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Chapter 1

Introduction

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

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you will understand • the fundamental features of bonds • the types of issuers • the importance of term to maturity of a bond • floating rate and inverse-floating rate securities • what is meant by a bond with an embedded option and the effect of an embedded option on a bond’s cash flow • the various types of embedded options Copyright © 2010 Pearson Education.Learning Objectives After reading this chapter. Publishing as Prentice Hall 2-2 . Inc.

Inc. you will understand • convertible bonds • the types f risks faced by investors in fixed income securities • the secondary market for bonds • the various ways of classifying financial innovation Copyright © 2010 Pearson Education. Publishing as Prentice Hall 2-3 .Learning Objectives (continued) After reading this chapter.

Bond Basics Bond are debt instruments Issuers (debtors) promise to repay the amount borrowed from investors plus interest over a specified period of time Plain vanilla bonds: fixed maturity date. Publishing as Prentice Hall 2-4 . fixed coupon Mortgage bonds (and their offspring) Copyright © 2010 Pearson Education. Inc.

Publishing as Prentice Hall 2-5 . cities and others) Corporates (includes asset-backed securities) Mortgages (commercial and residential) : passthroughs. Inc. stripped mortgage backed securities Copyright © 2010 Pearson Education.Bond Sectors Treasuries and agencies Municipals (includes states. collateralized mortgage obligations.

Bond Features Types of issuers: •Federal government and its agencies •Municipal governments •Corporations Term to maturity •Short term: 1-5 years •Intermediate: 5-12 years •Long term: 13 years + The term to maturity tells investors how long they will receive coupon interest and how long before they are repaid. Inc. it also affects the yield as market rates change Copyright © 2010 Pearson Education. Publishing as Prentice Hall 2-6 .

convertible or exchangeable bonds) To describe a bond. Inc. coupon and maturity (e. put provisons. Publishing as Prentice Hall 2-7 .Bond Features (continued) Principal (also redemption value. Treasury 8-3/4 of 8/15/2028) Copyright © 2010 Pearson Education. give its issuer.g. face or par) Coupon (nominal rate) Fixed coupon Floating coupon (reference rate) Deferred coupons (deferred-interest.. maturity value. payment in kind—including pik toggles) Amortization (amortizing and nonamortizing) Embedded options (call provisions. step-up.

Inc. Publishing as Prentice Hall 2-8 .Bond Risks Credit risk: risk investor will not get principal back Interest rate risk: market risk of price changes Reinvestment risk: risk that coupon payments may be reinvested at a different rate than the coupon Inflation risk: purchasing power risk Call risk: shortened maturity Exchange rate risk (for non $ bonds) Liquidity risk: marking to market Volatility risk: greater volatility enhances value of embedded options Risk risk: uncertainty of bond market innovations Copyright © 2010 Pearson Education.

Inc.Bond Trading Original issue securities Secondary markets Copyright © 2010 Pearson Education. Publishing as Prentice Hall 2-9 .

electronic.All rights reserved. No part of this publication may be reproduced. or otherwise. in any form or by any means. or transmitted. Inc. stored in a retrieval system. Copyright © 2010 Pearson Education. photocopying. Printed in the United States of America. without the prior written permission of the publisher. Publishing as Prentice Hall 2-10 . recording. mechanical.