Pricing Fixed Income Securities

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Pricing Fixed Income Securities

© All Rights Reserved

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DISCOUNT FACTORS

The discount factor between two dates, t and T, provides the

term of exchange between a given amount of money at t versus

a (certain) amount of money at a later date T:

The discount factor is denoted by Z(t,T)

If the Treasury issued 182-day Treasury bills at a price of Rs.97.477 for

Rs.100 of face value , it implies That is, market participants were willing

to exchange 0.97477 rupees on the first date for 1 rupee six months

later

This Treasury bill would not make any other payment between the two

dates

The ratio between purchase price and the payoff, 0.97477 =

Rs.97.477/Rs.100, can be considered the market-wide discount factor

for 6 months

DISCOUNT FACTORS

The notion of discount factor is unambiguous

while that of interest rate is not as it depends on

the compounding frequency.

Discount rates are at the heart of fixed income

securities analysis as they unambiguously

represent an exchange rate between money

today versus money tomorrow.

Maturities

Z( t, T) records the time value of money between

t and T

At any given time t, the discount factor depends

on its maturity T.

It is lower, the longer the maturity T.

That is given two dates T1 and T2, with T1 < T2, it

is always the case that

Z(t,T1) Z(t,T2)

prefer a money inflow sooner than later

Discount factors give the current value (price) of

receiving Re.1 at some point in the future

These values are not constant over time

One of the variables that determines this value is

inflation:

Higher expected inflation, makes less appealing

money in the future so discounts go down

Inflation is not the only variable that explains discount

factors

and Compounding Frequencies

Interest rates are closely related to discount

factors and are more similar to the concept of

return on an investment

Yet these are more complicated, because they

depend on the compounding frequency

The compounding frequency of interest

accruals refers to the number of times within a

year in which interests are paid on the invested

capital

For a given interest rate, a higher compounding

frequency results in a higher payoff

For a given payoff, a higher compounding

frequency results in a lower interest rate

and Compounding Frequencies

Discount factors and interest rates are intimately

related once we make explicit the compounding

frequency.

Given an interest rate and its compounding

frequency, we can define the discount factor.

Similarly , given a discount factor, we can define

an interest rate together with its compounding

frequency.

Compounding Frequencies

Two compounding frequencies are important:

semi-annual and continuous.

Semi-annual compounding

payment on treasuries.

matches

coupon

analytical convenience.

Formulas and derivations are much simpler under

the assumption of continuous compounding.

Discount Factor

We can derive the discount rate from the semiannually compounded interest rate.

Let r2 (t, T) denote the (annualized) semi-annually

compounded interest rate between t and T. The

2(T t )

payoff at T would be:

r2 (t , T )

Investment

at

t

Payoff at T =

Z(t, T) =

1

r2 (t , T )

2(T t )

Discount Factor

If the semi-annually compounded rate is 5%,the

corresponding discount rate is:

1

0.05

1

2*1

= 0.95181

Semi-annual Compounding

We can also obtain the semi-annual compounding rate from the discount rate

r2 t , T 2

Z t,T

1

2 T t

For a one year discount rate of 0.95181, the semi-annually compounded interest

rate is

= 2*[{(1/(0.95181)0.5} 1]

= 0.05 or 5%

For FFF

Let the discount factor Z(t,T) be given, and let

rn(t,T)

denote

the

annualized

n-times

compounded interest rate. Then rn(t,T) is defined

by the equation

1

rn t , T n

Z t, T

1

n T t

Z t,T

rn t , T

n T t

Continuous Compounding

The continuously compounded interest

rate is obtained by increasing the

compounding frequency

to

r t ,T n

T

t infinity

Z t,T e

r t,T

ln Z t , T

T t

Continuous Compounding

The relationship between a given interest rate rn

(t,T) with n compounding frequency and

continuously compounded interest rate r(t,T) is

given by:

rn t , T

r t , T n ln 1

rn t , T n e

r t ,T

n

The term structure of interest rates, or spot

curve, or yield curve, at a certain time t defines

the relation between the level of interest rates and

their time to maturity T

The term spread is the difference between long

term interest rates (e.g. 10 year rate) and the short

term interest rates (e.g. 3 month interest rate)

The term spread depends on many variables:

expected future inflation, expected growth of the

economy, agents attitude towards risk, etc.

The term structure varies over time, and may take

different shapes

Structure

Over Time

The price of zero coupon bonds (with a

principal value of Rs.100) issued by the

government is equal to:

Pz t , T 100 Z t , T

The subscript z is mnemonic of Zero

coupon bond

This means that from observed prices for

zero coupon bonds we can compute the

discount factors

A coupon bond can be represented

by a sequence of its cash payments.

If we know the discount factors Z( t,

T) to apply to these cash payments,

we can compute the value of a

coupon bond.

Coupon Bonds

Consider a coupon bond at time t with coupon

rate c, maturity T and payment dates T1,T2,,Tn =

T.

Let there be discount factors Z(t, Ti) for each date

Ti. Then thec value

the coupon bond can be

n

100 of

Pc t , Tn as:

Z t , Ti 100 Z t , Tn

computed

2

i 1

Pc t , Tn

also:

n

c

Pz t , Ti Pz t , Tn

2 i 1

Bonds

An example:

A 2-year coupon coupon bond pays half-yearly coupon of

Rs.2.1875

On the date of issue, the 6-month, 1-year, 1.5-years, and 2year discounts were Z(t,t+0.5) = 0.97862, Z(t,t+1) =

0.95718, Z(t,t+1.5) = 0.936826 and Z(t,t+2) = 0.91707

Therefore, the price of the bond on that date was

4

i 1

= Rs. 99.997

We can also represent the value of a coupon bond

using semi-annual interest rate r2 (t, T)

n

c / 2 100

100

Pc (t , Tn )

2(Ti t )

(1 r2 (t , Tn ) / 2) 2(Tn t )

i 1 (1 r2 (t , Ti ) / 2)

and equal to the semi-annual coupon rate, the

bond will trade at par

A No Arbitrage Argument

In well functioning markets in which both the coupon

bond Pc(t,Tn) and the zero coupon bond Pz(t,Tn) are

traded , if

c n

Pc t , Tn Pz t , Ti Pz t , Tn

2 i 1

then the arbitrageur can buy the bond for Pc(t,Tn)

and sell immediately c/2 units of zero coupon bond

with maturities T1,T2,,Tn-1 and (c/2+1) of the zero

coupon with maturity Tn

This strategy leads instantly to a profit. In a wellfunctioning market, such arbitrage opportunities

cannot last for long.

Bonds

With enough coupon bonds we can

compute the implicit value of zero

coupon bonds using the following

equation:

Pc t , Tn

n

c 100

Z t , Ti 100 Z t , Tn

2

i 1

Example

On t = June 30, 2005, the 6-month Treasury bill,

expiring on T1 = December 29, 2005, was trading at

Rs.98.3607

On the same date, the 1-year to maturity, 2.75%

Treasury note, was trading at Rs.99.2343

The maturity of the latter Treasury note is T2 = June

30, 2006

We can write the value of the two securities as:

Pnote(t,T2) = Rs.99.2343 = Rs1.375 Z(t,T1) +

Rs.101.375 Z(t,T2)

We

Rs.99.2343

Rs.1.375

Z t , T1 Rs

have two

equations

in.99.2343

two unknowns:

Rs.1.375 0.983607

Z t , T2

0.965542

Rs

.101.375

Rs

.101.375

Z(t,T1) = Rs.98.3607 / Rs.100 = 0.983607

.

Bonds

On the same date, t = June 30, 2005, the

December 31, 2006 Treasury note, with coupon

of 3%, was trading at Rs.99.1093

Denoting by T3 = December 31, 2006, the price

of this note can be written as:

P(t,T3) = Rs.1.5 Z(t,T1) + Rs.1.5 Z(t,T2) +

Rs.101.5 Z(t,T3) = Rs

Rs.99.1093

.99.1093 Rs.1.5[ Z (t , T1 ) Z (t , T2 )]

Z (t ,T3 )

Rs.101.5

Rs.99.1093 Rs.1.5(0.983607 0.965542)

Rs.101.5

= 0.947641

Bootstrap Methodology

With sufficient data we can obtain the discount factors for

every maturity This methodology is called bootstrap

methodology

Let t be a given date. Let there be n coupon bonds, with

coupon ci and maturities Ti. Assume that maturities are

regular intervals of six months. Then, the bootstrap

methodology to estimate discount factors, for every i = 1,

,n is as follows:

Pc t ,1T)1 is given by:

Z t , T1

100 1 c1 / 2

i 1 2,,n is given by:

Pc t , Ti ci / 2 100 j 1 Z t , T j

Z t , Ti

100 1 ci / 2

.

Bills

Treasury bills are quoted on a discount basis;

rather than quoting a price, Treasury dealers

quote the following:

100 Pbill t , T

360

d

100

days between t

n

calendar

P 100 1

d

360

and T

100 97.477 360

of a 182-day

d

4.99%

182

bill issued at a price of100

Rs.97.477

for Rs.100 of face

value as:

Bond Equivalent Yield on Treasury Bills:

BEY

100 P 365

P

n

Bills:

rt

P 100 e

P

e rt

100

P

rt ln

100

r

ln

t

100

Coupon Notes and Bonds

In the case of Treasury notes and bonds ,

interest accrues on the bond, if a bond is purchased

between the coupon dates,

It is market convention to quote these without any

inclusion of accrued interests, so:

Invoice (Dirty) Price = Quoted (Clean) Price + Accrued

Interest

Accrued Interest is given by:

Accrued Interest = Interest Due in Full Period

Number of Days Since Last Coupon Date/

Number of Days between Coupon Payments

A semi-annual Floating Rate Bond with maturity

T is a bond whose coupon payments at dates t =

0.5, 1, ., T are determined by the formula:

c t 100 r2 t 0.5 s

is a spread

Each coupon date is also called reset date as it is

the time when the new coupon is reset

If the spread of a floating rate bond is equal to

zero, the ex-coupon price of a floating rate bond on

any coupon date is equal to the bond par value

Consider a one year, semi-annual floating rate bond, with zero

spread:

which is known. If today, r2(0) = 2%, then: c(0.5) = 100 2% / 2 =

1

Also c(1) depends on the interest rate in six months r2(0.5) which is

unknown today, yet this doesn't matter since the cash flow at that

time will be (100 + c(1)), which means that the present value will

be:

V 0.5

100

1 r2 0.5 / 2

1 r2 0.5 / 2

bond at t=0.5 is 100 . Because 100

the

coupon

at time t=0.5 is known,

1

V 0

100

the value at t = 0 is:

1 2% / 2

.

When the spread (s) is not zero

Effectively the spread is a fixed payment on the bond

so we can

value it separately:

n

s Z 0, t

t 0.5 +

Price with spread = Price of no spread bond

zero

spread is just par (=100),n so that

s Z 0, t

t 0.5

Price with spread = 100+

How do we value a floating rate bond

outside of reset dates?

When the time 0 of the valuation is not a reset date:

We know that the bond will be worth

100(1+c(ti)/2) at the next reset date, note that

c(ti) is known

All we need to do is to apply the appropriate

discount to bring the value to t=0

Bonds

If reset date is t=0.25 and not t=0

We know the cum-coupon price at time t=0.25

We have to discount this cum-coupon back to t=0

at the current 3-month rate.

If the cum-coupon price at t=0.25 is Rs.101 and

the quarterly compounded 3-month rate is 2%,

then

Rs.101

Rs.100.50

(1 0.02 / 4)

Value of bond at 0 =

Let T1,T2,,Tn be the floating rate reset dates and

let the current date t be between time Ti and Ti+1: Ti

< t < Ti+1. The general formula for a semi-annual

floating rate bond with zero spread s is:

PFR t , T Z t , Ti 1 100 1 r2 Ti / 2

PFR t , T 100

implies:

Inverse Floater

An inverse floater is a security that pays a lower

coupon as interest rates go up.

A fixed reference rate is used from which the floating

rate is subtracted.

For example, if an inverse floater promises to pay

15% minus the short-term interest rate on an annual

basis with three years maturity, the coupon on the

bond is:

Where r1 (t-1) denotes the annually compounded rate

at time t-1.

Inverse Floater

If it is assumed that the coupon is always positive,

the bond does not pay any coupon when the short

rate is more than 15%.

The coupon payments are a combination of a fixed

rate bond and a floating rate bond.

This is the same as having a long position in a fixed

rate bond and a short position in a floating rate

bond.

However, such a view would mean that at maturity,

the principal received from the fixed rate bond is

used to pay for the principal of the floating rate

bond

Inverse Floater

Thus, only a long position in a fixed rate bond and

a short position in a floating rate bond does not

mimic an inverse floater.

However, when a long position in a zero coupon

bond of the same maturity is added, the position

mimics an inverse floater.

Price of Inverse floater: PZ (0,3)+PC (0,3) PFR

(0,3)

In the case of a leveraged inverse floater, the parity of

the floating rate to fixed rate is greater than one.

An example of a leveraged inverse floater is a bond

that pays a coupon of 25% minus two times the shortterm interest rate.

The coupon is given by:

C(t) = 25%- 2*r1 (t-1)

The portfolio that pays this cash flow would consist of

long two zero coupon bonds ,long a 25% fixed coupon

bond and short two floating rate bonds

Price of Leveraged Inverse floater: 2*P Z (0,3)+PC (0,3)

2*PFR (0,3)

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