2024 L1 FixedIncome

Last Revised: 06/02/2023
2024 Level 1 - Fixed Income
Learning Modules Page
Fixed-Income Instrument Features 2
Fixed-Income Cash Flows and Types 6
Fixed-Income Issuance and Trading 12
Fixed-Income Markets for Corporate Issuers 16
Fixed-Income Markets for Government Issuers 23
Fixed-Income Bond Valuation: Prices and Yields 27
Yield and Yield Spread Measures for Fixed-Rate Bonds 33
Yield and Yield Spread Measures for Floating-Rate Instruments 38
The Term Structure of Interest Rates: Spot, Par, and Forward Curves 43
Interest Rate Risk and Return 47
Yield-Based Bond Duration Measures and Properties 51
Yield-Based Bond Convexity and Portfolio Properties 55
Curve-Based and Empirical Fixed-Income Risk Measures 58
Credit Risk 62
Credit Analysis for Government Issuers 68
Credit Analysis for Corporate Issuers 73
Fixed-Income Securitization 77
Asset-Backed Security (ABS) Instrument and Market Features 81
Mortgage-Backed Security (MBS) Instrument and Market Features 87
This document should be used in conjunction with the corresponding learning modules in the 2024 Level 1 CFA® Program curriculum.
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1
Fixed-Income Instrument Features
a. describe the features of a fixed-income security
b. describe the contents of a bond indenture and contrast affirmative and

negative covenants
2
Fixed-Income Instrument Features

Page 1
Fixed-income ➞ debt such as loans and bonds

private agreements public securities
(borrower - lender) (many lenders, one borrower)
individuals banks investors corporation
corporations funds government
- all involve periodic interest payments plus principal

$ $ $ $ + FV - last payment
includes principal
investor 𝐜𝐨𝐮𝐩𝐨𝐧 𝐫𝐚𝐭𝐞 × 𝐅𝐕 (e.g. bullet bond)
lends ! 0
𝐦
periodicity
Bond Features/
government - national, local, supranational, quasi-gov’t.
Issuer
state, muni. agencies
private sector
- financial/non-financial
- SPE (e.g. ABS/MBS)
Page 2
Bond Features/
Maturity - date of final payment + principal repayment
tenor - time remaining to maturity
< 1 yr. to maturity at issuance - money market security
> 1 yr. to maturity at issuance - capital market security
perpetual bonds - no stated maturity (not very common)
Principal - par value, face value, amount repaid at maturity
- amortizing bond - some principal is repaid each payment
(e.g. mortgage, MBS)
Coupon Rate and Frequency
fixed - constant amount - monthly, quarterly, semi-annual, annual
floating - variable with some MRR - market reference rate
+
(FRN) spread - issuer specific (credit
constant over the life spread)
of the bond (higher quality ➞ lower spread)
3
Page 3
Coupon Rate and Frequency
zero - buy at a discount, mature at par (pure discount bond)
(ZCB)
Seniority - position in the capital structure (priority of claim on

assets)
Senior secured
Senior unsecured - pari passu - all sen. unsec. rank equally
Junior debt (subordinated)
Contingency Provisions - a clause that allows for an action if an
event or circumstance happen
- most common - calls, puts, convertibility (to equity)
Yield measures - current yield = annual coupon price
premium bonds price > par yield < coupon
discount bonds price < par yield > coupon
par bonds price = par yield = coupon
Page 4
Yield measures
yield to maturity - the bond’s IRR (mwrr) PMTs
- rate of return = YTM if: 𝐁𝐏𝟎 𝐁𝐏𝐓
1/ no default
𝐁𝐏
2/ held to maturity 1 𝐓4𝐁𝐏 5 - 1 = YTM
𝟎
3/ coupon reinvested at YTM rate
(if CFs are reinvested)
Yield curves - yields on all bonds with same features by

same issuer
typically upward sloping
government par curve
G-spread - a measure of credit risk
4
Page 5
Bond Indenture - legal contract
- contains: form of the bond, obligations of issuer, rights of
bondholders, sources of repayment
sovereign government - taxation, print currency
local/regional gov’t. - taxes, project cash flows
credit analysis corporate - operating cash flows for int./prin.
- evaluate OCF plus unsecured
value of collateral + pledge of specific assets
secured
ABS/MBS
tranche A senior
assets
loans ➞ CFs int. + prin. on tranche B
mortgages bonds
tranche C junior
Page 6
Bond Covenants
affirmative - typically impose no cost or restriction on operating
the business
- states what the issuer is required to do - typically
administrative
- pari passu clause - equal footing
- cross-default clause - a default on one is a default
on all
negative - what the issuer will not do
- limitations on liens (pledged assets)
- limitations on sales/leaseback (can’t sell the collateral)
- restrictions on issuance of debt more senior (negative
pledge clause)
- restriction on share buybacks/dividend/dividend increases
unless certain ratios are met (incurrence tests)
- limitations on additional debt
5
Fixed-Income Cash Flows and Types
a. describe common cash flow structures of fixed-income instruments and

contrast cash flow contingency provisions that benefit issuers and investors
b. describe how legal, regulatory, and tax considerations affect the issuance and
trading of fixed-income securities
6
Fixed-Income Cash Flows and Types

Page 1
Bullet bond - most common
- interest payments on coupon dates + principal at maturity
Fully amortizing bond - each payment is 𝒊 + 𝐏 (e.g. mortage)
5 yr., semi-annual, 3.2% issued at 300
e.g./ PV = -300 FV = 0 N = 10 𝐈#𝐘 = 1.6 CPT PMT = 32.70
Balance PMT 𝒊 𝐏
1. 300 32.70 4.8 27.90
2. 272.10 32.70 4.35 28.35 etc.
- credit risk declines over time as 𝐏 is repaid
- investors/lenders face higher reinvestment risk
Partially amortizing bond - each payment is 𝒊 + 𝐏, but not all 𝐏 is
repaid
- balloon payment at maturity
PV = -300 FV = 150 N = 10 𝐈#𝐘 = 1.6 CPT PMT = 18.75
Balance PMT 𝒊 𝐏
1. 300 18.75 4.80 13.95
2. 286.05 18.75 4.58 14.17 etc.
Page 2
e.g. mortgage Price = 500k
Loan = 400k 30 yr. FRM @ 3.50%
PV = -400,000 FV = 0 N = 12 × 30 = 360 𝐈# = 𝟑. 𝟓𝟎#
𝐘 𝟏𝟐 = . 𝟐𝟗𝟏𝟔
̇ CPT PMT = 1796.18
Sinking Funds - periodically retire a bond’s principal over time

Waterfall Structure
- 𝐢 paid to all classes of bonds
𝐏 flows to senior class first
7
Page 3
Variable Interest Debt - MRR + spread constant
less interest rate risk credit quality ↓
(i.e. price risk) since rate adjusts yield ↑ , price ↓
fixed rate - rates ↑, price ↓, coupon fixed
floating rate - rates ↑, price unch., coupon ↑
Step-up bonds - coupon rate steps up over time or is related to

same event
common credit quality ↓, coupon ↑ (less price risk)
with
e.g. credit-linked notes (tied to a credit rating)
- issuer may be able to issue at a lower yield initially
leveraged loans - loans to issuers of lower credit quality
PIK (payment in kind) bonds - payment of 𝒊 can be made by

increasing the principal
- will offer a higher yield
Page 4
Index-linked bonds - 𝒊 or 𝐏 linked to a specific index

e.g. inflation-linked (TIPS) most common
issued by gov’t.
- coupon is a real rate, 𝐏 adjusts by %∆CPI
e.g. 1000 @ 2% %∆CPI = 4% 1. 𝐢 = 20 FV = 1040

%∆CPI = 3% 2. 𝐢 = 20.80 FV = 1071.20
- called ‘capital-indexed’ ➞ protects the real value of 𝐏
- deflation won’t hurt however
max of par or inflation-adjusted amount
- ‘interest-indexed’ bonds ➞ commonly issued by companies
𝒊 = MRR + %∆CPI , fixed 𝐏
Zero coupon bonds - no 𝒊 , just 𝐏 ➞ purchased at discount
- all return is interest
8
Page 5
Zero coupon bonds
- common type ➞ Strips ➞ dealer buys capital market bonds
- sells each CF as a ZCB
- no reinvestment risk ➞ rate of return = YTM if held to maturity
Deferred coupon bonds - no 𝒊 for first few years, then higher 𝒊
thereafter
- typically issued at par, typically for construction projects
(do not generate CFs until
complete)
Page 6
Contingency Provisions
Callable bonds - issuer has the right to call all or part of the
bond prior to maturity
- the bond will have a higher yield vs. a non-callable bond
(straight)
- allows the issuer to refinance debt if interest rates fall
- calls are set at fixed prices at fixed times
103% 102% 101% 100%
issue first second last maturity

call call call
- if YTM > coupon (discount bond), call is OTM ➞ no value in

calling bond
- as YTM drops below coupon, price is capped at call price
- investor now faces call risk
9
Page 7
Callable bonds - may be a ‘make-whole’ call
- bonds called at a sov. bond YTM of similar maturity
Putable bonds - bondholder has the right to redeem the bond at
pre-determined prices on pre-determined dates
- typically at par
- issued at lower yields
- if YTM < coupon , put has no value
YTM > coupon , company faces put risk
Convertible bonds - convertible into equity at a conversion price/sh.
- will have a lower yield
𝐩𝐚𝐫 𝐯𝐚𝐥𝐮𝐞
4𝐜𝐨𝐧𝐯𝐞𝐫𝐬𝐢𝐨𝐧 𝐩𝐫𝐢𝐜𝐞 = conversion ratio
conversion value = conversion ratio × current share price

- if 𝐏𝟎 < con. price - bond trades like a bond
𝐏𝟎 > con. price - bond trades off the stock
Page 8
Convertible bonds
- often used by growth companies
- will also have a ‘forced conversion’ provision
- if 𝐏𝟎 > conv. price for a # of days, company calls
bonds at a lower price
Attached warrants (not embedded) - can trade separately
a right to buy stock at a predetermined price
Contingent convertible bond (CoCo) - typically issued by banks
e.g. if Tier 1 capital falls below a regulatory level,
CoCo s automatically convert to equity
- will have a higher yield
10
Page 9
Domestic bonds - issued in same country as company
US company issues a USD bond in the US
Foreign bond - issued in a different country than the issuer
US company issues a CAD bond in Canada
Euro bond - issued outside the jurisdiction of any single country,
usually unsecured, and can be denominated in any currency
- usually named for the currency they are denominated in
e.g. Euro-dollar , Euro-yen
US company issues EUR bonds, not registered in any
country
Global bond - issued in Euro bond market plus at least
one domestic market
- all 4 are subject to different legal, regulatory, and tax requirements
- the currency of issue has a stronger effect on price than where it

USD issued in Canada ➞ US yield curve matters is issued
Page 10
tax considerations
issuers - interest is tax-deductible
investors - taxable at marginal tax rate (interest)
- specific types of bonds may have some tax exempt qualities
i.e. cap-gains or interest exempt
e.g. UST - federal tax only
munis - tax exempt
- capital gains - may be a distinction between s.t./L.T. gains
ZCB - no coupon - but all discount amount is interest

- may be all taxable when received or
amortized each year
11
Fixed-Income Issuance and Trading
a. describe fixed-income market segments and their issuer and investor

participants
b. describe types of fixed-income indexes
c. compare primary and secondary fixed-income markets to equity markets
12
Fixed-Income Issuance and Trading

Page 1
Fixed Income markets can be
categorized along 3 dimensions
sov.
1/ issuer type (sector) corporate
issuers
2/ credit quality
corp. have many
SPE/SPV
3/ time to maturity fixed-income
instruments
- others ➞ geography, currency, ESG etc.
Credit Quality/ measured by credit

rating ➞ letter grade qualitative
measure of the ability to meet investors
debt obligations (captures both

POD and LGD) HY typically
probability loss given issued with
of default default 7-9 yr. mat.
Page 2
Credit Quality/
- both the issuer and the issues have ratings
same as senior unsecured
- 2 largest credit rating agencies ➞ Moody’s and S&P
- many institutional investors are restricted to instruments with
credit ratings and oftentimes some minimum
(must be rated) (IG only)
AAA, AA, A
BBB - or higher BBB, BBB -
fallen angels
HY - high yield ➞ speculative, junk ➞ BB+ or lower
sovereign government debt typically lowest risk in each market

- developed government bonds widely held for safety and income
- also a useful tool for central banks conducting monetary
policy
13
Page 3
Fixed Income Indexes/
- perform the same function as equity indexes
1/ track broad risk/return of different markets
2/ enable evaluation of market performance
3/ benchmarks for portfolios and investment managers
4/ form the basis for indexed investment strategies and products
differ: many more constituents than equity indexes bond funds
far more changes (issuance, maturity) rarely hold
- monthly rebalancing all bonds
market value of debt weighted - sampling
classified as aggregate indexes e.g. Bloomberg Barclay’s Global Agg.

(also have sub-indexes) (sov. gov’t., corporate, securitized, DM and EM)
sector, credit quality, time-to-maturity, etc...
HYG TLT
- all bonds are priced once a day to determine index value
Page 4
Primary FI markets/
- issuer sells a new bond to raise capital
- may be sold via public offering or private placement
for both
debut and may be underwritten non-underwritten
seasoned - underwriter and issuer agree unregistered
issuers on price, underwriter assumes small size or less well
risk of issuance known
- debut issuers typically replacing private debt with public debt
bonds are typically priced (i.e. yield) to sell at par

‘Re-opening of an existing bond’ - less common, a previous issue is added
to a current market price
IG issuance typically very quick, HY a longer process
typically brokered on a best efforts basis
- commission only
14
Page 5
Primary FI markets/
- for sovereign debt - typically sold by auction led by the
Treasury or Ministry of Finance
Secondary FI markets/
- mostly quote driven, OTC markets (i.e. dealer markets)
- some electronic trading (Treasury Direct)
- liquidity varies across segments (gov’t., IG, HY)
- bid-offer quoted in bps (more liquid = tighter)
- DM sov. gov’t. ‘on-the-run’ bonds are the most liquid
most recently issued
- IG - on-the-run of frequent issuers most liquid (dealers have
inventory)
- remaining ➞ very low liquidity
Distressed debt - bonds from issuers believed to be very close to, or in,
- trades well below par bankruptcy
- will trade until issuer liquidates or restructures
15
Fixed-Income Markets for Corporate Issuers
a. compare short-term funding alternatives available to corporations and

financial institutions
b. describe repurchase agreements (repos), their uses, and their benefits and
risks
c. contrast the long-term funding of investment-grade versus high-yield

corporate issuers
16
FI Markets for Corporate Issuers

Page 1
Short-term funding ➞ Non-financial/
Lines of credit
- uncommitted - banks can cancel at any time
- least reliable source of financing
up to a certain amount (credit line) for a maximum
period of time ( < 1 yr.)
floating rate + spread
no costs other than interest payments
- committed (regular) - a formal written commitment from the bank
- max term < 365 days - then must ‘rest the line’
- will involve a commitment fee on the full
or unused amount
- borrower does face renewal risk
- revolving credit agreements (revolvers)
- multi-year revolver agreements
- bank will add covenants (lender protections)
Page 2
Short-term funding ➞ Non-financial/
Secured loans - asset-backed loans (fixed assets, high-quality
receivables, marketable securities)
Factoring - selling AR - typically at a discount
- factor collects the AR
External, security-based:
Commercial paper ( ≤ 3 mos.) - issued by large, highly-rated companies
- unsecured notes to fund wc or as bridge financing
- typically rolled over (introduces rollover risk)
- usually requires a backup line of credit (committed)
➞ Financials/
Deposits - household/commercial (operational) deposits
- checking accounts, demand deposits that pay little to
no interest
- no duration or maturity, but they do have
a behavioral maturity (fee rebates, min. balances)
17
Page 3
Short-term funding ➞ Financials/
Savings deposits - non-transactional, usually a stated term
i.e. certificate of deposit (CD, term deposit)
< 1 yr. maturity, pays interest at maturity (add-on)
- non-negotiable CD ➞ 𝐏 + 𝐢 at maturity, penalty for
early withdrawal
- negotiable CD ➞ can be sold in the market
retail - small denomination ~ 1000+
institutional - large denomination ~ 100k
Interbank market - short term lending/borrowing among financial
institutions as either secured or unsecured
- overnight to 1 yr. @ MRR (interbank rate)
- banks hold funds with central bank - reserves
- excess reserves can be lent in the central bank
funds market
Page 4
Short-term funding ➞ Financials/
Interbank market
- lend/borrow at the central bank funds rate
upper bound - will lend at
- CB targets the rate
lower bound - will borrow at
- if a bank can’t borrow in the interbank market, they can
borrow from CB at the discount window
- collateral required, borrowing rate higher than CB funds
rate
- often invites greater oversight
Commercial paper - dominated by large financial institutions
- unsecured ( ~ 60% of issuance/annum.)
Short-term
ABCP - asset-backed loans
commercial paper Bank SPE ABCP
off balance sheet guarantee ➞ back-up credit facility
- less capital required for banks, investors get access to bank loan
returns
18
Page 5
Repurchase Agreements/
secured short-term funding source
- sale of a security with agreement to repurchase it
(sov. bonds usually)
- seller retains ownership of the

Security over the repo term
- gets the yield, buyer gets the repo
rate
- range from overnight to term repos
( > 1 day)
- repo may reference a group of securities
i.e. general (vs. specific) collateral
- seller pays the ‘general collateral’ repo

rate
- repos generally overcollateralized
Page 6
e.g./ 30-day repo, Security value $100M, 102% initial margin, repo rate = .25%
𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐩𝐫𝐢𝐜𝐞 𝟏𝟎𝟎𝐌
102% = 1.02 = X = 98,039,216
𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞 𝐩𝐫𝐢𝐜𝐞 𝐗
‘haircut’ = 𝟏𝟎𝟎𝐌 − 𝟗𝟖, 𝟎𝟑𝟗, 𝟐𝟏𝟔

= 1.96%
𝟏𝟎𝟎𝐌
Repurchase price = 98,039,216 × (1 + .0025#𝟑𝟎&𝟑𝟔𝟎') = 98,059,641

- if collateral value changes, margin may change
5 days later, collateral value = 103M.
amount due = 98,039,216 × (1 + .0025(𝟓&𝟑𝟔𝟎*) = 98,042,620
𝐗
102% = X = 100,003,472
𝟗𝟖, 𝟎𝟒𝟐, 𝟔𝟐𝟎
➞ overcollateralized by 2,996,527 ∴ release 2.996M in MV
variation or 𝟐, 𝟗𝟗𝟔, 𝟓𝟐𝟕

= 𝟐. 𝟗𝟏𝐌 𝐅𝐕
margin 𝟏. 𝟎𝟑
19
Page 7
- used for 3 specific purposes
1/ finance ownership of a security
2/ earn short-term income by lending funds on a secured basis
3/ borrow a security in order to short it (reverse repo)
e.g. buy a bond for 1000 with a yield of 3% and sell it in a repo for
980
repo rate 1%
term 30 days
yield amortized 3%
int. exp. = .867 ➞ min. default or liquidity risk
amortized gain = 𝟐. 𝟓𝟎.
𝐍𝐈𝐈 = 1.683
ROI = 𝟏. 𝟔𝟖𝟑1𝟐𝟎 = 8.415% for 30d (100.98% annualized)
- the longer the term, the higher the repo rate
- the lower the collateral quality/liquidity - the higher the repo rate
Page 8
Repurchase Agreements/ - short a security

1) borrow security (reverse repo) - typically very specific securities
(called specials or ‘on special’)
- negative repo rates typically - sec. buyer pays interest
2) sell security - get cash (earn cash rate)
3) buy security back (hopefully at a lower price)
4) return security - get cash back less reverse repo rate
- repos also used by central banks to affect the money supply
- repo rates are affected by
1/ money market interest rates
2/ collateral quality
3/ repo term
4/ collateral uniqueness - more unique, lower the repo rate
5/ collateral delivery - higher rates if collateral is not delivered
20
Page 9
Risks/ Default risk - counterparty may not repurchase
Collateral risk - with low quality collateral
Margining risk - counterparty may not meet margin calls if
collateral drops in value
Legal risk
Netting/settlement risk - money and collateral actually transfer
- risks can be reduced by using a triparty repo
a heavy reliance on the repo market

can create rollover and liquidity risks
under adverse market conditions
Page 10
Long-term corporate debt/ more stable funding

higher yields over time
= maturity premium
wider spreads at longer maturities
(more credit risk)
OAS
higher cost
debt but
more stable
lower cost but rollover risk ∴ less stable
funding
ability rate
uncertainty
21
Page 11
HY
IG spread
spread
- more concern about
default
𝐫𝐟 𝐫𝐟
more concern
about credit
migration
IG - relatively standardized, often sen. unsecured

- laddered debt maturity schedules (reduces rollover risk)
- typically > 15 yrs. at issuance
- can issue across the economic cycle, so can be interest rate
strategic
HY - < 10 yrs., lower overall issuance vs. IG
- difficult to issue in some economic environments, so must be
timing strategic ➞ interest rate taker
22
Fixed-Income Markets for Government Issuers
a. describe funding choices by sovereign and non-sovereign governments,

quasi-government entities, and supranational agencies
b. contrast the issuance and trading of government and corporate fixed-income

instruments
23
FI Markets for Government Issuers

Page 1
DM - developed market issuers
- strong, stable, well-developed domestic economy
- stable and transparent fiscal policy
EM - emerging market issuers
- higher growth but less stable and less well-diversified economies
- typically a dominant domestic industry (usually commodity-based)
- many more state-owned or state controlled enterprises
- bonds possibly denominated in a ‘restricted’ domestic currency
(limited convertibility due to illiquidity)
issued in domestic currency issued in a major foreign currency
- typically held by domestic (USD, EUR)
investors - external debt ➞ held by foreigners
- or debt from IMF/World Bank
- a nation’s fiscal policy determines the level of sovereign debt
required
Page 2
composition of debt
Short-term (1 - 12 months) T-Bills (ZCB)
medium term - long-term Notes, Bonds - fixed rate generally
- limited issuance of FRNs, TIPS
gov’t. guarantees - gov’t. agency debt (Ginnie Mae) - agency MBS
Ricardian equivalence
IF:/ taxpayers smooth consumption (i.e. save expected future taxes)
taxpayers form rational expectations that a tax cut today = higher
future taxes
capital markets are perfect with no transaction costs
taxpayers are altruistic on an intergenerational basis (i.e. pass on
tax savings to descendants)
then:/ taxpayer expects gov’t. debt to be offset by higher future taxes,

then a sov. gov’t. should be indifferent between collecting tax
today or raising debt of any maturity
24
Page 3
then:/ - governments should fund themselves with the shortest
possible maturity to minimize borrowing costs
(low rates due to liquidity premium and lack
But/ Conditions do not hold of maturity premium)
∴ debt maturity terms matter
- longer maturity = higher borrowing costs but greater fiscal
stability
Benefits of a maturity spectrum/
establishment of a 𝐫𝐟 benchmark for all other debt
- gov’t. issues benchmark securities (i.e. 2 yr., 5 yr., 10 yr., 30 yr.)
- increases market efficiency and transparency
use in managing and hedging interest rate risk
- bonds to hedge liability interest rate risk
- futures to hedge asset interest rate risk
use as collateral
use in monetary policy and forex reserves
Page 4
issuance of gov’t. debt usually by public auction

- investors submit competitive and non-competitive bids
yield and gets yield determined
amount at auction
Single price auction: highest yield (lowest price)
bids ranked
issue filled - ‘cut off’
lowest yield - all bond sold at this
multiple price
price
- everybody pays their bid
- all non-competitive bids
filled at this price
- bidders are mostly ‘primary dealers’ - must participate

- individual investors can use Treasury Direct to participate
- trade in secondary markets, either OTC (dealers) or exchange-traded
- on-the-run ➞ most recent issue - used as a benchmark yield
(closest to par)
25
Page 5
off-the-run - previous issues ➞ mostly owned by buy-and-hold investors

- less liquid, slightly higher yield
Treasuries have a number of ‘non-economic’ buyers
price insensitive
central banks - reserves, monetary policy
banks, insurance companies - regulatory requirement
(LOS 1)
government agencies - quasi-government entities
- have their own cash flows but also a
government guarantee
local/regional (state, provincial, municipal) - issue debt for general
purposes or a specific project general
obligation bonds
revenue bonds
- repaid by tax
- repaid by project’s
receipts
revenue stream
Page 6
Supranational Organizations e.g. IMF, World Bank

- typically provide financing to emerging economies
fund lend
members org. EM
- backup
finance issue
bonds
26
Fixed-Income Bond Valuation: Prices and Yields
a. calculate a bond’s price given a yield-to-maturity on or between coupon dates
b. identify the relationships among a bond’s prices, coupon rate, maturity, and
yield-to-maturity
c. describe matrix pricing
27
FI Bond Valuation: Prices and Yields

Page 1
market discount rate ➞ required yield ➞ required rate of return
(mdr)
𝐏𝐌𝐓𝟏 𝐏𝐌𝐓𝟐 𝐏𝐌𝐓𝐍 + 𝐅𝐕
𝐏𝐕 = + +⋯ +
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝐍
discount rate or yield
𝐍
𝐏𝐌𝐓𝐢 (IRR)
=; + 𝐅𝐕1(𝟏
(𝟏 + 𝐫)𝐢 + 𝐫)𝐍
𝐢%𝟏
e.g./ 3.2% 5-yr. semi at par ➞ market discount rate = coupon rate
- if market discount rate = 2.4%

N = 10 𝐈# = 1.2 PMT = 1.6 FV = 100 CPT PV = -103.75
𝐘
mdr < coupon ➞ premium bond
- if mdr = 4% N = 10 𝐈# = 2
𝐘 PMT = 1.6 FV = 100 CPT PV = -96.41
mdr > coupon ➞ discount bond
in Excel: = PV(rate, n per, pmt, FV, type)
𝐈# 0 = end - most common
𝐘 N PMT FV
1 = beg.
Page 2
yield-to-maturity (YTM)
- given 𝐏𝟎 , can always calculate YTM (IRR)
➞ 3.2% 5 yr. semi @ 108.15
N = 10 PV = -108.15 FV = 100 PMT = 1.6 CPT 𝐈#𝐘 = .7509
× 2 = 1.5019
excel: = YIELD(settlement, maturity, rate, pr, redemption, frequency, [basis]
DATE(YR, mo., d.) PMT PV FV PMTs/yr. day count

convention
ytm typically > 0
0 = 30/360
- may be 0 or < 0 if rates = 0 or < 0 respectively
typically sov. bonds e.g. ZCB issued at premium
ytm(ZCB) :
𝟏#
PV = 𝐅𝐕1(𝟏 + 𝐫)𝐍 1 + r = 8𝐅𝐕1𝐏𝐕9 𝐍
e.g./ 5 yr. ZCB @ 100.763
𝟏# 𝟏#
PV(𝟏 + 𝐫)𝐍 = FV r = 8𝐅𝐕1𝐏𝐕9 𝐍
-1 r = B𝟏𝟎𝟎#𝟏𝟎𝟎. 𝟕𝟔𝟑C 𝟓
-1
(𝟏 + 𝐫)𝐍 = 𝐅𝐕4𝐏𝐕 = - .15%
28
Page 3
when a bond is priced between coupon dates, it is quoted as
a flat price ➞ 𝐏𝐕 𝐟𝐥𝐚𝐭
- also has AI (accrued interest)
𝐏𝐕 𝐟𝐮𝐥𝐥 = 𝐏𝐕 𝐟𝐥𝐚𝐭 + 𝐀𝐈
dirty price quoted or clean price
- paid on trade settlement date
AI = 𝐭/𝐓 × PMT quoting flat price avoids volatility

associated with just the
𝐭 = days since last coupon (settlement date passage of time
- coupon date)
𝐓 = days between coupons
Day count convention ➞ 𝟑𝟎1𝟑𝟔𝟎 corporate bonds

𝐚𝐜𝐭1 government bonds
𝐚𝐜𝐭
Page 4
e.g./ 4.375% semi , coupon dates 15th of May/Nov.
1/ act/act AI for Jun. 27 settlement

𝐭 = 16 + 27 = 43 T = 16 + 30 + 31 + 31 + 30 + 31 + 15 = 184
M J M J J A S O N
AI = D𝟒𝟑4𝟏𝟖𝟒H × 1𝟒. 𝟑𝟕𝟓4𝟐5 = .5112/100 of par
2/ 30/360 𝐭 = 15 + 27 = 42 AI = B𝟒𝟐#𝟏𝟖𝟎C × D𝟒. 𝟑𝟕𝟓#𝟐E = .5104/100 of par

M J
➞ algebra: 𝟖𝟐1 = 𝟏
𝟖𝟒
𝟖𝟒,𝟐
𝐏𝐌𝐓𝟏 𝐏𝐌𝐓𝟐 𝐏𝐌𝐓𝐍 + 𝐅𝐕 𝐭
𝐏𝐕 𝐟𝐮𝐥𝐥 =1 + + ⋯+ : (𝟏 + 𝐫) *𝐓
(𝟏 + 𝐫) (𝟏 + 𝐫) 𝟐 (𝟏 + 𝐫)𝐍

= 𝟏+𝐭*
+ 𝟐+𝐭*
+ ⋯+ 𝐍+𝐭*
(𝟏 + 𝐫) 𝐓 (𝟏 + 𝐫) 𝐓 (𝟏 + 𝐫) 𝐓
29
Page 5
calculate PV here (N = remaining PMTs)
PMT PMT
𝐭
- then × (𝟏 + 𝐫) *𝐓 to get 𝐏𝐕 𝐟𝐮𝐥𝐥 then 𝐏𝐕 𝐟𝐮𝐥𝐥 - AI = 𝐏𝐕 𝐟𝐥𝐚𝐭
e.g./ 3.2% 5-yr. semi @ 100 , 𝟑𝟎#𝟑𝟔𝟎 ➞ mdr = 4%

- 𝐏𝐕 𝐟𝐥𝐚𝐭 and 𝐏𝐕 𝐟𝐮𝐥𝐥 90 days after first coupon date
𝐏𝐕 𝐭𝐞𝐦𝐩 ➞ N = 9, FV = 100, 𝐈#𝐘 = 2, PMT = 1.6 CPT PV = -96.735
𝐏𝐕 𝐟𝐮𝐥𝐥 = 96.375 × (𝟏. 𝟎𝟐)𝟗𝟎/𝟏𝟖𝟎 = 97.698
𝐏𝐕 𝐟𝐥𝐚𝐭 = 97.698 - (𝟏. 𝟔𝟎)B𝟗𝟎#𝟏𝟖𝟎C
= 96.898
Page 6
Coupon effect/
- lower coupon bonds ➞ higher proportion of total cash flows
occur at maturity
∴ higher discount rate ➞ lower PV than if coupon were higher
e.g. 30 yr. ZCB vs. 30 yr., 4.625% annual bond
if YTM = 4.625% PV = 25.759 PV = 100

-24.83% -14.34%
YTM ↑ 100 bps +33.39% PV = 19.364 +18.11%
PV = 85.665
YTM ↓ 100 bps PV = 34.361 PV = 118.107
Maturity effect/ - longer the tenor of the bond, the greater the
%∆PV for a ∆yield
(exception - low yield, long-term bonds at a discount)
30
Page 7
Constant yield-price trajectory/
pr.
- bond prices change with the passage of time
- premium or discount bonds are ‘pulled’ to par
disc.
- holding all else constant
Convexity effect/
%∆PV for a - ∆y > %∆PV for a + ∆y
P
inverse relationship
+ ∆y ➞ - ∆P
- ∆y ➞ + ∆P
- ∆y + ∆y 𝐲
Page 8
Matrix pricing/ - for bonds with no current market price

- illiquid or not yet issued
e.g. 3 yr., 4% semi corporate not actively traded
1/ Identify comparable bonds ➞ time to maturity, credit rating
2/ calculate YTM for each, and avg. YTM by maturity
3/ use linear interpolation
4/ use estimate YTM to calculate price
2 yr.
➞ avg. YTM = 3.8035
➞ 3 yr. ➞ 3.93183 3 yrs.
➞ avg. YTM = 4.1885

5 yr.
N=6 𝐈# = 1.965915 PMT = 2 FV = 100 (4.1885 - 3.8035)/3 = .12833

𝐘
CPT PV = - 100.191
31
Page 9
- linear interpolation can also be used to estimate required
yield spread (over benchmark rate)
e.g. 5 yr. bond yield for a new corporate issue?
- company has:
4 y, 3% annual at 102.40 (N = 4, PMT = 3, FV = 100, PV = -102.40)
CPT 𝐈#𝐘 = 2.364%
- no 4 yr. gov’t. bonds 3 yr. @ .75% 4 yr. = (.75% + 1.45%)/2 = 1.1%

5 yr. @ 1.45%
∴ required spread = 2.364% - 1.1% = 1.264%
yield spread
5 yr. yield = 1.45% + 1.264% = 2.714%
32
Yield and Yield Spread Measures for Fixed-Rate Bonds
a. calculate annual yield on a bond for varying compounding periods in a year
b. compare, calculate, and interpret yield and yield spread measures for fixed-
rate bonds
33
Yield & Spread Measures: Fixed Rate Bonds

Page 1
- yield measures (capital market securities) stated as annualized
and compounded
- depends on periodicity (# of interest payments/yr.)
e.g./ 5% stated annual rate
annual 1.05 5%
effective
semi-annual (𝟏. 𝟎𝟐𝟓) 𝟐
= 1.050625 5.0625% annual
quarterly (𝟏. 𝟎𝟏𝟐𝟓) 𝟒
= 1.050945 5.0945% yield
𝟏𝟐
monthly ̇
8𝟏. 𝟎𝟎𝟒𝟏𝟔9 = 1.051162 5.1162% (EAY)
continuous 𝐞.𝟎𝟓 = 1.051271 5.1271%
ZCB - no coupon, so periodicity is arbitrary

e.g. 5 yr. ZCB @ 80 B𝐫#𝟐C
annual 80 = 100/(𝟏 + 𝐫)𝟓 r = 4.564% (𝟏. 𝟎𝟐𝟓𝟔𝟓)𝟐 - 1
𝟏𝟎
semi-annual 800 = 100/B𝟏 + 𝐫#𝟐C r = 4.513% - yield per
quarterly 80 = 100/B𝟏 + 𝐫#𝟒C
𝟐𝟎
r = 4.4879% semi-annual period × 2
𝟔𝟎 (semi-annual bond basis
monthly 80 = 100/B𝟏 + 𝐫#𝟏𝟐C r = 4.4712%
yield or bond equivalent
continuous 80 = 100𝐞(𝐫𝐓 r = 4.4629% yield)
Page 2
- comparing periodicities:
𝐀𝐏𝐑 𝐦 𝐦 𝐀𝐏𝐑 𝐧 𝐧
E𝟏 + I = E𝟏 + I
𝐦 𝐧
e.g. 3.582% semi-annual bond basis
quarterly: . 𝟎𝟑𝟓𝟖𝟐 𝟐 𝐀𝐏𝐑 𝟒 𝟒
E𝟏 + I = E𝟏 + I
𝟐 𝟒
𝟏*
<(𝟏. 𝟎𝟑𝟔𝟏𝟒𝟏) 𝟒 − 𝟏C × 𝟒 = 𝐀𝐏𝐑 𝟒 = 𝟑. 𝟓𝟔𝟔%
𝟏*
monthly <(𝟏. 𝟎𝟑𝟔𝟏𝟒𝟏) 𝟏𝟐 − 𝟏C × 𝟏𝟐 = 𝐀𝐏𝐑 𝟏𝟐 = 𝟑. 𝟓𝟓𝟓𝟔%
compounding more frequently
3.582% ➞ 3.566% ➞ 3.5556% at a lower rate corresponds to
(2) (4) (12)
less frequently at a higher rate
e.g./ 20 yr. ZCB @ 69.43 vs. 20 yr. 4% semi @ 101.99

69.43 = 𝟏𝟎𝟎. N = 40 PMT = 2 PV = -101.99 FV = 100
𝟒𝟎
*𝟏 + 𝐫#𝟐- 𝐈# × 2 = 1.928
𝐘
r = 1.833
34
Page 3
- negative yields 5 yr. ZCB @ 103.72
𝟏#
annual B𝟏𝟎𝟎#𝟏𝟎𝟑. 𝟕𝟐C 𝟓
- 1 = -.7278%
𝟏#
semi IB𝟏𝟎𝟎#𝟏𝟎𝟑. 𝟕𝟐C 𝟏𝟎
− 𝟏K × 2 = -.7291%
𝟏#
monthly IB𝟏𝟎𝟎#𝟏𝟎𝟑. 𝟕𝟐C 𝟔𝟎
− 𝟏K × 12 = -.7303%
Street convention - yield quoted assuming payments are made

on scheduled dates (does not account for weekends
and holidays)
true yield - uses actual payment dates
- never higher than street convention since weekends and
holidays delay time to payment
government equivalent yield - restating a 𝟑𝟎1𝟑𝟔𝟎 as 𝐚𝐜𝐭1𝐚𝐜𝐭

𝐘𝐢𝐞𝐥𝐝𝟑𝟎* × 𝟑𝟔𝟓#𝟑𝟔𝟎
𝟑𝟔𝟎
Page 4
Simple yield = 𝐜𝐨𝐮𝐩𝐨𝐧 𝐩𝐚𝐲𝐦𝐞𝐧𝐭 + 𝐬𝐭𝐫𝐚𝐢𝐠𝐡𝐭 𝐥𝐢𝐧𝐞 𝐚𝐦𝐨𝐫𝐭. 𝐨𝐟 𝐩𝐫./𝐝𝐢𝐬𝐜.

𝐏𝐕 𝐟𝐥𝐚𝐭
(most common with Japanese government bonds)
Bonds with embedded options - calculate yield to call (first, second...)

e.g. 6.5% 7 yr. semi @ 106.25
call schedule
end of: yield to first call
1. 103.25 yr. 3 N= 6 FV = 103.25 PMT = 3.25 PV = -106.25 5.1496%

2. 102.50 yr. 4 N= 8 FV = 102.50 yield to 5.2472%
3. 101.75 yr. 5 N = 10 FV = 101.75 second call 5.3128%
4. 101 yr. 6 N = 12 FV = 101 5.3622%
100 yr. 7 N = 14 FV = 100 5.3736%
- lowest is called yield-to-worst (first call) ytm
- more precise way uses an option pricing model to get an option

adjusted price
35
Page 5
microeconomic factors
- issuer and the bond
In bps itself
can affect credit risk as
well
macroeconomic factors
- general economic growth,
business cycle, fiscal and
monetary policy
varies across financial markets

- fixed rate bonds often use gov’t. benchmark security (the most
recently issued ‘on the run’ security) ➞ G-spread
- floating - typically an interbank rate (e.g. SOFR)
Page 6
e.g./ 24 yr. 5.25% semi 𝟑𝟎&
𝟑𝟔𝟎 @ 123.50
issuer curve
20 yr. UST 2%
30 yr. UST 2.25% YTM
N = 48
(. 𝟎𝟐𝟐𝟓 − . 𝟎𝟐)
× 𝟒 = .𝟏 PMT = 2.625
𝟏𝟎
PV = -123.50
benchmark curve 2% + .1 = 2.1% FV = 100
(gov’t. or swap curve)
*𝐈#𝐘 × 𝟐- = 3.756%
20 24 30
G-spread = 3.756% - 2.1% = 165.5 bps
I-spread: same method but using swap rates (interbank rates)

- same currency, same tenor
Z-spread - zero volatility spread - constant spread over each spot rate
𝐏𝐕 = + + ⋯+
(𝟏 + 𝐳𝟏 + 𝐙) (𝟏 + 𝐳𝟐 + 𝐙)𝟐 (𝟏 + 𝐳𝐍 + 𝐙)
spot rates - derived from par curve
36
Page 7
OAS - option adjusted spread (non zero-volatility)
- requires a pricing model + estimate of interest rate volatility
OAS = Z spread + option value in bps (putable bond ➞ long the put)
callable bond ➞ short the call
z-spread - option value in bps
37
Yield and Yield Spread Measures for Floating-Rate Instruments
a. calculate and interpret yield spread measures for floating-rate instruments
b. calculate and interpret yield measures for money market instruments
38
Yield & Spread Measures: Floating Rate Bonds

Page 1
⇒ Yield Measures
1/ Floating rate instruments
- floating rate bonds, bank loans ➞ reference rate is usually a

short-term money market rate (SOFR)
- typically stated as MRR + spread

(1, 3, 6 months) quoted margin
- determined at beginning of the period, paid at the end

(in arrears)
Fixed Coupon Stable price
variable variable
price coupon
Page 2
⇒ Yield Measures/
1/ Floating rate bonds - common day count conventions
𝐚𝐜𝐭.. 𝐚𝐜𝐭..
𝟑𝟔𝟓 𝟑𝟔𝟎
yield spread over the reference rate ➞ quoted margin ➞ credit related
required margin ➞ spread required by investors to ➞ may even be
reflect changes in credit quality negative (sub-Libor)
- changes usually come from changes in the issuer’s credit

risk
∴ FRN with quoted margin = 50 bps with no changes in
credit risk, required margin = 50bps
PMT PMT premium between PMT dates for a
PV = 100 PV = 100
PV change in the reference
discount rate ➞ but PV pulled to
QM - quoted margin par as PMT date nears
DM - discount margin if QM = DM ➞ PV = 100 on reset date

QM > DM ➞ PV > 100 and QM < DM ➞ PV < 100
39
Page 3
⇒ Yield Measures/
1/ Floating rate bonds
(𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕
+ 𝐅𝐕
𝐏𝐕 = 𝐦 + 𝐦 + ⋯ + 𝐦
𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝟐
𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝐍
C𝟏 + F C𝟏 + 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌F C𝟏 + F
𝐦 𝐦 𝐦
e.g./ 2 yr. FRN, pays 6-mos. Libor + 50 bps, required spread = 40 bps
1.25%
Index = .0125
N= 4
QM = .005
DM = .004 PMT = (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 = (. 𝟎𝟏𝟐𝟓 + . 𝟎𝟎𝟓) × 𝟏𝟎𝟎 = . 𝟎𝟏𝟕𝟓 = . 𝟖𝟕𝟓
𝐦 𝟐 𝟐
𝐈4 = 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 . 𝟎𝟏𝟐𝟓 + . 𝟎𝟎𝟒 . 𝟎𝟏𝟔𝟓
𝐘 = = = . 𝟖𝟐𝟓%
𝐦 𝟐 𝟐
FV = 100
CPT PV = 100.196 QM > DM ∴ PV > 100
Page 4
⇒ Yield Measures/
1/ Floating rate bonds
e.g./ 5 yr. FRN, pays 3-mos. Libor, QM = 75 bps, PV = 95.50 (DM = ?)
1.10%
N = 20, FV = 100, PV = -95.50, PMT = !𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌0 × 𝐏𝐕 = 𝟏. 𝟖𝟓% × 𝟏𝟎𝟎 = . 𝟒𝟔𝟐𝟓
𝟒 𝟒
CPT 𝐈1𝐘 = .7045% ➞ (.007045 × 4) - .0110 = DM
DM = 171.8 bps
e.g./ 4 yr. FRN pays 3-mos. Euribor + 125 bps @ 98 (DM = ?)
N = 16 2%
PMT = 𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌 × 𝐏𝐕 = (. 𝟎𝟐 + . 𝟎𝟏𝟐𝟓) × 𝟏𝟎𝟎 = . 𝟖𝟏𝟐𝟓
FV = 100 𝐦 𝟒
CPT 𝐈#𝐘 = .009478 ⇒ (.009478 × 4) - Index = DM
PMT = .8125
PV = -98 = .017912
or/ 179.12 bps
40
Page 5
⇒ Yield Measures/
1/ Floating rate bonds assumes MRR is the same
for all cash flows
Z-DM - a constant DM added to each spot rate
forward rates e.g. 𝐟𝟑,𝟑 , 𝐟𝟔,𝟑 , 𝐟𝟗,𝟑 , 𝐟𝟏𝟐,𝟑 ...
(𝐌𝐑𝐑 + 𝐐𝐌) × 𝐅𝐕 (𝐟𝐌𝐑𝐑 + 𝐐𝐌) × 𝐅𝐕 (𝐟𝐌𝐑𝐑 + 𝐐𝐌) × 𝐅𝐕

+ 𝐏𝐕
𝐏𝐕 = 𝐦 + 𝐦 + ⋯+ 𝐦
-
𝐙 + 𝐙 𝐃𝐌
1𝟏 + 𝟏 5 𝐙𝟐 + 𝐙-𝐃𝐌 𝟐
𝐙𝐧 + 𝐙-𝐃𝐌 𝐍𝐦
𝐦 1𝟏 + 5 1𝟏 + 5
𝐦 𝐦
spot rates constant amount

and not MRR added to each spot rate
Page 6
⇒ Yield Measures/
2/ Money market instruments
annualized, but not compounded ⇒ instead
rates of return are stated on a simple interest basis
either discount rates or add-on rates
(T-bills, CP, BA) (CDs, repos)
Discount rates interest

𝐝𝐚𝐲𝐬 𝐲𝐫. 𝐅𝐕 − 𝐏𝐕 earned
PV = FV × I𝟏 − × 𝐃𝐑O ⇒ 𝐃𝐑 = I OI O
𝐲𝐫. 𝐝𝐚𝐲𝐬 𝐅𝐕
91-day T-bill, $10M, DR = 2.25% periodicity FV, not PV
360-day yr. ∴ DR will
𝐏𝐕 = $𝟏𝟎𝐌 × D𝟏 − 𝟗𝟏4𝟑𝟔𝟎 × . 𝟎𝟐𝟐𝟓H understate the rate of
return to the investor and
= $𝟗, 𝟗𝟒𝟑, 𝟏𝟐𝟓
the cost of funds to the
borrower
41
Page 7
⇒ Yield Measures/
Add-on rates PV = 𝐅𝐕
𝐝𝐚𝐲𝐬1 ⇒ AOR = ! 𝐲𝐫. 0 !𝐅𝐕 − 𝐏𝐕0
Q𝟏 + 𝐲𝐫. × 𝐀𝐎𝐑T 𝐝𝐚𝐲𝐬 𝐏𝐕
e.g./ 180-day BA, AOR = 4.38, 365-day yr., $10M periodicity 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐞𝐚𝐫𝐧𝐞𝐝
𝐩𝐫𝐢𝐜𝐞 𝐩𝐚𝐢𝐝
FV = PV(1 + 𝐝𝐚𝐲𝐬#𝐲𝐫. × AOR)
= $10M(1 + 𝟏𝟖𝟎#𝟑𝟔𝟓 × .0438) = $10,216,000
Note: FV = PV(𝟏 + 𝐫)𝐧 ➞ compounded interest

FV = PVQ𝟏 + 𝐝𝐚𝐲𝐬1𝐲𝐫. 𝐫T ➞ simple interest (money market yields)
➞ Sell after 45 days when AOR = 4.17%

𝟏𝟎, 𝟐𝟏𝟔, 𝟎𝟎𝟎
𝐏𝐕 = = $𝟏𝟎, 𝟎𝟔𝟎, 𝟖𝟐𝟗 ⇒ implies AOR = M𝟑𝟔𝟓N M𝟏𝟎, 𝟎𝟔𝟎, 𝟖𝟐𝟗 − 𝟏𝟎N
Q𝟏 + 𝟏𝟑𝟓1𝟑𝟔𝟓 ×. 𝟎𝟒𝟏𝟕T 𝟒𝟓 𝟏𝟎
= 4.934%
Page 8
⇒ Yield Measures/ ⇒ DR vs. AOR
⇒ 360 vs. 365
- convert all to AOR with 365d to compare:
e.g./ 90-day CP, DR = 5.76%, 360-day yr. vs. 90-day CD, AOR = 5.9%, 365d/yr.
PV = 100 × (1 - 𝟗𝟎#𝟑𝟔𝟎 × .0576) = 98.56
𝟏𝟎𝟎 − 𝟗𝟖. 𝟓𝟔
AOR = Q𝟑𝟔𝟓1 T E I = . 𝟎𝟓𝟗𝟐𝟓 vs. 5.9%
𝟗𝟎 𝟗𝟖. 𝟓𝟔
BEY - bond equivalent yield ➞ AOR for 365d.
- all 180 day A. PV = 100 × (1 - 𝟏𝟖𝟎#𝟑𝟔𝟎 × .0433) = 97.835
𝟏𝟎𝟎 − 𝟗𝟕. 𝟖𝟑𝟓
A - DR = 4.33, 360d AOR = D𝟑𝟔𝟓#𝟏𝟖𝟎E M N = 𝟒. 𝟒𝟖𝟕%
𝟗𝟕. 𝟖𝟑𝟓
B - DR = 4.36, 365d B. PV = 100 × (1 - 𝟏𝟖𝟎#𝟑𝟔𝟓 × .0436) = 97.84986
𝟏𝟎𝟎 − 𝟗𝟕. 𝟖𝟒𝟗𝟖𝟔
C - AOR = 4.35, 360d AOR = D𝟑𝟔𝟓#𝟏𝟖𝟎E M N = 𝟒. 𝟒𝟓𝟔%
𝟗𝟕. 𝟖𝟒𝟗𝟖𝟔
D - AOR = 4.45, 365d C. FV = 100 × (1 + 𝟏𝟖𝟎#𝟑𝟔𝟎 × .0435) = 102.175
ok! AOR = D𝟑𝟔𝟓#𝟏𝟖𝟎E M
𝟏𝟎𝟐. 𝟏𝟕𝟓 − 𝟏𝟎𝟎
N = 𝟒. 𝟒𝟏%
𝟏𝟎𝟎
42
The Term Structure of Interest Rates: Spot, Par, and Foward Curves
a. define spot rates and the spot curve, and calculate the price of a bond using
spot rates
b. define par and forward rates, and calculate par rates, forward rates from spot
rates, spot rates from forward rates, and the price of a bond using forward
rates
c. compare the spot curve, par curve, and forward curve
43
Term Structure of Rates: Par/Spot/Forward

Page 1
⇒ Maturity structure of interest rates/
yield
for bonds with the
maturity structure
same currency credit risk
or
term structure liquidity tax status
yield
curve same coupon (reinvestment
time to risk held constant)
maturity
government bond spot curve ➞ YTMs for zero-coupon bonds for a
(a.k.a. zero or strip curve) full range of maturities
upward sloping ➞ normal ➞ longer maturities have higher YTMs
downward sloping ➞ inverted
- no coupon ➞ no reinvestment risk, but/ most bonds have coupons
∴ need a term structure for coupon paying bonds, but/ older bonds
may have different tax/liquidity status ∴ use on-the-run bonds,
but/ there is limited data for the full range of maturities
∴ interpolate between dates
Page 2
- typically stated on
a semi-annual bond basis
- observed yields on recently issued ‘on-the-run’
coupon paying bonds
- gov’t. bond yield - 1 mos., 3 mos., 6 mos. ➞ money market, all converted
curve, coupon bonds to BEY (semi-annual basis)
⇒ Par Curve - sequence of YTMs such that each
bond is priced at par
- par rates are derived from spot rates
spots 𝐏𝐌𝐓 + 𝟏𝟎𝟎
𝟏𝟎𝟎 = PMT = 5.263%
1 yr. - 5.263% 𝟏. 𝟎𝟓𝟐𝟔𝟑
2 yr. - 5.616% 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝟏𝟎𝟎
𝟏𝟎𝟎 = + PMT = 5.606
𝟏. 𝟎𝟓𝟐𝟔𝟑 (𝟏. 𝟎𝟓𝟔𝟏𝟔)𝟐
3 yr. - 6.359%
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝟏𝟎𝟎
4 yr. - 7.008% 𝟏𝟎𝟎 = + + PMT = 6.306
𝟏. 𝟎𝟓𝟐𝟔𝟑 (𝟏. 𝟎𝟓𝟔𝟏𝟔) 𝟐 (𝟏. 𝟎𝟔𝟑𝟓𝟗)𝟑
etc…
44
Page 3
e.g./ spot rates: 3 yr. 5% annual bond
𝟓 𝟓 𝟏𝟎𝟓
1 yr. 2% (𝐙𝟏 ) 𝐏𝐕 = 𝟏. 𝟎𝟐 + 𝟏. 𝟎𝟑𝟐 + (𝟏. 𝟎𝟒)𝟑 = 𝟏𝟎𝟐. 𝟗𝟔
2 yr. 3% (𝐙𝟐 ) YTM: N= 3 PMT = 5 FV = 100 PV = -102.96
3 yr. 4% (𝐙𝟑 ) CPT 𝐈&
𝐘 = 3.935%
pulled towards r(3) since the
weight of the CFs are at T = 3.
e.g./ spot rates 𝟏=

𝐏𝐌𝐓
+
𝐏𝐌𝐓
…+
𝐏𝐌𝐓
+
𝐅𝐕
DF 𝟏 + 𝐫𝟏 (𝟏 + 𝐫𝟐 )𝟐 (𝟏 + 𝐫𝐍 )𝐍 (𝟏 + 𝐫𝐍 )𝐍
r(1) = .31% .9969
𝟏 𝟏 𝟏 𝟏
r(2) = .57% .9887 = 𝐏𝐌𝐓 + 𝐏𝐌𝐓 + ⋯ + 𝐏𝐌𝐓 + 𝐅𝐕
(𝟏 + 𝐫𝟏 ) (𝟏 + 𝐫𝟐 )𝟐 (𝟏 + 𝐫𝐍) 𝐍 (𝟏 + 𝐫𝐍 )𝐍
r(3) = .80% .9764
2.9620 = PMT 𝐃𝐅𝟏 + PMT 𝐃𝐅𝟐 + ... + PMT 𝐃𝐅𝐍 + FV 𝐃𝐅𝐧
calculate PMT 1 = PMT 𝚺DF + PV 𝐃𝐅𝐍
i.e. 3 yr. par rate PMT 𝚺DF = 1 - 𝐃𝐅𝐍 𝟏 − . 𝟗𝟕𝟔𝟒
PMT = (1 - 𝐃𝐅𝐍 ) 𝐏𝐌𝐓 = = . 𝟕𝟗𝟔𝟕%
𝟐. 𝟗𝟔𝟐𝟎
𝚺DF
Page 4
Forward curve ➞ based on forward rates
➞ agreed on today, received/paid in the future
➞ quoted as ‘when, what’
e.g./ 2y5y ➞ an agreement on a rate, when ➞ in 2 years

f(2,5) more common what ➞ a 5 yr. rate
- implied forward rates are calculated from spot rates
spots f(3,1) 3.65%
f(3,1)
3 yr. = 3.65%
4 yr. = 4.18% 4.18%
. 𝟎𝟒𝟏𝟖 𝟖
. 𝟎𝟑𝟔𝟓 𝟔 𝐟(𝟑, 𝟏) 𝟐
E𝟏 + I = E𝟏 + I E𝟏 + I
𝟐 𝟐 𝟐
semi-annual
𝟏;
bond basis (𝟏. 𝟎𝟐𝟎𝟗)𝟖 𝟐
ab c − 𝟏d = 𝐟(𝟑, 𝟏) = . 𝟎𝟐𝟖𝟖𝟗𝟏𝟒𝟓𝟐 × 𝟐
(𝟏. 𝟎𝟏𝟖𝟐𝟓)𝟔
= . 𝟎𝟓𝟕𝟕𝟖𝟐𝟗
45
Page 5
- deriving spot rates from forward rates:
𝟏;
r(1) = 1.88% r(2) = [(𝟏. 𝟎𝟏𝟖𝟖) × (𝟏. 𝟎𝟐𝟕𝟕)] 𝟐 - 1 = 2.324%
𝐟𝟏,𝟏 = 2.77% 𝟏;
r(3) = [(𝟏. 𝟎𝟏𝟖𝟖)(𝟏. 𝟎𝟐𝟕𝟕)(𝟏. 𝟎𝟑𝟓𝟒)] 𝟑 - 1 = 2.728%
𝐟𝟐,𝟏 = 3.54% 𝟏;
or g(𝟏. 𝟎𝟐𝟑𝟐𝟒)𝟐 (𝟏. 𝟎𝟑𝟓𝟒)h 𝟑 - 1 = 2.728%
𝐟𝟑,𝟏 = 4.12%
𝟏;
r(4) = [(𝟏. 𝟎𝟏𝟖𝟖)(𝟏. 𝟎𝟐𝟕𝟕)(𝟏. 𝟎𝟑𝟓𝟒)(𝟏. 𝟎𝟒𝟏𝟐)] 𝟒 - 1 = 3.074%
𝟏;
or g(𝟏. 𝟎𝟐𝟕𝟐𝟖)𝟑 (𝟏. 𝟎𝟒𝟏𝟐)h 𝟒
- 1 = 3.074
Page 6
forward
spot
par par
spot
forward
- forward curve is a series of 1 yr. forward rates ➞ f(1,1), f(2,1), f(3,1)

- forward rates are also referred to as break-even etc…
rate or no-arbitrage rates
Pricing/ - using spots 𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕

+ +
(𝟏 + 𝐫𝟏 ) (𝟏 + 𝐫𝟐 )𝟐 (𝟏 + 𝐫𝟑 )𝟑
- 3 yr. annual
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕
- using forwards + +
(𝟏 + 𝐫𝟏 ) (𝟏 + 𝐫𝟏 )(𝟏 + 𝐟(𝟏, 𝟏)) (𝟏 + 𝐫𝟏 )(𝟏 + 𝐟(𝟏, 𝟏))(𝟏 + 𝐟(𝟐, 𝟏))
46
Interest Rate Risk and Return
a. calculate and interpret the sources of return from investing in a fixed-rate

bond;
b. describe the relationships among a bond’s holding period return, its

Macaulay duration, and the investment horizon;
c. define, calculate, and interpret Macaulay duration.
47
Interest Rate Risk and Return

Page 1
- fixed rate bonds: 3 sources of return
1/ receipt of promised coupon and principal payments
on scheduled dates
2/ reinvestment of coupon payments
interest
rate risk 3/ potential capital gains/losses on sale of bond prior
to maturity
e.g./ 10 yr. 6.2% annual bond @ 100, no change in rates
1/ Buy and hold: 2/ 4 yr. investment horizon

𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 82.49256 𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 27.2032
(N = 10, PMT = 6.2, PV = 0, 𝐈&𝐘 = 6.2) (N = 4, PMT = 6.2, PV = 0, 𝐈&𝐘 = 6.2)
interest-on-interest = 20.49256 interest-on-interest = 2.4032
(82.49256 - 62) (27.2032 - 24.80)
Total FV = 182.49256 Total FV = 127.2032
horizon yield = 6.2% horizon yield = 6.2%
Page 2
premium
bond each point = bond’s carrying
100 value
= 𝐏𝟎 +⁄− amort. of disc./pr.
constant-yield price trajectory
discount
bond
T
- what if r ↑ 100 bps before first coupon
1/ Buy and hold: 2/ 4 yr. inv. horizon (T = 0 par bond)
𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 86.4754 𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 27.6092
(N = 10, PMT = 6.2, PV = 0, 𝐈&𝐘 = 7.2) (N = 4, PV = 0, PMT = 6.2, 𝐈&𝐘 = 7.2)
Total PV = 186.4754
𝟏#
𝐏𝐕𝐛𝐨𝐧𝐝 = 95.2627 (T = 4 discount
(N = 6, FV = 100, PMT = 6.2, 𝐈&𝐘 = 7.2) bond
)
horizon yield = 8𝐅𝐕1𝐏𝐕9 𝐓
- 1 𝟏'
horizon yield = 𝟏𝟐𝟐. 𝟖𝟕𝟏𝟗 𝟒
- 1 = 5.28%
𝟏' : =
= :𝟏𝟖𝟔. 𝟒𝟕𝟓𝟒= 𝟏𝟎𝟎
𝟏𝟎
- 1 = 6.4295% (vs. 6.2%)
𝟏𝟎𝟎
(vs. 6.2%)
48
Page 3
- 2 offsetting types of risk:
reinvestment risk - buy and hold only has this
price risk
𝐏𝐓 ↑ if r ↓ inverse price/yield
𝐏𝐓 ↓ if r ↑ relationship
- now assume 8 yr. investment horizon/ r ↑ 100 bps

𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 64.0707 (vs. 61.80656 @ r = 6.2)
(N = 8, PMT = 6.2, 𝐈*𝐘 = 7.2, PV = 0) if r ↓ 100 bps
𝐏𝐕𝟖 = 98.19698 𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 59.6296 (↓ 2.1769)
(N = 2, PMT = 6.2, FV = 100, 𝐈*𝐘 = 7.2)
𝟏'
𝐏𝐕𝟖 = 101.854 (↑ 1.854)
horizon yield = 𝟏𝟔𝟐. 𝟐𝟔𝟕𝟔𝟖 𝟖 - 1 = 6.23778 (N = 2, PMT = 6.2, FV = 100, 𝐈*𝐘 = 5.2)
: =
𝟏𝟎𝟎
(vs. 6.2%) 𝟏'
horizon yield = <𝟏𝟔𝟏. 𝟒𝟖𝟑𝟔@ 𝟖
- 1 = 6.173%
coupon reinv. + 2.264 𝟏𝟎𝟎
(vs. 6.2%)
cap. loss - 1.803
Page 4
Macaulay duration (MacDur) - the point in time where

any reinvestment gain/loss is offset by any
capital loss/gain for a one-time instantaneous parallel
shift in the yield curve
neg.
gap
Duration gap = MacDur - Investment horizon

pos. gap negative gap ➞ risk = lower rates
positive gap ➞ risk = higher rates
49
Page 5
MacDur ➞ the weighted average of the time to receipt

of cash flows based on 𝐏𝐕 𝐟𝐮𝐥𝐥 ➞ quoted as a measure of
𝐏𝐕 𝐟𝐮𝐥𝐥 using bond’s time
IRR
quoted as an
= IRR (array) 𝐂𝐅𝟏 annualized stat
r = 6.2 (in years)
𝚺𝐂𝐅
- also called the bond’s or
portfolio’s cash flow yield
Page 6
𝐏𝐌𝐓 𝐏𝐌𝐓 weight 𝐏𝐌𝐓

PV of weight
(𝟏 + 𝐫)𝐭 1 × (𝟏 + 𝐫)𝐭
(𝟏 + 𝐫)𝐭 CF of ×
𝐏𝐕 𝐟𝐮𝐥𝐥 CF 𝐏𝐕 𝐟𝐮𝐥𝐥 time
𝐏𝐌𝐓 Z𝟏 − 𝐭/𝐓[
𝟏,𝐭;
(𝟏 + 𝐫) 𝐓
between coupon dates
closed form formula
50
Yield-Based Bond Duration Measures and Properties
a. define, calculate, and interpret modified duration, money duration, and the
price value of a basis point (PVBP)
b. explain how a bond’s maturity, coupon, and yield level affect its interest rate
risk
51
Yield-Based Bond Duration: Measures and Properties

Page 1
assumes underlying bond cash flows are certain
price 𝚺 of all future cash flows (e.g. 5 yr., 4% annual bond, r = 0%)
PV = 120
par price sensitivity ➞ first derivative of price/yield
curve at a certain point
yield 𝐝𝐌𝐚𝐜𝐃𝐮𝐫
= ModDur = 𝐌𝐚𝐜𝐃𝐮𝐫
𝐝𝐏𝐕 𝐝𝐫 𝟏+𝐫
➞ $∆ in PV for a ∆yield
𝐝𝐫 yield/period
𝐝𝐏𝐕
I O
𝐝𝐫 = %∆𝐏𝐕 𝐟𝐮𝐥𝐥 for a ∆yield ⇒ %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = -ModDur × ∆yield
𝐏𝐕
calibrated for
100 bps change in yield
Page 2
e.g./ ModDur = 5 ⇒ 𝐏𝐕 𝐟𝐮𝐥𝐥 ↑ 5% for 100 bps ↓ in yield

%∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-5 × - .0100) = + 5%
- higher ModDur ➞ steeper the price-yield curve, the more sensitive

the bond to ∆yield (∆r)
e.g./ 5 yr., 3.2% semi @ 100

if ∆yield = 80 bps ↑
MacDur = 9.3203 (in semi annual periods)
ModDur = 𝟗. 𝟑𝟐𝟎𝟑 %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = -4.58676 × .008
= 9.17352
𝟏. 𝟎𝟏𝟔
= -3.6694%
AnnModDur = 9.17352/2 = 4.58676
(yields up, price down)
ApproxModDur/
S𝐫𝐢𝐬𝐞.𝐫𝐮𝐧T ➞ slope of tangent line
𝐏𝐕𝟎 - divide by 𝐏𝐕𝟎 ➞ sensitivity at a
point
52
Page 3
ApproxModDur/ ∆y = 100 bps ↑ ➞ 𝐏𝐕2
↓ ➞ 𝐏𝐕+
rise = 𝐏𝐕, - 𝐏𝐕A
𝐏𝐕( run = 2 ∆yield
𝐏𝐕𝟎 𝐏𝐕, − 𝐏𝐕A 𝟏 𝐏𝐕, − 𝐏𝐕A

ApproxModDur ≈ I O× =
𝐏𝐕0 𝟐 ∆𝐲𝐢𝐞𝐥𝐝 𝐏𝐕𝟎 𝟐 ∆𝐲𝐢𝐞𝐥𝐝 𝐏𝐕𝟎
𝐏𝐕𝟎 𝟏
ytm × will need a
∆y ∆y 𝟏 𝐏𝐕𝟎 convexity
yield/period adjustment
AnnMacDur ≈ AnnModDur (1 + r)
e.g./ 5 yr., 3.2% semi @ 100 𝟏𝟎𝟒. 𝟕𝟏𝟎𝟑 − 𝟗𝟓. 𝟓𝟑𝟐𝟏
ApproxModDur ≈
𝐏𝐕( = (N = 10, PMT = 1.6, 𝐈&𝐘 = 1.1, FV = 100) 𝟐 × . 𝟎𝟏 × 𝟏𝟎𝟎
CPT PV = 104.7103 ≈ 4.5891

𝐏𝐕0 = (N = 10, PMT = 1.6, 𝐈&𝐘 = 2.1, FV = 100)
CPT PV = 95.5321
Page 4
Money Duration ➞ $∆𝐏𝐕 𝐟𝐮𝐥𝐥 for a ∆yield

(dollar duration in US) DD = AnnModDur × 𝐏𝐕 𝐟𝐮𝐥𝐥
DD
and $∆𝐏𝐕 𝐟𝐮𝐥𝐥 = - DD × ∆yield
PVBP ➞ price value of a basis point ➞ $∆𝐏𝐕 𝐟𝐮𝐥𝐥 for a 1 bps

(or PV01/DV01) ∆yield
= 𝐏𝐕, − 𝐏𝐕A
𝟐
BPV = -ModDur × 𝐏𝐕 𝐟𝐮𝐥𝐥 × .0001

- DD
e.g./ 5 yr., 3.2% semi

𝐏𝐕( (N = 10, PMT = 1.6, 𝐈&𝐘 = 1.595, FV = 100)
CPT PV = 100.5396
PVBP = 𝟏𝟎𝟎. 𝟓𝟑𝟗𝟔 − 𝟗𝟗. 𝟗𝟓𝟒𝟏
𝐏𝐕0 (N = 10, PMT = 1.6, 𝐈&𝐘 = 1.605, FV = 100) 𝟐
CPT PV = 99.9541 = .044556
53
Page 5
ZCB - MacDur = time to maturity (100% of CF weight on last pmt.)

ModDur = MacDur (1 + r)
Perpetuity - MacDur = 𝟏 + 𝐫
𝐫
FRNs - 𝐌𝐚𝐜𝐃𝐮𝐫𝐟𝟏 = 𝐓 − 𝐭 fraction of time remaining until
𝐓 next reset date
e.g. 𝟓𝟔# ➞ 𝟏𝟖𝟎 − 𝟓𝟔 = 𝟏𝟐𝟒#
𝟏𝟖𝟎 ̇
𝟏𝟖𝟎 𝟏𝟖𝟎 = . 𝟔𝟖
Properties of Duration/ MacDur
ZCB
discount
bond
perpetuity
premium
bond
time to maturity
Page 6
- duration ↓ as time passes
MacDur
coupon payment ➞ nearest CF falls off
➞ weight shifts to further
cash flows
time to maturity
54
Yield-Based Bond Convexity and Portfolio Properties
a. calculate and interpret convexity and describe the convexity adjustment
b. calculate the percentage price change of a bond for a specified change in

yield, given the bond’s duration and convexity
c. calculate portfolio duration and convexity and explain the limitations of these
measures
55
Yield-Based Bond Convexity

Page 1
ModDur - first order effect (linear)

Convexity - second order effect (option-free bond)
- results in:
%∆𝐏𝐕 𝐟𝐮𝐥𝐥 for ↓ ∆y > %∆𝐏𝐕 𝐟𝐮𝐥𝐥 for ↑ ∆y
%∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (- ModDur × ∆y)

+ (𝟏&𝟐 × AnnConv. × ∆𝐲 𝟐 )
convexity adjustment
ApproxModDur = 𝐏𝐕, − 𝐏𝐕A ApproxConvexity = 𝐏𝐕, + 𝐏𝐕A − 𝟐 𝐏𝐕𝟎

𝟐 × ∆𝐲 × 𝐏𝐕𝟎 ∆𝐲 𝟐 𝐏𝐕𝟎
Page 2
5 yr., 3.2% semi @ 100
W.
𝟏 × 𝟐 × . 𝟎𝟏𝟓𝟕
(𝟏. 𝟎𝟏𝟔)𝟐
non-linearity
𝟕 × 𝟖 × . 𝟎𝟏𝟒𝟑
(𝟏. 𝟎𝟏𝟔)𝟐
𝐭𝐢𝐦𝐞𝐭 × 𝐭𝐢𝐦𝐞𝐭A𝟏 × 𝐖
fixed rate bond will have greater convexity: (𝟏 + 𝐈𝐑𝐑)𝟐
per period
the longer the time-to-maturity i.e. anything
÷
the lower the coupon that leads to
(𝐩𝐞𝐫𝐢𝐨𝐝𝐬/𝐲𝐫. )𝟐
the lower its ytm higher ModDur for
fixed rate bonds
56
Page 3
another factor is dispersion of cash flows
- for 2 bonds with the same duration, the one with the
greater dispersion of cash flows will have the greater convexity
e.g./ 30 yr., 4.625% annual @ 4.75% ytm
N = 30 PMT = 4.625 FV = 100 𝐈# = 4.75

𝐘 𝐏𝐕𝟎 = -98.02244
= 4.80 𝐏𝐕A = -97.24738
= 4.70 𝐏𝐕, = -98.80656
ApproxModDur = 𝟗𝟖. 𝟖𝟎𝟔𝟓𝟔 − 𝟗𝟕. 𝟐𝟒𝟕𝟑𝟖
= 𝟏𝟓. 𝟗𝟎𝟔𝟑𝟔
𝟐 × . 𝟎𝟎𝟎𝟓 × 𝟗𝟖. 𝟎𝟐𝟐𝟒𝟒
ApproxConvexity = 𝟗𝟖. 𝟖𝟎𝟔𝟓𝟔 + 𝟗𝟕. 𝟐𝟒𝟕𝟑𝟖 − 𝟐 × 𝟗𝟖. 𝟎𝟐𝟐𝟒𝟒
= 𝟑𝟔𝟗. 𝟔𝟒
. 𝟎𝟎𝟎𝟓𝟐 × 𝟗𝟖. 𝟎𝟐𝟐𝟒𝟒
∆ 50 bps ↓ %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-15.90636 × -.005) + (𝟏#𝟐 × 369.64 × -. 𝟎𝟎𝟓𝟐 )

= 0.0841 or + 8.41%
Page 4
DD = ModDur × 𝐏𝐕 𝐟𝐮𝐥𝐥 DC = AnnConvexity × 𝐏𝐕 𝐟𝐮𝐥𝐥

(money duration) (money Convexity)
$∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (- DD × ∆y) + (𝟏#𝟐 × DC × ∆𝐲 𝟐 )
e.g./ 100M (using previous example)
∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-15.90636 × 100M × .005) + (𝟏#𝟐 × 369.64 × 100M × . 𝟎𝟎𝟓𝟐 )

= 7.95318M + .46205M
= 8.41523 M
Portfolio Duration/Convexity
1/ calculate portfolio statistics ➞ i.e. weighted-average time to
correct
closer if YC is flat receipt of aggregate cash flows
2/ use weighted-average of each bond

approx.
using MV
57
Curve-Based and Empirical Fixed-Income Risk Measures
a. explain why effective duration and effective convexity are the most
appropriate measures of interest rate risk for bonds with embedded options
b. calculate the percentage price change of a bond for a specified change in

benchmark yield, given the bond’s effective duration and convexity
c. define key rate duration and describe its use to measure price sensitivity of
fixed-income instruments to benchmark yield curve changes
d. describe the difference between empirical duration and analytical duration
58
Curve-Based and Empirical Duration

Page 1
yield-based duration/convexity assumes a bond’s cash flows
do not change as interest rates change
contingency features (options, convertibility) make cash flows
rate dependent
- the appropriate measure of interest rate risk is the
sensitivity of 𝐏𝐕 𝐟𝐮𝐥𝐥 to ∆curve (not ∆yield)
par curve
Effective Duration (EffDur) and Effective Convexity

callable bond
negative MBS
convexity
positive
convexity
EffDur < ModDur EffDur ~ ModDur
Page 2
➞ positive convexity
throughout
even more convex
EffDur ~ ModDur EffDur < ModDur

EffDur ≈ 𝐏𝐕, − 𝐏𝐕A EffConvexity ≈ 𝐏𝐕, + 𝐏𝐕A − 𝟐𝐏𝐕𝟎
𝟐 ∆𝐜𝐮𝐫𝐯𝐞 𝐏𝐕𝟎 ∆𝐜𝐮𝐫𝐯𝐞𝟐 𝐏𝐕𝟎
change in par curve (parallel)
calculate spot rates, then calculate PV
(not quite parallel) ➞ ∆yield ➞ parallel shift in spot

∴ ModDur ≠ EffDur even for option-free bonds curve)
- ModDur = EffDur for a flat YC (par), or tenor is shorter, or bond

is priced close to par
59
Page 3
%∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (- EffDur × ∆curve) + (𝟏#𝟐 EffConv. ∆𝐜𝐮𝐫𝐯𝐞𝟐 )
with ∆yield, accuracy is improved by choosing

smaller ∆y to est. ModDur & ModConv.
- with ∆curve, larger moves has more accuracy
- small moves may not capture cash flow changes
from optionality
KRD - key rate duration (or partial duration)
- bond’s price sensitivity to a change in a specific par
rate
𝐊𝐑𝐃𝐫𝐤 = 𝟏 ∆𝐏𝐕 - helps identify shaping risk
−
𝐏𝐕 ∆𝐫𝐤
𝐧
b 𝐊𝐑𝐃𝐫𝐤 = 𝐄𝐟𝐟𝐃𝐮𝐫
𝐤6𝟏
- 𝐊𝐑𝐃𝐫𝐤 = ∆𝐏𝐕 𝟏
➞ (- 𝐊𝐑𝐃𝐫𝐤 × ∆𝐫𝐤 ) = ∆𝐏𝐕 = %∆𝐏𝐕 𝐟𝐮𝐥𝐥
𝐏𝐕 ∆𝐫𝐤 𝐏𝐕
Page 4
e.g./
𝐏𝐕𝟐 𝐏𝐕 𝐏𝐕
! × 𝟏. 𝟗𝟗0 + ! 𝟓 × 𝟒. 𝟗𝟑𝟖0 + ! 𝟏𝟎 × 𝟗. 𝟖𝟐𝟖0 = 5.36741
𝚺𝐏𝐕 𝚺𝐏𝐕 𝚺𝐏𝐕
0.711335 + 1.675139 + 2.980938 = 5.36741
(𝐊𝐑𝐃𝟐 ) (𝐊𝐑𝐃𝟓 ) (𝐊𝐑𝐃𝟏𝟎 )
e.g./
A: %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-.645 × -.0023) = .14835%
B: %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-1.483 × -.0025) = .37075%
C: %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-2.158 × -.0018) = .38844%
D: %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-2.982 × -.0010) = .2982%
60
Page 5
EffDur/ModDur ➞ analytical duration ➞ theoretical change
in 𝐏𝐕 𝐟𝐮𝐥𝐥 for ∆yield or ∆curve
Empirical duration ➞ observed ∆𝐏𝐕 𝐟𝐮𝐥𝐥 for actual ∆yield or ∆curve

➞ use historical data
- for gov’t. bonds, EffDur ~ EmpDur
- matters more for credit risky bonds since
𝛒𝐜𝐫𝐞𝐝𝐢𝐭 𝐬𝐩𝐫𝐞𝐚𝐝,𝐛𝐞𝐧𝐜𝐡𝐦𝐚𝐫𝐤 𝐲𝐢𝐞𝐥𝐝𝐬 < 𝟎
➞ curve ↑, spreads ↓
curve ↓, spread ↑
- the larger the component of yield is the credit spread,

the lower EmpDur vs. EffDur
61
Credit Risk
a. describe credit risk and its components, probability of default and loss given
default
b. describe the uses of ratings from credit rating agencies and their limitations
c. describe macroeconomic, market, and issuer-specific factors that influence

the level and volatility of yield spreads
62
Credit Risk
Page 1
- credit risk - risk of loss due to default
issuer specific factors failure to meet debt

general economic conditions obligations
Top-down
(macro)
Country Conditions Currency
- geopolitical - macro - domestic vs. foreign
- legal/political environment
Credit Risk
Bottom-up/
Capacity Capital Character Covenants Collateral
- ability to - level of - quality of - legal terms - quality and
service debt equity management of debt value of
agreement assets
quantitative
qualitative
Page 2
Sources of credit risk/
illiquidity risk
illiquidity - inability to raise funds

vs.
insolvent - A < L
63
Page 3
Measuring Credit Risk/

➞ principal + accrued - when LGD and POD are stated in %:
interest
credit spread ≈ LGD × POD
seniority of
claim e.g./ LGD = 80% POD = 1%: CS = .8% or 80 bps
value of
collateral (lower) profitability
(lower) coverage POD (higher)
annualized measure (higher) leverage
positive relationships
- positive
negative relationship
relationship
Page 4
3 majors - Moody’s provide credit ratings for

- Standard and Poors issuers/issues and monitor
- Fitch ongoing performance
- issuer pays (potential conflict of
interest)
credit ratings - letter-based - encapsulates LGD and POD
introduces credit migration risk - downgrade risk
64
Page 5
credit ratings tend to be sticky and lag market pricing

of credit risk
- rating outlook ➞ positive or negative ➞ more timely with
market conditions
- rating changes ➞ lagging
- some risks are difficult to capture in credit ratings

(litigation, environmental risk, natural disasters)
- may result in split ratings - different ratings by the 3
agencies
- ratings may involve miscalculation or unforeseen
changes not fully captured in a rating agency’s
forward-looking analysis
Page 6
credit spread risk - the risk of greater expected loss due

to changes in credit conditions
Factors affecting yield spread:
Macro factors - spread correlation with business cycle is negative
narrowest
expansion
- business/credit
- spreads contraction - spreads
cycle:
contract widen
widest
- addition of credit risk (i.e. HY)
portfolio diversification - in a bond portfolio
- lower 𝛒 with IG and sovereign yields
capital appreciation - equity-like performance over the business
cycle
equity-like returns with lower volatility
65
Page 7
higher credit rating ➞ lower yield
longer maturity, higher yield (within each credit rating)
IG - OAS < (𝐇𝐘𝐎𝐀𝐒 − 𝐈𝐆𝐎𝐀𝐒 )
low spreads and

upward sloping
HY inversion
- reflects near-term
credit market anticipating
tightness credit cycle
contraction
Page 8

Market factors
liquidity - wider spreads for more illiquid bonds
spread issuer size
tax lower = wider
credit quality
credit
financial conditions
- stressed = wider spreads
Issuer specific
- issuer financial performance
debt coverage and leverage levels
𝐂𝐅𝐲𝐫
`𝐨𝐛𝐥𝐢𝐠𝐚𝐭𝐢𝐨𝐧𝐬 B𝐀#𝐄C
𝐲𝐫
- relative spreads - compare issuer with similar industry and

credit quality comparables
e.g./ Industry A ➞ BBB rating 𝐎𝐀𝐒𝐚𝐯𝐠. ~ 220 bps
Company XYZ ➞ OAS = 300 bps estimated 80 bps issuer specific
66
Page 9
Price Impact of Spreads
yield = 𝐫𝐟 + spread
∴ ∆spread = ∆yield
- IG more concerned with spread risk (versus default for HY)
∆price due to ∆spread or ∆credit

rating
resulting in
%∆𝐏𝐕 𝐟𝐮𝐥𝐥
= (-AnnModDur × ∆spread)
+ (𝟏&𝟐 × AnnConv. × ∆𝐬𝐩𝐫𝐞𝐚𝐝𝟐 )
67
Credit Analysis for Government Issuers
a. explain special considerations when evaluating the credit of sovereign and

non-sovereign government debt issuers and issues
68
Credit Analysis for Government Issuers

Page 1
issued to conduct fiscal policy and meet budgetary needs

- repayment comes from taxes and other government
revenue (fees, tariffs, profit from state-owned comp.)
- developed market - default risk-free
- emerging/frontier markets - involve default risk (i.e. credit risk)

Qualitative factors of creditworthiness:
1/ Gov’t. institutions and policy
- political and economic stability
- rule of law, protection of property rights
- culture of debt repayment
- absence of conflict
- assessment of both ability and willingness to pay
Page 2
sovereign immunity - limitations in forcing a gov’t. to

declare bankruptcy or sell assets
- limits legal recourse of bondholders
2/ Fiscal flexibility - discipline over time and under different

economic scenarios
3/ Monetary effectiveness - level of independence
- record of sustainable growth with price
stability
4/ Economic flexibility - size of economy, level of per capita GDP,
degree of diversification and integration, growth
potential
- size of informal economy (difficult to collect taxes)
5/ External status - international trade, capital, forex policies
in terms of ability to service debt
69
Page 3
5/ External status
- reserve currency status - fully convertible and
frequently held by foreign central banks and other
investors (foreign currency assets - stocks, bonds)
- increases ability to access foreign investor base
- frontier/emerging - forex restrictions, capital controls, lack of

convertibility
Quantitative Factors
- no financial statements, only economic data
varies in terms of quality

and timing
- often lacks comparability
across countries
Page 4
1/ Fiscal strength
𝐬𝐮𝐫𝐩𝐥𝐮𝐬/𝐝𝐞𝐟𝐢𝐜𝐢𝐭1
𝐆𝐃𝐏 - a measure of fiscal discipline
2/ Economic growth and stability
70
Page 5
3/ External Stability - depends on whether foreign investors
are able and willing to hold assets in a country’s
currency
solvency
liquidity
emerging/frontier markets - commodity exports generates bulk

of foreign currency reserves
- commodity prices can be a primary factor
driving sovereign creditworthiness
Page 6
Non-sovereign credit risk:

1/ Agencies - quasi-gov’t. entities
- very similar credit risk to the sovereign
(implicit/explicit gov’t. guarantee)
2/ Government sector banks/Development financing
- similar to agencies in terms of credit rating and guarantees
3/ Supranational Issuers - established and owned by more than
one sovereign (e.g. World Bank)
4/ Regional gov’t. issuers - provincial/state/local

- issue municipal bonds (US) or local authority bonds (ex-US)
- some have the same credit rating as the sovereign, others
are rated separately (US)
- issue - general obligation (GO) bonds
- revenue bonds
71
Page 7
general obligation bonds - unsecured and backed by
general revenues of the issuing non-sovereign
- supported by taxing authority
- credit analysis treats them as a mini-economy without

broad fiscal or monetary authority
- revenue bonds - issued to finance a specific project

- higher degree of risk than GO bonds
(cash flows are single source)
- credit analysis focuses on the viability of the project
➞ DSCR ➞ revenue
obligation
payments
72
Credit Analysis for Corporate Issuers
a. describe the qualitative and quantitative factors used to evaluate a corporate

borrower’s creditworthiness
b. calculate and interpret financial ratios used in credit analysis
c. describe the seniority rankings of debt, secured versus unsecured debt and the
priority of claims in bankruptcy, and their impact on credit ratings
73
Credit Analysis for Corporate Issuers

(non-financial corporates) Page 1
Qualitative factors/
IG - affirmative (pos.)
HY - restrictive (neg.)
acceptable return
over cost of capital
size/timing of cash
more important for HY flows sufficient to
meet debt obligations
unsecured - asset stable/predictable CFs
quality
secured low business risk
less competitive
pressures
higher capacity to use

debt - lower POD
Page 2
Quantitative factors/
company growth
relative to GDP
business/credit cycle 𝐂𝐅
`𝐃𝐞𝐛𝐭
𝐎𝐛𝐥𝐢𝐠𝐚𝐭𝐢𝐨𝐧𝐬
ability to
meet short term
obligations outside
of CFs or asset sales
stable and recurring revenue

low reliance on debt (low leverage) Total Debt
Assets or/ Capital or/ CF
74
Page 3
Assess the financial health of a company
Identify trends over time
Compare within/across industries
Assess a firm’s ability to service debt from operations alone
Denominator/
prior to capital costs Interest expense + lease payments
and taxes
( or - Interest income)
EBITDA may be
used
EBITDA
EBITDAR
debt in numerator:
larger = worse CFO - dividends paid
debt in denominator:
larger = better debt obligations may also include lease
payments and other off-balance sheet obligations
Page 4
- use existing and projected ratios

compared against rating agencies
benchmarks
pledge of specific property

Seniority rankings/
first claim on specific assets
- priority of - if this does not satisfy
payment claims, balance becomes
equal with senior unsecured
most common type of
corporate bond
little or no recovery
in default
75
Page 5
Recovery rates/
- all creditors at the same seniority level are treated as one
class
- defaulted debt will continue to trade near its
expected recovery rates (varies by seniority)
- recovery rates: vary by industry
vary depending on when they occur in the business
cycle and the industry life cycle
(growth vs. secular decline)
represent an average across industries and
companies
priority of claims is a legal standard ➞ parties can agree otherwise
- senior claims may offer concessions to junior claims to
speed the process
minimize legal/accounting fees
minimize customer and management flight
Page 6
Issuer and issue ratings - same POD on all issues due to

cross default provisions
usually applies to its
- different LGD depending on
senior unsecured
(corporate family rating - CFR) priority
- rating adjustment method is called notching

- each notch is a rating
secured + 1 notch
- issuer rating = senior unsecured
junior - 1 notch
Structural subordination/
Holdco - debt
excess cash passed up to service
debt at Hold Co. level
Op.Co. Op.Cp. ∴ called structurally subordinate
1 2
- debt - debt CFs from Op.Co. service debt first
76
Fixed-Income Securitization
a. explain benefits of securitization for issuers, investors, economies, and

financial markets
b. describe securitization, including the parties and the roles they play
77
Fixed Income Securitization

Page 1
CF source reference portfolio or collateral
Covered bonds - assets (loans) don’t leave BS

- segregated collateral for bonds issued against it
- if a loan in the pool defaults, must be replaced by
another
Pass-through securities - loans are removed from BS and transferred to
a separate legal entity
- entity then issues securities backed by this pool of assets
- P + 𝒊 on loans passed through to bond investors of the entity
Bonds with structural enhancements - entity sells bonds with
different priorities of CFs rather than just one class
(credit or time tranching)
Page 2
subordination: a.k.a. tranching

- more than one bond class
that differs in how they receive
CFs
senior and subordinated
- lowest tranche typically called
the ‘equity’ tranche
- first-loss piece
MBS - bonds backed by a pool of mortgages (RMBS, CMBS, CMO)

non-mortgage ABS (CDO, CLO, CBO, CDO2)
Benefits to issuers/
- sell assets (loans, receivables) to free up cash to create more
loans beyond what a single BS could produce
- origination fees, loan fees, reduced capital requirements
78
Page 3
Benefits to investors: - access to a return series typically
not available via direct access
- can tailor interest rate risk (time tranche) and credit
risk (credit tranche) exposure
Benefits to economies and financial markets
increase liquidity versus original loan
increase market efficiency
increase sources of capital to finance assets
Risks timing of CFs
- as rates ↑, payment speed ↓ - extension risk
- as rates ↓, payment speed ↑ - contraction risk
credit risk of loans backing the ABS
Page 4
Originator sale of product on credit

origination of loan
sell loans P+𝒊

- serviced by originator
SPE
cash for loans
pass-through CFs
cash sell bonds

from backed by pool
sale of ABS of loans
Parties/ seller (depositor, originator)
SPE
servicer - usually the originator
+ third parties - legal, accounting, trustee, rating agencies
79
Page 5
Legal documents
purchase agreement - between seller and SPE
- outlines representations and warranties seller makes
about collateral
prospectus - describes the structure of the securitization, payments
to servicer and bond holders, list credit enhancements
Trustee (disinterested trustee) - holds assets, holds funds due to

bondholders until payment date
Role of the SPE
bankruptcy remote
- lower cost debt than if held on
Originator SPE
originator’s BS.
sells assets Bond investors - credit risk isolated

(legal separation) to pool of assets only
80
Asset-Backed Security (ABS) Instrument and Market Features
a. describe characteristics and risks of covered bonds and how they differ from
other asset-backed securities
b. describe typical credit enhancement structures used in securitizations
c. describe types and characteristics of non-mortgage asset-backed securities,

including the cash flows and risks of each type
d. describe collateralized debt obligations, including their cash flows and risks
81
Asset-Backed Securities & Market Features

Page 1
Covered Bonds/ typically commercial or residential
mortgages
remain on
issuer’s BS
dual recourse
- typically one bond class per pool

- issuer must replace any pre-paid or non-performing asset
- cover pool $ typically > $ issued bonds
(overcollateralization)
- loan-to-value ratio must meet certain standards
Page 2
Types
1/ hard bullet covered bonds - payments are accelerated with default
- issuer sells loans to meet full redemption
2/ soft bullet covered bonds - payments are delayed with default
e.g./ lack of pre-payments
- extend final redemption date usually up to 1 yr.
3/ conditional pass-through covered bonds - convert to pass-through after
original maturity date
➞ covered bonds usually carry lower credit risk and offer lower yields
(soft has lower credit risk than hard)
82
Page 3
SPE Credit Enhancements/ - internal
overcollateralization - sell 100M mortgages to SPE, get 95M cash
- retain 5% equity position
excess spread - avg. coupon on underlying collateral (aggregate interest
collected) less than avg. coupon on bonds (aggregate
interest paid)
6% w.a. int. 4.5% coupon bonds
150 bps to absorb losses or build up reserves

(excess cash would accrue to equity slice)
subordination - tranching
- different classes of bonds with different yields and
degrees of risk
- senior/subordinate structure
- distributions by waterfall approach
- int. to all classes, P to senior first - once paid, then to junior
Page 4
Waterfall
- lower tranches offer credit

protection to more senior bond
classes
external credit enhancements/ guarantees by banks or insurance

companies, cash collateral accounts (restricted cash on BS)
Non-mortgage ABS/
amortizing ➞ payments = P + 𝒊
non-amortizing - a lockout or revolving period where pre-payments

are reinvested ➞ 𝒊 only, then P + 𝒊 once lockout period
ends
83
Page 5
- revolving period ➞ early P
payments begin if specific
events occur
rapid amortization provision
if defaults > threshold
during revolving period, P late, membership
repayments begin overcollateralization and subordination are
typically used
Solar ABS ➞ solar loans/leases
- may qualify as green bonds (appeals to ESG funds)
- solar loans on residential homes ➞ must be a junior mortgage on
property if an existing mortgage is in place
- also may contain a pre-funding period ➞ the ability to acquire
loans/leases after the closing date of the bond issuance
- use overcollateralization, subordination, excess spread
Page 6
CDO - collateralized debt obligation - backed by a diversified pool of

one of more debt obligations
- if corporate/EM bonds - CBO
- if leveraged loans - CLO
- if other CDOs - structured finance CDO
- if CDS on other CDOs - synthetic CDO
- cash flows from being the seller of the CDS
CLO - tranched - collateral pool is not fixed - assets in the pool can
be bought and sold
- requires a collateral manager
P 𝒊
goal ➞ return on
assets
> return offered
on bonds sold
pre-pay.
gains/losses
84
Page 7
- senior/mezzanine
earn higher returns
than comparable
products
equity-like risk
- residual of
types: cash flow CLOs (most common) agg. CF in - agg. CF out
market value CLOs - tranche returns depend on MVp
synthetic CLOs - collateral pool is created with credit derivatives
- performance of assets determines the ability to pay tranches
- collateral manager must meet performance tests and collateral limits
- if manager fails, provision is triggered requiring payoff of
all P to senior bond class until tests are met
- effectively deleverages the CLO
Page 8
collateral portfolio not finalized until after the transaction closes
CLO lifecycle 8-10 yrs.
warehouse period 6-12 months - warehouse provider finances purchase

of loans - to be paid off with CLO proceeds
ramp-up period - after closing, excess CLO funds used to acquire
(3 - 5 months) more loans
reinvestment period - collateral manager permitted to actively trade
(up to 5 yrs.) underlying assets
amortization period - P + 𝒊 outflows
- waterfall distribution
- overcollateralization - if value of collateral falls below some
trigger value: ( par amt. of assets outstanding P of related
- then cash is diverted from tranche and all tranches
subordinate tranches to senior tranches senior to it
85
Page 9
Asset pool - typically senior secured loans (avg. credit rating of B)
- industry diversification criteria
- max % of non-senior secured loans
- limitations on amount of CCC rated loans
- CLO equity investor is the owner of the pool of loans and the
CLO debt investors provide the financing to acquire the pool of
loans
86
Mortgage-Backed Security (MBS) Instrument and Market Features
a. define prepayment risk and describe time tranching structures in

securitizations and their purpose
b. describe fundamental features of residential mortgage loans that are

securitized
c. 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
d. describe characteristics and risks of commercial mortgage-backed securities
87
MBS Instrument and Market Features

Page 1
Time tranching/
- MBS cash flows are uncertain ➞ scheduled and actual
payments typically differ
pre-payment risk ➞ level and amount of P paid back differs

from the contractually agreed schedule
- 2 components:
1) contraction risk - when interest rates ↓, pre-payments increase
(borrowers refinance at a lower rate)
∴ MBS maturity will be shorter
- MBS investor gets money back when reinvestment rates are lower
- introduces negative convexity P
straight bond
MBS
yield
Page 2
- 2 components:
2/ Extension risk - when interest rates rise, pre-payments slow down
- extends maturity of MBS which increases duration
- lower cash flows for reinvestment when rates are higher
- to avoid one or the other, MBS can be time tranched

e.g./ sequential tranching P +𝒊
A
senior tranche B 𝒊
P +𝒊 ↑ avoid extension risk
C 𝒊 𝒊 P +𝒊
D 𝒊 𝒊 𝒊 P + 𝒊 ↓ avoid contraction
subordinate E risk
88
Page 3
𝒕𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞 = price - deposit
Mortgage LTV ratio = 𝐛𝐨𝐫𝐫𝐨𝐰𝐞𝐝 𝐟𝐮𝐧𝐝𝐬
𝐩𝐫𝐨𝐩𝐞𝐫𝐭𝐲 𝐯𝐚𝐥𝐮𝐞 - over time, P
payments reduce
first lien on over time, ↑ HP numerator
underlying property increases denominator
- if default, foreclosure
and sale lower = less credit risk
incl. mortgage
➞ DTI - debt-to-income = 𝐝𝐞𝐛𝐭
- lower = better 𝐢𝐧𝐜𝐨𝐦𝐞 - monthly
(pre-tax gross)
Based on credit quality, 2 types of mortgages in US

1/ Prime - high credit quality, low DTI, first lien mortgage
2/ Sub-prime - lower credit quality, high DTI or high LTV mortgages
and may be second lien mortgages
Page 4
Agency vs. Non-agency MBS/

RMBS vs. CMBS
residential commercial
guaranteed by federal agency agency MBS
guaranteed by a GSE
not gov’t. guaranteed - issued by a private entity - non-agency
MBS
- non-conforming loans (do not qualify for agency inclusion)
Mortgage Contingency Features/
pre-payment option or early repayment option
- borrower may repay all or a portion of the P before
maturity
- introduces pre-payment risk
- can be mitigated with pre-payment penalties
- more common in Canada & Europe, not so much
in U.S.
89
Page 5
in default:
a) recourse - lender has a claim against borrower in default
if LTV > 100% (underwater mortgage)
- common in Canada and Europe
b) non-recourse - lender only has a claim against the property
- common in U.S.
- introduces the notion of strategic default
if LTV ratio > 100%, borrower can walk away even
if they can afford to make the payments
Page 6
mortgages
are
securitized
collecting payments from borrowers and

forwarding them to the SPE, initiating
foreclosures, etc.
- coupon rate on MBS ➞ pass-through rate (net interest or net coupon)
$𝐦𝐨𝐫𝐭 𝟏 $𝐦𝐨𝐫𝐭 𝟐
WAC = 𝐦𝐨𝐫𝐭𝐠𝐚𝐠𝐞 𝐫𝐚𝐭𝐞𝟏 + 𝐦𝐨𝐫𝐭𝐠𝐚𝐠𝐞 𝐫𝐚𝐭𝐞𝟐 + ⋯
𝚺$𝐩𝐨𝐨𝐥 𝚺$𝐩𝐨𝐨𝐥
WAM = $𝐦𝐨𝐫𝐭 𝟏 $𝐦𝐨𝐫𝐭 𝟐

𝐫𝐞𝐦𝐚𝐢𝐧𝐢𝐧𝐠 𝐦𝐨𝐧𝐭𝐡𝐬𝟏 + 𝐫𝐞𝐦𝐚𝐢𝐧𝐢𝐧𝐠 𝐦𝐨𝐧𝐭𝐡𝐬𝟐 + ⋯
𝚺$𝐩𝐨𝐨𝐥 𝚺$𝐩𝐨𝐨𝐥
90
Page 7
CMO - collateralized mortgage obligation
redistribute
pre-payment risk
- securitize other pass-through MBS or multiple loan pools
- sequential - pay CMO
➞ avg. life < avg. life of collateral
➞ avg. life > avg. life of

collateral
Page 8
other CMO structures:

Z-tranches - no P or 𝒊 until a pre-set date
accrues but not paid ➞ added to principal
- typically last tranche in a time tranche MBS
- average life > 20 yrs.
a.k.a.: accretion bonds or accrual bonds
Principal only (PO) securities - P only
- price very sensitive to prepayment rates and interest rates
𝐏𝟎 ↑ when rates ↓ or pre-payments ↑
- known dollar amount but unknown timing
- sold at discount to P - based on rates and estimated
pre-payment speeds
Interest only (IO) securities - 𝒊 only
- no face value or par value
- as pre-payments ↑, future CFs decline
91
Page 9
other CMO structures:
floating rate tranches - often subject to both a cap and a floor
- can also be structured as an inverse floater
Residual tranches - collect any remaining cash flows after all
obligations to other tranches are met
PAC and support tranches

planned
better construction of time tranches
amortization
class - all extra pre-payments absorbed by the
support tranches
Page 10
CMBS - backed by a pool of commercial mortgages or

income-producing properties
- commercial mortgages typically have a pre-payment
exemption period (e.g. no pre-payments for 5 years)
- may only be a single mortgage on a high value marquee property
- may only be one borrower with multiple property mortgages
- Europe - CMBS may include mortgages from different countries
- Europe CMBS - floating rate with a cap, US-fixed rate CMBS
Structure/
Call protection
- structural call protection - sequential - pay tranching
- loan level call protection - pre-payment lockouts, pre-payment
penalty points (i.e. 1% of outstanding loan balance),
defeasance ➞ next screen
92
Page 11
Call protection
defeasance - portfolio of gov’t. securities purchased that
fully replicates the remaining cash flows of the
mortgage (not the CMBS)
Balloon maturity provision - commercial real estate loans are not
fully amortizing
- payments are 𝒊 and maybe some P
- remaining P ➞ balloon payment end of YR5 or YR10
- balloon risk - borrower may not meet payment, may
be unable to roll-over loan, or cannot sell
for balloon payment amount
- lender may extend loan ➞ ‘workout period’
- creates extension risk in the CMBS
Page 12
CMBS risks
concentrated pool of loans - a few, heterogeneous
- a single default can have a significant impact
- due diligence involves analysis of underlying loan pool
DSCR = 𝐧𝐞𝐭 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐢𝐧𝐜𝐨𝐦𝐞 ➞ (income - cash exp.) - maintenance

𝐃𝐞𝐛𝐭 𝐬𝐞𝐫𝐯𝐢𝐜𝐞 CAPEX
key indicator P+𝒊
of credit > 1 ➞ cash flows can service debt
performance
- higher = better
93

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Last Revised: 06/02/2023

2024 Level 1 - Fixed Income

Learning Modules Page

Fixed-Income Instrument Features 2

Fixed-Income Cash Flows and Types 6

Fixed-Income Issuance and Trading 12

Fixed-Income Markets for Corporate Issuers 16

Fixed-Income Markets for Government Issuers 23

Fixed-Income Bond Valuation: Prices and Yields 27

Yield and Yield Spread Measures for Fixed-Rate Bonds 33

Yield and Yield Spread Measures for Floating-Rate Instruments 38

Interest Rate Risk and Return 47

Yield-Based Bond Duration Measures and Properties 51

Yield-Based Bond Convexity and Portfolio Properties 55

Curve-Based and Empirical Fixed-Income Risk Measures 58

Credit Analysis for Government Issuers 68

Credit Analysis for Corporate Issuers 73

Asset-Backed Security (ABS) Instrument and Market Features 81

Mortgage-Backed Security (MBS) Instrument and Market Features 87

© 2533695 Ontario Limited d/b/a MarkMeldrum.com. All rights reserved.

Fixed-Income Instrument Features

a. describe the features of a fixed-income security

b. describe the contents of a bond indenture and contrast affirmative and

Fixed-Income Instrument Features

Fixed-income ➞ debt such as loans and bonds

- all involve periodic interest payments plus principal

Seniority - position in the capital structure (priority of claim on

Yield curves - yields on all bonds with same features by

Fixed-Income Cash Flows and Types

a. describe common cash flow structures of fixed-income instruments and

Fixed-Income Cash Flows and Types

Sinking Funds - periodically retire a bond’s principal over time

Step-up bonds - coupon rate steps up over time or is related to

PIK (payment in kind) bonds - payment of 𝒊 can be made by

Index-linked bonds - 𝒊 or 𝐏 linked to a specific index

e.g. 1000 @ 2% %∆CPI = 4% 1. 𝐢 = 20 FV = 1040

issue first second last maturity

- if YTM > coupon (discount bond), call is OTM ➞ no value in

conversion value = conversion ratio × current share price

- the currency of issue has a stronger effect on price than where it

ZCB - no coupon - but all discount amount is interest

Fixed-Income Issuance and Trading

a. describe fixed-income market segments and their issuer and investor

b. describe types of fixed-income indexes

c. compare primary and secondary fixed-income markets to equity markets

Fixed-Income Issuance and Trading

Credit Quality/ measured by credit

debt obligations (captures both

sovereign government debt typically lowest risk in each market

classified as aggregate indexes e.g. Bloomberg Barclay’s Global Agg.

- all bonds are priced once a day to determine index value

- debut issuers typically replacing private debt with public debt

bonds are typically priced (i.e. yield) to sell at par

Fixed-Income Markets for Corporate Issuers

a. compare short-term funding alternatives available to corporations and

c. contrast the long-term funding of investment-grade versus high-yield

FI Markets for Corporate Issuers

- seller retains ownership of the

- seller pays the ‘general collateral’ repo

‘haircut’ = 𝟏𝟎𝟎𝐌 − 𝟗𝟖, 𝟎𝟑𝟗, 𝟐𝟏𝟔

Repurchase price = 98,039,216 × (1 + .0025#𝟑𝟎&𝟑𝟔𝟎') = 98,059,641

variation or 𝟐, 𝟗𝟗𝟔, 𝟓𝟐𝟕

Repurchase Agreements/ - short a security