FIXED INCOME SECURITIES

Calculation Of Discount Factors From Swap Rates OBSERVATIONS: PULL TO PAR EFFECT
Interest Rate Swap is a portfolio of long-short bonds &  Discount factor curve is always downward PRICE
Swap Rate refers to fixed rate.(i.e. Coupon Rate of a sloping. PREMIUM BOND
Bond Trading At Par)  If the spot rate curve is upward sloping,forward
Suppose, d rate curve lies above it & par rate curve lies FV PAR
Maturity Swap Rates before it.
 When spot rate curve is downward DISCOUNT BOND
0.5 3% sloping,forward rate curve lies below it & par
1 3.4% rate curve will lie above it. MATURITY
For a disc bond,ytm> coupon rate &
1.5 3.8% PAR RATE ytm is higher for
Par Rate is that coupon rate which makes the bond trade short-term maturity bond.
2 4%
at par.
For a premium bond,ytm<coupon
2.5 4.5%
c/2=(1-dT)/AT {THIS IS PERIODIC} rate & ytm is higher for higher
Then multiply the above answer with 2. maturity bond.
101.5 * d0.5=100.So,d0.5=0.9852. NOTE:
1.7* 0.9852+101.7d1=100.So, d1=0.9668. IMPACT OF MATURITY ON PRICE  LOWER COUPON BONDS
d1.5=[100-1.9(0.9852+0.9668)]/101.9.So, d1.5=0.945 ARE MORE VOLATILE.
d2=[100-2(0.9852+0.9668+0.945)]/102.So, d2=0.9236.  In a ZCB,ytm=last year’s
d2.5=[100-2.25(3.8206)]/102.25=0.8939 spot rate.
PRICE RETURNS
Calculation Of Spot Rates From Discount Factors One period Gross realized yield
P(1.5)>P(1)  If our forecast of =(C+P1-P0)/P0
Consider discount factor as the price of a $1 FV Bond. Short Term rates is Focussing on numerator of price
1/2t
z(t)=[{1/dt} -1]*2 > f(1) & f(1.5),we appreciation.we have P1-P0=
Yes, if coupon
Or should invest at z0.5 P1-x + x-y + y-P0
rate > f(1.5)
USING CALCULATOR: & roll it over.
1 FV  If our forecast of Spread rate carry roll
No,if coupon rate Short Term rates is Change change down
df ± PV
2n N <f(1.5) < f(1) & f(1.5),we Old Expected Curren
CPT i/y *2 should invest long spread Term t term
term i.e. at z1.5. To new Structure structu
OBSERVATIONS spread to Actual re to
 When the spot rate curve is upward New Term Expect
sloping,swap rate curve(similar to par rates) term Structure ed
lies below it. structur Spread Term
 When the spot rate curve is downward RETURN,SPREAD & YIELDS e same same Structu
sloping,swap rate curve(similar to par rates) re,
lies above it. Gross Return=(EVt-BVt-1)/ BVt-1 spread
 When spot rate curve is flat,the par rate Where EVt=FV of reinvested coupon amt+Ending same
curve=spot rate. Price CARRY ROLL DOWN
Long term amortizing or callable bonds with high P0=Pt[Rt,St]
FORWARD RATE coupon rate have highest Reinvestment Risks. Y=Pt+1[ R’t+1,St]
Net Return=Gross Return-Financing Cost
For a positive spread, Expected Term Structure
f0.5 0 0.5
Actual market price<model price Choice 1:Realised Forward scenario
f1 0.5 1 For a negative spread, Realised fwd rate=Implied fwd
f1.5 1 1.5 Actual market price>model price st
rate,Gross yield =1 fwd rate i.e.
Tuckman has expressed SPREAD as a spread over f(0,0.5)
INTERPRETATIONS benchmark Forward rate i.e. what needs to be Fwd rates do not include risk prem.
 Fwd Rate is the rate fixed today for added to each of the forward rates to ensure If realized fwd rate>implied fwd
borrowing/investing a sum of money later. that model price=market price. rate-Buy ST bond & roll them over
 It represents the incremental return, if One would like to buy bond with the higher If realized fwd rate<implied fwd
maturity of our investment is extended. spread,given the features of 2 bonds are exactly rate-Buy LT bond.
 If our forecast of Short Term rates is > f(1) & same. Choice 2:Unchanged Term
f(1.5),we should invest at z0.5 & roll it over. YTM(Yield To Maturity) is IRR of a bond i.e. Structure scenario
 If our forecast of Short Term rates is < f(1) & single discount rate which makes model New f(0,0.5)=old(0,0.5) whereas in
f(1.5),we should invest long term i.e. at z1.5. price=market price. Choice 1: New f(0,0.5)=old(f0.5,1)
 Forward Rate is THE INDIFFERENT RATE i.e. Note-r1=f1, Gross realized return wl depend on
indifferent btw investing at z1 or at z0.5 & r2= Geometric mean of f1 & f2 & so on relation btw bond’s coupon rate &
rolling it over. YTM is a complex average of various spot rates. last fwd rate before bond matures.
It is slightly less than r3 if coupon rates are low. Fwd rates include risk premium.
FORWARD RATE But,if coupon rate is higher, r1 & r2 start getting Choice 3:Unchanged Yield Scenario
[(Bigger 6mth factor/Smaller 6mth factor)1/gap-1]*2 higher weights such that ytm would fall in an Calculate initial ytm.We assume this
upward term structure environment. ytm after one period remains same.
Realised yield =YTM if bond is held to maturity & Gross Return=ytm.Ytm criticized
all intermediate cash flows are reinvested at ytm. bcoz of reinvestment assumption.
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