Level I Volume 5 2019 IFT Notes

2019 CFA® Exam Prep
IFT Study Notes
Volume 5
Fixed Income
Derivatives
Alternative Investments
This document should be read in conjunction with the corresponding readings in the 2019 Level I
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2018, CFA Institute. Reproduced and republished with permission from CFA Institute.
All rights reserved.
Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality
of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial
Analyst® are trademarks owned by CFA Institute.
Visit: www.ift.world
© IFT. All rights reserved

Copyright © 2018 IFT.
All rights reserved. This book or any portion thereof may not be reproduced or used in any manner
whatsoever without the express written permission of the publisher except for the use of brief
quotations in a book review.
Published in 2018 by IFT
Errata information can be found at: https://ift.world/errata
ISBN: 978-969-23321-0-1
© IFT. All rights reserved

Volume 5 2019 Level I Notes
Table of Contents
R50 Fixed Income Securities - Defining Elements .............................................................................4

1. Introduction ................................................................................................................................................. 4
2. Overview of a Fixed Income Security ................................................................................................. 4
3. Legal, Regulatory, and Tax Considerations ...................................................................................... 7
4. Structure of a Bond’s Cash Flows ....................................................................................................... 12
5. Bonds with Contingency Provisions ................................................................................................. 15
Summary .............................................................................................................................................................. 19
Practice Questions ............................................................................................................................................ 23
R51 Fixed Income Markets - Issuance Trading and Funding ................................................... 26

1. Introduction ............................................................................................................................................... 26
2. Overview of Global Fixed-Income Markets .................................................................................... 26
3. Primary and Secondary Bond Markets ............................................................................................ 28
4. Sovereign Bonds ....................................................................................................................................... 31
5. Non-Sovereign Government, Quasi-Government, and Supranational Bonds ................... 31
6. Corporate Debt .......................................................................................................................................... 32
7. Structured Financial Instruments ...................................................................................................... 36
8. Short-Term Funding Alternatives Available to Banks ............................................................... 37
Summary .............................................................................................................................................................. 41
R52 Introduction to Fixed Income Valuation ................................................................................... 47

1. Introduction ............................................................................................................................................... 47
2. Bond Prices and the Time Value of Money ..................................................................................... 47
3. Prices and Yields: Conventions for Quotes and Calculations .................................................. 53
4. The Maturity Structure of Interest Rates ........................................................................................ 68
5. Yield Spreads.............................................................................................................................................. 70
Summary .............................................................................................................................................................. 72
R53 Introduction to Asset Backed Securities ................................................................................... 81

1. Introduction ............................................................................................................................................... 81
2. Benefits of Securitization for Economies and Financial Markets .......................................... 81
© IFT. All rights reserved 1

3. How Securitization Works .................................................................................................................... 82

4. Residential Mortgage Loans ................................................................................................................. 86
5. Residential Mortgage-Backed Securities......................................................................................... 89
6. Commercial Mortgage-Backed Securities ....................................................................................... 96
7. Non-Mortgage Asset-Backed Securities .......................................................................................... 98
8. Collateralized Debt Obligations ....................................................................................................... 100
Summary ........................................................................................................................................................... 103
Practice Questions ......................................................................................................................................... 108
R54 Understanding Fixed-Income Risk and Return................................................................... 111

1. Introduction ............................................................................................................................................ 111
2. Sources of Return .................................................................................................................................. 111
3. Interest Rate Risk on Fixed-Rate Bonds ....................................................................................... 119
4. Interest Rate Risk and the Investment Horizon ........................................................................ 136
5. Credit and Liquidity Risk .................................................................................................................... 138
Summary ........................................................................................................................................................... 140
R55 Fundamentals of Credit Analysis ................................................................................................ 148

1. Introduction ............................................................................................................................................ 148
2. Credit Risk ................................................................................................................................................ 148
3. Capital Structure, Seniority Ranking and Recovery Rates .................................................... 149
4. Rating Agencies, Credit Rating and Their Role in Debt Markets ......................................... 151
5. Traditional Credit Analysis: Corporate Debt Securities ......................................................... 154
6. Credit Risk vs. Return: Yields and Spreads.................................................................................. 158
7. Special Considerations of HY, Sovereign, and Non-Sovereign Credit Analysis ............. 160
Summary ........................................................................................................................................................... 165
R56 Derivative Markets and Instruments ....................................................................................... 172

1. Introduction ............................................................................................................................................ 172
2. Derivatives: Definitions and Uses ................................................................................................... 172
3. The Structure of Derivatives Market ............................................................................................. 173
4. Types of Derivatives ............................................................................................................................. 175
5. The Purposes and Benefits of Derivatives ................................................................................... 182

6. Criticisms and Misuses of Derivatives........................................................................................... 184

7. Elementary Principles of Derivative Pricing............................................................................... 184
Summary ........................................................................................................................................................... 186
R57 Basics of Derivative Pricing and Valuation ........................................................................... 191

1. Introduction ............................................................................................................................................ 191
2. Fundamental Concepts of Derivative Pricing ............................................................................. 191
3. Pricing and Valuation of Forward Commitments ..................................................................... 196
4. Pricing and Valuation of Options..................................................................................................... 203
Summary ........................................................................................................................................................... 214
R58 Introduction to Alternative Investments ............................................................................... 222

1. Introduction ............................................................................................................................................ 222
2. Alternative Investments ..................................................................................................................... 222
3. Hedge Funds ............................................................................................................................................ 224
4. Private Equity ......................................................................................................................................... 232
5. Real Estate................................................................................................................................................ 236
6. Commodities ........................................................................................................................................... 240
7. Infrastructure ......................................................................................................................................... 242
8. Other Alternative Investments......................................................................................................... 244
9. Risk Management Overview ............................................................................................................. 244
Summary ........................................................................................................................................................... 246

R50 Fixed Income Securities - Defining Elements 2019 Level I Notes
R50 Fixed-Income Securities: Defining Elements

1. Introduction
There are two ways for an entity to raise capital: issuing equity and issuing fixed-income
securities. Fixed-income is a commonly used method for governments and companies to
borrow money from investors. Fixed-income securities differ from equities in several ways:
• A fixed-income investor has no ownership rights in the business.
• The money borrowed (principal) is repaid at maturity. In addition, interest on the
borrowed money is paid periodically.
• Fixed income investors get paid before the common shareowners; hence the risk is
lower.
Note that fixed-income security, bond, and debt are used interchangeably throughout this
reading.
2. Overview of a Fixed-Income Security
Three important elements that an investor should know when investing in fixed-income
securities are:
1. A bond’s features.
2. Legal, regulatory, and tax considerations.
3. Contingency provisions.
2.1. Basic Features of a Bond
The basic features of a fixed-income security include:
Issuer:
Issuer is the entity that has issued the bond, or the one who has borrowed money. It is
responsible for servicing the debt (paying interest and principal payments). Bonds can be
classified into the following categories based on the type of the issuer:
• Supranational organizations: Bonds issued by international organizations such as the
World Bank and IMF.
• Sovereign governments: Debt of national governments such as government of the
United States, Germany, or Italy.
• Non-sovereign governments: Bonds that are not issued by a national or central
government. Instead, these are issued by states, provinces, municipalities, etc. For
example, municipal bonds in the United States, etc.
• Quasi-government entities: Bonds issued by agencies that are financed either directly
or indirectly by the government. They are also called sub-sovereign or agency bonds.
For example, Ginnie Mae, Fannie Mae, and Freddie Mac in United States.
• Companies: Bonds issued by a corporate.
All bonds are exposed to credit risk. Credit risk is the risk that interest and principal

payments will not be made by the issuer as they come due. Credit rating agencies such as
Moody’s and S&P assign a rating to issuers based on this risk.
Bonds can be classified into two categories based on their creditworthiness:
• Investment grade.
• Non-investment grade, or high-yield or speculative bonds.
Maturity:
The maturity date is the date on which the last payment is made for a bond. Once a bond has
been issued, the time remaining until maturity is known as the tenor of the bond.
• If original maturity is one year or less, the bond is called money market security.
• If original maturity is more than a year, the bond is called capital market security.
Par value:
Also known as face value, maturity value, or redemption value.
• It is the principal amount that is repaid to bondholders at maturity.
• If market price > par value, the bond is trading at a premium.
• If market price < par value, the bond is trading at a discount.
• If market price = par value, the bond is trading at par.
Coupon rate and frequency
Coupon rate is the percentage of par value that the issuer agrees to pay to the bondholder
annually as interest. It can be a fixed rate or a floating rate. The coupon frequency may be
annual, semi-annual, quarterly, or monthly. Based on the frequency of coupon payments, we
can classify bonds into the following:
• Plain vanilla bond: It is the most basic type of bond with periodic fixed interest
payments during the bond’s life and the principal paid on maturity.
• Floating-rate bond or floating-rate notes or floaters: Unlike vanilla bonds, the interest
rate of a floating-rate bond is not fixed. The coupon payments are based on a floating
rate of interest like Libor (London Interbank Offered Rate) at the start of the period.
Some bonds specify the coupon rate as two components: a reference rate, such as
Libor, plus a spread. The coupon rate and coupon interest paid in every period
changes as the reference rate changes.
• Zero-coupon bonds or pure discount bonds: Bonds that have only one payment at
maturity. These are bonds that do not make a coupon payment over a bond’s life, and
are sold at a discount (less than the par value) at issuance. At maturity, the investor
receives the par value of the bond. Think of it as interest getting accumulated during
the bond’s life and being paid at maturity for a zero-coupon bond.
Currency denomination
• Bonds can be issued in any currency.
• Dual currency bonds pay interest in one currency and principal in another currency.

• Currency option bonds give the bondholders the option to choose between two
currencies they would like to receive their payments in.
Example
Test your understanding of the concepts discussed so far by answering the following
questions.
1. What is a sovereign bond?
2. What is credit risk?
3. In what time-frame does a money market security mature?
4. If a bond’s price is lower than its par value, it is called a _____ bond.
5. What is the periodic interest payment for a bond that has a par value of $1000 and a
coupon rate of 6%? The coupon payments are made semi-annually.
6. The coupon rate of a floating-rate note that makes payments in June and December is
expressed as six-month Libor + 50 bps. Assuming that the six-month Libor is 2.00% at
the end of June 2016 and 2.50% at the end of December 2016. What is the interest rate
that applies to the payment due in December 2016?
7. Which type of bond allows bondholders to choose the currency in which they receive
each interest payment and principal repayment?
Solution:
1. A bond issued by a central government such as the U.S. or German government is a
sovereign bond. A bond issued by the World Bank or by a province is not considered a
sovereign bond.
2. Credit risk is the risk of loss when an issuer fails to make full and timely payment of
interest and principal.
3. Less than one year. Capital market securities have maturity greater than one year.
4. Discount.
5. Annual coupon payment is 0.06 x 1000 = $60. The coupon payments are made semi-
annually, so $30 paid twice a year. You can calculate it as (0.06/2) x 1000 = $30.
6. The interest rate that applies to the payment due in December 2016 is the six-month
Libor at the end of June 2016 plus 50 bps. Thus, it is 2.50% (2.00% + 0.50%).
7. Currency option bond.
2.2. Yield Measures
There are two widely used yield measures to describe a bond: current yield and yield to
maturity.

Current yield or Running yield

Current yield is the annual coupon divided by the bond’s price and is expressed as a
percentage. For example, consider a three-year, annual coupon bond with a par value of
$100. The bond is issued at $95. The coupon rate is 10%, so the coupon payments are $10
10
every year. Current yield = 95 = 10.5%
Yield to Maturity (YTM)

Yield to maturity is the internal rate of return on a bond’s expected cash flows. In other
words, it is the expected annual rate of return an investor will earn if the bond is held to
maturity. It is also known as yield to redemption or redemption yield. The IRR can be
calculated easily using the financial calculator. Let us consider the same bond as in the
current yield example:
Input these values: CF0 = -95; CF1 = 10; CF2 = 10; CF3 = 110. Computing for IRR, you should
get 12.08%. As you can see, YTM is higher than the coupon rate. For a discount bond such as
this one, the YTM is higher than the coupon rate. A bond’s price is inversely related to its
yield to maturity.
3. Legal, Regulatory, and Tax Considerations
A bond is a contractual agreement between the issuer and the bondholders. In this section,
we will discuss the following:
1. Bond indenture (trust deed).
2. Legal and regulatory considerations.
3. Tax considerations.
3.1. Bond Indenture
Given below are a few terms related to bonds which we should remember:
Trust deed or bond indenture: A written legal agreement between the bond issuer and the
investor. The indenture has the following information:
• The name of the issuer.
• All the terms of a bond issue such as the type of bond.
• Its features such as the principal value, coupon rate, dates when interest payments
will be made, and maturity date.
• Issuer’s obligations.
• Bondholders’ rights.
• If the bonds are secured or not.
• Covenants.

• Contingency provisions like call option.

Collateral: Are assets or financial guarantees offered by the issuer for the underlying debt
issue. This is in addition to the promise to pay interest and principal. It is like a security for
the investors if the bond issuer (or borrower) fails to make payments.
Credit enhancement: Provision used by a company to improve its creditworthiness or
reduce the credit risk of a bond issue.
Covenant: Clauses that state what an issuer can and cannot do; includes restrictions
imposed on the issuer such as raising more capital to protect the bondholders. Specifies the
rights of bondholders.
Assume a company such as General Electric announces a $1 billion bond issue. Millions of
investors will invest in the issue. It is practically impossible for the company to enter into a
legal contract with each one of them, so it entrusts the fiduciary responsibility of the issue to
an intermediary called the trustee. The trustee is appointed by the issuer.
The trustee is a financial institution, like the trust department of a bank. The trustee holds
the indenture. Its duties are primarily administrative in nature like invoicing the issuer for
interest and principal payments, holding funds until they are paid, calling meetings of
bondholders, ensuring the issuer adheres to the terms stated in the indenture, etc. If the
issuer defaults, the role of the trustee becomes significant.
In addition to a bond’s features, an investor must review the following aspects (especially his
rights in case of a default):
• Legal identity of the bond issuer and its legal form.
• Source of payment proceeds.
• Asset or collateral backing.
• Credit enhancements.
• Covenants.
Legal Identity of the Bond Issuer and its Legal Form
The bond issuer has the legal obligation to pay the interest and principal. The issuer is
identified in the indenture by its legal name. Investors must understand who is issuing the
bond.
• For a sovereign bond, it is the entity responsible for managing the national budget
such as HM Treasury in the United Kingdom.
• For a corporate bond, it is the corporate legal entity such as Wal-Mart Stores Inc.,
Volkswagen AG, etc.

• Some companies are structured in a way that there is a holding company at the top,
under which there are many operating/group companies. Bonds may be issued by the
holding company, a parent company, or a subsidiary. It is important to evaluate the
credit risk of the company for which bond is being issued rather than the issuer.
• In case of securitized bonds, the sponsor has the legal obligation to pay the
bondholders. Sponsor is the financial institution in charge of the securitization
process.
Source of Repayment Proceeds
Investors need to know how the issuer intends to make interest payments and repay the
principal. The bond indenture specifies the source of revenue or how the issuer intends to
make interest and principal payments. We look at the repayment sources for each category
now.
• For supranational bonds: From repayment of previous loans or paid-in capital from
its members. For example, the World Bank may have given a loan to a particular
country. When the country pays back the loan, this money is used to pay the
bondholders. Paid-in capital is the amount contributed by member nations.
• For sovereign bonds: Tax revenues and printing new money. The government may
also increase taxes to service debt.
• Three sources for non-sovereign government debt issues: the taxing authority of the
issuer, cash flows of the project, special taxes or fees.
• For corporate bonds: Cash flow generated by the company’s primary operations. The
higher the credit risk, the higher the yield.
• For securitized bonds: Cash flows generated by the underlying assets such as
mortgages, credit card receivables, auto loans, etc. Securitized bonds are amortized,
i.e., the principal is paid back gradually over the bond’s life rather than in one
payment at maturity.
Asset or Collateral Backing
Collateral reduces credit risk.
• Secured vs. unsecured bonds: In a secured bond, assets are pledged as collateral to
ensure debt repayment in the case of a default. Unsecured bonds have no collateral.
• Seniority ranking: What this means is that if a company faces bankruptcy and its
assets are liquidated, the investors (or bondholders) are repaid based on seniority.
• Debentures: It is a type of bond that may be secured or unsecured. In most countries,
debentures refer to unsecured bonds. However, in some countries like the United
Kingdom and India, they are backed by collateral.
Bonds can be classified into the following based on the type of collateral backing:
• Collateral trust bonds: Bonds that are secured by a financial asset such as stocks and
other bonds. They are deposited by the issuer and held by the trustee.

• Equipment trust certificates: Bonds secured by physical assets or equipment such as

railroad cars, aircraft, or oil rigs.
• Mortgage-backed securities: They are backed by a pool of mortgages. The interest and
principal payments from the mortgages are used to pay the bond-holders. We will see
this in detail in the subsequent readings.
• Covered bond: Debt securities that are backed by a “cover pool” of assets such as
mortgage loans or public sector loans. In some ways they are similar to securitized
bonds such as MBS, but they offer a greater degree of protection.
Credit Enhancements (if any)
Credit enhancements are provisions used to reduce the credit risk of a bond issue using
additional collateral, insurance, or third-party guarantee. These are usually used for
securitized bonds. When credit risk is reduced, it increases the issue’s credit quality and
decreases the interest rate of the bond. There are two types of credit enhancements: internal
and external.
Internal credit enhancements: No external instrument is used in this case to increase the
credit quality.
• Senior/junior: In this structure, debt is segregated into different tranches with
different priority based on seniority. The cash flows generated from the assets are
allotted to these different tranches accordingly with the senior tranche getting paid
before the junior tranches. The subordinate or junior tranches offer credit protection
to the senior tranches.
• Overcollateralization: The process of posting more collateral than is required, to
obtain financing. The value of the asset pledged as collateral exceeds the value of the
loan.
• Excess spread: It is the difference between the interest rate received on the underlying
asset, and coupon rate paid to investors. The excess amount is deposited into a
reserve account which is used to absorb losses on assets. It is also called excess
interest cash flow.
External credit enhancements: Relies on a third party called a guarantor, to provide a
guarantee.
• Surety bonds/bank guarantees: A bond that guarantees to pay the investor if the
issuer defaults. It is similar to a bank guarantee but issued by an insurance company.
• Letter of credit: It is a document or a letter from a financial institution, typically a
bank. It guarantees the payment of interest and principal to investors if the issuer is
unable to pay.
Covenants (if any)
Note: This section is important and explicitly stated as a learning objective.
Bond covenants are legally enforceable rules that borrowers and lenders agree on at the

time of a new bond issue. Covenants can be affirmative (positive) or negative (restrictive).
Affirmative covenants indicate what the issuer must do. These are generally administrative
in nature. They do not impose additional costs on the issuer. For example, the issuer must:
• Make interest and principal payments on time.
• Comply with all laws and regulations.
• Maintain current lines of business.
• Insure and maintain assets.
• Pay taxes on time.
Negative covenants indicate what the issuer must not do. These are frequently costlier and
materially constrain the issuer’s potential business decisions. Examples include:
• Restrictions on debt: Limits on maximum acceptable leverage ratios and minimum
acceptable interest coverage ratios.
• Negative pledges: No additional debt can be issued that is senior to existing debt.
• Restrictions on prior claims: The issuer cannot collateralize assets that were
previously collateralized. The objective is to protect unsecured bondholders.
• Restrictions on distribution to shareholders: Restrictions on how much money can be
spent on dividends and buy-backs.
• Restrictions on asset disposals: A limit on the total amount of assets that can be
disposed during a bond’s life. The objective is to ensure the company does not
breakup.
• Restrictions on investments: This ensures no investment is made in a speculative
business and that the capital is invested in a going-concern business.
• Restrictions on mergers and acquisitions.
3.2. Legal and Regulatory Considerations
Fixed-income securities are subject to different legal and regulatory requirements
depending on where they are issued and traded. National bond market is the bond market in
a particular country.
• Domestic bonds: These are bonds that are issued and traded in a country, and
denominated in the currency of that country. Bonds in domestic currency issued by a
company incorporated in that country are called domestic bonds. For example, bonds
denominated in Yen, issued by Toyota to be traded in Japan.
• Foreign bonds: These are bonds issued by a foreign company but traded in the
domestic market. For example, bonds denominated in U.S. dollars issued by the
Australian Rio Tinto Group.
Eurobonds are issued internationally, outside the jurisdiction of any single country and are
denoted in currency other than that of the countries in which they trade. They are subject to
less regulation than domestic bonds.

Bearer Bonds versus Registered Bonds

In the case of bearer bonds, the trustee does not maintain a record of who owns the bonds.
That information is recorded in the clearing system. Investors prefer bearer bonds for tax
reasons. In the case of registered bonds, records of who owns the bond are maintained using
a name or serial number. Bonds in the national market tend to be registered bonds, while
international bonds are usually bearer bonds.
Global Bonds
Bonds that are issued simultaneously in multiple markets, such as the Eurobond market and
in at least one domestic bond market. This ensures sufficient demand for the issue
irrespective of the investors’ location.
3.3. Tax Considerations
There are two sources of return from a bond: income from coupon payments and capital
gain. The way these two components are treated for tax purposes is different.
• The income portion of a bond investment is generally taxed at the ordinary income
tax rate. For example, if you fall under the 30% income tax category, then the coupon
income will be taxed at this rate.
• Assume you buy a bond for $900 and later sell it for $1,000. This $100 is considered
capital gain. Tax on capital gain may be different for long-term and short-term
investments. Short-term is usually less than one year while more than one year is
considered long-term. Often, the tax rate for long-term capital gains is lower than that
for short-term capital gains.
• In some countries, a pro-rated portion of discount may be included in interest
income. For example, assume you buy a 3-year zero-coupon bond, with a par value of
$1,000, at $900. The gain of $100 is over three years. Now, the taxing authority in
some countries such as the U.S. may decide to tax this $100 gain on a pro-rata basis
over three years instead of taxing it all at once at the end of three years.
4. Structure of a Bond’s Cash Flows
Not all bonds are structured to make periodic interest payments and one lump-sum
principal payment at the end. In this section we will look at the different ways in which
principal and interest can be paid over the bond’s life.
4.1. Principal Repayment Structures
Bullet bond: The principal is paid all at once at maturity. Such a type of bond is called a
bullet bond.

Bullet Bond: Payment Structure for a 5-year, $1000 Bond with 6% Coupon Paid
Annually
Year Cash flow in $ Interest Principal Outstanding
Payment Repayment principal
(in $) (in $) (in $)
0 -1,000 1,000
1 60 60 0 1,000
2 60 60 0 1,000
3 60 60 0 1,000
4 60 60 0 1,000
5 1000 + 60 = 1060 60 1,000 0
Key points to be noted for a bullet bond (based on the table above):
• No part of the principal is paid before maturity. The $1,000 amount towards principal
is paid all at once at maturity.
• During the life of the bond, the principal remains outstanding.
• The last payment includes both the coupon payment of $60 and principal payment of
$1,000.
Fully amortized: A fully amortized bond is one in which the principal is paid little by little in
equal payments over the bond’s life, so that it is repaid in full by the maturity date. The
periodic payments made by the issuer consist of interest and a part of principal as shown for
a sample bond in the table below.
Fully Amortized Bond: Payment Structure for a 5-year, $1,000 Bond with 6%
Coupon Paid Annually, market interest rate = 6%
Year Investor cash Interest Principal Outstanding
flows in $ Payment Repayment principal
a=b+c (in $) (in $) (in $)
b c Pt-1-c
0 -1,000 1,000
1 237.40 60 177.4 822.6
2 237.40 49.36 188.04 634.56
3 237.40 38.07 199.32 435.24
4 237.40 26.11 211.28 223.96
5 237.40 13.44 223.96 0
Partially amortized: A partially amortized bond is one in which only a part of the principal
is repaid over the bond’s life. The remaining big part of the principal is paid at maturity
making it a balloon payment. This is a hybrid between the bullet and the fully-amortized
bond. The table below shows a sample bond.

Partially Amortized Bond: Payment Structure for a 5-year, $1,000 Bond with 6%
Coupon Paid Annually
Year Investor cash Interest Principal Outstanding
flows Payment Repayment principal
(Coupon) (in $) (in $) (in $)
in $
0 -1,000 1,000
1 201.92 60 141.92 858.08
2 201.92 51.48 150.43 707.65
3 201.92 42.46 159.46 548.19
4 201.92 32.89 169.03 379.17
5 401.92 22.75 379.17 0
Sinking Fund Arrangements
Sinking fund arrangement: This allows for full or partial amortization of a bond prior to its
maturity. It specifies the portion of the bond’s principal outstanding that must be repaid
each year throughout the bond’s life.
Three sinking fund arrangements:
• Standard: Issuer sends the repayment principal amount to the trustee. The trustee
then either redeems bonds to this value or decides which bonds to retire through a
lottery.
• Accelerated: Issuer retires more than the specified portion of the bond’s notional
principal. The amount redeemed steadily increases each year. If there is any
remaining principal, it is redeemed at maturity.
• Call provision: Bonds with call provision give the issuer the right to call (repurchase)
the bond before maturity. Callable bonds usually have higher yields as investors bear
the risk that they may be called. It is beneficial to the issuer and disadvantageous to
the bondholder. The bonds to be retired are selected randomly.
A sinking fund arrangement results in
• Lower credit risk: The objective of a sinking fund provision is to reduce credit risk for
investors because the issuer does not have to pay a large payment at maturity. From
an investor’s perspective, there is less credit risk as the principal is being paid over
the bond’s term.
• Higher reinvestment risk: Receiving principal payments before maturity also means
the investor has to bear reinvestment risk, i.e., if the money received cannot be
invested at the same or higher expected return. In a declining interest rate
environment, there is a risk of investing the proceeds at a lower rate.

4.2. Coupon Payment Structures

Fixed periodic coupons
• This is the most basic form of coupon payment. A fixed interest is paid either semi-
annually or annually.
Floating-rate notes (FRN)
• A bond whose coupon is set based on some reference rate plus a spread.
• FRNs can have floors (minimum interest rate), caps (maximum interest rate), or
collars (both a minimum and maximum rate).
• An inverse FRN is a bond whose coupon has a negative relationship with the
reference rate.
Other coupon structures
• Step-up coupons: Coupons increase by specified amounts on specified dates.
• Bonds with credit-linked coupons: Coupons change when the issuer’s credit rating
changes.
• Bonds with payment-in-kind coupons: Issuer can pay coupons with additional
amounts of the bond issue instead of cash.
• Bonds with deferred coupons: No coupons paid in the initial years but higher coupons
paid later.
• Index-linked bonds: Coupon payments and/or principal repayments are linked to a
price index.
5. Bonds with Contingency Provisions
A contingency provision is a clause in a legal document that allows for some action if the
event or circumstance does occur. It is also called an embedded option.
5.1. Callable Bonds
A callable bond gives the issuer the right to redeem all or part of the bond before the
specified maturity date. Investors face reinvestment risk with callable bonds, as it is not
possible to reinvest the proceeds at the previous higher interest rates. To compensate this
risk to an extent, issuers offer a higher yield and sell at a lower price than the respective non-
callable bonds.
Why companies issue callable bonds?
• To protect the issuer when market interest rates drop.
• Interest rates drop when market interest rates fall or the credit quality of the issuer
improves. The issuer has an opportunity to call the old bonds and replace them with
new cheaper bonds by saving on otherwise higher interest expenses.
• Companies also issue callable bonds to signal the market about their credit quality.
The following details about a callable bond are included in the indenture:

• Call price: Price paid by the issuer to the bondholder when the bond is called.
• Call premium: The amount paid on top of the face value as compensation to
bondholders as they will have to reinvest proceeds at a lower rate.
• Call schedule: The dates and prices at which the bond may be called.
• Call protection period: It is also known as the lockout period, deferment, or cushion
period. During this period, a bond may not be called by the issuer. It is typically in the
early days of a bond’s life to encourage investors to invest in the issue.
• Call date: The earliest date at which a bond may be called.
The three types of callable bonds based on exercise styles are listed below:
• American call: The issuer has the right to call the bond any time after the first call
date.
• European call: The issuer has the right to call the bond only once after the first call
date.
• Bermuda-style call: The issuer has the right to call the bond on specific dates after the
call protection period.
Example
Assume a hypothetical 20-year bond is issued on 1 December 2012 at a price of 97.315 (as a
percentage of par). Each bond has a par value of $100. The bond is callable in whole or in
part every 1 December from 2017 at the option of the issuer. The callable prices are shown
below.
Year Call Price Year Call Price
2017 103.78 2023 101.47
2018 103.54 2024 101.21
2019 103.10 2025 100.68
2020 102.81 2026 100.32
2021 102.23 2026 and thereafter 100.00
2022 101.59
1. What is the call protection period?
2. What is the call premium (per bond) in 2021?
3. What type of a callable bond is it most likely?
Solution:
1. The bonds were issued in 2012 and are first callable in 2017. The call protection period
is 2017 – 2012 = 5 years.
2. The call prices are stated as a percentage of par. The call price in 2021 is $102.23
(102.23% × $100). The call premium is the amount paid above par by the issuer. The call
premium in 2021 is $2.23 ($102.23 - $100).
3. It is a Bermuda call. The bond is callable every 1 December from 2017 – that is, on

specified dates following the call protection period. Thus, the embedded option is a
Bermuda call.
5.2. Putable Bonds
A putable bond gives the bondholder the right to sell the bond back to the issuer at a pre-
determined price on specified dates. Putable bonds offer a lower yield and sell at a higher
price relative to otherwise non-putable bonds. Putable bonds are beneficial to the
bondholder because:
• When interest rates rise, bond prices fall. If the selling price is pre-specified,
bondholders may put (sell) back the bond to the issuer at that price, which is higher
than the market price when interest rates rise.
• Cash can be reinvested at higher rates.
The following details about a putable bond are included in the indenture:
• Redemption dates.
• Selling price; usually equal to the face value of the bond.
• How many times the issuer allows bondholders to sell the bond during the bond’s life.
• One-time put: Gives bondholders a single sellback opportunity.
• Multiple put: More than one sellback opportunity available. Priced higher than one-
time put bonds.
Like callable bonds, putable bonds are also classified into three, based on their exercise
styles:
• American put: Bondholder has the right to sell the bond back to the issuer any time
after the first put date.
• European put: Bondholder has the right sell the bond back to the issuer only once on
the put date.
• Bermuda-style put: Bondholder has the right sell the bond back to the issuer only on
specified dates.
5.3. Convertible Bonds
A convertible bond is a hybrid security with both debt and equity features. It gives the
bondholder the right to exchange the bond for a specified number of common shares in the
issuing company.
Advantages of Convertible Bonds
From investor’s perspective From issuer’s perspective
Opportunity to convert into equity if share Reduced interest expense; lower yield
prices are increasing and participate in than otherwise non-convertible bond
upside. because of the conversion provision given
to bondholders.

Downside protection if shares prices are Elimination of debt if conversion option is

falling. exercised. So they do not have to repay the
debt.
Convertible bonds are usually callable.
Some terms associated with the conversion provision are given below:
• Conversion price: Price per share at which the convertible bond can be converted into
shares.
• Conversion ratio: Number of shares that each bond can be converted into.
Par value
Conversion ratio = Conversion price
• Conversion value: Current share price multiplied by the conversion ratio. It is also
called the parity value.
Conversion value = current share price * conversion ratio
• Conversion premium: Difference between the convertible bond’s price and its
conversion value.
Conversion premium = convertible bond’s price – conversion value
Warrant: A warrant is an attached option, not an embedded option. It gives the bondholder
the right to buy the underlying common shares at a fixed price called the exercise price any
time before the expiration date.
Contingent Convertible (CoCo) Bonds: These are bonds with contingent write-down
provisions. The bonds can be converted into equity contingent to a specific condition. For
example, a CoCo bond might be allowed to be converted into equity only after it reaches a
certain price.
Example
Assume that a convertible bond issued in the United Kingdom has a par value of £1,000 and
is currently priced at £1,200. The underlying share price is £56 and the conversion ratio is
25:1. What is the conversion condition for this bond?
Solution:
The conversion value of the bond is £56 × 25 = £1,400. The price of the convertible bond is
£1,200. Thus, the conversion value of the bond is more than the bond’s price, and this
condition is referred to as above parity.

Summary
LO.a: Describe the basic features of a fixed-income security.
The basic features of a fixed-income security include the specification of:
• Issuer: It is the entity that has issued the bond. The types of issuers include
supranational organizations, sovereign governments, non-sovereign governments,
quasi-government entities, and companies.
• Maturity: It is the date on which the last payment is made for a bond. Based on
maturity, bonds can be classified into money market security, capital market security,
and perpetual bonds.
• Par value: It is the amount an issuer agrees to pay the investor or bondholder on
maturity date. A bond is premium if sold above par, discount if sold below par, and at
par if sold at face value.
• Coupon rate and frequency: Coupon rate is the interest rate paid on a bond every year
by the issuer until its maturity date. Bonds that have only one payment at maturity
are called zero-coupon bonds.
• Currency denomination: A bond can be issued in any currency: the local currency, or
in a widely traded one like the yen, euro, or U.S. dollar. Bonds that pay coupon in one
currency and principal in another currency are called dual currency bonds.
LO.b: Describe functions of a bond indenture.
Bond indenture is a legal agreement between the bond issuer and the investor. It includes all
the terms of a bond issue such as the type of bond, its features such as principal value and
coupon rate, and maturity date. It also includes the dollar amount of issue, issuer’s
obligations, bondholders’ rights, when the coupon payments will be made, if the bonds are
secured or not, covenants, and contingency provisions.
LO.c: Compare affirmative and negative covenants and identify examples of each.
Bond covenants are legally enforceable rules that borrowers and lenders agree on at the
time of a new bond issue. Covenants can be affirmative (positive) or negative (restrictive).
Affirmative covenants indicate what the issuer must do. These are generally administrative
in nature. For example issuer must make interest and principal payments on time, comply
with laws and regulations, insure and maintain assets, etc.
Negative covenants indicate what the issuer must not do. These are frequently more costly
and materially constrain the issuer’s potential business decisions. Examples include
restriction on debt, negative pledges, restrictions on prior claims, restrictions on distribution
to shareholders, etc.
LO.d: Describe how legal, regulatory, and tax considerations affect the issuance and
trading of fixed-income securities.
Fixed-income securities are subject to different legal and regulatory requirements

depending on where they are issued and traded. National bond market is the bond market in
a particular country. It includes domestic bonds as well as foreign bonds. Eurobonds are
international bonds that can be denominated in any currency.
Other legal and regulatory issues are:
• Legal identity of the bond issuer and its legal form.
• Source of repayment proceeds.
• Asset or collateral backing: Collateral reduces credit risk. Bonds that have collateral
are called secured bonds. Debenture refers to unsecured bonds in most countries and
secured bonds in a few countries. Collateral backed bonds include collateral trust
bonds, equipment trust certificates, mortgage-backed, and covered bonds.
• Credit enhancements: These are provisions used to reduce the credit risk of a bond
issue using additional collateral, insurance, or third-party guarantee. Internal credit
enhancements include senior/junior tranches, over-collateralization and, excess
spread. External credit enhancements include surety bonds/bank guarantees, letter
of credit, etc.
Tax Considerations:
The two sources of return from a bond are treated differently for tax purposes:
• The income portion of a bond investment is generally taxed at the ordinary income
tax rate.
• Tax on capital gain may be different for long-term and short-term investments.
• In some countries, a pro-rated portion of discount may be included in interest
income.
LO.e: Describe how cash flows of fixed-income securities are structured.
The cash flows to investors can be divided into principal repayment and coupon payments.
Principal can be repaid in three ways:
• Bullet bond: Principal is paid all at once at maturity.
• Fully amortized: In this method the principal is paid little by little, in equal payments
over the bond’s life, so that it is repaid in full by the maturity date.
• Partially amortized: Only a part of the principal is repaid over the bond’s life. The
remaining large part of the principal is paid at maturity, making it a balloon payment.
This is a hybrid between the bullet and the fully-amortized bond.
The sinking fund arrangement allows for full or partial amortization of a bond prior to its
maturity. Three sinking fund arrangements are standard, accelerated, and call provision.
The different types of coupon payments are listed below:
• Fixed periodic coupon: A fixed interest is paid either semi-annually or annually.
• Floating rate notes: The coupon payments are not fixed; instead they are linked to a
benchmark reference rate such as Libor, short-term Treasury bills, etc.

• Step-up bond: Can be a fixed-rate or floating-rate bond. The coupon rate increases
over time.
• Credit-linked Coupon Bonds: The coupon rate changes when the bond’s credit rating
changes.
• Payment-in-kind Coupon Bonds: The issuer pays interest by issuing additional bonds.
• Deferred Coupon Bonds: Bonds that do not pay a coupon in the initial years, but
compensate by paying a higher coupon in the later years.
• Index-Linked Bonds: Coupon and/or principal payments are linked to an index.
• TIPS: Treasury inflation-protected securities issued by the U.S. government; linked to
the U.S.CPI.
LO.f: Describe contingency provisions affecting the timing and/or nature of the cash
flows of fixed-income securities and identify whether such provisions benefit the
borrower or the lender.
A contingency provision is a clause in a legal document that allows for some action if the
event or circumstance does occur.
Callable bond: It gives the issuer the right to redeem all or part of the bond before the
specified maturity date. Investors face reinvestment risk with callable bonds, as it is not
possible to reinvest the proceeds at the previous higher interest rates. When a bond is
redeemed early, the issuer has to make the lump-sum payment equal to the present value of
future coupon payments and principal. The three types of callable bonds are American call,
European call, and Bermuda-style call.
Putable bond: It gives the bondholder the right to sell the bond back to the issuer at a pre-
determined price on specified dates. Putable bonds offer a lower yield and sell at a higher
price relative to otherwise non-putable bonds. Putable bonds are beneficial to the
bondholder. The three types of putable bonds are American put, European put, and
Bermuda-style put.
Convertible bond: It allows the bondholder the right to exchange the bond for a fixed
number of common shares of the issuing company any time before maturity.
Advantages of Convertible Bonds
From an investor’s perspective From an issuer’s perspective
Opportunity to convert into equity Reduced interest expense; lower yield than
if share prices are increasing and otherwise non-convertible bond because of the
participate in upside. conversion provision given to bondholders.
Downside protection if shares Elimination of debt if conversion option is
prices are falling. exercised. So they do not have to repay the debt.
Convertible bonds are usually callable.
Warrant: It is an attached option, not an embedded option. It gives the bondholder the right
to buy the underlying common shares at a fixed price called the exercise price any time

before the expiration date.

Contingent Convertible Bonds: These are bonds with contingent write-down provisions. The
bonds can be converted into equity contingent to a specific condition.

Practice Questions
1. ABC Inc. issued bonds 1.5 years ago with an original maturity of 2 years. XYZ Inc. issued
bonds 3 months ago with an original maturity of 9 months. Currently, both these bonds
have a remaining tenure of 6 months. The bonds would most likely be classified as:
A. money market securities.
B. capital market securities.
C. ABC’s bonds are capital market securities and XYZ’s bonds are money market
securities.
2. A legal contract between a bond issuer and the bondholders, which defines the bond’s
features, the obligations of the issuer, and the rights of the bondholders is best described
as a bond’s:
A. covenant.
B. indenture.
C. debenture.
3. Which of the following is least likely a negative bond covenant?

A. The issuer will not violate laws or regulations.
B. The issuer is prohibited from investing in risky projects.
C. The issuer will not sell assets that have been pledged as collateral.
4. An investor in a country with an original issue discount tax provision buys a 10-year
zero-coupon bond at a deep discount to its par value. If the investor holds the bond until
the maturity date, the increase in the bond’s value will most likely be treated as:
A. a capital gain at maturity.
B. interest income every year until maturity.
C. tax-exempt income.
5. A zero-coupon bond can best be classified as a:

A. step-up bond.
B. credit-linked bond.
C. deferred coupon bond.
6. Compared to an otherwise similar option-free bond, which of the following bonds will
most likely trade at a lower price?
A. A putable bond.
B. A callable bond.
C. A convertible bond.
7. Which of the following best describes a convertible bond’s conversion value?

A. Price per share at which the bond may be converted to common stock.
B. Par value divided by conversion price.
C. Current share price multiplied by conversion ratio.

Solutions
1. C is correct. A bond with an original maturity of more than one year it is called capital
market security. A bond with an original maturity of one year or less is called money
market security.
2. B is correct. A bond indenture or trust deed is a contract between a bond issuer and the
bondholders, which defines the bond’s features, the obligations of the issuer, and the
rights of the bondholders.
3. A is correct. Negative covenants are restrictions on actions a bond issuer can take. B and
C are examples of restrictions. Complying with laws and regulations is an example of a
positive covenant.
4. B is correct. The original issue discount tax provision requires the investor to include a
prorated portion of the original issue discount in his taxable income every tax year until
maturity. The original issue discount is equal to the difference between the bond’s par
value and its original issue price.
5. C is correct. Since interest is effectively deferred until maturity, a zero-coupon bond can
be thought of as a deferred coupon bond. A and B are incorrect because both step-up
bonds and credit-linked bonds pay regular coupons. In a step-up bond, the coupon
increases by specified margins at specified dates. In a credit- linked bond, the coupon
changes when the bond’s credit rating changes.
6. B is correct. Put option and conversion option are benefits to the bondholders, therefore,
they will be willing to pay a higher price. A call option is a benefit to the issuer, therefore
bondholders demand a lower price.
7. C is correct. The conversion value of a bond is the current share price multiplied by the
conversion ratio. A is conversion price. B is conversion ratio.

R51 Fixed Income Markets - Issuance Trading and Funding 2019 Level I Notes
R51 Fixed Income Markets: Issuance Trading and Funding

1. Introduction
This reading will cover:
• How the bond markets are classified.
• Who the major issuers of debt are and what types of bonds they issue.
• How new bond issues are introduced in primary markets and then traded in
secondary markets.
• Sovereign bonds and non-sovereign bonds.
• Different types of corporate debt.
• The sources of short-term funding available to banks.
2. Overview of Global Fixed-Income Markets
2.1. Classification of Fixed-Income Markets
Fixed-income markets are often classified based on the following criteria:
Classification by Type of Issuer
Bond markets may be divided into three categories based on the type of issuers:
• Government and government-related sector, such as sovereign bonds, supranational
bonds, and non-sovereign (local) bonds. The largest issuers of bonds are
governments.
• Corporate sector, such as bonds issued by financial and non-financial companies.
• Structured finance sector, which are securitized bonds.
Classification by Credit Quality
Investors face credit risk, i.e., the risk of loss if the issuer fails to make timely payments of
interest and principal as they come due. Rating agencies like Moody’s, S&P, and Fitch assign
credit ratings to bonds. Bonds with a rating of BBB or above are considered investment
grade. Bonds below this rating are considered junk bonds.
This differentiation is important as certain investors such as banks and life insurance
companies may not be allowed to invest in junk bonds but only in investment grade bonds.
Classification by Maturity
Fixed-income securities can also be classified by the original maturity of the bonds when
they are issued:
• Money market securities: They are issued with a maturity at issuance that ranges
from overnight to one year. For example, T-bills issued by the US government or
commercial paper with short maturities issued by the corporate sector.
• Capital market securities: The original maturity is usually longer than a year.

Classification by Currency Denomination

Fixed-income securities can also be classified based on the currency in which they are
issued. The bond’s price (and cash flows) is affected by the interest rates of the country
whose currency the bond was issued in.
Classification by Type of Coupon
Bonds can be classified into the following based on the coupon rate:
• Fixed-rate: In a fixed-rate bond, the coupon rate and coupon payment are fixed.
• Floating-rate: In a floating-rate bond, the coupon payment is linked to a floating rate,
which is usually a reference rate plus a spread.
There are two parts to a floating rate: a reference rate and a spread.
The reference rate is reset periodically at the coupon date. As a result, the coupon rate more
or less reflects the market interest rates. The reference rate contributes to most of the
coupon rate and is usually an interbank offered rate. The most commonly used interbank
rate is Libor.
Interbank offered rates are the average interest rates at which banks may borrow unsecured
funds from other banks. The rates differ for different periods ranging from overnight to one
year. Examples of interbank offered rates include Libor, Euribor (Euro interbank offered
rate), Mibor (Mumbai interbank offered rate), etc. The respective currencies for Euribor and
Mibor are the Euro and Indian rupee.
The spread, on the other hand, is fixed at issuance and is a function of the issuer’s credit
quality or creditworthiness. The higher the quality, the lower the spread and vice versa. It is
a small component of the coupon rate.
Classification by Geography
Fixed-income markets may be classified based on where the bonds are issued and sold (we
saw this in detail in the previous reading):
• Domestic bonds: Bonds issued in a country in that country’s currency. The issuer is
domiciled in that country. For example, Ford issuing U.S. dollar denominated bonds in
the U.S.
• Foreign bonds: Bonds issued by an entity domiciled in another country. For example,
Toyota issuing dollar denominated bonds in the U.S.
• Eurobonds: International bonds sold outside the jurisdiction of any single country.
• Investors further classify bonds into those issued by developed economies and
emerging economies.
Other classifications:
Among other classifications, we have tax-exempt bonds and inflation-linked bonds.
• Tax-exempt bonds: Bonds whose interest/coupon payments are not taxable. For

example, munis or municipal bonds issued by local governments in the United States
are tax-exempt bonds. The coupon rate for a tax-exempt bond is usually lower than
an otherwise taxable bond, but since the interest is tax-free, the after-tax return of a
tax-exempt bond may be higher.
• Inflation-linked bonds: Bonds whose coupon and/or principal are indexed to
inflation. The objective is to give some protection (hedge) to investors against high
inflation and offer real returns in a high inflation environment.
2.2. Fixed-Income Indices
Fixed-income indices are used by investors for two purposes: to evaluate the performance of
investments and investment managers and to describe a given bond market or sector. The
index construction - security selection and weight of each security in the index- varies from
index to index.
The most popular fixed-income indices include Barclays Capital Global Aggregate Bond
Index, J.P. Morgan Emerging Market Bond Index, and FTSE Global Bond Index.
2.3. Investors in Fixed-Income Securities
Major categories of fixed-income investors include:
• Central banks: They use fixed-income securities as a tool to implement monetary
policy. Purchasing domestic bonds increases money supply. Similarly, selling bonds
decreases money supply. Central banks also buy and sell bonds denominated in other
currencies to manage the value of their currency and foreign reserves.
• Institutional investors: They are the largest group of investors in fixed-income
securities. This includes pension funds, hedge funds, endowments, charitable
foundation, insurance companies, and banks. Unlike equities that trade in primary
and secondary markets, bonds primarily trade over-the-counter. Many issues are not
liquid and tradable, making them out of reach for retail investors, but are preferred
by institutional investors.
• Retail investors: Unlike central banks and institutional investors, retail investors
primarily invest in bonds through mutual funds or ETFs. Many retail investors prefer
to invest in bonds because of the certainty of income in the form of interest payments
and principal payment at maturity. Also, fixed-income securities are not as volatile as
their equity counterparts.
3. Primary and Secondary Bond Markets
Primary bond markets are markets in which bonds are sold for the first time by issuers to
investors to raise capital. Bonds can be sold initially via a public offering or a private
placement. Secondary bond markets are markets in which existing bonds are subsequently
traded among investors. After the initial offering, bonds are bought and sold among
investors in the secondary market.

3.1. Primary Bond Markets

A company/government/any entity issues bonds in two ways: public offering and private
placement.
Public Offerings
As the name indicates, in a public offering, any member of the public may invest in a new
bond issue. The issuer does not sell bonds directly to each investor. Instead, the issuer avails
the services of an intermediary called the underwriter to facilitate the selling (placement)
process. The underwriter is usually an investment bank because banks have a good
understanding of how to market a new issue, tap their networks to locate investors, and
successfully place the issue.
The different bond issuing mechanisms are:
• Underwritten offering
• Best effort offering
• Shelf registration
• Auctions
Underwritten offerings: In an underwritten offering, an investment bank negotiates an
offering price with the issuer; the offering price is the price at which the issue will be sold. It
then buys the entire issue at the offering price and takes the risk of reselling it to investors
or dealers. Underwritten offering is also known as a firm commitment offering. The
underwriting process is graphically depicted below:
Best effort offering: Contrary to an underwritten offering, in a best effort offering issue, the
investment bank acts as a broker and only sells as many securities as it can instead of
committing to sell 100% of the issue. The unsold bonds are returned to the issuer. The
investment bank gets a commission for bonds sold at the offering price, faces less risk and
has less incentive to sell the issue than in an underwritten offering. Best effort offering is
usually preferred for riskier issues and corporate bonds.
Shelf registration: Shelf registration is a type of public offering where the issuer is not
required to sell the entire issue at once. The issuer files a single document with regulators
that describe a range of future issuances. The advantage is that the issuer does not have to

prepare a new document for every bond issue provided there is no change in the issuer’s
business and financial terms stated in the prospectus. This allows the issuer to save on
repeated administrative expenses and registration fees.
Auctions: Government bonds across the world are usually sold to investors via an auction.
Governments finance public debt by borrowing money through the central bank. An auction
is a public offering method that involves bidding, and is helpful in price discovery and
allocating securities. The United States follows a single-price auction method for its
sovereign securities such as T-bills, T-notes, TIPS, etc. In this method, all winning bids pay
the same price for the security and receive the same coupon rate.
Private Placement
As the name implies, the securities are not sold to the public in this type of funding. Instead,
they are sold only to a select group of investors such as institutional investors. Other
characteristics are as follows:
• It is typically a non-underwritten, unregistered offering of bonds, i.e., a private issue
need not comply with the registration requirements of a public offering such as
preparing a prospectus.
• It is also exempt from securities laws that govern a public issue.
• It can be accomplished directly between the issuer and the investor(s) through an
investment bank. Because privately placed bonds are unregistered and may be
restricted securities that can only be purchased by some types of investors, there is
usually no active secondary market to trade them.
• Institutional investors such as insurance companies and pension funds are typical
investors of privately placed bonds.
3.2. Secondary Bond Markets
Securities are traded among investors in the secondary market. Large institutional investors
and banks are the primary participants. Retail investors are limited here, unlike in the
equities market.
Secondary bond markets are structured as organized exchanges or as over-the-counter
markets.
• Organized exchange: Where buyers and sellers meet to arrange trades and comply
with the rules of the exchange.
• Over-the-counter (OTC) markets: Buy and sell orders are matched through a
communications network. Most bond trading happens in the OTC market.
It is important to understand the liquidity of a bond market:
• Liquidity is a measure of how quickly an investor can sell the bond and turn it into
cash. Similarly, it should also measure how quickly one can buy a bond to cover a
short position.
• Bid-ask or bid-offer spread reflects the liquidity of a market. The lower the spread,

the better the liquidity.

• Most of the liquidity in the international bond market is supplied by Eurobond
market makers.
Settlement is the process that occurs after a trade is made:
• It is usually T+1 (a day after the transaction date) for government and quasi-
government bonds and T+3 for corporate bonds.
• Cash settlement is one in which cash is paid and bond is received on the same day. It
is followed for some government and quasi-government bonds, and money market
securities.
4. Sovereign Bonds
Sovereign bonds are issued by national governments primarily for fiscal reasons. Taxes are
the primary source of revenue for a government. If tax revenue is insufficient, then a
government raises money by issuing sovereign bonds.
Sovereign securities are classified into two categories based on when they were issued: on-
the-run and off-the-run. On-the-run are recently issued sovereign securities that trade
frequently. They are also called benchmark bonds because the yields of other bonds are
determined relative to these bonds. Off-the-run refers to securities that were issued some
time ago. They are less liquid compared to on-the-run securities.
Sovereign bonds are not backed by collateral. Instead, they depend on the taxing authority,
i.e., the national government, to repay the debt. Rating agencies distinguish between a
sovereign bond issued in local currency and one in foreign currency. Local currency bonds
generally have a higher credit rating than foreign currency bonds, because if needed the
national government can print local currency to repay the bond, however it cannot print the
foreign currency.
Sovereign bonds can be fixed-rate, floating-rate or inflation-linked.
5. Non-Sovereign Government, Quasi-Government, and Supranational
Bonds
5.1. Non-Sovereign Bonds
Non-sovereign bonds are bonds issued by the local governments such as states, provinces,
and cities, and not by the national government. The characteristics of non-sovereign bonds
are as follows:
• Credit rating is usually high as rate of default is low. However they have a higher
credit risk than sovereign bonds and therefore demand a higher yield.
• The source of revenue for these bonds is the local taxing authority and the cash flows
from the project once it is commissioned.
• Funds raised from non-sovereign bonds are used for public projects such as

highways, bridges, dams, airports, metro, sewage systems, and schools.

5.2. Quasi-Government Bonds
Quasi-government bonds are bonds issued by non-government entities, but they are usually
backed by the government. The characteristics of these bonds are as follows:
• The credit risk is low.
• Taxes are not a source of revenue. They fund specific projects and cash flows from the
project/entity are used to service the debt.
• Examples are bonds issued by Federal National Mortgage Association (Fannie Mae),
Federal Home Loan Mortgage Corporation (Freddie Mac) in the U.S.
5.3. Supranational Bonds
Supranational bonds are bonds issued by international organizations such as the World
Bank, IMF, EIB, ADB, etc. They are usually plain-vanilla bonds. Sometimes callable or floaters
are also issued.
6. Corporate Debt
We now shift our focus from sovereign debt to corporate debt. Companies borrow primarily
from banks and only 30% of their financing needs come from the financial markets.
6.1. Bank Loans and Syndicated Loans
There are two types of bank loans: bilateral and syndicated.
• A bilateral loan is a loan from a single lender to a single borrower.
• A syndicated loan is a loan from a group of lenders, called the syndicate, to a single
borrower.
Most bilateral and syndicated loans are floating-rate loans, linked to a reference rate such as
Libor. For highly rated companies, both bilateral and syndicated loans can be more
expensive than bonds issued in financial markets.
6.2. Commercial Paper
A commercial paper is a flexible, readily available, and low-cost instrument issued by
companies to meet their short-term needs. They are issued for a short period, typically
between 15 days and one year.
A commercial paper may be regarded as the corporate equivalent of a T-bill because it is
short-term in nature. In a CP, since companies may borrow directly from the market, the cost
of borrowing is less than that of banks.
Companies use commercial paper:
• For working capital and seasonal demands for cash.
• As a source of bridge financing: CPs serve as an interim source of funding if market
conditions are not temporarily favorable to arrange permanent funding.

The characteristics of a commercial paper are as follows:

• The yield on commercial paper is greater than the yield on short-term sovereign
bonds because investors are exposed to credit risk. Credit risk varies from entity to
entity.
• Historically, the rate of default of CP is very low as they are short-term in nature, and
when CPs mature, they are usually rolled over into new CPs. It is called rolling over
the paper. The old CP is paid with the proceeds from the new CP. But what if the
issuer is unable to issue a new CP? This risk is called rollover risk. Rollover risk can be
mitigated by what is called backup lines of credit. These are backup funds from the
banks to ensure there is enough money to pay off a maturing CP.
US Commercial Paper vs. Eurocommercial Paper
The US commercial paper (USCP) market is the largest commercial paper market in the
world. Commercial paper issued in the international market is known as Eurocommercial
paper (ECP). The differences between the two are summarized in the table below:
USCP vs. ECP
Feature US Commercial Paper Eurocommercial Paper
Currency U.S. dollar Any currency
Maturity Overnight to 270 days Overnight to 364 days
Interest Discount basis Interest-bearing basis
T+2 (trade date plus two
Settlement T+0 (trade date)
days)
Can be sold to another
Negotiable Can be sold to another party
party
The key difference between a USCP and ECP is in the way interest is paid. USCP, like a zero
bond, is sold at a discount. The par value is paid on maturity. ECP, on the other hand, is sold
at par and the interest is paid along with the par value at maturity. The example below
illustrates this difference for a $100 million CP issued at 4% for 90 days.
$100 million, 90-day at 4% commercial paper
USCP: issued by U.S. Bank ECP: issued by a French
company
Interest: 100,000,000 x 0.04 x 90/360 100,000,000 x 0.04 x
= $1,000,000 90/360
= $1,000,000
At issuance, money Interest discounted from Par value: $100,000,000
received by par:
bank/company 100,000,000 –
1,000,000=$99,000,000

Bank/company pays at Par value = $100,000,000 Par value + interest =

maturity: 10,000,000 + 1,000,000 =
$101,000,000
Return on investment for 1,000,000/99,000,000 = 1,000,000/100,000,000 =
90 days 1.01% 1.00%
6.3. Corporate Notes and Bonds
Corporate bonds may be categorized based on several characteristics such as maturities,
coupon payment structures, and contingency provisions that we will discuss in this section.
Maturities
Short-term, medium-term, long-term: There is no formal categorization of what constitutes a
short-term, medium-term, and long-term security. But we will go with the classification
below based on common practice.
Classification of Corporate Bonds Based on Maturity
Original maturity Term What are they called?
Five years or less than five Short-term Notes
years (≤ 5)
Greater than 5 and less Medium-term
than 12 years
(> 5 and ≤ 12)
Greater than 12 years Long-term Bonds
(> 12)
Medium-term note (MTN): The term ‘medium’ in an MTN is a misnomer because the
maturities range from 2 years to greater than 30 years.
• MTNs are continuously offered through dealers or agents.
• MTNs can be broadly classified into short-term, medium to long-term, and structured
notes.
• Yield on an MTN is higher than a comparable bond, but liquidity is lesser.
• They primarily serve to bridge the funding gap between commercial papers (short-
term) and long-term bonds.
Coupon Payment Structures
Coupon payments for corporate notes and bonds vary based on the type of bond:
Note: We have seen most of these in the previous reading, so we will just skim through them
• Conventional coupon bond/plain vanilla bond: pays fixed-rate coupon periodically.
• Floating-rate note: Coupon payment linked to a reference rate.
• Credit-linked coupon bond: Coupon payment linked to issuer’s credit quality.
• Zero-coupon bonds: Pays no coupon; one payment equivalent to par value at
maturity.

• Deferred coupon bonds: Pays no coupon initially and a higher coupon later.
• Payment-in-kind coupon bond: Pays coupon in the form of securities, not cash.
Principal Repayment Structures
Broadly speaking there are three types of principal repayment structures. These are outlined
below:
1. Serial maturity structure: The bond matures in parts on several dates throughout the
bond’s life. The principal is repaid in parts instead of paying a lump sum at maturity. For
example, if a company issues $50 million for 5 years, then traditionally it repays the
principal of $50 million at once on maturity date. But in the case of a serial bond issue,
assume $20 million matures after two years, $10 million in the third year, and so on.
Which bonds will be retired at what date, is defined at issuance.
2. Term maturity structure: The bond’s entire principal is paid at once on maturity. It
carries more credit risk.
3. Sinking fund arrangement: The issuer sets aside funds so that it can retire specific
amounts of the principal each year. This is done in two ways: by repaying principal to a
certain percentage of bondholders each year, or the issuer may deliver bonds to the
trustee equal to the amount that must be retired that year.
Asset or Collateral Backing
Unlike highly-rated sovereign bonds that carry almost no default risk, all corporate bonds
have varying amounts of default risk. The objective of asset or collateral backing is to protect
investors in the event of a default. Secured debt, i.e., debt backed by collateral, is not
completely insulated from losses, but it is considered better than unsecured debt.
Contingency Provisions
Contingency provisions are clauses defined in a bond’s indenture to protect the bondholders.
These provisions specify under what conditions a bond may be redeemed or paid-off before
maturity. Some provisions benefit the issuer while some benefit the investor. The three
contingency provisions are call provision, put provision, and a convertible bond.
Issuance, Trading, and Settlement
Major points with respect to issuance, trading, and settlement are given below:
• New bond issues are sold by investment banks who act as underwriters/brokers.
• They are settled through the local settlement system, which in turn is connected to
the two primary Eurobond clearing systems: Euroclear and Clearstream.
• Bonds are traded through dealers who make a market. Dealers interact with
bondholders and with other dealers. So, it is essentially an over-the-counter market.
• The settlement now happens electronically. For a secondary bond, settlement could
take anywhere between T + 3 to T + 7 days while issuance of a new bond takes
several days.

• Bond prices are quoted in basis points.

7. Structured Financial Instruments
Structured financial instruments represent a broad sector of financial instruments including
asset-backed securities and collateralized debt obligations. A common characteristic of these
instruments is that they repackage and redistribute risks. In this section, we focus on the
following four categories of instruments:
7.1. Capital Protected Instruments
Capital protected instruments offer different levels of capital protection, and are only as
good as the issuer of the instrument. One example of a capital protected instrument is a
guarantee certificate that offers full capital protection. This is achieved by combining a bond
and a call option.
For example, consider an investor who has $100,000 to invest. The investor buys zero-
coupon bonds that will pay off $100,000 after one year. The investor pays $99,000 for the
bond and invests the remaining $1,000 from the purchase of the bond to buy a call option on
some asset that expires one year from now. Now, let us see what happens one year from now
when the bond matures. If the price of the underlying asset on the call option increases, the
call expires in the money. The investor gets $100,000 when the bond matures and profits
from the call option. If the price of the underlying asset on the call option falls, the call
expires worthless. The investor’s capital is still protected as he gets $100,000 when the bond
matures and loses the premium paid for the call option. The downside is limited to the
$1,000 premium paid for the call option.
7.2. Yield Enhancement Instruments
Yield enhancement refers to higher risk exposure and possibly a higher expected return. A
credit-linked note is an example of a yield enhancement instrument.
The characteristics of a CLN are as follows:
• It pays regular coupons but its redemption value depends on a well-defined credit
event such as a ratings downgrade of an underlying reference asset.
• If the event does not occur, then the investor will receive par value at maturity.
However, if the event occurs, then the investor receives the par value of the CLN
minus the nominal value of the underlying reference asset.
• A CLN therefore allows the issuer to transfer the credit risk to investors. Investors are
willing to buy CLNs because they offer higher coupons as compared to otherwise
similar bonds.
7.3. Participation Instruments
A participation instrument is a type of instrument that allows investors to participate in the
return of an underlying instrument. They give investors indirect exposure to a particular
index or asset price. A floating-rate bond is an example of a participation instrument whose

coupon rate adjusts periodically to a pre-defined formula.

Unlike capital-protected instruments that offer equity exposure, participation instruments
do not offer capital protection.
7.4. Leveraged Instruments
Leveraged instruments are structured financial instruments that offer higher returns for
small investments. An example of a leveraged instrument is an inverse floater. Unlike a
traditional floater, the cash flows are inversely related to changes in the reference rate.
When the reference rate decreases, the coupon payment of an inverse floater increases.
Inverse floater coupon rate = C - (L * R)
where:
C = the maximum coupon rate reached if the reference rate is equal to zero
L = the coupon leverage. This indicates the multiple the couple rate will change for a 100
basis points change in the reference rate
R = the reference rate on the reset date
Inverse floaters with a coupon leverage rate greater than 0 but lower than 1 are known as
deleveraged inverse floaters. Inverse floaters with a coupon leverage rate greater than 1 are
known as leveraged inverse floaters.
8. Short-Term Funding Alternatives Available to Banks
This section looks at where banks get their funds from in the short-term.
8.1. Retail Deposits
One of the primary sources of funds for a bank is the money deposited by retail (like you and
me) and commercial investors in their accounts. It is the lowest possible source of funding
for a bank. The three types of retail accounts and characteristics of each of these accounts
are discussed below:
Demand deposits or checking accounts
• Depositors have access to funds anytime.
• The funds may be used to pay for transactions.
• Little or no interest is paid.
Savings accounts
• Depositors have access to funds.
• Unlike checking account, savings accounts pay an interest. But they do not offer the
same transactional convenience.
Money market accounts
• Funds are available at short or no notice.
• Offer money market rates of return.

8.2. Short-Term Wholesale Funds

Central Bank Funds
• When a bank receives deposits from customers, a certain percentage of this money
must be kept as a reserve with the national central bank. The amount a bank keeps as
reserves varies based on its financial position: some have a deficit and some have a
surplus.
• The funds stashed in the central bank by all banks are collectively known as the
central bank funds market.
• Assume a bank is running low on cash and a customer wants to withdraw money
from this bank. The bank has two choices. It may withdraw cash from its reserve
account in the central bank to pay the customer, if it has sufficient funds. Or it may
borrow money from banks that have a surplus in their accounts at the central bank.
The funds, known as central bank funds, may be borrowed for a period up to one year
at rates known as central bank funds rates.
• If the borrowing is for one day, it is called overnight funds. If it is for more than one
day, then it is called term funds.
Interbank Funds
• Banks lend to and borrow from each other in the interbank market.
• It is an unsecured system of lending.
• The term may vary from overnight to one year.
• The reference rate at which they borrow is called the interbank offered rate. Or, they
may borrow at a fixed interest rate.
• Often large banks publish two rates: one at which they borrow and one at which they
lend.
Certificates of Deposit
• A certificate of deposit is a savings instrument with a maturity date, a fixed interest
rate, and can be issued in any denomination. The investor or bearer of the certificate
receives an interest at the end of the deposit period. CDs can be issued to individuals,
companies, trusts, funds, etc.
• There are two forms of CD: negotiable and non-negotiable CD.
• In a non-negotiable CD, the interest and deposit are paid at maturity. There is a
penalty if the depositor withdraws funds before maturity.
• In a negotiable CD, depositors are allowed to sell the deposits before maturity.
• There are two types of negotiable CDs:
o Large-denomination CDs: CDs of denomination of $1 million or more; often
traded among institutional investors.
o Small-denomination CDs: of lower denominations and meant for retail
investors.

8.3. Repurchase and Reverse Repurchase Agreements

A repurchase agreement or repo is a sale and repurchase agreement. It is an agreement
between two parties where the seller sells a security with a commitment to buy the same
security back from the purchaser at an agreed-upon price at a future date. It is similar to
borrowing funds against collateral. Assume there are two parties: banks A and B. A has a 90-
day T-bill that it sells to B for $99.50. It agrees to buy the same T-bill the next day for $99.51.
This was a means of borrowing $99.50 overnight for A. The 1¢ can be considered as the
interest for the borrowed amount.
Structure of Repurchase and Reverse Repurchase Agreements: We will look at some
terms related to repo with the help of the A and B example we saw earlier.
• Reverse repo: It was a repo arrangement from bank A’s (seller of security)
perspective. But from bank B’s perspective (purchaser of security), it is a reverse
repo.
• Repurchase price: The price at which A will buy back the security from B the next day
is called the repurchase price. The price at which the dealer repurchases the security
is called the repurchase price.
• Repurchase date: The date on which the dealer (A) repurchases the security (from B)
is called the repurchase date. In our example, it was the next day.
o Overnight repo: If the repurchase happens the next day, i.e., if the agreement is
for one day, it is called overnight repo.
o Term repo: If the repurchase happens after more than a day, it is called term
repo.
o Repo to maturity: If the agreement is honored until maturity, then it is called
repo to maturity.
• Repo rate: The interest rate negotiated between both the parties is called the repo
rate. In our example, 1¢ was the interest paid.
The factors that affect the repo rate include:
• The risk of the collateral: Highly rated collateral such as sovereign bonds exhibit low
risk and lower repo rates.
• Term of the repurchase agreement: The longer the term, the higher the rates.
• Delivery requirement: If the collateral is delivered to the lender, the rates are lower. If
the underlying collateral is not delivered to the counterparty, then the risk is higher
and so is the repo rate.
• Supply and demand: Collateral in high demand has lower repo rate. If the collateral is
scarce/low supply, the repo rate is lower.
• Interest rates of alternative financing.

Credit Risk Associated with Repurchase Agreements

Both the parties in a repo agreement face the risk of default from the counterparty. There is
credit risk even if the collateral is a highly rated sovereign bond. Let us analyze what
happens when each party defaults.
If the dealer defaults and cannot repurchase the collateral:

• The investor keeps the collateral and retains any income from the same.
• The investor is at a disadvantage if the price of the collateral falls below the
repurchase price (owed by the dealer).
If the investor defaults and cannot deliver the collateral:
• The dealer keeps the cash.
• The dealer is at a disadvantage if the price of the collateral rises above the price
quoted in the repurchase agreement. The dealer now holds less cash than the
collateral’s current value.
• The lender of funds carries a greater credit risk than the dealer. In order to protect
the investor, usually the amount lent is lower than the market value of the collateral.
• Haircut or repo margin = market value of security (collateral) – amount lent to dealer
• The amount of difference or repo margin depends on:
o Length of the repo. The longer the duration of the repo, the higher the risk and
greater the margin.
o Quality of the security used as collateral: The higher the quality, the lower the
margin.
o Creditworthiness of the dealer: The higher the creditworthiness, the lower the
margin.
o Supply and demand: If the collateral is in high demand / low supply then the
repo margin is lower.

Summary
LO.a: Describe classifications of global fixed-income markets.
Fixed-income markets are often classified based on the following criteria:
• The type of issuer: This can be further divided into three categories based on the
sectors: government sector, corporate sector, and securitized bonds.
• The bond’s credit quality. The bonds must be classified based on their
creditworthiness such as investment-grade, high-yield, or junk bonds.
• Maturity: Long term, medium term, short term.
• Currency denomination.
• Type of coupon: Bonds pay either a fixed rate or a floating rate of interest.
• Geography: Based on where the bonds are issued and sold.
• Other classifications: Among other classifications, we have inflation-linked bonds and
tax-exempt bonds.
LO.b: Describe the use of interbank offered rates as reference rates in floating-rate
debt.
Interbank offered rates are the average interest rates at which banks may borrow unsecured
funds from other banks. The rates differ for different periods ranging from overnight to one
year. Examples of interbank offered rates include Libor, Euribor (Euro interbank offered
rate), Mibor (Mumbai interbank offered rate), etc. In a floating-rate bond, the coupon
payment is linked to a floating rate that is usually a reference rate plus a spread. The
reference rate contributes to most of the coupon rate and is usually an interbank offered
rate.
LO.c: Describe mechanisms available for issuing bonds in primary markets.
Primary markets are markets in which bonds are sold for the first time by an issuer to raise
capital. Bonds may be issued in the primary market through a public offering or a private
placement.
Public offering: Any member of the public may buy the bonds.
Four types are:
• Underwritten offerings: The investment bank buys the entire issue and takes the risk
of reselling it to investors or dealers.
• Best effort offerings: The investment bank serves only as a broker and sells the bond
issue only if it is able to do so.
(Underwritten and best effort offerings are frequently used in the issuance of
corporate bonds).
• Shelf registrations: The issuer files a single document with regulators that allows for
additional future issuances.
• Auction: Price discovery through bidding. It is frequently used in the issuance of

sovereign bonds.
Private placement: Securities are not sold to the public directly, instead the entire issue is
sold to a qualified investor or to a group of investors (typically, large institutions).
LO.d: Describe secondary markets for bonds.
Secondary markets are markets in which existing bonds are subsequently traded among
investors. Most bonds are traded in over-the-counter (OTC) dealer markets. Some bonds are
traded on public exchanges. Institutional investors are the major buyers and sellers of bonds
in secondary markets.
LO.e: Describe securities issued by sovereign governments
Sovereign bonds are issued by national governments, primarily for fiscal reasons. Recently
issued sovereign securities are called on-the-run. Off-the-run refers to securities that were
issued some time ago. Sovereign bonds are not backed by collateral. Instead, they depend on
the taxing authority to repay the debt. The types of sovereign bonds include fixed-rate
bonds, floating-rate bonds and inflation-linked bonds.
LO.f: Describe securities issued by non-sovereign governments, quasi-government
entities, and supranational agencies.
Non-sovereign bonds are issued by local government instead of national government. They
have a higher credit risk than sovereign bonds and therefore demand a higher yield.
Quasi-government bonds or agency bonds are issued by quasi-government entities. These
are not government entities, but they are usually backed by the government. The credit risk
is low. They fund specific projects, and cash flows from the project are used to service the
debt.
Supranational bonds are issued by international organizations such as the World Bank, IMF,
EIB, ADB, etc. They are usually plain-vanilla bonds. Sometimes callable or floaters are also
issued.
LO.g: Describe types of debt issued by corporations.
Debt issued by companies includes the following types:
Bank loans and syndicated paper: A bilateral loan is a loan from a single lender to a single
borrower. A syndicated loan is a loan from a group of lenders, called the syndicate, to a
single borrower.
Commercial paper: It is a flexible, readily available, and low-cost instrument issued by
companies to meet their short-term needs.
Corporate notes and bonds: Corporate bonds can be categorized as short-term, medium-
term, and long-term security. Coupon payments for corporate notes and bonds vary based
on the type of bond. Principal repayment can be based on serial maturity structure, term
maturity structure, and sinking fund arrangement. Corporate bonds have a varying amount

of risk so they are backed by collateral to protect the investors. These bonds can have a call
provision, a put provision, or can be convertible bonds.
LO.h: Describe structured financial instruments
Structured financial instruments include:
• Capital Protected Instruments
• Yield Enhancement Instruments
• Participation Instruments
• Leveraged Instruments
LO.i: Describe the short-term funding alternatives available to banks.
Retail Deposits: One of the primary sources of funds for a bank is the money deposited by
retail investors in their accounts. The three types of retail accounts are demand deposits,
saving accounts, and money market accounts.
Central bank funds: When a bank receives deposits from customers, a certain percentage of
this money must be kept as a reserve with the national central bank. The funds stashed in
the central bank by all banks are collectively known as central bank funds market.
Interbank Funds: Banks lend to and borrow from each other in the interbank market. It is an
unsecured system of lending and the term may vary from overnight to one year.
Certificate of deposit: It is a savings instrument with a maturity date, a fixed interest rate,
and can be issued in any denomination. The investor or bearer of the certificate receives an
interest at the end of the deposit period. There are two forms of CD: negotiable and non-
negotiable CD.
LO.j: Describe repurchase agreements (repos) and the risks associated with them.
A repurchase agreement or repo is a sale and repurchase agreement. It is an agreement
between two parties where the seller sells a security with a commitment to buy the same
security back from the purchaser at an agreed-upon price at a future date. The interest rate
negotiated between both the parties is called the repo rate.
A haircut or repo margin is the difference between the market value of security (collateral)
and the amount lent to the dealer. Repurchase agreements are a common source of funding
for dealer firms and are also used to borrow securities to implement short positions. If you
look at the agreement from a lender’s perspective, it is a reverse repo agreement.

Practice Questions
1. Which of the following best describes a bond issued internationally, outside the
jurisdiction of any one country?
A. Eurobond.
B. Foreign bond.
C. Dual currency bond.
2. An appropriate reference rate for a floating rate note should least likely match the note’s:
A. maturity.
B. currency.
C. reset frequency.
3. In which type of primary market transaction does an investment bank buy and resell the
newly issued bonds to investors or dealers?
A. Single-price auction.
B. Best effort offering.
C. Underwritten offering.
4. Transactions in the secondary bond market most likely take place through:
A. dealer markets.
B. brokered markets.
C. organized exchanges.
5. Which of the following best describes sovereign bonds?

A. Bonds backed by the revenues of a specific project of a local government.
B. Bonds backed by the collateral of a national government.
C. Bonds backed by the taxing authority of a national government.
6. A bond issued by a multilateral agency such as the International Monetary Fund (IMF) is
best described as:
A. non-sovereign government bond.
B. supranational bond.
C. quasi-government bond.
7. A bond issue where the specific bonds that will mature and be paid off each year before
final maturity is not known, most likely has a:
A. term maturity
B. serial maturity
C. sinking fund arrangement.

8. Which of the following statements about negotiable certificates of deposits is most

accurate?
A. They are typically available in small denominations.
B. They can be sold in the open market prior to maturity.
C. A significant penalty is imposed if the depositor withdraws funds prior to maturity.
9. The repo margin on a repurchase agreement is most likely to be higher when:

A. the underlying collateral is in short supply.
B. the maturity of the repurchase agreement is short.
C. the credit risk associated with the underlying collateral is high.

Solutions
1. A is correct. Eurobonds are issued internationally, outside the jurisdiction of any single
country. B is incorrect because foreign bonds are considered international bonds, but
they are issued in a specific country, in the currency of that country, by an issuer
domiciled in another country. C is incorrect because dual currency bonds make coupon
interest payments in one currency and the principal repayment at maturity in another
currency.
2. A is correct. An appropriate reference rate for a floating-rate note should match its
currency and the frequency of rate resets, such as 6-month U.S. dollar Libor for a
semiannual floating rate note issued in U.S. dollars.
3. C is correct. In an underwritten offering the investment bank purchases all of the bond
issue and resells it to the investors or dealers.
4. A is correct. Transactions in the secondary bond market primarily take place through
dealers.
5. C is correct. Sovereign bonds are usually unsecured obligations of the national

government. They are not backed by collateral, but by the taxing authority of the national
government.
6. B is correct. Bonds issued by multilateral agencies that operate across national borders
are called supranational bonds.
7. C is correct. In a serial maturity structure, the bondholders know in advance which bonds
will be retired. In contrast, the bonds retired annually with a sinking fund arrangement
are designated by a random drawing. A is incorrect because a bond issue with a term
maturity structure is paid off in one lump sum at maturity.
8. B is correct. A negotiable certificate of deposit (CD) allows any depositor (initial or

subsequent) to sell the CD in the open market prior to maturity. A is incorrect because
negotiable CDs are mostly available in large (not small) denominations. C is incorrect
because a penalty is imposed if the depositor withdraws funds prior to maturity for non-
negotiable (instead of negotiable) CDs.
9. C is correct. The repo margin is the difference between the market value of the
underlying collateral and the value of the loan. The repo margin is typically higher when
the credit risk associated with the underlying collateral is high. The repo margin is
typically lower if the underlying collateral is in short supply (or if there is a high demand
for it) and when the maturity of the repurchase agreement is short.

R52 Introduction to Fixed Income Valuation 2019 Level I Notes
R52 Introduction to Fixed-Income Valuation

1. Introduction
In this reading, we will see how to value different types of fixed-income securities such as
fixed-rate bonds, floating-rate bonds, and money market securities. This reading will cover:
• How to price a bond.
• How bond prices and yields are calculated.
• The term structure of interest rates.
• Yield spreads over benchmark interest rates.
2. Bond Prices and the Time Value of Money
2.1. Bond Pricing with a Market Discount Rate
A bond’s price is the present value of all future cash flows at the market discount rate. The
discount rate is the rate of return required by investors given the risk of investment in the
bond. It is also known as the required yield, or required rate of return.
PMT PMT PMT+FV
PV of bond = (1+r)1 + (1+r)2 + ⋯ + (1+r)N
where:
PMT = coupon payment per period
FV= par value of the bond paid at maturity
r = market discount rate
N = number of periods until maturity
Example
The coupon rate on a bond is 4% and the payment is made once a year. The time to maturity
is five years and the market discount rate is 6%. What is the bond price per 100 of par value?
Solution:
Start by drawing a timeline for the cash flows. The par value of the bond or principal is $100.
A coupon payment of $4 is made every year. At maturity (at the end of five years), a payment
of $104 (principal of $100 + coupon of $4) is made.
We are required to calculate the present value of bond at time t = 0. For that, we discount all
the future cash flows at the market discount rate of 6%.

End of year Type of cash flow Amount Present value

1 Coupon 4 3.77
2 Coupon 4 3.55
3 Coupon 4 3.36
4 Coupon 4 3.17
5 Coupon + principal 104 77.71
91.56
4 4 4 4 104
Using the formula, PV = 1.06 + 1.062 + 1.063 + 1.064 + 1.065 = 91.575
Note: The table and formula above were just for your understanding.
On the exam, solve this quickly using a financial calculator:
N = 5; I/Y = 6; FV = 100; PMT = 4; PV = ? PV = -91.575
Notice the present value of the bond (91.575) is lower than the par value of the bond (100).
Premium, Par, and Discount Bonds
Example
Assume we have another bond with a coupon rate of 8%, paid annually. If the market
discount rate is again 6%, what is the price of the bond?
Solution:
Note that the coupon rate here is higher than the market rate. Calculate PV using these input
values: N = 5; I/Y = 6; PMT = 8; FV = 100; CPT PV
PV = -108.425. In this case, the present value of the bond is higher than its par value. Such a
bond is called a premium bond. Since the coupon rate (8%) is higher than the required
return of 6%, investors pay more than the par value for the bond.
What if the coupon rate is 6%?
N = 5; I/Y = 6; PMT = 6; FV = 100; CPT PV
PV = -100. The present value is equal to the par value of the bond.
What if the coupon rate is 2%?
N = 5; I/Y = 6; PMT = 2; FV = 100; CPT PV
PV = -83.151. This type of bond, which sells at a price below its par value, is called a discount
bond. Investors require a return of 6% but it pays a coupon of only 2%, so investors pay less.
Par, premium, or Relationship between coupon rate & market discount rate
discount
Par bond Coupon rate = market discount rate
Discount bond Coupon rate < market discount rate
Premium bond Coupon rate > market discount rate

2.2. Yield to maturity

The yield to maturity (YTM) is the internal rate of return on the cash flows – the uniform
interest rate that will make the sum of the present values of future cash flows equal to the
price of the bond. It is the implied market discount rate. In simpler terms, it is a bond’s
internal rate of return - the rate of return on a bond including interest payments and capital
gain if the bond is held until maturity. Yield to maturity is based on three important
assumptions:
• The investor holds the bond to maturity.
• The issuer does not default on payments and pays coupon and principal as they come
due.
• The investor is able to reinvest all proceeds (coupons) at the YTM. (This is an
unrealistic assumption as the interest rates may increase or decrease after the bond
is purchased. So the coupon may be reinvested at a higher or lower rate.)
Example
A $100 face value bond with a coupon rate of 10% has a maturity of 4 years. The price of the
bond is $80. What is its yield to maturity?
Solution:
Based on YTM’s definition, we come up with the equation below:
10 10 10 110
80 = (1+r)1 + (1+r)2 + (1+r)3 + (1+r)4
This equation can be solved using trial and error but it is much easier to use a financial
calculator: N = 4; PMT = 10; FV = 100; PV= -80; CPT I/Y = 17.34%. The bond is trading at a
discount. So the coupon rate (10%) must be lower than market rate (17.34%).
Example
Calculate the yields to maturity for the following bonds:
Bond Coupon Payment per Period Number of Periods to Maturity Price
A 2.50 3 102.80
B 2.00 5 97.76
C 0.00 48 23.425
Solution:
2.5 2.5 102.5
Bond A: 102.80 = (1 + r) + (1 + r)2 + (1 + r)3, r = 1.54%
2 2 2 2 102
Bond B: 97.76 = (1 + r) + (1 + r)2 + (1 + r)3 + (1 + r)4 + (1 + r)5, r = 2.48%
100
Bond C: 23.425 =(1 + r)48, r = 3.07%

2.3. Relationships between the Bond Price and Bond Characteristics

In this section, we will study the relationship between the bond price and market discount
rate. The underlying principle is that a bond’s price changes whenever there is a change in
market discount rate.
Inverse Effect and Convexity Effect
The bond price is inversely related to the market discount rate. As you can see from the
exhibit above, when the discount rate goes down, the price of the bond increases. This is
called the inverse effect. Remember that the price-yield relationship of a bond is not a
straight line. Also note that price changes are not linear for the same amount of change in
discount rate. At an interest rate of 20%, the price of the bond is 100. If the interest rate
decreases from 20% to 19%, the bond price increases by 4.34%. However, if the interest
rate increases from 20% to 21%, the bond price decreases by only 4.05%. This difference in
price change is called the convexity effect.
Coupon Effect
Consider three bonds (A, B, C) which have the same time to maturity but different coupon
rates.
Coupon Price Price % Price %
Bond
Rate At 20% At 19% Change At 21% Change
A 10.00% 58.075 60.950 4.95% 55.405 –4.60%
B 20.00% 100.000 104.339 4.34% 95.946 –4.05%
C 30.00% 141.925 147.728 4.09% 136.487 –3.83%
Note that the bond with lowest coupon rate has the highest interest rate sensitivity. In other

words, a 1% change in interest rates causes a greater % change in the price of bond A (10%
coupon) relative to bonds B (20% coupon) and C (30% coupon). This is called the coupon
effect.
Maturity Effect
For the same coupon rate, a longer-term bond has a greater percentage price change than a
shorter-term bond when their market discount rates change by the same amount. This is
called the maturity effect.
Summary of relationship between bond prices and discount rates
Inverse effect Bond price is inversely related to the discount rate.
Convexity The percentage price change is more when discount rate goes down
effect than when it goes up.
Coupon effect For the same time to maturity and same change in discount rate the
price of a low-coupon bond changes more than a high-coupon bond.
Maturity effect For the same coupon rate and same change in discount rate, the price
of a long-term bond changes more than a short-term bond.
Note: Low-coupon and Long-term bonds are more sensitive to changes in discount
rates.
Relationship between Bond’s Price and Maturity
If the yield stays constant, bond prices change and come closer to par as time passes and as
they near maturity date. This is called “pull to par”. For a premium bond, the price decreases
over time to par and for a discount bond, the price increases over time to par.
The exhibit below shows the constant-yield price trajectories for 5% and 10% annual
coupon payment, 8-year bonds. Both bonds have a market discount rate of 7.5%. The 5%
bond's initial price is 85.3567 and the 10% bond's initial price is 114.6433.
Year 5% Bond 10% Bond
1 85.3567 114.6433
2 86.7585 113.2415
3 88.2654 111.7346
4 89.8853 110.1147
5 91.6267 108.3733
6 93.4987 106.5013
7 95.5111 104.4889
8 97.6744 102.3256
100.0000 100.0000

Instructor’s Note
If the yield stays constant:
• A premium bond’s price decreases to par value as its time to maturity approaches zero.
• A discount bond’s price increases to par value as its time to maturity approaches zero.
• A par bond’s value remains unchanged as it approaches maturity.
2.4. Pricing Bonds with Spot Rates
Notice that we have used the same market discount rate for each of the future cash flows.
Ideally, the basic approach to price a bond is to discount each cash flow at the corresponding
market discount rate; hence, a sequence of discount rates must be used.
Spot rates are yields to maturity on zero-coupon bonds maturing at the date of each cash
flow. Since zero-coupon bonds have no intermediate cash flows, the actual yield on a zero-
coupon bond is used as the discount rate for a cash flow occurring at the same maturity date.
Bond price (or value) determined using spot rates is sometimes referred to as the bond’s
‘no-arbitrage’ value. If a bond’s price differs from its no-arbitrage value, an arbitrage
opportunity exists in the absence of transaction costs.
PMT PMT PMT+FV
PV = (1+Z 1
+ (1+Z 2
+ ⋯ + (1+Z N
1) 2) N)
where:
PMT = coupon payment
FV = par value of the bond
Z1 = spot rate or yield of zero-coupon bond for period 1
Z2 = spot rate or yield of zero-coupon bond for period 2
ZN = spot rate or yield of zero-coupon bond for period N

Example
The one-year spot rate is 2%, the two-year spot rate is 3%, and the three-year spot rate is
4%. What is the price of a three-year bond that makes a 5% annual coupon payment?
Solution:
Think of the bond as a portfolio of three zero-coupon bonds with one, two and three-year
maturities with yields of 2%, 3%, and 4% respectively. Draw a timeline for the cash flows.
5 5 105
Bond’s no-arbitrage value = 1.02 + 1.032 + 1.043 = 102.96
Is there a single rate (yield) for the bond that equals the present value of cash flows to its
purchase price? The YTM can be calculated as:
5 5 105
102.96 = 1
+ 2
+
(1 + r) (1 + r) (1 + r)3
Computing for r, we get 3.93%, which is the bond’s yield to maturity.
3. Prices and Yields: Conventions for Quotes and Calculations
3.1. Flat Price, Accrued Interest, and the Full Price
When a bond is between coupon dates, its price has two parts: flat price and accrued
interest. The sum of the two parts is called the full price or dirty price.
Full price or dirty price = Flat price + Accrued interest
PV full = PV flat + AI
Flat price = Full price – Accrued interest
t
Accrued interest = T x PMT
where:
t = number of days since the last coupon payment
T = number of days between coupon payments
PMT = interest payment per period
As indicated in the above equation, the accrued interest is based on the number of days since
the last coupon payment and the number of days between coupon payments. Here are two

conventions for calculating the number of days:

• Actual convention: Uses the actual number of days, including weekends, holidays and
leap days as in our example above.
• 30/360 convention: Assumes 30 days in a month and 360 days in a year.
Illustration of Flat Price and Dirty Price through an Example
Assume you own a two-year bond issued on 10 January 2017 with a par value of $100. The
bond pays a coupon of 8% half-yearly. The first coupon is due on 10 July 2017, the next on 10
January 2018, the third on 10 July 2018, and the final one is paid along with principal at
maturity date on 10 January 2019. The market discount rate is equal to the coupon rate and
so the flat price is 100. An investor wants to purchase the bond from you on 31 May 2017.
What is the full price he must pay?
You have held the bond for 140 days (since the bond was issued) and earned an interest for
this period even though it has not been paid. The next coupon payment is $4. Assuming each
period is 180 days the accrued interest is 4 x (140/180) = 3.11. The full price is 100.00 +
3.11 = 103.11. This is the amount you will receive on selling the bond.
Note that it is the flat (or clean) price which is quoted. The accrued interest increases every
day until the coupon payment. So, if the accrued interest was included there would be a
variation in bond quotes on a daily basis and a sudden drop after the coupon payment is
made, which is misleading.
The full price of a bond can also be calculated using the equation shown below.
t
PVfull = PV x (1 + r)T
where:
t = number of days since the last coupon payment
T = number of days between coupon payments
PV = present value of the bond (not the flat price)
Example
A 5% French corporate bond is priced for settlement on 14 July 2015. The bond makes semi-
annual coupon payments on 1 March and 1 September of each year and matures on 1
September 2020. Assuming a 30/360 day count convention for accrued interest, calculate
the full price, the accrued interest, and the flat price per EUR 100 of par value for the
following three yields to maturity: (I) 4.75%, (II) 5.00% and (III) 5.10%.
Solution:
Given the 30/360 day-count convention, there are 134 days between the last coupon on 1
March 2015 and the settlement date on 14 July 2015 (120 days for full months of March,
April, May, and June, plus 14 days in July). Therefore, the fraction of the coupon period that
has gone by is assumed to be 134/180. At the beginning of the period, there are 11 periods

to maturity.
I) Stated annual YTM of 4.75%
The price at the beginning of the period is 101.198 per 100 of par value.
2.5 2.5 102.5
PV = 1.02375 + 1.023752 + ⋯ + 1.0237511 = 101.198
134
The full price on 14 July is PV(full) = 101.198 × (1.02375180 ) = 102.979
134
The accrued interest is AI = 2.5 × (180) = 1.861
The flat price is PV(flat) = 102.979 - 1.861 = 101.118

II) Stated annual YTM of 5.00%
2.5 2.5 102.5
PV = 1.025 + 1.0252 + ⋯ + 1.02511 = 100.00
134
134

III) Stated annual YTM of 5.10%
2.5 2.5 102.5
PV = 1.0255 + 1.02552 + ⋯ + 1.025511 = 99.5256
134
134

The flat price of the bond is a little below par value, even though the coupon rate and the
yield to maturity are equal, because the accrued interest does not take into account the time
value of money. The accrued interest is the interest earned by the owner of the bond for the
time between the last coupon payment and the settlement date. However, that interest
income is not received until the next coupon date. The calculation of accrued interest in
practice neglects the time value of money. Therefore, compared to theory, the reported
accrued interest is a little “too high” and the flat price is a little “too low.”
3.2. Matrix Pricing
One can easily get information at what price a stock is trading. But, it is not easy to

determine the price of most bonds as they do not trade as often as equity. Matrix pricing is
an estimation process to find the market price of a not-so-frequently traded bond based on
the prices of comparable bonds with similar times to maturity, type of issuer, coupon rates,
and credit quality. This is also applicable for bonds that have not been issued yet.
For example, consider a three-year, 4% semi-annual bond X that you are trying to value.
Comparable bonds whose prices are known are shown in the matrix below. Based on the
four bonds, we can determine the price of bond X.
Matrix Pricing
2% coupon 3% coupon 4% coupon 5% coupon
Two years 98.5 102.25
3.786% 3.821%
Three years Bond X
Four years
Five years 90.25 99.125
4.181% 4.196%
There are five steps to determine the value of a bond using the matrix pricing method:
1. Determine the YTM of comparable bonds, which is given to us already. If it were not
given, you can calculate the YTM using the price and coupon. For example, YTM of a two-
year, 3% coupon is: N = 4; PMT = 1.5; FV = 100; PV = -98.5; CPT I/Y. I/Y = 3.786%.
2. Determine the average yield for two-year bonds:
0.03786 + 0.03821
= 0.038035
2
3. Determine the average yield for five-year bonds:
0.04181 + 0.4196
= 0.041885
2
4. Calculate the three-market discount rate using linear interpolation. We have the data
(yield) for two-year and five-year bonds, but not a three-year bond. From the graph you
can see that the YTM of a three-year bond = 0.038 + x.

3−2
x can be calculated as x (0.041885 - 0.038035) = 0.001283. Discount rate for the
5−2
three-year bond = 0.038035 + 0.001283 = 0.039318 = 3.39%.
5. Using 0.039318 as the discount rate, compute the price for the three-year bond.
N = 6; I/Y = 1.966; PMT = 2; FV = 100; CPT PV. PV = -100.1906.
A few points to be noted on matrix pricing:
• Matrix pricing is used when underwriting new bonds to estimate the required yield
spread over the benchmark rate.
• Benchmark rate is Libor, or a government bond with the same maturity as the bond
being priced.
• Assume the YTM for a new bond is calculated using the matrix pricing method as
2.2% and a comparable government bond has a yield of 2.0%. The difference between
the yield on a new bond over its benchmark rate is called the required yield spread
or spread over the benchmark. In this case, it is 0.2%.
• Yield spreads are always specified in basis points where 1 basis point is one-
hundredth of a percentage point. In this case, it is 20 basis points.
Example
An analyst decides to value an illiquid 3-year, 3.75% annual coupon payment corporate
bond. Given the following information and using matrix pricing, what is the estimated price
of the illiquid bond? Additional information: 2-year, 4.75% annual coupon payment bond
priced at 105.60 and 4-year, 3.5% annual coupon payment bond priced at 103.28.
Solution:
The required yield on the 2-year, 4.75% bond priced at 105.60 is 1.871%.
The required yield on the 4-year, 3.50% bond priced at 103.28 is 2.626%.
The estimated market discount rate for a 3-year bond having the same credit quality is the
1.871% + 2.626%
average of two required yields: 2
= 2.249%.

The estimated price of the illiquid 3-year, 3.75% annual coupon payment corporate bond is
104.3078 per 100 of par value.
3.75 103.75
3.75
+ 1.022492 + 1.022493 = 104.3078
1.02249
3.3. Yield Measures for Fixed-Rate Bonds

Before discussing yield measures for money market instruments, it is important to
understand the concept of periodicity. Periodicity is the number of compounding periods in
a year, or number of coupon payments made in a year.
The stated annual rate for a bond will depend on the periodicity we are assuming. The
stated annual rate is also called the annual percentage rate or APR.
Instructor’s Note
A quarterly coupon paying bond has a periodicity of four, while a semi-annual bond has a
periodicity of two, and a monthly-pay bond with a given annual yield would have a
periodicity of twelve.
Consider a 5-year, zero-coupon bond priced at 80 per 100 par value. What is the stated
annual rate for periodicity = 4, periodicity = 2, and periodicity = 1?
When periodicity = 4: compounding happens four times a year. N = 20; (5 years x 4 = 20).
PMT = 0 as it is a zero-coupon bond. PV = -80; FV = 100; CPT I/Y = 1.12. This is the rate for
each quarter. The stated annual rate is 1.12 x 4 = 4.487%.
When periodicity = 2: N = 10; PV = -80; PMT = 0; FV= 100; CPT I/Y = 2.2565. The stated
annual rate is 2.25 x 2 = 4.51%.
When periodicity = 1: N = 5; PV = -80; PMT = 0; FV= 100; CPT I/Y = 4.56%. With a periodicity
of 1, the stated annual rate is the same as the effective annual rate.
The formula for conversion based on periodicity is
APR m m APR n n
(1 + ) = (1 + )
m n
Example
A 4-year, 3.75% semi-annual coupon payment government bond is priced at 97.5. Calculate
the annual yield to maturity stated on a semi-annual bond basis and convert the annual yield
to:
1. An annual rate comparable to bonds that make quarterly coupon payments.
2. An annual rate comparable to bonds that make annual coupon payments.
Solution to 1:
The stated annual yield to maturity on a semiannual bond basis can be calculated using a
financial calculator: N = 8; PMT = 1.875; FV = 100; PV = -97.5; CPT I/Y. I/Y = 2.2195%.

Hence, the stated annual yield to maturity = 2.2195% x 2 = 4.439%.

0.04439 2 APR4 4
(1 + ) = (1 + )
2 4
APR 4 = 4.415%
The annual rate of 4.439% for compounding semiannually compares with 4.415% for
compounding quarterly.
Solution to 2:
0.04439 2
(1 + ) = (1 + APR1 )
2
APR1 = 4.488%
The annual percentage rate of 4.439% for compounding semiannually compares with an
effective annual rate of 4.488%.
The effective annual rate (EAR) is the yield on an investment in one year taking into
account the effects of compounding. This rate has a periodicity of one as there is only one
compounding period per year. EAR is used to compare the rate of return on investments
with different frequency of compounding (periodicities).
Listed below are a few more yield measures to be aware of:
• Semiannual bond equivalent yield: Yield per semi-annual period times two. If the yield
per semi-annual period is 2%, then the semi-annual bond equivalent yield is 4%.
• Street convention: It is the yield to maturity using a 30/360 day convention assuming
payments are made on scheduled dates, even if the payment date fell on a weekend or a
holiday.
• True yield: Yield to maturity calculated using an actual calendar of weekends and
holidays. For instance, assume the coupon date falls on 15 March 2015, which is a
Sunday. Street convention assumes the payment is made on that date, whereas true yield
assumes the payment is made on 16 March if it is a business day. The coupon payment is
discounted back from 16 March instead of 15 March.
• Government equivalent yield: Yield to maturity calculated using the actual day/count
convention used for U.S. Treasuries.
• Current yield: Sum of the coupon payments received over the year divided by the flat
price. It is also called the income or interest yield. Example: A 5-year, 8% semiannual
coupon payment bond is priced at $960. Its current yield is 80/960 = 0.0833 = 8.33%.
Current yield is not an accurate measure of the rate of return as it ignores the frequency
of coupon payments, reinvestment income, and capital gain/loss on a bond.
Annual cash coupon payment
Current yield =
Bond price

• Yield-to-call: Calculates the rate of return on a callable bond if it is bought at market

price and held until the call date. The difference between YTM and the yield-to-call is that
YTM assumes the bond is held to maturity. Calculation of yield-to-call is the same as YTM
where N = number of periods to call date and FV= call price.
• Yield-to-first call (YTFC): It is the internal rate of return if the bond was bought at
market price and held until the first call date.
• Yield-to-second call: Similarly, the yield on a callable bond if it was bought at market
price and held to the second call date is called yield-to-second call.
• Yield-to-worst: Yield is calculated for every scenario. The lowest yield is called the yield-
to-worst.
Example
An analyst observes the following statistics for two bonds:
Bond A Bond B
Annual Coupon Rate 6.00% 10.00%
Coupon Payment Frequency Semi-annually Quarterly
Years to Maturity 4 years 4 years
Price (per 100 par value) 95 110
Current Yield ? ?
Yield to Maturity ? ?
1. Calculate both yield measures for the two bonds.
2. How much additional compensation, in terms of yield to maturity, does a buyer of Bond A
receive for bearing additional risk compared with Bond B
Solution to 1:
The current yield for Bond A is 6/95 = 6.316% and the yield to maturity for Bond A is
7.469%.
The current yield for Bond B is 10/110 = 9.091% and the yield to maturity for Bond B is
7.106%.
Solution to 2:
Compare the yields for the same periodicity to answer this question. 7.106% for a
periodicity of four converts to 7.169% for a periodicity of two. The additional compensation
for the greater risk in Bond A is 30 bps (0.07469 - 0.07169).

Example
Consider a bond which is selling for $100 and has the following cash flows:
Calculate the yield-to-first call and yield-to-second call.

Solution:
The yield-to-first call can be calculated as follows: PV= -100; N = 5; PMT = 10; FV = 102; CPT
I/Y; I/Y = 10.325%. YTFC = 10.325%.
The yield-to-second call in our example will be 10.09%: PV= -100; N = 8; PMT = 10; FV =
101; CPT I/Y; I/Y = 10.09%.
Example
A bond with 4 years remaining until maturity is currently trading for 101.75 per 100 of par
value. The bond offers a 5% coupon rate with interest paid semiannually. The bond is first
callable in 2 years and is callable after that date on coupon dates according to the following
schedule:
End of Year Call Price
2 102.50
3 101.50
4 100.00
1. What is the bond's annual yield-to-first-call?
2. What is the bond's yield-to-worst?
Solution to 1:
The yield-to-first-call can be calculated with the following key strokes:
PV = -101.75, FV = 102.5, N = 4, PMT = 2.5, CPT I/Y = 2.6342.
To arrive at the annualized yield-to-first-call, the semiannual rate must be multiplied by two.
(2.6342 × 2 = 5.2684)

Solution to 2:
The yield-to-worst is 4.52%. The bond's yield to worst is the lowest of the sequence of
yields-to-call and the yield to maturity. Yield-to-first-call = 5.27%, Yield-to-second-call =
4.84%, and Yield to maturity = 4.52%.
3.4. Yield Measures for Floating-Rate Notes
Floating-rate notes (FRN) are instruments where coupon/interest payments change from
period to period based on a reference interest rate. Some important points to note about
floating-rate notes:
• The objective is to protect the investor from volatile interest rates.
• The reference rate, usually a money market instrument such as a T-bill or an
interbank offered rate like Libor, is used to calculate the interest payments. This rate
is determined at the beginning of each period, but the interest is actually paid at the
end of the period.
• Often, the coupon rate of an FRN is not just the reference rate, but a certain number of
basis points, called the spread, is added to the reference rate.
• The specified yield spread over the reference rate is called the quoted margin.
• The spread remains constant throughout the life of the bond. The amount of spread
depends on the credit quality of the issuer.
Example of a Floating Rate Note
Moody’s assigned a long-term credit rating of A2 to Nationwide, U.K.’s largest building
society. Nationwide issued a perpetual floating-rate bond with a coupon rate of 6 month
Libor + 240 basis points. The 2.4% quoted margin is a reflection of its credit quality. On the
other hand, AAA-rated Apple sold a three-year bond at 0.05% over three-month Libor in
2013 as its credit risk was very low.
Coupon rate of a FRN = reference rate + quoted margin
The required margin is the spread demanded by the market. We saw that the quoted
margin, or the spread over the reference rate, is fixed at the time of issuance. But what
happens if the floater’s credit risk changes and investors demand an additional spread for
bearing this risk? The required margin is the additional spread over the reference rate such
that the FRN is priced at par on a rate reset date. If the required margin increases
(decreases) because of a credit downgrade (upgrade), the FRN price will decrease (increase).
For example, assume a floater has a coupon rate of 3-month Libor plus 50 basis points. Six
months after issuance, the issuer’s credit rating is downgraded and the market demands a
required spread of 75 basis points. The coupon paid by the floater is lower than what the
market demands. As a result, the floater would be priced at a discount to par as the cash flow
is now discounted at a higher rate. The amount of the discount will be the present value of
differential cash flows, i.e., the difference between the required and quoted margins.
Conversely, if the credit rating of the issuer improves, the required margin would be below

the quoted margin, and the market will demand a lower spread.
How required margin affects a floater’s price at reset date
Relationship between quoted and Floater’s price at reset date
required margin
Required margin = quoted margin Par
Required margin > quoted margin Discount (below par)
Required margin < quoted margin Premium (above par)
The required margin is also called the discount margin. FRNs can be valued using the
model shown below.
FV FV FV
(Index+QM)∗ (Index+QM)∗ (Index+QM)∗ +FV
PV = m
Index+DM 1
+ m
Index+DM 2
+ ⋯+ m
Index+DM N
(1+ ) (1+ ) (1+ )
m m m
where:
PV = present value of the FRN
Index = reference rate, stated as an annual percentage rate
QM = quoted margin, stated as an annual percentage rate
FV = future value paid at maturity, or the par value of the bond
m = periodicity of the floating-rate note, or the number of payment periods per year
DM = discount margin; the required margin stated as an annual percentage rate
N = number of evenly spaced periods to maturity
Equation 1 for reference:
PMT PMT PMT+FV
PV of bond = (1+r)1 + (1+r)2 + ⋯ + (1+r)N
How to interpret the floating-rate note equation:

• Think of it as an extension of Equation 1, we will draw similarities between the two
equations.
FV
• (Index + QM) ∗ is the first interest payment similar to PMT of Equation 1, which is
m
the coupon payment per period.
• (Index + QM) is the annual rate.
• Since it is divided by periodicity we get the interest payment for that period.
• In Equation 1, cash flows are discounted at 1 + r. For FRN, the cash flow for the first
Index+DM Index+DM
period is discounted at 1+ , for the second period at (1 + ), and so
m m
on.
This is considered a simple model because of the following assumptions:
• The value is calculated only on reset dates. There is no accrued interest, so the flat
price is the full price.
• The model uses a 30/360 day-count convention, which means periodicity is always
an integer.

• The same reference rate is used in the numerator and denominator for all payment
periods.
Example
A 3-year Italian floating-rate note pays 3-month Euribor plus 0.75%. Assuming that the
floater is priced at 99, calculate the discount margin for the floater if the 3-month Euribor is
constant at 1% (assume 30/360 day-count convention).
Solution:
The interest payment for each period is (1.00% + 0.75%) / 4 = 0.4375%.
The keystrokes to calculate the market discount rate are: PV = -99, PMT = 0.4375, FV = 100,
N = 12, CPT I/Y = 0.5237 * 4, I/Y = 2.09%
The discount margin for the floater is 2.09% - 1% = 1.09% or 109 bps.
3.5. Yield Measures for Money Market Instruments
Money market instruments are short-term debt securities. They have maturities of one year
or less, ranging from overnight repos to one-year certificates of deposit.
Differences in Bond Market and Money Market Yields
Bond Market Yields Money Market Yields
YTM is annualized and compounded. Rate of return is annualized but not
compounded; stated on a simple interest
basis.
YTM calculated using the standard time Non-standard calculation using discount
value of money approach using a financial rates and add-on rates.
calculator.
YTM stated for a common periodicity for Instruments with different times to
all times to maturity. maturity have different periodicities for
the annual rate.
The calculation of interest of a money market instrument is different from calculating
accrued interest on a bond. Money market instruments can be classified into two categories
based on how the rates are quoted:
• Discount rates: T-bills, commercial paper (CP), and banker’s acceptances are discount
instruments. It means they are issued at a discounted price, and pay par value at
maturity. They do not make any payments before maturity. The difference between the
purchase price and par value at redemption is the interest earned. Note: Do not confuse
this discount rate with the rate used in TVM calculations.
Price of a money market instrument quoted on a discount basis
days to maturity
PV = FV x (1- x DR)
year

where:
PV = present value of the money market instrument
FV = face value of the money market instrument
days to maturity = actual number of days between settlement and maturity
year = number of days in the year. Most markets use a 360-day year.
DR = discount rate, stated as an annual percentage rate (APR)
Money market discount rate
Year FV−PV
Money market discount rate DR = (days to maturity) ∗ FV
FV-PV = interest earned on the instrument (this is the discount)

year
= periodicity of the instrument
days
• Add-on rates: Bank term deposits, repos, certificates of deposit, and indices such as
Libor/Euribor are quoted on an add-on basis. For a money market instrument quoted
using an add-on rate, interest is added to the principal to calculate the redemption
amount at maturity. In simple terms, if PV is the initial principal amount, days is the days
to maturity, and year is the number of days in a year, then the amount to be paid at
days to maturity
maturity is: FV = PV + PV x AOR x where AOR is the add-on rate stated on
year
an annualized basis.
Present value or price of a money market instrument quoted on an add-on basis
FV
PV = Days to maturity
1+ x AOR
Year
where:
PV = present value of the money market instrument
FV = amount paid at maturity including interest
days = number of days between settlement and maturity
year = number of days in a year
AOR = add-on rate stated as an annual percentage rate
Add-on rate
Year FV−PV
AOR = ( )∗
Days PV
Instructor’s Note
The primary difference between a discount rate (DR) and an add-on rate (AOR) is that the
interest is included on the face value of the instrument for DR whereas it is added to the
principal in case of AOR.
Example
Suppose that a banker’s acceptance will be paid in 91 days. It has a face value of $1,000,000.

It is quoted at a discount rate of 5%. What is the price of the banker’s acceptance?
Solution:
Days to maturity
PV = FV * (1 − ∗ DR)
Year
FV = 1,000,000
Days = 91
Year = 360 days
DR = 5%
91
PV = 1,000,000 ∗ (1 − ∗ 0.05) = $987,361
360
Suppose that a Canadian pension fund buys a 180-day banker’s acceptance (BA) with a
quoted add-on rate of 4.38% for a 365-day year. If the initial principal amount is CAD 10
million, what is the redemption amount due at maturity?
Solution:
Year FV − PV
AOR = ( ) ∗
Days PV
365 FV−10,000,000
0.0438 = 180 ∗ 10,000,000
FV = $10,216,000
Comparing Discount Basis with Add-On Yield
There are two approaches to compare the return of two money market instruments if one is
quoted on a discount basis and the other on an add-on basis.
First approach: If you don’t want to memorize one more formula, follow this approach:
1. Determine the present value of the instrument quoted on a discount basis.
2. Use the present value to determine the AOR.
3. Compare the two AORs to see which instrument offers a better return.
Second approach: Use the following relationship between AOR and DR:
Relationship between AOR and DR
DR
AOR = Days to maturity
1 − ∗ DR
Year
Example
A T-bill with a maturity of 90 days is quoted at a discount rate of 5.25%. Its par value is $100.
Calculate the add-on rate.
Solution:

Using the first approach:

FV = 100; Days = 90; Year = 360 days; DR = 5.25%
90
PV = 100 ∗ (1 − 360 ∗ 0.0525) = $98.687
360 100−98.687
AOR = * = 5.32%.
90 98.687
Using the second approach:

0.0525
AOR = 90 = 5.3198%
1− ∗ 0.0525
360
Example
Money market Instrument Quotation Basis Number of Days in the Year Quoted Rate
A Discount Rate 360 3.23%
B Discount Rate 365 3.46%
C Add-on Rate 360 3.25%
D Add-on Rate 365 3.35%
Given the four 90-day money market instruments, calculate the bond equivalent yield for
each of them. Which instrument offers the highest rate of return if the credit risk is the
same?
Solution:
90
A. The price of instrument A is 100 – (360 × 3.23) = 99.1925 per 100 of par value. The bond
365 100 – 99.1925
equivalent yield is ( 90 ) × = 3.30%.
99.1925
90
B. The price of instrument B is 100 – (365 × 3.46) = 99.1468 per 100 of par value. The bond
365 100 – 99.1468
equivalent yield is ( 90 ) × = 3.49%.
99.1468
90
C. The redemption amount per 100 of principal is 100 + (360 × 3.25) = 100.8125. The bond
365
equivalent yield is × (100.8125 - 100) = 3.295%.
90
D. The quoted rate for instrument D of 3.35% is the bond equivalent yield. Instrument B
offers the highest rate of return on a bond equivalent yield basis.
Periodicity of the Annual Rate
Another difference between yield measures in the money market and the bond market is the
periodicity of the annual rate. Because bond yields to maturity are computed using interest
rate compounding, there is a well-defined periodicity. For instance, bond yields to maturity
for semi-annual compounding are annualized for a periodicity of two. Money market rates
are computed using simple interest without compounding. In the money market, the
periodicity is the number of days in the year divided by the number of days to maturity.

Therefore, money market rates for different times to maturity have different periodicities.
Number of days in the year
Periodicity of a money market instrument = Number of days to maturity
Example
A 90-day T-bill has a BEY of 11%. Calculate its semiannual bond yield.
Solution:
The 11% BEY of the T-bill is based on a periodicity of 365/90. The periodicity of a
semiannual bond is 2. Give this information, we can create the equation shown below and
solve for r. We will get r = 0.1115 = 11.15%.
365
( )
90
0.11 r 2
(1 + 365 ) = (1 + )
2
90
4. The Maturity Structure of Interest Rates

Maturity or Term Structure of Interest Rates
The term structure of interest rates is the relationship between interest rates and bonds
with different times to maturity. The basic premise is that interest rates change when
inflation rates are expected to change over a period of time. For example, a one-year zero-
coupon bond may have an interest rate of 7.50%, while a two-year zero-coupon bond may
have an interest rate of 9.75%, assuming all the other factors are the same (currency, credit
rating, periodicity, etc.). The three common ways of representing the term structure of
interest rates are given below:
Spot rate curve: In our example above, the interest rates of zero-coupon bonds, 7.50% and
9.75% are called spot rates. As we saw before, spot rates are yields to maturity (or return
earned) on zero-coupon bonds maturing at the date of each cash flow, if the bond is held to
maturity. So, the spot rate curve is also called the zero or strip curve. The spot rate curve
plots different maturities on the x-axis and corresponding spot rates on the y-axis.
Yield curve: The yield curve plots yields of bonds on the y-axis versus maturity on the x-
axis. The main difference between a yield curve and a spot rate curve is that the yield curve
considers the coupon payments as well. The assumption in a spot rate curve is that there are
no coupon payments.
Par curve: The par curve plots yields to maturity for different maturities, but the bonds are
assumed to be priced at par.
Forward Rates
A forward rate is an interest rate in the future. The one-year interest rate after one year is an
example of a forward rate. The implied forward rate can be calculated using spot rates. As

always, this is best understood with the help of an example. Consider a scenario where the
one-year spot rate is 2%, and the two-year spot rate is 3%. This is illustrated below:
The forward rate f2 is the rate over the second year. This can be calculated if we assume the
following: $1 invested for two years at the 2-year spot rate of 3% should give same result as
$1 invested for 1 year at the one-year spot rate of 2% and then again at the forward rate, f2.
Mathematically, this can be expressed as: (1 + 0.03)2 = (1 + 0.02) (1 + f2)
Solving for f2, we get: f2 = 4.0098%.
The notation for a forward rate is expressed like this: 1y1y, 2y5y etc.; the first number refers
to the length of the forward period in years from today and the second number refers to the
tenor of the underlying bond. One of the applications of forward rates is that implied spot
rates can be calculated as geometric averages of forward rates. Bonds can then be priced
using implied spot rates. It gives the 1-year forward rate for zero-coupon bonds with various
maturities. For example, 1y1y is the 1-year forward rate for a two-year bond.
Time Period Forward Rate
0y1y 1.88%
1y1y 2.77%
2y1y 3.54%
3y1y 4.12%
Source: CFA Program Curriculum, Introduction to Fixed Income Valuation
Using the forward rates 0y1y and 1y1y, we can calculate the two-year spot rate as:
(1.0188) (1.0277) = (1 + z2)2
Calculating for z2, we get 2.32%.
A forward curve plots the forward rates, which is an estimation of what investors expect
the short-term interest rates to be. Each rate on the curve has the same time frame. Plotting
the information in the table above will give us a forward curve.
Example
Maturity Price Yield to Maturity
1 year 97.25 2.476%
2 years 94.50 2.906%

3 years 91.30 2.819%

Compute the "1y1y" and "2y1y" implied forward rates stated on a semi-annual bond basis.
Solution:
0.02476 2 2 0.02906 4
(1 + ) × (1 + IFR 2,2 ) = (1 + ) .
2 2
IFR 2,2 = 0.0167 × 2 = 3.34%.

The 1y1y implied forward rate is 3.34%.
0.02906 4 2 0.02819 6
(1 + ) × (1 + IFR 4,2 ) = (1 + ) .
2 2
IFR 4,2 = 0.0132 × 2 = 2.65%.

The 2y1y implied forward rate is 2.65%.
5. Yield Spreads
The yield spread is the difference in yield between a fixed-income security and a benchmark.
Say the YTM of a 3-year corporate bond is 7.00%. The benchmark rate is 3-year Libor, which
is 5.00%. The yield spread of the corporate bond relative to the benchmark is 2.00%.
Generally, the benchmark reflects macroeconomic factors. A spread reflects microeconomic
factors and aspects specific to the issuer, such as credit quality of the issuer and bond, tax
status, etc.
The YTM of a bond can be broken down into the following components:
Two related concepts are the G-spread and the I-spread.

• The G-spread is the yield spread in basis points over an interpolated government

bond. The spread is higher for bearing higher credit, liquidity, and other risks relative
to the government bond.
• The I-spread is the yield spread of a specific bond over the standard swap rate in that
currency of the same tenor.
The Z-spread (zero-volatility spread) is based on the entire benchmark spot curve. It is the
constant spread that is added to each spot rate such that the present value of the cash flows
matches the price of the bond. The Z-spread is also called the static spread as it is constant
for all periods.
The option-adjusted spread (OAS) is the Z-spread adjusted for the value of an embedded
option. Consider a callable bond with a Z-spread of 90 basis points, of which 10 basis points
are due to the embedded call option. In this case, the OAS is 90 – 10 = 80 basis points. If a
putable bond has a Z-spread of 180 basis points and the value of the put option is 10 basis
points, the OAS is 180 + 10 = 190 basis points. Based on these simple scenarios, it should be
clear that for a callable bond, the OAS is lower than the Z-spread, and for a putable bond, the
OAS is higher than the Z-spread.
Example
A 5% annual coupon corporate bond with 3 years remaining to maturity is trading at
100.175. The 3-year, 3% annual payment government benchmark bond is trading at 100.50.
The 1-year and 2-year government spot rates are 2.05% and 3.425% respectively. Calculate
the G-spread, the spread between the yields to maturity on the corporate bond and the
government bond having the same maturity.
Solution:
Solve for the time value of money approach on the corporate bond using the following
keystrokes:
PV = -100.175, PMT = 5, FV = 100, N = 3, CPT I/Y = 4.936
The yield to maturity for the corporate bond is 4.936%.
The yield to maturity of the government bond can be calculated with the following
keystrokes:
PV = -100.50, PMT = 3, FV = 100, N = 3, CPT I/Y = 2.824
The G-spread is 4.936% - 2.824% = 2.11% or 211 bps.

Summary
LO.a: Calculate a bond’s price, given a market discount rate.
A bond’s price is the present value of all future cash flows at the market discount rate, which
is the rate of return required by investors given the risk of investment in the bond.
PMT PMT PMT+FV
PV of bond = (1+r)1 + (1+r)2 + ⋯ + (1+r)N
LO.b: Identify the relationships among a bond’s price, coupon rate, maturity, and
market discount rate (yield to maturity).
Inverse effect Bond price is inversely related to discount rate.
Convexity effect For the same coupon/maturity bond: the percentage price
change is more when discount rate goes down than when it
goes up.
Coupon effect For the same time to maturity and same change in discount
rate: prices of low-coupon bonds change more than a high-
coupon bond.
Maturity effect For the same coupon rate and same change in discount rate:
prices of long-term bonds change more than short-term
bonds.
Note: Low-coupon and Long-term bonds are more sensitive to discount rates.
LO.c: Define spot rates and calculate the price of a bond using spot rates.
Spot rates are yields to maturity on zero-coupon bonds maturing at the date of each cash
flow. Since zero-coupon bonds have no intermediate cash flows, the actual yield on a zero-
coupon bond is used as the discount rate for a cash flow occurring at the same maturity date.
PMT PMT PMT + FV
PV = + + ⋯ +
(1 + Z1 )1 (1 + Z2 )2 (1 + ZN )N
where: ZN are the spot rates.
LO.d: Describe and calculate the flat price, accrued interest, and the full price of a
bond.
When a bond is between coupon dates, its price has two parts: flat price and accrued
interest. The sum of the two parts is called the full price or dirty price.
Full price or dirty price = flat price + accrued interest
t
Accrued interest = ∗ PMT
T
Full price of a fixed-rate bond between coupon payments:
t
PVfull = PV ∗ (1 + r)T

LO.e: Describe matrix pricing.

Matrix pricing is an estimation process to find the market price of a not-so-frequently traded
bond based on the prices of comparable bonds with similar times to maturity, type of issuer,
coupon rates, and credit quality.
The steps involved in matrix pricing are:
• Determine the YTM of comparable bonds (which is usually given in the question).
• Determine the average yields of different comparable bonds.
• Calculate the market discount rate using linear interpolation.
• Using the discount rate, compute the price of the bond.
LO.f: Calculate and interpret yield measures for fixed-rate bonds, floating-rate notes
and money market instruments.
The stated annual rate for a bond will depend on the periodicity we are assuming. The stated
annual rate is also called the annual percentage rate or APR.
• The semiannual bond equivalent yield is the yield per semi-annual period times two.
• Street convention is the yield to maturity using a 30/360-day convention assuming
payments are made on scheduled dates.
• True yield is the yield to maturity calculated using an actual calendar with weekends
and holidays.
• Current yield is the sum of the coupon payments received over the year divided by
the flat price.
• Yield-to-call calculates the rate of return on a callable bond if it is bought at market
price and held until the call date.
Floating-rate notes (FRN) are instruments where coupon/interest payments change from
period to period based on a reference interest rate. The coupon rate of a FRN is equal to the
sum of reference rate and quoted margin.
FV FV FV
(Index + QM) ∗ (Index + QM) ∗ (Index + QM) ∗ + FV
m m m
PV = + + ⋯+
Index+DM 1 Index+DM 2 Index+DM N
(1 + ) (1 + ) (1 + )
m m m
Money market instruments are short-term debt securities. They have maturities of one year
or less, ranging from overnight repos to one-year certificates of deposit. Money market
instruments can be classified into two categories based on how the rates are quoted;
discount rate and add on rate.
days to maturity
PV = FV ∗ (1 − ∗ DR)
year
FV
PV = days to maturity
1 + year
∗ AOR

DR
AOR = days to maturity
1 − ∗ DR
year
LO.g: Define and compare the spot curve, yield curve on coupon bonds, par curve, and
forward curve.
• The spot curve is also called the zero or strip curve. The spot curve plots different
maturities on the x-axis and corresponding spot rates on the y-axis.
• The yield curve plots yields of bonds on the y-axis versus maturity on the x-axis. The
main difference between a yield curve and a spot curve is that the yield curve
considers the coupon payments as well.
• The par curve plots yields to maturity for different maturities, but the bonds are
assumed to be priced at par.
• Forward curve plots the forward rates, which is an estimation of what investors
expect the short-term interest rates to be.
LO.h: Define forward rates and calculate spot rates from forward rates, forward rates
from spot rates, and the price of a bond using forward rates.
A forward rate is an interest rate in the future. The one-year interest rate after one year is an
example of a forward rate. The implied forward rate can be calculated using spot rates.
Consider a scenario where the one-year spot rate is 2%, and the two-year spot rate is 3%.
This is illustrated below:
The forward rate f2 is the rate over the second year. This can be calculated if we assume the
following: $1 invested for two years at the 2-year spot rate of 3% should give the same result
as $1 invested for 1 year at the one-year spot rate of 2% and then again at the forward rate,
f2.
Mathematically, this can be expressed as:
(1 + 0.03)2 = (1 + 0.02) (1 + f2)
Solving for f2, we get: f2 = 4.0098%.
LO.i: Compare, calculate, and interpret yield spread measures.
The yield spread is the difference in yield between a fixed-income security and a benchmark.
• G-spread is the yield spread in basis points over an interpolated government bond.
The spread is higher for bearing higher credit, liquidity, and other risks relative to the
government bond.
• I-spread is the yield spread of a specific bond over the standard swap rate in that

currency of the same tenor.

• Z-spread (zero-volatility spread) is based on the entire benchmark spot curve. It is
the constant spread that is added to each spot rate such that the present value of the
cash flows matches the price of the bond.
• Option-adjusted spread (OAS) is the Z-spread adjusted for the value of an embedded
option.

Practice Questions
1. A 10-year, 8% annual-pay bond has a par value of $100. If it has a yield to maturity of 9%,
the price of the bond is closest to:
A. $93.58
B. $95.64
C. $101.25
2. A 5-year, 8% semiannual-pay bond has a par value of $100. What is the price of the bond
if it has a yield to maturity of 10%?
A. $91.54
B. $92.28
C. $94.15
3. Suppose a bond’s price is expected to decrease by 3% if its market discount rate

increases by 100 basis points. If the bond’s market discount rate decreases by 100 basis
points, the bond price is most likely to change by:
A. 3%.
B. less than 3%.
C. more than 3%.
4. The following information is provided about three bonds that are currently trading at
par.
Bond Coupon Rate Maturity (years)
A 4% 20
B 4% 10
C 6% 10
If the market discount rate for all three bonds increases by 100 basis points, which bond
will most likely experience the greatest percentage change in price?
A. Bond A.
B. Bond B.
C. Bond C.
5. If spot rates are 4% for one year, 4.25% for two years, and 4.5% for three years, the price
of a $1,000 face value, 3-year, annual-pay bond with a coupon rate of 5% is closest to:
A. $998.74
B. $1,005.89
C. $1,014.19

6. An investor is considering selling a $1,000 face value, semi-annual coupon bond with a
quoted price of 103 and accrued interest since the last coupon of $25. Ignoring
transaction costs, how much will he receive at the settlement date?
A. $1,025.
B. $1,030.
C. $1,055.
7. Matrix pricing allows investors to estimate the market discount rates and prices for
bonds:
A. with different coupon rates.
B. that are infrequently traded.
C. with different maturities.
8. A bond with 10 years remaining until maturity is currently trading for 110 per 100 par
value. The bond offers a 6% coupon rate with interest paid semiannually. The bond’s
annual yield to maturity is closest to:
A. 4.74%
B. 5.26%
C. 6.28%
9. A bond with 5 years remaining until maturity is currently trading for 102 per 100 of par
value. The bond offers 8% coupon rate with interest paid semiannually. The bond is
callable at 103 in two years. What is the bond’s yield-to-call?
A. 8.1%
B. 8.3%
C. 8.7%
10. A floating rate note has a quoted margin of +50 basis points and a required margin of +25
basis points. The price of the note, on its next reset date, will be:
A. equal to par value.
B. less than par value.
C. more than par value.
11. A 365-day year bank certificate of deposit has an initial principal amount of $95 million
and a redemption amount at maturity of $100 million. The number of days between
settlement and maturity is 300. The bond equivalent yield is closest to:
A. 6.4%
B. 6.8%
C. 7.2%

12. A yield curve created from a sequence of yields to maturity on zero-coupon bonds is the:
A. par curve.
B. spot curve.
C. forward curve.
13. The 3-year spot rate is 9.25%, and the 2-year spot rate is 9%. What is the 1-year forward
rate two years from today?
A. 8.75%
B. 9.5%
C. 9.75%
14. An analyst wants to value a 3 year, 6% annual pay bond. The bond has par value of
$1,000. The current spot rate is 4%, 1-year forward rate 1 year from now is 5% and 1-
year forward rate 2 years from now is 6%. The value of this annual coupon pay bond is
closest to:
A. $1022.07.
B. $1024.35.
C. $1028.39.
15. A yield spread of a bond over an interest rate swap in the same currency and with the
same tenor as the bond is best described as:
A. I-spread.
B. Z-spread.
C. G-spread.
16. In case of putable bonds, the:

A. OAS < Z-spread.
B. OAS = Z-spread.
C. OAS > Z-spread.

Solutions
1. A is correct. N = 10, I/Y = 9, FV = 100, PMT = 8; CPT → PV = -$93.58
2. B is correct. N = 10, I/Y = 5, FV = 100, PMT = 4; CPT → PV = $92.28
3. C is correct. The relationship between bond prices and the market discount rate is not
linear. The percentage price change is greater in absolute value when the market
discount rate goes down than when it goes up by the same amount (the convexity effect).
If a 100 basis point increase in the market discount rate will cause the price of the bond
to decrease by 3%, then a 100 basis point decrease in the market discount rate will cause
the price of the bond to increase by an amount more than 3%.
4. A is correct. All else equal, the longer the term to maturity, the greater the price volatility.
All else equal, the lower the coupon rate, the greater the price volatility. Bond A has the
longest maturity and the lowest coupon rate. Therefore, it will experience the greatest
percentage change in price.
5. C is correct.
50 50 1,050
Bond value = + 2
+ = $1,014.19
1.04 1.0425 1.0453
6. C is correct. The seller will receive the full price, which is equal to the flat price plus the
interest accrued from the last coupon date.
Flat price = 1,000 x 103% = $1,030
Full price = $1,030 + $25 = $1,055
7. B is correct. For bonds that are infrequently traded, matrix pricing is a price estimation
process that uses market discount rates based on the quoted prices of similar bonds
(similar times to maturity, coupon rates, and credit quality).
8. A is correct.
N = 20, FV = 100, PMT = 3, PV = -110; CPT → I/Y = 2.37
YTM = 2 x 2.37 = 4.74%
9. B is correct.
N = 4, FV = 103, PMT = 4, PV = -102; CPT → I/Y = 4.15%
YTM = 2 x 4.15% = 8.3%

10. C is correct. If the required margin is less than the quoted margin, the credit quality of the
note has increased. Therefore, the price of the note on the reset date will be more than
par value.
11. A is correct. For money market instruments, the BEY is equal to the add-on yield based
on a 365 day year.
AOR = (365/ Days) x (FV-PV)/PV
= 365/300 x 5/95 = 6.40%
12. B is correct. The spot curve, also known as the strip or zero curve, is the yield curve
constructed from a sequence of yields to maturity on zero-coupon bonds. The par curve
is a sequence of yields to maturity such that each bond is priced at par value. The forward
curve is constructed using a series of forward rates, each having the same timeframe.
13. C is correct. (1.0925)3 = (1.09)2 x (1 + 2y1y)

2y1y = (1.0925)3/ (1.09)2 – 1 = 9.75%
2y1y ≈ 3(9.25%) – 2(9%) = 9.75%
14. C is correct.
60 60 1,060
Value of the bond = + + = $1.028.39
1.04 (1.04)(1.05) (1.04)(1.05)(1.06)
15. A is correct. The I-spread, or interpolated spread, is the yield spread of a specific bond
over the standard swap rate in that currency of the same tenor. The yield spread in basis
points over an actual or interpolated government bond is known as the G-spread. The Z-
spread (zero-volatility spread) is the constant spread such that is added to each spot rate
such that the present value of the cash flows matches the price of the bond.
16. C is correct.
OAS is the Z-spread after removing the impact of the embedded option.
OAS = Z-spread – Option value. The option value is negative since the options are a
benefit to bondholders.

R53 Introduction to Asset Backed Securities 2019 Level I Notes
R53 Introduction to Asset-Backed Securities

1. Introduction
Asset-backed securities (ABS) are based on a principle called securitization. The
securitization process involves pooling relatively straightforward debt obligations, such as
loans or bonds, and using the cash flows from the pool of debt obligations to pay off the
bonds created in the securitization process. The instruments which become part of the pool
are called securitized assets. A simple securitization process is illustrated in the figure
below:
In this illustration, a mortgage bank sells mortgage loans to thousands of homeowners. The
mortgage bank bundles the individual loans into a pool which is sold to a separate legal
entity generally referred to as a special purpose vehicle (SPV). The special purpose vehicle
issues bonds to investors. The collateral for the bonds is the pool of mortgage loans.
The term mortgage-backed security (MBS) is commonly used for securities which are
backed by high quality real estate mortgages. The term “asset-backed securities,” or ABS, is a
broader concept that refers to securities backed by other types of assets as well. In the
example above, we can say that the SPV issues MBS.
2. Benefits of Securitization for Economies and Financial Markets
In this section, we look at the benefits from the perspective of the three parties involved in
the securitization process: borrowers who are the homeowners, investors who want to buy
mortgages, and the intermediary connecting these two parties which is a commercial
bank/financial institution. Investors cannot lend directly to homeowners because they may
be willing to lend/invest only a small amount of money, say $10,000, whereas the
homeowner may require $100,000 as a mortgage loan. Second, the investor may not have all
the information needed to assess the risk of the property.
Benefits to investors are as follows:
• Securitization converts an illiquid asset into a liquid security.
• It gives investors direct access to the payment streams of the underlying mortgage

loans that would otherwise be unattainable.

• There are higher risk-adjusted returns to investors: pooling loans results in
diversification and lower risk for investors.
• It gives investors an opportunity to buy a small part of the home buyers’ mortgage in
the form of a security issued by the SPV.
• It gives exposure to the market, real estate in this example, without directly investing
in it.
Benefits to the bank or loan originator are as follows:
• It enables banks to increase loan origination, monitoring, and collections.
• It reduces the role of the intermediaries (known as disintermediation) like the bank.
However, note that an intermediary is still required to package and distribute
securities.
• Banks have the ability to lend more money if the demand for ABS and MBS is high
relative to if the money was self-financed (from deposits, debt, equity, etc.).
• There is greater efficiency and profitability for the banking sector: the mortgage-
backed securities, at least in the US market, trade actively in the secondary market
which improves the efficiency and liquidity of the financial market.
Benefits to the borrowers of the loan are as follows:
• It lowers the risk as the pooled loans offer a diversification benefit.
• The lower risk decreases the cost of borrowing for homeowners.
3. How Securitization Works
We look at the securitization process in detail in this section.
3.1. An Example of a Securitization
Kentara is a manufacturer of automobiles that range from $20,000 to $200,000. The majority
of sales are made through loans granted by the company to its customers, and the
automobiles serves as collateral for the loans. These loans, which represent an asset to
Kentara, have maturities of five years, carry a fixed interest rate and are fully amortizing
with monthly payments. Although the servicer of such loans need not be the originator of the
loans, the assumption is that Kentara is the servicer.
Steps in the securitization transaction:
• Now assume that Kentara has $100 million of loans, shown on its balance sheet as an
asset, and Kentara wants to raise another $100 million.
• Kentara can do this by securitizing the loans and sells them to a special purpose
entity (SPE), Automobile Trust (AT).
• The SPE is a separate legal entity and is also called a special purpose vehicle (SPV) or
a special purpose company. The legal form of the SPE varies by jurisdiction but, in
almost all cases, the ultimate owner of the loans - AT - is legally independent and
considered bankruptcy remote from the seller of the loans.

• AT gets $100 million in cash from investors by selling asset-backed securities, which
it pays to Kentara.
• The customers who bought the automobiles on loan make monthly payments. AT
uses this cash flow to pay investors of the ABS.
• Setting up a separate legal entity ensures that if Kentara files for bankruptcy, the
loans backing the ABS that are issued by AT are secure within the SPE and creditors
of Kentara have no claim on the loan.
The exhibit below illustrates the steps involved in the securitization transaction for Kentara:
Source: Adapted from CFA Program Curriculum, Introduction to Asset-Backed Securities

3.2. Parties to a Securitization and Their Roles
Let us look at the parties involved in a securitization transaction.
Party Role Party in our example
Seller of pool of Originates the loans and sells to a special Kentara
securities purpose entity (SPE).
SPV or trust or Buys the loans from the seller and issues Automobile Trust (AT)
issuer ABS.

Servicer Services loans such as collecting Kentara

payments from borrowers, notifying
borrowers who may be delinquent and, if
necessary, seizing automobiles from
borrowers who do not make payments on
time.
Note that a third party or the issuer may act as a servicer.
Other parties involved include independent accountants, underwriters, trustees, rating
agencies, and guarantors.
• Lawyers: Responsible for creating the legal documentation.
• Underwriters: Facilitate bond issuance.
• Rating agencies: Rate the securities issued.
Trustee: Safeguards the assets placed in the trust, and hold funds to be paid to bondholders.
3.3. Structure of a Securitization
In the Kentara example, assume 100,000 securities of Bond Class A were issued with a par
value of $1,000 per security to raise $100 million. All the certificate holders in this case are
treated equal because there is just one class of bondholders and there is no distinction
between bondholders with respect to payment time or credit risk.
However, in reality not all bond issues are created with a similar structure. The motivation
for the creation of different types of structures is to redistribute prepayment risk and credit
risk efficiently among different bond classes in the securitization.
Prepayment risk is the uncertainty that the actual cash flows will be different from the
scheduled cash flows, as set forth in the loan agreements, because borrowers may alter
payments to take advantage of interest rate movements.
Instructor’s Note
Prepayment risk cannot be eliminated, but can be redistributed.
In the Kentara example, assume the buyers of automobiles are scheduled to make monthly
payments towards the loan over 5 years. Instead, they prepay it in two years, perhaps
because the interest rates decline, or due to any other reason. Since the loan is prepaid
quicker than planned, the investors of ABS will also be paid quickly thereby reducing their
interest income.
Time tranching: Creation of bond classes to distribute the prepayment risk is called time
tranching. Cash flow received from customers is distributed among the tranches based on
certain parameters. For example, assume AT issued the following four bond classes, with a
total par value of $100 million, instead of one bond class:
• A1 ($30 million)

Since the motive is to distribute prepayment risk, the A1 class may have a lower prepayment
risk than A4. If customers prepay, then A4 bond-holders will get prepaid before A1.
Subordination and credit tranching: Subordination is another layering structure in
securitization. The bond classes differ in their exposure to credit risk, i.e., how they share
losses if the borrowers of the original loans default. An ABS is made up of a pool of loans. So,
any default in payment will have a cascading effect on the investors. Here, several tranches
of senior and subordinated classes are created and the credit risk is distributed to each class
in a disproportionate manner based on the investor’s choice.
Bond class Par Value ($ millions)
A (senior) 80
B (subordinated) 14
C (subordinated) 6
Total 100
In this example, all the losses are first absorbed by class C, then class B, and then class A.
However, class C can accept a loss of up to $6 million. Beyond that, it is absorbed by class B.
The risk is highest for class C and lowest for class A, in this example. Based on the high risk
high return rule, the expected return of class C bondholders will be higher than that of class
A bondholders.
3.4. Key Role of the Special Purpose Entity
The securitization of a company’s assets may include some bond classes that have better
credit ratings than the company itself or its corporate bonds. Thus, in the aggregate, the
company’s funding cost is often lower when raising funds through securitization than by
issuing corporate bonds.
To understand why the funding cost is lower, we will go back to the Kentara example and
consider two scenarios for raising $100 million: one in which Kentara issues a corporate
bond, and another in which it issues ABS by securitizing loans/receivable.
Corporate bond scenario: Kentara issues corporate bonds for $100 million with auto loans
as collateral. Assume credit-rating agencies such as Moody’s assign Kentara a credit-rating of
BB (below investment-grade). The corporate bond rating will also be based on the
company’s credit rating as it reflects the creditworthiness of debt securities. Kentara’s credit
spread depends on the following two factors:
• Primarily, credit rating (BB, in this case).
• Collateral, to a lesser extent.
The cost of funding for Kentara will be higher if it issues a corporate bond, and not an ABS,
for the following reasons:

• Higher risk: Investors perceive a higher risk given the company’s creditworthiness. In
case the company goes bankrupt or is reorganized, their claim to assets will follow
the absolute priority rule (defined in the next section). Though, in reality the absolute
priority rule has not been upheld in case of reorganizations. This means that it is not
necessary for the bondholders to be paid off before the other parties (equity holders,
other creditors). Hence, the credit spread for a corporate bond backed by a collateral
does not decrease substantially.
• Higher return: To compensate for the high risk, investors expect a high return.
• Higher credit spread: Credit spread is the difference between the interest rate the
issuer has to pay on the corporate bond and the benchmark interest rate. The riskier
the bonds, the larger the spread demanded by investors as compensation for risk.
Securitization Scenario
• Funding cost is low: The collateral (loans/receivable) is legally an asset of AT. Any
cash flow from the pool of loans will be paid to the investors of ABS. When an investor
buys a bond class, he has to evaluate the credit risk of the class he is investing in. The
credit rating of the bond class will depend on the quality of the collateral and capital
structure of the SPV, and not the credit rating of the company as in the corporate
bond.
• The lower the risk, the lower the funding cost: The assets belong to the SPV. If the
company goes bankrupt, the absolute priority rule is followed. The principle is that
senior creditors are paid in full before subordinate bondholders are paid anything. So
investors demand a lower return than a corporate bond. Lower return means lower
funding cost for the issuer.
• The SPV is a bankruptcy-remote vehicle unlike corporate bonds. It means bankruptcy
has no effect on an SPV. If the company goes bankrupt, the loans/receivable do not
belong to Kentara anymore and the investors will be paid based on the securitization
structure.
4. Residential Mortgage Loans
A mortgage loan is a loan secured by the collateral of some specified real estate property
which obliges the borrower to make a predetermined series of payments to the lender. In
simple words, it is a loan a buyer takes for buying a real estate property (land, apartment,
house, etc.); the collateral is the property being bought. If the buyer defaults on mortgage
payments, then it gives the lender the right to foreclose on the loan, take possession of the
property, and sell it to recover funds given as debt.
The cash flow of a mortgage consists of the following three components:
• Interest
• Scheduled principal payments
• Prepayments (any principal repaid in excess of the scheduled principal)

The amount lent as loan towards the purchase of the property is always less than the
purchase price. It is equal to the purchase price minus the down payment made by the buyer.
The buyer’s initial equity is equal to the down payment made.
The ratio of the mortgage loan amount to the property’s purchase price is called the loan-to-
value (LTV) ratio.
We will now look at the following characteristics of residential mortgage loans in detail:
• Maturity
• Mortgage rate
• Amortization schedule
• Prepayments and prepayment penalties
• Rights of the lender in a foreclosure
4.1. Maturity
Maturity: term of a mortgage is the number of years to maturity. It varies from one country
to the other. For example, in the United States it ranges from 15 to 30 years.
4.2. Interest Rate Determination
The interest rate on the mortgage loan is called the mortgage rate or contract rate. How the
mortgage rate is calculated varies across countries.
The four basic methods for calculating mortgage rate are:
• Fixed rate: The rate remains fixed during the life of the mortgage.
• Adjustable or variable rate: The adjustable-rate mortgage (ARM) is like a floating rate.
Here, the mortgage rate is reset periodically based on some reference rate or index.
• Initial period fixed rate: The mortgage rate is fixed for some initial period and then it
is adjusted for either a new fixed rate or variable rate. If the mortgage rate is fixed for
an initial period and then set to a new fixed rate, then it is called rollover or
renegotiable mortgage. If the mortgage rate is fixed for an initial period and then it
becomes adjustable, then it is called a hybrid mortgage.
• Convertible: The mortgage is initially either a fixed or an adjustable rate. Later, the
borrower may either convert it into a fixed or adjustable mortgage for the remainder
of the mortgage’s life.
4.3. Amortization Schedule
Residential mortgages are usually amortizing loans. The amount borrowed reduces
gradually over time as periodic mortgage payments are made. Mortgage payments consist of
interest payments and scheduled principal repayments. Let’s take the example of the Smiths
who borrow $100,000 to purchase a house, assume the terms of the loan are as follows:
Loan amount = $100,000; mortgage rate = 6%; maturity term = 30 years.
The periodic mortgage payment can be computed as:

PV = -100,000; N = 360 (=12 * 30); I = 0.5 = (6 / 12); FV = 0; CPT PMT

PMT = -599.95
Interest = 0.005 * 100,000 = $500. But, the monthly payment is $599.95. During the first
month, $99.95 goes towards reduction of principal. As time goes by, the amount of the
monthly mortgage payment towards principal reduction increases and that toward interest
decreases.
Since the outstanding mortgage balance of $100,000 reduces over time, it is called
amortization.
There are two types of amortizing loans:
• Fully amortizing loans: There is no outstanding balance at the end of the mortgage’s
life. The loan is fully repaid with the last mortgage payment.
• Partially amortizing loans: The sum of all the scheduled mortgage repayments is less
than borrowed amount. A last payment, called the balloon payment, is made equal to
the unpaid mortgage balance.
Based on interest/scheduled principal repayments, there are two types of mortgages:
• Interest-only mortgage: No scheduled principal repayment for a certain number of
years.
• Bullet mortgage: No scheduled principal repayment over the entire life of the loan.
The last payment is equal to the original loan amount.
4.4. Prepayment Options and Prepayment Penalties
Prepayment is a payment made in excess of the scheduled principal repayment. Assume 10
months after taking the loan, the interest rates fall. The Smiths choose to refinance by taking
a new loan and closing the existing one by prepaying. Another scenario is part prepayment,
where, let us say, in the first month the Smiths pay $1,000 instead of the scheduled $599.95
mortgage payment. $1,000 is broken down into three parts: $500 towards interest, $99.95
for scheduled principal payment, and $400.05 towards prepayment.
In some countries, there may be a penalty for prepayment as it hurts the lender (recall
‘prepayment risk’). The objective of imposing a penalty is to compensate the lender for the
difference in the contract rate and the prevailing mortgage rate when the borrower prepays
as rates decline.
4.5. Rights of the Lender in a Foreclosure
Recourse and non-recourse mortgage loans: If the borrower of a loan defaults on payments,
then the lender can seize the property and sell it. The proceeds from the sale may be less
than the outstanding mortgage balance, and not enough to recoup the losses. There are two
types of mortgage loans in such cases:
• Recourse loans: The lender can claim the shortfall (outstanding mortgage balance –
after the property is sold) from the borrower. For instance, if the borrower has other

properties or possessions such as an expensive car, or valuable art, then these could
be sold to fulfill the shortfall.
• Non-recourse loans: Most mortgage loans are non-recourse. The lender may sell the
property in case of a default and keep the proceeds. But, unlike a recourse loan, the
bank/lender cannot claim other assets of the borrower to fulfill the shortfall in the
outstanding mortgage balance.
5. Residential Mortgage-Backed Securities
Residential mortgage-backed securities are bonds created from the securitization of
residential mortgage loans. In the U.S., residential mortgage-backed securities are divided
into the following three sectors:
1. Those guaranteed by a federal agency (Ginnie Mae) whose securities are backed by
the full faith and credit of the U.S. government.
2. Those guaranteed by either of the two government-sponsored enterprises or GSEs
(Fannie Mae and Freddie Mac) but not by the U.S. government. They do not carry the
full faith and credit of the U.S. government.
3. Those issued by private entities that are not guaranteed by a federal agency or a GSE.
The first two sectors (guaranteed by the government or a quasi-government entity) are
called the agency RMBS. The third sector is called non-agency RMBS.
Examples of agency RMBS include:
• Mortgage pass-through securities
• Collateralized mortgage obligations
The two differences between agency RMBS issued by GSEs and non-agency RMBS are as
follows:
• Non-agency RMBS use credit enhancements to reduce credit risk, while agency RMBS
issued by the GSEs are guaranteed by the GSEs themselves.
• For a loan to be included in a pool of loans backed by an agency RMBS, it must satisfy

the underwriting standards of the government agencies.

5.1. Mortgage Pass-Through Securities
A mortgage pass-through security is created when one or more holders of mortgages form a
pool of mortgages and sell shares or participation certificates in the pool. The investors
receive a share of cash flows from the underlying pool of mortgage loans.
Cash Flow Characteristics
• Monthly mortgage payments consist of interest, scheduled principal repayment,
prepayments.
• Payments are made to security holders each month.
• The servicer collects monthly payments, sends payment notices to borrowers, sends
reminders if payments are overdue, maintains records of principal balances, etc.
• The servicing fee is part of the mortgage rate.
• The amount of cash flow from mortgage loans is not equal to that received by the
investors. Similarly, there is a delay in passing the cash flow from mortgage loans to
the security holders.
• Monthly cash flow of a mortgage pass-through security = monthly cash flow of the
underlying pool of mortgages - servicing and other fees. In other words, investors of
the mortgage pass-through security receive less than the cash flow coming in from
the mortgage loans because a servicing fee is collected by the servicer.
How is the rate and maturity of a mortgage loan calculated?
• Pass-through rate: A mortgage pass-through security’s coupon rate is called the pass-
through rate. For example, if the mortgage rate for a pool of mortgages is 8%, the
annualized servicing fee is 0.6%, then the investors receive an average return of
around 7.4%.
• Weighted average coupon (WAC): Each of the mortgage loans in the securitized pool
may not have the same mortgage rate. The WAC is found by weighting the rate of each
mortgage loan in the pool by the percentage of the mortgage outstanding relative to
the outstanding amount of all mortgages in the pool.
• Weighted average maturity (WAM): Similarly, not all the loans in the pool will have
the same maturity. WAM is found by weighting the remaining number of months to
maturity for each mortgage loan in the pool by the amount of the outstanding
mortgage balance.
Conforming and Non-conforming Loans
A mortgage loan must meet certain criteria to be included in a pool of loans backing an
RMBS. Listed below are some of the underwriting standards of an agency they must conform
to:
• Maximum loan-to-value ratio: It should be below the maximum LTV to conform.
• Maximum size of the loan

• Loan documentation
If a loan meets the underwriting standards, then it is called a conforming loan.
Non-conforming mortgages that serve as collateral for mortgage pass-through securities do
not meet the underwriting standards and are privately issued by thrift institutions,
commercial banks, etc.
Example
Assume that a pool includes four mortgages with the following characteristics:
Mortgage Outstanding Balance Coupon Rate Time to Maturity
1 $1,000 4.50% 28 months
2 $2,000 4.75% 42 months
3 $4,000 5.15% 37 months
4 $3,000 3.80% 60 months
Calculate the weighted average coupon rate and weighted average maturity.
Solution:
The total outstanding amount is $10,000 and hence, the weights are as follows: Mortgage 1 =
10%, 2 = 20%, 3 = 40% and 4 = 30%.
The weighted average coupon is:
0.10 × 4.50% + 0.20 × 4.75% + 0.40 × 5.15% + 0.30 × 3.80% = 4.60%
The weighted average maturity (WAM) is:
0.10 × 28 + 0.20 × 42 + 0.40 × 37 + 0.30 × 60 = 44 months
Prepayment risk: The risk associated with uncertainty in future cash flows because of
principal repayments is called prepayment risk. It has two components: contraction risk and
extension risk.
• Contraction risk is the risk that when interest rates decline, the security will have a
shorter maturity than was anticipated at the time of purchase because homeowners
refinance at now-available lower interest rates. For instance, assume the interest rate
is 8% when the Smiths take the loan. If two years later it falls to 6%, then they will
prepay the loan and refinance at the lower rate.
• Extension risk is the risk that when interest rates rise, fewer prepayments will occur
because homeowners are reluctant to give up the benefits of a contractual interest
rate that now looks low. From an investor’s perspective, the security becomes longer
in maturity than it was at the time of purchase.
Instructor’s Note
Contraction risk occurs when interest rates decline.
Extension risk occurs when interest rates rise.

Prepayment Rate Measures

To value a mortgage pass-through security, one must be able to forecast its cash flows. But,
the cash flows are uncertain because it is not known ahead of time when homeowners may
prepay principal during the mortgage’s life. The only way to predict future cash flows is by
making some assumptions about the prepayment speed/rate.
The two measures of prepayment rate are:
• Single month mortality rate: this is a monthly measure.
• Conditional repayment rate: this is an annual measure.
Single month mortality (SMM) measures prepayments in a month. An SMM of x% means that
x% of the outstanding mortgage balance at the start of the month minus the scheduled
principal repayment, will be repaid that month.
Prepayment for a month
SMM = Begining mortgage balance for month−Scheduled principal repayment for month
Conditional repayment rate (CPR) is an annualized version of SMM.

A CPR of 6%, for example, means that approximately 6% of the outstanding mortgage
balance at the beginning of the year is expected to be prepaid by the end of the year.
100 PSA prepayment benchmark: The 100 Public Securities Association (PSA) prepayment
benchmark is expressed as a monthly series of CPRs. The benchmark assumes that
prepayment rates are low for newer mortgages and increase as time passes. A PSA
assumption greater than 100 PSA means that prepayments are assumed to be faster than the
benchmark. In contrast, a PSA assumption lower than 100 PSA means that prepayments are
assumed to be slower than the benchmark.
Cash Flows
The cash flows associated with a mortgage pass-through security have the following
components:
• Scheduled principal repayment
• Principal pre-payment
• Interest payment
The interest payment is based on the principal outstanding at the start of the period and the
interest rate. The principal pre-payment can be estimated based on the SMM (or CPR)
number. The higher the SMM, the higher the prepayment.
Instructor’s Note
The curriculum shows the cash flow calculations for a hypothetical mortgage pass-through
security. If you have the time you can study the curriculum example. However, from a
testability perspective it is more important that you understand the concept which is
explained here.

Weighted Average Life

Recall that one of the basic characteristics of a bond is its maturity. But, in the case of a MBS
the legal maturity date does not reveal much about the characteristics of the security
because of prepayments.
The weighted average life (average life) gives investors an indicator of how long investors
can expect to hold the MBS before it is paid off. The table below shows the average life at
different prepayment rates. For instance, at a prepayment rate of 125 PSA, the average time
for principal repayment is 10.1 years. Notice that the average time drops drastically to 3.2
years as the prepayment rates go up to 600 PSA.
PSA assumption 100 125 165 250 400 600
Average life (years) 11.2 10.1 8.6 6.4 4.5 3.2
5.2. Collateralized Mortgage Obligation
The prepayment risk seen in mortgage pass-through securities can be reduced by
distributing the cash flows of these mortgage products to different classes or tranches
through a process called structuring.
Collateralized mortgage obligation (CMO) is one such security created based on this
principle of structuring where the cash flows (interest and principal) are redistributed to
different tranches based on a set of rules. The different classes of bondholders in a CMO have
different exposures to prepayment risk. The collateral for a CMO is a pool of mortgage pass-
through securities and not a pool of mortgage loans.
Advantages of a CMO
Following are the key benefits of a CMO:
• CMOs can be created to closely satisfy the asset/liability needs of institutional
investors, thereby broadening the appeal of mortgage-backed products.
• Some investors may want to increase their exposure to prepayment risk, while some
may want to reduce. Based on their individual needs and risk appetite, investors can
choose the CMO.
The most common types of CMO tranches are sequential-pay tranches, planned amortization
class (PAC) tranches, support tranches, and floating-rate tranches.
Sequential-Pay CMO Structures
Each class/tranche of bond in this CMO structure is retired sequentially. Let us consider a
CMO with four tranches. Note that this example is for simplicity. The coupon rate usually
varies by tranche.
Tranche Par amount(US $) Coupon rate (%)
A 389,000,000 5.5
B 72,000,000 5.5

C 193,000,000 5.5
D 146,000,000 5.5
Total 800,000,000
The prepayment risk is mitigated in this CMO by following these interest and principal
repayment rules:
For payment of monthly coupon interest: Disburse monthly coupon interest to each tranche
on the basis of the amount of principal outstanding for each tranche at the beginning of the
month.
For disbursement of principal payments:
Disburse principal payments to tranche A until it is completely paid off.
After tranche A is completely paid off, disburse principal payments to tranche B until it is
completely paid off.
After tranche B is completely paid off, disburse principal payments to tranche C until it is
After tranche C is completely paid off, disburse principal payments to tranche D until it is
The table below shows the average life of the collateral and different tranches at various
prepayment rates. For instance, at a prepayment rate of 165 PSA, the average life of the
collateral is 8.6 years, while it is 3.4 years and 19.8 years for tranches A and D respectively.
At higher levels of prepayment, the average life of tranche A falls to 1.6 years and to 7 years
for tranche D.
PSA Collateral Tranche A Tranche B Tranche C Tranche D
100 11.2 4.7 10.4 15.1 24.0
125 10.1 4.1 8.9 13.2 22.4
165 8.6 3.4 7.3 10.9 19.8
250 6.4 2.7 5.3 7.9 15.2
400 4.5 2.0 3.8 5.3 10.3
600 3.2 1.6 2.8 3.8 7.0
• Tranche A has the highest contraction risk while tranche D has the highest extension
risk.
• Tranches A and B provide protection against contraction risk for tranches C and D.
• Similarly, tranches C and D provide protection against extension risk for tranches A
and B respectively.
CMO Structures Including Planned Amortization Class and Support Tranches
In a CMO with a sequential pay-structure, there was a great variability in average

life/prepayment risk based on the prepayment rate. This is partly overcome with a CMO
structure called the planned amortization class (PAC) tranches. PAC tranches offer great
predictability as long as the prepayment rate is within a specified band over the collateral’s
life. PACs offer protection against both extension risk and contraction risk.
Two PSA prepayment rates must be specified to create a PAC tranche. The two prepayment
speeds used to create a PAC bond is called the PAC collar. The lower and upper PSA
prepayment assumptions are called the “initial PAC collar”, or the “initial PAC bond”.
The greater certainty of the cash flow for the PAC tranches comes at the expense of the non-
PAC tranches (called support tranches). The support tranches provide protection against
both contraction and extension risk by absorbing excess principal paid or forgoing principal
payment, if the collateral payments are slow.
The table below illustrates the life of PAC and support tranches at various prepayment rates.
As you can see, for a prepayment rate between 100 PSA and 250 PSA, the average life of the
PAC tranche is 7.7 years. Whereas, the average life of support tranche varies from 20 years
to 3.3 years. The prepayment speeds of 100 PSA and 250 PSA create the initial PAC collar.
PSA Life of PAC Life of Support
50 10.2 24.9
75 8.6 22.7
100 7.7 20.0
165 7.7 10.7
250 7.7 3.3
400 5.5 1.9
600 4.0 1.4
The support tranches defer principal payments to the PAC tranches if the collateral
prepayments are slow; support tranches do not receive any principal until the PAC tranches
receive their scheduled principal repayment.
Support tranches absorb any principal prepayments in excess of the scheduled principal
repayments that are made. This rule reduces the contraction risk of the PAC tranches. If the
support tranches are paid off quickly because of faster-than-expected prepayments, they no
longer provide any protection for the PAC tranches.
For example, a mortgage pass-through security has a greater average life variability than a
PAC tranche, but lesser than that of a support tranche. The bond classes in a CMO can either
be riskier or less risky than a mortgage pass-through security.
5.3. Non-agency Residential Mortgage-Backed Securities
Unlike agency residential mortgage-backed securities (RMBS), non-agency RMBS is not
backed by the government or a by a GSE; so, credit risk is a major concern for investors. For
agency RMBS, when the principal will be repaid (prepayment risk) was a major concern. For

non-agency RMBS, if and when (credit risk + prepayment risk) the principal will be paid is a
concern.
Based on the credit quality of the mortgage loans in the pool, the securities can be classified
into two:
• Prime loans: Borrower has high credit quality, strong credit history, sufficient income
to service the loan, and equity in the underlying property.
• Subprime loan: Borrower has low credit quality.
The two complementary mechanisms required in structuring a non-agency RMBS are:
1. The cash flows are distributed by rules, such as the waterfall, that dictate the
allocation of interest payments and principal repayments to different tranches with
various degrees of seniority/priority. Each tranche has a varying exposure to
prepayment and credit risk.
2. There are rules for the allocation of realized losses, which specify that subordinated
bond classes have lower payment priority than senior classes.
Two factors to consider when forecasting the future cash flows of a non-agency RMBS:
• Default rate for the collateral.
• Recovery rate. Since some part of the mortgage may be seized and sold, the recovery
rate is considered.
In order to obtain a favorable credit rating and to ensure some protection against losses in
the pool, non-agency RMBS and non-mortgage ABS often require one or more credit
enhancements.
• Internal credit enhancements include senior/subordinated structures, cash reserve
funds, overcollateralization, and excess spread accounts.
• External credit enhancements include third party guarantee, such as a monoline
insurance company.
6. Commercial Mortgage-Backed Securities
Commercial mortgage-backed securities (CMBS) are backed by a pool of commercial
mortgage loans on income-producing property. Important features of a CMBS are as follows:
• The underlying are loans to purchase or refinance a commercial property such as a
warehouse, apartment building, office building, hotels, health care facilities, etc.
• Commercial mortgage loans are non-recourse loans. Lenders can only stake a claim to
the income-producing property backing the loan in case of a default and not on any
other asset of the borrower.
• It is important to study the cash flows from the underlying properties for credit
analysis.
• There are two key indicators to assess the potential credit performance of a
commercial mortgage loan: 1) debt-to-service coverage ratio and 2) the loan-to-value
ratio.

Annual net operating income

Debt-to-service coverage ratio = Debt service
where:
Debt service = annual interest payment and principal repayment
Net operating income = rental income – cash operating expenses – a non-cash
replacement reserve
If DSC > 1.0, then cash flows from property are sufficient to service debt.
How to interpret DSC and LTV ratios:
• The higher the DSC ratio, the lower the credit risk and the better is the borrower’s
ability to service debt.
• A low loan-to-value ratio implies lower credit risk.
• Note: to memorize this formula, draw a parallel with interest coverage ratio from
FRA.
6.1. Credit Risk
The role of a credit-rating agency in the CMBS market is to give an opinion on the credit-
quality of the bond and provide any enhancement to achieve a desired credit rating. For
example, if specific DSC and LTV ratios are needed and those ratios cannot be met at the loan
level, then subordination is used to achieve the desired credit rating.
6.2. CMBS Structure
Interest and principal repayments in a CMBS are structured as follows:
• Interest on principal outstanding is paid to all tranches.
• The highest-rated bonds are paid off first in the CMBS structure.
• Losses arising from loan defaults are charged against the principal balance of the
lowest priority CMBS tranche outstanding. These tranches may be unrated by credit-
rating agencies and are called the “first-loss piece”, “residual tranche”, or “equity
tranche”.
Characteristics of a CMBS Structure
In this section, we look at two important characteristics of a CMBS structure: call protection
and balloon risk.
Call Protection
RMBS investors are exposed to prepayment risk since the borrowers have a right to prepay
and are not penalized for prepayment; they have an incentive to prepay. CMBS has
considerable call protection, which is protection against early prepayment of mortgage
principal. The call protection comes in two forms: at the structure level and at the loan level.

Call protection at the structural level:

Call protection at the structural level comes by structuring CMBS into sequential-pay
tranches, by credit rating. A lower-rated tranche cannot be paid off until the higher-rated
tranches are retired. But, in the case of a default, the losses must be charged to the lowest-
rated tranche first and last to the highest-rated tranche.
Call protection at the loan level:
There are four mechanisms that offer investors call protection at the loan level:
1. Prepayment lockouts: The borrower is prohibited from any prepayments during a
specific period of time.
2. Prepayment penalty points: The borrower must pay a fixed percentage of the
outstanding loan balance as prepayment penalty if he wishes to refinance.
3. Yield maintenance charges: Also known as “make-whole charge”. The borrower must
pay a penalty to the lender that makes refinancing uneconomical if the sole objective
was to get a lower mortgage rate.
4. Defeasance: Defeasance is a protection at the loan level that requires the borrower to
provide sufficient funds that can be invested in a portfolio of government securities to
replicate the cash flows in the absence of prepayments.
Balloon Risk
Residential mortgages are fully-amortizing loans that are fully amortized over a long period
of time. Usually, there is no principal outstanding after the last mortgage payment. But, many
commercial loans backing CMBS transactions are balloon loans which require a substantial
principal payment on the final maturity date. If the borrower is not able to make the lump
sum payment, he may ask for an extension of the loan over a period of time called the
“workout period”.
Balloon risk is a type of extension risk. The risk that a borrower will not be able to make the
balloon payment either because the borrower cannot arrange for refinancing or cannot sell
the property to generate sufficient funds to pay off the balloon balance is called “balloon
risk”.
7. Non-Mortgage Asset-Backed Securities
A wide range of assets apart from mortgage loans are used as collateral for asset-backed
securities. The most popular non-mortgage ABS are auto loan receivable-backed securities
and credit card receivable-backed securities. Based on the way the collateral pays, ABS can
be categorized into two types: amortizing and non-amortizing.
Examples of amortizing loans backing an ABS: mortgage loans and automobile loans.
An example of non-amortizing loans backing an ABS: credit card receivables.
ABS must offer credit enhancement to be appealing to investors.

7.1. Auto Loan ABS

Cash flows consist of interest payment, scheduled principal repayments and any
prepayments. For securities backed by auto loan receivables, prepayments result from any
of the following:
• Sales and trade-ins requiring full payoff of the loan.
• Repossession and subsequent resale of vehicles.
• Insurance proceeds received upon loss or destruction of vehicles.
• Payoff of the loan with cash to save on the interest cost.
• Refinancing of the loan at a lower interest rate.
All auto-loan backed securities have some form of credit enhancement such as:
• A senior/subordinated structure so the senior tranches have credit enhancement.
• Reserve account, overcollateralization, and excess interest on the receivables.
o The purpose of a reserve account is to provide credit enhancement. More
specifically, the reserve account is a form of internal credit enhancement that will
protect the bondholders against losses up to x% of the par value of the entire
issue.
o Overcollateralization means that the aggregate principal balance of the
automobile loan contract exceeds the principal balance of the notes. It represents
another form of internal credit enhancement. Overcollateralization can be used to
absorb losses from the collateral.
7.2. Credit Card Receivable ABS
Credit cards such as Visa and MasterCard are used to finance the purchase of goods and
services, as well as for cash advances. When a cardholder makes a purchase using a credit
card, he is agreeing to repay the amount borrowed (purchase amount) to the issuer of the
card within a certain period, typically a month. If the outstanding amount is not repaid
within this grace period, then a finance charge (interest rate) is applied to the balance not
paid in full each month.
Credit card receivables are pooled together to act as a collateral for credit card receivable-
backed securities. Cash flow, on a pool of credit card receivables consists of:
• Finance charges: These represent the periodic interest the credit card borrower is
charged on the unpaid balance after the grace period.
• Fees and principal repayments. Fees include any late payment fees and any annual
membership fees.
Characteristics of Credit Card Receivable-backed Securities
Payment Structure
• The security holders are paid an interest periodically (e.g., monthly, quarterly, or
semiannually). The interest rate may be fixed or floating.

• The principal payments made by borrowers do not flow through to investors during a
period known as the lockout period. Instead, the repayments are reinvested to issue
new loans. As a result, credit card receivables increase during the lockout period.
During this period, the cash flow to security holders comes from finance charges and
fees.
Amortization Provision
• Credit card receivable-backed securities are non-amortizing loans. The principal is
not amortized during the lockout period.
• Certain provisions in credit card receivable-backed securities require early
amortization of the principal if certain events occur. Such provisions are referred to
as “early amortization” or “rapid amortization” provisions and are included to
safeguard the credit quality of the issue. The only way the principal cash flows can be
altered is by triggering the early amortization provision. For example, if issuers
believe there may be a default in credit card repayments, then the principal
repayments will be used to pay security holders (investors) instead of reinvesting to
issue new loans.
There are two differences between credit card receivable-backed securities and auto loan
receivable-backed securities:
• Collateral for credit card receivable-backed securities are non-amortizing loans, while
the collateral for auto loan receivable-backed securities are fully amortizing loans.
• For auto loan receivable-backed securities, outstanding principal balance declines as
principal is distributed to bond classes each month. But, for credit card receivable-
backed securities the principal is reinvested to issue new loans during the lockout
period.
8. Collateralized Debt Obligations
A collateralized debt obligation is a generic term used to describe a security backed by a
diversified pool of one or more debt obligations (e.g., corporate and emerging market bonds,
leveraged bank loans, ABS, RMBS, CMBS, or CDO).
Like an ABS, a CDO involves the creation of a SPV. But, in contrast to an ABS, where the funds
necessary to pay the bond classes come from a pool of loans that must be serviced, a CDO
requires a collateral manager to buy and sell debt obligations, for and from the CDO’s
portfolio of assets, to generate sufficient cash flows to meet the obligations of the CDO
bondholders, and to generate a fair return for the equity holders.
The structure of a CDO includes senior, mezzanine, and subordinated/equity bond classes.
The whole process is illustrated below:

8.1. CDO Structure

The key components of a CDO structure are as follows:
• The CDO raises funds by issuing debt. The debt obligations are structured as bond
classes or tranches, such as senior, mezzanine, or subordinated classes with varying
risk and return expectations. Investors invest in a particular bond class based on their
risk appetite.
• The funds raised from the issuance of bonds are used by the collateral manager to
invest in assets. He seeks to earn a higher return from these assets than what is paid
to the bondholders.
• The excess spread is used to pay the equity holders and the CDO manager.
• The sources of cash flow to bondholders include interest, principal repayments, and
sale of collateral assets.
8.2. An Example of a CDO Transaction
Consider the following $100 million CDO. The collateral consists of bonds with a par value of
$100 million paying a fixed rate of 11%.
Tranche Par value (US $) Coupon rate
Senior 80,000,000 Libor + 70 bps
Mezzanine 10,000,000 9%
Subordinated/equity 10,000,000 -
Since the senior tranche requires a floating rate payment, the CDO manager enters into an
interest rate swap with another party for a notional amount of $80 million paying a fixed
rate of 8% and receiving Libor. This removes any uncertainty with respect to interest rate
movements.
Let us now evaluate the cash flows for each party.

Party Type of cash flow Amount

Collateral Pays interest each year. Coupon rate .11 x 100,000,000 = 11,000,000
= 11%
Senior Interest paid to senior tranche: Libor (Libor + 70bps) x 80,000,000 =
tranche + 70 bps Libor x 80,000,000 + 560,000
Mezzanine Interest paid: 9% 0.09 x 10,000,000 = 900,000
tranche
Interest rate CDO to swap counterparty: 8% 0.08 x 80,000,000 = 6,400,000
swap
Interest rate From swap counterparty to CDO: 80,000,000 x Libor
swap Libor
Total interest received 11,000,000
+ Libor x 80,000,000
Total interest paid Libor x 80,000,000 + 560,000
+ 900,000 + 6,400,000
= 7,860,000 + Libor x 80,000,000
Net interest = Interest received – 3,140,000
interest paid
From the net interest available, the CDO manager’s fees must be paid. If the fees are 640,000,
then the cash flow available to the subordinated/equity tranches is 3,140,000 – 640,000 =
2,500,000. The annual return for this tranche with a par value of $10 million is
2,500,000/10,000,000 = 25%
CDOs: Risks and Motivations
In the case of defaults in the collateral, there is a risk that the manager will fail to earn a
return sufficient to pay off the investors in the senior and mezzanine tranches. Investors in
the subordinated/equity tranche risk the loss of their entire investment.

Summary
LO.a: Explain benefits of securitization for economies and financial markets.
The benefits to investors are:
• Securitization converts an illiquid asset into a liquid security.
• It gives investors direct access to the payment streams of the underlying mortgage
loans that would otherwise be unattainable.
• There are higher risk-adjusted returns to investors: pooling of loans results in
diversification and lower risk for investors.
• It gives investors anywhere an opportunity to buy a small part of homebuyers’
mortgage in the form of a security issued by the SPV.
• Exposure to the market, real estate for example, without directly investing in it.
The benefits to the bank or loan originator are:
• It enables banks to increase loan origination, monitoring, and collections.
• It reduces the role of the intermediaries like the bank.
• Banks have the ability to lend more money if the demand for ABS and MBS is high
relative to if the money was self-financed.
• There is greater efficiency and profitability for the banking sector.
The borrowers of the loan benefit from securitization in the following ways:
• It lowers the risk as the pooled loans offer a diversification benefit. The lower risk, in
turn, decreases the cost of borrowing for homeowners.
LO.b: Describe securitization, including the parties involved in the process and the
roles they play.
The parties involved in the securitization process include:
• SPV (Special Purpose Vehicle): It is also called the trust or the issuer.
• Seller of pool of securities: It is also known as the originator or depositor.
• Servicer: Servicing involves collecting payments from borrowers, notifying borrowers
who may be delinquent, and if necessary, seizing equipment from borrowers who
default.
• Other parties: Independent accountants, underwriters, trustees, rating agencies, and
guarantors.
The motivation for the creation of different types of structures is to redistribute prepayment
risk and credit risk efficiently among different bond classes in the securitization.
Prepayment risk is the uncertainty that the actual cash flows will be different from the
scheduled cash flows.
Time tranching is the creation of bond classes to distribute the prepayment risk.
Subordination is another layering structure in securitization. The bond classes differ in their

exposure to credit risk.

LO.c: Describe typical structures of securitizations, including credit tranching and
time tranching.
In credit tranching, any credit losses are first absorbed by the tranche with the lowest
priority and after that by any other subordinated tranches.
In time tranching, different classes receive the principal payments from the underlying
securities sequentially as each prior tranche is repaid in full.
LO.d: Describe types and characteristics of residential mortgage loans that are
typically securitized.
The cash flow of a mortgage consists of the following three components: interest, scheduled
principal payments, and prepayments.
Following are the important characteristics of residential mortgage loans:
Maturity: The term of a mortgage is the number of years to maturity. It varies from one
country to the other.
Interest rate determination: Interest rate on the mortgage loan is called the mortgage rate or
contract rate. The four basic methods for calculating mortgage rate are fixed rate, variable
rate, initial period fixed rate, and convertible rate.
Amortization schedule: Residential mortgages are usually amortizing loans. The amount
borrowed reduces gradually over time as periodic mortgage payments are made.
There are two types of amortizing loans:
• Fully amortizing loans: There is no outstanding balance at the end of the mortgage’s
life.
• Partially amortizing loans: The sum of all the scheduled mortgage repayments is less
than the borrowed amount. A last payment, called the balloon payment, is made equal
to the unpaid mortgage balance.
Based on interest/scheduled principal repayments, there are two types of mortgages:
• Interest-only mortgage: No scheduled principal repayment for a certain number of
years.
• Bullet mortgage: No scheduled principal repayment over the entire life of the loan.
Recourse loans: The lender can claim the shortfall (outstanding mortgage balance – after
selling the property) from the borrower.
Non-recourse loans: The lender may sell the property in case of a default and keep the
proceeds but they cannot claim other assets of the borrower to fulfill the shortfall in
outstanding mortgage balance.
LO.e: Describe types and characteristics of residential mortgage-backed securities,

including mortgage pass-through securities and collateralized mortgage obligations,

and explain the cash flows and risks for each type.
Residential mortgage-backed securities (RMBS) are bonds created from the securitization of
residential mortgage loans. Examples of agency RMBS include:
• Mortgage pass-through securities
• Collateralized mortgage obligations
• Non-agency residential mortgage-backed securities
A mortgage pass-through security is created when one or more holders of mortgages form a
pool of mortgages and sell shares or participation certificates in the pool. The cash flow of a
mortgage pass-through security depends on the cash flow of the underlying pool of
mortgages and consists of monthly mortgage payments representing interest, the scheduled
repayment of principal, and any prepayments, net of servicing and other fees.
• Market participants measure the prepayment rate using two measures: the single
monthly mortality (SMM) rate and its corresponding annualized rate, namely, the
conditional prepayment rate (CPR). For MBS, the measure widely used by market
participants to assess the sensitivity of the securitized bonds to interest rate
movements is the weighted average life (WAL) or simply average life of the MBS,
instead of duration.
• Market participants use the Public Securities Association (PSA) prepayment
benchmark to describe prepayment rates. A PSA assumption greater than 100 PSA
means that prepayments are assumed to be faster than the benchmark, whereas a
PSA assumption lower than 100 PSA means that prepayments are assumed to be
slower than the benchmark.
• Prepayment risk includes two components: contraction risk and extension risk. The
former is the risk when interest rates decline; the security will have a shorter
maturity than was anticipated at the time of purchase because homeowners refinance
at now-available lower interest rates. The latter is the risk when interest rates rise;
fewer prepayments will occur because homeowners are reluctant to give up the
benefits of a contractual interest rate that now looks low.
LO.f: Define prepayment risk and describe the prepayment risk of mortgage-backed
securities.
Prepayment risk refers to the uncertainty about the timing of the principal component of the
cash flows.
Contraction risk is the risk that the loan principal will be repaid earlier than expected.
Extension risk is the risk that the loan principal will be repaid later than expected.
LO.g: Describe the characteristics and risks of commercial mortgage-backed
securities.
Two important characteristics of a CMBS structure: call protection and balloon risk.

Call protection
CMBS have considerable call protection, which is protection against early prepayment of
mortgage principal. The call protection comes in two forms: at the structure level and at the
loan level.
• Call protection at the structural level comes by structuring CMBS into sequential-pay
tranches, by credit rating.
• The four mechanisms that offer investors call protection at the loan level are payment
knockouts, prepayment penalty points, yield maintenance charges, and defeasance.
Balloon risk
Balloon risk is a type of extension risk. The risk that a borrower will not be able to make the
balloon payment, either because the borrower cannot arrange for refinancing or cannot sell
the property to generate sufficient funds to pay off the balloon balance, is called “balloon
risk”.
LO.h: Describe types and characteristics of non-mortgage asset-backed securities,
including the cash flows and credit risk of each type.
The most popular non-mortgage ABS are auto loan receivable-backed securities and credit
card receivable-backed securities.
Auto Loan Receivable-Backed Securities
Cash flows consist of interest payment, scheduled principal repayments and any
prepayments. All auto-loan backed securities have some form of credit enhancement.
Credit Card Receivable-Backed Securities
The credit card receivables are pooled together to act as a collateral for credit card
receivable-backed securities. Cash flow, on a pool of credit card receivables consists of
finance charges and fees, and principal repayments.
There are two differences between credit card receivable-backed securities and auto loan
receivable-backed securities:
• Collateral for credit card receivable-backed securities are non-amortizing loans, while
the collateral for auto loan receivable-backed securities are fully amortizing loans.
• For auto loan receivable-backed securities, outstanding principal balance declines as
principal is distributed to bond classes each month. But for credit card receivable-
backed securities, principal is reinvested to issue new loans during the lockout
period.
LO.i: Describe collateralized debt obligations, including their cash flows and credit
risk.
A collateralized debt obligation is a generic term used to describe a security backed by a
diversified pool of one or more debt obligations (collateral). The structure of a CDO includes

senior, mezzanine, and subordinated/equity bond classes. In the case of defaults in the
collateral, there is a risk that the manager will fail to earn a return sufficient to pay off the
investors in the senior and mezzanine tranches. Investors in the subordinated/equity
tranche risk the loss of their entire investment.

Practice Questions
1. Analyst 1: Securitization is beneficial for banks because it allows banks to maintain
ownership of their securitized assets.
Analyst 2: Securitization is beneficial for banks because it increases the funds available
for banks to lend.
A. Analyst 1 is correct
B. Analyst 2 is correct
C. Both analysts are incorrect
2. In a securitization, the loan servicer is least likely responsible for the:

A. issuance of the asset-backed securities.
B. collection of payments from the borrowers.
C. recovery of underlying assets for delinquent loans.
3. A securitization structure that allows investors to choose between extension risk and
contraction risk is least likely called:
A. credit tranching.
B. time tranching.
C. prepayment tranching.
4. Edward Hall obtains a non-recourse loan for $300,000. A year later when the outstanding
balance of the mortgage is $285,000, Edward cannot make his mortgage payments and
defaults on the loan. The lender forecloses and sells the house for $250,000. What
amount is the lender entitled to claim from Edward?
A. $0.
B. $35,000.
C. $50,000.
5. A conditional prepayment rate (CPR) of 9% means that approximately 9% of the

outstanding mortgage pool balance at the beginning of this year will be prepaid:
A. in the current month.
B. by the end of the year.
C. over the life of the mortgages.
6. The balloon risk in a CMBS can be best described as a type of:

A. extension risk.
B. contraction risk.
C. interest rate risk.
7. If a credit card receivables asset-backed security (ABS) has a lock-out feature:

A. no investors may sell the ABS for a certain period of time.

B. no payments are made to the ABS investor for a certain period of time.
C. no principal payments are made to the ABS investor for a certain period of time.
8. A debt security that is collateralized by a pool of bond obligations backed by corporate

and emerging market debt is most likely a:
A. CDO.
B. CMO.
C. CMBS.

Solutions
1. B is correct. Securitization allows banks to remove assets from their balance sheet,
therefore increasing the pool of available capital that can be loaned out.
2. A is correct. In a securitization, the special purpose vehicle (SPV) is responsible for the
issuance of the asset-backed securities. The servicer is responsible for both the collection
of payments from the borrowers and the recovery of underlying assets if the borrowers
default on their loans.
3. A is correct. Time tranching or prepayment tranching allows investors to choose

between extension risk and contraction risk. Credit tranching refers to creating a multi-
layered capital structure that has senior and subordinate tranches.
4. A is correct. In a non-recourse loan the lender can only look to the underlying property to
recover the outstanding mortgage balance and has no further claim against the borrower.
5. B is correct. The CPR is an annual prepayment rate.
6. A is correct. Balloon risk refers to the risk that a borrower will not be able to make the
balloon payment when due. Since the term of the loan will be extended by the lender
during the workout period, balloon risk is a type of extension risk.
7. C is correct. If a credit card receivables asset backed security (ABS) has a lock-out feature
no principal payments are made to the investor, instead the principal repayments are
reinvested in new receivables.
8. A is correct. A CDO is backed by an underlying pool of debt securities which may include
corporate and emerging market debt. Both CMO and CMBS have mortgages as collateral.

R54 Understanding Fixed-Income Risk and Return 2019 Level I Notes
R54 Understanding Fixed-Income Risk and Return

1. Introduction
This reading covers:
• Sources of return on a bond: reinvestment of coupon payments and receipt of
principal.
• How investors are exposed to different interest rate risk if the same bond is held for
different time periods.
• Duration and convexity as measures of interest rate risk.
• How duration and convexity can be used to predict a change in a bond’s price, and
assess credit and liquidity risks.
2. Sources of Return
The total return is the future value of reinvested coupon interest payments and the sale
price (or redemption of principal if the bond is held to maturity). The horizon yield (or
holding period rate of return) is the internal rate of return between the total return and the
purchase price of the bond.
Total return on a bond = reinvested coupon interest payments + sale/redemption of
principal at maturity
A bond investor has three sources of return:
• Receiving the full coupon and principal payments on the scheduled dates.
• Reinvesting the interest payments. This is also known as interest-on-interest.
• Potential capital gain or loss on sale of the bond, if the bond is sold before maturity
date.
Now, we will look at a series of examples that demonstrate the effect on two investors’
realized rate of returns when one of these variable changes: time horizon, interest rate at
which the coupons are reinvested, and market discount rates at the time of purchase and at
the time of sale.
In Examples 1 and 2, we look at the realized rate of return for two investors with different
time horizons for the same bond.
Example 1: Calculating the total return on a bond that is held until maturity
Investor 1: A “buy-and-hold” investor purchases a 5-year, 10% annual coupon payment bond
at 92.79 per 100 of par value and holds it until maturity. Calculate the total return on the
bond.

Solution:
10 10 10 10 110
92.79 = 1
+ 2
+ 3
+ 4
+
(1 + r) (1 + r) (1 + r) (1 + r) (1 + r)5
Use the following keystrokes to calculate the bond’s yield to maturity:
N = 5; PV = -92.79; PMT = 10; FV = 100; CPT I/Y;
Hence, r = 12%.
This is the yield to maturity at the time of purchase. However, this holds good only if all of
the following three conditions are true:
• The bond is held to maturity.
• The coupon and final principal payments are made on time (no default or delay).
• The coupon payments are reinvested at the same rate of interest.
To calculate the total return on the bond, we first need to calculate the interest earned when
coupon payments are reinvested.
Coupon reinvestment:
• The investor receives 5 coupon payments of 10 (per 100 of par value) for a total of 50,
plus the redemption of principal (100) at maturity. The investor has the opportunity to
reinvest the cash flows. If the coupon payments are reinvested at 12% (i.e., yield to
maturity), the future value of the coupons on the bond’s maturity date is 63.53 per 100 of
par value.
[10 x (1.12)4 ] + [10 x (1.12)3 ] + [10 x (1.12)2 ] + [10 x (1.12)1 ] + 10 = 63.53
• The first coupon payment of 10 is reinvested at 12% for 4 years until maturity, the
second is reinvested for 3 years, and so on. The future value of the annuity is obtained
easily using a financial calculator: N = 5; PV = 0; PMT = 10; I/Y = 12; CPT FV. FV = -63.53
• The amount in excess of the coupons, 13.53 (= 63.53 – 50), is the ‘interest-on-interest’
gain from compounding.
• The investor’s total return is 163.53, the sum of the reinvested coupons (63.53) and the
redemption of principal at maturity (100). The realized rate of return is 12%.
163.53
92.79 = (1+r)5
, r = 12%

Example 2: Calculating the total return on a bond that is sold before maturity
Now let us consider investor 2 who buys the same 5-year, 10% annual coupon payment
bond but sells the bond after three years. Assuming that the coupon payments are reinvested
at 12% for three years, calculate the total return on the bond.
Solution:
The future value of the reinvested coupons is 33.74 per 100 of par value.
[10 ∗ (1.12)2 ] + [10 ∗ (1.12)1 ] + 10 = 33.74
The interest-on-interest gain from compounding is 3.74 (= 33.74 – 30). After three years,
when the bond is sold, it has two years remaining until maturity. If the yield to maturity
remains 12%, then the sale price of the bond is 96.62.
10 110
+ = 96.62
(1.12)1 (1.12)2
The total return is 130.36 (= 33.74 + 96.62) and the realized rate of return is 12%.
130.36
92.79 = , r = 12%
(1 + r)3
This ‘r’ is called the horizon yield, the internal rate of return between the total return and the
purchase price of the bond. Horizon yield is equal to the original yield to maturity if:
• Coupon payments are reinvested at the same yield to maturity calculated at the time
of purchase of the bond. In our case, it is 12% as calculated in Example 1.
• There are no capital gains or losses when the bond is sold. It is sold at a price on the
constant-yield price trajectory. We arrive at the price 96.62 by taking 12% as the
constant yield for the remaining two years. If the yield is more than 12%, then losses
occur. Similarly, if the yield is less than 12%, then capital gains occur. This concept is
elaborated below:
Constant-yield price trajectory for a 5-year, 10% annual payment bond
The price of the bond at different time periods for a yield of 12% is plotted in the graph
below:

The calculations for determining the price are shown below:

Year Price Calculation
0 92.79 N = 5 ; I/Y = 12 ; PMT = 10 ; FV = 100 ; CPT PV
1 93.93 N = 4 ; I/Y = 12 ; PMT = 10 ; FV = 100 ; CPT PV
2 95.19 N = 3 ; I/Y = 12 ; PMT = 10 ; FV = 100 ; CPT PV
3 96.62 N = 2 ; I/Y = 12 ; PMT = 10 ; FV = 100 ; CPT PV
4 98.21 N = 1 ; I/Y = 12 ; PMT = 10 ; FV = 100 ; CPT PV
5 100
Observation:
There will be a capital gain if the bond is sold at a price above the trajectory at any point in
time during the bond’s life. This will happen if the yield is below 12%. Remember a bond’s
price and interest rates are inversely related. Similarly, there will be a capital loss if the bond
is sold at a price below the trajectory at any point in time during the bond’s life. This will
happen if the yield is above 12%. Any point on the trajectory represents the carrying value
of the bond at that time.
Next, we analyze what happens to the investors’ realized rate of return if interest rates go up
after the bond is purchased.
Example 3: Calculating an investor’s realized return when interest rates go up and
bond is held until maturity
The buy-and-hold investor purchases the same 5-year, 10% annual payment bond at 92.79.
After the bond is purchased and before the first coupon is received, interest rates go up to
15%.
Calculate the investor’s realized rate of return.
Solution:
Use the following keystrokes to calculate the future value of the reinvested coupons at 15%
for 5 years:
[10 x (1.15)4 ] + [10 x (1.15)3 ] + [10 x (1.15)2 ] + [10 x (1.15)1 ] + 10 = 67.42
The total return is 167.42 (= 67.42 + 100).
167.42
92.79 = ; r = 12.53%
(1 + r)5
The investor’s realized rate of return is 12.53%.
Observation:
Compared to the investor in Example 1 (12%), the realized return of this investor is higher
because the coupons are reinvested at a higher rate. There is no capital gain or loss because
the bond is held to maturity and the principal of 100 is redeemed.

Example 4: Calculating an investor’s realized return when interest rates go up and

bond is sold before maturity
The second investor buys the same 5-year, 10% annual payment bond at 92.79 and sells it in
three years. After the bond is purchased, interest rates go up to 15%. Calculate the investor’s
realized gain.
Solution:
The future value of the reinvested coupons at 15% after three years is:
[10 x (1.15)2 ] + [10 x (1.15)1 ] + 10 = 34.73
N = 3; PV = 0; PMT = 10; I/Y = 15; CPT FV; FV = -34.73
The sale price of the bond after three years is 91.87.
10 110
1
+ = 91.87
(1.15) (1.15)2
The total return is 126.60 (= 34.73 + 91.87), resulting in a realized three-year horizon yield
of 10.91%.
126.60
92.79 = , r = 10.91%
(1 + r)3
N = 3; PV = 92.79; FV = 126.60; CPT I/Y
Hence, r = 10.91%.
Observation:
Compared to the investor in Example 2 with a similar time horizon (12%), the realized
return to this investor is lower at 10.91% because there is a capital loss. Even though the
coupons are reinvested at a higher rate, the capital loss is greater than the gain from
reinvesting coupons.
Increase in the value of reinvested coupons = 34.73 − 33.74 = 0.99
Capital loss = 91.87 - 96.62 = -4.75. Capital gain or loss is always calculated relative to the
carrying value at that point in time.
Next, we look at the effect of realized returns when interest rates go down after the bond is
issued.
Example 5: Calculating an investor’s realized return when interest rates go down
The buy-and-hold investor purchases the same 5-year, 10% annual payment bond at 92.79
and holds the security until it matures. After the bond is purchased, and before the first
coupon is received, interest rates go down to 8%. Calculate the investor’s realized return.
Solution:
The future value of reinvesting the coupon payments at 8% for 5 years is 58.67 per 100 of
par value.
[10 ∗ (1.08)4 ] + [10 ∗ (1.08)3 ] + [10 ∗ (1.08)2 ] + [10 ∗ (1.08)1 ] + 10 = 58.67

The total return is 158.67 (= 58.67 + 100), the sum of the future value of reinvested coupons
and the redemption of par value.
158.67
92.79 = , r = 11.33%
(1 + r)5
The investor’s realized rate of return is 11.33%.
Observation:
The realized return is lower than that in Example 1 (12%) because the coupons are
reinvested at a lower rate of return. Since the bond is held to maturity, there is no capital
gain or loss.
Decrease in the value of reinvested coupons = 58.67 - 63.53 = - 4.86
Example 6: Calculating an investor’s realized return when interest rates go down
The second investor buys the same 5-year, 10% annual payment bond at 92.79 and sells it
after three years. After the bond is purchased, interest rates go down to 8%. Calculate the
investor’s realized return.
Solution:
The future value of the reinvested coupons at 8% after three years is:
[10 ∗ (1.08)2 ] + [10 ∗ (1.08)1 ] + 10 = 32.46
This reduction in the future value of coupon reinvestments is offset by the higher sale price
of the bond, which is 103.57 per 100 of par value.
10 110
+ = 103.57
(1.08)1 (1.08)2
The total return is 136.03 (= 32.46 + 103.57), resulting in a realized three-year horizon yield
of 13.60%.
136.03
92.79 = , 𝑟 = 13.60%
(1 + 𝑟)3
Observation:
The realized return is greater than that of the investors in Examples 2 and 4 with a similar
time horizon. It is primarily due to the capital gains.
Capital gain = 103.57 - 96.62 = 6.95
Decrease in the value of reinvested coupons = 32.46 - 33.74 = -1.28
As you can see, the capital gain is far greater than the decrease in the value of reinvested
coupons.
Interest rate risk affects the realized rate of return for any bond investor in two ways:
coupon reinvestment risk and market price risk. But, what is interesting is that these are
offsetting types of risk. Two investors with different time horizons will have different

exposures to interest rate risk. From the examples above, let us sum up what happens when
interest rates go up or down:
When interest rates go up or down:
• Reinvestment income is directly proportional to interest rate movements. The value
of reinvested coupons increases when the interest rate goes up.
• Bond price is inversely proportional to interest rate movements. Bond price
decreases when the interest rate goes up.
When does coupon reinvestment risk matter?
• Coupon reinvestment risk matters when an investor has a long-term horizon. If the
investor buys a bond and sells it before the first coupon payment, then this risk is
irrelevant. But a buy-and-hold investor as in Examples 1, 3, and 5 has only coupon
reinvestment risk.
When does market price risk matter?
• Market price risk matters when an investor has a short-term horizon relative to the
time to maturity. If the investor buys a bond and sells it before the first coupon
payment, then he is exposed to market price risk only. But a buy-and-hold investor
such as those in Examples 1, 3, and 5 has only coupon reinvestment risk, and no
market price risk.
Example 7: Calculating the purchase price of the bond for various YTM
An investor buys a five-year, 10% annual coupon payment bond priced to yield 8%. The
investor plans to sell the bond in three years once the third coupon payment is received.
Calculate the purchase price for the bond and the horizon yield assuming that the coupon
reinvestment rate after the bond purchase and the yield to maturity at the time of sale are
(1) 7%, (2) 8%, and (3) 9%.
Solution:
The purchase price is:
10 10 10 10 110
1
+ 2
+ 3
+ 4
+ = 107.99
(1.08) (1.08) (1.08) (1.08) (1.08)5
N = 5; PMT = 10; FV = 100; I/Y = 8; CPT PV, PV = -107.99.
Solution to 1:
With YTM at sale = 7%:
N = 3; PV = 0; PMT = 10; I/Y = 7; CPT FV, FV = -32.15.
The future value of the reinvested coupons after three years is 32.15.
10 110
(1.07)1
+ (1.07)2
= 105.42.
N = 2; I/Y = 7; PMT = 10; FV = 100; CPT PV, PV = 105.42.

The total return after three years is 137.57 (= 32.15 + 105.42).

The realized return calculated using the keystrokes: N = 3; PMT = 0; PV = 107.99; FV =
137.57; CPT I/Y,
r = 8. 4%.
137.57
107.99 = (1+r)3
, r = 8.40%.
If interest rates go down from 8% to 7%, then the realized rate of return over the three-year
investment horizon is 8.40%, higher than the original yield to maturity of 8%.
Solution to 2:
With YTM at sale = 8%, the future value of the reinvested coupons after three years is:
The sale price of the bond is calculated as:
N = 2, I/Y = 8, PMT = 10, FV = 100; CPT PV
The realized return calculated using the keystrokes: N = 3; PMT = 0; PV = -107.99; FV =
136.03; CPT I/Y.
r = 8%.
136.03
107.99 = , r = 8.00%
(1 + r)3
If interest rates remain 8% for reinvested coupons and for the required yield on the bond,
the realized rate of return over the three-year investment horizon is equal to the yield to
maturity of 8%.
Solution to 3:
With YTM at sale = 9%: the future value of the reinvested coupons after three years is:
The sale price of the bond is calculated as:
N = 2; I/Y = 9; PMT = 10; FV = 100; CPT PV
The realized return calculated using the keystrokes: N = 3; PV = -107.99; FV = 134.54; CPT
I/Y
134.54
107.99 = (1+r)3
, r = 7.60%;
If interest rates go up from 8% to 9%, the realized rate of return over the three-year

investment horizon is 7.60%; lower than the yield to maturity of 8%.

3. Interest Rate Risk on Fixed-Rate Bonds
In this section, we look at two measures of interest rate risk: duration and convexity.
3.1. Macaulay, Modified, and Approximate Duration
The duration of a bond measures the sensitivity of the bond’s full price (including accrued
interest) to changes in interest rates. In other words, duration indicates the percentage
change in the price of a bond for a 1% change in interest rates. The higher the duration, the
more sensitive the bond is to change in interest rates. Duration is expressed in years.
There are two categories of duration: yield duration and curve duration.
• Yield duration is the sensitivity of the bond price with respect to the bond’s own yield
to maturity.
• Curve duration is the sensitivity of the bond price with respect to a benchmark yield
curve such as a government yield curve on coupon bonds, the spot curve, or the
forward curve.
As indicated in the diagram above, there are several types of yield duration.
Macaulay duration is a weighted average of the time to receipt of the bond’s promised
payments, where the weights are the shares of the full price that correspond to each of the
bond’s promised future payments. Let us consider a 10-year, 8% annual payment bond. To
determine the Macaulay duration, we calculate the present value of each cash flow, multiply
by weight and add, as shown in the below exhibit
Exhibit 2: Macaulay Duration of a 10 – Year, 8% Annual Payment Bond
Period Cash flow Present Value Weight Period x Weight
1 8 7.246377 0.08475 0.0847
2 8 6.563747 0.07677 0.1535
3 8 5.945423 0.06953 0.2086
4 8 5.385347 0.06298 0.2519
5 8 4.878032 0.05705 0.2853

6 8 4.418507 0.05168 0.3101

7 8 4.002271 0.04681 0.3277
8 8 3.625245 0.04240 0.3392
9 8 3.283737 0.03840 0.3456
10 108 40.154389 0.46963 4.6963
85.503075 1.00000 7.0029
We can also use the following formula to calculate Macaulay Duration:
1+r 1 + r + [N ∗ (c − r)] t
MacDur = ( − c ∗ [ (1 + r)N − 1] + r) – T
r
where:
r = yield to maturity
t = number of days from the last coupon payment date to the settlement date
T = number of days in the coupon period
c = coupon rate per period
N = number of periods to maturity
Instructor’s Note:
Understanding how the Macaulay duration works is more important than memorizing the
formula.
Modified duration provides an estimate of the percentage price change for a bond given a
change in its yield to maturity. It represents a simple adjustment to Macaulay duration as
shown in the equation below:
Macaulay duration
Modified duration = 1+r
where: r is the yield per period.

Therefore, percentage price change for a bond given a change in its YTM can be calculated
as:
%ΔPV FULL ≈ −AnnModDur x ΔYield
The AnnModDur term is the annual modified duration, and the ΔYield term is the change
in the annual yield to maturity. The ≈ sign indicates that this calculation is estimation.
The minus sign indicates that bond prices and yields to maturity move inversely.
Example 8: Calculating the modified duration of a bond
A 2-year, annual payment, $100 bond has a Macaulay duration of 1.87 years. The YTM is 5%.
Calculate the modified duration of the bond.
Solution:
Modified duration = 1.87/(1 + 0.05) = 1.78 years
The percentage change in the price of the bond for a 1% increase in YTM will be:

-1.78 * 0.01 * 100 = -1.78%.

Approximate Modified Duration
Modified duration is calculated if the Macaulay duration is known. But there is another way
of calculating an approximate value of modified duration: estimate the slope of the line
tangent to the price-yield curve. This can be done by using the equation below:
(PV ) − (PV )
Approximate Modified Duration = 2 ∗ ∆yield
− +
∗ PV 0
where:
PV_ = price of the bond when yield is decreased;
PV0 = initial price of the bond
PV+ = price of the bond when yield is increased
Source: CFA Program Curriculum, Understanding Fixed-Income Risk and Return

Interpretation of the diagram:
• PV0 denotes the original price of the bond.
• PV+ denotes the price of the bond when YTM is increased and PV_ denotes the bond
price when YTM is decreased.
• Change in yield (up and down) is denoted by Δ yield.
• For slope calculation: vertical distance = PV− − PV+ and horizontal distance = 2 x Δ
yield.
How to calculate approximate modified duration (or estimate the slope of the price-
yield curve):
• The yield to maturity is changed (increased/decreased) by the same amount.
• Calculate the bond price for a decrease in yield (PV-).
• Calculate the bond price for an increase in yield (PV+).
• Use these values to calculate the approximate modified duration.
Once the approximate modified duration is known, the approximate Macaulay duration can

be calculated using the formula below:

Approximate Macaulay Duration = Approximate Modified Duration x (1 + r)
Example 9: Calculating the approximate modified duration and approximate Macaulay
duration
Assume that the 6% U.S. Treasury bond matures on 15 August 2017 is priced to yield 10%
for settlement on 15 November 2014. Coupons are paid semiannually on 15 February and 15
August. The yield to maturity is stated on a street-convention semiannual bond basis. This
settlement date is 92 days into a 184-day coupon period, using the actual/actual day-count
convention. Compute the approximate modified duration and the approximate Macaulay
duration for this Treasury bond assuming a 50bps change in the yield to maturity.
Solution:
The yield to maturity per semiannual period is 5% (=10/2). The coupon payment per period
is 3% (= 6/2). When the bond is purchased, there are 3 years (6 semiannual periods) to
maturity. The fraction of the period that has passed is 0.5 (=92/184).
The full price (including accrued interest) at an YTM of 5% is 92.07 per 100 of par value.
3 3 3 3 3 103 92
PV0 = [ 1
+ 2
+ 3
+ 4
+ 5
+ 6
] ∗ (1.05)(184)
(1.05) (1.05) (1.05) (1.05) (1.05) (1.05)
0.5
⇒ 89.85 × (1.05) = 92.07
Increase the yield to maturity from 10% to 10.5% - therefore, from 5% to 5.25% per
semiannual period, and the price becomes 90.97 per 100 of par value.
3 3 3 3 3 103
PV+ = [ 1
+ 2
+ 3
+ 4
+ 5
+ ]
(1.0525) (1.0525) (1.0525) (1.0525) (1.0525) (1.0525)6
92
∗ (1.0525)(184)
⇒ 88.67 × (1.0525)0.5 = 90.97
Decrease the yield to maturity from 10% to 9.5% - therefore, from 5% to 4.75% per
semiannual period, and the price becomes 93.19 per 100 of par value.
3 3 3 3 3 103
PV_ = [ 1
+ 2
+ 3
+ 4
+ 5
+ ]
(1.0475) (1.0475) (1.0475) (1.0475) (1.0475) (1.0475)6
92
∗ (1.0475)(184)
⇒ 91.05 × (1.0475)0.5 = 93.19
The approximate annualized modified duration for the Treasury bond is 2.41
93.19 − 90.97
ApproxModDur = = 2.41
2 ∗ 0.005 ∗ 92.07
The approximate annualized Macaulay Duration is 2.53
ApproxMacDur = 2.41 ∗ 1.05 = 2.53
Therefore, from these statistics, the investor knows that the weighted average time to

receipt of interest and principal payments is 2.53 years (the Macaulay Duration) and that the
estimated loss in the bond’s market value is 2.41% (the Modified Duration) if the market
discount rate were to suddenly go up by 1.0%.
3.2. Effective Duration
Bonds with embedded options and mortgage-backed securities do not have a well-defined
YTM. These securities may be prepaid well before the maturity date. Hence, yield duration
statistics are not suitable for these instruments. For such instruments, the best measure of
interest rate sensitivity is the effective duration, which measures the sensitivity of the bond’s
price to a change in a benchmark yield curve (instead of its own YTM).
(PV− ) − (PV+ )
Effective Duration =
2 ∗ ∆ curve ∗ PV0
Difference between approx. modified duration and effective duration:

The denominator for approx. modified duration has the bond’s own yield to maturity. It
measures the bond’s price change to changes in its own YTM. But, the denominator for
effective duration has the change in the benchmark yield curve. It measures the interest rate
risk in terms of change in the benchmark yield curve.
Example 10: Calculating the effective duration
A Pakistani defined-benefit pension scheme seeks to measure the sensitivity of its
retirement obligations to market interest rate changes. The pension scheme manager hires
an actuarial consultant to model the present value of its liabilities under three interest rate
scenarios
1. a base rate of 10%
2. a 50 bps drop in rates, down to 9.5%
3. a 50 bps increase in rates to 10.5%.
The following chart shows the results of the analysis:
Interest Rate Assumption Present Value of Liabilities
9.5% PKR 10.5 million
10% PKR 10 million
10.5% PKR 9 million
Compute the effective duration of pension liabilities. PV0 = 10, PV+ = 9, PV- = 10.5, and Δ
curve = 0.005. The effective duration of the pension liabilities is 15.
10.5 − 9
= 15
2 ∗ 0.005 ∗ 10
This effective duration statistic for the pension scheme’s liabilities might be used in asset
allocation decisions to decide the mix of equity, fixed income, and alternative assets.
3.3. Key Rate Duration
Key rate duration is a measure of a bond’s sensitivity to a change in the benchmark yield

curve at a specific maturity. This topic is covered in detail at Level II.

The duration measures we have seen so for assume a parallel shift in the yield curve. But
what if the shift in the yield curve is not parallel? Here it is appropriate to use ‘Key rate
duration’.
Key rate durations are used to identify “shaping risk” of a bond, which is a bond’s sensitivity
to changes in the shape of the benchmark yield curve. For instance, analysts can analyze the
interest rate sensitivity if the yield curve flattens or if the yield curve steepens.
3.4. Properties of Bond Duration
The input variables for determining Macaulay and modified yield duration of fixed-rate
bonds are:
• Coupon rate or payment per period
• Yield to maturity per period
• Number of periods to maturity
• Fraction of the period that has gone by
By changing one of the above variables while holding others constant, we can analyze the
properties of bond duration, which, in turn, helps us assess the interest rate risk. We will use
the formula for Macaulay duration to understand the relationship between each variable and
duration:
1+r 1 + r + [N ∗ (c − r)]
MacDur = { − c ∗ [ (1 + r)N − 1] + r} – (t⁄T)
r
The fraction of the coupon period that has gone by (t/T)

First, let us consider the relationship between fraction of time that has gone by (t/T) and
duration. There is no change to the expression in braces {} as time passes by. Fraction of
time (t/T) increases as time passes by. Assume T is 180. If 50 days have passed, then t/T =
0.277. If 90 days have passed, then t/T = 0.5. If 150 days have passed, then t/T = 0.83. As t/T
increases from t = 0 to t = T with passing time, MacDuration decreases in value. Once the
coupon is paid, t/T becomes zero and MacDuration jumps in value. When time to maturity is
plotted against MacDuration, it creates a saw tooth pattern as shown graphically below:


Interpretation of the Macaulay duration between coupon payments with a constant yield to
maturity:
• Note: Read the diagram from right to left. As time passes between coupon periods,
duration decreases in value.
• Once the coupon is paid, it jumps back up creating a saw tooth pattern.
Now, we look at the relationship between Macaulay duration and change in the coupon rate,
yield to maturity, and the time to maturity. This is depicted in the exhibit below:
Properties of the Macaulay Yield Duration

Time to maturity
The relationship between Macaulay Duration and time to maturity for four types of bonds
(zero-coupon, discount, premium, and perpetuity) at t/T = 0 are shown.
• Zero-coupon bond: Pays no coupon so c = 0. Plugging in c = 0 and t/T = 0 in MacDur
formula, we get Macaulay Duration = N. For a zero-coupon bond, duration is its time
to maturity.
• Perpetuity: A perpetual bond is one that does not mature. There is no principal to
redeem. It makes a fixed coupon payment forever. If N is a large number in the above
equation, then the second part of the expression in the braces becomes zero.
1
Denominator: N is an exponent. (1 + r)N is a very large number. So N
must be
(1 + r)
zero and the value in the numerator will not matter here. Macaulay duration of a
1+r
perpetual bond is as N approaches infinity.
r
• Premium bond: Bonds are trading at a premium above par or at par. The coupon rate
is greater than or equal to yield to maturity (r). The numerator of the second
expression in braces is always positive because c-r is positive. The denominator of the
second expression in braces is always positive. Second expression as a whole is
1+r
always positive. MacDuration = less than because the second expression in
r

1+r
braces is positive. As time passes, it approaches .
r
• Discount bond: For a discount bond, the coupon rate is below yield to maturity. The
Macaulay Duration increases for a longer time to maturity. The numerator of the
second expression in braces is negative because c-r is negative. Put together, the
1+r 1+r
duration at some point exceeds , reaches a maximum, and approaches (the
r r
threshold) from above. This happens when N is large and coupon rate (c) is below the
yield to maturity (r). As a result, for a long-term discount bond, interest rate risk can
be lesser than a shorter-term bond.
The above points are summarized below:
Relationship between bond duration and other input parameters
Bond parameter Effect on Duration
Higher coupon rate Lower
Higher yield to maturity Lower
Longer time to maturity Higher for a premium bond. Usually, holds true for a discount
bond, but there can be exceptions. Exception: low coupon
(relative to YTM) bond with long maturity.
Example 11: Calculating the approximate modified duration
A mutual fund specializes in investments in sovereign debt. The mutual fund plans to take a
position on one of these available bonds.
Time to Yield to
Bond Coupon Rate Price
maturity maturity
(A) 5 years 10% 70.093879 20%
(B) 10 years 10% 58.075279 20%
(C) 15 years 10% 53.245274 20%
The coupon payments are annual. The yields to maturity are effective annual rates. The
prices are per 100 of par value.
1. Compute the approximate modified duration of each of the three bonds using a 5 bps
change in the yield to maturity and keeping precision to six decimals (because
approximate duration statistics are very sensitive to rounding).
2. Which of the three bonds is expected to have the highest percentage price increase if the
yield to maturity on each decreases by the same amount – for instance, by 10 bps from
20% to 19.90%?
Solution to 1:
Calculate PV+ and PV_; then calculate modified duration.

Bond A:
PV0 = 70.093879;
10 10 10 10 110
PV+ = 1
+ 2
+ 3
+ 4
+ = 69.977386
(1.2005) (1.2005) (1.2005) (1.2005) (1.2005)5
PV+ = 69.977386
10 10 10 10 110
PV_ = 1
+ 2
+ 3
+ 4
+ = 70.210641
(1.1995) (1.1995) (1.1995) (1.1995) (1.1995)5
PV_ = 70.210641
70.210641 − 69.977386
ApproxModDur = = 3.33.
2 ∗ 0.0005 ∗ 70.093879
The approximate modified duration of Bond A is 3.33.
Bond B:
PV0 = 58.075279
10 10 10 10 110
PV+ = + + + … . + = 57.937075
(1.2005)1 (1.2005)2 (1.2005)3 (1.2005)4 (1.2005)10
PV+ = 57.937075
10 10 10 10 110
PV_ = + + + … . + = 58.213993
(1.1995)1 (1.1995)2 (1.1995)3 (1.1995)4 (1.1995)10
PV_ = 58.213993
58.213993 − 57.937075
ApproxModDur = = 4.77
2 ∗ 0.0005 ∗ 58.075279
The approximate modified duration of Bond B is 4.77.
Bond C:
PV0 = 53.245274
10 10 10 10 110
PV+ = 1
+ 2
+ 3
+ 4
..+ = 53.108412
(1.2005) (1.2005) (1.2005) (1.2005) (1.2005)15
PV+ = 53.108412
10 10 10 10 110
+ + + . . + = 53.382753
(1.1995)1 (1.1995)2 (1.1995)3 (1.1995)4 (1.1995)15
PV- = 53.382753
53.382753 − 53.108412
ApproxModDur = = 5.15.
2 ∗ 0.0005 ∗ 53.245274
The approximate modified duration of Bond C is 5.15.
Solution to 2:
Bond C with 15 years-to-maturity has the highest modified duration. If the yield to maturity
on each is decreased by the same amount – for instance, by 10bps, from 20% to 19.90% -

Bond C would be expected to have the highest percentage price increase because it has the
highest modified duration.
Interest Rate Risk Characteristics of a Callable Bond
A callable bond is one that might be called by the issuer before maturity. This makes the cash
flows uncertain, so the YTM cannot be determined with certainty. The exhibit below plots
the price-yield curve for a non-callable/straight bond and a callable bond. It also plots the
change in price for a change in the benchmark yield curve. Bond price is plotted on the y-axis
and the benchmark yield on the horizontal axis.

• The two bonds share the same features: credit risk, coupon rate, payment frequency,
and time to maturity, but their prices are different when interest rates are low.
• When interest rates are low (left side of the graph), the price of the non-callable bond
is always greater than the callable bond.
• The difference between the non-callable bond and callable bond is the value of the
embedded call option.
• The call option is more valuable at low interest rates because the issuer has an option
to refinance debt at lower interest rates than paying a higher interest to existing
investors. For instance, if a bond is callable at 102% of par, then its price cannot
increase beyond 102 of par even if interest rates decrease. This is the reason behind
the callable bond’s negative convexity.
• From an investor’s perspective a call option is risky. At low interest rates if the issuer
calls the bond (meaning the issuer pays back the money borrowed), then investors
must reinvest the proceeds at lower rates. Notice that at higher interest rates, there is
not much of a difference in price because the probability of calling the bond is less.
• At relatively low interest rates, the effective duration of a callable bond is lower than
that of non-callable bond, i.e., interest rate sensitivity is low.

Interest Rate Risk Characteristics of Putable Bond

• The diagram above shows the price-yield curve for a putable bond and a straight
bond.
• A putable bond allows the investor to sell the bond back to the issuer; usually at par.
• At low interest rates, there is not much of a difference between a straight bond and
putable bond.
• At high interest rates, the difference between the putable bond and straight bond is
the value of the put option.
• When interest rates rise, the price of the bond decreases. Investors buy putable bonds
to protect against falling prices as rates rise.
• The value of the put option increases as rates rise. This also limits the sensitivity of
the bond price to changes in benchmark rates.
3.5. Duration of a Bond Portfolio
In the previous section, we saw how to calculate the duration for an individual bond. What if
a portfolio consists of a number of bonds, how will its duration be calculated?
There are two ways to calculate the duration of a bond portfolio:
• Weighted average of time to receipt of the aggregate cash flows.
• Weighted average of the individual bond durations that comprise the portfolio.
The key points related to each method are outlined in the table below.
Weighted Average Time to Receipt of Weighted Average of Individual Bond
Aggregate Cash Flows Durations in Portfolio
Theoretically correct, but difficult to use in Commonly used in practice.
practice.

Cash flow yield not commonly used. Cash Easy to use as a measure of interest rate
flow yield is the IRR on a series of cash risk.
flows.
Amount and timing of cash flows might not More accurate as difference in YTMs of
be known because some of these bonds bonds in portfolio become smaller.
may be MBS, or with call options.
Interest rate risk is usually expressed as a Assumes parallel shifts in the yield curve,
change in benchmark interest rates, not as i.e., all rates change by the same amount in
a change in the cash flow yield. the same direction. That seldom happens in
reality.
Change in the cash flow yield is not
necessarily the same amount as the change
in yields to maturity on the individual
bonds.
Example 12: Calculating portfolio duration
An investment fund owns the following portfolio of three fixed-rate government bonds:
Bond A Bond B Bond C
Par value 15,000,000 20,000,000 40,000,000
Market value 14,769,542 25,650,379 43,796,854
Modified duration 4.328 5.643 7.210
The total market value of the portfolio is 84,216,775. Each bond is on a coupon date so that
there is no accrued interest. The market values are the full prices given the par value.
1. Calculate the average modified duration for the portfolio using the shares of market value
as the weights.
2. Estimate the percentage loss in the portfolio's market value if the yield to maturity on each
bond goes up by 10 bps.
Solution to 1:
The average modified duration of the portfolio is 6.23.
(14,769,542/84,216,775) × 4.328 + (25,650,379/84,216,775) × 5.643 +
(43,796,854/84,216,775) × 7.210 = 6.23.
Solution to 2:
The estimated decline in market value if each yield rises by 10 bps is 0.623%. -6.23 × 0.001 =
-0.00623.
3.6. Money Duration of a Bond and the Price Value of a Basis Point
The money duration of a bond is a measure of the price change in units of the currency in
which the bond is denominated, given a change in annual yield to maturity.
Money Duration = AnnModDur x PVFULL

ΔPVFULL ≈ -MoneyDur x Δyield

Consider a bond with a par value of $100 million. The current yield to maturity (YTM) is 5%
and the full price is $102 per $100 par value. The annual modified duration of this bond is 3.
The money duration can be calculated as the annual modified duration (3) multiplied by the
full price ($102 million): 3 x $102 million = $306 million. If the YTM rises by 1% (100 bps)
from 5% to 6%, the decrease in value will be approximately $306 million x 1% = $3.06
million. If the YTM rises by 0.1% (10 bps), the decrease in value will be $306 million x 0.1%
= $0.306 million.
An important measure which is related to money duration is the price value of a basis
point (PVBP). The PVBP is an estimate of the change in the full price given a 1 bp change in
the yield to maturity. The formal equation is given below.
PV− − PV+
PVBP =
2
where PV_ and PV+ are full prices calculated by decreasing and increasing the YTM by 1
basis point.
A quick way of calculating the price value of a basis point is to take the money duration and
multiply by 0.0001. For example, if the money duration of a portfolio is $200,000 the price
value of a basis point is $200,000 x 0.0001 = $20. (1 bp = 0.01% = 0.0001)
Example 13: Calculating money duration of a bond
A life insurance company holds a USD 1 million (par value) position in a bond that has a
modified duration of 6.38. The full price of the bond is 102.32 per 100 of face value.
1. Calculate the money duration for the bond.
2. Using the money duration, estimate the loss for each 10 bps increase in the yield to
maturity.
Solution:
1. First calculate the full price of the bond: $1,000,000 x 102.32% = $1,023,200. The money
duration for the bond is: 6.38 × $1,023,200 = $6,528,000.
2. 10 bps corresponds to 0.10% = 0.0010. For each 10 bps increase in the yield to maturity,
the loss is estimated to be: $6,528,000 × 0.0010 = $6,528.02.
Example 14: Calculating PVBP for a bond

Consider a $100, five-year bond that pays coupons at a rate of 10% semi-annually. The YTM
is 10% and it is priced at par. The modified duration of the bond is 3.81. Calculate the PVBP
for the bond.
Solution:
Money duration = $100 x 3.81 = $381.00

PVBP = $381 x 0.0001 = $0.0381

3.7. Bond Convexity
The graph below shows the relationship between bond price and YTM. It shows the
convexity for a traditional fixed-rate bond.

• Duration assumes there is a linear relationship between the change in a bond’s price
and change in YTM. For instance, assume the YTM of a bond is 10% and it is priced at
par (100). According to the duration measure, if the YTM increases to 11% the price
moves down to a point on the straight line.
• Similarly, the price moves up to a point on the straight line if the YTM decreases.
• The curved line in the above exhibit plots the actual bond prices against YTM. So in
reality, the bond prices do not move along a straight line but exhibit a convex
relationship.
• For small changes in YTM, the linear approximation is a good representation for
change in bond price. That is, the difference between the straight and curved line is
not significant.
• In other words, modified duration is a good measure of the price volatility.
• However, for large changes in YTM or when the rate volatility is high, a linear
approximation is not accurate and a convexity adjustment is needed.
Here we need to factor in the convexity. The percentage change in the bond’s full price with
convexity-adjustment is given by the following equation:
Change in the price of a full bond:
1
% ΔPVFULL = (−AnnModDur ∗ Δyield) + [2 ∗ AnnConvexity ∗ (Δyield)2 ]
Expression in first braces: duration adjustment
Expression in second braces: convexity adjustment
Approximate convexity can be calculated using this formula:

PV− + PV+ − 2 ∗ PV0

Approx. Convexity = (Δyield)2 ∗ PV0
where:
PV_ and PV+ = new full price when YTM is decreased and increased by the same amount
PV0 = original full price
The change in the full price of the bond in units of currency, given a change in YTM, can be
calculated using this formula:
1
ΔPVFULL ≈ − (MoneyDur x Δyield) + [ x MoneyCon x (Δyield)2 ]
2
Convexity is good
The following exhibit shows the price-yield curves for two bonds with the same YTM, price,
and modified duration, and why greater convexity is good for an investor.

• Both the bonds have the same tangential line to their price-yield curves.
• When YTM decreases by the same amount, the more convex bond appreciates more
in price.
• When YTM increases by the same amount, the more convex bond depreciates less in
price than the less convex bond.
• The bond with greater convexity outperforms when interest rates go up/down.
The relationship between various bond parameters with convexity is the same as with
duration.
For a fixed-rate bond,
• The lower the coupon rate, the greater the convexity.
• The lower the yield to maturity, the greater the convexity.
• The longer the time to maturity, the greater the convexity.
• The greater the dispersion of cash flow or cash payments spread over time, the
greater the convexity.

Effective Convexity
For bonds whose cash flows were unpredictable, we used effective duration as a measure of
interest rate risk. Similarly, we use effective convexity to measure the change in price for a
change in benchmark yield curve for securities with uncertain cash flows. The effective
convexity of a bond is a curve convexity statistic that measures the secondary effect of a
change in a benchmark yield curve. It is used for bonds with embedded options.
PV− + PV+ − 2 ∗ PV0
Effective Convexity = (Δcurve)2 ∗ PV0
Here is a summary of some important points related to bonds with embedded options:
• When the benchmark yield is high, prices of callable and non-callable bonds change
almost similarly for interest rate changes.
• When the benchmark yield is low, call option becomes more valuable to the issuer.
• Callable bonds exhibit negative convexity.
• Putable bonds always have positive convexity.
Example 15: Calculating the full price and convexity-adjusted percentage price change
of a bond
A German bank holds a large position in a 6.50% annual coupon payment corporate bond
that matures on 4 April 2029. The bond's yield to maturity is 6.74% for settlement on 27
June 2014, stated as an effective annual rate. That settlement date is 83 days into the 360-
day year using the 30/360 method of counting days.
1. Calculate the full price of the bond per 100 of par value.
2. Calculate the approximate modified duration and approximate convexity using a 1 bp
increase and decrease in the yield to maturity.
3. Calculate the estimated convexity-adjusted percentage price change resulting from a 100
bp increase in the yield to maturity.
4. Compare the estimated percentage price change with the actual change, assuming the
yield to maturity jumps to 7.74% on that settlement date.
Solution:
There are 15 years from the beginning of the current period on 4 April 2014 to maturity on 4
April 2029.
1. The full price of the bond is 99.2592 per 100 of par value.
FV = 100, I/Y = 6.74, PMT = 6.50, N = 15, CPT PV; PV = -97.777.
83
Full Price = 97.777 × 1.0674360 = 99.2592.
2. PV+ = 99.1689 .
FV = 100, PMT = 6.5, I/Y = 6.75, N = 15, CPT PV; PV = -97.687.
83
PV+ = 97.687 × 1.0675360 = 99.1689.

PV_ = 99.3497.
FV = 100, I/Y = 6.73, PMT = 6.5, N = 15, CPT PV; PV = -97.869.
83
PV_ = 97.869 × 1.0673360 = 99.3497.
99.3497 – 99.1689
ApproxModDur = (2 ∗ 99.2592 ∗ .0001) = 9.1075.
The approximate modified duration is 9.1075.

99.1689 + 99.3497 – (2 × 99.2592)
ApproxCon = = 201.493
.00012 ∗ 99.2592
The approximate convexity is 201.493.

3. The convexity-adjusted percentage price drop resulting from a 100 bp increase in the
yield to maturity is estimated to be -8.1% (-9.1075 + 1.00746).
Modified duration alone estimates the percentage drop to be 9.1075%. The convexity
adjustment adds 100.746 bps (0.5 × 201.493 × .012 = 1.00746%).
4. The new full price if the yield to maturity goes from 6.74% to 7.74% on that settlement
date is 90.7623. The actual percentage change in the bond price is -8.5603%. The convexity-
adjusted estimate is -8.1%.
Example 16: Calculating the approximate modified duration and approximate

convexity
The investment manager for a US defined-benefit pension scheme is considering two bonds
about to be issued by a large life insurance company. The first is a 25-year, 5% semiannual
coupon payment bond. The second is a 75-year, 5% semiannual coupon payment bond. Both
bonds are expected to trade at par value at issuance.
Calculate the approximate modified duration and approximate convexity for each bond using
a 5 bp increase and decrease in the annual yield to maturity.
Solution:
In the calculations, the yield per semiannual period goes up by 2.5 bps to 2.525% and down
by 2.5 bps to 2.475%.
The 25-year bond has an approximate modified duration of 14.18.
PV+ : FV = 100, I/Y = 2.525, PMT = 2.5, N = 50, CPT PV, PV = -99.2945.
PV__: FV = 100, I/Y = 2.475, PMT = 2.5, N = 50, CPT PV, PV = -100.7126.
100.7126 – 99.2945
ApproxModDur = = 14.18 and an approximate convexity of 284.
2 ∗ 100∗ 0.0005
100.7126 + 99.2945 – (2 ∗ 100)
ApproxCon = ( 100 ∗ 0.00052
) = 284. Similarly, the 75-year bond has an

approximate modified duration of 19.51 and an approximate convexity of 708.

4. Interest Rate Risk and the Investment Horizon
In this section, we look at how yield volatility affects the investment horizon. We also study
the interaction between the investment horizon, market price risk, and coupon reinvestment
risk.
4.1. Yield Volatility
If there is a change in a bond’s YTM, there will be a corresponding change in the price of a
bond. The change in the price can be explained as the product of two factors:
1. Price value of a basis point (PVBP): Impact on bond price of a one basis point change in
YTM. This factor is based on the duration and convexity of the bond.
2. Number of basis points: This is the change in yield measured in basis points.
The percentage change in the price of a bond for a given change in yield can also be
determined using this equation:
1
%ΔPVFULL = (−AnnModDur ∗ Δyield) + [2 ∗ AnnConvexity ∗ (Δyield)2 ]
Example 17: Ranking bonds in terms of interest rate risk

A fixed-income analyst is asked to rank three bonds in terms of interest rate risk. The
increases in the yields to maturity represent the "worst case" for the scenario being
considered.
Bond Modified Duration Convexity ∆Yield
A 3.65 14.8 50 bps
B 5.75 38.7 25 bps
C 12.28 146 15 bps
The modified duration and convexity statistics are annualized. ∆Yield is the increase in the
annual yield to maturity. Rank the bonds in terms of interest rate risk.
Solution:
Calculate the estimated price change for each bond:
Bond A:
The duration effect is -3.65 × 0.005 = -1.825%.
The convexity effect is 0.5 × 14.8 × 0.0052 = 0.0185%.
The expected change in bond price is -1.825% + 0.0185% = -1.8065%.
Bond B:
The convexity effect is 0.5 × 38.7 × 0.00252 = 0.0121%.


Bond C:
The convexity effect is 0.5 × 146 × 0.00152 = 0.0164%.
Bond C has the highest degree of interest rate risk (a potential loss of 1.8256%), followed by
Bond A (a potential loss of 1.8065%) and Bond B (a potential loss of 1.4254%).
4.2. Investment Horizon, Macaulay Duration, and Interest Rate Risk
The impact of a sudden change in yield on the price of a bond is of particular concern to
short-term investors (price risk). Long-term investors will also be concerned about the
impact of a change in yield on the reinvestment income (reinvestment risk). An investor who
plans to hold the bond to maturity will only be concerned about reinvestment risk.
Consider another 10-year, 8% annual coupon bond priced at 85.5 and YTM of 10.4%. If the
investment horizon is 10 years, the only concern is reinvestment risk. Consider a scenario
where interest rates go down. In this case, reinvestment income goes down. When the price
of the bond goes up, it does not matter to the investor because at maturity he will simply
receive par value.
When interest rates go up, the reinvestment income goes up. If the investment horizon is 4
years, then the major concern is price risk. In this case, the price effect dominates relative to
the gain/loss from reinvestment of coupons. If the investment horizon is 7 years, the
reinvestment risk and price risk offset each other. For this particular bond the Macaulay
duration is 7 years.
Macaulay duration indicates the investment horizon for which coupon reinvestment risk
and market price risk offset each other. The assumption is a one-time parallel shift in the
yield curve.
Note: Investment horizon is different from the bond’s maturity. In this case, the maturity is 10
years while the horizon is 7 years.
The duration gap of a bond a bond is defined as the Macaulay duration – investment
horizon.
Duration gap = Macaulay duration – Investment horizon
• If Macaulay duration < investment horizon, the duration gap is negative: coupon
reinvestment risk dominates.
• If investment horizon = Macaulay duration, the duration gap is zero: coupon
reinvestment risk offsets market price risk.
• If Macaulay duration > investment horizon, the duration gap is positive: market price

risk dominates.
Example 18: Calculating duration gap and assessing interest rate risk
An investor plans to retire in 8 years. As part of the retirement portfolio, the investor buys a
newly issued, 10-year, 6% annual coupon payment bond. The bond is purchased at par
value, so its yield to maturity is 6.00% stated as an effective annual rate.
1. Calculate the approximate Macaulay duration for the bond, using a 1 bp increase and
decrease in the yield to maturity, and calculating the new prices per 100 of par value.
2. Calculate the duration gap at the time of purchase.
3. Does this bond at purchase entail the risk of higher or lower interest rates? Interest rate
risk here means an immediate, one-time, parallel yield curve shift.
Solution to 1:
100.0736 – 99.9264
The approximate modified duration of the bond is 7.36 = ( ).
2 × 100 × 0.0001
PV0 = 100, PV+ = 99.9264

FV = 100, PMT = 6, I/Y = 6.01, N = 10, CPT PV, PV = -99.9264
PV_ = 100.0736; FV = 100, PMT = 6, I/Y = 5.99, N = 10, CPT PV, PV = -100.0736.
The approximate Macaulay duration = 7.36 × 1.06 = 7.8016.
Solution to 2:
Given an investment horizon of 8 years, the duration gap for this bond at purchase is
negative: 7.8016 - 8 = -0.1984
Solution to 3:
A negative duration gap entails the risk of lower interest rates. To be precise, the risk is an
immediate, one-time, parallel, downward yield curve shift because the coupon reinvestment
risk dominates market price risk. The loss from reinvesting coupons at a rate lower than 6%
is larger than the gain from selling the bond at a price above the constant-yield price
trajectory.
5. Credit and Liquidity Risk
So far in this reading, we focused on how to use duration and convexity to measure the price
change given a change in YTM. Now, we will look at what causes the YTM to change.
• The YTM on a corporate bond consists of two parts: government benchmark yield and
a spread over the benchmark. Change in YTM can be due to either of these or both.
• The change in the spread can result from a change in credit risk or liquidity risk.
• Credit risk involves the probability of default and degree of recovery if default occurs.
• Liquidity risk refers to the transaction costs associated with selling a bond.

• For a traditional (option-free) fixed rate bond, the same duration and convexity
statistics apply if a change occurs in the benchmark yield or a change occurs in the
spread.
• A change in benchmark yield could be because of a change in the expected rate of
inflation or expected real rate of interest.
• In practice, there is often the interaction between changes in benchmark yields and in
the spread over the benchmark, and between credit and liquidity risk. It is rare for
any individual component of the YTM to change.
Example 19: Calculating modified duration
Consider a 4-year, 9% coupon paying semi-annual bond with an YTM of 9%. The duration of
the bond is 6.89 periods. Calculate the modified duration.
Solution:
MacDuration 6.89
Modified duration = = .09 = 6.593 periods or 3.297 years.
1 +r 1+
2
For a one percent change in the annual YTM, the percentage change in the bond price is
3.297%.
Example 20: Calculating the change in the credit spread on a corporate bond
The (flat) price on a fixed-rate corporate bond falls one day from 96.55 to 95.40 per 100 of
par value because of poor earnings and an unexpected ratings downgrade of the issuer. The
(annual) modified duration for the bond is 5.32. What is the estimated change in the credit
spread on the corporate bond, assuming benchmark yields are unchanged?
Solution:
Given that the price falls from 96.55 to 95.40, the percentage price decrease is 1.191%.
-1.191% ≈ -5.32 × ∆Yield,
∆Yield = 0.2239%
Given an annual modified duration of 5.32, the change in the yield to maturity is 22.39 bps.

Summary
LO.a: Calculate and interpret the sources of return from investing in a fixed-rate bond.
A bond investor has three sources of return:
• Receiving the full coupon and principal payments on the scheduled dates.
• Reinvesting the interest payments. This is also known as interest-on-interest.
• Potential capital gain or loss on sale of the bond, if the bond is sold before maturity
date.
Interest rate risk affects the realized rate of return for any bond investor in two ways:
coupon reinvestment risk and market price risk.
• Reinvestment income is directly proportional to interest rate movements. The value
of reinvested coupons increases when the interest rate goes up.
• Bond price is inversely proportional to interest rate movements. Bond price
decreases when the interest rate goes up.
• Coupon reinvestment risk matters when an investor has a long time horizon. If the
investor buys a bond and sells it before the first coupon payment, then this risk is
irrelevant.
• Market price risk matters when an investor has a short time horizon.
LO.b: Define, calculate, and interpret Macaulay, modified, and effective durations.
Macaulay duration is the weighted average of the time to receipt of coupon interest and
principal payments.
Modified duration is a linear estimate of the percentage price change in a bond for a 100
basis points change in its yield to maturity.
Macaulay Duration
Modified duration =
(1 + r)
FULL
% ∆ PV ≈ −AnnModDur ∗ ΔYield
(PV − ) − (PV + )
Approximate Modified Duration =
2 ∗ ∆ yield ∗ PV0
Effective duration is a linear estimate of the percentage change in a bond’s price that would
result from a 100 basis points change in the benchmark yield curve.
(PV− ) − (PV+ )
Effective Duration =
2 ∗ ∆curve ∗ PV0
LO.c: Explain why effective duration is the most appropriate measure of interest rate
risk for bonds with embedded options.
The difference between modified duration and effective duration is that modified duration
measures interest rate risk in terms of a change in the bond’s own yield to maturity, whereas
effective duration measures interest rate risk in terms of changes in the benchmark yield

curve.
Bonds with an embedded option do not have a meaningful internal rate of return (YTM)
because future cash flows are contingent on interest rates.
Therefore, effective duration is the appropriate interest rate risk measure, not modified
duration.
LO.d: Define key rate duration and describe the use of key rate durations in measuring
the sensitivity of bonds to changes in the shape of the benchmark yield curve.
Key rate duration is a measure of the price sensitivity of a bond to a change in the spot rate
for a specific maturity.
Key rate durations can be used to measure a bond’s sensitivity to changes in the shape of the
yield curve, i.e., for non-parallel shifts in the yield curve.
LO.e: Explain how a bond’s maturity, coupon, and yield level affect its interest rate
risk.
The interest rate risk of a bond is measured by duration. All else equal:
• Duration increases when maturity increases.
• Duration decreases when coupon rate increases.
• Duration decreases when yield to maturity increases.
LO.f: Calculate the duration of a portfolio and explain the limitations of portfolio
duration.
The weighted average of the time to receipt of aggregate cash flows
• This method is better in theory.
• Its main limitation is that it cannot be used for bonds with embedded options or for
floating-rate notes.
The weighted average of the durations of individual bonds that compose the portfolio
• This method is simpler to use and quite accurate when the yield curve is relatively
flat.
• Its main limitation is that it assumes a parallel shift in the yield curve.
LO.g: Calculate and interpret the money duration of a bond and price value of a basis
point (PVBP).
The money duration of a bond is a measure of the price change in units of the currency in
which the bond is denominated, given a change in annual yield to maturity.
Money Duration = AnnModDur ∗ PV FULL
∆ PV FULL ≈ −MoneyDur ∗ Δyield
The PVBP is an estimate of the change in the full price, given a 1bp change in the yield to
maturity.

PV− − PV+
PVBP =
2
LO.h: Calculate and interpret approximate convexity and distinguish between
approximate and effective convexity.
A bond’s convexity can be estimated as:
PV− + PV+ − 2 ∗ PV0
Approx. Convexity =
(Δyield)2 ∗ PV0
Effective convexity of a bond is a curve convexity statistic that measures the secondary effect
of a change in a benchmark yield curve. It is used for bonds with embedded options.
PV− + PV+ − 2 ∗ PV0
Effective Convexity =
(Δcurve)2 ∗ PV0
LO.i: Estimate the percentage change of a bond for specified change in yield, given the
bond’s approximate duration and convexity.
The percentage change of a bond can be calculated using the following formula if modified
duration and convexity are given:
1
% Δ PV FULL = (−AnnModDur ∗ Δyield) + [ ∗ AnnConvexity ∗ (Δyield)2 ]
2
LO.j: Describe how the term structure of yield volatility affects the interest rate risk of
a bond.
If there is a change in a bond’s YTM, there will be a corresponding change in the price of a
bond. The change in the price can be explained as the product of two factors:
1. Price value of a basis point (PVBP): Impact on bond price of a one basis point change in
YTM. This factor is based on the duration and convexity of the bond.
2. Number of basis points: This is the change in yield measured in basis points.
The percentage change in the price of a bond for a given change in yield can also be
determined using this equation:
1
% Δ PV FULL = (−AnnModDur ∗ Δyield) + [ ∗ AnnConvexity ∗ (Δyield)2 ]
2
LO.k: Describe the relationships among a bond’s holding period return, its duration,
and the investment horizon.
The Macaulay duration can be interpreted as the investment horizon for which coupon
reinvestment risk and market price risk offset each other.
Duration gap = Macaulay duration – Investment horizon
• If the investment horizon is greater than the Macaulay duration of the bond, coupon
reinvestment risk dominates price risk. The investor’s risk is that interest rates will

fall. The duration gap is negative.

• If the investment horizon is equal to the Macaulay duration of the bond, coupon
reinvestment risk offsets price risk. The duration gap is zero.
• If the investment horizon is less than the Macaulay duration of the bond, price risk
dominates coupon reinvestment risk. The investor’s risk is that interest rates will
rise. The duration gap is positive.
LO.l: Explain how changes in credit spread and liquidity affect yield to maturity of a
bond and how duration and convexity can be used to estimate the price effect of the
changes.
• The YTM on a corporate bond consists of two parts: government benchmark yield
and a spread over the benchmark. Change in YTM can be due to either of these or
both.
• The change in the spread can result from a change in credit risk or liquidity risk.
• Credit risk involves the probability of default and degree of recovery if default
occurs.
• Liquidity risk refers to the transaction costs associated with selling a bond.
• For a traditional (option-free) fixed rate bond, the same duration and convexity
statistics apply if a change occurs in the benchmark yield or a change occurs in the
spread.
• A change in benchmark yield could be because of a change in the expected rate of
inflation or expected real rate of interest.

Practice Questions
1. A buy and hold investor purchases a zero coupon bond at a discount and holds the
security until it matures. Which of the following sources of return is most likely the
largest component of the investor’s total return?
A. Capital gain.
B. Principal payment.
C. Reinvestment of coupon payments.
2. An investor purchases a 10-year, 6% annual coupon bond with an YTM of 8%. After the
bond is purchased and before the first coupon is received, the YTM of the bond changes
to 9%. Assuming coupon payments are reinvested at the YTM, the investor’s return when
the bond is held to maturity is:
A. less than 8%.
B. more than 8%.
C. equal to 8%.
3. A 12% annual pay bond has 10 years to maturity. The bond is currently trading at par.
Assuming a 10 basis points change in yield to maturity, the bond’s approximate modified
duration is closest to:
A. 5.15.
B. 5.94.
C. 6.46.
4. The modified duration of a bond is 6.54. The approximate percentage change in price
using duration only for a yield decrease of 120 basis points is closest to:
A. 6.54%
B. 7.74%
C. 7.84%
5. Which of the following measures is most appropriate for measuring the interest rate risk
of a bond with an embedded call option?
A. Effective duration.
B. Modified duration.
C. Macaulay duration.
6. Bond A has a coupon rate of 6%. Bond B has a coupon rate of 4%. All else equal:
A. bond A will have a higher Macaulay duration.
B. bond B will have a higher Macaulay duration.
C. both bonds will have the same Macaulay duration.

7. Which of the following is a limitation of calculating a bond portfolio’s duration as the

weighted average of the yield durations of the individual bonds that compose the
portfolio?
A. It assumes a parallel shift in the yield curve.
B. It cannot be applied if the portfolio includes bonds with embedded options.
C. It is less accurate when the yield curve is less steeply sloped.
8. A bond with exactly 6 years remaining until maturity offers a 4% coupon rate with
annual coupons. The bond, with a yield to maturity of 5%, is priced at $94.9243 per 100
of par value. The estimated price value of a basis point for the bond is closest to:
A. 0.182.
B. 0.098.
C. 0.049.
9. A bond has a convexity of 95.6. The convexity effect, if the yield decreases by 120 basis
points is closest to:
A. 0.688%
B. 0.724%
C. 0.956%
10. A bond has an annual modified duration of 8.010 and annual convexity of 75.270. If the
bonds’ yield to maturity decreases by 50 basis points, the expected percentage price
change is closest to:
A. 4.005%
B. 4.099%
C. 5.105%
11. If an investor’s investment horizon is more than the Macaulay duration of the bond he
owns:
A. the investor is hedged against interest rate risk.
B. reinvestment risk dominates, and the investor is at the risk of lower rates.
C. market price risk dominates, and the investor is at the risk of higher rates.
12. A software company receives a ratings downgrade and the price of its fixed-rate bond
decreases. The price decrease was most likely caused by a(n):
A. decrease in the bond’s liquidity spread.
B. decrease in the bond’s underlying benchmark rate.
C. increase in the bond’s credit spread.

Solutions
1. C is correct. A zero coupon bond makes no coupon payments hence it has no

reinvestment income. Since the bond is held to maturity, there will be no capital
gain/loss. The largest component of the investor’s total return will be principal payment.
2. B is correct. Initially the YTM of the bond was 8%. The YTM then increased to 9%. The
increase in YTM will increase the reinvestment income over the life of the bond, so the
investor will earn more than 8%.
3. A is correct. The bond is priced at par which means that the initial YTM= coupon rate =
12% and V0 = 100
ΔYTM = 0.001
V- = 100.57
N = 10, PMT = 12, FV = 100, I/Y = 11.9; CPT → PV = 100.57
V+ = 99.44
I/Y = 12.1; CPT→ PV = 99.44
V− − V+ 100.57 − 99.44
Approximate modified duration = = = 5.15
2V0 ∆YTM 2 × 100 × 0.001
4. C is correct. -6.54 x -0.012 = 0.07848 = 7.848%
5. A is correct. The interest rate risk of a fixed-rate bond with an embedded call option is
best measured by effective duration. A callable bond’s future cash flows are uncertain
because they are contingent on future interest rates. The issuer’s decision to call the
bond depends on future interest rates. Therefore, the yield to maturity on a callable bond
is not well defined. Only effective duration, which takes into consideration the value of
the call option, is the appropriate interest rate risk measure. Yield durations like
Macaulay and modified durations are not relevant for a callable bond because they
assume no changes in cash flows when interest rates change.
6. B is correct. The coupon rate is inversely proportional to Macaulay duration.
7. A is correct. A limitation of calculating a bond portfolio’s duration as the weighted

average of the yield durations of the individual bonds, is that this measure implicitly
assumes a parallel shift to the yield curve (all rates change by the same amount in the
same direction). In reality, interest rate changes frequently result in a steeper or flatter
yield curve. This approximation of the “theoretically correct” portfolio duration is more
accurate when the yield curve is flatter (less steeply sloped). An advantage of this

approach is that it can be used with portfolios that include bonds with embedded
options. Bonds with embedded options can be included in the weighted average using the
effective durations for these securities.
8. C is correct.
PVBP = (PV- - PV+)/2 x par value x 0.01
PV- (Full price calculated by lowering the yield to maturity by one basis point)
N= 6, I/Y = 4.99, PMT=4, FV = 100. CPT PV = $94.9735
PV+(Full price calculated by raising the yield to maturity by one basis point)
N= 6, I/Y = 5.01, PMT=4, FV = 100. CPT PV = $94.8752
PVBP = ($94.9735 - $94.8752)/2 = 0.049
9. A is correct. Convexity effect = ½ x convexity x(ΔYTM)2 = ½ x 95.6 x 0.0122 = 0.0068832

or 0.688%
10. B is correct.
Total estimated price change = duration effect + convexity effect.
= - duration x ΔYTM + ½ x convexity x (ΔYTM)2
= - 8.010 x -0.005 + ½ x 75.270 x -0.0052 = 0.04099 or 4.099%
11. B is correct. The duration gap is equal to the bond’s Macaulay duration minus the
investment horizon. In this case, the duration gap is negative and reinvestment risk
dominates price risk. The investor risk is that interest rates will fall.
12. C is correct. The change was most likely caused by an increase in the bond’s credit
spread. The increase in credit risk results in a larger credit spread.

R55 Fundamentals of Credit Analysis 2019 Level I Notes
R55 Fundamentals of Credit Analysis

1. Introduction
This reading covers the basic principles of credit analysis, explores the relationship between
the credit risk and capital structure of the firm, the role of credit rating in debt markets, and
the impact of credit spreads on risk and return.
2. Credit Risk
Credit risk is the risk that the borrower will fail to make principal and/or interest payments
on time. Credit risk has two components:
• Default risk or default probability: The borrower may fail to pay the full amount or
a partial amount. The risk that the issuer fails to meet its obligation of making interest
and principal payments on time is called default risk.
• Loss severity or loss given default: How severe is the loss incurred by the investor.
What portion of the bond’s value (including interest) is not paid by the issuer. A
default leads to various severity of losses; for instance, the loss may be total, or the
bondholders may recover some value.
We combine both the components into a single term called the expected loss.
Expected Loss = Default probability x Loss severity given default
Loss severity = 1 - Recovery rate
Loss severity is expressed either as a monetary amount or as a percentage of the principal.
Expressing it as a percentage is more useful as it is independent of the invested amount.
The recovery rate is the percentage of principal amount recovered in the event of a default.
Important credit-related risks include:
• Spread risk: Corporate bonds are usually quoted as a spread (yield premium) over
risk-free bonds such as U.S. treasury bonds. The amount of spread is quoted in basis
points. Assume the spread was initially 200 basis points, but has now increased to
250 basis points. This widening may be because of two factors: downgrade risk and
an increase in market liquidity risk.
• Downgrade risk: It is the decline in an issuer’s creditworthiness, which makes
investors believe that the risk of default is higher. This results in widening of yield
spread on the issuer’s bonds to widen and its bond prices to fall. It is also known as
credit migration risk.
• Market liquidity risk: This is the risk that the price at which investors can buy or
sell may differ from the market price. A higher liquidity risk implies that it is more
difficult for investors to transact (buy/sell) at a fair price. This happens when dealers
show little interest in buying/selling bonds. The ability and willingness of dealers to
make markets is reflected in the bid-ask spread. If the market liquidity risk is high,

the bid-ask spread is wide.

Two issuer-specific factors that affect market liquidity risk are:
1. The size of the issuer (large size means more debt is traded and market liquidity risk
is low).
2. The credit quality of an issuer. The lower the quality, the higher the risk.
3. Capital Structure, Seniority Ranking, and Recovery Rates
3.1. Capital Structure
Capital structure refers to the way a firm finances its assets across operating units. In short,
it refers to the composition of equity (common share, preferred share) and debt (bank debt,
bonds of all seniority rankings) across its operating units.
Assume a company has a total capital of $100 million of which bank debt is $5 million, bonds
are $35 million, preferred shares are worth $10 million, and common equity accounts for
$50 million. This is a simple capital structure. You may also have complicated capital
structures with a holding company with multiple subsidiaries underneath it across
geographies issuing their own debt with different seniority ranking.
3.2. Seniority Ranking
A single borrower may issue debt with different maturity dates and coupons. These various
bond issues may also have different seniority rankings. Seniority ranking determines who
gets paid first, or who has the first claim on the cash flows of the issuer, in the event of
default/bankruptcy/restructuring. Bondholders are broadly classified into secured and
unsecured.
• Unsecured bonds are known as debentures. They have a general claim on an issuer’s
assets and cash flows.
• Secured bondholders have the first (direct) claim on cash flows in the event of a
default.
• Priority of claims determines who gets paid first.
The exhibit below shows seniority ranking.

Within each category of debt, there are types and sub-rankings. Let us look at each of the
items in detail now (in the order of priority for repayment):
Secured debt: Highest ranked debt in which some asset is pledged as collateral.
• First mortgage debt: A specific property is pledged.
• First lien debt: A pledge of certain assets such as buildings, patents, brands, property,
and equipment, etc.
• Second lien or third lien: Some more assets could be pledged as a second or third lien
to rank below the first mortgage/first lien.
Unsecured debt (in the order of ranking): Loss severity can be as high as 100%. Lowest
priority of claims. No asset is pledged as collateral. The types are:
• Senior unsecured
• Subordinated
• Junior subordinated
Companies issue debt with different ranking for the following reasons:
• Cost effective: Secured debt has a lower cost due to reduced credit risk.
• Less expensive than equity: From a borrower’s perspective, even though the cost of
issuing subordinate debt may not be as low as secured debt, it is less restrictive and is
relatively less expensive than equity.
• Investors invest in subordinated debt because the higher yield compensates the high
risk assumed.

3.3. Recovery Rates

Recovery rate is the percentage of the principal amount recovered in the event of default.
Key points related to recovery rates are given below:
• Pari passu: All creditors at the same level of capital structure fall under the same
class, and they will have the same recovery rates. For example, assume there are two
creditors in the senior secured class; one with a 3-year bond and the other with a 1-
year bond. The debt of the 1-year bondholder matures in 3 months while the debt of
the 3-year bondholder matures in 2.5 years. If there is a default, both the investors
will have the same recovery rates irrespective of the time left to maturity. This type of
equal ranking for the same class of bonds is called pari passu (on equal footing).
• Recovery rates vary by seniority ranking: If the seniority ranking is high, recovery
rate will also be high.
• Recovery rates vary by industry: If the industry is on a decline like the newspaper
publishing industry, then the recovery rates will be low. There may be companies
going bankrupt in industries during a recession (e.g., the steel industry in 2011-12),
but in general the recovery rates here are higher than those on a decline.
• Recovery rates depend on when they occur in a credit cycle: For instance, if a
default happened in 2008 at the peak of the recent credit crisis, then the recovery
rates would have been lower relative to, let us say, in 2004-05.
• Recovery rates vary across industries and across companies within an industry.
• Priority of claims is not always absolute:
o Secured holders have a claim to cash flows/asset in the event of a default before
anyone else. However, if the value of the pledged asset is less than the claim, then
the unpaid amount becomes the senior unsecured claim.
o Unsecured creditors have a right to be paid before common/preferred
shareholders.
o Senior creditors take priority over junior/subordinated creditors.
4. Rating Agencies, Credit Ratings, and Their Role in Debt Markets
Moody’s, S&P, and Fitch are the three main rating agencies. At least two of these agencies
assign a rating to the majority of the bonds. The credibility/dominance of the rating agencies
is because of:
• Their independent assessment of credit risk.
• Ease of comparison across bond issuers and issues.
• Regulatory and statutory reliance and usage.
• Issuer payment for ratings: This is controversial as some believe the rating may be
biased as it creates a conflict of interest between the issuer, investor, and the rating
agency.
• Growth of debt markets.

4.1. Credit Ratings

Be familiar with what the ratings are (Aaa represents the highest quality among investment
grade securities, etc.). The rating system is almost similar across agencies starting from A for
investment grade to C/D for junk.
Long-Term Ratings Matrix: Investment Grade vs. Non-Investment Grade
Moody’s S&P Fitch
Aaa AAA AAA
High-Quality
Aa1 AA+ AA+
Grade
Aa2 AA AA
Aa3 AA- AA-
Investment Upper- A1 A+ A+
Grade Medium Grade A2 A A
A3 A- A-
Baa1 BBB+ BBB+
Low-Medium
Baa2 BBB BBB
Grade
Baa3 BBB- BBB-
Moody’s S&P Fitch

Ba1 BB+ BB+
Ba2 BB BB
Ba2 BB- BB-
B1 B+ B+
Non- Low Grade or
B2 B B
Investment Speculative
B3 B- B-
Grade “Junk” Grade Caa1 CCC+ CCC+
or “High Caa2 CCC CCC
Yield” Caa3 CCC- CCC-
Ca CC CC
C C C
Default C D D
Source: CFA Program Curriculum, Fundamentals of Credit Analysis
• Bonds rated AAA/Aaa have the highest quality, lowest credit risk, and lowest
probability of default. They have extremely low default rates.
• Bonds rated Baa3/BBB- or higher are investment grade bonds. Investment grade is
further divided into high-quality, upper-medium and low-medium.
• Bonds rated lower than Baa3/BBB- are non-investment grade bonds. Non-investment
grade includes speculative and default bonds. These have higher default risk.
• Outlook: This is an additional indicator on a rating. The outlook can be positive,

stable, or negative.
• The rating agencies may also indicate the potential direction of the ratings by
including comments like “on review for a downgrade” or “on credit watch for an
upgrade.”
4.2. Issuer vs. Issue Ratings
Rating agencies provide two ratings:
• Issuer rating: This is based on the creditworthiness of the issuer. It applies to senior
unsecured debt. Also known as corporate family rating (CFR).
• Issue rating: This rating is assigned to a specific debt/financial obligation. It takes
into consideration the seniority ranking of the debt within the capital structure. Also
known as corporate credit rating (CCR).
Cross-default provision: It is believed that the probability of default on one issue is linked
to other issues of the same issuer. That is, a default on one issue triggers default on other
issues with the same default probability.
Notching: A rating methodology to distinguish rating between different liabilities (bond
issues) of an issuer. The objective is that two securities with the same rating should have the
same expected loss rate (probability of default * expected severity loss). Credit rating on
issues can be moved up or down by a notch based on the risk of default/severity loss.
Factors the rating agencies consider while assigning ratings (notching up/down):
• Probability of default: it is the primary factor that drives the rating.
• Priority of payment: who gets paid first in the event of a default; secured/senior
unsecured/subordinated?
• Structural subordination: this is when the issuer is a holding company rather than an
operating company. Assume both the holding company and each of its operating
subsidiaries has issued bonds. The debt of the subsidiaries gets serviced by its cash
flows and assets first before any of it can be passed on to the holding company. All
else equal, debt issued by the holding company will have a lower rating than the debt
issued by the subsidiary.
4.3. Risks in Relying on Agency Ratings
There is sufficient evidence that rating agencies, in general, have done a good job of
assigning ratings that reflect the risks involved. Investors rely on these ratings to assess the
credit risk of their investments. However, these ratings are not foolproof and have their own
limitations:
• Credit ratings can be very dynamic: Credit rating of a bond issue may change over
time. For instance, a bond may have had “AAA” rating when it was issued. But five
years later, it may be A. There have been instances where an “AAA” rated bond at
issuance has turned into non-investment grade or junk within three years.
• Rating agencies are not infallible: The high ratings on subprime-backed mortgage

securities are the best example of this. If the rating agencies had rated the issue
appropriate to their risk level, it would have made investors cautious.
• Idiosyncratic or event risks are difficult to capture in ratings: Rating agencies do
a poor job of foreseeing event risks because it is not possible and these cannot be
reflected in a credit rating. A recent example is of the March 2011 tsunami that hit
Japan, which in turn affected the credit risk of Tokyo Electric Power Company.
• Ratings tend to lag market pricing of credit: Bond prices move on a daily basis
based on the perceived credit risk in them, as the market sees it. But, rating agencies
do not revise their ratings that often. Investors who time their buy/sell decisions
solely on the ratings issued by agencies are at the risk of underperforming the
market. But, a sudden downgrade has a disastrous effect on bond prices.
5. Traditional Credit Analysis: Corporate Debt Securities
5.1. Credit Analysis vs. Equity Analysis: Similarities and Differences
In many ways, credit analysis may look similar to equity analysis, but there are some
important differences:
Credit Analysis vs. Equity Analysis
Credit Analysis Equity Analysis
Analysis focuses on the downside risk: is The focus is on analyzing the growth
the cash flow sustainable? Will the potential of a company (increase in EPS);
company be able to pay interest and how shareholder value will be maximized.
principal? How the company fares against its peers in
the industry.
Management has a legal obligation to its Maximizing shareholder value is the
bondholders. objective of management.
Analysts focus on balance sheet and cash Analysts focus more on income and cash
flow statements. How much of total capital flow statements.
is debt and what is the seniority ranking of
debt?
Bondholders do not participate in the Shareholders have unlimited upside, but
growth of a company but have limited are more exposed to loss. They stand to
downside risk in the event of a default. lose their investment entirety before
bondholders suffer a loss.
5.2. The Four Cs of Credit Analysis: A Useful Framework
The four Cs of credit analysis framework are:
• Capacity: The ability of the borrower to make interest and principal payments on
time over the term of the debt.
• Collateral: Quality and value of the assets pledged as collateral against the debt.
• Covenants: Terms and conditions of the agreement that the issuer must comply with.

• Character: Refers to the quality of the management. What is the financial history of
the issuer; has it defaulted on payments in the past, or has there been a case of
bankruptcy?
We will now look at each of the four Cs in detail.
Capacity
Capacity is the ability of a borrower to generate enough cash flows to service its debt. To
determine an issuer’s capacity in credit analysis, you can draw a parallel to the top-down
analysis in equity analysis. The steps involved are:
1. Industry structure
2. Industry fundamentals
3. Company fundamentals
4. Competitive position
Industry Structure
Let us begin by analyzing the industry structure using Porter’s five forces framework.
• Power of suppliers: Industries with few suppliers have greater credit risk. Fewer
suppliers → limited negotiating power → customers have no control over frequent
price raise.
• Power of buyers/customers: Industries with few buyers have greater credit risk.
Buyers have negotiating power.
• Barriers to entry: High barriers to entry have lower risk as competition is low and
pricing power is strong. Examples of high barriers to entry: high capital investment
(aerospace), large distribution systems (auto dealerships), high degree of regulation
(power plants, utilities).
• Substitution risk: Industries that offer products/services with great value and poor
substitutes have low credit risk and strong pricing power. Ex: jet airplanes.
• Level of competition: Highly competitive industries have less predictable cash flow
and higher credit risk. Ex: utilities, telecom companies.
Another factor to look at is the degree of operating leverage (DOL) in an industry/companies
within the industry. If DOL is high, then fixed costs are high. If fixed costs are high, then as
long as revenue is good, cash flows/profitability will be good.
The next step is to assess the industry’s fundamentals. What are its growth prospects? Does
it get affected by macroeconomic factors? Etc.
Industry Fundamentals
The capacity to pay is influenced by company fundamentals. Some of the key points in this
regard are given below:
• Cyclical or non-cyclical: Cyclical companies are affected by economic downturns. Their
revenues and cash flows are impacted adversely during a recession. If a company is in

a cyclical industry, then the level of debt must be low. Example: demand for steel fell
drastically following the recent credit crisis and slowdown in Europe. On the
contrary, non-cyclical companies in pharmaceutical and consumer products
industries outperformed during this period.
• Growth prospects: Should credit analysts analyze growth prospects like equity
analysts do? Yes to an extent, as weaker companies may struggle to sustain
themselves financially in slow-growth industries unless they merge with another
company, or are acquired by a larger company.
• Published industry statistics: Statistics published by rating agencies or government
agencies are a good source of information for credit analysts to get a sense of how the
industry is performing.
Company Fundamentals
Analysts must consider the following factors while evaluating a company’s fundamentals:
• Competitive position: What is the company’s market share – is it
increasing/decreasing? Is the company competitive within its industry? How is its
cost structure relative to its peers?
• Track record/operating history: How has the company performed over time through
different economic cycles? How does the balance sheet look like (debt vs. equity)?
How is the performance of the current management team?
• Management’s strategy/execution: What is the management’s strategy; to grow and to
compete? Is it too aggressive relative to its peers? Is it venturing into unrelated
businesses? How does it plan to finance its strategy?
• Ratios and ratio analysis: Ratio analysis is used to assess a company’s financial health
at any point in time, its performance over time, and how competitive it is relative to
its peers. Credit analysts calculate a number of ratios. Here, they are categorized into
the following three groups:
o Profitability and cash flow: This is important to see if a company is profitable and
generates enough cash flows to make interest/principal payments on time.
o Leverage.
o Coverage: Measures an issuer’s ability to meet its interest payments.
o Liquidity is another measure that analysts look at as high liquidity means lower
credit risk.
Key ratios used in credit analysis are:
Profitability ratios:
• Refers to operating income and operating profit margin. Operating income is
typically defined as earnings before interest and taxes.
• A higher profitability ratio indicates lower credit risk.
Cash flow measures: Cash flow is measured as
• Earnings before interest, taxes, depreciation, and amortization (EBITDA).

• Funds from operations (FFO).

• Free cash flow before dividends.
• Free cash flow after dividends.
A high cash flow indicates lower credit risk.
Leverage ratios: Includes
• Debt-to-capital ratio.
• Debt-to-EBITDA ratio.
• FFO-to-debt ratio.
Lower leverage indicates lower credit risk.
Coverage ratios: Includes
• EBIT-to-interest expense ratio.
• EBITDA-to-interest expense ratio.
Higher coverage ratios indicate lower credit risk.
Collateral
The objective of collateral analysis is to assess the value of the assets relative to the amount
of debt issued by a company. Credit analysts consider the collateral value if the probability of
default is too high.
Methods used by analysts to determine the quality and value of a company’s assets are
discussed below:
• One of the ways to calculate the quality of a publicly traded company’s assets is equity
market capitalization. For instance, if the company’s stock is trading below its book
value, then the quality of its assets is low.
• If capital expenditure is less than depreciation expense, then the quality of assets may
be low as the company is not investing enough in its business.
• How many intangible assets (patents/goodwill) does the company have on its balance
sheet? Patents are valuable and may be sold.
Collateral value is insignificant for companies with primarily human and intellectual capital
(e.g., software and investment management firms) as they do not have hard assets.
Covenants
Instructor’s Note:
This was discussed in detail in the introductory Fixed-Income Securities reading.
Covenants are clauses that state what an issuer can and cannot do. Bond covenants are
legally enforceable rules that borrowers and lenders agree on at the time of a new bond
issue. They are described in the bond prospectus. There are two types of covenants:
affirmative (positive) or negative (restrictive).

Affirmative covenants
• Indicate what the issuer must (is obligated to) do.
• Examples: Make interest and principal payments on time, comply with all laws and
regulations.
Negative covenants
• Indicate what the issuer must not do.
• Examples: Restrictions on debt, limits on maximum acceptable leverage ratios and
minimum acceptable interest coverage ratios, negative pledges such as no additional
debt can be issued that is senior to existing debt.
Character
Nowadays, most companies are publicly owned, instead of by individuals. Judging the
character of a management is different than it would be for an owner-managed firm.
• How sound is the management’s strategy for growth of the company?
• How successful was the management in executing strategies in the past?
• Are the accounting/tax policies too aggressive?
• Is there any history of fraud?
6. Credit Risk vs. Return: Yields and Spreads
We saw in equity that high risk meant a higher potential return. Similarly, issues with lower
credit ratings offer higher yields. The higher the credit risk, the higher the return potential,
and the higher the volatility of that return. The realized return will be different because
interest rates change over time.
As you can see in the exhibit below, junk bonds rated Caa offered the highest return, but also
experienced the highest volatility. In contrast, the average return of high-quality investment
grade bonds was the lowest at 6.18%. But, they were also the least volatile.
Source: CFA Program Curriculum,

Fundamentals of Credit Analysis

Yield on corporate bond

Yield on corporate bond = real risk-free interest rate + expected inflation rate + maturity
premium + liquidity premium + credit spread
Yield spread = liquidity premium + credit spread
Factors that affect the spread on corporate bonds:
• Credit cycle: Credit spreads narrow when the credit cycle improves; a spread is
narrower at the top of a credit cycle. Credit spreads widen when the credit cycle
deteriorates as seen during the recent credit crisis after 2008.
• Broader economic conditions: Credit spreads widen in a weak economy and narrow
in a strong economy.
• Market performance: Credit spreads widen in weak financial markets and narrow
under stable market conditions.
• Broker-dealers’ willingness to provide sufficient capital for market listing: Unlike
stocks that primarily trade on exchanges, bonds trade over the counter. Brokers and
dealers are market makers in the debt market. At times of crisis as seen during the
post-2008 period, many broker-dealer firms either closed down or were acquired.
The capital available for making markets reduced substantially.
• Market supply and demand: If the supply is more and demand is less, credit spreads
will widen. Conversely, if the demand is high and supply is low, then spreads tighten.
The first four factors were responsible for widening spreads in 2008-09.
How changes in spread affect the price and return of a bond:
Two factors that affect the return on a bond are:
• Modified duration: Price sensitivity to interest rate changes.
• Magnitude of the spread change.
Return impact is calculated using these formulae:
Return impact with and without convexity adjustment
For small changes in yield:
Return impact (without convexity adjustment) ≈ -ModDur x Δspread
For large changes in yield:
Return impact (with convexity adjustment) ≈ - (ModDur x Δspread) +
1
x Convexity x (Δspread)2
2
where ModDur is the modified duration

Note: The negative sign indicates that bond prices and yields move in opposite directions.
Relationship between spread changes and duration for credit-risky bonds
Spread changes Bond return/price Modified Duration

Narrow Positive (higher)

Wider Negative (lower)
Higher spread sensitivity Greater price volatility Higher/longer
7. Special Considerations of High-Yield, Sovereign, and Non-Sovereign

Credit Analysis
What is important from a credit analyst and an investor’s perspective when investing in
corporate bonds: to choose high-quality, investment-grade bonds. Can the same credit
analysis principles we have seen so far be applied to evaluate other credit-risky bonds as
well? Yes, to an extent, but there are differences. We look at three market segments: high-
yield corporate bonds, sovereign bonds, and municipal bonds.
7.1. High Yield
These are non-investment grade, junk bonds that are rated below Baa3/BBB by most
agencies.
Why do bonds issued by some companies get junk status?
Instructor’s Note: Remember the points from the four Cs in credit analysis that an
investment-grade bond must have. This list is just the opposite of that.
• Highly leveraged capital structure.
• Limited or negative free cash flow (no capacity).
• Weak or limited operating history.
• Highly cyclical business.
• Poor management (poor character).
• Risky financial policies.
• Declining industry.
• Lack of competitive advantages.
If the bond is at a risk of default, then the analysis must be more detailed than for an
investment-grade bond. The factors a credit analyst must focus on for a high-yield bond are
as follows:
• Liquidity and cash flow.
• Detailed financial projections.
• Debt structure.
• Issuer’s corporate structure.
• Covenants.
• Equity-like approach to high-yield analysis.
Let us look at each of the points in detail now:
Liquidity
• Investment grade companies have cash on their balance sheets or committed sources

of capital to roll over maturing debt.

• High-yield companies may not have access to debt/equity markets or other sources of
capital.
• Sources of liquidity (listed below are sources ordered from strongest to weakest) for a
high-yield company must be analyzed:
o Cash on the balance sheet – most reliable.
o Working capital.
o Operating cash flow.
o Bank credit facilities.
o Equity issuance – not reliable if market conditions are bad.
o Asset sales – least reliable.
Cause of concern/warning sign:
• Debt coming due in the next 6 to 12 months with low sources of liquidity.
Detailed financial projections
• Forecast future earnings and cash flow under different stress scenarios to see if credit
profile is improving, stable, or declining.
• Must take into account ongoing capital expenditures.
Debt structure
• High-yield companies issue debt with varying levels of seniority (second lien, senior
unsecured, subordinated, preferred stock). It is important to understand the debt
structure – how much debt is senior and subordinated? Within senior debt, how
much is secured and unsecured?
• Leverage (calculated as Debt/EBITDA ratio) must be calculated at each level of debt
to determine the recovery rate if default occurs. Leverage can either be calculated as
gross or net leverage. Gross leverage includes cash. In net leverage, cash is subtracted
from debt and calculated as (Debt-cash)/EBITDA.
• The lower the ranking → the lower the credit rating →the lower the expected
recovery rate.
Corporate structure
• High-yield investors must analyze an issuer’s corporate structure and distribution of
debt between the parent and its subsidiaries. Is the corporate structure complex?
• How does the cash flow between the parent (holding company) and its subsidiaries –
subsidiary to parent, or parent to subsidiary?
• Is the issuer a holding company? Do the holding company’s subsidiaries have
outstanding debt? How are the leverage ratios for each debt-issuing entity?
Covenant analysis
The covenants for high-yield issuer may include:
• Change of control put: If the issuer gets acquired, then this clause requires the issuer

to buy back the debt from investors either at par or small premium to par. The
objective is to protect them from a downgrade after acquisition or a weaker acquirer.
• Restricted payments: Defines how much cash can be paid to shareholders over time.
• Limitations on liens and additional indebtedness: Defines how much secured debt an
issuer can have. The objective is to protect unsecured bondholders in the event of
default by not having too many secured layers above them.
• Restricted versus unrestricted subsidiaries: Subsidiaries are classified as restricted
and unrestricted. Certain subsidiaries with significant assets may be classified as
restricted to help service parent-level debt.
Equity-like approach to high-yield analysis
• Risk and return profile of high-yield bonds falls somewhere in between high-quality
investment grade bonds and stocks.
• So, analyzing high-yield bonds like equities is useful.
• Credit analysts may analyze high-yield bonds by calculating enterprise value = equity
market capitalization + total debt – cash.
• Then, they may compare EV/EBITDA and Debt/EBITDA of different issuers as part of
their analysis.
7.2. Sovereign Debt
Governments issue sovereign debt to finance public projects such as infrastructure,
education, and airports, and to pay wages to government employees.
Types of debt issued by governments:

• Local (internal) debt: Issued in the sovereign’s own currency: easier to service as the
government can print money or raise taxes.
• External debt: Not denominated in the sovereign’s currency but some other currency,
like the U.S. dollar.
Characteristics of sovereign debt:
• Historically viewed as risk-free, but that is changing as seen post-2008. Many
Eurozone countries such as Greece and Spain were on the verge of default.
• Best able to service debt if a sovereign runs twin surpluses (current account surplus
and budget surplus).
• Two key issues to consider in sovereign analysis: the government’s ability to pay and
willingness to pay.
• Credit rating agencies distinguish between local currency debt and foreign currency
debt. Rating agencies usually assign a higher rating to local currency debt relative to
foreign currency debt.
Given below is a framework (adapted from S&P’s methodology) to evaluate sovereign credit
and assign sovereign debt ratings:

Framework for sovereign credit analysis

Political and economic profile Flexibility and performance profile
Institutional effectiveness and political External liquidity and international
risks investment position
• How were past political, economic, • Low external debt → better able to
financial crises handled? service foreign currency debt.
• Is there consistency in policy • Actively traded currency → less
framework? impacted by adverse shifts in global
• Is the government corrupt? investor portfolios (e.g., U.S. Dollar).
• Is the media biased/compromised?
• What is the willingness to implement
reforms?
Economic structure and growth prospects Fiscal performance, flexibility, and debt
• How is the income per capita? Higher burden
income per capita means a deeper tax • Decline in government debt/GDP →
base. strong credit.
• Size of public sector to private sector. • If
Government interest expense
< 5%, then it
expenditure
The public sector should be smaller
is good; > 15% is poor.
compared to the private sector. Net general government debt
• Age of population. A young population • < 30% is good.
GDP
implies an expanding tax base, and
contributes to GDP. Japan has an
ageing population that puts pressure
on health care and social services.
Monetary flexibility
• What is the exchange rate policy (listed
in order of maximum
independence/effectiveness) – free
floating currency, fixed rate or a hard
peg?
• Central bank
• Is the bank independent or does the
government influence its monetary
policy?
• Is controlling inflation (low, stable
levels) the objective?
• How developed is the banking system?

7.3. Non-Sovereign Government Debt

Non-sovereign government debt is debt issued by state, provincial, and local governments. It
generally refers to U.S. municipal bonds and consists of tax-exempt and (a small portion of)
taxable bonds.
General obligation bonds
• GO bonds are unsecured and issued with the full faith and credit of issuing
government.
• Credit analysis focuses on employment, per capita income, per capita debt, tax base,
etc.
• Over-reliance on one or two types of tax revenue (e.g., capital gains or sales tax) can
signal credit risk.
Revenue bonds
• Issued for specific project financing like toll road, bridge, etc.
• Credit analysis is similar to corporate bonds.
• Higher risk than GO bonds because of a single source of revenue.
• A key metric to calculate: debt-service-coverage ratio (DSCR), i.e., how much revenue
to cover debt service payments.
The higher the DSCR, the stronger the creditworthiness.

Summary
LO.a: Describe credit risk and credit-related risks affecting corporate bonds.
Credit risk is the risk of loss if the borrower fails to make scheduled payments of interest
and/or principal.
Credit-related risks include:
• Downgrade risk: Refers to a decline in an issuer’s creditworthiness.
• Market liquidity risk: Refers to a widening of the bid–ask spread on an issuer’s bonds.
LO.b: Describe default probability and loss severity as components of credit risk.
Credit risk has two components:
• Risk of default: The probability that the borrower will default.
• Loss severity: If the borrower does default, how severe is the loss.
Expected Loss = Default probability x Loss severity given default
LO.c: Describe seniority rankings of corporate debt and explain the potential violation
of the priority of claims in a bankruptcy proceeding.
Corporate debt is ranked by seniority or priority of claims; the following diagram shows this:
The priority of claims in bankruptcy is not always absolute. In bankruptcy, the court may
approve a repayment plan that does not follow the priority of claims order.
LO.d: Distinguish between corporate issuer credit ratings and issue credit rating and
describe the rating agency practice of notching.

Credit rating agencies, such as Moody’s, Standard & Poor’s, and Fitch issue credit ratings for
bonds which are opinions about a bond issue’s creditworthiness. These ratings help
investors compare the credit risk of different debt issues.
The rating agencies rate both issuers and issues.
• Issuer ratings reflect an issuer’s overall creditworthiness—its risk of default.
• Ratings for issues reflect factors such as their rankings in the capital structure.
Notching
• Notching refers to the practice of adjusting an issue credit rating upward or
downward, as compared to the issuer credit rating, to reflect the seniority or other
provisions in that specific issue.
LO.e: Explain risks in relying on ratings from credit rating agencies.
The risks of relying on ratings from credit rating agencies are:
• Credit ratings can be very dynamic.
• Rating agencies are not foolproof.
• Idiosyncratic or event risks are difficult to capture in the ratings.
• Ratings tend to lag market pricing of credit.
LO.f: Explain the four Cs (Capacity, Collateral, Covenants, and Character) of traditional
credit analysis.
The four Cs of the credit analysis framework are:
• Capacity: The ability of the borrower to make interest and principal payments on
time over the term of the debt. The steps involved are: Industry structure → industry
fundamentals → company fundamentals → competitive position.
• Collateral: Quality and value of the assets pledged as collateral against the debt.
• Covenants: Terms and conditions of the agreement that the issuer must comply with.
• Character: Refers to the quality of the management. What is the financial history of
the issuer has it defaulted on payments in the past, or has there been a case of
bankruptcy?
LO.g: Calculate and interpret financial ratios used in credit analysis.
Credit analysts use profitability, cash flow, leverage, and coverage ratios to assess the
issuer’s capacity. These ratios are explained in the next LO.
LO.h: Evaluate the credit quality of a corporate bond issuer and a bond of that issuer,
given key financial ratios of the issuer and the industry.
Key ratios used in credit analysis are:
Profitability ratios:
• Refers to operating income and operating profit margin. Operating income is
typically defined as earnings before interest and taxes.

• A higher profitability ratio indicates lower credit risk.

Cash flow measures: Cash flow is measured as:
• Earnings before interest, taxes, depreciation, and amortization (EBITDA).
• Funds from operations (FFO).
• Free cash flow before dividends.
• Free cash flow after dividends.
• A high cash flow indicates lower credit risk.
Leverage ratios: Includes
• Debt-to-capital ratio.
• Debt-to-EBITDA ratio.
• FFO-to-debt ratio.
• Lower leverage indicates lower credit risk.
Coverage ratios: Includes
• EBIT-to-interest expense ratio.
• EBITDA-to-interest expense ratio.
• Higher coverage ratios indicate lower credit risk.
LO.i: Describe factors that influence the level and volatility of yield spreads.
Yield on corporate bond = real risk-free rate + expected inflation + maturity premium +
liquidity premium + credit spread
Yield spread = liquidity premium + credit spread
Factors that affect the spread on corporate bonds:
• Credit cycle: Credit spreads narrow when the credit cycle improves; it is narrower at
the top of a credit cycle.
• Broader economic conditions: Credit spreads widen in a weak economy and narrow
in a strong economy.
• Market performance: Credit spreads widen in weak financial markets and narrow
under stable market conditions.
• Broker-dealers’ willingness to provide sufficient capital for market listing. Unlike
stocks that primarily trade on exchanges, bonds trade over-the-counter. Brokers and
dealers are market makers in the debt market.
• Supply and demand: If the supply is more and demand is less, credit spreads will
widen.
LO.j: Explain special considerations when evaluating the credit of high-yield,
sovereign, and municipal debt issuers and issues.
High-Yield Bonds
• They are more likely to default than investment grade bonds.
• More emphasis should be placed on an issuer’s sources of liquidity, as well as on its

debt structure and corporate structure.

• Covenant analysis and using an equity-like approach can be helpful.
Sovereign bonds
• Sovereign credit analysis includes assessing both:
o an issuer’s ability (Ability to pay will be high for debt issued in the country’s
own currency than for debt issued in foreign currency).
o willingness to pay its debt obligations.
Non-sovereign government debt
• Non-sovereign debt is usually either general obligation bonds or revenue bonds.
• General obligation (GO) bonds are backed by the taxing authority of the issuing non-
sovereign government. Therefore credit analysis of GO bonds is similar to sovereign
analysis.
• Revenue-backed bonds support specific projects, such as toll roads, bridges, airports,
and other infrastructure. Therefore credit analysis of revenue bonds depends on the
income generating capacity of the project.

Practice Questions
1. Credit risk is best measured by the:
A. expected loss.
B. severity of loss.
C. probability of default.
2. Which of the following would most likely have the highest priority of claims in a
bankruptcy proceeding?
A. Senior secured debt
B. Senior unsecured debt
C. Senior subordinated debt
3. ‘Notching’ is best described as the difference between :

A. a company credit rating and an industry average credit rating.
B. an issuer credit rating and an issue credit rating.
C. S&P credit rating and Moody’s credit rating.
4. A bond’s price did not fall when it was downgraded by S&P from A to A-. Which of the
following is the most likely explanation?
A. Bond prices never react to rating changes
B. The bond doesn’t trade often so the price hasn’t adjusted to the rating change yet
C. The market was expecting the rating change, and so it was already “priced in” to the
bond
5. To analyze the collateral of a company, a credit analyst would most likely assess the:
A. cash flows of the company.
B. growth prospects of the industry.
C. value of the company’s assets in relation to the level of debt.
6. Higher credit risk is indicated by a higher:

A. FFO/Debt ratio.
B. Debt/capital ratio.
C. EBIT/interest expense ratio.
7. Credit yield spreads will tend to widen when:

A. demand for bonds is high.
B. equities performed poorly.
C. economic conditions strengthen.

8. Which of the following factors in credit analysis is more important for municipal bonds
than for sovereign bonds?
A. Per capita income.
B. Power to levy and collect taxes.
C. Requirement to balance an operating budget.

Solutions
1. A is correct. Credit risk is best measured by expected loss which is the product of
probability of default and the severity of loss in the event of default. Neither component
alone completely reflects the risk.
2. A is correct. Among the listed senior secured debt comes first followed by senior
unsecured debt followed by senior subordinated debt.
3. B is correct. Notching refers to the credit rating agency practice of differentiating

between an issuer credit rating and an issue credit rating to reflect the seniority and
other provisions of the debt issue.
4. C is correct. The market was anticipating the rating downgrade and had already priced it
in. This is one of the risks of relying on credit ratings; credit ratings lag market pricing.
Bond prices often do react to rating changes, particularly multi-notch ones. Even if bonds
don’t trade, their prices adjust based on dealer quotations given to bond pricing services.
5. C is correct. The value of assets in relation to the level of debt is important to assess the
collateral of the company.
6. B is correct. A high Debt/Capital ratio is a sign of higher leverage and therefore higher
credit risk. High FFO/Debt ratio and EBIT/interest expense ratio indicate lower credit
risk.
7. B is correct. In weak financial markets, including weak markets for equities, credit
spreads will widen.
8. C is correct. Unlike sovereigns, municipalities cannot use the monetary policy to service
their debt. Therefore, they are usually required to balance their operating budget.

R56 Derivative Markets and Instruments 2019 Level I Notes
R56 Derivative Markets and Instruments

1. Introduction
This reading covers what is a derivative, why derivatives are needed, the different types of
derivatives and how they are priced.
2. Derivatives: Definitions and Uses
A derivative is a financial instrument that derives its value from the performance of an
underlying asset. In simple terms, a derivative is a legal contract between a buyer and a
seller, entered into today, regarding a transaction that will be fulfilled at a specified time in
the future. This legal contract is based on an underlying asset.
A derivative contract defines the rights of each party involved. There are two parties
participating in the contract: a buyer and a seller.
• Long: Buyer of the derivative is said to be long on the position. He has the right to buy
the underlying according to the conditions mentioned in the contract.
• Short: Seller of the derivative is said to be short. Remember “s” is for short and seller.
Let us take an example. Assume A is planning a family vacation to Fiji after six months and is
saving money for the trip. He estimates he will need 15,000 Fijian dollars (FJD) which in
today’s terms translates to 500,000 in his local currency (LCR). But he is worried that FJD
may appreciate, and the 500,000 will buy less FJD after six months. So he enters into a
contract with B to buy 15,000 FJD at a certain exchange rate six months from now – a week
before his travel. What has A done?
In a way, he has removed any uncertainty with respect to exchange rates in the future and
limited his risk. This agreement between A and the other party is a derivative where the
underlying is the exchange rate. The value of the contract fluctuates based on the underlying
exchange rate. A is long, and the party that agrees to deliver 15,000 FJD six months later is
short on the position. This agreement is shown in the exhibit below.
Derivatives are sometimes compared to insurance as they offer protection against

something. Like insurance, they have a value based on what they are protecting (usually the

asset), a definite life span, and an expiration date.

Risk management is the process by which an organization or individual defines the level of
risk it wishes to take, measures the level of risk it is taking, and adjusts the latter to equal the
former. Derivatives are an important tool for companies to manage risk effectively.
3. The Structure of Derivative Markets
In this section, we look at the characteristics of exchange-traded and over-the-counter
markets. The exhibit below shows the structure of the derivatives market.
3.1. Exchange-Traded Derivatives Markets

Derivatives traded on exchanges are called exchange-traded derivatives. Examples include
stock futures, currency futures. The exchange is the intermediary between the long and
short parties. It takes an initial margin from both the parties as a guarantee.
Exchange-traded derivatives are standardized. To standardize a derivative implies that the
contract is bound by terms and conditions, and there is little ability to alter those terms. The
contract clearly specifies when it can be traded, when it will expire, what is the lot size, a
minimum amount, and settlement price. There is no room for customization. The only aspect
not defined is the price. The price is determined by the buyers and sellers. For example, a
gold contract on CME defines its quality (995 fineness), contract size (100 troy ounces), how
it will be settled (physical), and so on.
The advantages of standardization are as follows:
• Liquidity: Standardization boosts liquidity as there is no ambiguity, unlike an OTC
market. All market participants are aware when a particular currency/stock future
will trade and when it will expire.
• Clearing and settlement process: Standardization facilitates in clearing and settlement.
After the trade is executed, the clearing and settlement process kicks in. The flow of

money and securities does not happen directly between the investors, as you can see
from the diagram below. Instead, it flows through a third party called the
clearinghouse. Clearing is the process by which the clearinghouse verifies the
execution of the transaction and the identity of the participants. Settlement refers to
the process in which the exchange transfers money from one party to another, or from
a participant to the exchange or vice versa.
• More transparent: The presence of a clearinghouse makes the whole process

transparent and minimizes the impact of default between the parties. All the
information regarding prices, settlement, and daily turnover is disclosed within
exchanges and clearinghouse which means there is a lack of privacy and flexibility.
• Credit guarantee: It goes without saying that one party loses while the other wins in a
derivative contract as it is based on the performance of the underlying. Clearinghouses
guarantee that the winning party gets paid by requiring participants to post a margin
(cash deposit) called margin or performance bonds, and uses these deposits to make a
payment in the event of default.
3.2. Over-the-counter Derivatives Markets
Unlike an exchange-traded derivative, OTC contracts are negotiated directly between two
parties without an exchange. The characteristics of OTC markets are as follows:
• OTC market comprises an informal network of dealers, typically banks, linked
electronically. These are also called dealer markets.
• Contracts are customized as per the client’s needs.
• Unlike an exchange-traded system where the clearinghouse guarantees settlement,
OTC derivatives have credit risk. Each party bears the risk that the other party will
default.
The key differences between exchange-traded and OTC markets are summarized below:
Differences between exchange-traded and OTC markets
Feature Exchange-traded OTC
Rules Standardized Customized
Where are the contracts traded Exchanges Dealer network
Intermediary Yes, an exchange No intermediary

Trading, clearing, and settlement Centralized Decentralized

Liquidity More Almost the same
Transparent Yes No
Level of regulation High Low
Flexibility/privacy No Yes
Margin required Yes May or may not be
Examples Futures and options Forwards and Swaps
Market Makers
Market makers can operate in both exchange-traded and OTC markets. The market makers
make money through the bid-ask spread. For instance, if party A wants to take a long
position, the market maker will take the opposite position, i.e., a short position. The market
maker will then look for another party, suppose B, with whom the market maker will take a
long position. In other words, the market maker will sell to party A and buy from party B.
The overall effect is cancelled out, and no matter what happens to the underlying, the market
maker is covered. The bid amount will be lesser than the ask price, and the difference
between both will generate a profit for the market maker.
4. Types of Derivatives
The following exhibit shows the different types of derivatives.

4.1. Forward Commitments

A forward commitment is a contract that requires both parties to engage in a transaction at a
later point in time (the expiration) on terms agreed upon today. The parties establish the
identity and quantity of the underlying, the manner in which the contract will be executed or
settled when it expires, and the fixed price at which the underlying will be exchanged. Both
the parties – the buyer and the seller - have an obligation to engage in the transaction at a
future date in a forward commitment.
We will look at the three types of forward commitments: forward contracts, futures
contracts, and swaps.
Forward Contracts
A forward contract is an over-the-counter derivative contract in which two parties agree to
exchange a specific quantity of an underlying asset at a later date at a fixed price they agree
on when the contract is signed. It is a customized and private contract between two parties.
Terms of a forward contract
• Price.
• Where the asset will be delivered.
• Identity of the underlying.
• Number of units or quantity of the underlying. For example, if the underlying is gold
and the price is fixed per gram, the number of grams to be delivered must be specified.
• It is a customized contract between two parties and not traded over the exchange.
Risk of a forward contract
• The long hopes the underlying will increase in value while the short hopes the asset
will decrease in value. One of the two will happen and whoever owes money may
default.
• With forward contracts, no money is exchanged at the start of the contract. Further,
the value of the contract is zero at initiation.
Payoff for long and short:
The diagram below illustrates the payoff diagram for long and short in a forward contract:

Notation:
• S0 = price of the underlying at time 0; ST = price of the underlying at time T
• FT = forward price fixed at inception at time t = 0
• T = when the forward contract expires
Example
Whizz wants to sell 500 shares of beverage maker FTC to Fizz at $50 per share after 180
days. What happens if the market price of FTC at expiry is $50, $60, $70 or $40?
Solution:
Fizz is the long party and Whizz is the short party.
At expiry from Fizz’s perspective (long) when market price is:
$50: payoff is 0 and no one gains or loses
$60: long gains by $10
$70: long gains by $20
$40: long loses by $10 as he can buy the asset cheaper by $10 directly from the market
instead of paying $50 to Whizz
From Whizz’s perspective, it is exactly the opposite to that of Fizz. When the share price
increases to $70, he loses $20 as he can sell it in market for $70 but is selling for only $50 to
Fizz.
The payoff for the long is depicted diagrammatically below:

Futures
A futures contract is a standardized derivative contract created and traded on a futures
exchange such as the Chicago Mercantile Exchange (CME). In a futures contract, two parties
agree to exchange a specific quantity of the underlying asset at an agreed-upon price at a
later date. The buyer agrees to purchase the underlying asset from the other party, the seller.
The agreed-upon price is called the futures price.
There are some similarities with a forward contract: two parties agreeing on a contract, an
underlying asset, a fixed price called the futures price, a future expiry date, etc. But the
following characteristics differentiate futures from a forward:
• The contracts are standardized.
• They are traded on a futures exchange.
• The fixed price is called futures price and is denoted by f. (Forward prices are usually
represented by F.)
• The biggest difference is that gains or losses are settled on a daily basis by the
exchange through its clearinghouse. This process is called mark to market.
• Settlement price is the average of final futures trades and is determined by the
clearinghouse.
• The futures price converges to a spot price at expiration.
• At expiry: the short delivers the asset and the long pays the spot price.
Let us take an example. Assume Ann enters into a contract to buy 100 grams of gold at $55
per gram after 90 days. The futures price is $55. At the end of day 1, the futures price is $58.
There is a gain of $3. So, $300 ($3 per gram x 100 grams) is credited to Ann’s account. This is
called marking to market. The account maintained by Ann is called the margin account.
Swaps
A swap is an over-the-counter contract between two parties to exchange a series of cash
flows based on some pre-determined formula. The simplest swap is a plain vanilla interest
rate swap. Consider two companies A and B in Hong Kong that enter into a swap agreement;
Company A agrees to pay 10% interest per year to company B for three years on a notional
principal of HKD 90,000. Company B, in turn, agrees to pay HIBOR + 150 basis points per

year to company A for the same period and on the same notional principal.
4.2. Contingent Claims
We now move to the other major category of derivative instruments called contingent
claims. The holder of a contingent claim has the right, but not the obligation to make a final
payment contingent on the performance of the underlying.
In a contingent claim, two parties, A and B, sign a contract at time 0 to engage in a
transaction at time T. Unlike a forward or futures contract, A has the right, but not the
obligation to make a payment and take delivery of the asset at time T.
There are three types of contingent claims: options, credit derivatives, and asset-backed
securities.
Options
An option is a derivative contract in which one party, the buyer, pays a sum of money to the
other party, the seller or writer, and receives the right to either buy or sell an underlying
asset at a fixed price either on a specific expiration date or at any time prior to the expiration
date. Options trade on exchanges, or they can be customized in the OTC market.
The buyer/holder of an option is said to be long.
The seller/writer of an option is said to be short.
There are two types of options based on when they can be exercised:
• European option: This type of option can be exercised only on the expiration date.
• American option: This type of option can be exercised on or any time before the
option’s expiration date.
There are two types of options based on the purpose it serves:
• Call option: Gives the buyer the right to buy the underlying asset at a given price on a
specified expiration date. The seller of the option has an obligation to sell the
underlying asset.
• Put option: Gives the buyer the right to sell the underlying asset at a given price on a
specified expiration date. The seller of the option has an obligation to buy the
underlying asset.
Assume there are two parties: A and B. A is the seller, writer, or the short party. B is the
buyer or the long party. A and B sign a contract, according to which B has the right to buy
one share of Strong Steel Inc. for $50 after six months.
In our example, B has bought the right to buy, which is called a call option. The right to sell is
called a put option. If B has the right to buy a share (exercise the option) of Strong Steel Inc.
anytime between now and six months, then it is an American-style option. But if he can
exercise the right only at expiration, then it is a European-style option. $50, the price fixed at
which the underlying share can be purchased, was fixed at inception and is called the strike

price or exercise price.

B bought the right to buy the share at expiration from A. So B has to pay A, a sum of money
called the option premium for holding this right without an obligation to purchase the share.
The call premium B paid is $3. An investor would buy a call option if he believes the value of
the underlying would increase.
Options are discussed in detail in a later reading. We will now briefly look at the payoff and
profit diagrams. The diagram below shows the call option payoff and profit for both a buyers
and sellers perceptive.
Put option: An investor would buy a put option if he believes the value of the underlying
would decrease. If it decreases by expiration date, the investor has a right to exercise the
option to sell the underlying at the exercise price, which will be greater than the then market
price.
Credit Derivatives
A credit derivative is a class of derivative contracts between two parties, a credit protection
buyer and a credit protection seller, in which the latter provides protection to the former
against a specific credit loss. The main type of credit derivative is a credit default swap.
Credit Default Swap
A credit default swap is a derivative contract between two parties, a credit protection buyer
and a credit protection seller, in which the buyer makes a series of cash payments to the
seller and receives a promise of compensation for credit losses resulting from the default of
a third party.

• A CDS is a form of insurance.

• The objective of a CDS is to buy protection to cover the loss of par value of the bond, if
a credit event occurs. A credit event is like bankruptcy, restructuring, or failure to pay
that impairs the borrower’s ability to make timely payments.
• The CDS transfers the credit risk of the borrower from one party (protection buyer) to
another (protection seller).
• If the borrower defaults, the CDS seller pays the CDS buyer.
Asset-Backed Securities
An asset-backed security is a derivative contract in which a portfolio of debt instruments is
assembled and claims are issued on the portfolio in the form of tranches, such that the
prepayments or credit losses are allocated to the most junior tranches first and the most
senior tranches last.
The following exhibit shows how asset-backed securities are created.
Listed below are the major points related to asset-backed securities:

• A pool of loans are grouped together to form a portfolio of loans.
• Financial institutions such as banks, auto companies, and credit card companies that

lend these loans, package them into marketable securities through a process called
securitization, and sell them to a special purpose vehicle. These financial institutions
are the originators of an ABS.
• These securities are called asset-backed securities because they are backed by the
receivables of an asset, such as home loan, auto loan, etc.
• Unlike investors of a bond, all the investors of an ABS do not receive the same rate of
return because it is affected by the prepayments of the underlying loans.
• ABS is typically divided into tranches or bond classes. The prepayment risk and credit
risk are typically different across the bond classes.
4.3. Hybrids
Hybrid instruments combine derivatives, fixed-income securities, currencies, equities, and
commodities. An example of a hybrid is a callable bond or a convertible bond that is created
by combining bonds and options.
4.4. Derivatives Underlyings
We have seen that derivatives are contracts that derive their value from an underlying. The
commonly used underlyings are listed below:
• Equities: Individual stocks and stock indices. Options on stocks and equity swaps are
the most commonly used derivatives.
• Fixed-Income Instruments: Bonds, notes. Options, forwards, futures, and swaps on
bonds are used.
• Interest Rates: Most widely used derivative. But the underlying is not an asset.
• Currencies: Currency is the underlying. Options, forwards, futures, and swaps on
currencies are used.
• Commodities: Any commodity such as food, oil, gold, silver, etc. Futures are the most
used commodity derivatives.
• Credit: Underlying is credit of some form. Examples of derivatives created on credit as
an underlying include CDS or CDO.
• Other: Contracts can also be based on several different types of underlying such as
weather, electricity, natural disasters, etc.
5. The Purposes and Benefits of Derivatives
The modern derivatives market finds its origin with the formation of the Chicago Board of
Trade in 1848. In the mid-1800s, Chicago was becoming a major hub of transportation and
commerce where farmers gathered to sell their agricultural produce every year from
September to November. As the city’s storage capacity was not adequate to store all the
grains during this period, some farmers found it economical to dump the grains in the
Chicago River (literally!) than cart it all the way back to their farms. The rest of the year, the
prices of the grains would rise sharply.
The Chicago Board of Trade introduced a financial instrument called a “to-arrive” contract

that a farmer could sell anytime of the year that specified the price and delivery date for the
grain. On that pre-determined date, he could deliver the grain. This ensured the farmers got
a fair price for their produce all through the year by entering into a contract ahead of time to
deliver the grains at some point in the future.
Some of the benefits of derivatives are listed below:
Risk Allocation, Transfer, and Management
Derivatives are a cost-effective way of transferring risk from one party to another. For
example, if an investor has a substantial investment in a stock that he does not want to sell
but reduce the risk, he can do so by taking a short position in a futures contract or buying a
put option.
Information Discovery
There are two primary advantages of futures markets:
• Price discovery: Futures prices reveal more information than spot prices. For
commodities that trade worldwide like gold, a futures contract expiring soon is a
better indicator of its value than gold price in India or the U.S. which may be wide
apart.
• Implied volatility: Implied volatility measures the risk of the underlying or the
uncertainty associated with options. With the models such as BSM to price an option,
it is possible to determine the implied volatility, and hence the risk.
Operational Advantages
Some of the major operational advantages associated with derivatives are given below:
• Lower transaction costs than the underlying.
• Greater liquidity than the underlying spot markets.
• Easy to take a short position.
Margin requirements and option premiums are low relative to the cost of the underlying
Market Efficiency
Any mispricing is corrected more quickly in the derivatives market than the spot market
because of operational advantages: low transaction costs, easier to take a short position, etc.
The market is more liquid as it attracts more market participants because of its low cost to
trade.
They allow investors to participate in price movements, both long and short positions are
allowed.
Some instruments may not be bought directly, but an investor can gain exposure to these
instruments through derivatives. For example, the weather.

6. Criticisms and Misuses of Derivatives

Studies researching the cause of a crash over the past 30 years always point to derivatives as
one of the primary reasons. The sub-prime crisis of 2007-08 was also caused by a derivative
– Credit Default Swap.
Speculation and Gambling
Derivatives are often compared to gambling as it involves a lot of speculation and risk taking.
An important distinction between speculation and gambling is that a very few benefit from
gambling. But speculation makes the whole financial markets more efficient.
Destabilization and Systemic Risk
Derivatives are often blamed to have destabilizing consequences on the financial markets.
This is primarily due to the high amount of leverage taken by speculators. If the position
turns against them, then they default. This triggers a ripple effect causing their creditors to
default, creditors’ creditors to default, and so on. A default by speculators impacts the whole
system. For example, the credit crisis of 2008.
Complexity
Another criticism of derivatives is their complexity. The models are highly complex and are
not easily comprehensible by everyone.
7. Elementary Principles of Derivative Pricing
Derivative pricing is based on the hedge portfolio concept: combination of a derivative and
underlying such that risk is eliminated. The hedge portfolio should earn the risk-free rate. A
derivative’s value is the price of the derivative that forces the hedge portfolio to earn the
risk-free rate. It is also important to understand the concepts of storage and arbitrage.
7.1. Storage
Certain kinds of derivatives like forward/future contracts where the underlying is a
commodity like food grain, gold, or oil require storage. Storage incurs costs and
consequently the forward/future price must be adjusted upwards.
7.2. Arbitrage
Arbitrage is the condition that if two equivalent assets or derivatives or combinations of
assets and derivatives sell for different prices, then this leads to an opportunity to buy at a
low price and sell at a high price, thereby earning a risk-free profit without committing any
capital.
Let us consider an example of a stock selling in two markets A and B. The stock is selling in
market A for $51 and in market B for $52. An arbitrage opportunity exists here as an
investor can buy the stock at a lower price in market A and sell it at a higher price in market
B.

The combined actions of arbitrageurs bring about a convergence of prices. Hence, arbitrage
leads to the law of one price: transactions that produce equivalent results must sell for
equivalent prices. If more people buy the stock in market A, and more people sell the stock in
market B, the stock’s price will converge in both the markets.

Summary
LO.a: Define a derivative, and distinguish between exchange-traded and over-the-
counter derivatives.
A derivative is a financial instrument that derives its value from the performance of an
underlying asset. It is a legal contract between a buyer and seller entered into today,
regarding a transaction that will be fulfilled at a specified time in the future.
Differences between exchange-traded and OTC markets
Feature Exchange-traded OTC
Rules Standardized Customized
Where are the contracts traded Exchanges Dealer network
Intermediary Yes, an exchange No intermediary
Trading, clearing, and settlement Centralized Decentralized
Liquidity More Almost the same
Transparent Yes No
Level of regulation High Low
Flexibility/privacy No Yes
Margin required Yes May be or not
Examples Futures and options Swaps
LO.b: Contrast forward commitments with contingent claims.
Forward commitments are contracts entered into at one point in time that require both
parties to engage in a transaction at a later point in time (the expiration), on terms agreed
upon at the start. Examples: forward contracts, futures contracts, and swaps.
The holder of a contingent claim has the right, but not the obligation, to make a final
payment, contingent on the performance of the underlying.
Example: call option and put option.
LO.c: Define forward contracts, futures contracts, options (calls and puts), swaps, and
credit derivatives, and compare their basic characteristics.
Forward contract is an over-the-counter derivative contract in which two parties agree to
exchange a specific quantity of an underlying asset on a later date, at a fixed price they agree
on when the contract is signed. It is a customized and private contract between two parties.
A futures contract is a standardized derivative contract, created and traded on a futures
exchange. In a futures contract, two parties agree to exchange a specific quantity of the
underlying asset at an agreed-upon price at a later date.
A swap is an over-the-counter contract between two parties to exchange a series of cash
flows based on some pre-determined formula.
A call option gives the buyer the right to buy the underlying asset at a given price on a

specified expiration date. The seller of the option has an obligation to sell the underlying
asset.
A put option gives the buyer the right to sell the underlying asset at a given price on a
specified expiration date. The seller of the option has an obligation to buy the underlying
asset.
Credit derivative is a class of derivative contracts between two parties, a credit protection
buyer and a credit protection seller, in which the latter provides protection to the former
against a specific credit loss.
LO.d: Describe purposes of, and controversies related to, derivative markets.
Benefits
• Risk allocation, transfer, and management protection with minimum investment.
• Information discovery.
• Price discovery.
• Implied volatility.
• Market efficiency.
Criticisms
• Speculation and gambling.
• Destabilization of financial markets.
LO.e: Explain arbitrage and the role it plays in determining prices and promoting
market efficiency.
Arbitrage
• Arbitrage is the condition under which two equivalent assets or derivatives or
combination of assets and derivatives sell for different prices.
• This allows us to buy at a low price and sell at a high price, and earn a risk-free profit
from this transaction without committing any capital.
Role
• The combined actions of arbitrageurs force the prices of similar securities to
converge.
• Hence, arbitrage leads to the law of one price: transactions that produce equivalent
results must sell for equivalent prices.

Practice Questions
1. Which of the following statements most accurately describes a derivative? A derivative:
A. passes through the returns of the underlying.
B. duplicates the performance of the underlying.
C. transforms the performance of the underlying.
2. In contrast to over-the-counter derivatives, exchange-traded derivatives would most

likely be:
A. customized.
B. less regulated.
C. more transparent.
3. An agreement to purchase a specific stock next month for $100 is:

A. a forward commitment.
B. a contingent claim.
C. both a forward commitment as well as a contingent claim.
4. Which of the following best describes an interest rate swap?

A. An agreement where two parties agree to exchange a series of cash flows.
B. An agreement where the credit seller provides protection to the credit buyer.
C. An agreement where the buyer has the right to purchase the underlying from the
seller.
5. Analyst 1: Options provide payoffs that are linearly related to the payoffs of the
underlying.
Analyst 2: Forwards provide payoffs that are linearly related to the payoffs of the
underlying.
A. Analyst 1 is correct.
B. Analyst 2 is correct.
C. Both analysts are correct.
6. Which of the following derivatives will most likely have a non-zero value at initiation of
the contract?
A. Futures
B. Forwards
C. Options
7. Derivatives are least likely to:

A. provide more opportunities to go short compared with the spot market.
B. prevent arbitrage.

C. improve liquidity.
8. Which of the following statements about arbitrage is least accurate?

A. Arbitrage can cause markets to be less efficient.
B. Arbitrage allows making a profit without risk.
C. Arbitrage allows making a profit without investment.

Solutions
1. C is correct. A derivative is a financial instrument that transforms the performance of the

underlying.
2. C is correct. Exchange traded derivatives are more transparent than over-the- counter
derivatives. They are also standardized and more regulated as compared to over-the-
counter derivatives.
3. A is correct. Forward commitments represent an obligation to buy/sell, whereas

contingent claims represent a right to buy/sell.
4. A is correct. Interest rate swap is an agreement between two parties to exchange a series
of cash flows. Option B describes a credit default swap. Option C describes a call option.
5. B is correct. Forwards provide payoffs that are linearly related to the payoffs of the
underlying. Whereas, the payoffs of options are non-linear, for example a call option will
provide a payoff only if the underlying crosses the strike price, otherwise it will expire
worthless and have a zero payoff.
6. C is correct. Futures and forwards have a zero value at initiation of the contract. Options
however have a non-zero value at initiation, equal to the option premium.
7. B is correct. Derivatives facilitate arbitrage transactions not prevent them. Option A and
C are correct statements.
8. A is correct. Arbitrage makes a market more efficient. Option B and C are correct
statements.

R57 Basics of Derivative Pricing and Valuation 2019 Level I Notes
R57 Basics of Derivative Pricing and Valuation

1. Introduction
The major questions addressed in this reading are:
• How does the pricing of the underlying asset affect the pricing of derivatives?
• How are derivatives priced using the principle of arbitrage?
• How are the prices and values of forward contracts determined?
• How are futures contracts priced differently from forward contracts?
• How are the prices and values of swaps determined?
• How are the prices and values of European options determined?
• How does American option pricing differ from European option pricing?
2. Fundamental Concepts of Derivative Pricing
2.1. Basic Derivative Concepts

This is a recap of what we saw in the previous reading.
Forward contract: It is a customized over-the-counter derivative contract in which two
parties agree that one party, the buyer, will purchase an underlying asset from the other
party, the seller, at a later date, at a fixed price they agree upon when the contract is signed.
Futures contract: It is a standardized derivative contract created and traded on a futures
exchange in which two parties agree that one party, the buyer, will purchase an underlying
asset from the other party, the seller, at a later date at a price agreed upon by the two parties
when the contract is initiated. There is also a daily settling of gains and losses and a credit
guarantee by the futures exchange through its clearinghouse.
Swap contract: It is an over-the counter derivate contract in which two parties agree to
exchange a series of cash flows whereby one party pays a variable series that will be
determined by an underlying asset or rate, and the other party pays either 1) a variable

series determined by a different underlying asset or rate or 2) a fixed series.

Option contract: It is a derivative contract in which one party, the buyer, pays a sum of
money to the other party, the seller or writer, and receives the right to buy or sell an
underlying asset at a fixed price either on a specific expiration date or at any time prior to
the expiration date.
2.2. Pricing the Underlying
The price or value of a financial asset is the expected future price plus any benefits such as
dividends or coupon interest minus costs discounted at a rate appropriate for the risk
assumed. The exhibit below shows how to get the current price S0 of an asset by discounting
its expected future price E(ST ), by the risk-free rate r, plus the risk premium λ, over the
period from 0 to T.
Source: CFA Program Curriculum, Basics of Derivative Pricing and Valuation

E (S )
The price of the underlying at time t = 0 is given by S0 = (1 + r +T λ)T - θ + γ
Let us now decompose this expression and understand what each of the terms means.
• Expected future value 𝐸(𝑆𝑇 ): Let’s say that the expected future value of the underlying
asset a year later at t = 1 is 100. It cannot be known for sure and its value a year later,
given by the normal distribution 𝐸(𝑆𝑇 ), is the expected value.
E (S )
• Discount rate: The first term (1 + r +T λ)T is the present value of expected future price of
an asset with no interim cash flows (in our case, 100) where r = risk-free rate. Given
that the value in the future is uncertain, it is not appropriate to discount it at the risk-
free rate, so a risk premium λ is added to the risk-free rate. If the riskiness of the asset
is high, then λ is high.
E (S )
• The present value of the asset is then given by (1 + r +T λ)T
• γ is the present value of any benefits of holding the asset between t = 0 and t = 1. γ is
added to the current price. It is assumed that the benefits are certain, so their future
value is discounted at the risk-free rate to calculate γ. γ includes both monetary and
non-monetary benefits. For an asset like stocks, the dividend paid is an example of
monetary benefit. Convenience yield is the non-monetary benefit of holding an asset.
The pleasure one derives from looking at one’s art collection or gold is an example of

non-monetary benefit.
• θ is the present value of the costs of holding an asset between t = 0 and t = 1. It is
subtracted from the current price. For example, if the asset is gold and you rent a
locker to store it safely, then this cost incurred that must be subtracted from the
current price.
• Cost of carry is the net cost of holding an asset. Cost of carry = θ − γ
2.3. The Principle of Arbitrage
Arbitrage is a type of transaction undertaken when two assets or portfolios produce
identical results but sell for different prices. Let us take the example below:

Interpretation:
• The exhibit above is self-explanatory. Assets A and B have the same values at time T,
but initially at time t = 0, asset A sells for lesser than asset B. This leads to an arbitrage
opportunity.
• For example, at t = 0, assume A is priced at 100 and B is priced at 101. If you borrow B
and sell it, and buy A for 100, the net cash is 101 – 100 = 1.
• At time t = T, both A and B are priced the same. Sell asset A. Use the proceeds to buy B
and return it since it was borrowed initially. The net cash flow is 0.
Arbitrage opportunities are exploited quickly and hence do not last for long. In the above
example, when the arbitrage opportunity exists, the demand for A will go up causing its price
to go up. Similarly, when more people sell B, its demand goes down, leading to a decrease in
its price causing the prices of both the assets to come to the same level. It is not just the
difference in price that matters; one needs to consider the transaction costs as well. If the
transaction costs exceed the benefit from an arbitrage opportunity, then it is not worth
exploiting.
Law of one price: If two assets have the same expected return in the future, then their
market price today must be the same.

Arbitrage and Derivatives

The price of a derivative is tied to the price of the underlying. For example, if the price of a
stock goes up, then a call option on the stock also goes up. Therefore, a derivative can be
used to hedge an underlying, or vice versa. For example, if you are long on Google stock, then
you can either short the call option or buy a put option to eliminate your risk.
Since the risk is eliminated, the expected return is the risk-free return.
A derivative must be priced such that no arbitrage opportunities exist, and there can be only
one price for the derivative that earns the risk-free return. If it earns a return in excess of the
risk-free rate, then arbitrage opportunities exist for (underlying + derivative) position.
Arbitrage and Replication
An asset and a derivative can be combined to produce a risk-free bond in one of the ways
shown below. Conversely, an asset and the risk free asset can be combined to produce a
derivative.
There are two ways to replicate when the underlying asset is a stock:
• Buy stock + put option = risk-free rate
• Buy stock – risk-free rate = short put option
Replication is the creation of an asset or portfolio from another asset, portfolio, and/or
derivative. Why is replication needed? Isn’t it easier to just buy a government security to
earn the risk-free rate instead of buying the asset and a derivative? There are some
situations under which replication is valuable:
• When transaction costs are lower.
• When one of the components, say the derivative, is not rightly priced resulting in an
arbitrage opportunity.
Risk Aversion, Risk Neutrality, and Arbitrage-Free Pricing
Risk aversion: Most investors are risk-averse and expect a compensation (risk premium) for
assuming risk. As we have seen earlier, a derivative can be combined with an asset to
mitigate the risk and produce a risk-free asset. We saw in the previous section what factors
affect a derivative’s pricing. Since the risk aversion of an investor does not impact derivative

pricing, one can derive the derivative price assuming investors are risk-neutral. When
pricing derivatives, use the risk-free rate, i.e., the price of a derivative can be calculated by
discounting it at the risk-free rate rather than the risk-free rate plus a risk premium.
When pricing assets, a risk premium is added to the risk-free rate. Recall, the first term of the
E (S )
current price S0 of an asset is (1 + r +T λ)T where λ is the risk premium. This means that the
asset’s price in the spot market factors in the risk aversion of an investor. Since the risk
aversion is already captured in the asset pricing, it is not included in a derivative’s pricing.
Risk-neutral pricing: Derivative pricing is sometimes called risk-neutral pricing because there
is only one derivative price, which combined with the underlying asset, can earn the risk-
free rate.
Arbitrage-free pricing: The overall process of pricing derivatives by arbitrage and risk-
neutrality is called arbitrage-free pricing. It is also called the principle of no arbitrage.
Limitations to execute arbitrage transactions include:
• It may not be possible to short sell assets.
• Information on arbitrage opportunities/volatility of the asset may not be easily
accessible, and it can be risky to execute if one lacks accurate information on the
inputs.
• Arbitrage requires capital, which may not be easily available to everyone to maintain
positions. For instance, if exploiting an arbitrage opportunity requires $100 million, it
is not easy to borrow so much money to engage in a transaction.
Clearinghouses do not place any restrictions on transactions that can be arbitraged.
A hedge portfolio is one that eliminates arbitrage opportunities and implies a unique price
for a derivative.
2.4. The Concept of Pricing vs. Valuation
This section lays the foundation for the subsequent sections. We look at two terms, price and
value, and what they mean in context to different assets/derivatives.
Stock price vs. value
• The price of a stock is its market price while the value of a stock is its intrinsic value
often determined by fundamental analysis (by analyzing a company’s financial
statements, and discounting future cash flows). Alternatively, the book value of a
company is compared to its market value.
• For instance, if the intrinsic value of a stock is 110 and its market price is 100, then it
means investors must buy the stock.
Option contract price versus value
• The price is similar to what we saw above for a stock. For instance, the price of a call
option is its market price or what you would pay to buy the call option. The value of a

call option is based on the underlying and other variables that impact the option.
Forwards, futures, and swaps
• Unlike stocks, bonds, or options, these do not require an initial cash outlay.
• Their price and value cannot be compared to each other.
• The price of a forward contract is the fixed price or rate that is embedded in the
contract; it represents the price or rate at which the underlying will be purchased at a
later date.
• The value changes over the life of the contract. It is zero at initiation. Over time, as
spot price or rate changes, the value to each party changes. If the price of the
underlying increases, then the value to the long also increases.
3. Pricing and Valuation of Forward Commitments
3.1. Pricing and Valuation of Forward Contracts
Let us take an example. Assume Leo owns a share of GE, whose spot price today (S0) is $100.
Rachel enters into a forward contract with Leo today to buy a share of GE at $101 after 1
month.
The terms, parties, and ways to settle the contract are described below:
• $101 is the forward price; the contract is for a period of 1 month.
• Neither Rachel nor Leo pays any money to each other at t = 0 when they enter into the
contract.
• Rachel is the long party and Leo is the short party.
• When the contract expires after 1 month, the forward contract can be settled in two
ways: 1) Rachel pays $101 to Leo and receives the share in return; 2) if GE trades at
$103 after 1 month, then Leo pays $2 (the difference between the agreed-upon
forward price and the current stock price) to Rachel.
• There is a risk of default in forward contracts. If the stock price increases to $103,
Rachel faces the risk that Leo fails to deliver the share as agreed. Conversely, if the
stock price decreases to $99, Leo faces the risk that Rachel does not buy the share as
agreed upon.
• Is there an alternative way for Rachel to buy this asset? Yes, to wait until time T and
buy the asset at its then spot price ST. The drawback is that one cannot be sure what
the price of the asset will be then; it may be more, or less.
The above example is shown in a generic way in the diagram below. It shows the
transactions from a buyer’s perspective at times t = 0 when the contract is initiated and time
t = T, when the contract expires.

Interpreting the notation and key features of a forward contract:

• Forward price: It is denoted by F0 (T) where subscript 0 indicates the price that is
agreed upon at time t = 0 and T indicates the contract ends at time T.
• Spot price: It is denoted by St . At t = 0, spot price is S0 . When the forward contract
expires at t = T, the spot price is ST . At any time during the life of the contract, it is
denoted by St .
• Value of the contract at time t is denoted by Vt (T).
• The price to be paid at time T when the contract expires is fixed at time t = 0.
• No money exchanges hands at time t = 0, i.e., no party pays anything to the other at t =
0.
The forward price agreed at the initiation date of the contract is the spot rate compounded at
the risk-free rate over the life of the contract.
F0 (T) = S0 x (1 + r)T
Assuming a risk-free rate of 10%, spot price of S0 = $100, and time period of 1 month, we
calculate the forward price as:
1
T = 12 = 0.0833; F0 (T) = S0 x (1 + r)T = 100 × (1.1)0.0833 = 101
Why is the forward price equal to the spot rate compounded at the risk-free rate over the
contract period?
In theory, if Rachel did not enter into the forward contract, then she could invest $100 for
period T in a risk-free asset and earn 10% or $101 after 1 month. So, the forward contract
must earn the risk-free rate as an excess return will result in an arbitrage opportunity.
Value of a forward contract at initiation
Value of a forward contract at initiation = 0
The value of a forward contract at initiation is zero because neither party pays any money to
the other. There is no value to either party.
• At the end of the contract, Leo, as the short party, is obligated to sell the asset to the
buyer (Rachel) for $101.
• Given a spot price of $100, a risk-free rate of 10%, and a forward price of $101, there
is no advantage to either party at t = 0. The forward price is such that no party can
earn an arbitrage profit.
Value at expiration for the long party:

Vt (T) = ST − F0 (T)
where:
ST = spot price of the underlying
F0 (T) = forward price agreed in the contract

The value of a forward contract is positive to the long party if ST > F0 (T) and negative if
ST < F0 (T) at expiration.
Value at expiration for the short party:
Vt (T) = −(ST − F0 (T))
The value of a forward contract is positive to the short party if F0 (T) > ST and negative
if F0 (T) < ST at expiration.
If the spot price at time T is 105, then Rachel (long) gets the asset by paying 101 and can
immediately sell it for 105 at the then market price. Value to the long = ST − F = 105 - 101 =
4.
Value of a forward contract during the life of the contract
F
Value during the life of the contract Vt = St – (1 + r)T−t
This is the difference between the spot price at time t, and the present value of forward price
for the remaining life of the contract. In our example, at t = 15 days, if St = 106, then Vt = 106
101
– (1.1)0.5 = 9.7. Since the price has gone up, the value to the long party is positive.
Instructor’s Note
As market conditions change, only the value of a forward contract changes. Its price does not
change as it is fixed at contract initiation.
Forward Price with Benefits and Costs
Now, let us consider an asset with benefits and costs. How is the forward price for such an
asset calculated? The forward price of an asset with benefits and/or costs is the spot price
compounded at the risk-free rate over the life of the contract minus the future value of those
benefits and costs.
F0 (T) = (S0 – γ + θ) x (1 + r)T
It can be rewritten as:
F0 (T) = (S0 ) x (1 + r)T – (γ − θ) x (1 + r)T
where
γ = present value of the benefit. It is subtracted from the spot price because if you own
the asset, you receive any benefits associated with the asset, during the life of the
contract.
θ = present value of costs incurred on the asset during the life of the contract. These
costs make it more expensive to hold the asset and hence increase the forward price.
In the previous example, assume $10 is the present value of benefits from the asset and $20
is the present value of costs associated with holding the asset. The forward price at time 0

when Rachel enters into the contract is:

F0 (T) = (100 – 10 + 20)(1.1)0.0833 = 110.9.
The value of a forward contract is the spot price of the underlying asset minus the present
value of the forward price. The value of the contract at time t is given by the expression
below:
Value of the forward contract
F (T)
Vt (T) = St – (1+r)
0
T−t
(without benefits and costs)
F0 (T)
Vt (T) = St – (γ - θ) (1 + r)t - (1+r)T−t
(with benefits and costs)
In other words, the value of the contract is the spot price minus the net benefit for the
remaining period, minus the present value of the forward price. Note that (γ - θ) is the net
benefit.
Instructor’s Note
The forward price can be lower than the spot price though it is not common.
F = S (1 + r)t + FV (costs) – FV (benefits)
When the future value of benefits is higher than the future value of costs and the
compounded spot price, then the forward price is lower than the spot price. If a commodity
is in short supply, then its non-monetary benefits/convenience yield may be higher.
Forward Rate Agreement (FRA)
So far, the forward contracts we have seen had an asset as the underlying. But some forward
contracts, which have an interest rate as the underlying, are called forward rate agreements.
FRAs allow us to lock in a rate today for a loan in the future and act as a hedge against
interest rate risk. They are forward contracts that allow participants to make a known
interest payment at a later date and receive, in return, an unknown interest payment.
The payoffs on an FRA are determined by market interest rates at expiration:
• If reference rate at FRA expiration is greater than the FRA rate, then the long benefits.
• If reference rate at FRA expiration is lower than the FRA rate, then the short benefits.
Example of an FRA
The exhibit below shows going long a 30-day FRA in which the underlying is 90-day Libor.


Interpretation:
• FRAs are usually based on LIBOR (London Interbank Offered Rate). The FRA
described above is a 30-day FRA in which the underlying is the 90-day LIBOR.
• Assume the time now is t = 0 and you need to borrow $100 million after 30 days. You
are concerned that the interest rate represented by LIBOR might increase between
now and 30 days, and would like to lock in a rate available now of 5%. This is the rate
that will be applicable on the loan 30 days later. This removes any uncertainty
regarding the interest payment on the loan, as it is fixed today. The rate is for a
period, in this case for 90 days. You enter into an agreement today to borrow $100
million 30 days later at a rate of 5% for 90 days.
• After 90 days, if the rate increases to 6%, then you benefit as your outflow is based on
5%, but you receive an inflow based on 6%. However, you lose if the rate decreases to
4% as the outflow will be higher than what you receive.
• Are FRAs of interest only to parties that borrow money? No, even parties that lend
money engage in FRAs to lock in an interest rate if they believe the rates will go down
in the future.
Synthetic FRA: Instead of engaging in a real FRA, a synthetic FRA can be constructed by
lending a 30-day Eurodollar time deposit and buying a 120-day Eurodollar time deposit.
Instructor’s Note
A quick summary of the concepts discussed in earlier readings.
1. The rate on a zero-coupon bond is also a spot rate.
2. Term structure of interest rates: interest rates on loans of different maturities. For
example, the 30-day rate is 6%, 60-day rate is 7% and so on.
3.2. Pricing and Valuation of Futures Contracts
Futures contracts have standard terms, are traded on a futures exchange, and are more

heavily regulated than forward contracts. Some of its characteristics are listed below:
• Marking to market: Futures contracts are marked to market on a daily basis. What this
means is that if there is a gain or loss on the position relative to the previous day’s
closing price, then the gain is credited to the winning account by deducting the
amount from the losing account.
• Credit guarantee: We saw that there was a default risk inherent in every forward
contract. In futures contracts, there is a credit guarantee by the futures exchange
through the clearinghouse.
• Clearinghouse: The clearinghouse is the counterparty to every trade on the exchange.
• Daily cash flow: In a forward contract, the gain or loss is realized at the end of the
contract period. But, in a futures contract, there is a cash flow on a daily basis.
Relationship between futures prices and interest rates
• If futures prices are positively correlated with interest rates, futures contracts are
more desirable to holders of long positions than are forwards because there are
intermediate cash flows on which interest can be earned. This cash flow can be
invested at higher interest rates.
• If interest rates are constant, or have zero correlation with futures prices, then
forwards and futures prices will be the same.
• If futures prices are negatively correlated with interest rates, then it is more desirable
to have forwards than futures to holders of long positions.
Payoffs and Valuation of Futures Contracts
Let us take a simple example to compare the payoffs and valuation of a forward contract
with a futures contract over three days. The futures price at the end of every day is given
below with the price at initiation being 100.
Gain to Long in a Forward Contract

Forward contracts Futures contracts
Payoff Ignoring the time value of If the time value of money is considered,
money, total payoff is the same then it depends on the correlation of
for forward and futures contract. futures and interest rate.
Value Zero at initiation. Zero at initiation. Keeps rising until
Keeps on increasing until settlement on the next trading day.
expiration of contract. Becomes zero once marked to market. For
instance, increase from 0 to 1 on day 1.
Credit risk Higher Lower because of daily settlement

3.3. Pricing and Valuation of Swap Contracts

To understand how swaps work, let us consider a 3-year plain vanilla interest rate swap
with annual settlement where the fixed-rate payer pays 10% and the floating rate payer pays
an interest based on LIBOR. LIBOR rates at t = 0, 1, and 2 are 9%, 10%, and 11%.
Interpretation:
• At times 0, 1, and 2, the two parties exchange a series of payments. The fixed rate
payer makes a fixed payment of 10% and receives a floating payment based on the
value of the underlying at that point in time. Here is it 9%, 10%, and 11% respectively.
• Like a forward rate agreement, rates are locked in for future. So, a swap is similar to a
series of forward contracts, with each contract expiring at specific times, where one
party agrees to make a fixed payment and receive a variable payment. But, the prices
of the implicit forward contracts embedded in a swap are not equal.
• It is like getting into multiple forward rate agreements to lock in rates for different
periods in the future at a different forward price.
Swap is a series of off-market forward contracts where:
• Each forward contract is created at a price and maturity equal to the fixed price of the
swap with the same maturity and payment dates respectively.
• This means that the series of FRAs built into a swap are all off-market FRAs - some
with positive values and some with negative values.
• The combined value of the off-market FRAs is zero.
Now, how do we determine the price of a swap that would result in a combined value of its
FRAs to be zero? This is discussed in the following section.
Difference between Price and Value of a Swap Contract
Some key points regarding the price and value of a swap or as follows:
• The value of a swap at initiation is typically equal to zero.
• The swap price is determined at initiation through a process known as replication.
No-arbitrage pricing is the key to pricing a swap. Replication implies that the
valuation of a swap price is the present value of all the net cash flow payments from
the swap.
• The value of a swap changes during the life of the contract.
Example of a Swap
Consider a 3-year plain vanilla interest rate swap with annual settlement where the fixed-

rate payer pays 10% and the floating-rate payer pays based on LIBOR. LIBOR rates at t = 0, 1,
and 2 are 9%, 10%, and 11%.
The fixed rate of the swap is referred to as its price. In this case, it is 10%. A swap can be
replicated as follows:
• Step 1: Buy a floating-rate bond or any asset that pays coupons of unknown value S0,
S1, q….SN at times t = 1, 2 ..N.
• Step 2: Borrow money to purchase this floating rate bond (equivalent to issuing a
fixed-rate bond); the payments for the money borrowed are equal fixed-payments of
FS0 (t) at t=1, 2, …N. This must have the same cash flow as the swap.
• The rate at which the money for the floater was borrowed is the price of the swap.
Given the no-arbitrage pricing, the fixed rate on the swap must be equal to the fixed
rate at which the fixed-rate bond was issued in step 2.
• The value of the swap during the life of a swap is based on the present value of the
expected future cash flows. The cash flows, floating payments in particular, are based
on the market price of the underlying.
4. Pricing and Valuation of Options

Let us look at the different types of options.
There are two parties in any option:
• Long party: The buyer of an option or the party that holds the position is the long
party.
• Short party: The seller of an option or the party that writes the position is the short
party.
Types of options based on purpose:
• Call option: Gives the buyer the right, not the obligation, to buy the underlying asset at
a given price on a specified expiration date. The seller of the option has an obligation
to sell the underlying asset. The given price is called the strike price or exercise price.
For example, if the exercise price is 25, then the buyer has the right to buy the
underlying at 25.

• Put option: Gives the buyer the right, not the obligation, to sell the underlying asset at
a given price on a specified expiration date. The seller of the option has an obligation
to buy the underlying asset.
Types of options based on when they can be exercised:
• European option: This type of option can be exercised only on the expiration date.
• American option: This type of option can be exercised on or any time before the
option’s expiration date.
4.1. European Option Pricing
Value of European Option at Expiration
Call option
• At expiration, the value of a call option is the greater of zero or the value of the
underlying asset minus the exercise price.
• CT = max (0, ST – X )
Put option
• At expiration, the value of a put option is the greater of zero or the exercise price
minus the value of the underlying.
• PT = max (0, X − ST )
Relationship between the value of the option and the value of the underlying
• The value of a European call option is directly related to the value of the underlying.
• The value of a European put option is inversely related to the value of the underlying.
Effect of the Exercise Price
Consider two call options with similar attributes (time to expiration, underlying) but
different exercise prices. Assume the exercise price for call option 1 is 25 and that for call
option 2 is 30. The right to buy at a lower price of 25 will be more valuable than the right to
buy at a higher price of 30.
Similarly, in the case of a put option, the right to sell for a higher price is more valuable than
the right to sell for a lower price.
Relationship between the value of the option and the exercise price
• The value of a European call option is inversely related to the exercise price.
• The value of a European put option is directly related to the exercise price.
Moneyness of an option: Indicates whether an option is in, at, or out of the money. The table
below shows the moneyness of an option for various relative values of S and X.
Call Option Put Option
In the money S>X S<X
At the money S=X S=X
Out of the money S<X S>X

Effect of Time to Expiration

Longer-term options should be worth more than shorter-term options. For instance, you
have a bought a call option on a stock at an exercise price of $25. Which one would be more
valuable to you; an option that expires in a week or an option that expires a year later?
Without doubt, the option that expires a year later as it gives enough time for the stock price
to increase and make the option valuable.
But, is it true for a put option? Partly, yes. The more the time to expiration, the more the
opportunity for the stock to fall below its exercise price. What does the put option holder get
in return when the underlying falls below the exercise price? Just the exercise price. The
longer the holder waits to exercise the option, the lower the present value of the payoff. If
the discount rate is high, then a longer time to expiration results in a lower present value for
the payoff.
Relationship between the value of the option and the time to expiration
• The value of a European call option is directly related to the time to expiration.
• The value of a European put option can be directly or inversely related to the time to
expiration. Inversely related under these conditions: the longer the time to
expiration, the deeper the option is in the money, and the higher the risk-free rate.
Effect of the Risk-free Rate of Interest
If the risk-free rate is high, then the call price is higher. For example, you want to invest in a
stock whose price is $100. You can either buy the stock for $100 or buy the call option on the
stock for $5. Both these actions give you exposure to the stock. If you buy the call option,
then you can invest the remaining $95. If the interest rates are high, then buying the call
option is more valuable because of the interest earned.
In the case of puts, the longer time to expiration with a higher risk-free rate lowers the
present value of the exercise price when the option is exercised. That is, when the time to
expiration is longer you get the money later and, if the risk-free rate is high, it is discounted
by a higher number which lowers the value of the payoff.
Relationship between the value of the option and the risk-free interest rate
• The value of a European call option is directly related to the risk-free interest rate.
• The value of a European put option is inversely related to the risk-free interest rate.
Effect of Volatility of the Underlying
Volatility is good for both call and put options. If the underlying stock becomes more volatile,
then the probability of the options expiring deep in the money becomes greater.
Relationship between the value of the option and the volatility of the underlying
• The value of a European call option is directly related to the volatility of the
underlying.
• The value of a European put option is directly related to the volatility of the

underlying.
Effect of Payments on the Underlying and the Cost of Carry
Call option Put option
Benefits (dividends on Stocks and bonds Decreases because Increases
stocks, interest on fall in value when call holders do not
bonds, convenience dividends and get these benefits.
yield on commodities) interest are paid.
Carrying costs Increases as call Decreases
holders do not
incur these costs.
Relationship between the value of the option and benefits/costs of the underlying
• A European call option is worth less the more benefits that are paid by the
underlying. The call option is worth more the more the costs that are incurred in
holding the underlying.
• A European put option is worth more the more benefits that are paid by the
underlying. The put option is worth less the more costs that are incurred in holding
the underlying.
Lowest Price of Calls and Puts
In this section, we look at the least price one would be interested in paying for a call option.
Let us consider a call option on a stock with a strike price of X that expires at time T. The
initial price of the underlying at time t = 0 is S0 , the underlying price at expiration is ST , and
the risk-free rate is r%. If the option is in the money, the payoff at expiration will be ST – X.
The lowest price of the call option is given by:
X
c0 > = max (0, S0 – (1+r)T )
Interpreting the above equation:

• It is based on the premise that a call option is equivalent to buying the asset by
borrowing the present value of X at a risk-free rate of r%.
• It is the present value of X because you would have to pay X and take delivery of the
asset at time T. The payoff for this transaction is ST - X (this number can even be
negative). In the case of a call option, it can either be zero (out-of-the-money) or ST-X.
• The price of a call option must be at least zero and not a negative value because if it is
less than zero, then it cannot be exercised.
X
• (1+r)T
is the present value of the exercise price X. So, the lowest price of a call option is
X
c0 > = max (0, S0 – (1+r)T ).
Similarly, a put option is equivalent to selling short an asset and investing the proceeds
(present value of X) in a risk-free bond at r% for T periods. It will pay X at expiration. A put
can never be worth less than zero as the holder cannot be forced to exercise it. The lowest

price for a put option is given by:

X
p0 > = max (0, (1+r)T -𝑆0 )
Put-Call Parity for European Options

The four instruments in a put-call parity are as follows:
• Asset: An asset such as a stock with no carrying costs and no interim cash flows. At
time 0, the price of the stock is S0.
• Zero-coupon bond: A zero-coupon bond with a face value of X that matures at time T.
X
At time 0, the value of this bond is (1 + r)T .
• Call option: A call option on the stock with a strike price of X that expires at time T. ST
is the underlying price at expiration T.
• Put option: A put option on the stock with a strike price of X that expires at time T.
Note: the strike price, X, of the options is the same as the par value of the bond.
According to put-call parity, fiduciary call = protective put.
A protective put is like buying insurance for an asset you own, specifically a stock, to protect
against a downside. A protective put is to buy the underlying and buy a put option on it. For
instance, you own 1,000 shares of Apple, the market is highly volatile and you are worried
about a huge decline in the near term. To limit the downside risk, you can buy a put option
on the stock by paying a premium. This is called a protective put.
Interpretation:
• As you can see, the downside risk is limited to the premium paid for the put. If the
underlying price falls below X, it can be still be sold at X by exercising the put option.
• If the underlying rises above X, then it can be sold at the market price and the put
option expires worthless.
A fiduciary call is a long call plus a risk-free bond. The diagram below shows the payoff for a
fiduciary call:

The table below shows how the fiduciary call is equal to the protective put under two
possible scenarios: when the stock is above the exercise price (call is in the money) and the
stock is below the exercise price (put is in the money).
Outcome at time T when: Put expires in the money Call expires in the money
→ (ST < X) (ST > = X)
Protective put
Asset ST 0
Long puts X-ST 0
Total X ST
Fiduciary call
Long call 0 ST – X
Risk-free bond X X
Total X ST
Fiduciary Call Protective Put

Constituents Long call + risk-free bond Long put + stock
Equation X
c0+ (1+r)T p0+S0
Payoff at T if call expires in ST ST
the money (ST > = X)
Payoff at T if put expires in X X
the money
(ST < X)
Easy way to remember B+C P+S
(alphabetical order BCPS)
X
Put-call parity: c0+ (1+r)T = p0 + S0
If, at time 0, the fiduciary call is not priced the same as the protective put, then there is an
arbitrage opportunity. The put-call parity relationship can be rearranged in the following
ways:

X
Synthetic call: c0 = p0 + S0 – (1+r)T
X
Synthetic bond: (1+r)T = p0 + S0 – c0
X
Synthetic stock: S0 = c0+ (1+r)T – p0
X
Synthetic put: p0 = c0+ (1+r)T - S0
Put-Call Forward Parity for European Options

In this section, we see how to create protective put with a forward contract. Recall we saw in
an earlier section that:
Asset – Forward = Risk-free Bond (long asset + short forward = risk-free bond)
Rearranging, we get: Asset = Forward + risk-free bond
Now, if we substitute the asset part in a protective put with the above equation, then we get:
Protective put: Asset + put = Forward + risk-free bond + put
The exhibit below shows that the payoff is the same for a protective put with an asset as well
as a forward contract when the put expires in and out of the money.
Outcome at T
Put Expires In the Put Expires Out of the
Money (𝐒𝐓 < 𝑋) Money (𝐒𝐓 ≥ 𝐗)
Protective put with asset
Asset ST ST
Long put X - ST 0
Total X ST
Protective put with forward contract
Risk-free bond Fo (𝑇) Fo (𝑇)
Forward contract ST − Fo (𝑇) ST − Fo (𝑇)
Long put X - ST 0
Total X ST
Interpretation:
• The risk-free bond has a par value equal to the forward price of F0 (T).
• Value of the forward contract at expiration = ST – F0 (T).
• Notice that the value of the forward contract at expiration is the same irrespective of
whether the put expires in or out of the money.
According to put-call parity, since a fiduciary call = protective put, a fiduciary call must be
equal to a protective put with a forward contract.

Bond + Call = Long Put + Asset

Replacing S in the above equation with a forward contract, we get:
Bond + Call = Long Put + Long forward + Risk-free bond
The exhibit below shows that the payoffs for fiduciary call is equal to protective put when
call and put expire in the money.
Outcome at T
Put Expires In the Put Expires Out of the
Money (𝐒𝐓 < 𝑋) Money (𝐒𝐓 ≥ 𝐗)
Protective put with forward contract
Risk-free bond Fo (𝑇) Fo (𝑇)
Forward contract ST − Fo (𝑇) ST − Fo (𝑇)
Long put X - ST 0
Total X ST
Fiduciary call
Call 0 ST − 𝑋
Risk-free bond X X
Total X ST
4.2. Binomial Valuation of Options
This section deals with the payoff of an option. The payoff of an option depends on the value
of the underlying at expiration, which cannot be known with certainty ahead of time. What
matters from an option’s perspective is whether it expires in or out of the money, i.e.,
whether the stock price was above or below the strike price at expiration.
The binomial model is a simple model for valuing options based on only two possible
outcomes for a stock’s movement: going up and going down. The exhibit below shows the
binomial option-pricing model.

The notations used in the model are explained below:

Notation Explanation
S0 Value of the stock at time t = 0
C0 Price of the call option at time t = 0
Price of the stock at time t = 1; + indicates the price of the stock
S1+
went up
Price of the stock at time t = 1; - indicates the price of the stock went
S1-
down
c1+ Value of the call option at t = 1
c1- Value of the call option at t = 1
u Up factor = S1+/S0
D Down factor = S1-/S0
Π and 1- π are called the synthetic probabilities; they represent the weighted average of
producing the next two possible call values, a type of expected future value. By discounting
the future expected call values at the risk-free rate, we can get the current call value.
Risk-neutral probability
1+r−d
Π= u−d
where:
r = risk-free rate
u = up factor; d = down factor
Let us do a numerical example to calculate the call price using a 1 – period binomial model
now. Data already given to us is in normal font, while the calculated ones are in bold.
The value of the call option at time 0 using the 1-period binomial model is 6.35.

Call price using the binomial model

πc1+ + (1 − π)c1−
c0 =
1+r
where:
π = risk-neutral probability
r = risk-free rate
c0 = price of call option at time 0
Some important points about the binomial pricing model:
1. Volatility of the underlying: The volatility of the underlying is important in
determining the value of the option. It is shown in the difference between 𝑆1+ and 𝑆1− .
The higher the volatility, the greater the difference between the stock prices 𝑆1+ and 𝑆1− ,
and 𝑐1+ and 𝑐1− .
2. The probabilities of the up and down moves do not appear in the formula.
3. Instead, what is used is the synthetic or pseudo probability, π, to determine the
1+r−d
expected future value. Π = u−d
4. The formula for calculating c0 is the expected future value discounted at the risk-free
rate.
Binomial Value of Put Options
What is the value of the put option using the same principle discussed in the previous
section?
Assume the following data is given:
S0 = 40; u = 1.2; d= 0.75; X = 38; r = 5%; p0 =?

The value of the put option at time 0 using the 1-period binomial model is 2.537.
4.3. American Option Pricing
So far we looked at the payoff and valuation of European options. Now we will discuss
American options.
• The primary difference between the two is that American options can be exercised
any time before expiration or exercise date. So, they are more valuable than European
options since the holder can exercise the option before maturity date.
• Early exercise is not mandatory (required) so the right to exercise early cannot have a
negative value.
• American options cannot sell for less than European options.
Some important points on American/European options:
• If there are no interim cash flows on the underlying asset before the call expires like
dividends on stocks, then it is not prudent to exercise the option.
• American call prices can differ from European call prices only if there are cash flows
on the underlying, such as dividends or interest; these cash flows are the only reason
for early exercise of a call.
• American put prices can differ from European put prices, because the right to exercise
early always has value for a put, which is because of a lower limit on the value of the
underlying.
• If the underlying stock pays a dividend, then it is prudent for a put option holder not
to exercise the option until its expiration. This ensures he receives the dividend on the
stock.

Summary
LO.a: Explain how the concepts of arbitrage, replication, and risk neutrality, are used
in pricing derivatives.
Arbitrage is a type of transaction undertaken when two assets or portfolios produce
identical results but sell for different prices.
A derivative must be priced such that no arbitrage opportunities exist, and there can only be
one price for the derivative that earns the risk-free return.
Asset + Derivative = Risk-free asset
Replication is the creation of an asset or portfolio from another asset, portfolio, and/or
derivative.
Risk aversion of the investor does not impact derivative pricing. Risk-free rate is used for
pricing derivatives.
The overall process of pricing derivatives by arbitrage and risk neutrality is called arbitrage-
free pricing.
LO.b: Distinguish between value and price of forward and futures contracts.
Price Value
The price of a stock is its market price. The value of a stock is its intrinsic value,
often determined by a fundamental analysis.
The price of an option is similar to what we The value of a call option is based on the
saw above for stocks. underlying and other variables that impact
the option.
The price of a forward contract is the fixed Value changes over the life of the contract. It
price or rate that is embedded in the is zero at initiation. Over time, as spot price
contract; it represents the price or rate at or rate changes, the value to each party
which the underlying will be purchased at changes.
a later date.
LO.c: Explain how the value and price of a forward contract are determined at
expiration, during the life of the contract, and at initiation.
• At initiation the value of forward contract is zero.
• Value at expiration: ST - F
F
• Value during the life of the contract: Vt = St – (1 + r) T−t
LO.d: Describe monetary and nonmonetary benefits and costs associated with holding
the underlying asset, and explain how they affect the value and price of a forward
contract.
The forward price of an asset with benefits and/or costs is the spot price compounded at the

risk-free rate over the life of the contract minus the future value of benefits and plus the
future value of costs.
The value of a forward contract is the spot price of the underlying asset minus the present
value of the forward price.
LO.e: Define a forward rate agreement and describe its uses.
FRAs have an interest rate as the underlying. They allow us to lock in a rate today for a loan
in the future. They allow us to make a known interest payment at a later date and receive, in
return, an unknown interest payment.
LO.f: Explain why forward and futures prices differ.
• Futures contracts have standard terms, are traded on a futures exchange, and are
more heavily regulated than forward contracts.
• Futures contracts are marked to market on a daily basis. Whereas in a forward
contract, the gain or loss is realized at the end of the contract period.
• If interest rates are constant, or have zero correlation with futures prices, then
forwards and futures prices will be the same.
• If futures prices are negatively correlated with interest rates, then it is more desirable
to buy forwards than futures for a long position.
LO.g: Explain how swap contracts are similar to but different from a series of forward
contracts.
A normal forward has a zero value at the start because of no-arbitrage pricing. In a swap,
since the fixed price is priced different than the market price, it has a non-zero value at the
start and is called an off-market forward. A swap is a series of off-market forward contracts
where:
• Each forward contract is created at a price and maturity equal to the fixed price of the
swap with the same maturity and payment dates respectively.
• This means that the series of FRAs built into a swap are all off-market FRAs: some
with positive values and some with negative values.
• The combined value of the off-market FRAs is zero.
LO.h: Distinguish between the value and price of swaps.
• The value of the swap: As with forwards and futures, the value of a swap at initiation is
equal to zero.
• Swap price: The fixed rate of the swap is referred to as its price.
• The value of the swap during the life of a swap is based on the present value of the
expected future cash flows. The cash flows, floating payments in particular, are based
on the market price of the underlying.
LO.i: Explain how the value of a European option is determined at expiration.
The value of a European call at expiration is the exercise value, which is the greater of zero

or the value of the underlying minus the exercise price.

CT = max (0, ST – X )
The value of a European put at expiration is the exercise value, which is the greater of zero
or the exercise price minus the value of the underlying.
PT = max (0, X − ST )
LO.j: Explain the exercise value, time value, and moneyness of an option.
Moneyness
• Refers to whether an option is in the money or out of the money.
• If immediate exercise of the option would result in a positive payoff, then the option
is in the money.
• If immediate exercise would result in loss, then the option is out of the money.
• If immediate exercise would result in neither a gain nor a loss, then the option is at
the money.
Call Option Put Option
In the money S>X S<X
At the money S=X S=X
Out of the money S<X S>X
Exercise value
• Exercise value of an option is the maximum of zero and the amount that the option is
in the money.
Time value
• Prior to expiration an option also has time value in addition to exercise value.
• The time value of an option is the amount by which the option premium exceeds the
exercise value.
• When an option reaches expiration, the time value is zero.
LO.k: Identify the factors that determine the value of an option, and explain how each
factor affects the value of an option.
Increase in Value of call option will Value of put option will
value of the underlying Increase Decrease
exercise price Decrease Increase
risk-free rate Increase Decrease
time to expiration Increase Increase (exception: a few
European puts)
volatility of the underlying Increase Increase
costs incurred while holding Increase Decrease
the underlying

benefits received while Decrease Increase

holding the underlying
LO.l: Explain put–call parity for European options.
According to put-call parity, fiduciary call = protective put.
Long call + risk-free bond = Long put + stock
X
c0+ (1+r)T = p0+S0
LO.m: Explain put–call–forward parity for European options.

According to put-call parity, since a fiduciary call = protective put, a fiduciary call must be
equal to a protective put with a forward contract.
Bond + Call = Long Put + Asset
Replacing asset in the above equation with a forward contract + risk free bond, we get:
Bond + Call = Long Put + Long forward + Risk-free bond
LO.n: Explain how the value of an option is determined using a one-period binomial
model.
The binomial model is a simple model for valuing options based on only two possible
outcomes for a stock’s movement: going up and going down.
Π and 1- π are called the synthetic probabilities; they represent the weighted average of
producing the next two possible call values. By discounting the future expected call values at
the risk-free rate, we can get the current call value.
1+r−d
П=
u−d
πc1+ + (1 − π)c1−
c0 =
1+r
LO.o: Explain under which circumstances the values of European and American
options differ.
• If the underlying asset has a cash flow such as dividend or interest, then American call
prices will be more than European call prices, because the option can be exercised
early to collect this cash flow.
• American put prices will always be higher than European put prices, because the
right to exercise early always has value for a put.

Practice Questions
1. An arbitrage transaction generates a net inflow of funds:
A. throughout the holding period.
B. at the end of the holding period.
C. at the start of the holding period.
2. The price of a forward contract:

A. is the amount paid at initiation.
B. is the amount paid at expiration.
C. fluctuates over the term of the contract
3. At the initiation of a forward contract on an asset that neither receives benefits nor
incurs carrying costs during the term of the contract, the forward price is equal to the:
A. spot price.
B. future value of the spot price.
C. present value of the spot price.
4. Which of the following factors most likely explains why the spot price of a commodity in
short supply can be greater than its forward price?
A. Opportunity cost
B. Lack of dividends
C. Convenience yield
5. To the holder of a long position, it is more desirable to own a forward contract than a
futures contract when interest rates and futures prices are:
A. negatively correlated.
B. uncorrelated.
C. positively correlated.
6. The value of a swap is equal to the present value of the:

A. fixed payments from the swap.
B. net cash flow payments from the swap.
C. underlying at the end of the contract
7. At expiration, a European put option will be valuable if the exercise price is:
A. less than the underlying price.
B. equal to the underlying price.
C. greater than the underlying price

8. For a European call option with two months until expiration, if the spot price is below the
exercise price, the call option will most likely have:
A. zero time value.
B. positive time value.
C. positive exercise value
9. If the risk-free rate increases, the value of an in-the-money European put option will most
likely:
A. decrease.
B. remain the same.
C. increase.
10. The value of a European call option is inversely related to the:

A. exercise price.
B. time to expiration.
C. volatility of the underlying.
11. Based on put-call parity, a trader who combines a long asset, a long put, and a short call
will create a synthetic:
A. long bond.
B. fiduciary call.
C. protective put.
12. Combining a protective put with a forward contract generates equivalent outcomes at
expiration to those of a:
A. fiduciary call.
B. long call combined with a short asset.
C. forward contract combined with a risk-free bond.
13. Which of the following is least likely to be required by the binomial option-pricing model?
A. Spot price.
B. Two possible prices one period later.
C. Actual probabilities of the up and down moves.
14. Which of the following circumstances will most likely affect the value of an American call
option relative to a European call option?
A. Dividends are declared.
B. Expiration date occurs.
C. The risk-free rate changes.

Solutions
1. C is correct. An arbitrage transaction is undertaken when two assets or portfolios

produce identical results but sell for different prices. A trader buys the lower priced asset
and sells the higher priced asset. This generates a net inflow of funds at the start of the
holding period. Because the two assets or portfolios produce identical results and the
payoffs offset each other, there is no money gained or lost at the end of the holding
period.
2. B is correct. The forward price is agreed upon at the start of the contract and is the fixed
price at which the underlying will be purchased (or sold) at expiration. This price stays
fixed over the term of the contract.
3. B is correct. At initiation, the forward price is the future value of the spot price.
4. C is correct. Since the commodity is in short supply, there is a convenience in holding the
asset. This convenience yield may result in lower forward prices.
5. A is correct. If futures prices and interest rates are negatively correlated, forwards are
more desirable. If futures prices and interest rates are uncorrelated, forward and futures
prices will be the same. If futures prices are positively correlated with interest rates,
futures contracts are more desirable.
6. B is correct. The value of a swap is the present value of all the net cash flow payments
from the swap.
7. C is correct. A European put option will be valuable at expiration if the exercise price is
greater than the underlying price.
8. B is correct. A European call option with two months until expiration will typically have
positive time value. Since the spot price is below the exercise price it will have zero
exercise value.
9. A is correct. An in-the-money European put option decreases in value with an increase in

the risk-free rate. This is because a higher risk free rate reduces the present value of any
proceeds received on exercise.
10. A is correct. The value of a European call option is inversely related to the exercise price.
Both the time to expiration and the volatility of the underlying are positively related to

the value of a European call option.
11. A is correct. A long bond can be synthetically created by combining a long asset, a long
put, and a short call.
12. A is correct. Put−call forward parity demonstrates that the outcome of a protective put
with a forward contract equals the outcome of a fiduciary call.
13. C is correct. In a binomial option-pricing model, we use pseudo or “risk-neutral”

probabilities. Therefore, the actual probabilities of the up and down moves in the
underlying are not required. Both the spot price of the underlying and two possible
prices one period later are required by the binomial option-pricing model.
14. A is correct. When a dividend is declared, an American call option will have a higher
value than a European call option because an American call option holder can exercise
early to capture the value of the dividend.

R58 Introduction to Alternative Investments 2019 Level I Notes
R58 Introduction to Alternative Investments

1. Introduction
This reading will cover the basic categories and characteristics of alternative investments
and how to value hedge funds, private equity, real estate, and commodities. We will also
briefly look at the role they play in diversifying a portfolio.
2. Alternative Investments
Traditional investments: Long-only positions in stocks, bonds, and cash.
Alternative investments: All other investments including real estate, commodities, hedge
funds, private equity funds, etc.
The general characteristics of alternative investments are listed below:
• High fees because of active management and expertise required in managing the
portfolio.
• Low diversification within the alternative investment portfolio because the required
investment amount is typically high.
• High use of leverage
• Illiquid; restrictions on redemptions: It is not always easy to liquidate the investment.
For example, if you bought a real estate property, it is not as easy to sell.
• Narrow manager specialization: For example, within private equity, you have
leveraged buyout and venture capital. There are managers who focus only on
leveraged buyouts within private equity.
• Low correlation with traditional investments; may be correlated during times of
financial crisis.
• Low level of regulation and less transparency.
• Limited and potentially problematic risk and return data: The risk and return data of
hedge fund and private equity indices are biased, as we will see later.
• Unique legal and tax considerations.
2.1. Categories of Alternative Investments
The main categories of alternative investments are:
Hedge funds
• They are private investment vehicles that manage portfolios of securities and
derivative positions using a variety of strategies.
• They aim for absolute returns independent of market performance.
Private equity funds
• They invest in the equity of private companies or public companies that want to
become private.
• They are further divided into

o Leveraged buyout funds: Invest in established companies.

o Venture capital funds: Invest in startups.
Real estate
• Investments in buildings, farmland, timberland, either directly or indirectly.
Commodities
• Investment in physical assets such as grains, metals, crude oil, etc.
• The main vehicles used for investment in commodities are commodity future
contracts and funds benchmarked to commodity indices.
Infrastructure
• Investments in capital intensive, long-lived, real assets such as roads, dams, and
schools, which are intended for public use and provide essential service.
Other
• Investments in any other tangible asset such as art, wine, stamps, coins, etc.
• Or intangible assets such as patents.
2.2. Returns to Alternative Investments
Broadly speaking, there are two strategies for generating returns: passive and active.
• Passive managers assume that markets are efficient and rely only on beta return.
Beta is a measure of systematic risk. Example: If a manager invests the entire amount
in an ETF tracking the S&P 500, like Vanguard S&P 500 ETF, then he is a passive
manager.
• Active managers assume that inefficiencies exist and can be exploited to earn an
excess positive return after accounting for beta risk.
Active investment strategies can be classified into the following three categories:
• Absolute return: Some managers seek to generate returns that are independent of
market returns (absolute return). There is no benchmark to beat like a market index.
Therefore, the beta of absolute return strategies must be close to zero.
• Market segmentation: Managers with no limitations on investment categories try to
move into higher-returning segments, whereas inflexible managers stick to the
restrictions (market segmentation). For example, a portfolio may have constraints
that prohibit any investments in a particular geographical area, or a sector like
tobacco, or how much can be invested in low-quality securities. These restrictions
mean the managers are limited to certain market segments.
• Concentrated portfolios: Some managers concentrate investments among fewer
securities with the hope that these securities will outperform the broader market.
2.3. Portfolio Context: Integration of Alternative Investments with Traditional
Investments
What is the motivation for investing in alternative investments? One of the primary drivers

is the low correlation of alternative investment with traditional investments. This low
correlation along with relatively high returns on some alternative investment categories
results in a substantial diversification benefit.
2.4. Investment Structures

The most common structure for many alternative investments is a partnership. It consists of
two entities:
• General partner (GP): The fund is the general partner (GP). These are the partners
responsible for managing the private equity firm and making the investment
decisions. It is usually a limited liability company.
• Limited partners (LP): The investors who provide capital are the limited partners.
They bear the risk associated with investments and have a fractional partnership in
the fund.
3. Hedge Funds
History: Alfred Winslow Jones created a “hedged” fund in 1949. The purpose of this fund
was to hedge long-only stock portfolio. The fund followed three key principles:
• Always maintain short positions.
• Always use leverage.
• Only charge an incentive fee of 20% of the profits with no fixed fees.
Over time, the principles have changed. The following are the characteristics of hedge funds
today:
• Aggressively managed portfolios of investments across asset classes and regions use
leverage, take long/short positions, and/or use derivatives.
• Generate high returns: either absolute or over a specified benchmark with minimal
restrictions.
• Set up a private investment partnership with a limited number of investors who are
willing to make a large initial investment.
• Investors are required to keep the money with the fund for a certain period – lockup
period. Redemptions are not immediate. Usually, require a minimum notice period of
30 to 90 days.
• Invest anywhere there is a high return opportunity as restrictions are less.
A portfolio of hedge funds is often referred to as a fund of funds. This instrument makes

hedge funds accessible to smaller investors. Other benefits include:

• Better redemption terms.
• More diversification as they invest in hedge funds across geographies and strategies.
3.1. Hedge Fund Strategies
There are several hedge fund strategies. These fall in four major categories:
• Event-driven: A short term, bottom-up strategy that aims to profit from pricing
inefficiencies before a major potential corporate event. Ex: bankruptcy, acquisition,
merger, restructuring of a company, asset sale (large pocket of land in a prime
location).
• Relative value: A strategy that seeks to profit from price discrepancy between
related securities such as stocks and bonds.
• Macro: Uses a top-down approach to identify trends based on changes in economic
policies across the globe. The strategies could focus on currency markets, fixed
income markets, or based on changes in interest rates. Trades are based on expected
movement in economic variables.
• Equity hedge: Bottom-up strategy. Not focused on event-driven or macro strategies.
Take long and short positions in equity/equity derivative securities.
The sub-classifications under each category are listed below:
Sub-classification under event-driven category
Merger Arbitrage • Go long (buying) on the stock of the company being
acquired and go short on the stock of the acquiring
company.
• Risk: many corporate events such as merger do not occur as
planned and if the fund has not closed its positions on time,
it may incur losses.
Distressed/restructuring • Purchase and profit from debt securities of companies that
are either in bankruptcy or near bankruptcy.
• Strategy: the fixed income securities would be priced at a
significant discount to their par value; these can be sold
later at a profit at settlement (liquidation or equity stake)
• Other complicated strategies: Buy senior debt/short junior
debt.
• Buy preferred stock/short common stock.
Activist • Purchase a managing equity stake in a public company that
is believed to be mismanaged, and then influence its
policies.
• May advocate restructure, changes in strategy, hiving off
non-profitable units, etc.

Special Situations •
Purchase equity of companies engaged in restructuring
activities other than merger/bankruptcy.
Sub-classification under relative value category
Fixed-Income • A market neutral strategy to exploit mispricing in
Convertible Arbitrage convertible bond and issuer’s stock.
• Long position in convertible debt + short position in issuer’s
common stock.
Note: A convertible bond is a bond (hybrid security) that can be
converted into common stock at a pre-determined price at a pre-
determined time. Usually, the yield is lower than a comparable
bond.
Fixed-Income Asset • Exploit mispricing of asset-backed securities.
Backed
Fixed-Income General • Exploit mispricing between two corporate issuers, between
corporate and government issuers, or between different
parts of the same issuer’s capital structure.
Volatility • Go long or short market volatility within a specific asset
class.
Multi-Strategy • Generate consistently absolute positive returns irrespective
of how the equity, debt, or currency markets are
performing.
• Does not focus on one strategy, but allocates capital across
different strategies where investment opportunities exist.
Ex: equity long/short, convertible arbitrage, merger
arbitrage, etc.
The curriculum does not present any sub-classifications under the macro category.
Sub-classifications under the equity hedge category
Market Neutral • Uses quantitative/fundamental analysis to identify
undervalued/overvalued securities.
• Strategy: buy (long) undervalued securities and sell (short)
overvalued securities. Hold equal dollar amounts in both
positions.
• Neutral with respect to market risk, i.e., the portfolio beta is
close to zero.
Fundamental Growth • Uses fundamental analysis to identify companies with high
growth potential and capital appreciation.
• Strategy: long position in such stocks.
Fundamental Value • Uses fundamental analysis to identify undervalued
companies.
• Strategy: long position in such stocks.

Quantitative Directional • Uses technical analysis to identify overvalued and

undervalued companies.
• Strategy: long position in undervalued securities and short
position in overvalued securities.
• Weight of long and short positions depends on the market
cycle.
Short Bias • Uses quantitative/fundamental analysis to identify
overvalued securities.
• Strategy: short position in overvalued securities.
Sector Specific • Uses quantitative/fundamental analysis to identify
mispricing in a specific sector.
• Strategy: long on undervalued securities/short on
overvalued securities.
3.2. Hedge Funds and Diversification Benefits
The following points demystify some of the beliefs regarding hedge funds and their
diversification benefits:
Myth Reality
Hedge funds make money regardless of It has been found that there is a lack of
stock market direction. performance persistence. For instance, the
hedge funds have earned a very high
return in some years, followed by poor
returns in the subsequent years.
Hedge funds earn absolute returns True arbitrage opportunities are hard to
because of their flexibility in taking long find in an efficient market. Hedge funds
and short positions despite market drive liquidity, which, in turn, makes the
volatility. market more efficient (not the other way
round).
Low correlation with stocks provides For the period since 2000, the low
diversification benefit. correlation claim holds only for 2000-02;
between 2003 and 2009, there was a high
correlation between stocks and hedge
funds.
3.3. Hedge Fund Fees and Other Considerations

Investors must consider the fee structure before making an investment in hedge funds.
Common fee structure is 2 and 20 which means 2% management fee and 20% incentive fee.
Funds of funds charge an additional 1 and 10 fee (1% management fee and 10% incentive

fee).
• Incentive fee is usually calculated on profits net of management fees or on profits
before management fees.
• Sometimes the incentive fee is paid only if the returns exceed a hurdle rate.
• In some cases, the incentive fee is paid only if the fund has crossed the high water
mark. A high water mark is the highest value net of fees (or the highest cumulative
return) reported by the fund so far. This is to ensure investors do not pay twice for
the same performance.
Some other considerations are discussed below:
Hedge funds may use leverage to seek high returns
• Leverage magnifies losses and gains.
• They are required to put up collateral when using derivatives. If the position incurs a
loss, then the collateral acts as a safeguard against any default. The amount of
collateral depends on the creditworthiness of the investor.
• Generally, hedge funds trade through prime brokers who provide services like
administration, lending, short borrowing, and trading. The prime broker lends the
money to hedge funds to make investments, while the fund puts up the collateral.
Redemptions can magnify losses
• Occurs if a fund is performing poorly.
• Drawdowns (decline in NAV) might trigger redemptions.
• Redemption may require hedge fund managers to liquidate positions and incur
transaction costs.
• Redemption fees, notice periods, and lock-up periods seek to minimize impact of
drawdowns.
• Funds of funds offer more redemption flexibility.
• Hedge funds are subject to relatively low regulation. Low regulation is one of the
reasons why they are not transparent with respect to strategies or reporting returns.
• Hedge funds are often registered in offshore locales such as the Cayman Islands.
Example
Consider a hedge fund with an initial investment of 200 million; the fee structure is 2 and 20
and is based on year-end valuation. In year 1, the return is 30%.
1. What is the total fee if management fee and incentive fee are calculated independently?
What is the investor’s effective return?
2. What is the total fee if the incentive fee is calculated after deducting the management fee?
Investor’s net return?
3. If there is a hurdle rate of 5% and fees are based on returns of in excess of 5%, what is
the total fee? What is the investor’s net return?
4. In the second year, the fund declines to 220 million. Assume that management fee and

incentive fee are calculated independently as indicated in Part 1, but now a high water
mark is also used in fee calculations. What is the total fee? What is the investor’s net
return?
5. In the third year, the fund value increases to 256 million. What is the total fee and
investor’s net return?
Solution:
1. Initial investment grows to: 200 x 1.3 = $260 million.
Profit = $60 million.
Management fee: 0.02 x 260 = $5.2 million.
Incentive fee which is 20% of profit = 20% x 60 = $12 million.
Total fee = $5.2 million + $12 million = $17.2 million.
260−17.2
Investor’s return = − 1 = 21.4%
200
2. Incentive fee after deducting management fee = 20% x (260 – 200 - 5.2) = 10.96.
Total fee = 5.2 + 10.96 = $16.16 million.
260−16.16
Investor’s return = − 1 = 21.92%.
200
As you can see the return is better than Part 1 because incentive fee paid is relatively less
here.
3. There is a hurdle rate of 5%. So, 200 x 0.05 = $10 million must be subtracted before
incentive fees are paid.
Incentive fee = 0.2 x (260 – 200 - 5.2 - 10) = 8.96.
Total fee = 5.20 + 8.96 = $14.16 million.
Incentive fee is further reduced and the investor’s return is enhanced.
260−14.16
Investor’s return = − 1 = 22.92%.
200
4. Management fee = 0.02 x 220 = 4.4. To calculate the incentive fee, we need to determine
whether the fund value has exceeded the high water mark. The high water mark was
achieved at the end of Year 1. This value was 260 million – 17.2 million = 242.8 million. The
incentive fee is 0 because the fund value is below the high water mark. Hence the total fee =
$4.4 million.
220−4.4
Investor’s return = − 1 = -11.2%
242.8
5. Management fee = 256 x .02 = 5.12. Since $256 has exceeded high water mark of 242.8
million, an incentive fee would be paid. Incentive fee = (256 - 242.8) x 0.2 = 2.64. Total fee =
5.12 + 2.64 = 7.76 million.
256− 7.76
Investor’s net return = − 1 = 15.14%.
215.6
Example
An investor is contemplating investing £200 million in either the Hedge Fund (HF) or the

Fund of Funds (FOF). FOF has a "1 and 10" fee structure and invests 10% of its assets under
management in HF. HF has a standard "2 and 20" fee structure with no hurdle rate.
Management fees are calculated on an annual basis on assets under management at the
beginning of the year. Management fees and incentive fees are calculated independently. HF
has a 25% return for the year before management and incentive fees.
1. Calculate the return to the investor of investing directly in HF.
2. Calculate the return to the investor of investing in FOF. Assume that the other
investments in the FOF portfolio generate the same return before management fees as
HF and have the same fee structure as HF.
Solution to 1:
HF has a profit before fees on a £200 million investment of £50 million (= 200 million ×
25%). The management fee is £4 million (= 200 million × 2%) and the incentive fee is £10
million (= 50 million × 20%). The return to investor is 18% (= (50 - 4 - 10) / 200).
Solution to 2:
FOF earns an 18% return or £36 million profit after fees on £200 million invested with
hedge funds. FOF charges the investor a management fee of £2 million (= 200 million × 1%)
and an incentive fee of £3.6 million (= 36 million × 10%). The return to the investor is 15.2%
(= (36 - 2 -3.6) / 200).
Example
The hedge fund had an initial investment of $60 million. At the end of the first year, the value
was 70 million after fees. At the end of the second year, the value was 80 million before fees.
The fund has a 2 and 20 fee structure and incentive fees are calculated using a high water
mark and a soft hurdle rate of 5%. Calculate the total fee paid for year 2.
Solution:
Management fee = 80 x .02 = 1.6 million
Incentive fee = (80 - 70) x .2 = 2 million
Total fee = 1.6 + 2 = 3.6 million
3.4. Hedge Fund Valuation Issues
Hedge funds are valued on a daily, weekly, monthly, and/or quarterly basis.
The value of a hedge fund depends on the value of underlying positions.
The price used for valuation depends on whether market prices are available and if the
underlying position is liquid. There are three possibilities:
• Market prices available for underlying liquid positions: When market prices are
𝑏𝑖𝑑+𝑎𝑠𝑘
available, the fund decides what price to use. Common practice is to quote at 2
.

A conservative approach is to use bid prices for long and ask prices for short.
• Market prices are not available for underlying illiquid positions: Estimated
values calculated through statistical models are used.
• Market prices are available for underlying illiquid positions: A liquidity discount
or haircut must be considered to reflect fair value. Some funds report two NAVs:
trading and reporting. Trading NAV incorporates liquidity discounts. Reporting NAV
is based on quoted prices.
3.5. Due Diligence for Investing in Hedge Funds
Key due diligence points to consider are divided into two categories:
Quantitative due diligence:
• Investment strategy: In which markets does the hedge fund invest in? What is the
strategy – long/short, relative arbitrage, market neutral, etc.? Is the performance
repeatable?
• Investment process: How is the strategy implemented?
• Competitive advantage: A lot of information is considered proprietary (the reason
behind a fund’s performance) which the fund may not be willing to share freely with
outsiders.
• Track record: How are the returns calculated and reported; what are the fees? Is the
historical performance data readily available? It is an indicator of future performance.
Investors expect a minimum track record of two years.
• Size and longevity: If a fund has existed for a long time then this implies that it has not
caused significant losses to investors.
Qualitative due diligence:
• Management: Is the management skilled and accountable to the fund?
• Key person risk: What is the compensation for the key people in the firm? Is there a
big incentive for them to stay with the firm? How many people have left the firm
recently, and why?
• Reputation: Is the fund manager reputed? Does he have the necessary
experience/pedigree to manage the fund? What has his contribution been in the
performance?
• Investor relations: Is the fund proactive in sharing information (transparent) with its
investors in an effort to strengthen the relationship?
• Plans for growth.
• Systems risk management: Can the fund manager explain the risks taken? Are you
satisfied with the answers given, or do you think something is being hidden?
• Prime broker: Who is the prime broker, and who is the custodian for securities?

4. Private Equity
Private equity means investing in private companies or public companies with the intent to
take them private. The sponsors (or investment managers) raise capital over a period of time
to invest money in multiple companies in a specific sector or geographic region. For instance,
you may have a health care PE fund or a real estate PE fund. They call for a specific amount
of investment from investors (to be paid over a certain period of time in specific amounts)
who are looking for opportunities to earn a high rate of return.
There are four main categories of private equity:
• Leveraged Buyouts: Borrowed funds are used to buy an established company.
• Venture Capital: This refers to investments in companies that have not been
established yet.
• Development Capital: It refers to minority equity investments in mature companies
that require funds for growth or expansion, restructuring, entering a new territory,
an acquisition, etc.
• Distressed Investing: It involves buying the debt (such as corporate bond, bank
debt, etc.) of companies going through financial troubles. The company may be in
bankruptcy proceedings, or likely to default on debt. The distressed securities are
available at a bargain. Institutional investors such as hedge funds or private equity
firms buy these distressed securities after carefully evaluating because they believe
the company may not be in as bad a position as the market believes it to be and the
cash flow problems may be temporary. They accept risk, expect the debt to increase
in value and make a profit in the end.
Instructor’s Note
This reading focuses on leveraged buyouts and venture capital. For development capital and
distressed investing it is sufficient to know the brief descriptions given above.
4.1. Private Equity Structure and Fees
Private equity structure is very similar to what we saw in hedge funds.
• Structured as limited partnerships with investors. They are not structured as
corporations to avoid double taxation. Corporations pay dividends to investors who
then have to pay taxes. The partnership structure avoids double taxation.
o The private equity firm is the general partner (GP). Firm and GP are used
interchangeably. A GP commits a certain amount of capital to the fund. The
decision making authority lies with the general partner.
o Investors are limited partners (LP). They are passive investors who have
committed the capital but do not have any authority in what companies to invest
in and when, or when to divest.
o The investment manager makes all the investment-related decisions such as what
companies to invest in, to divest, calling for capital, etc.

• Committed capital: It is the amount that limited partners have agreed to provide the
fund. PE funds raise committed capital and then draw those funds over a period of 3-
5 years when specific investment opportunities arise. The GP decides when to call for
committed capital from the LPs.
• Management fee is 1-3% of committed capital: This is an important distinction from
hedge funds where management fees are based on the assets under management.
• The GP typically receives 20 percent of the total profit of the private equity fund as an
incentive. GPs usually do not receive any incentive fee until the LPs have received
their initial investment back. This is covered in detail in Level II.
4.2. Private Equity Strategies
Leveraged Buyouts
Leveraged buyout is an acquisition of an established public or private company with
borrowed funds. If the target company is a public company then after the acquisition, the
company becomes private, i.e., the target company’s equity is no longer publicly traded. In
this scenario, the LBO is referred to as a “going private” transaction.
The acquisition is significantly financed through debt, hence the name leveraged buyout.
LBOs capital structure consists of equity, bank debt, and high-yield bonds. The firm (GP) puts
in some money of its own, raises a certain amount from LPs, and a substantial amount of
money is borrowed in the form of debt to invest in companies.
For example, assume the GP invests in a target company that requires an investment of $100
million. In this, the GP invests $20 million of its money (equity), $70 million from bank debt,
and the remaining $10 million is raised by issuing high-yield bonds.
There are three changes that happen to a company as a result of a leveraged buyout:
• An increase in financial leverage.
• Change in management or the way the company is run.
• If the target company is previously public, after the LBO it becomes private.
Why LBO?
• To improve the company’s operations; to add value and eventually increase cash
flows and profits.
• Leverage will enhance potential returns once the restructuring/growth strategy is
complete and the company turns profitable. Debt is central to an LBO structure.
Buyouts are rarely done entirely using equity.
There are two types of LBOs:
• Management buyouts (MBO): Current management team purchases and runs the
company.
• Management buy-ins (MBI): Current management team is replaced and the acquirer
team runs the company.

Target companies for LBOs are as follows:

• Undervalued stock price: PE firms buy companies which are out of favor currently.
• Willing management.
• Inefficient companies: To generate attractive returns by acquiring inefficiently
managed companies and turning them around.
• Low leverage: Companies that do not have a large portion of debt currently. This way,
PE firms can use debt to fund their purchase.
• Strong and stable cash flow: In an LBO transaction, the acquiring company finances
the purchase with a large portion of the debt. If there is a stable cash flow, it makes
interest payments easier.
• Lots of physical assets.
Venture Capital
Venture capital firms invest in private companies (portfolio companies) with significant
growth potential. The time horizon is typically long-term. The distinction between VC and
LBO is that the latter invests in mature companies, whereas VC invests in growing
companies with a good business plan and strong prospects for future growth. Other
important points related to VCs are given below:
• The company being invested in is often called the portfolio company as it will become
a part of the VC’s portfolio of investments.
• Venture capitalists are actively involved in the companies they invest in.
• The rate of return expected depends on the stage the company is in when the
investment happens.
• VC investing can take place at various stages
Formative stage: Company is still being formed.
o Angel investing: Financing provided at the idea stage.
o Seed stage financing: Financing provided for product development and market
research.
o Early stage: Financing for companies moving towards operation, but before
commercial production and sales. Fund to initiate commercial production and
sales.
Later stage financing: For expansion after commercial production and sales but
before IPO.
Mezzanine stage: Preparing to go public.
Exit Strategies
The goal of private equity is to improve new or underperforming businesses and exit them at
high valuations. Typically, investments (target companies) are held for an average of 5 years.
The holding period may be longer or shorter. Common exit strategies are:
• Trade sale: Selling the company to a competitor or any strategic buyer. It can be done
through auction or private negotiation. For instance, if a PE firm (GP) invested in a

small generic pharma company, it may sell it to large pharma firm after a few years.
• IPO: Company goes public, i.e., it sells all or some of its shares to public investors.
• Recapitalization: Re-leverages itself when interests are low. Not a true exit strategy,
but introduces leverage or re-leverages.
• Secondary sale: Assume you are a VC firm that focuses on early stage companies. You
may sell the portfolio company later to another private equity firm that focuses on
later stage companies.
• Write off/liquidation: This is a worst-case scenario when the investment has not gone
as planned. The company’s prospects do not look promising, so the VC firm sells the
assets or writes it off to focus on other projects.
4.3. Private Equity: Diversification Benefits, Performance, and Risk
Private equity may provide higher return opportunities relative to traditional investments.
Some of its benefits include the following:
• Access to private companies.
• Ability to actively manage and improve portfolio companies.
• Diversify the portfolio because of lower correlation with stocks and bonds.
• Easy to use leverage.
Investors should identify and invest in the best performing private equity funds.
4.4. Portfolio Company Valuation
Three approaches to value a portfolio company are listed below:
• Market or comparable: Values a company or its equity using multiples of different
measures. Example: EBITDA multiple used to value large, mature private companies.
• Discounted cash flow: Values a company as the present value of the expected future
cash flows. Free cash flow to the firm and weighted average cost of capital are used to
estimate the value of a company.
• Asset based: Values a company based on the values of its underlying assets less the
value of any related liabilities.
Example
A private equity fund is considering purchasing a media company that had an EBITDA of
$100 million. In the past year, three media companies were sold for 6x EBITDA, 8x EBITDA,
and 7x EBITDA. What is the maximum value the private equity fund is most likely to assign
to the media company?
Solution:
The maximum value the private equity fund is most likely to assign is that using the highest
multiple (8 × 100 million = 800 million).

4.5. Private Equity: Investment Considerations and Due Diligence

Due diligence is important before making private equity investments. Here are some factors
to consider:
• Current and anticipated economic conditions, including interest rates and capital
availability, must be considered before making an investment.
• Another factor to consider is refinancing risk as lack of refinancing options can lead to
default.
• Long-term commitment: Private equity investments are illiquid and are best suited
for investors with a long-term horizon. The period between investing in a portfolio
company and exiting is long, and in between there are limited liquidity options.
• Carefully select GP
o One of the critical factors behind the success of a private equity fund is its GP as
the GP along with the investment manager makes the decision where to invest,
how much to invest (how much of committed capital must be drawn), and when
to invest. So evaluating the GP’s knowledge and experience is critical.
o Relevant questions to ask would be: Is the valuation methodology right? Are the
GP’s interests aligned with that of LPs?
• Many other due diligence questions are similar to what we saw with hedge funds.
5. Real Estate
Key reasons for investing in real estate are listed below:
• Potential for competitive long-term returns (income and capital appreciation).
• Rent for long-term leases will lessen the impact of economic shocks.
• Diversification because of low correlation with other asset classes such as stocks,
bonds.
• Inflation hedge.
Investment characteristics of real estate are as follows:
• Indivisibility.
• Unique characteristics (no two properties are identical).
• Fixed location.
• Operational management.
• Local markets can be very different from national or global markets.
5.1. Forms of Real Estate Investment
Real estate investing can be categorized along two dimensions: public/private markets and
debt/equity based. The four quadrants are filled with examples below:

Basic forms of real estate investments and examples

Debt Equity
Private Mortgages Direct ownership of real estate.
Construction lending Ownership can be through sole
ownership, joint ventures, real
estate limited partnerships, etc.
Public Mortgage-backed securities Shares in real estate corporations.
(residential and commercial). Shares of real estate investment
Collateralized mortgage trusts (REITs).
obligations
If you are investing in a debt-based real estate investment, it means you are lending money
to a purchaser of real estate. A classic example is a mortgage loan. This is considered a real
estate investment because the value of the mortgage loan is related to the value of the
underlying property. A debt-based real estate investment could be private or publicly
traded. Mortgage loans and construction loans are examples of private debt-based real
estate investments. Mortgage-backed securities are often traded on public markets. Hence,
these are considered public debt-based real estate investments. Debt-based real estate
investments are discussed in the fixed income segment of the curriculum. This section
focuses on equity-based real estate investments.
Equity-based investments represent ownership of real estate properties. Ownership can be
through sole ownership, joint ventures, real estate limited partnerships, etc. A variation of
equity-based investments is leveraged ownership: Assume a building costs $10 million, and
you put $3 million of your money and borrow $7 million. This is called leveraged ownership.
That is, leveraged ownership is where a property is obtained through equity and mortgage
financing.
REITs: REITs combine the features of mutual funds and real estate. An REIT is a company
that owns income-producing real estate assets. In REITs, average investors pool their capital
to invest (take ownership) in several large-scale, diversified income-generating real estate
properties. The REIT issues shares, where each share represents a percentage ownership in
the underlying property. The income generated is paid as a dividend to the shareholders.
The value of the shares is based on the dividend. REIT shares often trade publicly on
exchanges. It is a way for individual investors to earn a share of the income from commercial
properties (office buildings, warehouses, and shopping malls) without buying them. Risk and
return of REITs vary based on the types of properties they invest in. Equity REITs invest
primarily in residential and commercial properties.
5.2. Real Estate Investment Categories
Real estate properties can also be categorized based on use:

Residential Property
• Properties such as residences, apartment buildings, and vacation homes, purchased
with the intent to occupy.
• Most home buyers cannot fund the home entirely with cash. Instead, it is leveraged
equity, i.e., they borrow money (loan/mortgage) to make the purchase.
• Financial institutions lend money (debt financing) through mortgages for purchasing
a home. A due diligence of the borrower is done to ensure that he has the capacity
(sufficient cash flows) to make the payments on the loan on time, he is making the
remaining equity investment in the home, and adequate insurance is in place on the
home.
Commercial Property
• Undertaken by investors (both institutional and HNIs) with limited liquidity needs
and long time horizons.
• Primarily comprises office buildings purchased with the intent to rent.
• Direct investment: can be equity or debt financed.
• Debt financing: lender must ensure the borrower is credit worthy. The property must
generate enough cash flows through rent to service the debt. How much loan the
borrower can get (based on loan-to-value ratio) depends on the value of the property.
• Equity investing: Requires active and experienced management.
• Indirect investment is done through REITs, CMBS (commercial mortgage-backed
securities).
Timberland and Farmland
• Timberland functions as a factory and store. The return comes from the sale of
timber. It has low correlation of returns with other asset classes. By not harvesting,
storage of timber becomes easy. The trees can be harvested based on the price: more
harvest when price goes up and delayed harvest when the price is down. Three
return drivers include growth, timber price changes, and land price appreciation.
• Farmland is perceived to provide a hedge against inflation. Two types of farm crops
include crops that are planted and harvested annually, and permanent crops that
grow on trees. Return drivers for farmland are harvested quantities, commodity
prices, and land price appreciation.
5.3. Real Estate Performance and Diversification Benefits
There are a number of indices to measure real estate returns that vary based on the
underlying constituents and longevity. There are three categories, in general:
• Appraisal Index: Uses estimates of values as inputs to the index. The appraisal
values are based on comparable sales and cash flow analysis techniques. This means
that actual transaction prices are not used by the index because real estate assets do
not transact very often and managers do not take the effort to revalue property
frequently. Ideally, the properties are supposed to be appraised once a year, but some

properties may have been appraised more than a year earlier.

• Repeat Sales Index: Uses repeat sales of properties to construct the indices; the
change in the price of properties with repeat sales is measured in this method. These
indices suffer from sample selection bias because it is highly unlikely that the same
properties come up for repeat sales every year.
• REIT Index: Uses the prices of publicly traded shares of REITs to construct the
indices. The accuracy of the index depends on how frequently the shares of the index
trade.
5.4. Real Estate Valuation
Until a real estate property is sold, its actual value is not known and must be estimated. This
estimation process is known as appraising the property.
Common techniques for appraising real estate property are as follows:
• Comparable sales approach
• Income approach
• Cost approach
These methods are discussed in detail below:
Comparable Sales Approach
The comparable sales approach compares the property being appraised to similar properties
that have been recently sold. The properties must have similar characteristics such as
location, condition, age, and size. If there is a difference in characteristics, then adjustments
must be made.
Income Approach
The income approach can be applied in two ways: the direct capitalization approach and the
discounted cash flow approach.
With the direct capitalization method, we estimate a property’s net operating income (NOI)
for the upcoming year and then divide by a capitalization rate. The relevant formulas are
given below:
NOI = Income to the property – property taxes – insurance – maintenance – utilities –
repairs (depreciation and income taxes are not deducted)
expected annual NOI
Value of the property = expected capitalization rate
where: capitalization rate = discount rate – growth rate

With the discounted cash flow method, the present value of the property is calculated by
discounting future projected cash flows for a finite number of periods. The final resale value
is estimated using the direct capitalization method.

Cost Approach
The cost approach involves estimating the value of land and then the cost of building the
property using current costs.
REIT Valuation
There are two approaches to estimate the intrinsic value of a REIT:
• Income-based
• Asset-based
The income-based method is similar to direct capitalization. There are two income
measures: funds from operations (FFO) and adjusted FFO (AFFO).
FFO = Net income + depreciation – gains from sales of real estate + losses on sales of real
estate
AFFO adjusts the FFO for recurring capital expenditures.
The asset-based method is based on calculating REIT’s net asset value (NAV).
NAV = estimated market value of REIT’s assets – liabilities
5.5. Real Estate Investment Risks
Like any investment, real estate investing has its risks if the outcome does not turn out to be
as per expectations.
• Property values are subject to variability based on national and global economic
conditions, local real estate conditions (more supply than demand or demand more
than supply), and interest rate levels.
• Ability to select, finance, and manage real estate properties. This includes collecting
rent, maintenance, undertaking repairs on time, and finally disposing the property.
Economic conditions may be different when the property was bought and when it is
sold.
• Expenses may increase unexpectedly.
• Leverage magnifies risks to equity and debt investors.
6. Commodities
Commodities are physical products which include energy (oil), base metals (zinc, lead,
copper), precious metal (gold, silver), agricultural products (grains, coffee), and other
products (freight, carbon credits). Generally, commodity investments take place through
derivative instruments, because one incurs storage and transportation costs for holding
commodities physically.
The return on commodity investment is based on price changes only rather than an income
stream such as dividends. Commodities are attractive to investors as they are considered a
hedge against inflation. Historically, the correlation between commodities and traditional

investments has been low.

6.1. Commodity Derivatives and Indices
Commodity derivative contracts may trade on exchanges or over the counter. The popular
derivatives include futures, forwards, options, swaps, and commodity index futures.
6.2. Other Commodity Investment Vehicles
Besides derivative contracts, other ways of getting exposure to commodities include:
• Exchange traded funds (ETF).
• Common stock of companies exposed to a particular commodity.
• Managed future funds
o Similar to hedge funds, and are actively managed.
o Invest in commodity futures and forwards.
o Usually follow a 2 and 20 fee structure.
• Individual managed accounts
o Managed by expert professional money managers for HNIs and institutional
investors.
o Funds specializing in specific commodity sectors such as chemicals, refineries.
o Management fees range from 1 to 3 per cent of committed capital.
o Specific commodity sector funds that give exposure to particular commodities.
6.3. Commodity Performance and Diversification Benefits
Commodities are viewed as a good inflation hedge. Commodity prices impact inflation
calculation, especially food and energy (oil).
• Low correlation with traditional investments results in diversification benefit.
• Investing in commodities offers a potential for returns as investors will invest in
commodities if they believe prices will increase in the short or medium term.
6.4. Commodity Prices and Investments
Commodity spot prices are a function of supply and demand, the costs of production and
storage, value to users, and global economic conditions.
• Supplies of commodities depend on production and inventory levels.
• Demand of commodities depends on the consumption needs of end users.
• Demand may be high while supply may be low during economic growth; conversely,
demand may be low and supply high during times of economic slowdown.
• If demand changes very quickly during any period, resulting in supply-demand
mismatch, it may lead to price volatility.
How are commodity futures contracts priced?
• The price of a futures contract can be calculated using the following formula:
Future price ≈ Spot price (1 + r)^t + Storage costs – Convenience yield
where: convenience yield is the value associated with holding the physical asset;

r is the short-term risk-free interest rate

• Future prices may be higher or lower than spot prices, based on convenience yield.
• For no arbitrage to occur, Future price ≈ Spot price (1+r). But commodities incur
storage costs. So they must be added to the future price and we get Future price ≈
Spot price (1 + r) + storage costs. Storage and interest costs are collectively known as
“cost of carry”.
• Why subtract the convenience yield? Because the buyer does not possess the
commodity as of now, until the end of the contract. Since he has given up this
convenience, it must be subtracted from the future price. That’s how we arrive at
Future price ≈ Spot price (1 + r) + storage costs - convenience yield
• Futures price may be higher or lower than the spot price based on the convenience
yield.
Contango: Future price > Spot price
Backwardation: Future price < Spot price
Markets tend to be in contango when there is little or no convenience yield.
Markets tend to be in backwardation when the convenience yield is high.
There are three sources of return for a commodity futures contract:
1. Roll yield: Difference between the spot price of a commodity and the price specified
by its futures contract.
2. Collateral yield: It is the interest earned on the collateral. It is assumed the futures
contracts are fully collateralized and that the collateral is invested in risk-free assets.
3. Spot prices: Determined by the relationship between current supply and demand.
7. Infrastructure
The assets underlying infrastructure investments are capital intensive, long-lived assets.
Infrastructure assets were primarily owned, financed, and operated by the government. Of
late, they are financed privately with the intent of selling the newly built assets to the
government. The provider of the assets and services has a competitive advantage as the
barriers to entry are high due to high costs.
Investors invest in infrastructure assets expecting capital appreciation. Some of the
advantages to investors from investing in infrastructure are as follows:
• a steady income stream.
• diversification because of low correlation of infrastructure assets to traditional
investments.
• protection against inflation.
• match the long-term liability structure of some investors such as pension funds.
7.1. Categories of Infrastructure Investments
Infrastructure investments may be categorized based on different criteria such as underlying

assets, stage of development of the underlying assets, and geographical location of the
underlying assets. Let us look at the various sub-categories now.
Infrastructure investments based on underlying assets: They can be further classified
into economic and social infrastructure assets.
• Economic infrastructure assets: These include transportation, communication, and
social utility assets that are needed to support economic activity. Examples of
transportation assets are roads, airports, bridges, tunnels, ports, etc. Examples of
utility assets are assets used to transmit and distribute gas, electricity, generate
power, etc. Examples of communication assets are assets that are used to broadcast
information.
• Social infrastructure assets: These are assets required for the benefit of the society
such as educational and healthcare facilities.
Infrastructure investments based on the stage of development of the underlying
assets: They can be further classified into brownfield and greenfield investments.
• Brownfield investments: These are investments in existing investable infrastructure
assets. These may be assets, with a financial and operating history, which the
government wants to privatize.
• Greenfield investments: These are investments in yet-to-be-constructed
infrastructure assets. The objective may be to construct and sell the assets to the
government, or hold and operate the assets.
Infrastructure assets may also be categorized based on their geographical location.
7.2. Forms of Infrastructure Investments
Investors may invest either directly or indirectly in infrastructure investments. The
investment form affects the liquidity and the income and cash flows to the investor.
The advantages of investing directly in infrastructure are that investors have a control over
the asset and can capture the full value of the asset. But the downside of a large investment is
that it results in concentration and liquidity risks.
Some of the forms of indirect investments include:
• Shares of publicly traded infrastructure companies
• Master limited partnerships (MLPs)
• Exchange-traded funds
• Listed funds
• Private equity funds
• Unlisted mutual funds
Investing in publicly traded infrastructure companies and master limited partnerships offer
the benefit of liquidity. Publicly traded infrastructure securities also have a reasonable fee
structure, transparent governance, and provide the benefit of diversification.

7.3. Risks and Returns Overview

Infrastructure investments with the lowest risk have stable cash flows and higher dividend
payout ratios, but they also have lower expected returns and lesser growth opportunities. An
example of a low risk infrastructure investment is toll roads, or a brownfield investment in
an asset leased to a government school. An example of a high-risk infrastructure investment
is a private equity fund with a greenfield investment.
Some of the risks associated with infrastructure investments include:
• Revenues being different than expected.
• Leverage creates financial, operational, and construction risk.
• Regulatory risk
8. Other Alternative Investments
There are many other investments that are not considered traditional investments (stocks,
bonds, and cash). These often fall under the category of collectibles. Collectibles are tangible
assets such as fine art, fine wine, rare stamps, coins, jewelry, watches, sports memorabilia,
etc. Risks associated with collectibles include the following:
• These do not provide current income.
• These are very illiquid instruments and hence the risk is very high.
• Investors must have a personal interest/expertise in these items to make the right
choice for investment so as to avoid fraud, fake, etc.
9. Risk Management Overview
9.1. Investment and Risk Management Process
Both investor and the investment manager must be concerned about risk management to
ensure that the investments are consistent with the portfolio policies. Each alternative
investment has a separate fund manager, so the investor must also ensure that the portfolio
risk is effectively managed by the manager across different alternative investment
categories. Additional points to keep in mind:
• Risks vary across alternative investments. For example, the risks associated with
private equity will be different from the risks for direct real estate or commodities.
Private equity investments have a long lockup period and are illiquid, so the right
fund/manager selection is important.
• Historical returns and standard deviations of the indices may be different from the
returns and volatility of the alternative investments; the returns tend to be biased
upward. The indices are created based on funds voluntarily reporting data.
• Reported correlations may vary from actual correlations. Performance may be highly
correlated with business cycles and correlations keep changing. During one period,
you may observe high correlation whereas low correlation in another period. In
short, the investor must do due diligence to assess the risk and use the appropriate

correlation number before investing (for proper diversification).

• Hedge fund risk is monitored by a chief risk officer, who should be separated from the
investment process. Limits on leverage, sector, and individual positions must be
specified.
9.2. Risk-Return Measures
Traditional risk measures such as the Sharpe ratio assume a normal distribution of returns.
The measures are not always appropriate for alternative investments because:
• Many alternative investments exhibit asymmetric risk and return profile, which
means they might have high kurtosis (leptokurtic) and negative skewness. Downside
risk measures such as VaR and Sortino ratio will underestimate the loss for a
negatively skewed distribution.
• Alternative investments such as hedge funds and private equity have limited
transparency. This is because the alternative investment industry is not as regulated
as traditional investments.
• Most alternative investments are relatively illiquid.
9.3. Due Diligence Overview
Hedge fund and private equity returns depend heavily on the fund manager. Due diligence of
the manager is important to ascertain he has the right skill and expertise. When evaluating
past results, investors should be wary of consistent, good performance as there is a
possibility of fraud.
Security Market Indices: Indices for Alternative Investments
The material below is reproduced from an earlier reading as it summarizes what we have seen
so far.
• Commodity indices consist of futures contracts on one or more commodities.
o Performance of index and underlying commodities can be different.
o Common to have multiple indices with same commodities, but in different
proportions; weighting methods are also different; different risk-return profile.
• Real estate indices represent the market for real estate securities and the market for
real estate.
o Appraisal indices, repeat sales indices, REIT indices.
• Hedge fund and private equity indices
o Constituents determine the index.
o Poorly performing funds are less likely to report.
o Index returns overstated due to survivorship, backfill, and other biases.

Summary
LO.a: Compare alternative investments with traditional investments.
Traditional investments include long-only position in stocks, bonds, and cash. All other
investments are classified as alternative investments.
Alternative investments include investments in:
• real estate
• commodities
• private equity
• hedge funds
Compared to traditional investments, alternative investments typically have:
• Lower liquidity.
• Less regulation.
• Lower transparency.
• Higher fees.
• Limited and potentially biased historical risk and return data.
• Unique legal and tax considerations.
LO.b: Describe categories of alternative investments.
Category Description
Hedge Funds • Private investment vehicles.
• Manage portfolios of securities and derivative positions.
• Aim for absolute returns.
Private • Invest in companies that are not publicly listed.
Equity Funds • Divided into leveraged buyouts (of established companies) and
venture capital (investing in startups).
Real Estate • Investments in buildings, farmland, private/commercial real estate
equity, private/commercial real estate debt, REIT, etc.
Commodities • Investing in physical commodities such as grains, metals, and crude
oil.
• Investments in commodity futures contracts.
Other • Any other tangible asset, such as art, wine, stamps, coins, and
intangible assets such as patents.
LO.c: Describe potential benefits of alternative investments in the context of portfolio
management.
One of the primary drivers for investing in alternative investments is the low correlation of
alternative investment with traditional investments.
This low correlation along with relatively high returns on some alternative investment

categories results in a substantial diversification benefit.

LO.d: Describe hedge funds, private equity, real estate, commodities, and other
alternative investments, including, as applicable, strategies, subcategories, potential
benefits and risks, fee structures, and due diligence.
Hedge funds
• Uses a partnership structure with a general partner who manages the fund and
accepts unlimited liability and limited partners (investors) who own fractional
interests in the partnership and have limited liability.
• The general partner typically receives a management fee based on assets under
management and an incentive fee based on the performance of the fund.
• Hedge funds are typically classified by strategy into four broad categories:
o Event-driven: Includes merger arbitrage, distressed/restructuring, activist
shareholder, and special situations.
o Relative value: Strategies that seek to profit from pricing discrepancies.
o Macro: Strategies based on top-down analysis of global economic trends.
o Equity hedge: Strategies based on bottom-up analysis. Includes market
neutral, fundamental growth, fundamental value, quantitative directional, and
short bias.
• During a financial crisis the correlation of returns between global equities and hedge
funds tends to increase, which reduces the hedge funds’ usefulness as a diversifying
asset class.
Private equity
• Uses a partnership structure with a general partner who manages the fund and
accepts unlimited liability, and limited partners (investors) who own fractional
interests in the partnership and have limited liability.
• The general partner typically receives a management fee based on committed capital
and an incentive fee based on the performance of the fund.
• Dominant strategies in private equity funds are leveraged buyouts and venture
capital. Other strategies also include development capital and distressed investing.
• Types of LBOs include
o Management buyouts: The existing management team is involved in the
purchase.
o Management buy-ins: External management team replaces the current
management.
• Stages in venture capital include
o Formative stage: Consists of angel investing, seed, and early stages.
o Later stage: Company is in expansion phase.
o Mezzanine stage: Company is preparing for an IPO.
• Exit strategies for investments in portfolio companies include:

o Trade sale: Company is sold to a competitor or another strategic buyer.

o IPO: Company is sold to the public.
o Recapitalization: Company is re-leveraged when interest rates are low.
o Secondary sale: Company is sold to another private equity firm or another
investor.
o Write off/ liquidation: Worst case scenario, company is sold at a loss.
• Historically, private equity has provided potential diversification benefits. However,
an investor must identify top performing private equity managers to benefit from
private equity.
Real estate
• Primary reasons to invest in real estate include:
o Potential for competitive long term returns.
o Rental income.
o Diversification benefits.
o Inflation hedge.
• Investment characteristic of real estate include:
o Indivisibility.
o Unique characteristics (no two properties are identical).
o Fixed location.
o Operational management.
o Local markets can be very different from national or global markets.
• Basic forms of real estate investments are shown in the following table
Debt Equity
Private Mortgages Direct ownership of real estate.
Construction lending Ownership can be through sole
ownership, joint ventures, real estate
limited partnerships etc.
Public Mortgage-backed securities Shares in real estate corporations.
(residential and commercial). Shares of real estate investment
Collateralized mortgage trusts (REITs).
obligations
• Historically, real estate returns are highly correlated with global equity returns but
less correlated with global bond returns.
Commodities
• Commodity investments can be achieved by investing in actual physical commodities
or in companies that produce commodities. However, usually commodity investing is
achieved using commodity derivatives.
• The returns are based only on changes in price. They do not include an income
stream such as dividends, interest, or rent.
• The return on a commodity investment includes:

o Collateral yield: Return on collateral posted to satisfy margin requirements.

o Price return: The gain or loss due to changes in the spot price.
o Roll yield: Gain or loss resulting from re-establishing future positions. Roll
yield is positive if futures market is in backwardation and negative if the
market is in contango.
• Commodities are viewed as a good inflation hedge. They also have a low correlation
with traditional investments and can provide diversification benefits.
Infrastructure
• Infrastructure assets are real assets that are planned for public use and to provide
essential services. They are typically capital intensive and long-lived.
• These assets are expected to generate stable cash flows that should adjust for
economic growth and inflation. They may also provide capital appreciation.
LO.e: Describe, calculate, and interpret management and incentive fees and net-of-fees
returns to hedge funds.
Investors must consider the fee structure before making an investment in hedge funds.
Common fee structure is 2 and 20, which means 2% management fee and 20% incentive fee.
Funds of funds charge an additional 1 and 10 fee.
• Incentive fee is usually calculated on profits net of management fees or on profits
before management fees.
• Sometimes, the incentive fee is paid only if the returns exceed a hurdle rate.
• In some cases, the incentive fee is paid only if the fund has crossed the high water
mark. High water mark is the highest value net of fees (or the highest cumulative
return) reported by the fund so far.
LO.f: Describe issues in valuing and calculating returns on hedge funds, private equity,
real estate, and commodities.
Hedge funds
• They often invest in securities that are not actively traded. The values of such
securities must therefore be estimated.
• They also invest in securities that are illiquid relative to the size of the hedge fund’s
position. The values of such securities must be adjusted for illiquidity (using trading
NAV)
Private equity
Portfolio companies must be valued using one of the following approaches:
• Market/comparables approach: Values a company based on multiples.
• Discounted cash flow approach: Present value of expected future cash flows
• Asset based approach: Value is based on underlying assets- liabilities

Real estate
Real estate properties must be valued using one of the following approaches:
• Comparable sales approach: Value based on recent sales of similar properties.
• Income approach: Present value of expected future cash flows from the property.
• Cost approach: Replacement cost of a property.
REIT (Real Estate Investment Trusts) can be valued using:
• Income based approach.
• Asset based approach.
Commodities
• A commodity futures price is equal to spot price compounded at the risk-free rate +
storage costs – convenience yield.
• Convenience yield is the value of having the physical commodity for use over the
period of the futures contract.
LO.g: Describe risk management of alternative investments.
• Alternative investments often have limited and potentially biased historical risk and
return data. Because of this, managing risks associated with alternative investments
can be challenging.
• Traditional risk and return measures such as standard deviation of returns may be
misleading as a measure of risk.
• Some key risks to consider are:
o Operational risk.
o Financial risk.
o Counterparty risk.
o Liquidity risk.
• Due diligence is also required to evaluate if:
o The investment complies with its prospectus.
o There is a suitable organizational structure and policies in place for managing
investments, operations, risk, and compliance.
o The fund terms are reasonable.

Practice Questions
1. Which of the following is least likely to be considered an alternative investment?
A. Private equity funds.
B. Real estate.
C. Long-only stock funds.
2. Compared to traditional investments, alternative investments are most likely to be

characterized by:
A. high fees.
B. high liquidity.
C. more regulation.
3. Which of the following alternative investment will be least liquid?

A. Private equity funds.
B. Commodity-linked ETF.
C. Real estate investment trusts.
4. An investor may prefer a fund of funds to a single hedge fund if he seeks:

A. lower fees.
B. more due diligence.
C. higher returns.
5. In which stage of financing is angel investing capital typically provided?

A. Formative stage.
B. Later stage.
C. Mezzanine stage.
6. An equity hedge fund uses technical analysis to identify potential long and short
positions. It is most likely pursuing a:
A. market neutral strategy.
B. relative value strategy.
C. quantitative directional strategy.
7. An investor is looking for competitive long-term total return driven by both income
generation and capital appreciation. The investor’s goals will be best satisfied with an
investment in:
A. hedge funds.
B. commodities.
C. real estate.

8. A hedge fund established a high water mark of $200 million two years ago. The end-of-
year value before fees for last year was $180 million. This year’s end-of-year value before
fees is $210 million. The fund has a “2 and 20” fee structure. Management fees are paid
independently of incentive fees and are calculated on end-of-year values. The total fees
paid this year is closest to:
A. $4.2 million.
B. $6.2 million.
C. $10.2 million.
9. Which of the following is least likely a source of return for commodities related
investments?
A. Dividend yield.
B. Collateral yield.
C. Roll yield.
10. A private equity fund values portfolio companies by using estimated multiples of cash
flows. The valuation approach used by the fund is most likely a(n):
A. asset-based approach.
B. discounted cash flow approach.
C. market/comparables approach.
11. Which of the following measures is least appropriate to assess the downside risk of an
alternative investment?
A. Sortino ratio.
B. VaR (Value at risk)
C. Standard deviation of return.

Solutions
1. C is correct. Long-only equity funds are typically considered traditional investments and
real estate and private equity funds are typically classified as alternative investments
2. A is correct. Compared to traditional investments, alternative investments have higher

fees, lower liquidity, and less regulation.
3. A is correct. Private equity funds typically require lockup periods and are illiquid.
Commodity ETFs and REITs are publically traded and typically very liquid.
4. B is correct. A FOF manager is expected to provide more due diligence, but this comes at
a cost of higher fees (two layers) and, therefore, lower returns.
5. A is correct. Formative-stage financing occurs when the company is still in the process of
being formed. Angel investing capital is typically raised in this stage.
6. C is correct. Quantitative directional strategies use technical analysis. A market neutral

strategy maintains approximately equal values in long and short positions. A relative
value strategy seeks to profit from unusual pricing issues.
7. C is correct. One of the key reasons for investing in real estate is the potential for
competitive long-term total returns driven by both income generation and capital
appreciation.
8. B is correct.
Management fee = 2% of $210 million = $ 4.2 million
Incentive fee = 20% of ($210 million - $200 million) = $2 million.
Total fees = 4.2 + 2 = $6.2 million.
9. A is correct. Main sources of return for a commodities futures contract are collateral
yield, roll yield, and spot price return.
10. C is correct. In the market/comparables approach, market or private transaction values

of similar companies are used to estimate multiples of EBITDA, net income, or sales to
estimate the value of portfolio companies.
11. C is correct. Downside risk measures focus on the left side of the return distribution
curve where losses occur. The standard deviation of returns assumes that returns are

normally distributed, however many alternative investments do not exhibit close-to-

normal distribution of returns. The Sortino ratio and the value-at-risk measure are both
measures of downside risk.

2019 Level I Notes
Notes

2019 Level I Notes
Notes

Level I Volume 5 2019 IFT Notes

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Level I Volume 5 2019 IFT Notes

Uploaded by

Copyright:

Available Formats

2019 CFA® Exam Prep

IFT Study Notes

© IFT. All rights reserved

Published in 2018 by IFT

Errata information can be found at: https://ift.world/errata

© IFT. All rights reserved

R50 Fixed Income Securities - Defining Elements .............................................................................4

R51 Fixed Income Markets - Issuance Trading and Funding ................................................... 26

R52 Introduction to Fixed Income Valuation ................................................................................... 47

R53 Introduction to Asset Backed Securities ................................................................................... 81

© IFT. All rights reserved 1

3. How Securitization Works .................................................................................................................... 82

R54 Understanding Fixed-Income Risk and Return................................................................... 111

R55 Fundamentals of Credit Analysis ................................................................................................ 148

R56 Derivative Markets and Instruments ....................................................................................... 172

© IFT. All rights reserved 2

6. Criticisms and Misuses of Derivatives........................................................................................... 184

R57 Basics of Derivative Pricing and Valuation ........................................................................... 191

R58 Introduction to Alternative Investments ............................................................................... 222

© IFT. All rights reserved 3

R50 Fixed-Income Securities: Defining Elements

© IFT. All rights reserved 4

© IFT. All rights reserved 5

© IFT. All rights reserved 6

Current yield or Running yield

Yield to Maturity (YTM)

© IFT. All rights reserved 7

• Contingency provisions like call option.

© IFT. All rights reserved 8

© IFT. All rights reserved 9

• Equipment trust certificates: Bonds secured by physical assets or equipment such as

© IFT. All rights reserved 10

© IFT. All rights reserved 11

Bearer Bonds versus Registered Bonds

© IFT. All rights reserved 12

© IFT. All rights reserved 13

© IFT. All rights reserved 14

4.2. Coupon Payment Structures

© IFT. All rights reserved 15

© IFT. All rights reserved 16

© IFT. All rights reserved 17

Downside protection if shares prices are Elimination of debt if conversion option is

© IFT. All rights reserved 18

© IFT. All rights reserved 19

© IFT. All rights reserved 20

© IFT. All rights reserved 21

before the expiration date.

© IFT. All rights reserved 22

3. Which of the following is least likely a negative bond covenant?

5. A zero-coupon bond can best be classified as a:

7. Which of the following best describes a convertible bond’s conversion value?

© IFT. All rights reserved 23

© IFT. All rights reserved 24

© IFT. All rights reserved 25

R51 Fixed Income Markets: Issuance Trading and Funding

© IFT. All rights reserved 26

Classification by Currency Denomination

© IFT. All rights reserved 27

© IFT. All rights reserved 28

3.1. Primary Bond Markets

© IFT. All rights reserved 29

© IFT. All rights reserved 30

the better the liquidity.

© IFT. All rights reserved 31