maturity.– This is needed to calculate Net Asset Value (NAV)
© Neev Knowledge Management – Pristine
• Liquidity Risk: The risk that the investor will have to sell a bond below its indicated value.– Indicated value: last traded price
• The primary risk measure – The bid/ask spread
• The wider the bid-ask spread, the lower the liquidity, the greater the liquidity risk.
• Retail Investors– For investors who plan to hold the security until maturity, not need to mark to market and liquidity risk is
not a major concern.
• Institutional Investors– Need to mark to market, even if they plan to hold until maturity.– This is needed to calculate Net Asset Value (NAV)
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• Liquidity Risk: The risk that the investor will have to sell a bond below its indicated value.– Indicated value: last traded price
• The primary risk measure – The bid/ask spread
• The wider the bid-ask spread, the lower the liquidity, the greater the liquidity risk.
• Retail Investors– For investors who plan to hold the security until maturity, not need to mark to market and liquidity risk is
not a major concern.
• Institutional Investors– Need to mark to market, even if they plan to hold until maturity.– This is needed to calculate Net Asset Value (NAV)
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• Liquidity Risk: The risk that the investor will have to sell a bond below its indicated value.– Indicated value: last traded price
• The primary risk measure – The bid/ask spread
• The wider the bid-ask spread, the lower the liquidity, the greater the liquidity risk.
• Retail Investors– For investors who plan to hold the security until maturity, not need to mark to market and liquidity risk is
not a major concern.
• Institutional Investors– Need to mark to market, even if they plan to hold until maturity.– This is needed to calculate Net Asset Value (NAV)
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Exchange Rate Risk
• Exchange Rate Risk:– The risk of receiving less of the domestic currency when investing in a bond that makes payments in a
currency other that the manager’s domestic currency is called exchange rate risk or currency risk.
• When you invest in a bond whose payments are not in your domestic currency, the cash flows youreceive depend on the exchange rate at the time of the cash inflows.
• If the foreign currency depreciates relative to the domestic currency, you receive less units of thedomestic currency upon exchange.
© Neev Knowledge Management – Pristine
• Exchange Rate Risk:– The risk of receiving less of the domestic currency when investing in a bond that makes payments in a
currency other that the manager’s domestic currency is called exchange rate risk or currency risk.
• When you invest in a bond whose payments are not in your domestic currency, the cash flows youreceive depend on the exchange rate at the time of the cash inflows.
• If the foreign currency depreciates relative to the domestic currency, you receive less units of thedomestic currency upon exchange.
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• Exchange Rate Risk:– The risk of receiving less of the domestic currency when investing in a bond that makes payments in a
currency other that the manager’s domestic currency is called exchange rate risk or currency risk.
• When you invest in a bond whose payments are not in your domestic currency, the cash flows youreceive depend on the exchange rate at the time of the cash inflows.
• If the foreign currency depreciates relative to the domestic currency, you receive less units of thedomestic currency upon exchange.
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• Exchange Rate Risk:– The risk of receiving less of the domestic currency when investing in a bond that makes payments in a
currency other that the manager’s domestic currency is called exchange rate risk or currency risk.
• When you invest in a bond whose payments are not in your domestic currency, the cash flows youreceive depend on the exchange rate at the time of the cash inflows.
• If the foreign currency depreciates relative to the domestic currency, you receive less units of thedomestic currency upon exchange.
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Inflation Risk
• Inflation risk: refers to the risk of errosion of the purchasing power of the returns from the security as a
result of unexpected rise in inflation
• Example: Last year, you purchased a 1 year zero coupon bond with a 8% interest rate and the inflation was
3%. That means your purchasing power only increased by (8%-3% = 5%)..
• Inflation protection bonds eliminate inflation risk.
© Neev Knowledge Management – Pristine 58
• Inflation risk: refers to the risk of errosion of the purchasing power of the returns from the security as a
result of unexpected rise in inflation
• Example: Last year, you purchased a 1 year zero coupon bond with a 8% interest rate and the inflation was
3%. That means your purchasing power only increased by (8%-3% = 5%)..
• Inflation protection bonds eliminate inflation risk.
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Yield Volatility
• Price of a Callable Bond = Price of Option Free Bond – Price of Embedded Option
• Price of a Putable Bond = Price of Option Free Bond + Price of Embedded Option
Type of Embedded Option Volatility Risk Due toCallable Bonds An increase in expected yield
volatilityPutable Bonds A decrease in expected yield volatility
© Neev Knowledge Management – Pristine 59
• Price of a Callable Bond = Price of Option Free Bond – Price of Embedded Option
• Price of a Putable Bond = Price of Option Free Bond + Price of Embedded Option
Volatility Risk Due toAn increase in expected yieldvolatilityA decrease in expected yield volatility
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Questions
1. Ted works for a fixed income fund; he wants to buy a bond for his portfolio. Which of the following bondswill have the least sensitivity to interest rate risks
A. A 10% coupon bond with a maturity of 15 yearsB. A zero-coupon bond with a maturity of 20 yearsC. A 8% coupon bond with a maturity of 15 years
2. A company has to make a balloon loan payment of $5,000,000 in 3 years. Which of the following options isbest for the company to make repayment and to minimize reinvestment risk. All bonds are non-callable andare otherwise similar except as noted with face values of $5,000,000. Market rates are at 5.0%.
A. 4-year, zero coupon bond priced to yield 5.5%B. 2-year, zero-coupon bond priced to yield 9.0%.C. 3-year, zero coupon bond priced to yield 5.0%.
3. Which of the following has the highest interest rate risk?:A. Zero coupon bondB. Floating rate bondC. Fixed coupon bond
© Neev Knowledge Management – Pristine
1. Ted works for a fixed income fund; he wants to buy a bond for his portfolio. Which of the following bondswill have the least sensitivity to interest rate risks
A. A 10% coupon bond with a maturity of 15 yearsB. A zero-coupon bond with a maturity of 20 yearsC. A 8% coupon bond with a maturity of 15 years
2. A company has to make a balloon loan payment of $5,000,000 in 3 years. Which of the following options isbest for the company to make repayment and to minimize reinvestment risk. All bonds are non-callable andare otherwise similar except as noted with face values of $5,000,000. Market rates are at 5.0%.
A. 4-year, zero coupon bond priced to yield 5.5%B. 2-year, zero-coupon bond priced to yield 9.0%.C. 3-year, zero coupon bond priced to yield 5.0%.
3. Which of the following has the highest interest rate risk?:A. Zero coupon bondB. Floating rate bondC. Fixed coupon bond
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1. Ted works for a fixed income fund; he wants to buy a bond for his portfolio. Which of the following bondswill have the least sensitivity to interest rate risks
A. A 10% coupon bond with a maturity of 15 yearsB. A zero-coupon bond with a maturity of 20 yearsC. A 8% coupon bond with a maturity of 15 years
2. A company has to make a balloon loan payment of $5,000,000 in 3 years. Which of the following options isbest for the company to make repayment and to minimize reinvestment risk. All bonds are non-callable andare otherwise similar except as noted with face values of $5,000,000. Market rates are at 5.0%.
A. 4-year, zero coupon bond priced to yield 5.5%B. 2-year, zero-coupon bond priced to yield 9.0%.C. 3-year, zero coupon bond priced to yield 5.0%.
3. Which of the following has the highest interest rate risk?:A. Zero coupon bondB. Floating rate bondC. Fixed coupon bond
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1. Ted works for a fixed income fund; he wants to buy a bond for his portfolio. Which of the following bondswill have the least sensitivity to interest rate risks
A. A 10% coupon bond with a maturity of 15 yearsB. A zero-coupon bond with a maturity of 20 yearsC. A 8% coupon bond with a maturity of 15 years
2. A company has to make a balloon loan payment of $5,000,000 in 3 years. Which of the following options isbest for the company to make repayment and to minimize reinvestment risk. All bonds are non-callable andare otherwise similar except as noted with face values of $5,000,000. Market rates are at 5.0%.
A. 4-year, zero coupon bond priced to yield 5.5%B. 2-year, zero-coupon bond priced to yield 9.0%.C. 3-year, zero coupon bond priced to yield 5.0%.
3. Which of the following has the highest interest rate risk?:A. Zero coupon bondB. Floating rate bondC. Fixed coupon bond
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Questions (Cont...)
4. The value of a putable bond will be:A. Higher than the value of an option-free bond.B. Lower than the value of an option-free bond.C. More or less equal to the value of an option-free bond
5. On the reset date, the value of a floating rate security will be:A. Trading at a premium.B. Trading at a discount.C. Trading at par
6. Which of the following is least correct?:A. A Treasury security has no credit risk.B. A floating rate bond protects against inflation risk.C. A AAA bond has no credit risk.
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4. The value of a putable bond will be:A. Higher than the value of an option-free bond.B. Lower than the value of an option-free bond.C. More or less equal to the value of an option-free bond
5. On the reset date, the value of a floating rate security will be:A. Trading at a premium.B. Trading at a discount.C. Trading at par
6. Which of the following is least correct?:A. A Treasury security has no credit risk.B. A floating rate bond protects against inflation risk.C. A AAA bond has no credit risk.
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4. The value of a putable bond will be:A. Higher than the value of an option-free bond.B. Lower than the value of an option-free bond.C. More or less equal to the value of an option-free bond
5. On the reset date, the value of a floating rate security will be:A. Trading at a premium.B. Trading at a discount.C. Trading at par
6. Which of the following is least correct?:A. A Treasury security has no credit risk.B. A floating rate bond protects against inflation risk.C. A AAA bond has no credit risk.
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4. The value of a putable bond will be:A. Higher than the value of an option-free bond.B. Lower than the value of an option-free bond.C. More or less equal to the value of an option-free bond
5. On the reset date, the value of a floating rate security will be:A. Trading at a premium.B. Trading at a discount.C. Trading at par
6. Which of the following is least correct?:A. A Treasury security has no credit risk.B. A floating rate bond protects against inflation risk.C. A AAA bond has no credit risk.
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Solutions
1. A. The longer the maturity the higher the interest rate sensitivity. Lower coupon rates also increasethe sensitivity of bond prices to changes in interest rates. A ZCB has the highest sensitivity to interestrate changes
2. C. Since all the choices are non-callable, the treasurer will prefer a zero-coupon to a coupon bond.While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannoteliminate reinvestment risk. One exception is zero-coupon bonds, since these bonds deliverpayments in one lump sum at maturity. Although the 3-year coupon bond fulfills the treasurer’srequirement concerning funds for repayment, it does not minimize reinvestment risk.Among the zero-coupon bonds, the one that best matches the loan’s maturity will minimizereinvestment risk. The treasurer will thus prefer the 3-year, zero-coupon bond. If he purchased the 4-year zero-coupon bond, he would have to sell the bond prior to maturity to payoff the loan and wouldface price risk. The 2-year zero-coupon bond is attractive because of the higher yield. However, thebond matures one year before the loan is due and would expose the firm to reinvestment risk.
3. A. Zero coupon bond4. A. Higher than the value of an option-free bond5. C. Trading at par6. C. A AAA bond has no credit risk
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1. A. The longer the maturity the higher the interest rate sensitivity. Lower coupon rates also increasethe sensitivity of bond prices to changes in interest rates. A ZCB has the highest sensitivity to interestrate changes
2. C. Since all the choices are non-callable, the treasurer will prefer a zero-coupon to a coupon bond.While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannoteliminate reinvestment risk. One exception is zero-coupon bonds, since these bonds deliverpayments in one lump sum at maturity. Although the 3-year coupon bond fulfills the treasurer’srequirement concerning funds for repayment, it does not minimize reinvestment risk.Among the zero-coupon bonds, the one that best matches the loan’s maturity will minimizereinvestment risk. The treasurer will thus prefer the 3-year, zero-coupon bond. If he purchased the 4-year zero-coupon bond, he would have to sell the bond prior to maturity to payoff the loan and wouldface price risk. The 2-year zero-coupon bond is attractive because of the higher yield. However, thebond matures one year before the loan is due and would expose the firm to reinvestment risk.
3. A. Zero coupon bond4. A. Higher than the value of an option-free bond5. C. Trading at par6. C. A AAA bond has no credit risk
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1. A. The longer the maturity the higher the interest rate sensitivity. Lower coupon rates also increasethe sensitivity of bond prices to changes in interest rates. A ZCB has the highest sensitivity to interestrate changes
2. C. Since all the choices are non-callable, the treasurer will prefer a zero-coupon to a coupon bond.While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannoteliminate reinvestment risk. One exception is zero-coupon bonds, since these bonds deliverpayments in one lump sum at maturity. Although the 3-year coupon bond fulfills the treasurer’srequirement concerning funds for repayment, it does not minimize reinvestment risk.Among the zero-coupon bonds, the one that best matches the loan’s maturity will minimizereinvestment risk. The treasurer will thus prefer the 3-year, zero-coupon bond. If he purchased the 4-year zero-coupon bond, he would have to sell the bond prior to maturity to payoff the loan and wouldface price risk. The 2-year zero-coupon bond is attractive because of the higher yield. However, thebond matures one year before the loan is due and would expose the firm to reinvestment risk.
3. A. Zero coupon bond4. A. Higher than the value of an option-free bond5. C. Trading at par6. C. A AAA bond has no credit risk
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1. A. The longer the maturity the higher the interest rate sensitivity. Lower coupon rates also increasethe sensitivity of bond prices to changes in interest rates. A ZCB has the highest sensitivity to interestrate changes
2. C. Since all the choices are non-callable, the treasurer will prefer a zero-coupon to a coupon bond.While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannoteliminate reinvestment risk. One exception is zero-coupon bonds, since these bonds deliverpayments in one lump sum at maturity. Although the 3-year coupon bond fulfills the treasurer’srequirement concerning funds for repayment, it does not minimize reinvestment risk.Among the zero-coupon bonds, the one that best matches the loan’s maturity will minimizereinvestment risk. The treasurer will thus prefer the 3-year, zero-coupon bond. If he purchased the 4-year zero-coupon bond, he would have to sell the bond prior to maturity to payoff the loan and wouldface price risk. The 2-year zero-coupon bond is attractive because of the higher yield. However, thebond matures one year before the loan is due and would expose the firm to reinvestment risk.
3. A. Zero coupon bond4. A. Higher than the value of an option-free bond5. C. Trading at par6. C. A AAA bond has no credit risk
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Agenda
• Features of Debt Securities
• Risks Associated with Investing in Bonds
• Overview of Bond Sectors and Instruments
• Understanding Yield Spreads
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• Features of Debt Securities
• Risks Associated with Investing in Bonds
• Overview of Bond Sectors and Instruments
• Understanding Yield Spreads
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Key Issues In Overview Of Bond Sectors And Instruments
• Characteristics of Government Securities
• Types of Securities
• Stripped Treasury Securities
• Securities issued by US Federal Agencies
• Mortgage-backed securities
• Collateralized Mortgage Obligation
• Securities issued by Municipalities in US
• Securities issued by Corporations
• Asset-Backed Security
• Collateralized debt Obligation
• Issuing bonds in the Primary market
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• Characteristics of Government Securities
• Types of Securities
• Stripped Treasury Securities
• Securities issued by US Federal Agencies
• Mortgage-backed securities
• Collateralized Mortgage Obligation
• Securities issued by Municipalities in US
• Securities issued by Corporations
• Asset-Backed Security
• Collateralized debt Obligation
• Issuing bonds in the Primary market
64
Key Issues In Overview Of Bond Sectors And Instruments
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Characteristics Of Government Securities
Government securities are considered to be free of default risk. It is also known as sovereign debt.
Bonds issued by national governments in foreign currencies are normally referred to as sovereignbonds.
However for a person in the US, the sovereign debt of another company will have credit risk.
© Neev Knowledge Management – Pristine
Government securities are considered to be free of default risk. It is also known as sovereign debt.
Bonds issued by national governments in foreign currencies are normally referred to as sovereignbonds.
However for a person in the US, the sovereign debt of another company will have credit risk.
65
Characteristics Of Government Securities
Government securities are considered to be free of default risk. It is also known as sovereign debt.
Bonds issued by national governments in foreign currencies are normally referred to as sovereignbonds.
However for a person in the US, the sovereign debt of another company will have credit risk.
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Government securities are considered to be free of default risk. It is also known as sovereign debt.
Bonds issued by national governments in foreign currencies are normally referred to as sovereignbonds.
However for a person in the US, the sovereign debt of another company will have credit risk.
65
Types Of Government Securities
Types of Securities
• Treasury Securities:
– Treasury Bills: Maturity of less than one year and do not make interest payment. Issued at discount topar.
– Treasury Notes: Pay semiannual interest rates. Maturities of 2, 3, 5, 10 years.– Treasury Bonds: Pay semiannual interest rates. Maturities of 20, 30 years.– Treasurt Inflation Protected Securities(TIPS): Pay semiannual interest rates. Maturities of 5, 10, 20 years.
The par value is adjusted semi annually to account for the change in inflation.
• On-the-run Treasury Securities: Most recent auctioned securities.
• Off-the-run Treasury Securities: Older issued securities
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Types of Securities
• Treasury Securities:
– Treasury Bills: Maturity of less than one year and do not make interest payment. Issued at discount topar.
– Treasury Notes: Pay semiannual interest rates. Maturities of 2, 3, 5, 10 years.– Treasury Bonds: Pay semiannual interest rates. Maturities of 20, 30 years.– Treasurt Inflation Protected Securities(TIPS): Pay semiannual interest rates. Maturities of 5, 10, 20 years.
The par value is adjusted semi annually to account for the change in inflation.
• On-the-run Treasury Securities: Most recent auctioned securities.
• Off-the-run Treasury Securities: Older issued securities
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Types of Securities
• Treasury Securities:
– Treasury Bills: Maturity of less than one year and do not make interest payment. Issued at discount topar.
– Treasury Notes: Pay semiannual interest rates. Maturities of 2, 3, 5, 10 years.– Treasury Bonds: Pay semiannual interest rates. Maturities of 20, 30 years.– Treasurt Inflation Protected Securities(TIPS): Pay semiannual interest rates. Maturities of 5, 10, 20 years.
The par value is adjusted semi annually to account for the change in inflation.
• On-the-run Treasury Securities: Most recent auctioned securities.
• Off-the-run Treasury Securities: Older issued securities
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Types of Securities
• Treasury Securities:
– Treasury Bills: Maturity of less than one year and do not make interest payment. Issued at discount topar.
– Treasury Notes: Pay semiannual interest rates. Maturities of 2, 3, 5, 10 years.– Treasury Bonds: Pay semiannual interest rates. Maturities of 20, 30 years.– Treasurt Inflation Protected Securities(TIPS): Pay semiannual interest rates. Maturities of 5, 10, 20 years.
The par value is adjusted semi annually to account for the change in inflation.
• On-the-run Treasury Securities: Most recent auctioned securities.
• Off-the-run Treasury Securities: Older issued securities
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Stripped Treasury Securities
• Separate Trading of Registered Interest and Principal Securities(STRIPS): Introduced by Treasury in
1985
• As the Treasury did not issue and zero-coupon bonds, bankers separated the coupons due on normal
securities and sold the coupons and the principal amount as zero-coupon bonds
– Coupon STRIPS: STRIPS created from coupon payments
• Coupon STRIPS: Acrrued Interest is Taxed every year even though interest is not paid until maturity.
• Thus, they have negative cash flows until maturity.
– Principal STRIPS: STRIPS created from the Principal
• For some foreign players, the interest gained on Principal STRIPS are taxed as capital gains tax.
• They are preferred by those foreign entities.
© Neev Knowledge Management – Pristine
• Separate Trading of Registered Interest and Principal Securities(STRIPS): Introduced by Treasury in
1985
• As the Treasury did not issue and zero-coupon bonds, bankers separated the coupons due on normal
securities and sold the coupons and the principal amount as zero-coupon bonds
– Coupon STRIPS: STRIPS created from coupon payments
• Coupon STRIPS: Acrrued Interest is Taxed every year even though interest is not paid until maturity.
• Thus, they have negative cash flows until maturity.
– Principal STRIPS: STRIPS created from the Principal
• For some foreign players, the interest gained on Principal STRIPS are taxed as capital gains tax.
• They are preferred by those foreign entities.
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• Separate Trading of Registered Interest and Principal Securities(STRIPS): Introduced by Treasury in
1985
• As the Treasury did not issue and zero-coupon bonds, bankers separated the coupons due on normal
securities and sold the coupons and the principal amount as zero-coupon bonds
– Coupon STRIPS: STRIPS created from coupon payments
• Coupon STRIPS: Acrrued Interest is Taxed every year even though interest is not paid until maturity.
• Thus, they have negative cash flows until maturity.
– Principal STRIPS: STRIPS created from the Principal
• For some foreign players, the interest gained on Principal STRIPS are taxed as capital gains tax.
• They are preferred by those foreign entities.
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• Separate Trading of Registered Interest and Principal Securities(STRIPS): Introduced by Treasury in
1985
• As the Treasury did not issue and zero-coupon bonds, bankers separated the coupons due on normal
securities and sold the coupons and the principal amount as zero-coupon bonds
– Coupon STRIPS: STRIPS created from coupon payments
• Coupon STRIPS: Acrrued Interest is Taxed every year even though interest is not paid until maturity.
• Thus, they have negative cash flows until maturity.
– Principal STRIPS: STRIPS created from the Principal
• For some foreign players, the interest gained on Principal STRIPS are taxed as capital gains tax.
• They are preferred by those foreign entities.
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Types Of U.S. Federal Agencies Securities
Securities Issued by US Federal Agencies
Debt securities issued by various US Federal Agencies are called Agency Bonds. These can be:
– Federally related institutions
• Export-Import Bank of the United States
• Goverment National Mortgage Association (Ginnie Mae)
– Government sponsered enterprises(GSEs)
• Federal National Mortgage Association (Fannie Mae)
• Federal Home Loan Mortgage Corportion (Freddie Mac)
• These two institutions issued CMO‘s.
Debentures are unsecured securities. Generally issued by GSEs
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Securities Issued by US Federal Agencies
Debt securities issued by various US Federal Agencies are called Agency Bonds. These can be:
– Federally related institutions
• Export-Import Bank of the United States
• Goverment National Mortgage Association (Ginnie Mae)
– Government sponsered enterprises(GSEs)
• Federal National Mortgage Association (Fannie Mae)
• Federal Home Loan Mortgage Corportion (Freddie Mac)
• These two institutions issued CMO‘s.
Debentures are unsecured securities. Generally issued by GSEs
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Types Of U.S. Federal Agencies Securities
Securities Issued by US Federal Agencies
Debt securities issued by various US Federal Agencies are called Agency Bonds. These can be:
– Federally related institutions
• Export-Import Bank of the United States
• Goverment National Mortgage Association (Ginnie Mae)
– Government sponsered enterprises(GSEs)
• Federal National Mortgage Association (Fannie Mae)
• Federal Home Loan Mortgage Corportion (Freddie Mac)
• These two institutions issued CMO‘s.
Debentures are unsecured securities. Generally issued by GSEs
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Securities Issued by US Federal Agencies
Debt securities issued by various US Federal Agencies are called Agency Bonds. These can be:
– Federally related institutions
• Export-Import Bank of the United States
• Goverment National Mortgage Association (Ginnie Mae)
– Government sponsered enterprises(GSEs)
• Federal National Mortgage Association (Fannie Mae)
• Federal Home Loan Mortgage Corportion (Freddie Mac)
• These two institutions issued CMO‘s.
Debentures are unsecured securities. Generally issued by GSEs
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Mortgage-backed Securities
• MBS is a security which is backed by a pool of loans. These pool of loans act as a collateral for these
securities and also provide the regular cash flows to service these securities.
• Cash Flows from a mortgage:
– Interest payment
– Scheduled principal repayment
– Excess Principal repayment
• As there is no restriction on the repayment of the principal amount, investors face a high Prepayment
risk.
© Neev Knowledge Management – Pristine
• MBS is a security which is backed by a pool of loans. These pool of loans act as a collateral for these
securities and also provide the regular cash flows to service these securities.
• Cash Flows from a mortgage:
– Interest payment
– Scheduled principal repayment
– Excess Principal repayment
• As there is no restriction on the repayment of the principal amount, investors face a high Prepayment
risk.
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• MBS is a security which is backed by a pool of loans. These pool of loans act as a collateral for these
securities and also provide the regular cash flows to service these securities.
• Cash Flows from a mortgage:
– Interest payment
– Scheduled principal repayment
– Excess Principal repayment
• As there is no restriction on the repayment of the principal amount, investors face a high Prepayment
risk.
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• MBS is a security which is backed by a pool of loans. These pool of loans act as a collateral for these
securities and also provide the regular cash flows to service these securities.
• Cash Flows from a mortgage:
– Interest payment
– Scheduled principal repayment
– Excess Principal repayment
• As there is no restriction on the repayment of the principal amount, investors face a high Prepayment
risk.
69
Mortgage-backed Securities
• Mortgage Loans
– It is a loan secured by the collateral of some specified real estate.
– Default -“Foreclosure“
– Each payment includes both interest and principal -> Ammortized
– Prepayment has no penalty and can be:
• For the entire principal outstanding
• Partial Amount – called Curtailment
• Mortgage Pass-through Security:
– Homeowners' payments pass from the original bank through a government agency (like Ginnie Mae, Fannie
Mac, Freddie Mac) or investment bank to investors of the securities in proportion of their holding. That is why the
name, Pass-through.
– Prepayments are more predictable based on historical prepayment experience.
© Neev Knowledge Management – Pristine
• Mortgage Loans
– It is a loan secured by the collateral of some specified real estate.
– Default -“Foreclosure“
– Each payment includes both interest and principal -> Ammortized
– Prepayment has no penalty and can be:
• For the entire principal outstanding
• Partial Amount – called Curtailment
• Mortgage Pass-through Security:
– Homeowners' payments pass from the original bank through a government agency (like Ginnie Mae, Fannie
Mac, Freddie Mac) or investment bank to investors of the securities in proportion of their holding. That is why the
name, Pass-through.
– Prepayments are more predictable based on historical prepayment experience.
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• Mortgage Loans
– It is a loan secured by the collateral of some specified real estate.
– Default -“Foreclosure“
– Each payment includes both interest and principal -> Ammortized
– Prepayment has no penalty and can be:
• For the entire principal outstanding
• Partial Amount – called Curtailment
• Mortgage Pass-through Security:
– Homeowners' payments pass from the original bank through a government agency (like Ginnie Mae, Fannie
Mac, Freddie Mac) or investment bank to investors of the securities in proportion of their holding. That is why the
name, Pass-through.
– Prepayments are more predictable based on historical prepayment experience.
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• Mortgage Loans
– It is a loan secured by the collateral of some specified real estate.
– Default -“Foreclosure“
– Each payment includes both interest and principal -> Ammortized
– Prepayment has no penalty and can be:
• For the entire principal outstanding
• Partial Amount – called Curtailment
• Mortgage Pass-through Security:
– Homeowners' payments pass from the original bank through a government agency (like Ginnie Mae, Fannie
Mac, Freddie Mac) or investment bank to investors of the securities in proportion of their holding. That is why the
name, Pass-through.
– Prepayments are more predictable based on historical prepayment experience.
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Mortgage-backed Securities
• Stripped MBS:
– These STRIPS are either Interest-only(IO) of Principal-only(PO) STRIPS. The holder of a IO loses out on
interest as a result of prepayment of the principal. The PO gains as a result of prepayment.
• Collateralized Mortgage Obligations (CMO)
– Created to distribute prepayment risk among different classes of bonds.
© Neev Knowledge Management – Pristine
• Stripped MBS:
– These STRIPS are either Interest-only(IO) of Principal-only(PO) STRIPS. The holder of a IO loses out on
interest as a result of prepayment of the principal. The PO gains as a result of prepayment.
• Collateralized Mortgage Obligations (CMO)
– Created to distribute prepayment risk among different classes of bonds.
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• Stripped MBS:
– These STRIPS are either Interest-only(IO) of Principal-only(PO) STRIPS. The holder of a IO loses out on
interest as a result of prepayment of the principal. The PO gains as a result of prepayment.
• Collateralized Mortgage Obligations (CMO)
– Created to distribute prepayment risk among different classes of bonds.
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• Stripped MBS:
– These STRIPS are either Interest-only(IO) of Principal-only(PO) STRIPS. The holder of a IO loses out on
interest as a result of prepayment of the principal. The PO gains as a result of prepayment.
• Collateralized Mortgage Obligations (CMO)
– Created to distribute prepayment risk among different classes of bonds.
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Collateralized Mortgage Obligation
• This is complex version of a Mortgage Passthrough security. The payments are not disbursed in the
proportion of the holding. Tranches are created out of the passthrough security. These Tranches
have varying properties. For ex: A CMO with Tranche I, II and III maybe structured such that Tranche
I is repaid first followed by Tranche II and Tranche II.
• The reason for creating a CMO is:
– To redistribute the prepayment risk. In the above example: Tranche III bears most of the credit risk and
Tranche I bears most of the prepayment risk.
– To create securities with varying maturities. Trance II will have the longest maturity in the above example.
• Investors invest in a particular Tranche as per their requirements depending on the risks they are
willing to take on of the risk they want to avoid.
© Neev Knowledge Management – Pristine
• This is complex version of a Mortgage Passthrough security. The payments are not disbursed in the
proportion of the holding. Tranches are created out of the passthrough security. These Tranches
have varying properties. For ex: A CMO with Tranche I, II and III maybe structured such that Tranche
I is repaid first followed by Tranche II and Tranche II.
• The reason for creating a CMO is:
– To redistribute the prepayment risk. In the above example: Tranche III bears most of the credit risk and
Tranche I bears most of the prepayment risk.
– To create securities with varying maturities. Trance II will have the longest maturity in the above example.
• Investors invest in a particular Tranche as per their requirements depending on the risks they are
willing to take on of the risk they want to avoid.
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• This is complex version of a Mortgage Passthrough security. The payments are not disbursed in the
proportion of the holding. Tranches are created out of the passthrough security. These Tranches
have varying properties. For ex: A CMO with Tranche I, II and III maybe structured such that Tranche
I is repaid first followed by Tranche II and Tranche II.
• The reason for creating a CMO is:
– To redistribute the prepayment risk. In the above example: Tranche III bears most of the credit risk and
Tranche I bears most of the prepayment risk.
– To create securities with varying maturities. Trance II will have the longest maturity in the above example.
• Investors invest in a particular Tranche as per their requirements depending on the risks they are
willing to take on of the risk they want to avoid.
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• This is complex version of a Mortgage Passthrough security. The payments are not disbursed in the
proportion of the holding. Tranches are created out of the passthrough security. These Tranches
have varying properties. For ex: A CMO with Tranche I, II and III maybe structured such that Tranche
I is repaid first followed by Tranche II and Tranche II.
• The reason for creating a CMO is:
– To redistribute the prepayment risk. In the above example: Tranche III bears most of the credit risk and
Tranche I bears most of the prepayment risk.
– To create securities with varying maturities. Trance II will have the longest maturity in the above example.
• Investors invest in a particular Tranche as per their requirements depending on the risks they are
willing to take on of the risk they want to avoid.
72
Securities Issued By Corporations
• Structured Notes: These are basically debt securities that also contains an embedded derivativecomponent. One example is Equity Linked Notes (ELNs) wherein the return on the debt instrument islinked to the return on the equity.
• Commercial Paper: is a short-term, unsecured debt instrument used by corporate to raise funds.Maturities range from 2 days to 270 days.– Directly-placed paper is sold directly to the investors (large investors).– Dealer-placed paper is sold to investors through a commercial-paper dealer.
• Certificate of Deposit: is issued by banks to raise money from the public. Negotiable CDs can bebought and sold in the secondary market.
• Bankers Acceptance: is a bank gaurantee that a loan will be repaid. This is used primarily tofacilitate foreign trade.
© Neev Knowledge Management – Pristine
• Structured Notes: These are basically debt securities that also contains an embedded derivativecomponent. One example is Equity Linked Notes (ELNs) wherein the return on the debt instrument islinked to the return on the equity.
• Commercial Paper: is a short-term, unsecured debt instrument used by corporate to raise funds.Maturities range from 2 days to 270 days.– Directly-placed paper is sold directly to the investors (large investors).– Dealer-placed paper is sold to investors through a commercial-paper dealer.
• Certificate of Deposit: is issued by banks to raise money from the public. Negotiable CDs can bebought and sold in the secondary market.
• Bankers Acceptance: is a bank gaurantee that a loan will be repaid. This is used primarily tofacilitate foreign trade.
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• Structured Notes: These are basically debt securities that also contains an embedded derivativecomponent. One example is Equity Linked Notes (ELNs) wherein the return on the debt instrument islinked to the return on the equity.
• Commercial Paper: is a short-term, unsecured debt instrument used by corporate to raise funds.Maturities range from 2 days to 270 days.– Directly-placed paper is sold directly to the investors (large investors).– Dealer-placed paper is sold to investors through a commercial-paper dealer.
• Certificate of Deposit: is issued by banks to raise money from the public. Negotiable CDs can bebought and sold in the secondary market.
• Bankers Acceptance: is a bank gaurantee that a loan will be repaid. This is used primarily tofacilitate foreign trade.
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• Structured Notes: These are basically debt securities that also contains an embedded derivativecomponent. One example is Equity Linked Notes (ELNs) wherein the return on the debt instrument islinked to the return on the equity.
• Commercial Paper: is a short-term, unsecured debt instrument used by corporate to raise funds.Maturities range from 2 days to 270 days.– Directly-placed paper is sold directly to the investors (large investors).– Dealer-placed paper is sold to investors through a commercial-paper dealer.
• Certificate of Deposit: is issued by banks to raise money from the public. Negotiable CDs can bebought and sold in the secondary market.
• Bankers Acceptance: is a bank gaurantee that a loan will be repaid. This is used primarily tofacilitate foreign trade.
73
Asset-Backed Security
• Asset-backed security: It is a security whose value and income payments are backed by a specified
pool of underlying assets. These can be auto loans, corporate receivables, etc.
• In order to enhance the rating of these securities, the financial assets are transferred to a Special
Purpose Vehicle(SPV). This ensures that the SPV becomes a bankruptcy remote entity and the
securities receive a higher rating resulting in lower borrowing costs
• Apart from the above, the SPV may go for some external credit enhancements to improve the ratings
it receives:
– Corporate Guarantee
– Letters of Credit
– Bond Insurance
© Neev Knowledge Management – Pristine
• Asset-backed security: It is a security whose value and income payments are backed by a specified
pool of underlying assets. These can be auto loans, corporate receivables, etc.
• In order to enhance the rating of these securities, the financial assets are transferred to a Special
Purpose Vehicle(SPV). This ensures that the SPV becomes a bankruptcy remote entity and the
securities receive a higher rating resulting in lower borrowing costs
• Apart from the above, the SPV may go for some external credit enhancements to improve the ratings
it receives:
– Corporate Guarantee
– Letters of Credit
– Bond Insurance
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• Asset-backed security: It is a security whose value and income payments are backed by a specified
pool of underlying assets. These can be auto loans, corporate receivables, etc.
• In order to enhance the rating of these securities, the financial assets are transferred to a Special
Purpose Vehicle(SPV). This ensures that the SPV becomes a bankruptcy remote entity and the
securities receive a higher rating resulting in lower borrowing costs
• Apart from the above, the SPV may go for some external credit enhancements to improve the ratings
it receives:
– Corporate Guarantee
– Letters of Credit
– Bond Insurance
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• Asset-backed security: It is a security whose value and income payments are backed by a specified
pool of underlying assets. These can be auto loans, corporate receivables, etc.
• In order to enhance the rating of these securities, the financial assets are transferred to a Special
Purpose Vehicle(SPV). This ensures that the SPV becomes a bankruptcy remote entity and the
securities receive a higher rating resulting in lower borrowing costs
• Apart from the above, the SPV may go for some external credit enhancements to improve the ratings
it receives:
– Corporate Guarantee
– Letters of Credit
– Bond Insurance
74
Collateralized Debt Obligations (CDO‘s)
• Collateralized Debt Obligation(CDO): It is a type of structured asset-backed security (ABS) whose
value and payments is derived from a underlying pool of debt securities.
• The pool can consist of one or more of the following:
– US Domestic Investment grade and high yield corporate bonds (CBO)
– US Domestic Bank Loans (CLO)
– Emerging market bonds (CBO)
– Special Situation loans and distressed debt
– Foreign bank loans (CLO)
– Asset backed securities
– Residential and commercial MBS’s
– other CDOs
• The CDO is structure into Tranches, each with its own rating.
© Neev Knowledge Management – Pristine
• Collateralized Debt Obligation(CDO): It is a type of structured asset-backed security (ABS) whose
value and payments is derived from a underlying pool of debt securities.
• The pool can consist of one or more of the following:
– US Domestic Investment grade and high yield corporate bonds (CBO)
– US Domestic Bank Loans (CLO)
– Emerging market bonds (CBO)
– Special Situation loans and distressed debt
– Foreign bank loans (CLO)
– Asset backed securities
– Residential and commercial MBS’s
– other CDOs
• The CDO is structure into Tranches, each with its own rating.
75
Collateralized Debt Obligations (CDO‘s)
• Collateralized Debt Obligation(CDO): It is a type of structured asset-backed security (ABS) whose
value and payments is derived from a underlying pool of debt securities.
• The pool can consist of one or more of the following:
– US Domestic Investment grade and high yield corporate bonds (CBO)
– US Domestic Bank Loans (CLO)
– Emerging market bonds (CBO)
– Special Situation loans and distressed debt
– Foreign bank loans (CLO)
– Asset backed securities
– Residential and commercial MBS’s
– other CDOs
• The CDO is structure into Tranches, each with its own rating.
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• Collateralized Debt Obligation(CDO): It is a type of structured asset-backed security (ABS) whose
value and payments is derived from a underlying pool of debt securities.
• The pool can consist of one or more of the following:
– US Domestic Investment grade and high yield corporate bonds (CBO)
– US Domestic Bank Loans (CLO)
– Emerging market bonds (CBO)
– Special Situation loans and distressed debt
– Foreign bank loans (CLO)
– Asset backed securities
– Residential and commercial MBS’s
– other CDOs
• The CDO is structure into Tranches, each with its own rating.
75
Primary And Secondary Bond Markets
Primary market
• The deal is underwritten by investment bankers. This can be by way of:
– Firm Commitment (or)
– Best Efforts basis
• In private placements, the issuer must furnish a private placement memorandum. This is similar to a
prospectus except it does not contains ‚“ non-material“ information and not subject to SEC review.
Secondary market
• Fair values are determined
• Liquidity
• Can be traded
– Over the Counter
– Over Exchanges
© Neev Knowledge Management – Pristine
Primary market
• The deal is underwritten by investment bankers. This can be by way of:
– Firm Commitment (or)
– Best Efforts basis
• In private placements, the issuer must furnish a private placement memorandum. This is similar to a
prospectus except it does not contains ‚“ non-material“ information and not subject to SEC review.
Secondary market
• Fair values are determined
• Liquidity
• Can be traded
– Over the Counter
– Over Exchanges
76
Primary And Secondary Bond Markets
Primary market
• The deal is underwritten by investment bankers. This can be by way of:
– Firm Commitment (or)
– Best Efforts basis
• In private placements, the issuer must furnish a private placement memorandum. This is similar to a
prospectus except it does not contains ‚“ non-material“ information and not subject to SEC review.
Secondary market
• Fair values are determined
• Liquidity
• Can be traded
– Over the Counter
– Over Exchanges
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Primary market
• The deal is underwritten by investment bankers. This can be by way of:
– Firm Commitment (or)
– Best Efforts basis
• In private placements, the issuer must furnish a private placement memorandum. This is similar to a
prospectus except it does not contains ‚“ non-material“ information and not subject to SEC review.
Secondary market
• Fair values are determined
• Liquidity
• Can be traded
– Over the Counter
– Over Exchanges
76
Questions
1. An investor wants to invest in a security with the least prepayment risk. From the following list ofsecurities he is least likely to invest inA. Mortgage loansB. Mortgage pass throughsC. CMOs
2. Transferring the assets to a Special Purpose Vehicle helps do all of the following except:A. Improve the credit ratings of the issue.B. Creates a bankruptcy remote entity.C. Reduce the risk associated with the securities.
3. A bond has more reinvestment risk when?A. It is bullet payment bondB. It has an embedded put optionC. It has higher coupon rate than currently available market interest rate
4. A Treasury Security with a 10 year maturity is called a:A. Treasury BillB. Treasury BondC. Treasury Note
© Neev Knowledge Management – Pristine
1. An investor wants to invest in a security with the least prepayment risk. From the following list ofsecurities he is least likely to invest inA. Mortgage loansB. Mortgage pass throughsC. CMOs
2. Transferring the assets to a Special Purpose Vehicle helps do all of the following except:A. Improve the credit ratings of the issue.B. Creates a bankruptcy remote entity.C. Reduce the risk associated with the securities.
3. A bond has more reinvestment risk when?A. It is bullet payment bondB. It has an embedded put optionC. It has higher coupon rate than currently available market interest rate
4. A Treasury Security with a 10 year maturity is called a:A. Treasury BillB. Treasury BondC. Treasury Note
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1. An investor wants to invest in a security with the least prepayment risk. From the following list ofsecurities he is least likely to invest inA. Mortgage loansB. Mortgage pass throughsC. CMOs
2. Transferring the assets to a Special Purpose Vehicle helps do all of the following except:A. Improve the credit ratings of the issue.B. Creates a bankruptcy remote entity.C. Reduce the risk associated with the securities.
3. A bond has more reinvestment risk when?A. It is bullet payment bondB. It has an embedded put optionC. It has higher coupon rate than currently available market interest rate
4. A Treasury Security with a 10 year maturity is called a:A. Treasury BillB. Treasury BondC. Treasury Note
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1. An investor wants to invest in a security with the least prepayment risk. From the following list ofsecurities he is least likely to invest inA. Mortgage loansB. Mortgage pass throughsC. CMOs
2. Transferring the assets to a Special Purpose Vehicle helps do all of the following except:A. Improve the credit ratings of the issue.B. Creates a bankruptcy remote entity.C. Reduce the risk associated with the securities.
3. A bond has more reinvestment risk when?A. It is bullet payment bondB. It has an embedded put optionC. It has higher coupon rate than currently available market interest rate
4. A Treasury Security with a 10 year maturity is called a:A. Treasury BillB. Treasury BondC. Treasury Note
77
Questions(Cont...)
5. Which of the following bonds has the highest risk:A. Unlimited tax general obligation bondsB. Prefunded BondsC. Revenue Bonds
6. Which of the following is not an reason for creating a CMO:A. To reduce the total riskB. To redistribute the prepayment riskC. To create securities with varying maturities
7. Which of the following bonds is not an external credit enhancement for a SPV:A. Letters of CreditB. Over CollateralizationC. Bond Insurance
© Neev Knowledge Management – Pristine
5. Which of the following bonds has the highest risk:A. Unlimited tax general obligation bondsB. Prefunded BondsC. Revenue Bonds
6. Which of the following is not an reason for creating a CMO:A. To reduce the total riskB. To redistribute the prepayment riskC. To create securities with varying maturities
7. Which of the following bonds is not an external credit enhancement for a SPV:A. Letters of CreditB. Over CollateralizationC. Bond Insurance
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5. Which of the following bonds has the highest risk:A. Unlimited tax general obligation bondsB. Prefunded BondsC. Revenue Bonds
6. Which of the following is not an reason for creating a CMO:A. To reduce the total riskB. To redistribute the prepayment riskC. To create securities with varying maturities
7. Which of the following bonds is not an external credit enhancement for a SPV:A. Letters of CreditB. Over CollateralizationC. Bond Insurance
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5. Which of the following bonds has the highest risk:A. Unlimited tax general obligation bondsB. Prefunded BondsC. Revenue Bonds
6. Which of the following is not an reason for creating a CMO:A. To reduce the total riskB. To redistribute the prepayment riskC. To create securities with varying maturities
7. Which of the following bonds is not an external credit enhancement for a SPV:A. Letters of CreditB. Over CollateralizationC. Bond Insurance
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Solutions
1. A. Mortgage pass throughs have lower prepayment risks as compared to individual mortgages as the
prepayment risk is spread over the entire portfolio of loans pooled in the pass through. CMOs or
Collateralized Mortgage Obligations are a type of mortgage pass throughs.
2. C. By converting the assets to liquid cash the originating agency can improve its liquidity ratios. The
liquid cash can then be reused in the business. By improving its capital adequacy ratio it can improve
its credit ratings. Also a SPE can be structured in such a manner that it is bankruptcy remote.
However the risk associated with the securities is not removed.
3. C. The correct answer is It has higher coupon rate than currently available market interest rate.
Higher the coupon rate, greater the reinvestment risk.
4. C. Treasury Note
5. C. Revenue Bonds
6. A. To reduce the total risk
7. B. Over Collateralization
© Neev Knowledge Management – Pristine
1. A. Mortgage pass throughs have lower prepayment risks as compared to individual mortgages as the
prepayment risk is spread over the entire portfolio of loans pooled in the pass through. CMOs or
Collateralized Mortgage Obligations are a type of mortgage pass throughs.
2. C. By converting the assets to liquid cash the originating agency can improve its liquidity ratios. The
liquid cash can then be reused in the business. By improving its capital adequacy ratio it can improve
its credit ratings. Also a SPE can be structured in such a manner that it is bankruptcy remote.
However the risk associated with the securities is not removed.
3. C. The correct answer is It has higher coupon rate than currently available market interest rate.
Higher the coupon rate, greater the reinvestment risk.
4. C. Treasury Note
5. C. Revenue Bonds
6. A. To reduce the total risk
7. B. Over Collateralization
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1. A. Mortgage pass throughs have lower prepayment risks as compared to individual mortgages as the
prepayment risk is spread over the entire portfolio of loans pooled in the pass through. CMOs or
Collateralized Mortgage Obligations are a type of mortgage pass throughs.
2. C. By converting the assets to liquid cash the originating agency can improve its liquidity ratios. The
liquid cash can then be reused in the business. By improving its capital adequacy ratio it can improve
its credit ratings. Also a SPE can be structured in such a manner that it is bankruptcy remote.
However the risk associated with the securities is not removed.
3. C. The correct answer is It has higher coupon rate than currently available market interest rate.
Higher the coupon rate, greater the reinvestment risk.
4. C. Treasury Note
5. C. Revenue Bonds
6. A. To reduce the total risk
7. B. Over Collateralization
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1. A. Mortgage pass throughs have lower prepayment risks as compared to individual mortgages as the
prepayment risk is spread over the entire portfolio of loans pooled in the pass through. CMOs or
Collateralized Mortgage Obligations are a type of mortgage pass throughs.
2. C. By converting the assets to liquid cash the originating agency can improve its liquidity ratios. The
liquid cash can then be reused in the business. By improving its capital adequacy ratio it can improve
its credit ratings. Also a SPE can be structured in such a manner that it is bankruptcy remote.
However the risk associated with the securities is not removed.
3. C. The correct answer is It has higher coupon rate than currently available market interest rate.
Higher the coupon rate, greater the reinvestment risk.
4. C. Treasury Note
5. C. Revenue Bonds
6. A. To reduce the total risk
7. B. Over Collateralization
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Extra-Quiz Questions
1. A floating rate issue has the following provision in which the coupon rate is calculated as 6-monthLIBOR – 80 basis points. The issue has a floor at 5.5%. If the 6-month LIBOR on the reset date is5.8%, the coupon rate is closest toA. 4.5%B. 5.5%C. 5.0%
2. A $100 par value bond has duration of 12.7 If the price rises to 104.57 when the yield declines by 50basis points, the price when the yield drops by 50 basis points is closest toA. 95.7B. 91.8C. 92.5
3. Carl and Karen are CFA Level I candidates. Carl says that a zero coupon bond has higher interestrate risk than a coupon bond of the same maturity. While Karen says that a callable bond has highervolatility risk than an option-free bond. Which of the two statements are most likely correct
© Neev Knowledge Management – Pristine
1. A floating rate issue has the following provision in which the coupon rate is calculated as 6-monthLIBOR – 80 basis points. The issue has a floor at 5.5%. If the 6-month LIBOR on the reset date is5.8%, the coupon rate is closest toA. 4.5%B. 5.5%C. 5.0%
2. A $100 par value bond has duration of 12.7 If the price rises to 104.57 when the yield declines by 50basis points, the price when the yield drops by 50 basis points is closest toA. 95.7B. 91.8C. 92.5
3. Carl and Karen are CFA Level I candidates. Carl says that a zero coupon bond has higher interestrate risk than a coupon bond of the same maturity. While Karen says that a callable bond has highervolatility risk than an option-free bond. Which of the two statements are most likely correct
80
Carl Karen
A No Yes
B Yes No
C Yes Yes
1. A floating rate issue has the following provision in which the coupon rate is calculated as 6-monthLIBOR – 80 basis points. The issue has a floor at 5.5%. If the 6-month LIBOR on the reset date is5.8%, the coupon rate is closest toA. 4.5%B. 5.5%C. 5.0%
2. A $100 par value bond has duration of 12.7 If the price rises to 104.57 when the yield declines by 50basis points, the price when the yield drops by 50 basis points is closest toA. 95.7B. 91.8C. 92.5
3. Carl and Karen are CFA Level I candidates. Carl says that a zero coupon bond has higher interestrate risk than a coupon bond of the same maturity. While Karen says that a callable bond has highervolatility risk than an option-free bond. Which of the two statements are most likely correct
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1. A floating rate issue has the following provision in which the coupon rate is calculated as 6-monthLIBOR – 80 basis points. The issue has a floor at 5.5%. If the 6-month LIBOR on the reset date is5.8%, the coupon rate is closest toA. 4.5%B. 5.5%C. 5.0%
2. A $100 par value bond has duration of 12.7 If the price rises to 104.57 when the yield declines by 50basis points, the price when the yield drops by 50 basis points is closest toA. 95.7B. 91.8C. 92.5
3. Carl and Karen are CFA Level I candidates. Carl says that a zero coupon bond has higher interestrate risk than a coupon bond of the same maturity. While Karen says that a callable bond has highervolatility risk than an option-free bond. Which of the two statements are most likely correct
80
Extra-Quiz Questions
4. For a 100 basis points downward shift in the yield curve which of the following bonds will have thelowest percentage price changeA. An option-free bondB. A callable bondC. A putable bond
5. A $ 10mn par value bond can be redeemed at the following pricesSuppose the investor decides to redeem the $10 mnbond on 31st December 2005.The price that the investor will get is closest toA. $10.4 mnB. $12mnC. $16mn
6. Value of a 15-year, 8.5% annual coupon bond callable in five years is at 94.4 (prices are statedas a percentage of par). A straight bond that is similar in all other aspects as the callable bond ispriced at 100.0. Which of the following is closest to the value of the call option?A. 2.8B. 4.4C. 5.6
© Neev Knowledge Management – Pristine
4. For a 100 basis points downward shift in the yield curve which of the following bonds will have thelowest percentage price changeA. An option-free bondB. A callable bondC. A putable bond
5. A $ 10mn par value bond can be redeemed at the following pricesSuppose the investor decides to redeem the $10 mnbond on 31st December 2005.The price that the investor will get is closest toA. $10.4 mnB. $12mnC. $16mn
6. Value of a 15-year, 8.5% annual coupon bond callable in five years is at 94.4 (prices are statedas a percentage of par). A straight bond that is similar in all other aspects as the callable bond ispriced at 100.0. Which of the following is closest to the value of the call option?A. 2.8B. 4.4C. 5.6
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4. For a 100 basis points downward shift in the yield curve which of the following bonds will have thelowest percentage price changeA. An option-free bondB. A callable bondC. A putable bond
5. A $ 10mn par value bond can be redeemed at the following pricesSuppose the investor decides to redeem the $10 mnbond on 31st December 2005.The price that the investor will get is closest toA. $10.4 mnB. $12mnC. $16mn
6. Value of a 15-year, 8.5% annual coupon bond callable in five years is at 94.4 (prices are statedas a percentage of par). A straight bond that is similar in all other aspects as the callable bond ispriced at 100.0. Which of the following is closest to the value of the call option?A. 2.8B. 4.4C. 5.6
2001- 2003 106%2003-2005 104%2005-2007 102%
2007 onwards 100%
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4. For a 100 basis points downward shift in the yield curve which of the following bonds will have thelowest percentage price changeA. An option-free bondB. A callable bondC. A putable bond
5. A $ 10mn par value bond can be redeemed at the following pricesSuppose the investor decides to redeem the $10 mnbond on 31st December 2005.The price that the investor will get is closest toA. $10.4 mnB. $12mnC. $16mn
6. Value of a 15-year, 8.5% annual coupon bond callable in five years is at 94.4 (prices are statedas a percentage of par). A straight bond that is similar in all other aspects as the callable bond ispriced at 100.0. Which of the following is closest to the value of the call option?A. 2.8B. 4.4C. 5.6
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2007 onwards 100%
Extra-Quiz Questions
7. Carl an analyst with a fixed income hedge fund states that investments in high yield securities fromemerging economies carries a number of risk factors. Which of the following is least likely to be listedas a risk when investing in high yield securities from emerging marketsA. Sovereign riskB. Exchange rate riskC. Downgrade risk
8. What is least likely to be accurate regarding Interest rate risk?A. It is a risk of having to reinvest at rates that are lower than what an investor is currently receivingB. Interest rate risk is commonly measured by the bond's durationC. Can be reduced by buying bonds with longer duration
© Neev Knowledge Management – Pristine
7. Carl an analyst with a fixed income hedge fund states that investments in high yield securities fromemerging economies carries a number of risk factors. Which of the following is least likely to be listedas a risk when investing in high yield securities from emerging marketsA. Sovereign riskB. Exchange rate riskC. Downgrade risk
8. What is least likely to be accurate regarding Interest rate risk?A. It is a risk of having to reinvest at rates that are lower than what an investor is currently receivingB. Interest rate risk is commonly measured by the bond's durationC. Can be reduced by buying bonds with longer duration
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7. Carl an analyst with a fixed income hedge fund states that investments in high yield securities fromemerging economies carries a number of risk factors. Which of the following is least likely to be listedas a risk when investing in high yield securities from emerging marketsA. Sovereign riskB. Exchange rate riskC. Downgrade risk
8. What is least likely to be accurate regarding Interest rate risk?A. It is a risk of having to reinvest at rates that are lower than what an investor is currently receivingB. Interest rate risk is commonly measured by the bond's durationC. Can be reduced by buying bonds with longer duration
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7. Carl an analyst with a fixed income hedge fund states that investments in high yield securities fromemerging economies carries a number of risk factors. Which of the following is least likely to be listedas a risk when investing in high yield securities from emerging marketsA. Sovereign riskB. Exchange rate riskC. Downgrade risk
8. What is least likely to be accurate regarding Interest rate risk?A. It is a risk of having to reinvest at rates that are lower than what an investor is currently receivingB. Interest rate risk is commonly measured by the bond's durationC. Can be reduced by buying bonds with longer duration
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Solutions
1. B.– Coupon rate = ref rate + quoted margin = 5.8% - 80 basis points = 5.0%. Since the floater has a floor at
5.5%. The coupon is set to 5.5% on the reset date.2. B.
Duration = Price if yield declines – price if yield rises2 * (initial price) * (change in yield in decimals)
Price if yield declines = 104.57 – 12.7*2*100*0.005 = 91.83. B.
– Callable options have lower volatility risk than option-free bond because of the embedded call option inthe bond. Zero-coupon bonds have a higher interest rate risk and their prices can change significantly ifthe yields change.
4. B.– The value of a callable bond does not rise as much as a comparable option-free bond. Price of a putable
bond = price of an option-free bond + price of the embedded put. So when the yield curve is shifteddownwards the price of a putable bond will change more than a comparable option-free bond.
5. A.– The redemption price is calculated as $10mn * 104% = %10.4 mn.
© Neev Knowledge Management – Pristine
1. B.– Coupon rate = ref rate + quoted margin = 5.8% - 80 basis points = 5.0%. Since the floater has a floor at
5.5%. The coupon is set to 5.5% on the reset date.2. B.
Duration = Price if yield declines – price if yield rises2 * (initial price) * (change in yield in decimals)
Price if yield declines = 104.57 – 12.7*2*100*0.005 = 91.83. B.
– Callable options have lower volatility risk than option-free bond because of the embedded call option inthe bond. Zero-coupon bonds have a higher interest rate risk and their prices can change significantly ifthe yields change.
4. B.– The value of a callable bond does not rise as much as a comparable option-free bond. Price of a putable
bond = price of an option-free bond + price of the embedded put. So when the yield curve is shifteddownwards the price of a putable bond will change more than a comparable option-free bond.
5. A.– The redemption price is calculated as $10mn * 104% = %10.4 mn.
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1. B.– Coupon rate = ref rate + quoted margin = 5.8% - 80 basis points = 5.0%. Since the floater has a floor at
5.5%. The coupon is set to 5.5% on the reset date.2. B.
Duration = Price if yield declines – price if yield rises2 * (initial price) * (change in yield in decimals)
Price if yield declines = 104.57 – 12.7*2*100*0.005 = 91.83. B.
– Callable options have lower volatility risk than option-free bond because of the embedded call option inthe bond. Zero-coupon bonds have a higher interest rate risk and their prices can change significantly ifthe yields change.
4. B.– The value of a callable bond does not rise as much as a comparable option-free bond. Price of a putable
bond = price of an option-free bond + price of the embedded put. So when the yield curve is shifteddownwards the price of a putable bond will change more than a comparable option-free bond.
5. A.– The redemption price is calculated as $10mn * 104% = %10.4 mn.
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1. B.– Coupon rate = ref rate + quoted margin = 5.8% - 80 basis points = 5.0%. Since the floater has a floor at
5.5%. The coupon is set to 5.5% on the reset date.2. B.
Duration = Price if yield declines – price if yield rises2 * (initial price) * (change in yield in decimals)
Price if yield declines = 104.57 – 12.7*2*100*0.005 = 91.83. B.
– Callable options have lower volatility risk than option-free bond because of the embedded call option inthe bond. Zero-coupon bonds have a higher interest rate risk and their prices can change significantly ifthe yields change.
4. B.– The value of a callable bond does not rise as much as a comparable option-free bond. Price of a putable
bond = price of an option-free bond + price of the embedded put. So when the yield curve is shifteddownwards the price of a putable bond will change more than a comparable option-free bond.
5. A.– The redemption price is calculated as $10mn * 104% = %10.4 mn.
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Solutions
6. C.– The bond rated as B+ has low credit worth and hence is highly speculative. Since the objectives of the
fund allow them to invest in only investment grade securities. Sally cannot invest in the 16% 10-yearcoupon bond.
7. C.– A high yield bond has generally a low-credit and is of speculative nature. Investments in foreign currency
bonds carry exchange rate risks. The bonds also have sovereign risk due to the risk of actions of theforeign government in case of default.
8. B– Interest rate risk can be reduced by buying bonds with a longer duration.
© Neev Knowledge Management – Pristine
6. C.– The bond rated as B+ has low credit worth and hence is highly speculative. Since the objectives of the
fund allow them to invest in only investment grade securities. Sally cannot invest in the 16% 10-yearcoupon bond.
7. C.– A high yield bond has generally a low-credit and is of speculative nature. Investments in foreign currency
bonds carry exchange rate risks. The bonds also have sovereign risk due to the risk of actions of theforeign government in case of default.
8. B– Interest rate risk can be reduced by buying bonds with a longer duration.
84
6. C.– The bond rated as B+ has low credit worth and hence is highly speculative. Since the objectives of the
fund allow them to invest in only investment grade securities. Sally cannot invest in the 16% 10-yearcoupon bond.
7. C.– A high yield bond has generally a low-credit and is of speculative nature. Investments in foreign currency
bonds carry exchange rate risks. The bonds also have sovereign risk due to the risk of actions of theforeign government in case of default.
8. B– Interest rate risk can be reduced by buying bonds with a longer duration.
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6. C.– The bond rated as B+ has low credit worth and hence is highly speculative. Since the objectives of the
fund allow them to invest in only investment grade securities. Sally cannot invest in the 16% 10-yearcoupon bond.
7. C.– A high yield bond has generally a low-credit and is of speculative nature. Investments in foreign currency
bonds carry exchange rate risks. The bonds also have sovereign risk due to the risk of actions of theforeign government in case of default.
8. B– Interest rate risk can be reduced by buying bonds with a longer duration.
84
Five Minute RecapRisks associated withInvesting in Bonds:• Interest Rate risk• Yield Curve risk• Call Risk• Prepayment risk• Reinvestment risk• Credit risk• Currency risk• Default risk• Repayment of
principal risk• Soveriegn risk• Volatility risk• Inflation risk• Liquidity risk• Exchange rate risk
VariableDuration or Interest
Rate Risk
Maturity in Longer Higher
Coupon Rate is Higher Lower
Embedded Call Option Lower
Embedded Put Option Lower
The following features of a security issubject to higher Reinvestment Risk:• Amortising• Higher coupon• Call feature• Prepayment option
© Neev Knowledge Management – Pristine 85
Risks associated withInvesting in Bonds:• Interest Rate risk• Yield Curve risk• Call Risk• Prepayment risk• Reinvestment risk• Credit risk• Currency risk• Default risk• Repayment of
principal risk• Soveriegn risk• Volatility risk• Inflation risk• Liquidity risk• Exchange rate risk
The following features of a security issubject to higher Reinvestment Risk:• Amortising• Higher coupon• Call feature• Prepayment option
Price of a Callable Bond = Price of Option Free Bond – Price of Embedded OptionPrice of a Putable Bond = Price of Option Free Bond + Price of Embedded Option
Interest rate tools used toimplement the Fed‘s monetarypolicy:• Discount rate• Open Market Operations• Bank Reserve requirements• Pursuation
Agency Bonds are issued by various US Federal Agencies• Federally related institutions
• Export-Import Bank of the United States• Goverment National Mortgage Association (Ginnie Mae)
• Government sponsered enterprises(GSEs)• Federal National Mortgage Association (Fannie Mae)• Federal Home Loan Mortgage Corportion (Freddie Mac)
Dirty Price = Clean Price + Accrued InterestDuration or Interest
Rate Risk
Higher
Lower
Lower
Lower
The following features of a security issubject to higher Reinvestment Risk:• Amortising• Higher coupon• Call feature• Prepayment option
Special Purpose Vehicle(SPV).• Used to enhance the rating of ABS• SPV becomes a bankruptcy remote entity
ratetaxMarginal1*YieldTaxableYieldTaxAfter
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The following features of a security issubject to higher Reinvestment Risk:• Amortising• Higher coupon• Call feature• Prepayment option
Price of a Callable Bond = Price of Option Free Bond – Price of Embedded OptionPrice of a Putable Bond = Price of Option Free Bond + Price of Embedded Option
Expandingeconomy, creditspreads becomenarrowContractingeconomy, creditspreads widen.
Agency Bonds are issued by various US Federal Agencies• Federally related institutions
• Export-Import Bank of the United States• Goverment National Mortgage Association (Ginnie Mae)
• Government sponsered enterprises(GSEs)• Federal National Mortgage Association (Fannie Mae)• Federal Home Loan Mortgage Corportion (Freddie Mac)