Fixed Income

Fixed Income Securities
Daniel Velasquez, Ph.D (c)
Universidad EAFIT
dvelas18@eafit.edu.co
January 27, 2020
Daniel Velasquez, Ph.D (c) (EAFIT) Class notes January 27, 2020 1 / 96
Overview
1 Introduction
2 Pricing Bonds
3 Measuring Yield
4 Factors A↵ecting Bond Yields and the Term Structures of Interest Rates
The Term Structure of Interest Rate
5 Treasury and Federal Agency Securities
6 Corporate Debt Instruments
7 Bond Price Volatility
8 Bond Portfolio Construction
9 Portfolio Immunization
Contenidos del curso
1 Elementos básicos de los mercados de deuda.

2 Precio y rendimiento de los instrumentos financieros de deuda.
3 Estructura a plazo de la tasa de interés.
4 Volatilidad de precios.
5 Estrategias de inversión en instrumentos de deuda (inmunización)
Evaluation
1 Activity 10%. February 21.

2 Midterm 25%. March 6.
3 Midterm 25%. April 3.
4 Final paper presentation 10%. May 15.
5 Reading reports. 10%. During the semester.
6 Final 20%. week 17-18.
Capital Markets in Colombia
Equity - COP 123 mn 2.87%

Currencies - COP 1,611 mn 37.93%
Fixed Income - COP 2,574 mn 59.74%
Colombian market overview: BVC beamer presentation.
Stylized facts in fixed income
Definition (Bond)
Is a debt instrument where the issuer has the obligation to repay to the
investor the amount borrowed plus agreed interest over a specified period
of time.
Issuer→Bond→Investor
Shares give dividends, fixed income instruments grant interest or
coupons.
When a company pays dividends?
Bonds represent a known cash flow pattern.
Overview of bond features
Type of Issuer
Credit Ratings (Country, sector)
Term to Maturity
Principal and Coupon Rate (nominal rate)
Coupon Bond
Zero Coupon Bond
Floating Rate and inverse floating rate Bonds
Amortization Feature
Embedded Options
Call and put Options, convertible Bonds.
Time value of money
Opportunity cost
Money has time value because of the opportunity to invest it at some
interest rate.
Future Value
Pn = P0 (1 + r )n
Where:
n = number of periods
Pn = Future value n periods from now
Po = Original principal
r = interest rate per period (decimals)
Future Value
Exercise
Suppose that a pension fund manager invest 50 million dollars in a
financial instrument (bond, commercial paper...) that promises to pay
7.7% per anual for 10 years.
What is the future value (FV) of the investment?
Now calculate the FV if the interest payments are 2 times per year,
what happen if the payments are 3 times per year?
Annual interest rate

r=
Number of times interest is paid per year
n = Number of times interest is per year x number of years
Future Value of an Ordinary Annuity
Future Value of an Ordinary Annuity


(1 + r )n 1
Pn = A
r
Exercise
Suppose that a portfolio manager purchase a 50 million dollars bond
with maturity of 10 years that promise to pay 9% interest per year.
How much will the portfolio manager have if the bond is held until
the maturity, and the annual payments are reinvested at an annual
interest rate of 7%?
What happen if the payments are twice per year?
Present Value
Present Value

1
P0 = PV = Pn
(1 + r )n
Excersise
A portfolio manager has the opportunity to purchase a financial
instrument that promises to pay 50 million dollars 10 years from now
with no interim cash flow, if the manager wants to earn an annual
interest rate of 10%.
What is the present value of the investment?
What happen if the capitalization is twice per year?
Present Value of a Series of Future Values
Present Value of a Series of Future Values
n
X Pt
PV =
(1 + r )t
t=1
Excersise
Suppose that a portfolio manager is considering the purchase of a financial
instrument that promise to pay 1.000 per 3 years and 21.000 in the fourth
year, the annual interest rate is 8%. What is the present value of the
investment?
Present Value of an Ordinary Annuity
Present Value of an Ordinary Annuity
" 1
#
1 (1+r )n
PV = A
r
Excersise
Suppose that an investor expects to receive $100 at the end of each year
for the next 8 years, the annual interest rate is 9%. What is the present
value of this ordinary annuity?
Pricing a Bond
The price of any financial instrument is the present value of its

expected cash flow:
Cash Flow to the maturity
Periodic coupon interest payments
Facial or par value at maturity
Required yield (Discount rate)
C C C C M
P= + + + ... + +
1+r (1 + r )2 (1 + r )3 (1 + r )n (1 + r )n
n
X C M
P= +
(1 + r )t (1 + r )n
t=1
Exercise
Consider a 15 years, 12% coupon bond with a par value of $5000.
Suppose that the required yield on this bond is 8%. What is the present
value (price) of the bond?
+ Present value of coupon payments

+ Present value of par (maturity value)
= Price
" 1
#
1 (1+r )n M
P=C +
r (1 + r )n
Price - Yield relationship
Definition
The price of a Bond change in the opposite direction from the change in
the required yield.
Relationship between coupon rate, required yield and price
If the coupon rate is the same yield the price of the bond will be
equal to the par value.
If yield rise above coupon rate, market value of the bond will be lower
than its par value.
If yield is lower than the coupon rate, the bond must sell above its
par value
Discount Bond:
coupon rate < yield $ price < par value
Par Value Bond:
coupon rate = yield $ price = par value
Premium Bond:
coupon rate > yield $ price > par value

Relationship between Bond Price and time
Par value Bond: No changes to maturity.
Discount Bond: Increase price to maturity.
Premium bond: Decrease price to maturity.
Reasons for the change in the price of a bond

1 Change in the yield (Credit quality of issuer, macroeconomics,
politics, elections, weather...)
2 The bond is moving towards maturity.
3 Changes in yield of other bonds.
Next Coupon payment due in less than six months
When an investor purchase a bond whose next coupon payment is due in

less than six months, the accepted method for computing the price of the
bond is:
n
X C M
P= +
(1 + r )v (1 + r )t 1 (1 + r )v (1 + r )n 1
t=1
where:
days between settlement and next coupon
v=
days in six months period
Floating Rate Bond
In floating rate bonds cash flow is not known.

The coupon rate will be a fixed part plus a variable part (spread,
margin).
couponfloating % = reference rate% + spread%
The price of a floater will depends on the spread and the restrictions
imposed to the yield.
The yield usually has a cap and a floor.
Floaters Bonds are created depending on a collateral. The coupon
and the par value of a floater has to be less or equal to the collateral.
Floating Rate Bond
Consider a 10 years 7.5% semi annual coupon Bond. The collateral

par value is 1000m. Then creates a Floater with par value of 50m
and an Inverse Floater of 50m.
floater coupon = reference rate + 1%
inverse floater coupon = 14% reference rate

collateral coupon = 7.5% = 0.5(7.5% + 1%) + 0.5(14% 7.5%)
To find the cap, solve:
x = ↵(x + spread) + (1 ↵)(y x)
The floater price is:
inverse price = collateral price + floater price
Risks associated with investing in Bonds
Interest rate Risk

Reinvestment risk
Call Risk
Credit Risk
Inflation Risk
Exchange Rate Risk
Liquidity Risk
Volatility Risk
Risk Risk
Computing the yield of an investment
Definition
A bond yield is the interest rate that make the present value of the future
cash flows equal to the price.
CF1 CF2 CF3 CFn

P= + + ...
(1 + y )1 (1 + y )2 (1 + y )3 (1 + y )n
n
X CFt
P=
(1 + y )t
t=1
Suppose a 5 years bond with par value of $1000 and coupon of 8%

semiannual. The price of the bond in the market is $922 What is the
required yield?
Annualizing Yields
The simple interest rate is annualized by multiply the rate per the
times is payed in a year.
rannual = rmonthly ⇤ 12
The simple interest rate does not take into account the
compounding periods.
Nominal interest rate are not comparable unless their compounding
periods are the same.
E↵ective interest rate coverts nominal rates into annual compound
interest. To find it:
e↵ective annual yield = (1 + periodic interest rate)m 1
periodic interest rate = (1 + e↵ective annual yield)1/m 1
Annualizing Yields
1 Suppose a periodic interest rate of 4% and the frequency of payment

twice a year.
2 Suppose a periodic interest rate of 3% and the frequency of payment
three times a year.
3 Suppose a periodic interest rate of 0.5% and the frequency of
payment eight times a year.
Which has the highest e↵ective annual yield?
Conventional Yield Measures
Current Yield
Current yield relates the annual coupon interest to the market price.
annual dollar coupon interest
current yield =
price
Current yield reflects what you will earn if you buy a bond and hold it
for one year.
The price of the Bond changes but not the coupon due to the face
value does not change either.
Excersise
What is the current yield for a 20 years 8% bond with a par value of $1000
selling in the market at $821.
80
current yield = = 9.74%
821
Conventional Yield Measures
Yield to Maturity
Is the interest rate that will make present value of the cash flows equal
to market price.
X n
C M
P= +
t=1
(1 + y )t (1 + y )n
Excersise
Consider a bond wit a cash flow of 30 coupon payments of $35 every six
months and a face value of $1000 to be paid in 15 years, the market price
is $1160. What is the current yield?
Yield to Call
In some cases the issuer may be entitled to call the bond prior to the
maturity date.
The price at which the bond may be call is the call price.
A call schedule determinate the days when the bond may be called
and at what price.
For this kind of bonds we have to calculate yield to call.
n⇤
X Ct M⇤
P= +
(1 + y )t (1 + y )n⇤
t=1
Where:
M*= Call price.
n*= Number of periods until the assumed call date.
Yield to Call
Consider a 18 years 11% coupon bond with par value of $1000 selling
at $1169. Suppose the first call date is 8 years from now and the call
price is $1055.
Find the yield to call
Find the yield to maturity.
Yield to Put
Yield to Put
A put option give the right to the bondholder to sell the bond.
n⇤
X Ct M⇤
P= +
(1 + y )t (1 + y )n⇤
t=1
Where:
M*= Put price.
n*= Number of periods until the assumed put
Consider a 11% coupon 18 years bond selling for $1169. The Bond is
putable at par value $1000 in five years. Find Yield to Put
Yield for a Portfolio
Yield to Worst
Is the minimum yield: to maturity, to call, to put.
Yield of a Portfolio
Is not simply the average of weighted average of the yield to maturity
of each component.
Is computed depending on the cash flow from the portfolio making it
equal to the market price.
Consider the next example.
Yield for a Portfolio
Coupon Par
Bond Maturity Price Yield
rate % Value
A 7.0 5 10.000.000 9.209.000
B 10.5 7 20.000.000 20.000.000
C 6.0 3 30.000.00 28.050.000
Find the yield of each bond.

Find the value of the portfolio.
Make the cash flows form the portfolio.
Find the yield from the portfolio.
Yield spread measure for floating rate securuties
The coupon of a floater changes periodically based on the fixed rate

plus the margin. Sometimes is difficult to estimate cash flows.
1 Determinate the cash flows assuming a constant interest rate.

2 Select a margin.
3 Discount the cash flows.
4 Make the cash flows equal to the price.
Exercise
Consider a floating rate bond with 6 years maturity, selling at 99.3098,
pays a rate based on some reference plus 80 basis points. the coupon rate
is reset every six months. Assume the reference interest rate is 10%.
What is the margin required for the market price
Potential source of a Bonds dollar returns
1 The periodic coupon

2 Any capital gain or loses when the bonds matures or is called or puted.
3 Interest income generated from reinvestment the cash flows.
Reinvestment Income.
Determining the reinvestment income

(1 + r )n 1
reinvestment income = C nC
r
Consider a 15 years, 7% coupon bond, with $1000 par value selling at

$769.40. Find the reinvestment income
What happen if the reinvestment is made in a rate less than the yield?
Yield to maturity and reinvestment risk
Reinvest the cash flows at a lower rate than the yield.

The longer the maturity the higher would be the reinvestment risk.
The zero coupon bonds have no reinvestment risk.
Total Return
Yield to maturity is a promised yield if this 2 conditions are held:

1 The bond is held until maturity.
2 All coupons are reinvested at the yield to maturity.
A buyer with a 5 years investing horizon needs to purchase a bond, which
is the best?
Coupon Yield to
Bond Maturity
rate % maturity %
A 5 3 9.0
B 6 20 8.6
C 11 15 9.2
D 8 5 8.0
Total Return
The total return measure takes the expectations into account and will
determine the best investment for the investor, depending on personal
expectations.
Computing total return
Suppose that an investor with a three years investment horizon is
considering purchasing a 20 years 8% coupon bond for $828.40, with a
yield to maturity of 10%. The investor will reinvest the coupons at an
annual rate of 6% and that at the end of the planned investment horizon
the then 17 years bond will be selling to o↵er a yield to maturity of 7%.
Calculate the total return.
Total Return calculation steps
STEPS
1 Compute the total coupon payments plus the reinvestment interest.
2 Determining the projected sale price after 3 years.
3 Add the amounts in step 1 and in step 2.
4 Obtain the semi annual return.
 1/6
1375.25
Semi annual return = 1
828.40
5 Double the semi annual return.
Base Interest Rate
Base rates are the becnhmark rates.

Base rates are the minimum rates that investor will accept for
investing in a non treasury security.
Issuers of base rates securities are the ones who have less credit risk
in the world or country.
Take a look on global interest rates: bondsupermart
www.bondsupermart.com
Yield Spread
Yield spread is the di↵erence between the yields on any two bonds.
yield spread = yield on bond A yield on bond B
yield spread is expressed in basis points.
1pb = 0.01%
the yield spread reflects the risk associated in invest on a bond,

related to the base rate.
Bechmark spread is used when a bond is benchmark and the other is
not benchmark. Risk Premium
benchmark spread = non benchmark bond yield benchmark bond yield
Yield Spread
The risk premium is measured by taking the ratio of the yield spread
to yield level.
yield on bond A yield on bond B
relative yield spread =
yield on bond B
the yield ratio:
yield on bond A
yield ratio =
yield on bond B
for example the Goldamn Sachs GB Bond with 3.65% coupon with a
yield of 3.723% with 5 years to maturity. The base rate for 5 years is
2.16%. Calculate yield spread, relative yield spread and yield
ratio
Factors that a↵ect the benchmark spread
1 The type of issuer.

2 The perceived creditworthiness of the issue.
3 The term or maturity of the issue.
4 The provisions that grant either the issuer or the investor the option
to do something.
5 The taxability of the interest received.
6 The expected liquidity of the issue.
Yield Curve
The yield curve is the graphical depiction between the yield on bonds
of the same credit quality but di↵erent maturities.
Problems with the yield curve
There are coupons in bonds that a↵ect price and yield. Is difficult to
find the true yield.
To handle the problem we need to create the spot rate curve.
The spot rate curve is derived form theoretical considerations
applied to the yields on the actually traded bonds.
The theoretical spot rate curve is the depiction of the term
structure of interest rate
Constructing theoretical Spot Rate Curve
Determinate the par value rates

Interpolate the par value rates
Construct the theoretical spot rate
CF1 CF2 CF3 + M
M= + +
(1 + z1 ) (1 + z2 )2 (1 + y )3
With the par coupon rates of 0.5, 1, 2, 5, 7 and 10 years, construct

the theoretical spot rate curve.
with the spot rates value a 10 years bond with 10% coupon.
Forward Rates
Forward rates represent the market consensus about the future of the
interest rates.
Forward Rates
(1 + r2 )T2 = (1 + r1 )T1 (1 + rf )T2 T1
Given the spot rates in the past example find each 6 months forward
rate.
Shape of the Term Structure
Positively slope (Normal).

Negatively slope (Inverted).
flat.
Theories:
1 Expectations theory.
Pure Expectations theory.

Liquidity theory.
Preferred habitat theory.
2 Market Segmentation theory.
Shape of the Term Structure
1 Expectations theory: The behavior of short term forward rates are

determined by the expectations on future short term rates.
Pure Expectations theory: Forward rates exclusively represent the
expected future rates.
Liquidity theory: Implied forward rates will not be an unbiased
estimate of the markets expectations of future rates because they
embody a liquidity premium.
Preferred habitat theory: Term structure reflects the expectation of
future interest rate plus a risk premium reflecting the imbalance of
demand and supply of funds in a given maturity.
2 Market Segmentation theory: Neither investors nor borrowers are
willing to shift from one maturity sector to another to take advantage
of opportunities arising from di↵erences between expectations and
forward rates.
Swap Rate Yield Curve
Two or more parties exchange interest payments on specified dates.

One party pays a fixed rate and the other party pays a floating rate.
The floating rate is usually indexed in LIBOR rate.
Key Points
There is a Term Structure of Interest Rates that is approximated

by the Theoretical Spot Rate Curve.
The di↵erence between yields in bonds is called yield spread,
benchmark spread.
The spread is a↵ected by the risk associated with the inversion.
The price of the bonds must be find with the spot rates.
The theories about the shape of the yield curve are used by the
investors to trade securities.
Fixed Principal Securities
Treasury Bills:
Their maturity is less than one year.
They have no coupons.
They sell at discount.
Treasury Notes:
Maturity from 2 to 10 years.
Have coupons.
Usually sell at par value.
Treasury Bonds:
Maturity more than 10 years.
Have coupons.
Usually sell at par value.
Treasury Inflation Protection Securities - TIPS
The dollar coupon amount and the par value are indexed with the
Inflation Rate
Each six months the dollar coupon and the par value will change due
to the inflation.
Suppose a 5 years TIPS with a 3.5% coupon rate with semiannual
payments, the annual expected inflation for the next 5 years is 3%. Find
the cash flows
The Treasury Auction Process
1 Primary Market (Treasury).

Non-Competitive bid.
Competitive bid.
2 Secondary Market: Act as a Market Makers.
3 Bid-to-cover ratio.
Auction Process
For example, suppose debt managers are seeking to raise $10 billion in
ten-year notes with a 5.130% coupon, and, in aggregate, they have
received seven bids from lenders as follows:
Bid 1 for $1.00 billion at 5.115%

The total bids received is $19.5 billion
Bids accepted is $10 billion
Bid to Cover Ratio=1.95
Price quotes for Treasury Bills
Treasury Bill values are quoted on a Bank Discount Basis:

D 360
Yd = ⇥
F t
Yd = Annualized Yield
D = Di↵erence between Face Value and Price
F = Face Value
F = Days remaining to maturity
Consider a Treasury bill with 100 days to maturity, with a face value of
$100.000, selling at $99100. Find the yield in Bank Discount Basis.
Quotes on Treasury Coupon Securities
Calculate the yield as usual, but need to add the accrued interest to
calculate dirty price.
In dirty price the buyer compensates the seller for the accrued interest
between coupon payments.
annual dollar coupon days in AI period
AI = ⇥
2 days in coupon period
Suppose that there are 50 days in the accrued interest period, there are
183 days in a coupon period, and the annual dollar coupon is $8. Find
the accrued interest.
Bond Equivalent Yield
The Bond Equivalent Yield = Money Market Equivalent Yield is a measure

that seeks to make the Treasury bills comparable with Notes and Bonds.
360 ⇥ Yd
MM equivalent yield =
360 t ⇥ Yd
Note: The Yield is the Bank Discount calculated.
Consider a Treasury bill with 100 days to maturity, with a face value of
$100.000, selling at $99100. Find the MM Equivalent Yield.
Stripped Treasury Securities
Because of the demand for zero-coupon bonds, the private sector

artificially created such securities.
Consider a 500m par value 10 years bond (Note), with semiannual
coupons, the annual coupon rate is 5%.
Construct 20 zero-coupon bonds, what is the yield of each one?
The problem with this instruments is the taxes and insurance costs.
Suppose that the market price of a bond is greater than the
theoretical price. They will buy until the market price equals
theoretical price (Reconstitution).
Corporate Debt Instruments
Corporate Debt Instruments

Corporate Bonds. Sectors
Medium-Term Notes. Public Utilities.
Commercial Papers. Transportation.
Bank Loans. Bank/finance.
Convertible Corporate Industrial.
Bonds. Yankee and Canandian.
Asset Backed Securities.
Balance Sheet Bank ABC
Bank ABC
Assets Liabilities
Cash 10 Customer deposits 80
Securities 50
-Bonds Bonds issued
-Stocks -senior bonds issues 25
-Derivatives -subordinated bond issued 15
Loans and mortgages 100 Short term borrowing 30
-Corporates Reserves 20
-Retail Total Liabilities 170
-Government
Other Assets 20 Equity 30
Short term lending 20 Preferred stocks 10
Common stocks 20
Total Assets 200 Total Liabilities + Equity 200
Seniority of Debt in a Corporations Capital Structure
The capital structure is the way in which the firms management has
elected to finance itself.
Capital structure = equity + liabilities
The optimal capital structure is the one which maximizes the value of
the firm.
Modigliani, F., Miller, M. H. (1963).
Seniority of Debt in a Corporations Capital Structure
In the case of a liquidation or reorganization, the order to pay the

obligations is:
1 Senior secured debt: Is backed by a collateral (properties).

2 Senior unsecured debt: Is not backed by a collateral (properties).
3 Senior subordinated debt: In the case of borrower default, creditors
who own subordinated debt won’t be paid out until after senior debt
holders are paid in full.
4 Subordinated debt: The last in receive payments.
Corporate Debt Ratings
Some firms do their own credit analysis.

Other firms contract other firms, the main credit analysis firms are:
Moodys Investors service.
Standard Poors Corporation.
Fitch Ratings.
Debt obligations grade:
1 Prime.
2 High Quality.
3 Upper Medium.
4 Medium Grade.
5 Junk Debt.
Bonos ”Carrasquilla” - Entendamos que paso!
Tasa pactada: UVR+8%+3%(costos)
Vencimiento: 19 años
Calidad Crediticia: AA+
En el 2010 el precio del petroleo fue 90 USD.
Valor facial: 500.000 millones COP.
Los municipios no fueron emisores directos de ningn bono, el esquema
funcion desde el patrimonio autnomo Grupo Financiero de
Infraestructura GFI que fue el vehculo financiero que realiz la emisin y
luego con esos recursos otorg crditos a los municipios, los cuales
entregaron como garanta de pago sus ingresos futuros para el sector
de agua potable y saneamiento bsico, APSB, provenientes del sistema
de general de participaciones SGP.
Multiples captadores de dinero en Panama recibian el dinero de
inversionistas extranjeros. shadow banking
Se estima que la pérdida es superior a 1.25 billones de COP.
UVR
Credit Ratings
Special Structures for High Yield Bonds
Original high yield bonds.

Fallen Angels.
1 Deferred coupon bonds.

2 Step up bonds.
3 Payment in kind bonds.
Corporate Bonds Market
OTC market.
Medium Term Notes.
Structured notes.
Equity-Linked notes.
Commodity-linked notes.
Currency-linked notes.
Commercial papers.
Bank Loans.
Collateralized loans obligations.
Corporate Risks
Default Risk.
Altman Z-score:
https://en.wikipedia.org/wiki/Altman_Z-score
Default Loss Rate = Default Rate ⇥ (100% Recovery Rate)
Corporate Downgrade Risk.

Corporate Credit Spread Risk
Bond Price Volatility
Price vs Yield relationship.

Property 1: The price of a bond moves in opposite from a change in
yield, the percentage change is not the same for all bonds.
Property 2: For small changes in yield, the percentage change is the
same whether the yield increase or decrease.
Property 3: For large changes in yield, the percentage price change
is not the same for an increase as it is for a decrease in the required
yield.
Property 4: For a large change in yield, the percentage price increase
is greater than the percentage price decrease.
Characteristics of a Bond That A↵ect Its Price Volatility
Characteristics of a Bond That A↵ect Its Price Volatility

1 For a given term to maturity and initial yield, the lower the coupon
rate. The greater the price volatility.
2 For a given coupon rate and initial yield, the longer the term to
maturity, the greater the price volatility.
E↵ects of the Yield to Maturity

The higher the yield, the lower the price volatility.
How to Measure Bonds Volatility?
Price Volatility
Price Value of Basis Points

Price value of a basis point (PVBP) is the dollar change in the price when
the yield changes by 1 basis point.
Yield Value of Price Change

Calculate the change in yield from a possible price change. And from this
calculate the change in dollar price of a bond from changes in yield.
Duration
Macaulay Duration.
Modified Duration.
Duration
Bonds Price:
C C C C M
P= + + + ... + +
1+y (1 + y )2 (1 + y )3 (1 + y )n (1 + y )n
To calculate the change in price due to a small change in yield, we do the

first derivative:
dP ( 1)C ( 2)C ( n)C ( n)M
= + + ... + +
dy (1 + y )2 (1 + y )3 (1 + y )n+1 (1 + y )n+1
Dividing in both sides for P to obtain percentages changes. We can find

Macaulay Duration
1C 2C nC nM
(1+y )1
+ (1+y )2
+ ... + (1+y )n + (1+y )n
Macaulay Duration =
P
Macaulay Duration - Modified Duration
Macaulay Duration
Pn tC nM
t=1 (1+y )t + (1+y )n
Macaulay Duration =
P
Modified Duration: Percentage change in price for a given change in
yield.
Macaulay Duration
Modified Duration =
1+y
Properties of Duration
For zero-coupon bonds, the duration is equal to the maturity.

For zero-coupon bonds, modified duration is less than the maturity.
Lower coupon bonds generally have greater the modified and
Macaulay duration.
The longer the maturity the greater the modified duration.
The greater the modified duration the greater the volatility of the
bond price.
Approximating Price Changes
Percentage price change:

dP
= modified duration ⇥ dy
P
Consider a 25 years 6% bond selling at 70.3570 to yield 9%.
Calculate the modified duration. if yield change for 9% to 9.1%.
Calculate the percentage change in price. What happen if the
changes are form +200 and -200 basis points?
Portfolio Duration
The portfolio duration is simply the weighted average duration of the

bonds in the portfolio.
We can find the contribution of each bond to the total portfolio
duration.
Contribution
Bond Market Value Portfolio Weight Duration to Portfolio
Duration
A 10m 0.1 4
B 40m 0.4 7
C 30m 0.3 6
D 20m 0.2 2
Total 100m 1
Convexity
The durations are good measures of price changes due to small

changes in yield, buy they ignore the convexity of the price yield
relationship.
To capture the curvature form the price yield relationship we can use
the convexity.
The slope becomes flatter as the yield increases.
Convexity
We can use first two terms of a Taylor series to approximate the price
changes:
dP 1 d 2P 2
dP = dy + (dy ) + error
dy 2 dy 2
The second term of the equation must be solve with an approximation:
n
X t(t + 1)C
d 2P n(n + 1)M
= +
dy 2 (1 + y )t+2 (1 + y )n+2
t=1
Calculation of Convexity
For a 9% coupon bond, with maturity in 5 years, with a 9% yield and a
face value of 100. Calculate:
The second derivative.
Convexity measure (half year).
Convexity measure (years).
Dollar convexity measure.
Percentage Price Change Using Duration and Convexity
Modified Duration:
Percentage change in bond price = (modified duration)(dy )
Convexity Measure:
1
Percentage change in bond price = (convexity measure)(dy )2
2
Calculations
Consider a 25 years 6% bond selling to yield 9%. The required yield change
from 9% to 11%. Calculate the change in price with both methods.
Portfolio Theory and Risk Decomposition
Markowitz portfolio theory, 1950. Mean-Variance portfolio

The logarithmic returns from the price of an asset:
✓ ◆
Pt,i
Rt,i = ln 8i = {1, 2}
Pt 1,i
The weights of the portfolio can be defined as:

2
X
1= wi
i=1
The return and the variance of the portfolio:
E (Rp ) = w1 R1 + w2 R2
var (Rp ) = w12 var (R1 ) + w22 var (R2 ) + 2w1 w2 cov (R1 , R2 )
The covariance between the assets can be defined as:

cor (R1 , R2 )
cov (R1 , R2 ) =
SD(R1 )SD(R2 )
var (Rp ) = w12 var (R1 )+w22 var (R2 )+2w1 w2 cor (R1 , R2 )SD(R1 )SD(R2 )
The variance of the portfolio:
var (portfolio) = f (individual variance, correlation between assets)
The variance form a portfolio, can be decomposed in:

1 Systematic Risk.
2 Idiosyncratic Risk.
Investor do not have the techniques to properly manage risk. (Value

at Rsik - Expected Shortfall). Cardona, E., Mora-Valencia, A.
Velsquez-Gaviria, D. Risk Manag (2018). https://rd.springer.
com/article/10.1057/s41283-018-0046-z#citeas
Sharpe theory, 1963. Relationship between an asset and its
”benchmark”.
Ri = ↵ + Rm + ✏i
The Beta and the Alpha.
Issues of portfolio variance
1 Assumes that the probability distribution associated with the returns

is normal. The financial returns exhibit:
Fat Tails.
skewness.
Volatility Agglomerations.
2 The tracking error.
The goal of the portfolio manager

Beat the market, assuming less risk than the market.
Tracking Error
In the Bonds Market, the risk is measured using the tracking error: which
is the standard deviation of the return of the portfolio relative to the
return of the benchmark index.
active returnt = portfolio returnt benchmark returnt
tracking error = SD(active return)
The problem with the tracking error is that is an ex-post risk

measure. The manager this an ex-ante measure to predict future risk.
For this is usually common to estimate VaR or CVaR of the active
returns.
A tracking error close to zero indicates passive investment strategies.
Cell-Based Approach to bond portfolio construction
The Benchmark is divided into cells, each sell represents a di↵erent

characteristic of the benchmark.
Duration.
Coupon.
Maturity.
Market sector.
Credit quality.
Call Factors.
Active trading
Active trading is taking own decisions in how invest.

Active traders are most of the time riskier than passive traders.
To move way form the benchmark, managers must have a view.
Views can be obtained by two ways:
Creating expectations about the future behavior of the di↵erent sectors
of the national and foreign economy that are transferred to the prices
of the bonds.
Insider Trading
Multi-Factor model for Portfolio Construction
Multi-factor model uses statistical methods to estimate a securities

expected return.
The drivers of the returns are called risk factors.
Risk Factors Tracking Error

Yield curve risk 3.9
Swap Spread risk 2.6
Volatility Risk 1.3
Goverment spread risk 0.8
Corporate spread risk 2.8
Securitized spread risk 2.5
Immunization strategy
”The investment of the assets in such a way that the existing business
is immune to a general change in the rate of interest” F.M
Reddington, 1952.
The reinvestment risk associated with the coupons payment.
If the interest rate changes, the Target accumulated value will
changes to.
Immunizes implies that the manager should look for a coupon bond
so that however the market yield changes, the change in the interest
on interest will be o↵set by the change in the price.
The KEY to immunization
To immunize a portfolios target accumulated value, a manager must

construct a bond portfolio such that:
1 The duration of the portfolio is equal to the duration of the liability.

2 The present value of the cash flow from the portfolio equals to the
present value of the future liability.
The Manager should rebalance the portfolio each 6 months to ensure that
the portfolios duration be equal to the liability duration.
transaction cost vs achieve the accumulated value
Immunization Risk
Immunization Risk
CF1 (1 H)2 CF2 (2 H)2 CFn (n H)2

ir = + 2
+ ... +
1 y (1 y ) (1 y )n
CF cash flow of the portfolio at period t.

H length (years) of the liability.
y yield for the porfolio.
n time to receipt the last cash flow
Fong, H. G., Vasicek, O. (1983). The trade o↵ between return and risk in
immunized portfolios. Financial analysts journal, 73-78. https:
//www.jstor.org/stable/4478684?seq=1#page_scan_tab_contents
Properties of Duration, implications in Bond Portfolio
1 Duration for coupon bonds are less than the maturity. For zero
coupon are equal to the maturity.
2 The lower the coupon the greater the duration.
3 The longer the maturity the greater the price volatility.
4 The higher the yield the lower the price volatility.

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Fixed Income Securities

Daniel Velasquez, Ph.D (c)

January 27, 2020

1 Elementos básicos de los mercados de deuda.

1 Activity 10%. February 21.

Equity - COP 123 mn 2.87%

Colombian market overview: BVC beamer presentation.

Annual interest rate

Future Value of an Ordinary Annuity

Present Value of a Series of Future Values

Present Value of an Ordinary Annuity

The price of any financial instrument is the present value of its

+ Present value of coupon payments

coupon rate < yield $ price < par value

Par Value Bond:

coupon rate = yield $ price = par value

coupon rate > yield $ price > par value

Reasons for the change in the price of a bond

When an investor purchase a bond whose next coupon payment is due in

In floating rate bonds cash flow is not known.

couponfloating % = reference rate% + spread%

Consider a 10 years 7.5% semi annual coupon Bond. The collateral

floater coupon = reference rate + 1%

inverse floater coupon = 14% reference rate

x = ↵(x + spread) + (1 ↵)(y x)

The floater price is:

inverse price = collateral price + floater price

Interest rate Risk

CF1 CF2 CF3 CFn

Suppose a 5 years bond with par value of $1000 and coupon of 8%

e↵ective annual yield = (1 + periodic interest rate)m 1

periodic interest rate = (1 + e↵ective annual yield)1/m 1

1 Suppose a periodic interest rate of 4% and the frequency of payment

Find the yield of each bond.

The coupon of a floater changes periodically based on the fixed rate

1 Determinate the cash flows assuming a constant interest rate.

1 The periodic coupon

Consider a 15 years, 7% coupon bond, with $1000 par value selling at

Reinvest the cash flows at a lower rate than the yield.

Yield to maturity is a promised yield if this 2 conditions are held:

Base rates are the becnhmark rates.

yield spread = yield on bond A yield on bond B

yield spread is expressed in basis points.

the yield spread reflects the risk associated in invest on a bond,

1 The type of issuer.

Determinate the par value rates

With the par coupon rates of 0.5, 1, 2, 5, 7 and 10 years, construct

(1 + r2 )T2 = (1 + r1 )T1 (1 + rf )T2 T1

Positively slope (Normal).

Pure Expectations theory.

1 Expectations theory: The behavior of short term forward rates are

Two or more parties exchange interest payments on specified dates.

There is a Term Structure of Interest Rates that is approximated

1 Primary Market (Treasury).

Bid 1 for $1.00 billion at 5.115%

Treasury Bill values are quoted on a Bank Discount Basis:

The Bond Equivalent Yield = Money Market Equivalent Yield is a measure

Because of the demand for zero-coupon bonds, the private sector

Corporate Debt Instruments

In the case of a liquidation or reorganization, the order to pay the

1 Senior secured debt: Is backed by a collateral (properties).

Some firms do their own credit analysis.

Original high yield bonds.