Fixed Income Securities Essay

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Fixed Income Securities Essay
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  • University/College:
    University of California

  • Type of paper: Thesis/Dissertation Chapter

  • Words: 537

  • Pages: 2

Fixed Income Securities

Objectives: This course is intended to analyze the fixed income securities markets and its implications for investments. It will analyze the market characteristics, instruments, selling techniques, pricing and valuation issues, floating rate instruments, risk and return of fixed income securities, portfolio management techniques, term structure modeling, corporate debt and convertibles, bonds with embedded options, sub-national debt analysis, credit risk analysis, and interest rate risk management with swaps, options and futures. The course intends to cover the specific features of the Indian Fixed Income Securities Markets. The course will construct several Excel based techniques to analyze bond cashflows analytics.

Course Structure: The course will include lectures, bond cash flows analysis, term paper assignments and class exercises.

Contents: Lecture 1: Indian Fixed Income Markets, Institutional Arrangements, Market Participants and Instruments, Investors Perspectives, Market Conventions, Debt Management & Monetary policies

Lecture 2: Bond Valuation, Time Value of Money, Price and Yield Conventions, Bond Valuation using Yield Curve, Yield & return, horizon return; Valuation of Repo & Reverse Repo

Lecture 3: Valuation of other Bonds: Floating Rate securities, Inflation index bonds, bonds with embedded options

Lecture 4: Introduction to Bloomberg, Interpretations of Fixed Income Instruments using Bloomberg Templates, Understanding Market Quotes and Conventions

Lecture 5: Corporate Bonds, Valuation, Implications for Rating & Migration, Investment Grade and Low Rated Bonds, Valuation of Convertibles

Lecture 6 & 7: Risk Identification in Bonds: Duration, Convexity, and Portfolio Immunization

Lecture 8 : Yield Curve Analysis, Par Bootstrapping, Modeling YC using Nelson-Seigel and Spline Methods, Spot & Forward rates, , Valuation of STRIPS

Lecture 9: Term Structure of Interest Rates theories; Interest Rate Models (Cox-Ingersoll-Ross, Vasicek, HJM Model)

Lecture 10: Government Securities Auction, Market Implications, WI Markets, Auction & Primary Dealers Lecture 11: Auction & Bidding: Game (students play bidding game and trade online in Computer Lab)

Lecture 12: Bond Portfolio Construction & Management; Bullet, Barbell & Ladder Strategies, Construction of Bond Portfolio; Portfolio with Corporate Bonds

Lecture 13, 14 & 15: Interest Rate Derivatives: FRAs, Swaps, Futures, Options, Eurodollar Futures, OIS(Overnight Index Swaps), OIS Trading & Arbitrage

Lecture 16: Bonds with embedded options, BDT Model(Modeling Interest Rate Tree)

Lecture 17: Mortgage-Backed Securities, Prepayments, Option Adjusted Spreads(OAS)

Lecture 18: Credit Derivatives, Valuation of Credit Default Swaps, Indian CDS

Lecture 19 & 20: Assignment Discussions & Presentations

Other handouts:

The course will provide several articles in debt and fixed income securities, circulars of RBI and FIMMDA, empirical techniques dealing with bond management, as well as my presentations, excel spreadsheet calculations, valuation templates from Bloomberg as well as web resources.

Expectations: My expectation is that students work hard during the course, understand bond mathematics, how Indian bond market works and its implications on fixed income investing as an asset class, and portfolio implications for banks and financial institutions.

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Fixed Income Securities Essay

Facebooktwittergoogle_plusredditpinterestlinkedinmail
Fixed Income Securities Essay
Rate this post

  • University/College:
    University of Chicago

  • Type of paper: Thesis/Dissertation Chapter

  • Words: 1036

  • Pages: 4

Fixed Income Securities

1. Briefly explain why many corporations prefer to issue callable long-term corporate bonds rather than noncallable long-term bonds.

There are three main reasons why a corporation may be interested in calling a bond. * Interest rated have fallen, so they can refinance at a lower rate. * Credit quality has improved, so they can refinance at a lower rate. * Assets have been sold, so money is available to pay off debt.

2. Briefly explain the idea behind an Immunized Bond Portfolio.

With an Immunized Portfolio, the duration and convexity of the assets is set to match the duration and convexity of the liabilities. The PV of the assets is set greater than the PV of the liabilities. For small changes in yield, the asset value should increase or decrease proportionally to the changes in the value of the liabilities. This method insures that the return on the assets and the return on the liabilities remain the same. Another way of looking at it is that immunization sets the price risk exactly equal to the reinvestment risk.

3. Explain why an Interest Only Strip (IO MBS) usually gains value when interest rates increase.

IO Strips receive the interest portion of a MBS. If interest rates decrease, then prepayments should speed up. If this happens, then smaller payments are received in the future. While these smaller payments are discounted at a lower rate, the net effect is usually a decrease in value.

4. Briefly explain what happens to the price of a straight bond (no options) when the yield increases – and why.

Price goes down when yields go up. I needed you to tell me why. I accepted any of the three reasons from the Bond Analytics lecture notes.

5. Briefly describe how the Federal Reserve moves rates in the Federal Funds Market.

The Federal Reserve cannot trade in the Federal Funds Market. However, banks have other alternatives for raising cash to deposit with the Federal Reserve. The Fed can trade in those markets to change yields. The Repo Market is their most common tool, though they can also change the Discount Rate for borrowing funds from the Fed. In addition, they can change the Reserve Requirements.

6. Suppose that you want to hedge the interest rate risk of a Fixed Income Security that has negative convexity. Suppose that you can create a perfect hedge with futures and options (paying a premium to buy the options). As an alternative, you can use hedge with futures alone. If you believe that the true volatility will be much lower than the implied volatility of the options, which alternative should you choose? Why?

If you believe that the implied volatility of the options is too high, then you would also believe that the options are overpriced. It would be cheaper to hedge with futures alone if you are right.

7. Briefly explain the idea behind splitting a companion CMO tranche into a floating rate class and an inverse rate floating rate class.

Breaking the companions into a floater and inverse floater does not change the prepayments – but affects the level of risk associated with it. Floaters have very little price risk – so prepayments do not have much of an effect on price (unless there is a low cap). There is reinvestment risk for floaters, but those investing in floaters will not mind prepayments, since they are reinvested at a similar rate. Inverse Floaters will be very sensitive to prepayments. However, faster prepayments increase the values. In addition, these are highly convex, long duration instruments, so they can be hedged with futures. Many people only discussed the Floater and neglected to discuss the Inverse Floater. Many said that if the cap is hit, these become fixed cash flow bonds (so less risk). They do not. They become fixed rate bonds that have a lot of prepayment risk. Several people mentioned the cap being a present value (despite the fact that I warned about this in class). It is calculated to a preset value.

8. Suppose that a fixed cash flow treasury bond is split into two bonds, a floater and an inverse floater. Briefly explain why the Inverse Floating Rate Bond has a much longer effective duration than the underlying fixed cash flow.

If rates increase, then both bonds lose value because they are discounted at a higher rate. But the inverse Floater will also lose value because the coupon payments decrease. The opposite holds when rates decrease. Therefore, the price impact is greater for Inverse Floaters than for Straight Bonds.

Note that there is another way to think of this. A portfolio made up of an inverse floater and a floater must have the same duration as a fixed cash flow bond. Since the floater has a very short duration, the inverse floater must have a longer duration than the average.

9. Briefly explain why Salomon Brothers was able to make a profit while they were squeezing the Two-Year Treasury.

Salomon Brothers operated in four markets.

1. They paid a little more than the fair price for the bonds in the Primary Market, but that allowed them to control the issue. In order to do this they illegally bought more than they were allowed to buy. 2. They paid a fair price in the When-Issued market. Doing so gave them even greater control over the issue. 3. They charged a higher than fair price in the Secondary Market. They sold the issue slowly in order to maintain the premium. 4. The loaned the security in the Repo Market at special rates. Others had to deliver that particular bond, so would be forced to lend money at low rates.

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