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Lecture 1

Lecture 1

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Introduction

FINC 6014 Fixed Income Securities

FACULTY OF ECONOMICS & BUSINESS

Lecture outline
› UoS outline
- Schedule - Assessments

› Introduction to fixed income securities
- Classification of debt
- Participants - Risks of investing in fixed income

- Risk-return history
- Primary and secondary markets

Overview
› Why are you here?
- Importance for degree? - Employment opportunities? - You’re worried about your superannuation?

› What is Fixed Income Securities about?

Contact details
› Lecturers
- Andrew Ainsworth (Course Co-ordinator) - Phone: 9036 7992 - Email: andrew.ainsworth@sydney.edu.au

- Office: Room 408, Level 4, Economics & Business Building
- Consultation Times: Wednesday 10-11

- Abhishek Das - Phone: 9114 0830 - Email: abhishek.das@sydney.edu.au - Office: Room 456, Level 4, Merewether Building - Consultation Times: Monday 10-11

and Portfolio Strategies. Academic Press .Textbooks › Prescribed text . 7th Edition.J. Futures and Other Derivatives.Hull. Pearson Education › The following useful texts are on library reserve: . Analysis and Strategies. L. 7th Edition. P. Pearson Prentice Hall . Risk Management.Martellini.Fabozzi. Priaulet and S. Priaulet (2003) Fixed Income Securities: Valuation. (2009) Options. (2010) Bond Markets. J. (2009) Fixed Income Markets and Their Derivatives. John Wiley [available online via the library catalogue] . 3rd edition.Sundaresan.. F. S.

Assessments Assessment task Mid-semester exam Group assignment Final exam Weighting 25% 25% 50% Due date Week 7 Fri 22 October Exam period Length 1 hour 12 pages 3 hours .

Mid-semester exam › The objective of the mid-semester exam is to motivate you to regularly revise the course material and to complete the tutorial questions › The exam will provide you with feedback on your performance over the first 6 weeks of the course › The exam will be 1 hour in duration and will be held in Week 7 › It will examine all material covered in Weeks 1 to 6 .

.Group assignment › Information about the structure of the group assignment will be provided on Blackboard by the end of Week 3 › The project is to be completed in groups of 3-4 students in the same stream › Students are to begin forming groups from Week 1 and must have completed the group formation process by Week 3 › Each group will be required to submit a group formation form in the lecture in Week 3 › There will be a Blackboard discussion forum for group formation to facilitate the process for students to set up groups › The group assignment is due strictly by 4:00 p.m. on Friday 22 October › Assignments must be submitted both electronically via Blackboard and in hard copy using an assignment box.

Final examination › This will be a closed-book examination of three hours duration held during the Examination Period › The questions will cover the entire 13 weeks of the course › Further details on the final exam will be provided in Week 13 .

the awarded grade will be reduced to zero if the assessment is handed in 9 days after the due date .Penalties for late assessments › Students will be penalised at a rate of 10 percent of the available mark per day for assignments received after the due time and date › For example.

There will be an informal questionnaire in the middle of semester for you to let the teaching staff know what they are doing well and what needs to be improved .Feedback › All results for assessment during the semester will be posted on Blackboard no later than two weeks after the assessment is completed › The solutions to the mid-semester exam and the assignment will be discussed during the lecture after the marks have been released › Collection of feedback from you .

29 Ch 30 . 17 Ch 18 Ch 7. 28 12 13 18 Oct 25 Oct Interest Rate Derivatives II Credit Default Swaps and Review Ch 28.EXAM Active and Passive Portfolio Management Liability-Driven Strategies and Bond Fund Performance AVCC Common Week Securitisation Interest Rate Derivatives I Ch 2. 24 Ch 25. 11. 22 Ch 23. 3 Ch 4 Ch 5. 2 2 3 4 5 6 7 8 9 2 Aug 9 Aug 16 Aug 23 Aug 30 Aug 6 Sep 13 Sep 20 Sep 27 Sep Bond Prices and Yields Duration and Convexity The Yield Curve and the Term Structure Bonds with Embedded Options Corporate Debt and Credit Risk Modelling No lecture .Topic schedule Week Week beginning 1 26 Jul Topic Introduction Reading Ch 1. 13 Ch 27. 26 10 11 4 Oct 11 Oct Ch 10.

Classification of debt .Risk-return history .Risks of investing in fixed income .Primary and secondary markets .Lecture outline › Introduction to fixed income securities .Participants .

The contractual amount of interest – frequency and size of interest payment › Debt securities are . called principal. is committed to paying back the bondholder the cash amount borrowed. or the borrower. plus periodic interests calculated on this amount during a given period of time .Issued by borrowers to obtain capital . Priaulet and Priaulet (2003) › “Plain vanilla” bond specifies .Martellini. is a financial claim by which the issuer. or a bond.These cash flows can be secured or unsecured .Introduction to fixed income securities › A debt security.Fixed date when amount borrowed (principal) is due .

BHP › Coupon rate . annual.U.4 March 2010 › Issued amount .S Treasury.Billions › Outstanding amount .Overview of debt contracts › Issuer . semi-annual › Maturity date .7%.4 March 2040 › Issue date .5.

Currently trading in the bond market › Market yield .Overview of debt contracts › Market price .Callable. sinking fund provisions › Credit-rating category . convertible.Investment vs.Internal rate of return that forces price of security to equal PV of future CFs › Contractual features . non-investment grade . puttable.

How bondholders will be compensated .Bankruptcy events. and . unsecured debt › Debt contracts specify .Cash-flow rights › Debt contracts typically have precedence over residual claim such as equity › Bond covenants rank the seniority of different debt securities › Secured vs.

Issue debt securities to raise capital › Investors .Invest savings by purchasing debt securities › Intermediaries .Participants in debt markets › Three broad categories of players in debt markets › Issuers .Assist buyers and sellers by making markets .

Maximise capital raised .Liquid secondary market for repurchasing and refinancing . corporations. banks. foreign institutions .Issuers › Governments.Alter issuance decisions if market of issuer-specific conditions change . special-purpose vehicles (SPVs).Minimise funding costs .

Earn the bid-ask spread by making a secondary market . tenders and underwriting in primary markets . commercial banks.Intermediaries (sell-side) › Investment banks.Prop desk trading . credit-rating agencies . dealers.Provide risk management services and earn fees .Assist in auctions.

managed funds. asset management companies.Obtain diversification . households .To alter previous investment decision at low cost . insurance companies.To receive capital market expertise .To buy securities at a fair market price . commercial banks. pension funds.Investors (buy-side) › Sovereign wealth funds.

conduct open market operations and provide discretionary liquidity › Federal agencies (US) .Helps direct credit to the housing sector .e. financing a budget deficit › Central banks .e.Issue and invest in debt securities .Participants › Governments .g. Federal National Mortgage Association (Fannie Mae) .g.Set monetary policy.

Issue both ST and LT securities .Invest in debt securities .Banks lend and borrow in the interbank market › Financial institutions and dealers . invest. issue and arbitrage in debt markets ... etc.Intermediate.Assist in securitisation of mortgages. .Participants › Corporations and banks .

etc .Obtain debt from banks and financial institutions (e.Actual investments depend on mandate › Households .Pension funds.g.Invest through superannuation/pension funds or managed investments . housing.Participants › Buy-side institutions . credit cards) . cars.Trade fixed income securities to maximise returns given a certain mandate . university endowments.Invest in debt markets on behalf of households .

govt › Municipal bonds .Types of U. debt securities › Treasury .S. Illinois.Issued by state and local govts (e.Issued by federally related institutions and government sponsored enterprises (e. San Francisco) › Agency .S.g. Fannie Mae) .Debt obligation of the U.g.

Short-term debt (<13 months) › Mortgage related .Types of U. and foreign corporations › Money market .S.S.Issued by both U. debt securities › Corporate .Securities backed by mortgage loans › Asset backed .Securities backed by a pool of assets .

debt outstanding 10000 9000 8000 7000 $US biillion Municipal Treasury Mortgage-Related Corporate Debt Federal Agency 6000 5000 4000 3000 2000 1000 0 1996 1998 2000 2002 2004 2006 2008 Money Markets Asset-Backed .U.S.

debt issuance 3500 3000 2500 2000 1500 1000 Municipal Treasury Mortgage-Related Corporate Debt Federal Agency Asset-Backed $US billion 500 0 1996 1998 2000 2002 2004 2006 2008 .S.U.

corporate issuance 3500 3000 2500 Non-Agency MBS $US billion 2000 1500 Straight Corporate Debt Asset-Backed Debt Convertible Debt Common Stock 1000 500 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Preferred Stock .U.S.

S.U. trading volume by sector 600 500 400 $US billion Municipal Treasury Agency MBS Corporate Debt Federal Agency 300 200 Equity 100 0 1996 1998 2000 2002 2004 2006 2008 .

Australian bond issuance .

Australian non-govt bond issuance .Domestic .

Australian non-govt bond issuance -Offshore .

Risks of investing in bonds › Interest rate risk (including reinvestment) › Credit risk › Liquidity risk › Contractual risk › Inflation risk › Event risk › Tax risk › Foreign exchange risk .

Most important source of risk .Reinvestment of coupons also affected .If interest rates ↑ → bond prices ↓ so investors make a capital loss .Risks of investing in bonds › Interest rate risk .Inverse relationship between prices and interest rates .Problem if investor has to sell bond prior to maturity .

Risks of investing in bonds › Credit risk .Treasury securities do not carry credit risk .Risk that issuer may not be able make contractual payments to bondholders .Credit ratings agencies assess credit risk .Why? .What about Greek government debt securities? .

Risks of investing in bonds › Liquidity risk .The ability to trade large size quickly. at low cost.394)) .Why is this a risk? . p. when you want to trade (Harris (2003.

Issuers may be able to “call” a bond .If interest rates decline then an issuer is more likely to call a bond as they can refinance at a cheaper rate .Risks of investing in bonds › Contractual risk (call risk) . and higher yield than similar instruments without a call feature .Callable bonds should have a lower price.

Inflation affects the real purchasing power of coupon payments .Risks of investing in bonds › Inflation risk .Can invest in inflation indexed bonds or floating rate bonds .Fixed coupon securities incorporate compensation for expected inflation at issuance .

The risk of adverse price changes if a company restructures or mergers with another company › Foreign exchange risk .An Australian fund manager invests in Japanese government bonds › Model risk .More relevant for interest rate derivatives than plain vanilla bonds .Risks of investing in bonds › Event risk .Pricing models can be incorrect .

Risk-return history › Would you invest in bonds or equities? › Why? › And in the last 2 years? .

Risk-return history 1200 1000 Australian Equities 800 Australian Bonds 600 Global Equities 400 200 Global Bonds 0 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 .

Risk-return history 50% 40% Australian Bonds 30% 20% 10% 0% Australian Equities -10% -20% -30% -40% 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 .

Risk-return history 50% Global Equities 40% Global Bonds 30% 20% 10% 0% -10% -20% -30% -40% 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 .

Risk-return history 50% 40% Global Bonds 30% 20% 10% 0% Australian Bonds -10% -20% -30% -40% 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 .

9% 18.8% 5.8% 14. Mean Std.9% 17.Risk-return history › Annual returns from 1991 to 2009 Aust Aust Bonds Equities Global Bonds Global Equities Geo.0% 7.6% .6% 5.2% 10. 8. Dev.

P. UBS and others .Distribute the securities to investors .Dealers include Barclays Capital.Hedge their positions . Deutsche Bank.Organisation of fixed income markets › Primary markets . J. Morgan. underwriting procedures or tenders .Debt securities are obtained by dealers using auctions.Investors provide capital to borrowers .Dealers need to .Market where borrowers issue debt securities .Assess demand for the issue .Price the issue .

Dealers provide bid-ask quotes .Market where previously issued securities are traded .Organisation of fixed income markets › Secondary markets .Differs to trading of stocks on exchanges .Generally over the counter (OTC) structure .Investors buy and sell in the secondary market .

Conclusion › This lecture has provided an overview of .Participants in fixed income markets .The types of fixed income securities .The historical performance of the fixed income asset class .Fixed income market structures › Next week .Bond prices and yields .

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