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Christophe Dispas

Fundamentals

What is a bond?

Fundamentals

Debt of a borrower (issuer) towards a lender (bondholder) Financial obligation

Time Value of Money

Stream of future cash flows : Interest payments Principal repayment Principal : legal structure different from its coupons Bond indenture Any assets a prior claim of creditors? Garantees and commitments?

Fixed Income : Valuation and Analysis- 2

Fixed Income Portfolio Management Strategies

Fundamentals

Coupon and principal Name – Coupon – Maturity

Fundamentals

Face value : Total amount repaid at maturity Used to determine coupon payments Time to maturity Maturity date

Time Value of Money

Fixed Income Portfolio Management Strategies

Coupon payment : coupon rate x face value Annually, semi-annually, … Legal differences : expected return pre tax and after tax

Fixed Income : Valuation and Analysis- 3

Fundamentals

Fundamentals

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis- 4

Fundamentals

Price quotes

Fundamentals

Market value Percentage of the face value US : in 32nds of a percent Size of minimum price change

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis- 5

6 .Fundamentals Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Fundamentals Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.7 .

Fundamentals Accrued interest Fundamentals To compare bonds => Clean price Clean price = net of interest Time Value of Money Buy or Sell : pro-rata basis of the coupon added to the clean price Dirty price = clean price + accrued interest Fixed Income Portfolio Management Strategies Accrued interest = Principal x (Coupon rate/Nr.8 . Coupons per year) x fractional coupon period Fixed Income : Valuation and Analysis.

Fundamentals Accrued interest : use the right conventions Coupon Frequency Accrued Interest Fundamentals Government Bonds USA Semi-annual Japan UK France Semi-annual Semi-annual Annual Annual Annual Semi-annual Semi-annual Semi-annual Actual/Actual Actual/365 Actual/Actual Actual/Actual Actual/Actual Actual/Actual Actual/365 Actual/Actual Actual/Actual Time Value of Money Germany Netherlands Canada Australia Italy Fixed Income Portfolio Management Strategies Corporate Bonds USA Annual or Semi-annual 30/360 UK Semi-annual Actual/365 or Actual/Actual * Eurobonds Issued before 1/1/99 Issued after 31/12/99 Annual (some Semi-annual) Annual (some Semi-annual) 30/360 Actual/Actual Fixed Income : Valuation and Analysis.9 .

Fundamentals Types of fixed income securities Fundamentals Straight bond Interest payments periodically Principal at maturity Sinking-fund provision Sinker percentage : retire a portion of the outstanding debt (sinker percentage). each year Callable bonds Issuer has the right to repurchase the bond at call price. at call date Protect issuer if interest rate drop Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.10 .

Fundamentals Types of fixed income securities Putable bonds : bondholder has the right Fundamentals Bullet bonds : bonds that cannot be redeemed prior to maturity Perpetual bonds : principal never redeemed Zero-coupon bonds : Do not pay any interest Generally issued at large discount to the face value Time Value of Money Fixed Income Portfolio Management Strategies Stripped bonds : Zero-coupon bonds Artificially created from default risk free government bonds Fixed Income : Valuation and Analysis.11 .

Fundamentals Types of fixed income securities Income bonds : Pays interest only if profits of the issuing firm are adequate enough to pay interest A missed coupon is not a default Cumulative / non-cumulative Floating rate notes : Coupon adjusted periodically Depend on a base or benchmark rate Dual currency bonds : Interest paid in one currency.12 . principal in another Foreign interest payment securities Multiple currency clause bonds Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

13 .Fundamentals Types of fixed income securities Convertible bond : The holder can exchange the security for shares of the company Terms set in the bond indenture (number of shares. …) Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Fundamentals 4 types of bonds based on the issuer : Domestic bonds : Domestic issuer Usually in local currency Foreign bonds : Foreign issuer Local market Usually local currency Eurobonds : Multinational syndicate All countries other than the one in whose currency the bond is denominated Trade in the international marketplace Global Bonds Fixed Income : Valuation and Analysis.14 Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies .

15 .Fundamentals Money market instruments : Fundamentals Short term debt securities Maturities up to 12 months Time Value of Money Liquid Very large denominations Fixed Income Portfolio Management Strategies Interest earned expressed on the bank discount basis Fixed Income : Valuation and Analysis.

16 .Fundamentals Money market instruments : Fundamentals Treasury bills Discount with respect to the face value Time Value of Money Interest = face value – purchase price Competitive auction : bid is filled if price entered is high enough (relative to other participants’ bid) Fixed Income Portfolio Management Strategies Non-competitive auction : price is equal for all the subscribers (marginal price or average price) Interest rate and credit risk very low Fixed Income : Valuation and Analysis.

17 .Fundamentals Money market instruments : Fundamentals Commercial paper Short term unsecured debt Time Value of Money Issued by large and well-known companies Usually guaranteed by a bank line of credit Rating Fixed Income Portfolio Management Strategies Most frequent maturities : 1 or 2 months Source of funds cheaper than the ordinary bank borrowing Fixed Income : Valuation and Analysis.

Fundamentals Money market instruments : Fundamentals Bankers’ acceptance Commercial bills of exchange whose credit risk has been guaranteed by a bank Time Value of Money Traded at a discount Accepting institution is obligated to pay Fixed Income Portfolio Management Strategies The bank receive a fee Usually less risky than commercial paper Fixed Income : Valuation and Analysis.18 .

paid at maturity Cannot be withdrawn.19 .Fundamentals Money market instruments : Fundamentals Certificate of deposit (CD) Time deposit with a bank Time Value of Money Usually a given period of time Usually a fixed rate of interest. but can be sold over the secondary market Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Fundamentals Government bonds : Fundamentals Maturity higher than 1 year US Government bonds : Time Value of Money Fixed Income Portfolio Management Strategies Treasury notes : up to 10 years Treasury bonds : 10 to 30 years Semi-annual coupon payments Government guaranteed : low credit risk Circulation is managed by Central Bank book-entry form : no physical circulation Fixed Income : Valuation and Analysis.20 .

21 . Over 10 years : bonds Classification based on the nature of the issuer : traditional classification is sectorial Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis. interest payments are semi-annual Time Value of Money Bond indenture can be very specific and complex Up to 10 years : notes.Fundamentals Corporate securities Fundamentals Issued by private and public corporations Usually.

22 .Fundamentals Corporate securities Fundamentals Credit quality : Offer document Ratings Protection : Mortgage bonds Collateral trust bonds Senior claim Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Fundamentals Corporate securities Debenture bond : recovery rate is the same as general creditors’ one (the claim is junior) Fundamentals Subordinated debenture bonds : Rank after secured bonds in claim on corporate earnings and assets Difference in protection = difference in yield Secured => ordinary => subordinated Time Value of Money Fixed Income Portfolio Management Strategies Call provision Sinking funds : Control the credit risk Balloon payment : amount remaining Accelerated sinking fund Fixed Income : Valuation and Analysis.23 .

Fundamentals Indices Fundamentals General price performance of a group of bond issues Broad-based market indices or sub-segments Time Value of Money Brokers publish indices to sell tracking and rebalancing services to investors Total return indices Fixed Income Portfolio Management Strategies Non liquid bonds : fair price Fixed Income : Valuation and Analysis.24 .

Fundamentals Indices Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.25 .

Fundamentals Indices Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.26 .

27 .Fundamentals Indices Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

future not => to differ consumption requires incentive : interest rate Fundamentals Simple vs compound interest Simple interest = (initial value) . (Nbr of years) Hypothesis : interest payments are not reinvested Compound interest Time Value of Money Fixed Income Portfolio Management Strategies Interest is reinvested Compound interest = (initial amount) . (interest rate) .1] Fixed Income : Valuation and Analysis. [(1+ interest rate)nbrofyears .Time value of money Present is certain.28 .

29 .Time value of money Simple interest Fundamentals Time Value of Money Compound interest Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

1] = 967.15 EUR Fixed Income : Valuation and Analysis. 0. 10 = 700 EUR Compound interest Fixed Income Portfolio Management Strategies 1000 EUR .07 .30 .Time value of money Simple interest Fundamentals Time Value of Money 1000 EUR . [(1+ 0.07)10 .

Time value of money Present and future value Fundamentals Present value of future payment : discounting Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.31 .

32 .Time value of money Present and future value Fundamentals Present value of future payment : discounting Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Present and future value Future value of a payment : compounding Fundamentals Time Value of Money Example : 100 000 EUR deposited in a bank account with 5% annual interest rate End year 1 : 100 000 EUR .05) = 105 000 EUR End year 2 : 105 000 EUR . (1+0.33 .05) = 110 250 EUR Equals : 100 000 EUR . (1+ 0. (1 + 0.05)2 Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

0.105)67 = 804 030.34 . 67) = 8 035 EUR Compound interest : 1000 EUR .105 . (1+0.Time value of money Present and future value Fundamentals High interest rate and long investment period lead to greater accumulation of compound interest Example 1000 EUR.5%. 67 years Time Value of Money Fixed Income Portfolio Management Strategies Simple interest : 1000 EUR + (1000 EUR .69 EUR Fixed Income : Valuation and Analysis. interest rate = 10.

35 .Time value of money Annuities Fixed amount paid each year for a specified number of years Hypothesis : Time Value of Money Fundamentals First payment is received one year from now Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Annuities Fundamentals Present value Time Value of Money Future value Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.36 .

Time value of money Annuities Fundamentals Future value Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.37 .

Time value of money Continuous discounting and compounding Fundamentals Compounding can take place more than annually Initial amount N invested at a rate R during n years : Time Value of Money When m tends to infinity : Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.38 .

39 .Time value of money Continuous discounting and compounding Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

40 .Time value of money Continuous discounting and compounding Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

41 .Time value of money Bond yield measures Fundamentals Current yield Time Value of Money Fixed Income Portfolio Management Strategies The price is the clean price Bond’s current yield varies inversely with the bond’s price Fixed Income : Valuation and Analysis.

42 .Time value of money Bond yield measures Current yield Fundamentals Not adequate to compare bonds Current yield of a zero-coupon bond is zero Current yield of a bond under par decrease as the bond approaches maturity Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

43 .Time value of money Bond yield measures Yield to maturity Fundamentals Discount rate that equals present value of future cash flows and market price : Time Value of Money Fixed Income Portfolio Management Strategies Internal rate of return (IRR) of the investment in the bond Fixed Income : Valuation and Analysis.

44 .Time value of money Bond yield measures Fundamentals Yield to maturity Time Value of Money Fixed Income Portfolio Management Strategies Assumes bond is held to maturity Cash flows are received as scheduled YTM is not the total return of a bond Fixed Income : Valuation and Analysis.

45 .Time value of money Bond yield measures Fundamentals Yield to maturity From semi-annual to annual yield : Time Value of Money On a Euromarket : Fixed Income Portfolio Management Strategies On the US or English market : Fixed Income : Valuation and Analysis.

46 .Time value of money Bond yield measures Fundamentals Yield to maturity Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

72% Fixed Income : Valuation and Analysis.Time value of money Bond yield measures Fundamentals Yield to maturity Time Value of Money Fixed Income Portfolio Management Strategies With annual coupon : 4.47 .

f = (nbr of days between last coupon and today / nbr total of days between the two coupons) Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.Time value of money Bond yield measures Fundamentals Yield to maturity between two coupon payment dates Accrued interest Total price = Market price + f .48 . Coupon Usually.

49 .Time value of money Bond yield measures Fundamentals Yield to maturity between two coupon payment dates Adjusted formula : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Yield to maturity Fundamentals Yield to maturity between two coupon payment dates Time Value of Money Fixed Income Portfolio Management Strategies NB : With a financial calculator.50 . the clean price is used to compute Fixed Income : Valuation and Analysis.

Time value of money Yield to maturity Fundamentals Yield to maturity between two coupon payment dates Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.51 .

52 .Time value of money Yield to maturity Fundamentals Influences on the yield to maturity : the coupon effect Time Value of Money Fixed Income Portfolio Management Strategies => Calculate bond prices Fixed Income : Valuation and Analysis.

53 . calculate YTM Fixed Income : Valuation and Analysis.Time value of money Yield to maturity Fundamentals Influences on the yield to maturity : the coupon effect Time Value of Money Fixed Income Portfolio Management Strategies => With these prices.

Time value of money Yield to maturity Fundamentals Influences on the yield to maturity : the coupon effect Time Value of Money Fixed Income Portfolio Management Strategies => YTM is an average of the spot rates Fixed Income : Valuation and Analysis.54 .

55 .Time value of money Yield to maturity Fundamentals Influences on the yield to maturity : the coupon effect Time Value of Money Fixed Income Portfolio Management Strategies ⇒YTM is an average of the spot rates Fixed Income : Valuation and Analysis.

YTM will underestimate the corresponding spot rate R0.T Fixed Income : Valuation and Analysis.t are increasing.Time value of money Yield to maturity Influences on the yield to maturity : the coupon effect Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies ⇒ If R0.56 .

57 .Time value of money Yield to maturity Influences on the yield to maturity : the coupon effect Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies ⇒ Bias increase for larger coupon rates Fixed Income : Valuation and Analysis.

Time value of money Yield to maturity Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.58 .

Time value of money Bond yield measures Fundamentals Yield to call Time Value of Money Assumes that the bond will be called Assumes that all cash flows are received as scheduled through the call date Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.59 .

60 .Time value of money Bond yield measures Fundamentals Yield to call Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Bond yield measures Fundamentals Yield to call Time Value of Money Fixed Income Portfolio Management Strategies Yield to call differs from yield to maturity Discounting period is shorter Final cash flow is generally higher Fixed Income : Valuation and Analysis.61 .

Time value of money Bond yield measures Fundamentals Japanese current yield Current yield adjusted for capital gain/losses : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.62 .

63 .Time value of money Bond yield measures Yield to average life Fundamentals Time Value of Money Full principal repayment supposed to occur on the average life date Useful to compare bonds with a series of principal repayment with bullet bonds Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

64 .Time value of money Bond yield measures Fundamentals Yield to average life Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Bond yield measures Fundamentals Yield to average life Time Value of Money Fixed Income Portfolio Management Strategies => Comparable to bullet bond with maturity = AL Fixed Income : Valuation and Analysis.65 .

66 .Time value of money Bond yield measures Fundamentals Call-adjusted yield To compare YTM of callable and non-callable bonds Time Value of Money Price of the non callable bond = price of the callable bond + value of the call option Yield to call = YTM bullet bonds with maturity date = call date YTM callable bond = YTM bullet bond with price adjusted for the price of the call Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

67 .Time value of money Bond yield measures Call-adjusted yield Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Other basic concepts Fundamentals Dates essential while determining any rate of interest : Commitment date : fixed rate on the loan Lending date : money is to be loaned Repayment date : money is to be repaid Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.68 .

spot rates are quoted as annual rates Fixed Income : Valuation and Analysis.Time value of money Other basic concepts Fundamentals Spot rates : R0.t : Annual interest rate received on a zero coupon bond maturing at t ONE final payment for interest and principal Commitment date and lending date are the same Time Value of Money Fixed Income Portfolio Management Strategies Generally.69 .

Time value of money Other basic concepts Fundamentals Spot rates : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.70 .

71 .Time value of money Other basic concepts Fundamentals Spot rates : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

**Time value of money
**

Other basic concepts

Fundamentals

Forward rates : Ft,h : Rate of interest of a bond with commitment date (0) different from lending date (t) Pay only one cash flow Generally annual rates

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis- 72

**Time value of money
**

Other basic concepts

Fundamentals

Forward rates :

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis- 73

**Time value of money
**

Other basic concepts

Fundamentals

Forward rates :

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis- 74

**Time value of money
**

Other basic concepts

Fundamentals

Relation between spot rate and forward rate

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis- 75

**Time value of money
**

Other basic concepts

Fundamentals

Relation between spot rate and forward rate

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis- 76

77 .Time value of money Other basic concepts Fundamentals Relation between spot rate and forward rate Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

78 .Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.79 .

80 .Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

81 .Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.82 .

2%)^4 ) / ( (1+4.1%)^3 ) ]-1 Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.Time value of money Fundamentals [ ( (1+4.83 .

84 .Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

85 .Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

86 .Time value of money Term structure of interest rates Fundamentals Relationship between the yields on comparable bonds with different maturities Time Value of Money Appreciation of the interest rate-maturity relationship is essential in bond management Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Term structure of interest rates Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.87 .

Time value of money Term structure of interest rates Fundamentals Problems in building term structure of interest rates Use only zero-coupon bonds (reinvestment risk) Time Value of Money Some rates are unavailable Few corporates zero-coupon bonds Practical solution : yield curve Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.88 .

89 .Time value of money Yield curve Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Definitions Fundamentals Term structure : relationship between spot rates and time to maturity Yield curve : relationship between yield to maturity and time to maturity => To analyze maturity-return relationship. spot rates are better Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.90 .

91 .Time value of money Definitions Fundamentals Nominal rate = real interest rate + inflation premium + risk premium Real interest rate : compensation for deferring consumption Inflation premium : preserve investor’s purchasing power over time Time Value of Money Fixed Income Portfolio Management Strategies Risk premium : protects investors against all other potential negatives Fixed Income : Valuation and Analysis.

92 .Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

93 .Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Risks should be (sufficiently) similar for useful yield curves : Fundamentals Liquidity risk Credit risk Time Value of Money Call risk Coupon rate Fixed Income Portfolio Management Strategies Degree of premium/discount Fixed Income : Valuation and Analysis.94 .

95 .Time value of money Term structure of interest rates : shapes Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

96 .Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Term structure of interest rates : shapes Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies => Short maturity : monetary policy.97 . long maturity : inflationary expectations Fixed Income : Valuation and Analysis.

98 .Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis.99 .

Time value of money Theories of term structures Expectations hypothesis Fundamentals Liquidity preference Market segmentation theory Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis100 .

Time value of money Theories of term structures Expectations hypothesis Fundamentals Reflects market consensus forecast on future interest rates levels Implicit forward rate is an unbiaised estimate of the future spot rate : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis101 .

Time value of money Theories of term structures Expectations hypothesis Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis102 .

prices should adjust If implicit forward rates are unbiaised estimate of future spot rate : ⇒ Without transaction costs.Time value of money Theories of term structures Expectations hypothesis Fundamentals If all investors choose a rollover strategy. each bond is a perfect substitute for any other bond. these 3 strategies are equivalent : Buy and hold strategy Rollover strategy Buy a bond and sell it prior to maturity Fixed Income : Valuation and Analysis103 Time Value of Money Fixed Income Portfolio Management Strategies . whatever its maturity In this case.

Time value of money Theories of term structures Expectations hypothesis Fundamentals Explains the slope of the curve : slope = expectation of rates Assumptions of this theory : Homogenous expectations Investors choose between short and long-term bonds in order to maximise their final expected wealth for a given investment period No transaction costs Bond markets are efficients Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis104 .

Time value of money Theories of term structures Expectations theories Fundamentals Time Value of Money Naive expectations hypothesis : Expected returns for any strategy for any holding period are equal Local expectations : Refers only to total returns over a (short) period beginning at the present Unbiased expectations : Forward rates equals future EXPECTED spot rates Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis105 .

Time value of money Theories of term structures Fundamentals Expectations theories Return to maturity expectations : Expected return of holding a bond up to maturity has to be equal to the expected return we would obtain by rolling over a sequence of single-period bonds over the same horizon Yield to maturity version : This version deals with periodic returns. while return to maturity version is concerned with total returns over the investment horizon Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis106 .

Time value of money Theories of term structures Expectations theories Fundamentals In Cox. Ingersoll and Ross (1981) : Only local expectations theory is consistant with an equilibrium (arbitrage profits for the others) The remaining four versions are not equivalent or consistant with each other with UNCERTAIN interest rates Inconsistency of the naive expectations theory hypothesis Relation derived for a one year period is inconsistant with relation derived for a two year period under the naive expectations hypothesis Fixed Income : Valuation and Analysis107 Time Value of Money Fixed Income Portfolio Management Strategies .

Time value of money Theories of term structures Liquidity preferences Fundamentals In expectation theory. investors don’t have maturity preference Liquidity preference theory : investors prefer to hold liquid securities Liquidity = convert a bond into cash. minimising the loss Fluctuation risk is higher for long term bonds investors prefer short term securities Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis108 .

Time value of money Theories of term structures Liquidity preferences Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis109 .

Time value of money Theories of term structures Liquidity preferences Fundamentals Borrowers prefer to issue long to avoid interest rates fluctuations Time Value of Money Liquidity premium or term premium Two factors in the observed term structure of interest rates : Future expected short term spot rates A positive liquidity premium Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis110 .

Time value of money Theories of term structures Liquidity preferences Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis111 .

Time value of money Theories of term structures Liquidity preferences Fundamentals Time Value of Money Expected return on buy and hold strategy has to be higher than the expected return on a rollover strategy Liquidity premium increase with time Term structure of interest rate should be mainly upward sloping Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis112 .

Time value of money Theories of term structures Fundamentals Market segmentation and preferred habitat theories Bond markets : distinct markets that differ by their maturity Time Value of Money Issuer and investors have a preferred maturity. and sufficiently risk-averse to operate ONLY in this spectrum Supply and demand determine the price in the maturity range Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis113 .

Time value of money Theories of term structures Market segmentation and preferred habitat theories Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis114 .

Time value of money Theories of term structures Market segmentation and preferred habitat theories Fundamentals Risk premium can be positive. negative or zero Time Value of Money Market clearing price is the interest rate Fixed Income Portfolio Management Strategies Term structure of interest rates : supply and demand of each individual segments Flow of funds in the market segments could predict changes in the term structure of interest rates Fixed Income : Valuation and Analysis115 .

Time value of money Theories of term structures Fundamentals Market segmentation and preferred habitat theories Explains the four basic term structure : Time Value of Money Positively sloped : preference for the short term Negatively sloped : preference for the long term Flat : similar preferences Fixed Income Portfolio Management Strategies Humped : different preferences for different maturities Fixed Income : Valuation and Analysis116 .

Time value of money Theories of term structures Fundamentals Market segmentation and preferred habitat theories Limits : Time Value of Money Relative yields should push investors change of segment for a sufficiently higher yield Investor should quit preferred habitat if risk premium is high enough to cover risks and costs leaving it Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis117 .

Time value of money Theories of term structures Fundamentals Stochastic process no-arbitrage approaches Term structure and bond prices are related to some stochastic factors Time Value of Money Factors evolves over time according to a particular hypothesized stochastic process No arbitrage opportunity Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis118 .

Time value of money Theories of term structures Fundamentals Stochastic process no-arbitrage approaches Example : Ogden model (1987) Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis119 .

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis120 .

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis121 .

credit risk and. often.01%) Fixed Income : Valuation and Analysis122 Time Value of Money Fixed Income Portfolio Management Strategies . tax status Spread = risk premium Spreads : measured in basis points (1bp = 0.Time value of money Bond price analysis Yield spread analysis Fundamentals Yield spread : differential in the yields of two or more bonds Yield spread analysis : causes and consequences of those spreads Usually measured against the yield of a treasury security having comparable maturity Highest quality in marketability.

Time value of money Bond price analysis Yield spread analysis Fundamentals Relative yield spread Time Value of Money Yield ratio Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis123 .

Corp. financial) Credit quality (Rating) Maturity Coupon Determinants of yield spreads : Time Value of Money Fixed Income Portfolio Management Strategies Maturity Credit Embedded options Tax status Liquidity Fixed Income : Valuation and Analysis124 .Time value of money Bond price analysis Yield spread analysis Fundamentals Types of spreads : Type of issuer (Treasury.

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis125 .

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis126 .

Time value of money Bond price analysis Yield spread analysis Fundamentals Determinants of yield spreads : Credit Time Value of Money Probability of default Expected yield lower than promised yield Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis127 .

Time value of money Bond price analysis Yield spread analysis Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis128 .

Time value of money Bond price analysis Yield spread analysis Fundamentals Credit spread : Tend to widen when the economy is likely to face recession Higher probability of default in recession Lower recovery rate Time Value of Money Fixed Income Portfolio Management Strategies Formula (p=probability of total payment) Fixed Income : Valuation and Analysis129 .

Time value of money Bond price analysis Yield spread analysis Fundamentals Credit spread : Formula with recovery rate : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis130 .

Time value of money Bond price analysis Fundamentals Yield spread analysis Embedded options Time Value of Money Options benefits the party who can choose to exercise it => yield differential Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis131 .

Time value of money Bond price analysis Yield spread analysis Fundamentals Tax status Net income matters for investors Time Value of Money Taxable bond has to pay higher yield to compete with an exempt bond Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis132 .

Time value of money Bond price analysis Yield spread analysis Fundamentals Tax status To compare taxable and non taxable bonds : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis133 .

the lower the required yield Marketability : broad and deep market Fixed Income Portfolio Management Strategies Time Value of Money Time to maturity : at maturity.Time value of money Bond price analysis Yield spread analysis Fundamentals Liquidity The greated the expected liquidity. but is utilized as a collateral to borrow funds Fixed Income : Valuation and Analysis134 . cash Financiability : the issue can be liquid.

Time value of money Bond price analysis Bond valuation Fundamentals Discounted cash flow method Equilibrium concept Time Value of Money Fixed Income Portfolio Management Strategies Example : ZC bond. pay 1000 EUR in 5 years. 7 year bond ? Fixed Income : Valuation and Analysis135 . discount rate = 7%.

Time value of money Bond price analysis Bond valuation Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis136 .

discount rate varies from maturity to maturity Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis137 .Time value of money Bond price analysis Bond valuation Fundamentals Generally.

Time value of money Bond price analysis Bond valuation Static arbitrage and valuation of coupon bonds Fundamentals A coupon-bearing bond can be visualised as a portfolio of zero-coupon bonds Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis138 .

only the final cash flow is modified Fixed Income : Valuation and Analysis139 .Time value of money Bond price analysis Bond valuation Fundamentals Static arbitrage and valuation of coupon bonds A coupon-bearing bond can be visualised as a portfolio of zero-coupon bonds Time Value of Money Bond price = price of replicating ZC bond portfolio Fixed Income Portfolio Management Strategies If the final repayment is not made at par.

Time value of money Bond price analysis Bond valuation Fundamentals Static arbitrage and valuation of coupon bonds Semi annual coupon : same formula but : Time Value of Money CFt = cash flow received at the end of the SEMI-ANNUAL period (ex : 2% on a 4% coupon) R = required rate of the SEMI-ANNUAL period T : nbr of years x 2 Fixed Income : Valuation and Analysis140 Fixed Income Portfolio Management Strategies .

Time value of money Bond price analysis Bond valuation Fundamentals Static arbitrage and valuation of coupon bonds Floating rate bonds : Time Value of Money New coupon = market spot rate for the next period After the coupon payment. bond should be at par Short term zero coupon with maturity = next coupon payment (sell the bond at 100) Fixed Income : Valuation and Analysis141 Fixed Income Portfolio Management Strategies .

Time value of money Bond price analysis Bond valuation Fundamentals Static arbitrage and valuation of coupon bonds Floating rate bonds : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis142 .

Time value of money Bond price analysis Bond valuation Fundamentals Static arbitrage and valuation of coupon bonds Floating rate bonds : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis143 .

Time value of money Bond price analysis Bond valuation Fundamentals Static arbitrage and valuation of coupon bonds Floating rate bonds : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis144 .

Time value of money Bond price analysis Bond valuation Fundamentals Static arbitrage and valuation of coupon bonds Floating rate bonds : Time Value of Money Coupon rate not always equal to the market spot rate for the next period Default risk Fixed Income Portfolio Management Strategies Announcement of the next coupon rate not always on the previous-coupon payment date Fixed Income : Valuation and Analysis145 .

Time value of money Bond price analysis Bond valuation Fundamentals Static arbitrage and valuation of coupon bonds The impact of the coupon rate Time Value of Money Higher coupon will be worth more than a lower coupon issue with the same maturity Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis146 .

Time value of money Bond price analysis Bond valuation Fundamentals The impact of the discount rate of interest Bond price inversely related to the discount rate of interest Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis147 .

Time value of money Bond price analysis Bond valuation Fundamentals Strips markets Separately Traded Registered Interest and Principal Time Value of Money Zero coupon notes Example : Treasury with 10 years to maturity : Fixed Income Portfolio Management Strategies 20 zero-coupon from 6 mths to 10 years One 10 year zero coupon Created by financial institutions Receive a prespecified sum at a prespecified date Fixed Income : Valuation and Analysis148 .

Time value of money Bond price analysis Fundamentals Price / yield relationship Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis149 .

Time value of money Bond price analysis Price / yield relationship Fundamentals Current yield : focuses solely the coupon return Yield to maturity : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis150 .

market rate must = YTM YTM must be expressed in annual equivalent Equivalence of YTM and total return not supported by theory Fixed Income : Valuation and Analysis151 Time Value of Money Fixed Income Portfolio Management Strategies .Time value of money Bond price analysis Price / yield relationship Fundamentals Yield to maturity : proxy for total return if All coupon reinvestment at YTM (in reality at market rate) Reinvestment rate risk : long term bonds. high coupon rate If sold before maturity.

Time value of money Bond price analysis Price / yield relationship Fundamentals Yield to maturity vs total return : Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis152 .

Time value of money PRICING Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis153 .

Time value of money PRICING Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis154 .

**Time value of money
**

TERM STRUCTURE OF INTEREST RATES

Fundamentals

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis155

**Time value of money
**

TERM STRUCTURE OF INTEREST RATES

Fundamentals

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis156

**Time value of money
**

Risk measurement Bond return : change in price + cash flows + reinvestment

Fundamentals

Risk of a bond : impact of market factors on return characteristics Systematic risk : volatility in total bond return due to interest rate fluctuation Increasing interest rate volatility : bond from safe to risky

Time Value of Money

Fixed Income Portfolio Management Strategies

Price risk : sell a bond prior to the maturity date Reinvestment risk Price risk and reinvestment risk act in opposite directions

Fixed Income : Valuation and Analysis157

**Time value of money
**

Risk measurement Instantaneous change in the bond’s yield

Fundamentals

Long maturity bonds are more sensitive

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis158

**Time value of money
**

Risk measurement Instantaneous change in the bond’s yield

Fundamentals

Long maturity bonds are more sensitive Same relationship if rates decrease

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis159

Time value of money Risk measurement Instantaneous change in the bond’s yield Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis160 .

Time value of money Risk measurement Instantaneous change in the bond’s yield Fundamentals Low coupon bonds are more volatile Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis161 .

Time value of money Risk measurement Instantaneous change in the bond’s yield Fundamentals Low yield bonds are more volatile Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis162 .

Time value of money Risk measurement Instantaneous change in the bond’s yield Fundamentals Bond with sinking fund provision less volatile Callable bonds are less volatile Time Value of Money Price volatility is not a symmetric phenomenon Current market yield : 6% Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis163 .

Time value of money Risk measurement Fundamentals Risk measurement tools Time to maturity Time Value of Money Number of years until bond’s final maturity date Long maturity bonds riskier Wait longer to recover principal More sensitive to interest rate fluctuations Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis164 .

Time value of money Risk measurement Risk measurement tools Fundamentals Time to maturity Weak risk tool Cash flows prior to final maturity Linear relationship between time to maturity and price volatility Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis165 .

Time value of money Risk measurement Risk measurement tools Fundamentals Weighted average maturity (average life) Time Value of Money Only considers principal repayments Fixed Income Portfolio Management Strategies Identical to time to maturity for bullet bonds Better for Sinking requirement and MBS Insensitive to the coupon differentials Fixed Income : Valuation and Analysis166 .

Time value of money Risk measurement Risk measurement tools Fundamentals Weighted average cash flow Time Value of Money Repayments are considered on a nominal basis Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis167 .

Time value of money Risk measurement Risk measurement tools Fundamentals Duration and modified duration Average time at which the cash flow occur Time Value of Money Present value of each cash flow Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis168 .

Time value of money Risk measurement Risk measurement tools Fundamentals Duration and modified duration Duration (Macaulay’s duration) is mesured in years Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis169 .

Time value of money Risk measurement Risk measurement tools Fundamentals Duration and modified duration Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis170 .

Time value of money Risk measurement Risk measurement tools Fundamentals Duration and modified duration Duration of a ZC = maturity Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis171 .

Time value of money Risk measurement Risk measurement tools Fundamentals Duration and modified duration Different coupon frequency. sinking fund requirements : same methodology Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis172 .

Time value of money Risk measurement Duration and modified duration Fundamentals Interpretations Takes into account : Time Value of Money Cash flows YTM P Coupon-bearing bond and ZC maturing on the duration date of the coupon bearing issue Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis173 .

Time value of money Risk measurement Duration and modified duration Fundamentals Interpretations Time (in years) at which the total value of the bond is not sensitive to interest rate variation If you sell at the time of its duration. holding period return = current market yield Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis174 .

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis175 .

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis176 .

Time value of money Risk measurement Duration and modified duration Fundamentals Implicit assumptions All cash flows are discounted at k = YTM Time Value of Money Term structure of interest rate is flat Fisher and Weil’s duration Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis177 .

Time value of money Risk measurement Duration and modified duration Fundamentals Determinants of duration Time to maturity Coupon Accrued interest Market yield Sinking fund Call features Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis178 .

Time value of money Risk measurement Duration and modified duration Fundamentals Determinants of duration D generally positively related to time to maturity Time Value of Money Maximum value of duration (annual) : Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis179 .

Time value of money Risk measurement Duration and modified duration Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis180 .

Time value of money Risk measurement Duration and modified duration Fundamentals Determinants of duration D inversely related to the coupon rate of interest Higher coupon lead to a decline in duration. but at a diminishing rate Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis181 .

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis182 .

Time value of money Risk measurement Duration and modified duration Fundamentals Determinants of duration D inversely related to the buildup of accrued interest D increases on coupon payment date Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis183 .

Time value of money Risk measurement Duration and modified duration Fundamentals Determinants of duration D inversely related to the general level of interest rates (yield level) Higher discount rate = lower duration Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis184 .

Time value of money Risk measurement Duration and modified duration Fundamentals Using duration to approximate price changes Time Value of Money Modified duration (sensitivity) Fixed Income Portfolio Management Strategies Price duration Duration : estimating change in the price for SMALL change in the yield Fixed Income : Valuation and Analysis185 .

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis186 .

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis187 .

8 years Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis188 . Duration : 7.Time value of money Risk measurement Convexity Fundamentals Initial market yield : 6%.

Time value of money Risk measurement Convexity Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis189 .

Time value of money Risk measurement Convexity Fundamentals Duration attempts to estimate convex relationship with a straight line Duration = instantaneous value : Time has an effect Will not exhibit the asymmetry in price volatility Always underestimate the new price Time Value of Money Fixed Income Portfolio Management Strategies Accuracy depends on the convexity Duration : not for large variation in yield Use convexity IN ADDITION to duration Fixed Income : Valuation and Analysis190 .

Time value of money Risk measurement Convexity Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis191 .

Time value of money Risk measurement Convexity Fundamentals Option-free bond always has a positive convexity => Market yield change has always a positive effect on price Time Value of Money Fixed Income Portfolio Management Strategies Convexity = Rate of change of the slope of the price-yield curve with respect to yield changes Fixed Income : Valuation and Analysis192 .

Time value of money Risk measurement Convexity Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis193 .

Time value of money Risk measurement Convexity Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis194 .

Time value of money Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis195 .

Time value of money Risk measurement Duration and convexity between coupon payment dates Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis196 .

duration of a portfolio will vary linearly over time. except when there is a coupon payment Fixed Income : Valuation and Analysis197 .Time value of money Risk measurement Impact of coupon payments and time lapse on duration Fundamentals Duration will suddenly increase at the coupon payment Time Value of Money Fixed Income Portfolio Management Strategies Duration will decrease linearly with time between two coupon payments All other things being equal.

bond risk proxy based on three assumptions : A small change in the yield A parallel shift in the yield.Time value of money Risk measurement Restrictions on using the duration and convexity Fundamentals Duration. whatever the maturity Instantaneous change in yield Time Value of Money Fixed Income Portfolio Management Strategies ⇒ Assumes a flat yield curve ⇒ Functional duration : price sensitivity to a particuliar rate change Fixed Income : Valuation and Analysis198 .

Time value of money Risk measurement Portfolio duration and convexity Fundamentals Duration of a bond portfolio is simply the weighted average of the durations of the individual bonds Time Value of Money Fixed Income Portfolio Management Strategies Convexity of a bond portfolio is simply the weighted average of the convexities of the individual bonds Fixed Income : Valuation and Analysis199 .

Time value of money Credit risk Likelihood that the security’s issuer will default on payment of interest and/or principal Not able to honor the bond indenture Time Value of Money Fundamentals Factor affecting credit risk Economic and financial current and prospective conditions Fixed Income Portfolio Management Strategies Economic / Industry / Firm specific considerations Fixed Income : Valuation and Analysis200 .

Time value of money Credit risk Economic / Industry considerations Fundamentals Economic cyclicality Growth prospects Time Value of Money Research & development expenses Competition Fixed Income Portfolio Management Strategies Sources of supply Degree of regulation Labor Fixed Income : Valuation and Analysis201 .

Time value of money Credit risk Ratio analysis Fundamentals Cash flow from operations (long term) Liquidation of some assets Time Value of Money Another source of financing => Analysis of balance sheet & income statement accounts Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis202 .

Time value of money Credit risk Ratio analysis Fundamentals Common size ratios Profitability ratios Time Value of Money Liquidity ratios Solvency ratios Fixed Income Portfolio Management Strategies Activity ratios Fixed Income : Valuation and Analysis203 .

Standard & Poor’s Analyse various financial data : Time Value of Money Fundamentals of the company Industry data Fixed Income Portfolio Management Strategies Macro-economic data => Probability of the default in interest and/or principal payments Fixed Income : Valuation and Analysis204 .Time value of money Credit risk Credit rating and rating agencies Fundamentals EX : Moody’s.

Time value of money Credit risk Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis205 .

Time value of money Credit risk Credit rating and rating agencies Fundamentals Independant and unbiaised datas Directly reflect the probability of default Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis206 .

Time value of money Credit risk Credit rating and rating agencies Fundamentals Aaa-Baa : Investment quality Ba-B : High yield Time Value of Money Caa-C : May have already defaulted and be moving towards bankrupcy High yield : Fallen angels to new issues Fixed Income Portfolio Management Strategies Bond ratings have a direct effect on the borrowing costs of the issuer Fixed Income : Valuation and Analysis207 .

Time value of money EVALUATION AND RISK Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis208 .

Time value of money EVALUATION AND RISK Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis209 .

Time value of money EVALUATION AND RISK Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis210 .

Fixed Income Portfolio Management Strategies Active Management : to beat the benchmark Forecasting returns Fundamentals Parallel shifts of the yield curve More or less steep yield curve Time Value of Money Convexity of the yield curve Sector spreads Fixed Income Portfolio Management Strategies Corporate spreads … Portfolio Construction Information ratio maximisation and optimisation Fixed Income : Valuation and Analysis211 .

Fixed Income Portfolio Management Strategies Active Management in practice Constant duration Fundamentals Mean reversion process Interest rates above their average value => to decline Match duration of the index until upper trigger limit. then back to average level of the index duration Time Value of Money Fixed Income Portfolio Management Strategies Assumption : mean reverting process in interest rates Risk : Change in medium term inflation rate => adjust the model Fixed Income : Valuation and Analysis212 .

Fixed Income Portfolio Management Strategies Active Management in practice Return enhancement Fundamentals Use of a valuation model Buy the cheap bonds Time Value of Money Arbitrage type Options overwriting Fixed Income Portfolio Management Strategies Forecast is on the timing of long term interest rates Fixed Income : Valuation and Analysis213 .

Fixed Income Portfolio Management Strategies Active Management in practice Return enhancement Fundamentals Minimisation of the value of the bond portfolio Liability funding method Time Value of Money Fixed Income Portfolio Management Strategies Two constraints : IRR of the bond portfolio must equal IRR to discount present value of the liability Fixed Income : Valuation and Analysis214 .

Fixed Income Portfolio Management Strategies Active Management in practice Fundamentals Return enhancement Minimisation of the value of the bond portfolio Time Value of Money Maximasing IRR of the bond portfolio Homogeneous in terms of quality rating Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis215 .

Fixed Income Portfolio Management Strategies Active Management Fundamentals Yield spread strategies Type of issuer Time Value of Money Credit risk Coupon level Maturity Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis216 .

Fixed Income Portfolio Management Strategies Active Management Yield spread strategies Fundamentals Positioning of the portfolio components to gain from movements in yield spreads Time Value of Money Bond swapping : Sell overvalued bond for undervalued one Credit spread : lower quality trade at a spread Fixed Income Portfolio Management Strategies Tend to widen when recession If economic activity is approaching the peak : flight to quality Fixed Income : Valuation and Analysis217 .

Fixed Income Portfolio Management Strategies Active Management Yield spread strategies Fundamentals Call provision Level of interest rates Time Value of Money Volatility Decrease in interest rates : swap callable for non callable Fixed Income Portfolio Management Strategies Forecasting term structure of interest rates Bond swapping : buy cheapest bonds based on these assumptions Fixed Income : Valuation and Analysis218 .

twist and butterfly of the yield curve Time Value of Money Yield curve changes : maturity can have a significant impact on total return of the portfolio Bullet strategies / Barbell strategies / Ladder strategies Bullet : concentrated on a given point of the yield curve Barbell : extremes of the yield curve Fixed Income : Valuation and Analysis219 Fixed Income Portfolio Management Strategies .Fixed Income Portfolio Management Strategies Active Management Yield curve strategies Fundamentals Take advantage of the forecasted movements Shift.

Fixed Income Portfolio Management Strategies Active Management Fundamentals Yield curve strategies Laddering Time Value of Money Maturity spacing Passive portfolio approach Wrong maturity risk minimized Fixed Income Portfolio Management Strategies Reinvestment risk minimized Fixed Income : Valuation and Analysis220 .

Fixed Income Portfolio Management Strategies Active Management Yield curve strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis221 .

new issues Illiquidity Bond futures : rarely on indices but on notional bonds Fixed Income : Valuation and Analysis222 .Fixed Income Portfolio Management Strategies Passive Management Fundamentals Buy and hold Control risk : duration of the portfolio = duration of the index Indexation Time Value of Money Differences with equity indexing : Benchmarks are broader Fixed Income Portfolio Management Strategies Turnover is larger : bonds mature.

Fixed Income Portfolio Management Strategies Passive Management Fundamentals Indexation Differences with equity indexing : Time Value of Money Synthetic replication is impossible Bonds more interchangeable and less specific than equities Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis223 .

Fixed Income Portfolio Management Strategies Passive Management Fundamentals Indexing technology Stratified sampling Time Value of Money Limit the number of bonds Avoid trading too small bond positions Fixed Income Portfolio Management Strategies Avoid being in the illiquid segment Fixed Income : Valuation and Analysis224 .

quality) Select a limited number of bonds in each cells Average characteristics and appropriate weight Fixed Income : Valuation and Analysis225 Fixed Income Portfolio Management Strategies . maturity.Fixed Income Portfolio Management Strategies Passive Management Indexing technology Fundamentals Stratified sampling Building index portfolio Time Value of Money Benchmark partitioned into cells based on characteristics (sector. duration.

Fixed Income Portfolio Management Strategies Passive Management Indexing technology Fundamentals Optimised sampling Time Value of Money Overcome the drawbacks of the stratified sampling approach Giving ex-ante measure of the tracking error Fixed Income Portfolio Management Strategies Optimiser : risk trade-off between factors and transaction costs Choose the level of tracking error Fixed Income : Valuation and Analysis226 .

Fixed Income Portfolio Management Strategies Passive Management Immunisation Fundamentals Increase in interest rates : Lower value of the bond portfolio Time Value of Money Higher return on the coupon reinvestment Balance price risk and reinvestment risk Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis227 .

**Fixed Income Portfolio Management Strategies
**

Passive Management

Immunisation

Fundamentals

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis228

**Fixed Income Portfolio Management Strategies
**

Passive Management

Fundamentals

Immunisation Short time horizon : effect on the bond price is higher Long time horizon : effect of reinvestment of coupons is higher Time-horizon for which the final wealth will be the same, whatever initial interest rate variation

Time Value of Money

Fixed Income Portfolio Management Strategies

If time horizon = duration : investor not affected by interest rates variations Create portfolio with duration = time horizon of the investor

Fixed Income : Valuation and Analysis229

**Fixed Income Portfolio Management Strategies
**

Passive Management

Immunisation

Fundamentals

** Portfolio has to be rebalanced whenever a coupon payment comes due
**

Time Value of Money

Portfolio should be rebalanced for each change in interest rates Reinvestment of coupon can affect immunization equilibrium

Fixed Income Portfolio Management Strategies

=> Immunization has to be dynamic (rebalance frequently)

Fixed Income : Valuation and Analysis230

**Fixed Income Portfolio Management Strategies
**

Passive Management

Immunisation

Fundamentals

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis231

**Fixed Income Portfolio Management Strategies
**

Passive Management

Fundamentals

Immunisation Tradeoff between frequent rebalancing and minimizing the transaction costs

Time Value of Money

Protects against loss but eliminates benefits from interest rate variation Based on duration : assumes parallel shift of the flat interest rate term structure Time-passing and yield changing : portfolio non-immunized

Fixed Income : Valuation and Analysis232

Fixed Income Portfolio Management Strategies

Fixed Income Portfolio Management Strategies Passive Management Fundamentals Liability Funding Funding a given set of future liabilities Time Value of Money Build bond portfolio to fund the liability stream Compensate the interest rate risk on the liability side Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis233 .

Fixed Income Portfolio Management Strategies Passive Management Fundamentals Liability Funding Immunisation Time Value of Money Fund a liability stream and control for parallel shifts in the yield curve L = Present value of the liability stream Fixed Income Portfolio Management Strategies A = Present value of the cash-flow stream from the bond portfolio Fixed Income : Valuation and Analysis234 .

Fixed Income Portfolio Management Strategies Passive Management Liability Funding Fundamentals Single period immunisation Goal : fund the liability and avoid risk of a parallel shift of the interest rate term structure Solution : buy zero coupon bonds Problem : such ZC bonds may not exist. so use of ordinary bonds Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis235 .

Fixed Income Portfolio Management Strategies Passive Management Fundamentals Liability Funding Single period immunisation Time Value of Money Both liability and bond portfolio should be discounted at the same rate (IRR) Duration of bond portfolio and liability are equal (single period : duration = maturity) Fixed Income Portfolio Management Strategies Limited to parallel movements Convexity Infinite number of portfolios with duration = T. choose the bond with cash-flow around the liability maturity => less sensitive to non-parallel shifts Fixed Income : Valuation and Analysis236 .

the smaller the risk Immunisation = dynamic strategy Fixed Income : Valuation and Analysis237 .Fixed Income Portfolio Management Strategies Passive Management Fundamentals Liability Funding Single period immunisation Time Value of Money Dispersion of bond portfolio around its duration : Fixed Income Portfolio Management Strategies The smaller the dispersion.

Fixed Income Portfolio Management Strategies Passive Management Liability Funding Fundamentals Multiperiod immunisation Time Value of Money Fund a stream of several liabilities Technique for a single liability to each of the several liabilities Identify the duration of the liability stream Risk of discontinuities if large liability matures at a specific time (dynamic readjustment of the bond portfolio duration) Fixed Income : Valuation and Analysis238 Fixed Income Portfolio Management Strategies .

Fixed Income Portfolio Management Strategies Passive Management Fundamentals Liability Funding Surplus immunisation Time Value of Money Investor owns assets in excess of the present value of his liabilities S=A–L Fixed Income Portfolio Management Strategies To immunise : Positive surplus : Duration of A should be smaller Fixed Income : Valuation and Analysis239 .

Fixed Income Portfolio Management Strategies Passive Management Fundamentals Liability Funding Cash flow matching Time Value of Money Create a bond portfolio whose stream of cash flows exactly matches stream of liabilities Create a ZC for each liability and maturity Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis240 .

Fixed Income Portfolio Management Strategies Passive Management Liability Funding Fundamentals Cash flow matching With normal bonds : iterative process Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis241 .

Fixed Income Portfolio Management Strategies Passive Management Fundamentals Liability Funding Cash flow matching Time Value of Money Linear programming techniques : least-cost cash flow matching Drawbacks : Fixed Income Portfolio Management Strategies Difficulties of perfect date matching Difficult exact amount matching (rounding in the bond quantities) Fixed Income : Valuation and Analysis242 .

Fixed Income Portfolio Management Strategies Passive Management Liability Funding Fundamentals Asymmetric cash matching Cash flows on the bond portfolio matures only BEFORE Build a non-callable bond portfolio of homogeneous characteristics Cumulative bond cash flow larger than cumulative cash flow of the liabilities (any liabilities is funded) Amount and maturity of cash flows should match as far as possible (limit term structure risk factor) Fixed Income : Valuation and Analysis243 Time Value of Money Fixed Income Portfolio Management Strategies .

Fixed Income Portfolio Management Strategies Passive Management Fundamentals Liability Funding Asymmetric cash matching Technique : minimising the value of the portfolio : the Time Value of Money cheapest portfolio is also the best cash flow match Only with bonds of the same quality Cash in advance to fund liabilities Fixed Income Portfolio Management Strategies Reinvestment based on an assumption for cash rate ⇒ Reinvestment risk if cash is actually smaller ⇒ Take advantage of the evolution of the term structure to build an even cheaper bond portfolio Fixed Income : Valuation and Analysis244 .

Fixed Income Portfolio Management Strategies Passive Management Fundamentals Liability Funding Symmetric cash matching Time Value of Money If you can borrow cash for a short period. bond cash flow can occur AFTER Bond portfolio with cash flows AROUND the maturity of liabilities Can be cheaper depending on the borrowing costs Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis245 .

Fixed Income Portfolio Management Strategies Portfolio construction based on a factor model Volatility of the term structure => MFM for better risk control Fundamentals Model specification Single factor duration model Time Value of Money Fixed Income Portfolio Management Strategies For instantaneous change in yield Ignore the interest accrual Assume that duration is constant through time Fixed Income : Valuation and Analysis246 .

Fixed Income Portfolio Management Strategies Portfolio construction based on a factor model Fundamentals Single factor duration model Relates volatility of a bond return to the volatility of its current yield Time Value of Money Duration = factor exposure of the bond Assumptions : Term structure is flat Fixed Income Portfolio Management Strategies Only small parallel shifts Explains 75% of the variance of non-callable US Treasury bond return Quality of the forecast can be improved with convexity Fixed Income : Valuation and Analysis247 .

Fixed Income Portfolio Management Strategies Portfolio construction based on a factor model Full term structure MFM Fundamentals Time Value of Money Return of a bond is a weighted average of the return of the discount bonds Fixed Income Portfolio Management Strategies Z = exposure of a bond to all discount bonds W = covariance matrix for the return of the set of discount bonds ⇒ Fully predictive risk model ⇒ Not convenient for complicated movements in the curve Fixed Income : Valuation and Analysis248 .

Fixed Income Portfolio Management Strategies Portfolio construction based on a factor model The shift. twist and butterfly MFM Fundamentals Smaller number of factors => easier to model movements of the term structure Risk : loosing risk explanation Time Value of Money Factors : Return of the shift factor Return of the twist factor Return of the butterfly factor Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis249 .

Negative on intermediate (more concave curve) Time Value of Money Fixed Income Portfolio Management Strategies W = 3 x 3 covariance matrix of the shift. negative on long term (steeper curve. twist and butterfly returns Fixed Income : Valuation and Analysis250 . twist and butterfly MFM Fundamentals If RS > 0 : parallel shift in the term structure (positive return on discount bonds => discount yields declined) If RT > 0 : positive return on short term maturities. positive twist) If RB > 0 : Positive return on both end of maturities.Fixed Income Portfolio Management Strategies Portfolio construction based on a factor model The shift.

sinking fund provisions Default risk Tax Fixed Income : Valuation and Analysis251 .Fixed Income Portfolio Management Strategies Portfolio construction based on a factor model Summary and needed enhancements Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies There are other risks than movements in the term structure Existence of options.

Fixed Income Portfolio Management Strategies Portfolio construction based on a factor model Fundamentals Summary and needed enhancements Specific part in the explanation of the return of a bond is relatively small Time Value of Money Bonds are more interchangeable Less emphasis on diversification Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis252 .

Fixed Income Portfolio Management Strategies Portfolio construction based on a factor model Fundamentals Interest rate anticipation strategies Active bond management : scenario for the forecast of the movements of the yield curve Time Value of Money Build a portfolio with risk exposure consistant with his prediction of the term structure movements Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis253 .

**Fixed Income Portfolio Management Strategies
**

Portfolio construction based on a factor model

Fundamentals

** Interest rate anticipation strategies
**

Forecast downward parallel shift of the term structure

=> More exposed to the shift factor than the benchmark Forecast steeper term structure : => Exposure to the twist factor higher than the benchmark Forecast more concave term structure : => Exposure to the butterfly factor higher than the benchmark Overweight sector, rating, …

Fixed Income : Valuation and Analysis254

Time Value of Money

Fixed Income Portfolio Management Strategies

**Fixed Income Portfolio Management Strategies
**

Portfolio construction based on a factor model

Fundamentals

** Interest rate anticipation strategies
**

Build bond portfolio

Time Value of Money

** Duration, convexity consistent with his
**

scenario Risk model

Fixed Income Portfolio Management Strategies

Optimiser to minimise tracking error with constrains on risk exposures Forecast factor returns => maximise forecasted risk adjusted active return of the bond portfolio

Fixed Income : Valuation and Analysis255

**Fixed Income Portfolio Management Strategies
**

Computing the hedge ratio : the modified duration method Hedge bond portfolio with future contracts

Fundamentals

Optimal hedge ratio :

Time Value of Money

** Assumes only parallel shifts in the yield curve
**

Fixed Income Portfolio Management Strategies

Risk if big differences between MDS and MDF Omits convexity (convexity between CTD and asset being hedged) Optimal number of contracts change with CTD

Fixed Income : Valuation and Analysis256

**Fixed Income Portfolio Management Strategies
**

Computing the hedge ratio : the modified duration method Number of future contracts :

Fundamentals

Time Value of Money

Fixed Income Portfolio Management Strategies

** Short hedge : Sell interest rate futures to « freeze » low interest rates today
**

Fixed Income : Valuation and Analysis257

Fixed Income Portfolio Management Strategies

Fundamentals

Time Value of Money

Fixed Income Portfolio Management Strategies

Fixed Income : Valuation and Analysis258

Fixed Income Portfolio Management Strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis259 .

Fixed Income Portfolio Management Strategies EVALUATION AND RISK Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis260 .

Fixed Income Portfolio Management Strategies EVALUATION AND RISK Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis261 .

Fixed Income Portfolio Management Strategies EVALUATION AND RISK Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis262 .

Fixed Income Portfolio Management Strategies EVALUATION AND RISK Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis263 .

Fixed Income Portfolio Management Strategies EVALUATION AND RISK Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis264 .

Fixed Income Portfolio Management Strategies EVALUATION AND RISK Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis265 .

Fixed Income Portfolio Management Strategies EVALUATION AND RISK Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis266 .

Fixed Income Portfolio Management Strategies EVALUATION AND RISK Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis267 .

Fixed Income Portfolio Management Strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis268 .

Fixed Income Portfolio Management Strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis269 .

Fixed Income Portfolio Management Strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis270 .

Fixed Income Portfolio Management Strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis271 .

Fixed Income Portfolio Management Strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis272 .

Fixed Income Portfolio Management Strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis273 .

Fixed Income Portfolio Management Strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis274 .

Fixed Income Portfolio Management Strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis275 .

Fixed Income Portfolio Management Strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis276 .

Fixed Income Portfolio Management Strategies Fundamentals Time Value of Money Fixed Income Portfolio Management Strategies Fixed Income : Valuation and Analysis277 .

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