Fixed Income Securities

Prof. Nicolae Gârleanu

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.1

High-Level Course Objectives

I This course is an introduction to the topic of fixed income

I As such, it aims to strike a balance between breadth and depth
I Market features
I Historical patterns
I Analytical tools
I Specific goals:
I Get to know major fixed income markets and standard instruments
I Understand determinants of value of fixed-income securities & derivatives
I Acquire tools to value fixed-income securities & derivatives

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.2

Learning

I Most efficient way is to study lecture notes

I Work out numerical examples on your own, step by step
I Zoom lecture recordings can viewed again, fast forwarded, etc.

I Do the problems on homework sets, even if you submit solutions as a group

=
I Ask questions!
I In class
I In office hours: instructor and TA
I Via email: instructor and TA
I Of your group mates and other peers

I Stay curious, read news, wonder

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.3

Grading

I Two graded problem sets

I Each problem set worth 15% of final grade
- - - -

I Problem sets to be turned in groups of up to four students; one copy per group
-

I One final exam

I 80 minutes; 70% of final grade
I Open book — may use anything other than the internet
line
I March 6, time
- TBA 4:30pm , on -

I Class participation may be taken into account in borderline cases ←

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.4

Communication and Support

I Instructor:
I Email: fin525sp22@gmail.com, garleanu@wustl.edu

I
-

I Office hours: Wednesdays, 7:15pm–8:15pm, via Zoom

I TA:
.
I Email: fin525sp22@gmail.com, won-chang.choi@wustl.edu
I Office hours: Tuesdays, 5:00pm–6:00pm, via Zoom
I Canvas:
I Lecture notes
I

I
Problem sets
±
Supplementary notes and readings
Spreadsheets

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.5

Textbooks

I Textbooks are optional. Suggested textbooks:

l
I Fixed Income Securities: Valuation, Risk, and Risk Management, by Pietro
Veronesi, 1st Edition, 2010, Wiley
I Fixed Income Securities: Tools for Todays Markets, by Bruce Tuckman and Angel
Serrat, 3rd Edition, 2012, Wiley Finance
I Fixed Income Mathematics, by Frank Fabozzi, 4th Edition, 2006, McGraw-Hill

I All textbooks contain much more detail, and go much farther in terms of
material, than we’ll cover in the class. One goal of the class is to prepare you
to read such texts on your own
I The internet, as you would expect, is a very rich source of information — but
be a little cautious

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.6

 Topics

I. Fixed-income securities and yield curves ~ 1.5

I
sessions

II. Interest-rate risk management ~ 1 session

{
III. Forwards, futures, and swaps r
'

~ 2.5 Sessions
IV. Options .

V. Credit risk
VI. Mortgages and securitization :

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.7

 I. Fixed-Income Securities
and Yield Curves

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.8

 Roadmap

1. Universe of fixed-income securities i.

2. Bond basics and US Treasury market

7.*
3. Portfolios and No Arbitrage ←

4. Discount factors, rates, yields

-

5. The yield curve: construction and economic determinants

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.9

Fixed-Income Securities

I “Fixed-income” securities promise a fixed stream of payments

i r n
- -

I Pre-specified dates
- -
- -
=

I Pre-specified amounts⇤
I Fixed-income universe:
I US treasuries (nominal): notes, bills, bonds ←
I I US treasuries (real): Treasury inflation protected securities (TIPS)
→ I Local government: Municipal bonds (munis)
→ I Agency and government sponsored enterprises (GSE)
→ I Foreign government (sovereign)
I Corporate bonds
→ I Loans: collateralized and uncollateralized =.

I Mortgage-backed securities (MBS), asset-backed securities (ABS)

fin .it#h-tTieug
-
- -

→I Repos, Fed funds, LIBOR

. = - -

I Fixed income derivatives: swaps, forwards, futures, options

•I Credit derivatives

⇤ Sometimes in terms of other quantities; e.g., inflation (TIPS) or LIBOR (floating rate notes)

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.10

A Multitude of Rates
-

- n - n -

# I

→
.
- -
-

;
→

→
:

:-O
.

! I

i. - - -

l
N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.11
A Multitude of Rates

E- ,

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.12

US Fixed-Income Securities: Outstanding ($Bn)

:
Mortg. Corp. Fed Ag. Money Asset-
Year Munis Treas. Total
Related Debt Secs. Markets Backed
1990 1,178.6 2,195.8 1,340.1 1,363.5 421.5 609.9 67.2 7,176.6
1992 1,295.4 2,754.1 1,774.3 1,563.3 462.4 579.0 117.3 8,545.9
1994 1,325.8 3,126.0 2,352.9 1,941.7 727.7 623.5 162.8 10,260.3
1996 1,261.6 3,444.7 2,606.4 2,267.5 925.8 803.0 298.2 11,607.2
1998 1,402.7 3,340.5 3,243.4 2,819.1 1,302.1 1,172.6 478.0 13,758.4
2000 1,480.7 2,951.9 4,119.3 3,438.1 1,853.7 1,614.0 701.9 16,159.6
2002 1,762.8 3,205.3 5,289.4 4,043.7 2,377.7 1,374.9 904.8 18,958.6
2004 2,876.1 3,945.8 6,301.7 4,563.4 2,700.6 1,399.1 1,100.2 22,887.0
2006 3,284.7 4,328.0 8,389.9 4,883.5 2,634.0 1,958.4 1,656.9 27,135.3
2008 3,665.9 5,783.6 9,467.4 5,500.0 3,210.6 1,599.8 1,829.5 31,056.9
2010 3,967.3 8,853.0 9,258.4 6,726.9 2,538.8 1,057.6 1,507.8 33,909.8
2011 3,930.2 9,928.4 9,075.5 6,840.5 2,326.9 969.3 1,359.0 34,429.8
2012 3,931.6 11,046.1 8,838.1 7,249.6 2,095.8 952.3 1,280.3 35,393.9
2013 3,866.4 11,854.4 8,742.6 7,674.7 2,056.9 951.6 1,285.7 36,432.3
2014 3,822.1 12,504.8 8,842.0 8,040.7 2,028.7 930.4 1,349.4 37,518.2
2015 3,838.4 13,191.6 8,894.8 8,272.8 1,995.4 941.5 1,376.6 38,511.0
2016 3,885.0 13,908.2 9,023.4 8,675.9 1,971.7 884.9 1,391.8 39,740.8
2017 3,899.3 14,468.8 9,304.5 8,996.8 1,934.7 965.9 1,457.9 41,027.9
2018 3,842.1 15,608.0 9,732.3 9,231.5 1,841.6 996.0 1,615.6 42,867.0
2019 3,862.2 16,673.3 10,307.6 9,566.4 1,726.2 1,045.2 1,677.6 44,858.5
2020 3,978.7 20,973.1 11,214.0 9,759.3 1,693.6 1,535.8 986.9 50,141.4
3Q21
- .

-
4,035.6
✓ !
21,872.6 11,905.5
✓ 10,010.0
✓ 1,446.8
.

.pe
1,475.6
. - - -
1,071.4
.
- -
51,817.5
-

Source: https://www.sifma.org/resources/research/us-fixed-income-issuance-and-outstanding/

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.13

US Fixed-Income Securities: Outstanding

=:
Source: https://www.sifma.org/resources/research/fixed-income-chart/

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.14

US Fixed-Income Securities: Trading Volume ($Bn/Day) =

Agency Non-Agency Corp. Fed Ag.

Year Munis Treas. ABS
MBS MBS Debt Secs.
1996 1.1 203.7 38.1 - - - 31.1
1997 1.1 212.1 47.1 - - - 40.2
1998 3.3 226.6 70.9 - - - 47.6
1999 8.3 186.5 67.1 - - - 54.5
2000 8.8 206.5 69.5 - - - 72.8
2001 8.8 297.9 112.0 - - - 90.2
2002 10.7 366.4 154.5 - - 17.8 81.8
2003 12.6 433.5 206.0 - - 18.0 81.7
2004 14.8 499.0 207.4 - - 17.3 78.8
2005 16.9 554.5 251.8 - - 16.6 78.8
2006 23.1 524.7 254.6 - - 16.9 74.4
2007 25.1 570.2 320.1 - - 16.4 83.0
2008 19.4 553.1 344.9 - - 14.3 104.5
2009 12.5 407.9 299.9 - - 19.9 77.7
2010 13.3 528.2 320.6 - - 20.5 11.2
2011 11.3 567.8 243.3 4.4 1.5 20.6 9.6
2012 11.3 518.9 280.4 4.5 1.5 22.6 9.7
2013 11.2 545.4 222.8 4.1 1.3 24.7 6.6
2014 9.9 505.0 178.0 3.7 1.5 26.7 5.3
2015 8.6 490.0 193.0 3.1 1.4 27.9 4.5
2016 10.6 519.1 206.6 2.9 1.3 29.6 5.4
2017 10.8 505.2 209.1 2.5 1.4 30.6 4.1
2018 11.6 547.8 218.1 2.4 1.4 31.2 3.5
2019 11.5 593.6 247.6 2.7 1.5 35.3 4.1
2020 12.0 603.2 289.8 3.2 1.9 41.0 5.1
2021 8.8 .
.
629.1
✓ 285.0 1.4 37.8 2.8
. -
1.4
. - .
. .

Source: https://www.sifma.org/resources/research/us-fixed-income-trading-volume/
N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.15
Global Debt Outstanding

'

1)
:
,

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.16

Global Debt Outstanding

;
N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.17
 Roadmap

1. Universe of fixed-income securities

2. Bond basics and US Treasury market
-

3. Portfolios and No Arbitrage

4. Discount factors, rates, yields

5. The yield curve: construction and economic determinants

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.18

Bond Basics

I Bonds are the most fundamental fixed-income securities

I E↵ectively, bonds are loans made to the issuer
I Specifically, bond cashflows are determined by
I Price P ←
I Face value F , also known as par, paid at maturity T
=
I Coupon payments
I rate c ) annual coupon cF
Annual coupon ☐ if a- 4%
,
F- 10,000
400
I Coupon frequency k: k payments of cF/k per year annual coupon :
-

I The coupon rate may be fixed or floating (i.e., function of other quantities)
I Additional features
I Attached options (putability, callability)
e.si ,
12=2 ( i. e.)
→

payments
→ -

→ I Covenants 2 coupon
→ I Amortization
pryor ) , then
each payment is 200

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.19

Zero Coupon Bonds

I Purest form of borrowing/lending

I No coupon payments
I A single payment made by issuer: face value (F ) at maturity (T )
→ ←

I Price P is quoted per $100 of face value, regardless of actual face value
I E.g., the U.S. Treasury issued a 182-day bill on August 26, 2004, with maturity
date February 24, 2005, for a price of $99.115
-

I Examples
I The US Treasury bills — obligations with maturity up to one year
-

I STRIPS — “Separate Trading of Registered Interest and Principal Securities” —

program creates zero coupon bonds from the coupons of longer maturity Treasuries

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.20

Coupon Bonds
I A coupon bond pays
I Face value F maturity
=

I A regular payment named coupon at a given annual frequency

I E.g., consider a 2-year Treasury note
I The coupons rate c is expressed annually. M
E
I The coupon frequency is k = 2 (semi-annual) ) each coupon payment is cF/2

of
c
2
F

F
o
c
2
F o
c
2
F c
2
F
0 6m 1y 18m 2y

I The 2-year note maturing on December 31, 2022 has coupon rate c = 0.125% "

I On June 30 and December 31, 2021 and 2022, it pays $1000 ⇥ 0.00125/2 = $0.625
r
- - , r .

I In addition, on December 31, 2022, it also pays $1,000

I Most Treasury coupon rates are fixed. Treasury FRN and many corporate
bonds have floating-rate coupons, whose coupon payments are tied to a
reference variable rate (e.g., T-bills or LIBOR)
-

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.21

US Treasury Market

I Issuer: The US Treasury Department sells regularly a variety of obligations to

finance the government operations
I Bills
I Notes
I Bonds

I Lenders:
I The Federal Reserve ←

I Foreign entities a-

I Banks ←

I Mutual and pension funds insurance

- - ,

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.22

 US Treasury Securities Properties

Name Maturity Coupon Rate Principal

Treasury Bills 4, 13, 26, and 52 weeks
'
'
'
None Fixed

I I
'

Treasury Notes 2, 5, and 10 years Semi-annual, fixed Fixed

Treasury Bonds 30 years Semi-annual,= fixed Fixed
Treasury FRN 2 years Quarterly, floating
. . -
Fixed
→TIPS 5, 10, and 20 years Semi-annual, fixed CPI adjusted

FRN (floating rate notes) interest is computed as the sum of the latest 13-week
T-bill rate, which changes weekly, and a fixed spread.

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.23

US Treasury Market: Size
I Total value debt held by the public (mostly marketable securities):
⇠ $22.9 trillion
I
:
The country further owes the value of the intra-governmental holdings
⇠ $6.4 trillion
I Main holder: The Federal Reserve, $5,911.5B (Q3 2021)
-
-

I Foreign holders:
Country Oct 2021 Oct 2020
→ Japan 1320.4 1273.1
→ China, Mainland 1065.4 1054.0
United Kingdom 579.8 442.8
l Ireland 324.3 316.3

l
-

-
Luxembourg 314.3 266.2
-S Switzerland 291.8 255.5
→ Cayman Islands 257.7 221.5
Brazil 247.7 262.9
Taiwan 242.4 218.2
France 239.6 136.9
Hong Kong 233.4 226.6
N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.24
US Treasury Market: Market Structure

I The Treasury auctions securities in the primary market to

I Primary dealers (currently 24): NYFed website displays current list. These

÷
institutions, which have to bid, also trade directly with the Fed in secondary
markets, where they also act as market-makers
I Other security firms
I Individuals, via Treasury Direct
I Features of the primary market
I Weekly auctions  6m bills, at regular but longer intervals for other securities
I Number and amount o↵ered change over time with funding needs
I Some issues are “reopened”: additional amount of previously issued security auctioned
I 503 auctions, issued approximately $19.683 trillion in securities in 2020
I The price of the bond is $100 (par); it is the coupon (yield) one bids
I Securities are distributed to bidders, at the lowest market clearing yield in order:
1. Competitive bids (bidders specify the yield; maximum bid is 35% of amount o↵ered)
= bids (bidders accept market clearing yield; $10K  Bid  $5M)
2. Non-competitive

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.25

Primary Dealers
Amherst Pierpont Securities LLC
BMO Capital Markets Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Credit Suisse AG, New York Branch
Deutsche Bank Securities Inc.
HSBC Securities (USA) Inc.
J.P. Morgan Securities LLC
Morgan Stanley & Co. LLC
Nomura Securities International, Inc.
Societe Generale, New York Branch
UBS Securities LLC.
Source: https://www.newyorkfed.org/markets/primarydealers
N. Gârleanu – Fin 525
Bank of Nova Scotia, New York Agency
BNP Paribas Securities Corp.
BofA Securities, Inc.
Citigroup Global Markets Inc.
Daiwa Capital Markets America Inc.
Goldman Sachs & Co. LLC
Je↵eries LLC
Mizuho Securities USA LLC
NatWest Markets Securities Inc.
RBC Capital Markets, LLC
TD Securities (USA) LLC
Wells Fargo Securities, LLC
I. Fixed-Income Securities, p.26
US Treasury Market: Market Structure

I Once auctioned, securities are subsequently traded in an active secondary

market by
I Financial institutions (banks, mutual and pension funds, etc.)
I Retail investors
I Features of the secondary market:
I Over-the-counter (OTC), intermediated by dealers and brokers
I Inter-dealer trade accounts for the largest volume of trade (2 x retail)
I Typical trade size $10M–$100M
-
I Individual investors can participate through Treasury Direct or brokers

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.27

Treasury Market: Liquidity

I Similar bonds may have di↵erent liquidity levels

I The most recent issue of given maturity known as on-the-run; others are
-

o↵-the-run
I On-the-run, and to a certain extent first o↵-the-run, are more liquid than the
others
I Consequently these issues have a liquidity premium, which translates into an yield
that can be up to 10-20bp lower.
-

I Question: Can one buy o↵-the-run and short on-the-run to close position 6m later,
when all are o↵-the-run?

LTCM

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.28

Quoting and Day-Count Conventions: Treasury Bills
I 1, 3, and 6 month Bills are usually auctioned weekly; 1 year Bills monthly
I Bills are quoted as a discount
I For a bill maturing in n days, the discount d is defined as
360 100 P
÷
7*0
d= ⇥
. n ✓ 100 ◆
nd
) P = 100 ⇥
, 1 a
360

-1
I ±
Note the actual/360 convention — actual # days left vs 360 in full year
-

I E.g., a bill maturing on Aug 11 has 86 days to maturity on May 17

I If quoted discount is 0.260%, then its price is
→
✓ ◆
86 ⇥ 0.26/100
U
P = 100 ⇥ 1 - -

= 99.93789
360
I This is the price per $100 FV, so actual cost for 1 bill with FV $10,000, say, is
-

99.93789 ⇥ $10, 000/100 = $9, 993.789

Foo
- - - - - -

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.29

Treasury Bill Description

I
N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.30
Quoting and Day-Count Conventions: Treasury Bonds
I Notes and bonds: distinguish btw quoted (“clean”) and paid (“dirty”) prices

÷
I Dirty price includes accrued interest
I Accrued interest is computed using an actual/actual convention
I If t0 is the last coupon-payment date, t1 next coupon date, and t settlement
date (one day after trade), then:
€-1B ,

-0
c Actual # days between t0 and t
Accrued interest = F ⇥ ⇥
2 Actual # days between t0 and t1
I Example today -
Quoted
I Let t0 = Apr 30, t1 = Oct 31, t = May 17; c = 0.02625, P = 103.6172

*Éy
-

I Accrued interest is
•
(2.625/2) ⇥ (17/184) = 0.12126
I You pay (dirty price)

$(103.6172 + 0.1216) = $103.7385

I Beyond treasuries: there are a number of other day-count conventions, best

looked up when one needs them. E.g., Wikipedia
N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.31
Treasury Bond Description

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.32

Treasury FRN Description

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.33

 Roadmap

1. Universe of fixed-income securities

2. Bond basics and US Treasury market
3. Portfolios and No Arbitrage

4. Discount factors, rates, yields

5. The yield curve: construction and economic determinants

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.34

Basic Features of Investments
I A position in a security consists of a given number of shares
I Position can be
I Long: buy the security, number of shares is positive

:
I Short: borrow and sell security, number of shares is negative
I Collateral: frequently borrowing or shorting require providing a security or
cash as guarantee
I E.g., when you have $100 and want to buy $400 worth of a bond
I You give broker $100
I Broker buys $400 worth of bond, keeps custody of entire position: collateral
I You pay broker interest on $300
I E.g., when shorting a share costing $100
I You might give broker $50
I Broker borrows share for and sells it for $100
I Broker keeps $150 cash as collateral, pays you interest on it
I Repo (repurchase agreement):
I Sale of a security for cash
I Simultaneous agreement to buy it back next day (usually) at fixed price — equal
to original price plus interest at repo rate
I E↵ectively, entering a repo is borrowing against collateral; reverse repo is lending
N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.35
Positions and Portfolios

I Portfolio: collection of positions in various securities

I Portfolio weights: the proportions of portfolio value invested in di↵erent
securities
I Leverage: using borrowing to allow taking larger positions
I Example:
I Let P (2) = P (10) = $100 be Treasury note prices, and W = $5M your wealth
-

= of the 2y note, $1M of 10y note, and place $1M in money market,
-

I If you buy $3M -

then your portfolio weights are 60%, 20%, and 20% respectively
" " " '

z ¥ 5-

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.36

Positions and Portfolios

I Portfolio: collection of positions in various securities

I Portfolio weights: the proportions of portfolio value invested in di↵erent
securities
I Leverage: using borrowing to allow taking larger positions
I Example:
I Let P (2) = P (10) = $100 be Treasury note prices, and W = $5M your wealth
I If you buy $3M of the 2y note, $1M of 10y note, and place $1M in money market,
then your portfolio weights are 60%, 20%, and 20% respectively
I If instead you borrow $3M from your broker to purchase a $6M of the 2y note and
== -
$2M of 10y note, then
-

I Your portfolio weights are 6M/5M=120%, 2M/5M=40%, 3M/5M=–60%

•

P
-

i wi = I
-

I By construction, these weights (wi ) add up to 1: 1

I You are levered; your leverage is 3M/5M=60%
-

I
o
You have $5M equity, $8M assets, and $3M debt
-
-

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.36

Portfolio Price

I Trading prices in real markets:

I Buying and selling take place at di↵erent prices: bid and ask
I The bigger and faster the trade, the worse the price: “price-impact”
I For simplicity and clarity, we consider an idealized market
I Price (value) of portfolio: sum of prices of components
I Example: P1 = 98, P2 = 101. A portfolio (⇧) consisting of n1 = 5 shares of
security 1 and n2 = 15 shares of security 2 costs

P ⇧ = n 1 P1 + n 2 P 2
- -
- -

= 5 ⇥ 98 + 15 ⇥ 101 = 2005

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.37

Returns
I An investment return is a measure of profit relative to investment
I The gross return between dates t and T equals
-

↳ "

Rt,T =
Total value at T ←
"

holding period return

Price paid at t ←

I The net return between dates t and T equals

Total value at T Price paid at t
rt,T = Rt,T 1=
Price paid at t
I The value at T could be a payo↵ from a security, a sale price, or a combination
of both. For example:
I If bond costs Pt = 90 and pays 100 at maturity T , rt,T = 10/90 = 11.11%
-
-
- -

I If bond costs Pt = 90, pays coupon c = 2 in 6m, and then sells for PT = 95, then
-

95 + 2 90
rt,T = - -

= 7.78%
90
I Note that even if all cashflows of bond are known, selling before maturity
entails risk, because future price is risky (unknown in advance)
N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.38
No Arbitrage and Law of One Price

,g-
I Law of One Price: Two portfolios having the same payo↵s must have the same
price
I Otherwise, there is arbitrage: can make money with no risk of loss
I Buy cheaper portfolio and sell more expensive one ) positive cashflow
I Payo↵s from portfolio bought cancel out exactly the other ones
I Smart money (hedge funds, investment banks, etc.) would take advantage until
prices converged sufficiently
I Example:
I Security 1 pays X11 = 100 at time 1 and costs P1 = 98 now (time 0) lyn 2-Cb
F I
. .

Security 2 pays X22 = 100 at time 2 and costs P2 = 95 now Lyn 2-Cb
.

I
* Security 3 pays X31 = 2 at time 1 and X32 = 102 at time 2
. • a.ua
I Security 3 pays the same as a specific portfolios of securities 1 and 2
I Consequently, security 3 must cost
Sec. (i) Pi Xi1 Xi2
X31 X32
P3 = P1 + P2
{
1 98 100 0
X11 X22
2 95 0 100
2 102 ?
FV=lo2
= 98 + 95 = 98.86 13 2 102 ✗ in
100 100 •
•
^ teb 2
FV=2 n' tcsz
N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.39
 Roadmap

1. Universe of fixed-income securities

2. Bond basics and US Treasury market
3. Portfolios and No Arbitrage

4. Discount factors, rates, yields

5. The yield curve: construction and economic determinants

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.40

Present Value and Interest Rates

I $100 invested today (date t) at (annualized) rate r grows to $(1 + r)T t

100 in
ÑtM
=
year T retort
e.
g. , too → moms ? '
I $(1 + r)T t
100 is the future value of $100
- - -

=
÷.-
-
.

I Conversely, to have $100 at T , we must invest $100/(1 + r)T t

at t
I T t
$100/(1 + r) is the present value (PV) of $100
I Future and present values depend on the time horizon (T ) and interest rate
I The value $100 is just an example; notions apply to any amount
I We define

Z(t, T ) := 1/(1 + r)T t

= (1 + r) (T
=
t)

as the discount factor

I PV of $1 at T ) price of a zero coupon bond paying $1 at T
I It tells us how to discount future payments
I Exchange factor between future (T ) and current (t) money

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.41

Discount Factors across Maturities and Time

=
e-
-

→
,

Source: P. Veronesi, Fixed Income Securities

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.42

Discount Factors across Maturities and Time

:&
'

3m

Source: Federal Reserve

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.43

Review Examples

Present Value Rate Time Future Value

"
$1,000 3.25% 1.0 year(s) •
1,000×(1+0.0325)
"
$5,000 4%
1
4.0 year(s)
,
51000×(1+0.04)

Future Value Rate Time Present Value

$7,000 2.5% 3 71000 / ( 1.02513
'
7,000×1.025-3

Rate Time Discount Factor

-2°
2.25%
-
20
- f. 0225

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.44

Compounding: EAR vs APR

I Suppose you earn 2% interest every six months

I
-0
At the end of one year, $100 grows to $100 ⇥ (1 + 0.02)2 = $104.04

I We can express this interest rate in several ways

I 2% is the 6m (non annualized) rate
I 4.04% is e↵ective annual rate (EAR)
I As if all interest paid at the end of the year
I 4% (2%⇥2) is annual percentage rate (APR)
I With semi-annual compounding

I Annualized rates ease comparison across maturities and compounding

frequencies
I We may use either rate, as long as we are clear. We can convert via

1 + EAR = (1 + APR/2)2

( 0¥12
"
+

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.45

Compounding Frequency
I The notion of APR is tied to the frequency (k) with which interest accrues
I Examples of various market conventions
k Frequency Name Market
1 Annual EAR Eurobonds
2 Semi-annual Bond equivalent U.S. Treasuries
yield (BEY)
12 Monthly Monthly Mortgages, credit cards
365 Daily Overnight Fed funds
I General relation between EAR and APR at frequency k, denoted rk :
k
1 + EAR = (1 + rk /k)
- u

I As k grows without bounds, we obtain continuous compounding

1 + EAR = ercc
I Can compute PV (of 100, say) equivalently using any of these conventions
100 100 100
PV = T
= kT
= rcc T
(1 + EAR) (1 + rk /k) e
N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.46
Continuous Compounding

I Continuous compounding is abstraction: no market compounds continuously

I Numerically, given typical rate level, very close to overnight
I Continuous compounding can be very convenient analytically
I Some formulae are nicer and easier to interpret (e.g., forward rates)
I A whole class of models is written in continuous time and therefore rely directly
on this concept. E.g.,
I Black-Scholes-Merton for equities, commodities, foreign exchange, etc.
I Vasicek, Heath-Jarrow-Morton for fixed income

I We will frequently use continuous compounding for simplicity when making

the actual compounding frequency explicit is not central
I Typical notation: r (rather than rcc )

I Remember: Any e↵ective rate can be expressed at any compounding frequency

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.47

Example: APR=10%

Frequency k EAR
Annual 1 10.000%

-1¥
Semi-annual 2 10.250%
1+-1)
"
Quarterly 4 '"

Monthly 12 10.471%
increasing
÷
Weekly 52 10.507%

✓
Daily 365 10.516% " •
Hourly 8760 10.517%
Continuous 1 10.517%

Formulae:

EAR = (1 + rk /k)k 1
rcc
EAR = e 1

Note: The EAR increases with the compounding frequency for fixed APR

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.48

Example: EAR=10%

Frequency k APR
Annual 1 10.000%
"
Semi-annual 2 ① + 1)
.
2-
1) ✗ 2=-9.76 :
Quarterly 4 9.646
Monthly 12 9.569%
Weekly 52 9.540%
Daily 365 9.532%
Hourly 8760 9.531%

at
Continuous 1

Formulae:
⇣ ⌘
rk = k ⇥ (1 + EAR)1/k 1
rcc = log(1 + EAR)

Note: The APR decreases with the compounding frequency for fixed EAR

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.49

Loans
I Commercial loans are frequently structured to provide equal payments at a
given frequency
I The frequency is usually monthly
I This is same structure as an “annuity”
I Examples: mortgages, car and student loans
I PV of remaining payments on a loan is called loan balance
I I
Example: You take a $7,500 three-year loan
I 36 equal monthly payments
-

I Interest rate is 8.5% (APR, compounded monthly)

What is the monthly payment?
.

7500 =
PV ( G @ 1m) + PUG @ 2m ) +
. - -
+ PVCG
'
@ 364
e-
=i¥¥+¥yz+
. - +

G' ק?(1t° annuity tatoi

"
=

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.50

Loan Example (cont’d)

E!4+r5i= f- ( 1- Citrix =A(361

d
r=
00,0¥ Yv=36

=
31.68

7500=0×31.68 G-
3%-81237

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.51

Loan Example (cont’d)
36-6
I
µ
After you made 6 payments, what is the loan balance?

Pvc
remaining
30 payments )
=
237 ✗ A ( 3 e)
"
26.94
=
6,379

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.51

Interest Rates across Maturities and Time

:
÷:*
0

N. Source: Quandl
Gârleanu – Fin 525 I. Fixed-Income Securities, p.52
Term Structure of Interest Rates

I Interest rates across maturities: “term structure of interest rates”

I The comparable units makes the shape of the interest rate vs maturity graph
meaningful
I We can talk about
I Level: average level of IR across maturities
-

I Can be low or high

I Slope: di↵erence between long- and short-maturity rates
→
I Low (flat) or high (steep), positive or negative (“inverted” curve)
→ I Curvature: whether term structure steeper at low or high maturities
I Negative (e.g., dip in the middle of curve) or positive (e.g., hump)

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.53

Term Structure of Interest Rates

i r,

.is:p; Hislop .

A
j
Source: P. Veronesi, Fixed Income Securities

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.54

Prices vs Rates: Zero Coupon Bonds

I Zcb prices (or discount factors) contain exactly same information as rates
I Compute discount factors from rates:
1 k(T t)
Z(t, T ) = = (1 + rk (t, T )/k)
(1 + rk (t, T )/k)k(T t)
1
Z(t, T ) = r(t,T )(T t) = e r(t,T )(T t)
e
I Compute rates from discount factors:
⇣ 1
⌘
rk (t, T ) = k ⇥ Z(t, T ) k(T t) 1
1
r(t, T ) = log (Z(t, T ))
T t
I What to do for securities with multiple cashflows, e.g., coupon bonds?

N. Gârleanu – Fin 525 I. Fixed-Income Securities, p.55