Fixed Income Securities

Global Asset Management

 Terminology

• Security:
– A financial instrument that is traded on a well-
developed market

• Fixed income security:

– A security that gives a fixed(definite) cash stream

• Why fixed income is important?

 What are they?

• Saving deposit
– Bank account

• Money market instruments = less than 1yr

– Commercial paper (unsecured loans to corporates)

• Bond
– Fixed maturity with fixed face value
– Discount bond(zero-coupon), coupon bond
 US government bond

• Treasury bills
– 13, 26, 52 weeks
– Discount, highly liquid

• Treasury notes
– 1 to 10 years
– Coupons every 6 month

• Treasury bonds
– More than 10 years
– Coupons every 6 month
 From other issuers

• Municipal bonds
– Issued by local governments
– Exempt from federal and local taxes

• Corporate bonds
– Issued by corporation to raise money
– Usually OTC

• Sovereign bonds: by foreign government

 Bond rating

• Pricing factors for bond:

– Yield, economic situations, credit, etc.

• Credit rating: by private rating agencies

– Moody’s, Standard and Poor’s, Fitch, etc.
– 한국신용평가
Rating classifications
 Other fixed income securities

• Mortgage
– A loan secured by property
– MBS(mortgage backed securities) issued against a
large pool of mortgages

• Annuity
– Money paid periodically according to a fixed
schedule.
– Perpetuity is a annuity paid forever. E.g. consol
 Valuation

• Valuing a consol
 Bond Pricing Formula

• Let F be a face value, annual coupon is C, and

coupons are paid m times a year. Let’s suppose
there are n coupons are remaining.

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• 𝑃= ! #
+∑ $%"
"
! %
"# "#
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Why?
Let’s do some excel example!
 Bond Pricing Formula

• What if interest rate is NOT constant?

• Even though the interest rate is NOT constant

in reality, let’s assume there is hypothetical rate
which is constant.
 Yield to Maturity

• We call that constant rate as YTM

• Interpretation of YTM
– Average interest rate over time to maturity
– The average yield rate when you hold that bond
until the maturity
 Yield to Maturity

• Price VS. YTM

– LOW YTM means HIGH PRICE and vice versa
– HIGH YTM means LOW PRICE and vice versa
– YES, they essentially contains the same information

• Let’s try the excel again

• What about the interest rate VS. YTM?

 Duration

• Maturity: simply the time remained.

• People wanted to know the EFFECTIVE TIME

remaining with respect to the cash flow.

• First definition of Duration

 Duration

• Properties:
– Always positive.
– Zero coupon bond? Maturity = duration (verify)
– Duration of coupon bonds shorter than maturity
(Why?)

• Interpretation:
– Weighted Average of time remaining with respect
to the cash flow!
 Duration

• Macaulay duration: simply plug YTM when you

compute.
 Modified Duration

• Remember the relationship between interest

rate and YTM.
• People are curious about the sensitivity of
bond price to the change of YTM!
Modified Duration
Modified Duration