Fixed Income Combined Notes Week 1 To 5

FIN 525: FIXED-INCOME SECURITIES
Week 1: INTRODUCTION, BONDS, YIELD,

DURATION & CONVEXITY
NGOC-KHANH TRAN
SPRING 2018
Acknowledgement: Slides are based on class notes

by Prof. D. Lucas (MIT)
2 Class logistics
 Learning objectives
 Grading
 Communications
 Topic coverage
Course Objectives
3
 Objectives: Become familiar with fixed-income

analytics.
 Get to know major fixed income markets and standard

instruments
 Acquire tools to value fixed income securities & their

derivatives
 Acquire tools to understand, manage & speculate on the

risk of fixed income investments
Learning
4
 Most efficient way to learn in this class is to study

the lecture notes (slides)
 work out numerical examples therein to make sure
you understand the steps.
 Do homework either by yourself or actively

contribute to your homework group.
 Ask questions in class or in office hours.

 Lecture questions: ask/email instructor or TA
 Pset questions: can also consult TA in office hours.
Grading
5
 Two problem sets, 15% each.

 Psets can be done in groups of up to four
students. Only one write-up per group required.
 80-min Final exam (in class), 70%
 Exam is open-book (actually, open-everything)
except internet.
 Class participation may be considered in
borderline cases – bring/exhibit your name card
could help here.
Communications
6
 Instructor’s e-mail: ntran@wustl.edu
 Instructor’s office hours: 10:30am-12:00 (noon)

Thursdays/ SH Room 208
 TAs/office hours: Thao Vuong,

tvuong@wustl.edu 10:00am-11:30am
Tuedays/ SH Room 220
 Lecture slides, Psets, supplemental notes and

readings, etc., will be posted on Blackboard
before class.
Textbooks
7
 Textbooks are optional:

1. “Fixed Income Securities,” by Pietro Veronesi, 1st Edition,
2010, Wiley.
2. “Derivatives Markets,” by Robert McDonald. 3rd Edition,
2012, Prentice Hall.
3. “Fixed Income Securities; Tools for Todays Markets,” by
Bruce Tuckman, 2nd Edition, 2002, Wiley Finance.
 Any Fixed-Income textbooks will cover much
more than this 6-week Intro class
 Takingthis class will mainly help read Fixed-
Income textbooks (if interested).
Topic outline
8
First topical class on FI security: tradeoff b/w

breadth and depth.
 Topic 1: Introduction, bond, treasuries market.
 Topic 2: Yield curve and its leading theories.
 Topic 3: Futures, Forwards and Swap contracts.
 Topic 4: Option on fixed-income (FI) securities.
 Topic 5: Credit risks.
 Topic 6: Mortgages and Securitization.
 Week 7: Final exam (Tue, Feb 27, 2018).

9 Topic 1-1: Introduction to fixed-income
securities
 Basics of Bond: Bond equivalent yield,
effective annual yield
 US Treasuries market
 Yield curves
 Duration and Convexity
Fixed-income securities
10
Fixed-income (FI) securities promise a series of pre-specified

payments at pre-determined points in time.
The Universe of Fixed Income Securities
 US treasuries: bills, notes, bonds.
 Treasury inflation protected securities (TIPS).
 Muni’s (Municipal bonds)
 Agencies, government sponsored enterprises (GSE)
 Mortgage-backed securities
 Corporate bonds
 Emerging market bonds
 LIBOR and swaps
 Fixed income derivatives
 Credit derivatives
US Fixed-income market: outstanding ($ Billions)
11
Source: https://www.sifma.org/resources/research/us-bond-market-issuance-and-outstanding/
US Fixed-income market: Trading volume
12
Average Daily Trading Volume ($ Billions)
Source: https://www.sifma.org/resources/research/us-bond-market-trading-volume/
Bond Basics
13
The most fundamental fixed-income (FI) securities are

bonds.
Bond cash flows (CF) are determined by:

 Price, “P”
 Face value, “F” (also called par), paid at maturity T
 Coupon payment:
 Annual coupon rate “c”  annual coupon = cF
 Coupon frequency “k”  per-period coupon =cF/k
 Attached options, covenants, amortization schedules, etc.

Zero-coupon bond
14
 No coupon payment
 A single CF: face value F (usually $1,000) paid at
maturity T
 Price P quoted as a fraction of face value F
 E.g.: “… a zero-coupon bond maturing in 3 years

is currently quoted at price $98.3 per $100 of face
value.”
Typical coupon bond
15
 Coupon amounts
 Coupon rate = fraction "c" of face value paid annually
 Annual coupon value=“C” denotes annual dollar coupon
 Payment Frequency (or coupon period)

 semiannual payments: each coupon = (c/2) * F
 quarterly payments: each coupon = (c/4) * F
 Compounding periods: k
 payments are compounded k times each year
 Length of each compounded period is (1/k) year
 Price quoted as a fraction of face value

 Note: without expressing otherwise, coupon period is identical to
compounding period
Example: coupon bond
16
 E.g. 1-1: What are CFs associated with buying a 7.2%

coupon bond with a face value of $1,000 with
semiannual coupon payments, a maturity of 2 years,
and a price quoted at $98 per $100 of face value?
 Answer: c=7.2%; F=$1000; T=2 yr; P=$980; k=2;

C=$1000*7.2%=$72 (per year) ; C/2=$36 (per period)
Basic Players in a Bond
17
Long position Short position

 Long/buy a bond  Short/issue/sell a
 Pay current price bond
now  Receive current price
 Receive frequent now
coupon payments  Pay frequent
and face value in coupons and face
future value in future
 Lend money  Borrow money
US Treasury Market: Intro
18
 Issuer: to finance the national debt of the U.S.

government, the Treasury (not Federal Reserve)
issues
 bills,
 bonds,
 notes.
 Lenders (who buy Treasuries):

The Federal Reserve, Foreigners, Commercial Banks,
Mutual Funds, Corporations, Individuals.
Great Info Resource: https://www.treasurydirect.gov/

US Treasury Market: Size
19
 Current US National Debt (as of Jan/11/2018)

$14,825,224,222,475.65
 Plus Intra-governmental holdings
$5,668,177,352,488.42
 Top-10 Foreign Gov. holders of US debt (Oct-16 & Oct-17)
1. China, Mainland: $1115.7 billion USD $1189.2 billion USD
2. Japan: $1131.9 billion USD $1093.9 billion USD
3. Ireland: $271.0 billion USD $312.4 billion USD
4. Brazil: $254.7 billion USD $270.0 billion USD
5. Cayman Islands: $262.0 billion USD $269.9 billion USD
6. Switzerland: $235.2 billion USD $254.0 billion USD
7. UK: $207.2 billion USD $225.9 billion USD
8. Luxembourg: $216.0 billion USD $217.9 billion USD
9. Hong Kong: $186.3 billion USD $192.3 billion USD
10. Taiwan: $188.6 billion USD $181.7 billion USD
Sources: https://www.treasurydirect.gov/NP/debt/current
http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt
US Treasury Market: Size
20
 Current US National Debt (as of Jan/11/2018)

$14,825,224,222,475.65
 Plus Intra-governmental holdings
$5,668,177,352,488.42
 US National reserves (including gold, in current Dollar)
2014: $ 434,416,453,480.00
2015: $ 383,728,469,500.00
2016: $ 405,942,340,670.00
 US GDP (in current Dollar)
2017: $ 19,500,600,000,000.00
Additional sources: http://data.worldbank.org/indicator/FI.RES.TOTL.CD?end=2015&locations=US&start=1960

https://www.bea.gov/national/index.htm#gdp
US Treasure Market: Review
21
Sources: http://zfacts.com/p/318.html
US Treasure Market: Recent
22
Q: Why national debt has increased so much lately?

A: Great recession  large spending (unemployment benefits, food
stamps, and social security payments for early retirement) and tax cut to
ease economic downturn  large increase in national debt.
And (in future) Trump admin’s New Tax Cut (corp. tax rate 35% to 21%)
Source: https://tradingeconomics.com/united-states/government-debt-to-gdp
US Treasury Market: Classification
23
Maturity
 T-Bills (quoted at a discount): up to 1 year
4 weeks.
 3-month bills are issued with 13 weeks or 91 days to
maturity.
 6-month bills are issued with 26 weeks or 182 days
to maturity.
 T-Notes (semi-annual coupons): 1 to 10 yrs.
 T-Bonds (semi-annual coupons): over 10 yrs.
US Treasury Market: Classification
24
With respect to Inflation

 Most are nominal.
 TIPS (Treasury Inflation-Protected Securities).
 The principal of a TIPS increases with inflation, and

decreases with deflation.
With respect to On-the-run vs. off-the-run

 On-the-run: Newly (newest) issued, most liquid
securities.
 Off-the-run: not the most recently issued bond,
somewhat less liquid.

US Treasury Market: Market Structure
25
Primary (New Issue) market

 Auctions are held at regularly scheduled intervals by the
Treasury (called “Treasury Auction”).

 Treasury auctions = Implementation of monetary policy
 The Fed uses about 23 "primary dealers" to carry out
“open market operations.” Many other securities firms

also participate.
Secondary market
 Very active OTC secondary market made by dealers and
brokers.
 Biggest volume of trade (2x retail market) is between
dealers. A typical trade is $10-$100 million in this market.
US Treasury Market: Market Structure
26
Treasury Auction (2017: 277 auctions, 8,522,000 $ Billions issued)

 Every week the Treasury sells a previously announced
quantity of 91 and 182 day bills in a sealed auction.

 Longer bills and bonds are also sold at regular but less
frequent intervals.
 In the Treasury bill auction, bills are distributed to
bidders, at the lowest market clearing yield, in the order of

priority:
(1) The Fed
(2) Competitive bids (bidders specify/submit yields)
(3) Non-competitive bids (up to $5 million, bidders
accept yields settled at auctions)
US Treasury Market: 23 Primary Dealers
27
 Bank of Nova Scotia, New York Agency.  J.P. Morgan Securities LLC.
 BMO Capital Markets Corp.  Merrill Lynch, Pierce, Fenner &
 BNP Paribas Securities Corp. Smith Incorporated.
 Barclays Capital Inc.  Mizuho Securities USA Inc.
 Cantor Fitzgerald & Co.  Morgan Stanley & Co. LLC.
 Citigroup Global Markets Inc.  Nomura Securities International,
Inc.
 Credit Suisse Securities (USA) LLC
 RBC Capital Markets, LLC.
 Daiwa Capital Markets America Inc.
 RBS Securities Inc.
 Deutsche Bank Securities Inc.
 Societe Generale, NY Branch.
 Goldman, Sachs & Co.
 TD Securities (USA) LLC.
 HSBC Securities (USA) Inc.
 UBS Securities LLC.
 Jefferies LLC.
 Wells Fargo Securities, LLC.
Sources: https://www.newyorkfed.org/markets/primarydealers
US Treasury Market: Individual Investors
28
 Individual investors can buy Bills, Notes, Bonds,

TIPS from US Treasuries by opening an account in
TreasuryDirect. (This is a secondary market!)
 Online transactions (available 24/7): can purchase,
and reinvest securities and perform account
maintenance from your home or work computer.
 No maintenance fees!
 (They can also buy them through a bank or broker.)
https://www.treasurydirect.gov/indiv/myaccount/myaccount_treasurydirect.htm
US Treasury Market: Interest Rates
29
 Who Sets Interest Rates: The market does, but rates are
influenced by government policy.
 The Fed controls several key short-term rates:
 Discount rate (rate for loans from Fed to temporarily illiquid
banks)
 Federal funds rate target (Inter-bank overnight lending rate)
 Fed keeps rate near target by buying/selling Treasury bonds
(injecting/withdrawing reserves): buy bonds to decrease
interest rates
 “Quantitative easing” (QE): print money and buy
securities, e.g., Treasury securities (but more recently, also
buy MBSs)
US Treasury Market: characteristics
30
Misc. advantages and disadvantages:
 Exempt from state and local taxation.
 Very active secondary market fosters highest liquidity.
 Provide collateral for margin accounts, repos, etc.
 High liquidity means low yields, and rates can become

disconnected from other (riskier) markets
US Treasure Market: Salomon Brothers 91’ Bond Scandal
31
 I-banks buy securities at auction to resell to

clients.
 Can “squeeze” the market if can buy enough of
the auctioned securities to make it difficult for
other investment banks to fulfill their forward
obligations to customers.
 Treasury rule: No one bank or bidder can take
more than 35% of the auction.
US Treasure Market: Salomon Brothers 91’ Bond Scandal
32
 Mozer (head Gov. bond trader with Solomon Bros)

made illegal bids twice (08/90 and 05/91). In 08/90,
Mozer made 105% bids for T-Notes (35% each in name of Solomon
Bros, Quantum Fund, & Warburg).
 Action was uncovered by SEC in second time.
 Solomon fined (then record high) $290 mm
 Solomon’s CEO Gutfreund ousted in 08/91.

Source: http://www.businessinsider.com/salomon-brothers-treasury-bond-scandal-2012-7?op=1
Bond Yields
33
 There are many conventions for bond yields.
 We focus on three conventions:
1. Yield to maturity (YTM)
2. Bond equivalent yield (BEY)
3. Effective annual yield (EAY)

Yield to Maturity (YTM)
34
 Definition: YTM is the single interest rate, “y” that equates

the price of a bond, “P”, to the present value of future CFs,
when CFs are discounted at that rate “y”.
 Note: YTM is yield per coupon-period, thus is not necessarily
annualized (if coupon period is not annual).
 For annual coupon bond (# periods N= time to maturity T)

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑇
YTM is such “y” that: 𝑃= + + ⋯+
1+𝑦 (1+𝑦)2 (1+𝑦)𝑇
 For semiannual coupon bonds (# periods N=2T)
𝐶𝐹1 𝐶𝐹2 𝐶𝐹2𝑇
YTM is such “y” that: 𝑃= + + ⋯+
1+𝑦 (1+𝑦)2 (1+𝑦)2𝑇
Bond Equivalent Yield (BEY)
35
 BEY is the most common way coupon bond yield is quoted

 Definition: BEY “y” is the simple annualized YTM quoted
on semiannual compounding basis (# compounding
periods N=2T).
𝐶𝐹1 𝐶𝐹2 𝐶𝐹2𝑇

BEY is such “y” that: 𝑃 = 𝑦 + 𝑦 + ⋯+ 𝑦
1+ (1+ )2 (1+ )2𝑇
2 2 2
 Name sake (BEY) arises from T-bonds, which have

semiannual coupon payments (and thus conventionally
taken, semiannual compounding).
 BEY applies to all bonds (not only bonds paying coupons
semiannually): see e.g. 1-3 below.
Effective annual yield (EAY)
36
 Definition: EAY “y” is the return earned over the year,

stated as a simple interest rate (i.e., for simple
compounding, pretend/assume no reinvestment
opportunities in the middle of the year).
 So if BEY is the quoted bond equivalent yield, investors

earn BEY/2 every six months. The corresponding EAY “y”
is:
𝐵𝐸𝑌 2
y= 1+ −1
2
 Obviously (by construction of the above formula), EAY is

always an annualized quantity.
Example: yield conventions for coupon bonds
37
 E.g. 1-2: 20-year bond, 7% coupon, semiannual payment,

price $130 quoted per $100 face value. What is yield to
maturity (YTM), bond equivalent yield (BEY), effective
annual yield (EAY).
 YTM:
3.5 3.5 3.5+100
130 = + + ⋯+ → 𝑦 = 2.34%
1+𝑦 (1+𝑦)2 1+𝑦 40
 BEY:
3.5 3.5 3.5+100
130 = 𝑦+ 𝑦 2
+ ⋯+ 𝑦 40
→ 𝑦 = 4.67%
1+ 2 (1+ 2 ) 1+ 2
𝐵𝐸𝑌 2 4.67% 2
 EAY: y= 1 + −1= 1 + − 1 = 4.73%
2 2
 (see Excel file enclosed, posted on Blackboard)
Example: yield conventions for zero coupon bonds
38
 E.g. 1-3: 19-year zero-coupon bond, price $870 quoted per

$1000 face value. What is yield to maturity (YTM), bond
equivalent yield (BEY), effective annual yield (EAY).
1000
 YTM: 870 = → 𝑦 = 14.94%
1+𝑦
 BEY (note: 𝐶𝐹1 = 𝐶𝐹2 = ⋯ = 𝐶𝐹37 = 0; 𝐶𝐹38 = 1000)
1000
870 = 𝑦 38
→ 𝑦 = 0.734%
1+ 2
𝐵𝐸𝑌 2 0.734% 2
 EAY: y= 1 + −1= 1 + − 1 = 0.736%
2 2
Yields: Excel Functions and online calculators
39
 Excel “RATE” or “YIELD” function can compute YTM.
 Excel “PRICE” function can compute the price per

$100 face value of a security that pays periodic
interest.
 Can also use online bond calculators (There are many

of these). For e.g., the following site offers calculator
for different quantities related to bond valuation.
http://www.investopedia.com/calculator
40 Topic 1-2: Basic Bond Math
 Yield curves
 Duration and Convexity
 Managing Duration & Convexity Risk
Yield curves
41
 Interest rates (yields) change with investment horizons:

plausibly, distant future has lot (more) uncertainties.
 The yield curve gives the yield on fixed income securities
as a function of their time to maturity (a.k.a., term-
structure of interest rate)
 There are many yield curves. This class: The yield curve is
associated with T-bill and T-bonds (not other fixed-
income securities). Click here to see the latest Yield
Curves reported/compiled by US Dept. of Treasury.
 A special case: Spot(*) yield curve is most easily computed
from zero coupon bonds. It shows how bond equivalent
yield (BEY) changes with maturity.
(*) “Spot” means the curve always plots the current yield (starting from
now/today) to some future date of maturity (instead of from future to future).
Constructing yield curves
42
𝐹 𝐹 1/2𝑇
P= 𝑦 →𝑦 𝑇 =2× −1
(1+ )2𝑇 𝑃
2
 Fixing par (e.g., F=100), spot yield curve 𝑦 𝑇 can be

computed from prices P of zero coupon bonds of
different maturity T.
 E.g. 1-4: Construct the spot yield curve from the

following 10 zero-coupon bonds (F=100).
1. First, we compute the BEY y(T) for each maturity T

2. Then, we plot y(T)
Plotting yield curves
43
P ($) 99 95 91 87 83 79.5 76 72.5 69.5 66
T (yr) 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
BEY(%) 2.02 5.20 6.39 7.09 7.59 7.80 8.00 8.20 8.25 8.49
Pricing using yield curves
44
 If we know the entire yield curve, we can compute

the price of fixed-income securities by no-
arbitrage principle (assuming no defaults).
 E.g. 1-5: Given the yield curve computed in e.g. 1-4,

compute the price P of a 2-year, semiannual
coupon bond per $1000 face value, with coupon
rate of 9%?
Pricing using yield curves
45
From e.g. 1-4 T (yr) 0.5 1 1.5 2
BEY(%) 2.02 5.20 6.39 7.09
Answer:
Let 𝑟1 (0, 𝑇) be the BEY for the period (0,T) (subscript
1 indicates annualized value (i.e., 1 year))
45 45 45 1045
P= + + +
𝑟1 (0,0.5) 𝑟1 (0,1) 2
𝑟 (0,1.5) 3
𝑟 (0,2) 4
1+ 1 + 1+ 1 1+ 1
2 2 2 2
45 45 45 1045
= 2.02% + 5.20% 2
+ 6.39% 3
+ 7.09% 4
= 1037
1+ 2 1+ 2 1+ 2 1+ 2
Risk in FI market: first step
46
Yield curve (or interest rate) risk

 Market or price risk: arises from uncertainty about bond prices
at the future time of sale (from bond holders’ perspective).
 Reinvestment risk: arises from the uncertain reinvestment rate
on coupon income.
 Timing or call risk (also related to credit risk)
Default risk
 Credit or default risk (not a concern for US Treasuries)
 Political or legal risk, Event risk
Liquidity risk
 Marketability or liquidity risk (also related to credit risk)
 Inflation or purchasing power risk (TIPS can help for T-bonds)

Yield curve risk (1-st step to quantify the risk)
47
 Recall Price-Yield relation:

Annual yield y; maturity T; compounding frequency k; total # of
periods n=k*T n  k T
CFi
P( y )   i
i 1  y
 1  
 k 
Price P is very sensitive to movement in yield y. Yield y is volatile for
both short and long terms (see graphs in next slides)!
Duration and convexity measure the sensitivity of price P to yield y,

hence can quantifies the yield curve risk
 Two most common definitions of duration
Macaulay duration
Modified duration
Yield curve risk (1-st step to quantify the risk)
48
n  k T
CFi
 Price-Yield relation: P( y )   i
i 1  y
 1  
 k 
Price P is very sensitive to movement in yield, and yield is volatile (see below)!
Short-term yield Long-term yield
Modified duration
49
Definition: Modified duration is percentage change in price over change

in yield
dP / P 1 dP D
Dm     Dm 
dy P dy  y
1  
 k
Properties:
Modified duration 𝐷𝑚 quantifies how price change with yield
dP   PDm dy
High duration bonds mean % change in price varies

substantially with yields (interest rates).
But note that this is only first-order (or linear) approximation.
Convexity will correct for second-order approximation.
For zero coupon bond: 𝐷𝑚 ≤ 𝑇
Macaulay duration
50
Definition: Macaulay duration is percentage change in price over

percentage change in yield (note: dP/dy<0 )
 y
1   1 nk T i CFi T
PV (CFt )
D 
P
k  dP
dy
D     t
P i 1 k  y i t PV (TotalCF )
1  
 k
where PV(X) denote the present value of cash flow X.

 Properties (assuming no defaults):
Macaulay duration D is weighted average of coupon periods
Thus, duration of a zero-coupon bond equals to its maturity: 𝐷 = 𝑇
Duration of coupon bond is less than or equal to its maturity: 𝐷 ≤ 𝑇
The higher the coupon rate the shorter the duration
The higher the yield the shorter the duration

Computing durations
51
 E.g. 1-6: 20-year 5%-coupon bond, semiannual

payments, yielding 9% on bond equivalent basis.
1. What are PV of cash flows, and bond price per $100

face?
2. What is Macaulay duration D?
3. What is modified duration?

Computing durations
52
 Answer to e.g. 1-6 (see excel file or using online calculator):

1. Bond equivalent yield y=9% implies
P = 𝑃𝑉 𝐶𝐹1 + 𝑃𝑉 𝐶𝐹2 + ⋯ + 𝑃𝑉 𝐶𝐹40 =

2.5 2.5 2.5+100
9% + 9% 2 +…+ 9% 40
= 63.20
1+ 2 1+ 2 1+ 2
2. Macaulay duration
40
𝑖 𝑃𝑉(𝐶𝐹𝑖 )
D= × = 10.87 years
2 𝑃
𝑖=1
9%
3. Modified duration 𝐷𝑚 = 𝐷/ 1 + = 10.40 (years)
2
Duration and change in prices
53
 E.g. 1-7 (cont. e.g. 1-6): 20-year 5%-coupon bond,

semiannual payments, yielding 9% on bond
equivalent basis.
1. BEY now changes to 9.5%, what is price

(percentage) change computed using duration? What
is actual price (percentage) change?
2. BEY now changes to 11.5%, what is price

(percentage) change computed using duration? What
is actual price (percentage) change?
Duration and change in prices
54
Answer to e.g. 1-7 (see excel file):

1. Case dy=0.5% : using duration, we find
dP
= −𝐷𝑚 𝑑𝑦 = −10.40 × 0.5% = −𝟓. 𝟐𝟎%
P
Actual price drop (see excel file) is -5.01 %
2. Case dy=2.5% : using duration, we find

𝑑𝑃
= −𝐷𝑚 𝑑𝑦 = −10.40 × 2.5% = −𝟐𝟔. 𝟎𝟏 %
𝑃
Actual price drop (see excel file) is -21.65 %
Remark: so when yield change dy is sizable, price change dP

using duration (linear approx.) is not reliable.
Graphic interpretation
55
𝒅𝑷 𝒚 𝟏 𝒅𝑷 𝟏 𝟏 𝒅𝟐 𝑷
% change in price: = 𝒅𝒚 + 𝟐 (𝒅𝒚)𝟐
𝑷(𝒚) 𝑷(𝒚) 𝒅𝒚 𝟐 𝑷(𝒚) 𝒅𝒚
Convexity
56
𝑑𝑃 𝑦 1 𝑑𝑃 1 1 𝑑2 𝑃 2
% change in prices: = 𝑑𝑦 + (𝑑𝑦)
𝑃(𝑦) 𝑃(𝑦) 𝑑𝑦 2 𝑃(𝑦) 𝑑𝑦 2
 Definition: Convexity is 2nd-order derivative of price
1 d 2P 1 n  k T i (i  1) CFi
CV 
P dy 2
  k2 i2
P i 1  y 
1  
 k
 Thus convexity gives second-order correction to price change (see
previous graph)
𝑑𝑃 𝑦 1
= −𝑫𝒎 × 𝑑𝑦 + 𝑪𝑽 × (𝑑𝑦)2
𝑃(𝑦) 2
Convexity and change in prices
57
 E.g. 1-8 (cont. e.g. 1-7): 20-year 5%-coupon bond,

semiannual payments, yielding 9% on bond equivalent
basis.
1. Compute the bond’s convexity
2. BEY now changes to 9.5%, what is price % change

computed using duration & convexity? Compare this to
actual % change.
3. BEY now changes to 11.5%, what is price % change

computed using duration & convexity? Compare this to
actual % change.
Convexity and change in prices
58
Answer to e.g. 1-8 (see excel file):

1 𝑘𝑇 𝑖(𝑖+1) 𝐶𝐹𝑖
1. Convexity: 𝐶𝑉 = 𝑖 𝑦 𝑖+2
= 160.86
𝑃 𝑘2
1+𝑘
2. Case dy=0.5%: using duration and convexity

dP 1
= −𝐷𝑚 𝑑𝑦 + 𝐶𝑉 (𝑑𝑦)2 = −𝟓. 𝟎𝟎%
P 2
price drops are: [actual: -5.01 %], [using duration: -5.20%]
3. Case dy=2.5%: using duration and convexity

dP 1
= −𝐷𝑚 𝑑𝑦 + 𝐶𝑉 (𝑑𝑦)2 = −𝟐𝟎. 𝟗𝟖%
P 2
price drops are: [actual: -21.65 %], [using duration: -26.01%]
Duration and convexity for portfolios
59
Portfolio with 3 bonds: A,B,C

These bonds have respective dollar values: 𝑉𝐴 , 𝑉𝐵 , 𝑉𝐶 in portfolio
𝑉𝐴 𝑉𝐵 𝑉𝐶
Weights: 𝑤𝐴 = ; 𝑤𝐵 = ; 𝑤𝐶 =
𝑉𝐴 +𝑉𝐵 +𝑉𝐶 𝑉𝐴 +𝑉𝐵 +𝑉𝐶 𝑉𝐴 +𝑉𝐵 +𝑉𝐶
Approximately:
Portfolio yield (BEY): 𝒚𝑷 = 𝒘𝑨 𝒚𝑨 + 𝒘𝑩 𝒚 𝑩 + 𝒘𝑪 𝒚𝑪
Portfolio duration: 𝑫𝒎,𝑷 = 𝒘𝑨 𝑫𝒎,𝑨 + 𝒘𝑩 𝑫𝒎,𝑩 + 𝒘𝑪 𝑫𝒎,𝑪
Portfolio convexity: 𝑪𝑽,𝑷 = 𝒘𝑨 𝑪𝑽,𝑨 + 𝒘𝑩 𝑪𝑽,𝑩 + 𝒘𝑪 𝑪𝑽,𝑪

Portfolio risk management: Immunization
60
 Immunization idea: Adjusting portfolio’s duration &

convexity help to reduce yield curve risk on portfolio
 Goal: to be able to meet a set of liabilities (i.e., a target
future value) by devising and investing in a portfolio of
bonds
 How to implement: Choose a portfolio to match
 the modified duration of liabilities (delta hedging).
 the present value of liability (cash matching).
 How it works: Liabilities and Portfolio will move together

 Users: pension funds, life insurance companies, banks
(managing duration gap).
Immunization at work
61
 E.g. 1-9: Suppose a pension fund has commitment

(liability) to pay 20o million USD in 10 year. It also
can invest in coupon bonds A and B (semiannual
payments) as given below. Compute the
immunization portfolio.
bond Coupon T (year) y 𝑫𝒎 𝑪𝑽 Price (per
(year) F=1000)
A 5% 20 7% 11.47 185.55 786.45
B 10% 10 8% 6.51 56.46 1135.91
liability none 10 8% 9.62 97.08 456.39
Table constructed using online calculator form

http://facweb.plattsburgh.edu/razvan.pascalau/BondForm.php
Immunization at work
62
bond Coupon T (year) y 𝑫𝒎 (yr) 𝑪𝑽 Price (per

F=1000)
A 5% 20 7% 11.47 185.55 786.45
B 10% 10 8% 6.51 56.46 1135.91.
Liability none 10 8% 9.62 97.08 456.39
Answer to e.g. 1-9:

 choose bond weights to match duration
11.47𝑤𝐴 + 6.51𝑤𝐵 = 9.62; 𝑤𝐴 +𝑤𝐵 = 1

implying 𝒘𝑨 = 𝟎. 𝟔𝟑; 𝐰𝐁 = 𝟎. 𝟑𝟕
200×106 6
 PV of Liability: 456.39 × = 91.28 × 10
103
6
 Long bond A: 91.28 × 10 × 𝑤𝐴 = 57.51 million USD
6
 Long bond B: 91.28 × 10 × 𝑤𝐵 = 33.77 million USD
Yield-Convexity Tradeoff
63
 E.g. 1-10 (cont. e.g. 1-9): Compare the yield and

convexity of the immunization portfolio (AB) and
the liability. Explain their differences.
Asset 𝑫𝒎 (year) Price (mil) Yield (BEY) 𝑪𝑽 Name
Portfolio 9.62 91.28 7.37% 137.79 Barbell

(0.63A+0.37 portfolio
B)
Liability 9.62 91.28 8.00% 97.08 Bullet
portfolio
 Answer: Portfolio (AB) has lower yield, but higher

convexity. Why?
 High yield is good, but high convexity is also great!
Yield-Convexity Tradeoff
64
𝑑𝑃 𝑦 1
= −𝐷𝑀 𝑑𝑦 + 𝐶𝑉 (𝑑𝑦)2
𝑃(𝑦) 2
 For convexity 𝐶𝑉 > 0, bond price always increases for any fluctuation in
yield (either dy>0 or dy<0).
 So given same duration 𝐷𝑀 , higher convexity is better for long position in
bond.
Bullet vs. Barbell Strategies
65
 Portfolio (AB) thus trades off lower yield for higher convexity
(compared to the liability).
 Nomenclature:
 Bullet: Single bond of medium (moderate) maturity
 Barbell: Portfolio of short and long-maturity bonds
 Given same duration, Barbell has higher convexity

Delta and Gamma hedging
66
 E.g. 1-10 shows the trade off between duration and

convexity.
 Q: But can we hedge both duration and convexity risk?

 Duration hedging: similar to delta hedging (i.e., option’s 1st order
hedging against movement in price of the underlying).
 Convexity hedging: similar to gamma hedging (i.e., option’s 2nd
order hedging against movement in price of the underlying ).
 A: Yes, form portfolio (like “diversification”).

 Caveat: will not be able to match the present value (PV)
of liability exactly.
Delta and Gamma hedging at work
67
 E.g. 1-11 (cont. e.g. 1-9): Suppose a pension fund

has commitment (liability) to pay 200 mil USD in
10 year. It also can invest in coupon bonds A and B
(semiannual payments) given below.
 Compute delta (duration) hedging using only bond A
or B
 Compute delta and gamma hedging (duration and
convexity) hedging using a portfolio of bonds A and B
bond Coupon T (year) y 𝑫𝒎 𝑪𝑽 Price (per
(year) F=1000)
A 5% 20 7% 11.47 185.55 786.45
B 10% 10 8% 6.51 56.46 1135.91
liability none 10 8% 9.62 97.08 456.39
Delta and Gamma hedging at work
68
bond Coupon T (year) y 𝑫𝒎 (year) 𝑪𝑽 PV (mil)

A 5% 20 7% 11.47 185.55
B 10% 10 8% 6.51 56.46
liability none 10 8% 9.62 97.08 91.28
Answer to e.g. 1-11

 Using only bond A: to match duration of the liability, hold (long) 𝑋𝐴 dollars in
bond A
11.47 × 𝑋𝐴 = 𝟗. 𝟔𝟐 × 𝟗𝟏. 𝟐𝟖 𝑚𝑖𝑙 → 𝑋𝐴 = 76.6 𝑚𝑖𝑙
 Similarly, hold (long) 𝑋𝐵 dollars in bond B
6.51 × 𝑋𝐵 = 𝟗. 𝟔𝟐 × 𝟗𝟏. 𝟐𝟖 𝑚𝑖𝑙 → 𝑋𝐵 = 134.9 𝑚𝑖𝑙
 Using both A and B, can match both duration and convexity
11.47 × 𝑋𝐴 + 6.51 × 𝑋𝐵 = 𝟗. 𝟔𝟐 × 𝟗𝟏. 𝟐𝟖 𝑚𝑖𝑙
185.55 × 𝑋𝐴 + 56.46 × 𝑋𝐵 = 𝟗𝟕. 𝟎𝟖 × 𝟗𝟏. 𝟐𝟖 𝑚𝑖𝑙
which imply longing 𝑋𝐴 = 𝟏𝟒. 𝟓 𝐦𝐢𝐥 in bond A, and 𝑋𝐵 = 𝟏𝟎𝟗. 𝟒 𝐦𝐢𝐥 in bond B.
(Note: delta/gamma hedging does not match PV of liability, it just matches the
change dP in value of liability).
Immunization vs. Delta & Gamma hedging
69
Immunization Delta & Gamma

 Matches duration  Matches duration
 Matches present  Does not match
value present value
 Does not match  Matches convexity
convexity  Works for larger
 Works for small yield yield changes dy
changes dy
In practice, both strategies require dynamic adjustments

Week 2: FORWARD RATE, YIELD CURVE RISK

AND ECONOMIC MODELS OF YIELD CURVE
NGOC-KHANH TRAN
SPRING 2018

2 Topic 2-1: Forward rates
 Constructing yield curves by bootstrapping

 Yield curve risk (next step)
 Expected inflation
Yield curve and Bootstrapping
3
 Yield curve is critically important economically

because it richly contains info about
 economic conditions (growth, inflation, defaults)
 monetary policies (Fed.)
 investors’ expectations (sentiments)
 Yield curve is critically important practically

because it can price other payoff by arbitrage
(recall e.g. 1-5), facilitate hedge and speculation
 But how to construct the yield curve?
 From prices of zero-coupon bonds: recall e.g. 1-4.
 From prices of coupon bonds: see next!
Bootstrapping: Idea
4
 Collect data on prices and coupon rates for bonds

of increasing maturities.
 Start with shortest maturities, and proceed
recursively (i.e., bootstrapping) to back out yields
𝐶1 +𝐹
 𝑃1 = → 𝑦1
1+𝑦1
𝐶1 𝐶2 +𝐹
 𝑃2 = + → 𝑦2
1+𝑦1 (1+𝑦2 )2
 ……
𝐶1 𝐶𝑛−1 𝐶𝑛 +𝐹
 𝑃𝑛 = + ⋯+ + → 𝑦𝑛
1+𝑦1 (1+𝑦𝑛−1 )𝑛−1 (1+𝑦𝑛 )𝑛
Bootstrapping at work
5
 E.g. 2-1: Constructing the spot yield curve (on

bond equivalent basis) from the following data
available on T-bonds.
Maturity Coupon Price Implied
(month) (s.a. %) (per $100 face) BEY (%)
6 7.5 99.47 ?
12 11 102.07 ?
18 8.75 99.41 ?
24 10.125 101.02 ?
3.75+100
 99.47 = → 𝑦1 = 8.6% (𝐵𝐸𝑌)
1+(𝑦1 /2)
5.5 5.5+100
 102.07 = + 𝑦2 2 → 𝑦2 = 8.8%
1+(𝑦1 /2) (1+ )
2
Bootstrapping at work
6
4.38 4.38 4.38+100

 99.41 = + 𝑦 + 𝑦 → 𝑦3 = 9.2%
1+(𝑦1 /2) (1+ 22 ) 2 (1+ 23 )3
5.06 5.06 5.06 100+5.06
 101.02 = + 𝑦2 2 + 𝑦 + 𝑦 → 𝑦4 = 9.6%
1+(𝑦1 /2) (1+ 2 ) (1+ 23 ) 3 (1+ 24 )4
Now can fill in the table:
Maturity Coupon Price Implied

(month) (s.a. %) (per $100 face) BEY (%)
6 7.5 99.47 8.6
12 11 102.07 8.8
18 8.75 99.41 9.2
24 10.125 101.02 9.6
Bootstrapping: Matrix operation
7
Bootstrapping is linear system, so plug data into a matrix!

3.75+100 1
 99.47 = Let 𝑥1 ≡ 1+(𝑦
1+(𝑦1 /2) 1 /2)
5.5 5.5+100 1
 102.07 = 1+(𝑦 + 𝑦 Let 𝑥2 ≡ 𝑦
1 /2) (1+ 2 )2 (1+ 2 )2
2 2
4.38 4.38 4.38+100 1
 99.41 = 1+(𝑦 + 𝑦 + 𝑦 Let 𝑥3 ≡ 𝑦
1 /2) (1+ 2 )2 (1+ 3 )3 (1+ 3 )3
2 2 2
5.06 5.06 5.06 100+5.06 1
 101.02 = + 𝑦2 2 + 𝑦 + 𝑦 Let 𝑥4 ≡ 𝑦
1+(𝑦1 /2) (1+ 2 ) (1+ 23 )3 (1+ 24 )4 (1+ 24 )4
103.75 0 0 0   x1   99.47 
 5.5 105 .5 0 0   x  102.07 
  2   
 4.38 4.38 104.38 0   x3   99.41 
     
 5.06 5.06 5.06 105.06  x4  101.02
Bootstrapping: Generality
8
 More generally, we can do bootstrapping with un-ordered

data on prices and coupons
1
Let 𝑥𝑖 ≡ 𝑦 𝑖
1+ 2𝑖
 Then generally, the yield curves solve a linear (matrix)
system: This method works for arbitrary set of data, as
long as matrix is non-singular
   0    x1   P1 
    0 x  P 
  2    2 
       
    
  0 0    xn   Pn 
(“×” denotes a given numerical value)
Yield curve risk: next step
9
 Litterman and Scheinkman (Goldman Sachs, 1991) point out that

most of the variation in returns on all FI securities can be explained in
terms of three “factors”
 level (parallel movement of yield curve): accounts for 85% of
Treasury yield curve changes
 steepness (yield curve slopes up or down): accounts for 5% of
Treasury yield curve changes
 curvature (yield curve becomes more or less convex): accounts for
3-4% of Treasury yield curve changes
Yield curve risk: level (parallel) shift
10
 If (expect that) yield curve shifts up

across all maturities
 Bond prices would drop for all
maturities
 Hedging strategy: long 2yr bond and
short 30yr bond (or vice versa)
such that portfolio’s duration is
zero (delta hedging, recall e.g. 1-11)
 Speculating strategy: short 2yr bond and short
30yr bond
 Later, if yield curve actually shifts down across all maturities

 All bond prices surge
 Hedging portfolio: value changes little (because of delta hedging)
 Speculating portfolio: loses big! This is the dark side (high risk) of
all speculating strategies.
Yield curve risk: steepening/flattening
11
 If (expect that) yield curve would slope

up (i.e., steepening)
 2yr bond price would surge, 30yr bond
price would drop (relatively)
 Hedging strategy: long 2yr bond and
long 30yr bond (or vice versa)
 Speculating strategy: long 2yr bond
and short 30yr bond
 Later, if yield curve actually slopes down

 2yr bond price drops, 30yr bond price surges (relatively)
 Hedging portfolio: value changes little
 Speculating portfolio: loses big!
Yield curve risk: curvature (or butterfly)
12
 If (expect that) yield curve would curve up

(i.e., curvature increases)
 2yr and 30yr yields decrease, 10yr yield increases
 2yr bond and 30yr bond prices
surge, 10yr bond price drop
 Hedging strategy: long 2yr and 30yr
bond and long 10yr bond (or vice versa)
 Speculating strategy: long 2yr and 30yr
bond and short 10yr bond
 Later, if yield curve actually becomes less curved

 2yr bond and 30yr bond prices drop, 10yr bond price surges
 Hedging portfolio: value changes little
 Speculating portfolio: loses big!
Yield curve risk: example
13
T  2yr 10yr 30yr

y 3.5% 5% 5.5%
𝑫𝑴 = 𝑇/(1 + 𝑦) 1.93 9.52 28.44
 E.g. 2-2: Consider three zero-coupon bonds. Using the 2yr zero as the
reference bond, the 2-to-10 yield spread is 150 bps, and the 2-to-30 spread is
200 bps. [Assuming annual compounding].
 Steepener: You expect the 2-to-10 spread will increase but not sure of the
future overall direction of the interest rate. What is the strategy that
speculates on this view but can hedge against level risk? [Assuming $100
notional value of portfolio]
 Compute change in portfolio’s value under parallel shift of +10 bps.
 Compute change in portfolio’s value when 𝑦2 drops by 15 bps and 𝑦10
increases by 5bps.
14
T 2yr 10yr 30yr

y
 3.5% 5% 5.5%
𝑫𝑴 = 𝑇/(1 + 𝑦) 1.93 9.52 28.44
Answer to e.g. 2-2:

 “… expect the 2-to-10 spread will increase”  long $𝑉2 of 2yr bond,
short $𝑉10 of 10yr bond.
 “… but not sure of the overall direction of the interest rate” 
portfolio should have zero modified duration.
1.93𝑉2 + 9.52𝑉10 = 0
𝑉2 + 𝑉10 = 100
implying 𝑉2 = $125.43 (long in 2yr bond), and 𝑉10 = −$25.43
(short in 10yr bond).
15
Answer to e.g. 2-2 (cont.)
T 2yr 10yr Portfolio

y 3.5% 5%
𝑫𝑴 1.93 9.52
Value V 125.43 -25.43 100
New y (10bps up- 3.6% 5.1%
shift)
Change dV −𝟏𝟐𝟓. 𝟒𝟑 × 𝟎. 𝟏% × 1.93 −𝟐𝟓. 𝟒𝟑 × 𝟎. 𝟏% × 9.52 ≈𝟎
= −𝟎. 𝟐𝟒𝟐𝟎𝟖 = 𝟎. 𝟐𝟒𝟐𝟎𝟗
New y 3.35% 5.05%

(steepening)
Change dV 𝟏𝟐𝟓. 𝟒𝟑 × 𝟎. 𝟏𝟓% × −𝟐𝟓. 𝟒𝟑 × (−𝟎. 𝟎𝟓%) × 𝟎. 𝟒𝟖𝟒𝟏

1.93 =0.3631 9.52 =0.1211
16
 E.g. 2-3: Consider three zero-coupon bonds of e.g. 2-2. Butterfly: the 2yr
and 30yr zeros will move up while the 10yr zero will move in opposite
direction. Not sure about the overall future direction of the interest rate,
nor about the future movement in the slope of the yield curve.
Describe qualitatively your strategy to speculate on this view while
being able to hedge against level and slope risk.
 Answer to e.g. 2-3:
2yr and 30yr bond price would drop, while 10yr bond price would surge, so
the speculating strategy is to short 2yr and 30yr bonds, and long 10yr bond.
How to hedge level risk: under level shift, [10yr] and [2yr & 30yr] bond prices
will move in same directions, so short one and long the other in right $
amount will foster delta hedging against this level risk.
How to hedge slope risk: when yield curve steepens or flattens, 2yr and 30yr
bond prices will move in opposite directions, so short both bonds in right $
amount will foster hedging against this slope risk.
Expected inflation and FI market
17
 Most of FI securities pay (and are quoted) in nominal

term
 A rare exception is TIPS (Treasury Inflation Protected
Securities): makes up 10% of all treasuries, first issued in ‘97
 Nominal yield 𝑦𝑁 is observable from bond price (assuming
𝐹
zero coupon, T=1, annual compounding): = 1 + 𝑦𝑁
𝑃
 Real yield 𝑦𝑅 and expected inflation 𝐸 𝜋 are more elusive
𝐹
= 1 + 𝑦𝑅 × 1 + 𝐸 𝜋
𝑃
 Thus 1 + 𝑦𝑁 = 1 + 𝑦𝑅 × 1 + 𝐸 𝜋 , or
𝐸 𝜋 ≈ 𝑦𝑁 − 𝑦𝑅
Inferring expected inflation
18
How to infer the expected inflation:

 Statistical models
 Ask people (surveys)
 Look at prices of TIPS (to get 𝑦𝑅 ) vs. nominal T-bonds (to
get 𝑦𝑁 ):
𝐸 𝜋 ≈ 𝑦𝑁 − 𝑦𝑅
 TIPS has performed phenomenally well since introduced
in the late 1990s
 By product: Market pricing of TIPS allows Fed to measure
expectation about inflation directly.
 Caveats: 𝐸 𝜋 also contains liquidity risk premium (b/c TIPS
is less liquid than T-Bonds) as well as inflation risk premium
(b/c inflation risk premium).
Inferring expected inflation
19
Graphs show expected inflation 𝐸 𝜋 ≈ 𝑦𝑁 − 𝑦𝑅 computed from nominal

bond’s yield 𝑦𝑁 and TIPS (real) yield 𝑦𝑅 (source: Gurkaynak, Sack,
Wright, 2010)
20 Topic 2-2: Theories of yield curves
 Forward rates
 Leading theories of yield curve
 Basics of forwards and futures contracts
Forward rates: by example
21
 Forward rates are interest rates, prevailing from a future point in time
to another future point, & implied by yield curve (and no arbitrage).
 E.g. 2-4: Suppose 6-mo BEY 𝑦1 = 6%, and 1-yr BEY 𝑦2 = 8%.
 What is the (implied and annualized) interest rate for the period 6-
mo to 1-yr from now?
 How a fund can make sure to lend, say, $100 at that rate in future?
 Looking forward, in 1 year, 1 USD now will be

𝑦1 𝒇𝟏,𝟐 𝑦2 2
 1+ 1+ = 1+ → 𝒇𝟏,𝟐 = 𝟏𝟎. 𝟎𝟐%
2 2 2
Forward rates: by example
22
 Answer (cont):
 6 months from now, fund wants to lend (notionally) $100 at (annualized)
rate 𝑓1,2 = 10.02% for 6 months.
 They can do that by:
𝑦1
1. Going short (issue/sell) $100/ 1 + in 6-mo bond now and
2
𝑦1
2. Going long (buy) $100/ 1 + in 1-year bond now
2
(So this is a zero net investment strategy now)
So 6mo from now fund will have to deliver (i.e., just like put aside for lending)
to the buyer of 6-mo bond buyer (face & interest of this 6mo bond):
𝑦1 𝑦1
$100/ 1 + × 1+ = $100
2 2
And, 1-yr from now the fund will receive (from long position in 1-yr bond)
𝑦1 𝑦2 2 𝑓1.2
$100/ 1 + × 1+ = $100 × 1 + = $105.01
2 2 2
Then practically, fund is lending $100 at annualized rate 𝑓1.2 for period 6mo to
1yr (from now).
Forward rates
23
 Definition: 𝒇𝟏 𝟎, 𝒎, 𝒎 + 𝒏 is per − period forward rate from

period m to period m+n. By no-arbitrage
𝑚 𝑛
1 + 𝑦𝑚 1 + 𝑓1 0, 𝑚, 𝑚 + 𝑛 = 1 + 𝑦𝑚+𝑛 𝑚+𝑛
which implies
𝟏/𝒏
𝟏+𝒚𝒎+𝒏 𝒎+𝒏
𝒇𝟏 𝟎, 𝒎, 𝒎 + 𝒏 =
𝟏+𝒚𝒎 𝒎
 Notation: 𝑓1 0, 𝑚, 𝑚 + 𝑛
 Subscript 1 indicates this is rate per one period
 Index 0 indicates the forward rate perceived now
 m is (future) starting period, m+n is ending period
Forward rates: properties
24
𝟏/𝒏
𝟏+𝒚𝒎+𝒏 𝒎+𝒏
𝒇𝟏 𝟎, 𝒎, 𝒎 + 𝒏 =
𝟏+𝒚𝒎 𝒎
Properties:
 Forward rates are known now and thus can be locked in
now by trading FI securities (e.g. 2-2).
 Forward rates are not future spot rates(*): forward rates
are only an indicator of future spot rates.
 Thus forward rates are informative about the market’s
expectation about future interest rate.
 Note: In above formula, y and f are effective per-period rates. (Rates
on bond equivalent basis (BEY) must be divided by 2 first to get to 6-
month period rate, see e.g. 2-2)
(*) Future spot rate: is a rate that will be realized in a future date, and
cannot be known for sure any time before that future date.
Yield curve from forward rates
25
 No-arbitrage: Can as well construct yield curve

from forward rates.
1 + 𝑦𝑛 𝑛= 1 + 𝑓1 (0,0,1) × 1 + 𝑓1 (0,1,2) × ⋯ × 1 + 𝑓1 (0, 𝑛 − 1, 𝑛)
 Note: All forward rates are perceived now (index 0).

Theories of yield curves
26
 Alternative theories attempt to explain, from

(macro) economic conditions and investors’
perception:
 the shape of yield curve
 the movement of yield curve
 Leading theories are:

 Rational (risk-based) convexity effect
 Market Segmentation/Prefer Habitat
 Unbiased Expectation Hypothesis
 Liquidity preference
Convexity effect
27
 Convexity effect stems from volatility (i.e., risk) of

interest rate.
 It predicts (or explains) the pull-down of long-end of the
yield curve. Intuitions:
 Uncertainty increases with horizons
 Thus, longer-term bonds (assuming no default) are

relatively more valuable (expensive)
 Thus, all else equal, long-term yield is relatively lower
Market segmentation
28
 Some investors (e.g., pension funds, life insurers)

primarily trade long-maturity securities
 Others (e.g., banks) primarily trade short-maturity
securities
 Supply and demand operate independently in these
markets (segmentation)
 Segmentation
then may explain
why yields differ
across maturities
𝒚𝟏 ≠ 𝒚𝟏𝟓
Preferred habitats
29
 A milder version of market segmentation theory

 While investors have preferred maturities for trading
purpose, they will switch habitats when rate (return)
differentials are sufficiently large. This explains 𝒚𝟏 ≠ 𝒚𝟏𝟓 , but
their difference should not be too large.
 Evidence for either market segmentation or preferred habitat

is mixed (plausible! No single theory explains everything).
Expectation hypothesis (EH): rationale
30
 To formalize the intuition behind EH, consider the following setting:
1-yr yield 2-yr yield forward coupon face price compoun-

ding
𝑦1 𝑦2 𝑓1(0,1,2) 0% $100 𝑃0 annually
100
 Pricing: 𝑃0 = 1+𝑦1 × 1+𝑓1 0,1,2
(1)
 If market expects that at t=1, 1-yr yield (called future spot yield) is 𝑦1,2, the value of
100
bond at time t=1 is 𝑃1 =
1+𝑦1,2
𝑃 100
 Thus at time t=0, 𝑃0 = 1 = (2)
1+𝑦1 1+𝑦1 × 1+𝑦1,2
 Comparing Eqs. (1), (2) would imply 𝑓1 0,1,2 = 𝑦1,2, but as can only have some
expectation about future spot rate 𝑦1,2, EH postulates that
𝑓1 0,1,2 = 𝐸0 𝑦1,2
Expectation hypothesis (EH)
31
 Formally and more generally, Expectation Hypothesis theory

postulates that: “The forward rates implied by the term
structure are equal to the market's expectation of future spot
rates over the period covered by the forward rate.”
𝑓𝑛 0, 𝑚, 𝑚 + 𝑛 = 𝐸0 𝑦𝑚,𝑚+𝑛
 Alternative & concise statement of EH: “Forward rate is an

unbiased predictor of future spot yield.”
Expectation hypothesis vs. business cycles
32
 Observations in interest rate market: Yield curve tends to

 slope up at the beginning of expansions
 slope down at the end of expansions
 Basic question: Are these consistent with EH? Answer: YES!

 When economy starts booming: Investment opportunities open up
demand for money is expected  bonds will be issued in abundance (to
borrow money) bonds will be cheaper looking forward  interest rate will
be higher looking forward  yield curve slopes up
Expectation hypothesis vs. business cycles
33
 Observations in interest rate market: Yield curve tends to

 slope up at the beginning of expansions
 slope down at the end of expansions
 Basic question: Are these consistent with EH? Answer: YES!

 When economy starts contracting:
 Money demand is to drop  cash supply will be abundant  interest rate
is to drop  yield curve slopes down
 People expect down turn  save more to smooth consumption by buying
bonds  bonds more expensive looking forward  yield curve slopes
down
Expectation hypothesis: shortcomings
34
 Expectation hypothesis assumes several strong assumptions:

1. Investors view securities with different maturities are perfect substitutes for
one another: No liquidity concerns about of long maturities. [Recall that you have to
commit in (long and short) positions in bond markets in order to lock on forward rates]
2. Expectations are held with absolute certainty

 The math behind EH is not flawless
 Recall that from the pricing of bond

100 100
= 𝑃0 = 𝐸
1+𝑦1 × 1+𝑓1 0,1,2 1+𝑦1 × 1+𝑦1,2
1 1
implies only =𝐸
1+𝑓1 0,1,2 1+𝑦1,2
 while EH states something neater but quite different:

1 + 𝑓1 0,1,2 =𝐸 1 + 𝑦1,2
 Note that 𝑌 = 𝐸 𝑋 is not the same as 𝑌 −1 = 𝐸 𝑋 −1
Liquidity preference theory
35
 Liquidity preference theory postulates that “Investors

require a premium for investing in longer-term debt.”
 Required premium is called “liquidity premium” or “term
premium”
 E.g.: Forward rate𝑓1 0,4,5 = 4%, but market may expect
only𝐸 𝑦4,5 = 3% only, because locking on 𝑓1 0,4,5 = 4%
sacrifices liquidity
 Thus, liquidity premium corrects for expectation hypothesis
by adding a liquidity premium
𝑓𝑛 0, 𝑚, 𝑚 + 𝑛 = 𝐸 𝑦𝑚,𝑚+𝑛 + 𝐿 0, 𝑚, 𝑚 + 𝑛
 That is, the forward rate perceived by investors goes beyond
the expected future spot yield because of their liquidity
preference.
Liquidity preference in the data
36
 Statistically, analyses suggest that

 Size of liquidity premium L is from a few basis points to over 1%
 liquidity premium varies substantially with time and market
condition (plausible!)
 However, it is very difficult to have precise statistical tests of liquidity
preference theory, because tests involve (mostly unobservable) investors’
expectation about future yield.
37 Topic 2-3: Forward contracts
 Basics of Forward contracts

 No arbitrage and Forward price
 Forwards vs. Futures
Forward contract: Basics
38
 Forwards: are contracts, in which first party has the obligation to

deliver (sell) the underlying assets (e.g., bonds) to the second party
at a pre-determined date and price. The second party has the
obligation to accept (buy) this delivery.
 E.g. forward contract: “… I will deliver to you in one year $1 million
face value of a 3 year 6% coupon Treasury note, at a price of $98 per
$100 face value”.
 Thus, a forward contract specifies 4 aspects of future transactions
today:
 what is to be deliver (bonds, in this FI class)
 the quantity to be delivered
 the delivery date
 the price to be paid
 In this class, we mostly consider forward contract on bonds.

Basic Players in forward contract on bonds
39
Long position Short position
 The “buyer” of the  The “seller” of the

forward contract forward contract
 Has the obligation to  Has the obligation to
buy bonds sell bonds
 Thus, has obligation to  Thus, has obligation to
lend money in future borrow money in
at a rate specified future at a rate
today specified today
Thus, forwards market allows investors to lock in future

interest rate today!
Forward price (from BEY)
40
 Forward price 𝑭𝑷 is the price specified in the forward contract, at which

the bonds are bought/sold at the delivery date.
 Obviously, 𝑭𝑷 is agreed upon (predetermined) now at the signing date
(t=0) by both parties of the contract
𝒚𝒕 𝟐𝒕
 By no arbitrage, the forward price is 𝑭𝑷 = 𝑷𝟎 × 𝟏 + where
𝟐
 𝑡 is the delivery time (by convention, 𝑡 = 0 is now)
 𝑷𝟎 is the current price (at 𝑡 = 0) of the bond to be delivered (thus, 𝑷𝟎 is also
the present value of all cash flows of the bond)
 𝒚𝒕 is the spot yield (on bond equivalent basis) for the horizon 𝑡
Forward price (from EAY)
41
𝒚𝒕 𝟐𝒕
𝑭𝑷 = 𝑷𝟎 × 𝟏 + 1
𝟐
 Forward price 𝑭𝑷 can also be conveniently
computed from effective annual yield EAY.
 Recall that relation between EAY and BEY

𝑦𝑡 2 𝑦𝑡 2
𝐸𝐴𝑌 = 1 + −1 or 1 + = 1 + 𝐸𝐴𝑌
2 2
 Thus, forward price 𝑭𝑷 in 1 becomes

𝑭𝑷 = 𝑷𝟎 × 𝟏 + 𝑬𝑨𝒀 𝒕
Forward price: arbitrage strategy
42
 E.g. 2-5: Consider a forward contract on a 10-year 5% coupon bond

(annual payments) to be delivered in two years. The contract is for
delivery of a bond with face value of $100. Currently (t=0) this bond
is priced at par, and 1-year EAY 𝑦1 = 3.5%, 2-year EAY 𝑦2 = 4.2%.
 Assuming no arbitrage, compute the forward price 𝐹𝑃 of this
contract.
 If currently, this forward contract offers $110 as forward price,
form the trading strategy to exploit this arbitrage.
 If currently, this forward contract offers $107 as forward price,
form the trading strategy to exploit this arbitrage.
Forward price: example
43
 Answer to E.g. 2-5:
 Note that, even the coupon bond has not yet come to live, market
can already start trading on it: this is a great feature of forward
market to facilitate borrowing/lending/speculating in future rate
NOW!
 So actually, market trades the ownership of all CFs to be produced
by the 10yr coupon bond.
 Thus, the current price 𝐏𝟎 of such (not-yet-born) coupon bond is
simply the present value of all future cash flows of this (not-yet-
born) 10yr coupon bond!
44
 Answer to E.g. 2-5 (cont.):
 10yr coupon bond’s CFs: 𝑪𝑭𝟏 = 𝟓 comes in year 3; … ; 𝑪𝑭𝟏𝟐 =

𝟏𝟎𝟓 comes in year 12.
 No-arbitrage forward price:
𝐅𝐏 = 𝐏𝟎 × 𝟏 + 𝐄𝐀𝐘 𝐭 = 𝟏𝟎𝟎 × 𝟏 + 𝟒. 𝟐% 𝟐 = 𝟏𝟎𝟖. 𝟔
 Note: in forward contract no money needs to be paid at the
signing date, so forward price is simply the contractual price
specified in the forward contract.
45
 Answer to E.g. 2-5 (c0nt.):
 If forward contract is offered at $110: it is overvalued (compared to no-

arbitrage price of $108.6.). Sell forward to get arbitrate profit!
 At t=0, short the forward contract (to deliver 10yr coupon bond at t=2)
 At t=0, borrow $100 at 2-year EAY 𝒚𝟐 = 𝟒. 𝟐% (i.e. issue a 2-yr zero-coupon
bond), use it to buy the 10yr coupon bond (currently price at par=$100)
 Thus, net investment at t=0 is zero: short 2yr zero-coupon bond, long 10yr
coupon bond (both of same current value of $100)
 At t=2, deliver the bond, and receive forward price $110
 At t=2, pay back the loan plus 2-yr interest: 𝟏𝟎𝟎 × 𝟏 + 𝟒. 𝟐% 𝟐 = 𝟏𝟎𝟖. 𝟔
 Thus, at t=2, make a sure profit of 𝟏𝟏𝟎 − 𝟏𝟎𝟖. 𝟔 = $𝟏. 𝟒 from a zero-net
investment at time t=0.
46
 Answer to E.g. 2-5 (c0nt.):
 If forward contract is offered at $107: it is undervalued (compared to no-arbitrage

price of $108.6). Buy forward to get arbitrate profit!
 At t=0, long the forward contract (to receive 10yr coupon bond at t=2)
 At t=0, sell (issue) 10yr coupon bond to market (i.e. promise to pay (𝐶𝐹1 , … , 𝐶𝐹10 ))
to get $100. Lend this $100 for 2 years, earning 2-yr EAY 𝑦2 = 4.2% as interest rate.
 Thus, net investment at t=0 is zero.
𝟐
 At t=2, get back the loan plus 2-yr interest: 𝟏𝟎𝟎 × 𝟏 + 𝟒. 𝟐% = 𝟏𝟎𝟖. 𝟔
 At t=2, pay forward price $𝟏𝟎𝟕 to receive the 10yr coupon bond to pay (𝐶𝐹1 , … , 𝐶𝐹10 )
 Thus, at t=2, make a sure profit of 𝟏𝟎𝟖. 𝟔 − 𝟏𝟎𝟕 = $𝟏. 𝟔 from a zero-net investment
at time t=0.
Forward contract: Zero-sum game
47
Remarks:
 Recall: forward price is simply the contractual price specified in the

contract.
 Forward price is NOT the price (cost) of the forward contract: price of
forward contract is actually zero at the signing date: it is a fair price to both
parties looking forward.
 As time evolves, price of bond unfolds, and at deliver date, the bond actual
spot price eventually will be higher or lower than the forward price. Thus
one party wins some money, the other loses by exactly that amount of
money. Forward contracts are zero-sum game!
 Why investors trade forward contracts (when not for speculation/betting

purposes): they simply want to lock on fixed interest rates (either as
lender or borrower) in future, or to hedge their other positions! This makes
T-bond forwards market very popular!
Futures contract
48
Futures are quite similar to forwards, but differ in some
institutional details
Futures Forwards
 Standardized contracts  Highly customized
(e.g., size, maturity, etc.) (flexible) contracts
 Traded on an organized  Traded over-the-counter
market (e.g. here for CME) (OTC) market
 Marked to the market  No money change hands
(margin call) daily till maturity
 Lower counterparty risk  Higher counterparty risk
 More liquid  Less liquid
CME: Chicago Mercantile Exchange: world’s largest futures exchange

Week 3: REPOS, FUTURES, AND SWAPS
NGOC-KHANH TRAN
SPRING 2018

2 Topic 3-1: REPURCHASE AGREEMENT
 Repurchase agreement (Repo) market

 Many uses of Repo
 Repo vs. Forwards on Bonds
Repurchase Agreement (Repo)
3
 Repurchase agreement (repo) is a short-term borrowing

contract
 the borrowing (loan) is collateralized by securities
 Repurchase agreement contract specifies two trades (for

exchanging the collaterals):
 the borrower sells securities (i.e., collaterals in Repo
contract) to the lender at an agreed upon price today.
 It is also agreed that the borrower will buy the same
securities back from the lender at a specified future
date and price.
 Key: ownership of the securities actually is transferred
to the lender for the duration of the loan
Repurchase Agreement: further details
4
 Repos are a short-term

 Most commonly, the borrowings and returns are
overnight
 Longer terms exist: 1-mo to 6-mo terms
 Most Repos are direct transactions between banks and

their customers, or between dealers.
 Nomenclature: The borrower enters a “repurchase
agreement” (Repo), while the lender enters a “reverse
repurchase agreement” (Reverse)
 There is no secondary market for Repos: but one can get
out of an Repo by "reversing in" or "reversing out" (taking
an opposite position in another Repo contract)
Repurchase: Scheme
5
Repurchase Agreement: risk and return
6
 Because Repos are collateralized, short-term loans, among

large players, the risk involved is considered small.
 But RPs are not risk free
 The value of the collateral can change over time, and
there have been several dramatic instances of fraud.
 Lender is often protected by a “haircut”
 Haircut is the difference between the market value and
the (lower) value ascribed to collateral used in the repos
 Haircut is usually expressed as % of the market price
 Interest rate depends on the quality of the collateral and

the maturity of the Repo. Interest on Repos is quoted as a
simple interest rate on a 360 day basis.
Haircuts
7
Repo: example
8
 E.g. 3-1: You purchase $1,000,000 face value in T-

bills for $975,000 in an overnight repurchase
agreement quoted at 8.75%.
 Are you borrowing or lending money?
 Assume a haircut of 2%, what is the fair market
value of the amount of T-bills purchased.
 What is the interest payment?
 How much do you sell the bills back for the next
day?
Repo: example
9
 Answer to E.g. 3-1: You purchase $1,000,000 face value in T-bills for $975,000
in an overnight repurchase agreement quoted at 8.75%.
Are you borrowing or lending money?

We’re accepting (purchasing) T-bills as collateral, thus we are lending
money. We’re lending $975,000
 Assume a haircut of 2%, what is the fair market value of the amount of T-
bills purchased?
We are lending $975,000 and accepting T-bills of 2% more than this value as
collateral. Thus the market $ amount of T-bill used as collateral (i.e.,
purchased) is
𝟏 + 𝟐% × 𝟗𝟕𝟓, 𝟎𝟎𝟎 = $𝟗𝟗𝟒, 𝟓𝟎𝟎
(Note: we can proceed a bit differently: call X the fair market value of the T-bills used as collaterals,
2% of which will be deducted as the haircut: so 𝟏 − 𝟐% × 𝑿 = $𝟗𝟕𝟓, 𝟎𝟎𝟎 → 𝑿 = $𝟗𝟗𝟒, 𝟗𝟎𝟎)
Repo: example
10
 Answer to E.g. 3-1 (cont.):

 What is the interest payment?
Recall that a simple interest rate on a 360 day basis, thus $
interest payment is
𝟏
𝟗𝟕𝟓, 𝟎𝟎𝟎 × 𝟖. 𝟕𝟓% × = 𝟐𝟑𝟔. 𝟗𝟖
𝟑𝟔𝟎
 How much do you sell the T-bills back for the next day?
𝟗𝟕𝟓, 𝟎𝟎𝟎 + 𝟐𝟑𝟔. 𝟗𝟖 = 𝟗𝟕𝟓, 𝟐𝟑𝟔. 𝟗𝟖
(Note: the haircut would materialize only when the money

borrower defaults on the Repo contract. In this case, money
lender can sell collaterals (T- bills) to market to fetch
$𝟗𝟗𝟒, 𝟓𝟎𝟎, while losing the loan of $𝟗𝟕𝟓, 𝟎𝟎𝟎. When there is
no default, haircut is not capitalized by either parties in Repo.)
Use of Repos
11
 Short-term borrowing and lending

 Investing short-term idle cash (e.g., by corporations).
 Obtaining required reserves (by banks and other depository
institutions).
 Financing dealer inventories (e.g., inventories can be used as
collaterals to borrow money for dealers)
 Obtaining cash while avoiding realizing capital gains or
losses from selling securities.
 Adjusting the money supply (by the Fed)
 Creating "synthetic" forward positions.
 Sometime, firms go to Repo market not to borrow money, but
to get securities (e.g., to sell short)
 Similarly, Speculating on interest rate and spread movements
(usually by dealers and arbitrageurs).
Using Repos to create synthetic forward contract
12
 E.g. 3-2: Use Repo market, create the forward contract that
allows you receive (i.e., long) 3-yr bond in 6 months.
 Answer to E.g. 3-2 :
 Idea: We want to receive (get back) bonds in 6 mo. So, at t=0
enter the 6-mo repo contract as a money borrower.
 Thus, give up (3.5-yr) bonds now, and repurchase (get back)
(3-yr) bonds in 6mo at predetermined (forward) price
(which can be computed from the quoted interest rate and
haircut as in e.g., 3-1)
Using Repos to create synthetic forward contract
13
 Answer to E.g. 3-2 (cont. ) :
 At t=0: use the money (borrowed in the Repo) to buy 3.5-yr

bonds, then use these 3.5-yr bond as collateral in the repo
contract. Thus, at t=0, the net investment is zero (no cash
involved, just as in forward contract).
 At t=6mo: receive (get back) the bonds (which at that time
has become a 3-yr bonds then), and pay principal and
interest (just like paying the forward price in the forward
contracts).
14 Topic 3-2: FUTURES
 Futures on Eurodollars
 Futures on T-bonds
 Duration hedging using Forwards &
Futures
Standard futures contracts
15
 Recall: futures are standardized contracts.

 Consider two most popular futures contracts
 Futures on 3-mo Eurodollars
 Futures on T-bonds
 Preliminaries:
 Eurodollars: are USD deposits (e.g., CD account) to a
banks outside US. So Eurodollars are USD bonds but
outside Fed’s jurisdiction.
 LIBOR (London Interbank Offered Rate): is the average
(surveyed) interest rate that London’s leading banks
would pay for borrowing from other banks.
(“surveying” is subject to possible coordinated manipulation: 2012
Libor scandal)
3-mo Eurodollar Futures
16
 Standardized contract to buy/sell Eurodollars (think of Eurodollars as

a bond) at pre-determined price at a future date.
 So, Eurodollar futures allow to lock in fixed rate in future in
lending/borrowing USD (with banks) outside US:
 Long futures=Buy bonds =Lend money
 Short futures=Sell bonds = Borrow money
 3-mo Eurodollar futures:
 Deliver Eurodollar (the bond) of face value of 1 mil USD
 Delivery months are Mar, Jun, Sep, Dec
 Eurodollar (the bond) matures 3-mo after the delivery date
3-mo Eurodollar Futures: Settlement
17
 3-mo Eurodollar futures: Settlement

 Contracts are quoted as (100 − 𝑖), where 𝑖 the (annualized) averaged
interest rate (3-mo LIBOR) that London banks report they would
borrow for 3-mo loan
 At t: Eurodollar value to be delivered at T (if 3-mo LIBOR is i) is
106 6
90
𝑃𝑡 = ≈ 10 × 1 − ×𝑖
90 360
1+ ×𝑖
360
 Next day, at t+1day: suppose 3-mo LIBOR rate increases by q basis
𝑞
points (bps), so new 3-mo LIBOR rate is 𝑖 + , and new price
10000
6
90 𝑞
𝑃𝑡+1𝑑𝑎𝑦 = 10 × 1 − × 𝑖+ = 𝑃𝑡 − 𝑞 × $25
360 10000
 Thus, if LIBOR rate increases by q bps, the long party in future loses
𝑞 × $25; if LIBOR rate decreases by q bps, the long party in future
gains 𝑞 × $25
3-mo Eurodollar Futures: Marking to market
18
 3-mo Eurodollar futures: Settlement

 Daily cash settlement: Loss (or gain) are marked to the market daily,
and funds are posted to (or withdrawn from) margin account daily.
 E.g. 3-3: A fund enters a long position in one 3-mo Eurodollar future
contract quoted at 97.35 maturing next March.
 What is the implied rate in the futures market currently (day 0)?
Answer: 𝑖 = 100% − 97.35% = 2.65%
 What happens to fund’s margin account over time?
Answer: It depends on the path of the 90-day LIBOR rate in the market
LIBOR (i) Daily change ($) Cummu change ($)
Day 1 2.70% -125 -125
Day 2 2.71% -25 -150
Day 3 2.65% 150 0
Day 4 2.68% -75 -75
Day 5 2.63% 125 50
Managing duration using futures
19
 E.g. 3-4: A bank has a liability of 100,000 USD face due 6mo
from now. The current 6-mo BEY is 7%. Fund is concerned that
this yield will change by the time the liability due date arrives.
How fund can hedge against duration risk for this liability
using 3-mo Eurodollar futures?

 Duration risk is the risk that yields of all maturities will
change (up or down) by the same amount (i.e., level risk, or
parallel shift of yield curve)
 Under a change 𝑑𝑦 > 0 in the yield (0n bond equivalent

basis), the present value of liability changes by (note that
liability is like shorting zero coupon bonds)
0.5(𝑦𝑟)
𝑑𝐿 = 𝐿𝐷𝑚,𝐿 𝑑𝑦 = $105 × 7% × 𝑑𝑦 = $48,309 × 𝑑𝑦
1+
2
Managing duration using futures
20
 Answer to e.g. 3-4 (cont.):

 To hedge duration in its liability (a short position), fund longs (buys) 𝑁
contracts of the standard 3-mo Eurodollar futures. Under the parallel
change 𝑑𝑦 > 0 in LIBOR, its position in these futures changes (drops) by
(note: 𝑑𝑦 is in %, 100 × 𝑑𝑦 is in bps)
𝑑𝑃 = −𝑁 × $25 × 100 × 𝑑𝑦 = −$2500 × 𝑁 × 𝑑𝑦
 Duration hedging is successful when 𝑑𝐿 + 𝑑𝑃 = 0, which implies

2500 × 𝑁 = 48,309 ⟹ 𝑁 = 19.3
 Remark: Why do we need 19.3 (so many) future contracts on 3-mo

Eurodollar to hedge just $100,000 liability? This is because, future
contracts are zero net investment (no principals change hands ever), and
thus we need a lot of these contracts to make their total value’s change
sizable (to match/hedge the changes in present value of liability).
A digression: LIBOR scandal (2012)
21
 Libor is average interest rate estimated by leading banks in London that

they would be charged if borrowing from other banks.
 Rates are not necessarily actual: reported rates are what banks think they
would borrow at.
 Libor is reference rate in many ($340 trillions, notional) financial
contracts & derivatives (Futures, Swap, Mortgage, …)
 Banks inflated/deflated their rates so as to profit from trades, or boost their
creditworthiness (Allegation: manipulation is at least from 1991)
 Because Libor is a pooled survey, manipulation works only if there is a
collusion b/w those who submit the rates. Indeed, traders at the
participant banks communicated with each other their desire to see a
higher or lower LIBOR to aid their trading positions.
 Excerpt from Wikipedia (2006, Barclay trader to rate submitters):
“Hi Guys, We got a big position in 3m libor for the next 3 days. Can we
please keep the lib or fixing at 5.39 for the next few days. It would
really help. We do not want it to fix any higher than that. Tks a lot.”
 Fault was in part on loose design/verification of original Libor surveying
system.
 Obvious change: Report only actual borrowing rates, banks!
T-bond Futures: Institutional details
22
 Futures on T-bonds :
 Deliver (qualified) T-bonds of face value of 100,000 USD
 Delivery months are Mar, Jun, Sep, Dec
 but with considerable flexibilities (to the short party of the future
contract):
 Short party can choose to deliver any T-bonds with time to maturity (or
to first call) longer than 15 years (as of delivery date), and this choice
can be made at delivery date (Why? Because there is a universe of T-bonds
outstanding, and with time-to-maturity larger than 15 years, they have characteristics similar enough)
 Short party can choose when in delivery month to deliver the bond
T-bond Futures: flexibility
23
 What T-bond to be delivered does matter!
 Flexibilities (apparently) favor the seller of future contract,

so they must be accounted for in the contract settlement
price (using conversion factor, as seen in next slide)
 The spot value (on delivery date) of T-bond depends on its

CFs and spot BEY 𝑦𝑡 :
𝑪𝑭𝒊
𝑷𝒕 = 𝒊 𝒚𝒕 𝒊
𝟏+
𝟐
thus short party will wait till delivery date to choose the
then-cheapest (lowest 𝑷𝒕 ) qualified bond to deliver.
T-bond Futures: conversion factor Cf
24
 Conversion factor (Cf)

 Short party (future seller) would tend to deliver cheapest T-bond:
conversion factor (Cf) is a way to compensate long party (future
buyer) for this adverse choice of short party
 Cf is T-Bond price per $1 par if BEY is 6% (conventionally)

𝑪𝑭 𝑪𝑭𝒊
𝐂𝐟 ≡ 10−5 × 𝒊 𝟔%𝒊 𝒊 = 10−5 × 𝒊 𝒊 𝟏.𝟎𝟑
𝟏+
𝟐
 When at delivery, spot yield is not 6%, Cf is approximately proportional

to price of T-bond to be delivered)
 Cf is known for sure when we know which bond is to be delivered!
 10−5 accounts for the facts that Cf is bond price per $1 par, while T-
bond Futures are contract on 100,000 USD par (because in above formula, 𝑪𝑭𝒊
are cash flows of bond with 100,000 USD face, which is to be delivered in the futures
contract)
T-bond Futures: settlement
25
 T-bond future settlement (received by short party) is made

to depend on conversion factor Cf:
𝐬𝐞𝐭𝐭𝐥𝐞𝐦𝐞𝐧𝐭 = 𝑭𝒇 × Cf
 𝐹𝑓 is future price pre-specified in future contract at signing

date
 𝐹𝑓 is similar to forward price 𝐹𝑃 pre-specified in forward

contract-see week-2 lecture)
 Note: Thus 𝐹𝑓 is not price of the future, it is the price of

the delivered assets (bonds) specified in and agreed upon in
the future contract.
26
 Why conversion factor helps? Because it balances the payoff

to short party!
 At delivery date, short party receives the future’s settlement,
and deliver the (qualified) T-Bond of its choice
 So net payoff (on deliver date) to short party is:
−5
𝐶𝐹𝑖 𝐶𝐹𝑖
𝐹𝑓 × Cf−𝑃𝑡 =𝐹𝑓 × 10 × 𝑖
− 𝑖
1.03 𝑦𝑡
𝑖 𝑖 1+
2
27
 Why conversion factor helps? (cont)
−5
𝐶𝐹𝑖 𝐶𝐹𝑖
𝐹𝑓 × Cf−𝑃𝑡 =𝐹𝑓 × 10 × 𝑖
− 𝑖
1.03 𝑦𝑡
𝑖 𝑖 1+
2
 Clearly,when short party picks the cheap (low cash

flows) bond to deliver, the payoff it receives is also
small. This prevents unfair profits to short party.
 Still,
as conversion factor Cf is not exactly
proportional to spot bond price 𝑃𝑡 , short party still
has some room to pick up the cheapest bond for
delivery
T-bond Futures: example
28
 E.g. 3-5: Suppose that the Treasury bond futures price is $102.25 per $100
face (i.e., $102,250 per $100,000 face). At the delivery date, the short party
of the future contract chooses to “deliver” 9%-coupon T-bond with 24
years to maturity. Also on the delivery date, the spot BEY of this bond
turns out to be 7%
 Compute the conversion factor Cf
 Upon delivery of the bond, how much money does the short party
receive from the long party?
 What is the net payoff the short party earns at delivery date?
 Instead, on delivery date, the spot BEY of this bond turns out to be
only 5%. Compute net payoff to short party on delivery date?
29
 Answer to E.g. 3-5:

 Compute the conversion factor:
The conversion factor is the price of 24-yr 9% -coupon Bond

(semiannual coupon payments) per $1 par if BEY is 6%, which is
(can also use online calculator here) 1.38. Specifically, this is
𝟎.𝟎𝟒𝟓 𝟎.𝟎𝟒𝟓 𝟏.𝟎𝟒𝟓
Cf= 𝟔% + 𝟔% 𝟐 + ⋯+ 𝟔% 𝟒𝟖
= 𝟏. 𝟑𝟖
𝟏+ 𝟐 𝟏+ 𝟐 𝟏+ 𝟐
 Upon delivery of the bond, how much the short receive?

Short party receive the settlement amount equal to future price
$102,250 scaled by conversion factor 1.38:
$𝟏𝟎𝟐, 𝟐𝟓𝟎 × 𝟏. 𝟑𝟖 = $𝟏𝟒𝟏, 𝟏𝟎𝟓
per future contract of $100,000 face
30
 Answer to E.g. 3-5 (cont):

 What is the net payoff the short party earns at delivery date?
The short party needs to deliver the bond to the long party.
Given the info (24-yr 9% -coupon Bond yielding 7% BYE), the
price of this bond is $1.23 per $1 face (or $123,000 per $100,000
face).
Thus, on the delivery date, the net payoff to the short party is
the difference between what it receives and what it has to give
up (to the other counterparty in the future contract), which is:
$𝟏𝟒𝟏, 𝟏𝟎𝟓 − $𝟏𝟐𝟑, 𝟎𝟎𝟎 = $𝟏𝟖, 𝟏𝟎𝟓

31

 Spot BEY is 5%. Compute net payoff to short party on delivery
date?
At this new spot BEY=5%, the 24-yr 9%-coupon bond price is $1.56
per $1 face (or $156,000 per $100,000 face) on delivery date.
Note: Change in spot BEY does not affect either conversion factor, or
the forward price specified in contract, hence the future settlement
remains at $𝟏𝟎𝟐, 𝟐𝟓𝟎 × 𝟏. 𝟑𝟖 = $𝟏𝟒𝟏, 𝟏𝟎𝟓
Net payoff to short party then is

$𝟏𝟒𝟏, 𝟏𝟎𝟓 − $𝟏𝟓𝟔, 𝟎𝟎𝟎 = −$𝟏𝟒, 𝟖𝟗𝟓
32

 Look-back: the payoff (profit vs. loss) of T-bond future
depends crucially on the realization of the spot BEY 𝒚 of the
underlying bond. This is because this spot yield determines
the realized (spot) price 𝑷𝒕 of the bond on delivery date.
[Short party might somewhat mitigate this type of loss by
picking the cheapest but qualified bond to deliver].
33 Topic 3-3: Interest rate swaps
 Floating rate bond

 Interest rate swaps
 Pricing, use, and risk of swaps
Floating rate bonds
34
 Floating rate bonds have:

 coupon rate being reset at each period. Thus, coupon rate is variable (i.e., floating)
and known (set) only one-period before the time that coupon is paid out .
 at each reset time, coupon rate being reset to be the one-period yield, so that
coupon payment in period 𝑖 is 𝑪𝒊 = 𝐅 × 𝒚𝒊−𝟏 . Thus, effectively, at each period, the
price of floating rate bond is reset to par :
𝑷𝑻 +𝑪𝑻 𝐅+𝐅×𝒚𝑻−𝟏 𝑷𝑻−𝟏 +𝑪𝑻−𝟏 𝐅+𝐅×𝒚𝑻−𝟐

𝑷𝑻−𝟏 = = = 𝐅; 𝑷𝑻−𝟐 = = =F
𝟏+𝒚𝑻−𝟏 𝟏+𝒚𝑻−𝟏 𝟏+𝒚𝑻−𝟐 𝟏+𝒚𝑻−𝟐
and similarly, we have 𝑷𝒊 = 𝐅 ∀𝒊

Note: for floating coupon bonds, price always equals par simply because coupon
rate is adjusted to be exactly the discount rate
Floating rate bonds: Duration
35
 E.g. 3-5: Consider a floating rate bond with semiannual payment. The current
BEY 𝑦𝑖 = 7%. Compute the modified duration of this bond.
 At any period i, can treat the floating rate bond effectively just as a zero-
coupon bond, with effective face being 𝑭 + 𝑪𝒊+𝟏 = 𝑭 + 𝑭 × 𝒚𝒊 (why? This
is because 𝑭 accounts for all future coupons after 𝑪𝒊 )
 Thus, as for all zero coupon bond, the current (year i) modified duration
of the floating rate bond is
6𝑚𝑜 0.5
𝐷𝑖,𝑚 = = = 0.483 yr
1 + 𝑦𝑖 /2 1 + 3.5%
Note: because spot yield 𝑦𝑖 varies over time, so does the duration of
floating rate bond.
Interest rate swap
36
 “Plain vanilla” interest rate swap is a financial contract between two

counterparties to exchange fixed interest rate payments for floating
interest rate payments (fixed for floating).
 A notional principal amount is set (at signing date), upon which
interest rate payments are determined and paid at regular intervals
over the life of the contract. But no principal is exchanged.
 Fixed rate payor: The counterparty who pays a fixed rate, and receives
a floating rate in the swap. The fixed rate payor is said to have "bought
the swap" or is long in the swap.
 Floating rate payor: The counterparty who pays a floating rate, and
receives a fixed rate in the swap. The fixed rate payor is said to have
“sold the swap" or is short in the swap.
Interest rate swap: floating rates
37
 Floating rates in Interest rate swap

 At period i, the floating rates 𝒚𝒊 are usually referenced (with a possible spreads)
on standard floating (i.e. spot) rates such as LIBOR, or yields on Treasuries
notes available at that time i: 𝒚𝒊 = 𝑳𝑰𝑩𝑶𝑹𝒊 + 𝒄𝒐𝒏𝒔𝒕𝒂𝒏𝒕 𝒔𝒑𝒓𝒆𝒂𝒅
 Poorer credit-risk counterparties will have to pay a higher spread above the
standard floating rate (LIBOR, Treasury rate, etc.) or, more commonly, post
collateral or obtain a third party credit guarantee.
 Swap banks regularly send out indication pricing schedules for dealers to use as a
reference in pricing swaps. A typical schedule (with bid/ask spread) might look like
Bank pays Bank receives Current
Maturity fixed rate fixed rate TN rate
2 yrs 2 yr TN sa +20 bps 2 yr TN sa +30 bps 8.55%
Interest rate swap: fixed rates
38
 Fixed rates in interest rate swap

 At signing date when swaps are initiated, the fixed rates c are determined such
that the present value of floating and fixed payments are equal (so that swaps are
fair contract to both counterparties initially). F is the notional principal:
𝑷𝑭𝒍𝒐𝒂𝒕𝒊𝒏𝒈 = 𝑷𝑭𝒊𝒙𝒆𝒅 ⟹ 𝑓𝑖𝑥𝑒𝑑 𝑟𝑎𝑡𝑒 𝒄

 As time evolves, realized floating yields 𝒚𝒊 will be most likely different from their
values predicted at the signing date.
 When realized floating yields are higher (than predicted initially), fixed rate
payor gains
 When realized floating yields are lower(than predicted initially), floating rate
payor gains
Pricing of interest rate swap
39
 Pricing interest rate swap (what follows applies at the signing date only):
 Fixed-rate payor shorts coupon bond at par (as it pays fixed), longs a floating rate
bond (as it receives floating)
 Floating-rate payor shorts floating rate bond (as it pays floating), longs a coupon
bond at par (as it receives fixed)
 Thus, at the signing date (recall that price of floating rate bond is always the par, or
notional principal 𝑭 specified in the swap contract)
𝑷𝑭𝒊𝒙𝒆𝒅 = 𝑷𝑭𝒍𝒐𝒂𝒕𝒊𝒏𝒈 = 𝑭 or more specifically,
−𝟏
𝒄×𝑭 𝒄×𝑭 𝒄×𝑭+𝑭 𝟏 𝟏 𝟏 𝟏
+ 𝟐
+ ⋯ + = 𝑭 ⟹ 𝒄 = 𝟏 − + + ⋯ +
𝟏 + 𝒚𝟏 𝟏 + 𝒚𝟐 𝟏 + 𝒚𝑻 𝑻 𝟏 + 𝒚𝑻 𝑻 𝟏 + 𝒚𝟏 𝟏 + 𝒚𝟐 𝟐 𝟏 + 𝒚𝑻 𝑻
Swap duration
40
 E.g. 3-6: Consider a new 5-year interest rate swap, offering a fixed rate of
6% (semiannual payments), and a floating rate of 6-month LIBOR.
 What is the modified duration from the perspective of the fixed rate
payor?
 What is the modified duration from the perspective of the floating
rate payor?
 Answer to 3-6:
 5-year fixed rate bond with a 6% (semiannual) coupon selling at par
has a modified duration of 4.26 yr (using online calculator).
 The modified duration of the floating rate bond is
6𝑚𝑜 0.5
= = 𝟎. 𝟒𝟖𝟓 𝒚𝒓
1+𝑦/2 1+6%/2
 Hence, the duration to fixed-rate payor (who longs floating and shorts
fixed) is 𝟎. 𝟒𝟖𝟓 − 𝟒. 𝟐𝟔 = −𝟑. 𝟕𝟕 𝒚𝒓
 Hence, the duration to floating-rate payor (who longs fixed and shorts
floating) is 𝟒. 𝟐𝟔 − 𝟎. 𝟒𝟖𝟓 = 𝟑. 𝟕𝟕 𝒚𝒓
Use of swap: Duration/Maturity restructuring
41
 Duration/maturity restructuring: A firm may

want to change the duration of its portfolio, or to
switch from fixed-rate payor to floating-rate payor
(or vice versa), because term of its business has
changed
 Why/How firms do this?

 Swap market is highly liquid: it offers low bid/ask
spread for standard swaps and for good-credit
participants
 Firm wishing to switch from fixed to floating debt
will often find it cheaper to enter a swap than to
buy back their fixed coupon bonds and seek new
floating rate financing (or vice versa)
Use of swap: Hedging balance sheet risk
42
 E.g. 3-7: It is December 18, 2014, and: Southwest S&L finances (i.e., lends)
$10 mil in new 10-year mortgages.
 The current mortgage rate is 10% per year, fixed (i.e., SW (Southwest)
receives this rate in this mortgage loan from mortgage holder).
 The current 3-month rate on time deposits is 8%.
 If the mortgages are financed with 3-month time deposits (CDs) (i.e.
SW borrows $10 mil from 3-month CDs to lend to the mortgage holder),
a profit of 2% is locked in over the first three months.
 But after that, the bank bears the risk that CD interest rates might rise.
How SW can hedge this risk?
 Answer to e.g. 3-7: This balance sheet risk can be hedged very effectively
using interest rate swap.
Assets Liabilities
10-yr mortgage: $10 mil Debt: $9.5 mil in 3-mo (CD)
deposits
Equity: $0.5 mil (owes this to SW
shareholders)
43
 Answer to e.g. 3-7 (cont.): The idea is SW (1) is borrowing 10 mil

from CDs, and thus is paying floating (CD) rate (2) is receiving
10% (annualized) interest payments from mortgage holders (3) SW
is concerned about increase in CD rate, as well as re-investment
rate for the 10% interest it is receiving.
Southwest should enter into an interest rate swap such that:
 Maturity = 10 years (to match the 10-yr mortgage SW is lending out)
 Fixed rate payor = SW (because SW is receiving 10% fixed from
mortgage)
 Paying Fixed Rate = 8.65% (affordable, because SW is receiving 10%)
 Receiving Floating Rate = LIBOR (SW can use these floating rate
payments to pay (similar) floating CD rate)
 Payment Frequency = Semiannual for both fixed and floating (this is
standard for plain-vanilla interest rate swap).
44
 Answer to e.g. 3-7 (cont.):

45
 Answer to e.g. 3-7 (cont.): But this swap is not a perfect hedge
for SW for several reasons:
 Mortgages are usually amortized over their lifetime, so that
the principal balance is declining.
 The frequency of the mortgage payments (often monthly)
does not match the semiannual frequency of the fixed
payments on a plain vanilla swap.
 The three month rate paid to depositors (CD) does not
match the six month LIBOR rate received in the swap.
 Mortgages can usually be prepaid (accelerated payment).
 This leads to the need/advent of customized (non-standard)
swaps. E.g., Amortizing swaps, Swaptions, etc.
Note: Specialized swaps can be more expensive because they require more
paperwork and a counterparty may be harder to locate.
Use of swap: Customization
46
 E.g. 3-8: Firms A and B both seek better financing for 5-year loan
 Firm A has an improving credit rating, and prefers to borrow at a
floating rate.
 Firm B has a worsening credit rating, and prefers to borrow at a fixed
rate.
 If borrowing directly from the market, firms are offered the following
rates at the best
Offers from market Firm A Firm B

Fixed 8% 11%
Floating Libor+2% Libor+3%
How can firms design (customize) swap contract to improve their

financing needs?
Use of swap: Customization
47
 Answer to E.g. 3-8: Firms A and B should do both of the following:

 Enter a 5-year swap with the following terms (which, in practice, are
accomplished via intermediaries)
 Firm A pays Firm B LIBOR
 Firm B pays Firm A 7.5%
 Borrow in the spot market:

 Firm A borrows fixed at 8% in the market
 Firm B borrows floating at LIBOR+3% in the market
 Thus(given A likes borrowing floating, B fixed)

 Firm A effectively borrows at
LIBOR+0.5%
 Firm B effectively borrows at
10.5%
 Both A and B can borrow at
lower rates that market’s best offers
Swap risk: Default
48
 Defaults in Swap Contracts: Because swap contracts

do not involve exchange of principal amounts,
default loss is limited
 Ifa default occurs, the non-defaulting

counterparty is released from the swap agreement.
 Generally there is no cash loss, but there can be a

large present value cost because the swap must be
replaced at the current, potentially higher rate.
Default in swap: example
49
 E.g. 3-9: Consider the following swap underwritten by a

intermediary: Notional principal = $30 million; Maturity = 5 years;
Payments exchanged annually. Floating rate: the LIBOR. Fixed
rates: bid T+.4%, ask T+.5%; where T is yield on Treasury Notes at
swap signing date. Originally, Treasury notes rate T=10%.
 Say that the five-year yield on Treasury notes falls to 9.5% (from
10%). What is the effect on the value of each swap to the
intermediary if there is no default?
 Next, imagine a default by Firm B. What happens?
Default in swap: example
50

5-yr T-Notes falls to 9.5% . What is value of swaps to the intermediary ?
 Clearly, swaps values stay same since neither fixed rate changes
Next, imagine a default by Firm B. What happens?

 The intermediary immediately ceases to pay LIBOR to firm B, but the
obligation to Firm A remains.
 To replace Swap B, the intermediary must accept payments at the current
rate of 9.50% + .5%.
 The gross cost of the default to the intermediary is approximately .50% per
year or $150,000 annually.
 The present value of the loss of depends on when the default occurs,
relative to the remaining maturity of the swap.
Week 4: SPECULATIVE STRATEGIES ON

SPREADS, AND OPTIONS ON INTEREST
RATES
NGOC-KHANH TRAN
SPRING 2018

2 Topic 4-1: SPECULATIVE STRATEGIES ON
SPREADS
 Speculative Strategies on Spreads

 Mini case: Proctor & Gamble Swap (1994)
 Mini case: Long Term Capital Management
(1998)
Speculating on interest rate movements
3
Once investors have (supposedly solid) expectations/speculations about the future

interest rates, they form trading strategies either to hedge their exposure or take
bets (speculating).
 If one expects rates to rise, one can:
 shorten duration of portfolio (to prevent/reduce loss in portfolio value)

 sell interest rate futures (i.e., sell bond in future at currently high price, to lock on
borrowing currently low interest rate)
 enter swap as fixed rate payor (i.e., to pay current low rate, expect to receive higher floating
rates in future)
 sell bond call options (bond will become cheaper, no call exercise, earn option
commission)
 buy bond put options (expect bond price to drop, so put option would be “in the money”)
 If one expects rates to fall, one can:
 lengthen duration of portfolio
 buy interest rate futures
 enter swap as floating rate payor
 buy bond call options
 sell bond put options
Implementing speculation using FI securities
4
 If spotting undervalued security (& expect that price will go up):

 Ordinarily: Buying the security now, sell it later when price corrects
(increases) itself
 Fixed-income way: Entering a long position in forward contract to lock
in currently low buy-price. On the delivery date, accept the security,
resell it to market at higher price. (Advantage: No down payment, no
storage, cash settlement)
 If spotting overvalued security (& expect that price will go down):
 Ordinarily (short sell): Borrowing the security now, sell it to market,
hope price will correct (drop) itself, then buy back security (cheaply),
return it to the lender.
 Fixed-income way: Entering a short position in forward contract to lock
in currently high sell-price. On the delivery date, buy security cheaply
from market, delivery it to fulfill forward contract obligation.
(Advantage: No security borrowing, no storage, cash settlement)
Speculating on spread movement
5
 Spread is the difference in rates. Movement in spreads results

from the relative movement between rates.
 Once investors have (solid) expectations about spreads, they
can form speculative strategies
 Usually, spread speculation has two components (convictions)
 right now, the spread is incorrect (abnormal)
 later on, market will correct this and the spread will become
“normal” (convergence)
Speculating on spread movements: the risk
6
 Relative rate movements (i.e., spreads) is likely more predictable than

broad market changes. Spreads move because of
 Transitory factors (e.g., just one summer hotter than usual)
 Permanent factors (e.g., global warming)
 Because speculative strategy on spreads movement is a bet on the rates’

convergence, and the loss (risk) will come if the spreads, however
incorrect/abnormal they are, will not converge within trading horizons
 The spread speculation risk is in mistaking a permanent change for a
transitory one. Why?
 Transitory factors will get spreads back to normal range (convergent)
 Permanent factors will not necessarily foster a convergence in spreads  lose money
in speculative bets.
 The speculative strategy usually require leverage (to size up the potential
gain): this makes loss much worse when spreads do not converge!
A digression: CMT rate
7
 CMT=Constant Maturity Treasury Rate. This is an index on interest

rate based on Treasuries yields, published by the Fed Board.
 For e.g., 5-yr CMT rate is an average yield on related US Treasury
securities adjusted to a constant maturity of 5 year
Proctor & Gamble 1994’s Swap Loss
8
 P&G bet (i.e., taking excessive speculative position) in the interest rate
swap market led to $157 mil loss.
 Transactions: Two 6-mo swaps, Notional value = $100 mil each. One on
German Bund (German Gov Bond); one on US Dollar
 NY Times (here) : “The swaps were based on borrowed money, which

exaggerated market swings tremendously and meant big money if P&G
was right - as it had been on some previous derivative deals. But the two
losing contracts, which were for floating-rate notes in dollars and Deutsche
marks, were written through Bankers Trust Co. on the assumption that U.S.
and German interest rates would continue to fall.”
 McDonough, president of the Federal Reserve Bank of New York: "People of

my generation who are not astrophysicists have to strain to understand
these products. To put it simply and directly, if the bosses do not or cannot
understand both the risks and the rewards in their products, their firm
should not be in the business."
9
 P&G USD swap: structure of the deal

 P&G agreed to pay a floating coupon of
5𝑦𝑟 𝐶𝑀𝑇𝑦𝑖𝑒𝑙𝑑 30𝑦𝑟 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
𝐿𝐼𝐵𝑂𝑅 + 0.98 × −
0.05 100
 P&G was slated to receive fixed-coupon payment that was “substantially
above market”
 P&G USD swap: rationales of the deal

 Currently, 5yr CMT yield is 5%, and 30yr 7.6% coupon (semiannual
payments) bond yielding 6.5% (BEY) has price
3.8 3.8 3.8 + 100
+ 2 + ⋯+ 60 = 100
6.5% 6.5% 6.5%
1+ 1 + 1 +
2 2 2
 then P&G pays LIBOR flat
 while it receives substantially above market rates
 so it sounds like a good deal…

10
 P&G USD swap: if interest rates fall at all maturities

 say CMT yield drops from 5% to 4%
 30-yr bond yield drops from 6.5% to 5.5%, new bond price
𝑃𝑛𝑒𝑤 = 𝑃 + 𝑑𝑃 = 𝑃 − 𝑃𝐷𝑀 𝑑𝑦
= 100 + 100 × 12.8 × 0.01 = 112.8
 then P&G pays

4% 112.8
𝐿𝐼𝐵𝑂𝑅 + 0.98 × − = 𝐿𝐼𝐵𝑂𝑅 − 32.8%
0.05 100
 while it receives substantially above market rates
 and they laughed all the way to the bank …
11
 P&G USD swap: but when interest rates rise at all maturities
 Say CMT yield surges from 5% to 6%
 30-yr bond yield surges from 6.5% to 7.5%, new bond price
𝑃𝑛𝑒𝑤 = 𝑃 + 𝑑𝑃 = 𝑃 − 𝑃𝐷𝑀 𝑑𝑦
= 100 − 100 × 12.8 × 0.01 = 87.2
 then P&G pays

6% 87.2
𝐿𝐼𝐵𝑂𝑅 + 0.98 × − = 𝐿𝐼𝐵𝑂𝑅 + 32.8%
0.05 100
 and it is the time to call in some legal help …
12
 P&G USD swap: Look-back

 what when wrong: the basic duration risk was not hedged in this
swap. (Both terms in the contract move in the same direction
under changes in yield).
 Why? Because they were speculating (they bet on the drop of
interest rates). P&G’s business is in soap, but not swap. So they got
their bet guided/formulated by Bankers Trust Co.
 Why rates would drop? Remember up to that time Greenspan had
never raised rate.
 But enough was enough: Greenspan raised rate for first time right
after the swap was implemented.
 Leverage: loss was of large order ($157 mil) because P&G borrowed
money (leverage) to increase its exposure (stake) to interest rate
movements via the swap bets.
LTCM
13
(Based on the write-up by Prof. R. Susmel, Bauer School, U of Houston)

 LTCM (Long-term Capital Management):
 Hedge fund founded in 1994, staffed by all-star traders and finest
academics (including Robert Merton & Myron Scholes, 1997 Nobel Prize
winners for Black-Scholes-Merton option pricing paradigm)
 Edges: combination of the academics' quantitative models and the
traders' market judgment and execution capabilities
 Sophisticated investors, including many large investment banks, flocked
to the fund, investing $1.3 billion at inception
 September 1998: the fund had lost substantial amounts of the investors'
equity capital, was on the brink of default
 The Fed orchestrated a $3.5 billion rescue package from leading U.S.
investment and commercial banks. In exchange the participants received
90% of LTCM's equity.
LTCM
14
 LTCM's main strategy was to make convergence trades:

 These trades involved finding securities pairs that were mispriced relative to one
another, taking long positions in the cheap ones and short positions in the
expensive ones.
 There were four main types of trade:
Convergence among U.S., Japan, and European sovereign bonds;
Convergence among European sovereign bonds;
Convergence between on-the-run and off-the-run U.S. government bonds;
Long positions in emerging markets sovereigns, hedged back to dollars.
 Leverage required:
 Because these differences in values were tiny, the fund needed to take large and
highly-leveraged positions in order to make a significant profit.
 At the beginning of 1998, the fund had equity of $5 billion and had borrowed
over $125 billion — a leverage factor of roughly 30:1.
 LTCM's partners believed, on the basis of their complex computer models, that
the long and short positions were highly correlated and so the net risk was small.
LTCM: On-the-run/off-the-run spread
15
 Off-the-run bonds: previously issued T-bonds (tend to be cheaper,

thus offer higher yields)
 On-the-run bonds: newly issued T-bonds (tend to be more
expensive, thus offer lower yields)
16
 E.g. 4.1 (On-the-run/off-the-run spread): Currently, the (newly

issued) 30yr bonds yields 𝑦𝐴,0 = 4% (BYE) [call this on-the-run bond
A] , while the (previously issued) 29.5yr bonds yields 𝑦𝐵,0 = 5% (BYE)
[call this off-the-run bond B]. For simplicity, assume that both are
zero-coupon).
 If you believe that in 6mo, when on-the-run bonds become off-the-
run, both bonds’ yields will converge to 5%. What is your strategy to
speculate on this view? (For the sake of numerically explicit, assume
throughout that your notional dollar-exposure is $200).
 If indeed when 6mo comes, spot BEYs for both bonds A and B
converge: 𝑦𝐴,6𝑚𝑜 = 𝑦𝐵,6𝑚𝑜 = 5%, how much money have you made?
 If instead when 6mon comes, spot BEYs actually diverges, with
𝑦𝐴,6𝑚𝑜 = 3% and 𝑦𝐵,6𝑚𝑜 = 6%, how much money have you made?
17
 E.g. 4.1 (On-the-run/off-the-run spread): Currently, the (newly

issued) 30yr bonds yields 𝑦𝐴,0 = 4% (BYE) [call this on-the-run bond
A] , while the (previously issued) 29.5yr bonds yields 𝑦𝐵,0 = 5% (BYE)
[call this off-the-run bond B]. For simplicity, assume that both are
zero-coupon) …
18
 Answer to E.g. 4.1:

What is your strategy to speculate on the convergence of the yields?
 The view is that, when bonds become off-the-run, they will become
cheaper (yields increase) and equal other off-the-run bonds.
 Specifically, bond A price will drop 6mo from now (when it becomes 29.5
yr bond), and thus the yields will become equal.
 The simplest strategies is to short $100 in bond A, and long bond B.
Specifically, at t=0 (now):
1. Short $100 in bond A
2. Long $100 in bond B
100 100
 Current (t=0) price of bonds: 𝑃𝐴,0 = ; 𝑃𝐵,0 =
1+2% 60 1+2.5% 59
 Portfolio holdings (i.e., the number of bonds in portfolio) are:
100 60 ; 100 59
𝑁𝐴 = − = − 1 + 2% 𝑁𝐵 = = 1 + 2.5%
𝑃𝐴,0 𝑃𝐵,0
19

𝑦𝐴,6𝑚𝑜 = 𝑦𝐵,6𝑚𝑜 = 5%, how much money have you made?
 Given these spot yields, new bond prices at t=6mo are
100 100
𝑃𝐴,6𝑚𝑜 = ; 𝑃𝐵,6𝑚𝑜 =
1+2.5% 59 1+2.5% 58
 Thus, the total profit made is simply the new value of portfolio at
t=6mo (recall: the net investment at t=0 is zero)
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑁𝐴 × 𝑃𝐴,6𝑚𝑜 + 𝑁𝐵 × 𝑃𝐵,6𝑚𝑜

1 + 2% 60 1 + 2.5% 59
= 100 × − + = 0.26
1 + 2.5% 59 1 + 2.5% 58
 Thus, as yields converge as speculated, the strategy made money

albeit little (26 cents per 200 dollar exposure)  needs for leverage
to scale up this profit.
20

𝑦𝐴,6𝑚𝑜 = 3%; 𝑦𝐵,6𝑚𝑜 = 6%, how much money have you made?
 Given these spot yields, new bond prices at t=6mo are
100 100
𝑃𝐴,6𝑚𝑜 = ; 𝑃𝐵,6𝑚𝑜 =
1+1.5% 59 1+3% 58
 Thus, the total profit made is simply the new value of portfolio at
t=6mo (recall: the net investment at t=0 is zero)
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑁𝐴 × 𝑃𝐴,6𝑚𝑜 + 𝑁𝐵 × 𝑃𝐵,6𝑚𝑜

1 + 2% 60 1 + 2.5% 59
= 100 × − 59
+ 58
= −0.59
1 + 1.5% 1 + 3%
 Thus, as yields has widened (instead of converged as speculated),
the strategy loses money. Coupled with high leverage, the loss can
be huge!
LTCM: look-back
21
 Above e.g. 4.1. exemplifies the loss of LTCM in bets on the convergence of
on-the-run/off-the-run bonds’ yields.
 Why yields did not converge: 1998’s Russian sovereign default might
have caused great concerns for illiquidity (off-the-run bond) and thus
keep on-the-run bonds highly valuable for extended period of time. This
not only prevented the yields’ convergence, but actually made them more
diverge.
LTCM: look-back
22
 Panic creditors’ and market’s bet on the collapse of LTCM by

withdrawing funds and short selling its shares made its
demise more inevitable
 Yields would (must) eventually converge, but panic market
with flight-to-quality mood was not patient enough to hang
on to see LTCM’s convergence bet unfolded
 The lesson learned: LTCM experience spoils some of the
supposed "free lunch" features of taking liquidity risk. These
plays can indeed generate excellent risk-adjusted returns,
but only if held for a long time. Unfortunately the only real
source of capital that is patient enough to take fluctuations
in market values, especially through crises, is equity capital,
but not leverage.
23 Topic 4-2: INTEREST RATE OPTIONS
 IR Option pricing by replication

 Binomial model
 Callable and puttable bonds
 Caps, floors, collars
 Swaptions
Interest rate options
24
 Call options on bond gives the buyer the right to buy the bond at the pre-
specified strike price, in exchange for the premium (i.e. the cost to buy the
options) paid up front
 Put options on bond gives the buyer the right to sell the bond at the
specified strike price, in exchange for the premium paid up front
 An American option can be exercised anytime prior to maturity
 An European option can only be exercised on the date it matures
 Popular IR derivatives:
 callable bonds (bond issuer can buy back bond before maturity)
 puttable bonds (bond holder can sell back the bond to bond issuer before
maturity)
 caps, collars, and floors (simple IR derivatives with references to LIBOR)
 options on futures (e.g., Eurodollars and Treasury notes)
 swaptions (fixed or floating payors have option to exit the swap early)
 prepayable mortgages
Interest rate options: payoff graph
25
 European options’ payoff graph at maturity:

 Payoff as function of bond prices
 Payoff as function of interest rates

Interest rate options: pricing by replication
26
 Recall: Options on stock can be replicated by a portfolio of bond and the

underlying stock. Then by no arbitrage, price of the option equals value of
portfolio
 Interest rate options can be priced similarly, using a replicating portfolio of
bonds of various maturities.
 E.g. 4.2: Consider a European call option on a 2-period zero-coupon bond
that allows you to purchase it in one period for $95 per $100 face value. This
underlying 2-period bond is traded at $90.53 per $100 face. Also available for
trades is the 1-period zero-coupon bond. Suppose that the interest rates
follow binomial process depicted by the binomial tree below,
Form a bond portfolio to replicate this option to compute its price.

27
 Answer to E.g. 4.2: The option’s strike price is $95 and option’s maturity is at
t=1. Note that
 All bonds have (conventionally) face value of $100
 Interest rates (yields) are forward-looking (that is, rate given at t applies for
period from t to t+1)
 Denote A and B respectively the one- and two-period bonds (from t=0 perspective)
100 100
 Bond prices are: 𝑃𝐴 0 = 1+𝑟 = 1+5% = 95.24; 𝑃𝐵 0 = 90.53 (as given)
0
𝑃𝐴 1, 𝑢 = 𝑃𝐴 1, 𝑑 = 100 (at maturity, bond pays face regardless in whatever state)

100 100 100 100
𝑃𝐵 1, 𝑢 = 1+𝑟 = 1+5.5% = 94.79; 𝑃𝐵 1, 𝑑 = 1+𝑟 = 1+4.5% = 95.69
1,𝑢 1,𝑑
 At t=1, option allows buying bond B for $95, which implies the following option payoff
in state u and d at t=1
𝑉 1, 𝑢 = max 94.79 − 95,0 = 0; 𝑉 1, 𝑑 = max 95.69 − 95,0 = 0.69
28
 Answer to E.g. 4.2 (cont.): Now we want to form a portfolio of 𝑥𝐴 units of

bond A and 𝑥𝐵 units of bond B to replicate the payoff of the option.
 At t=1, the replication equations are:
𝑥𝐴 × 𝑃𝐴 1, 𝑢 + 𝑥𝐵 × 𝑃𝐵 1, 𝑢 = 𝑉(1, 𝑢) or 𝑥𝐴 × 100 + 𝑥𝐵 × 94.79 = 0

𝑥𝐴 × 𝑃𝐴 1, 𝑑 + 𝑥𝐵 × 𝑃𝐵 1, 𝑑 = 𝑉(1, 𝑑) or 𝑥𝐴 × 100 + 𝑥𝐵 × 95.69 = 0.69
Solving this system we get: 𝑥𝐴 = −0.73; 𝑥𝐵 = 0.76.

That is, a portfolio of [short 0.73 bonds A, long 0.76 bond B] replicates the
payoff of option price in every state at time t=1.
 By no arbitrage, the value of this portfolio must also equal the value of
the option at time t=0. That is, the price of the option at time t=0 is
𝑉 0 = 𝑥𝐴 × 𝑃𝐴 0 + 𝑥𝐵 × 𝑃𝐵 0 = −0.73 × 95.24 + 0.76 × 90.53 = 𝟎. 𝟐𝟎
Interest rate options: risk-neutral pricing
29
 Note that in the above example we do not need to know the

probabilities of states u and d in at t=1. The reason is that as
long as we can find the replicating portfolio that produces
identical payoff for the option in every state at t=1, we can
price the option by finding the value of replicating portfolio.
 Yet there is a way to infer the (risk-neutral) probabilities of

these states u and d. And then option price can also be inferred
from these probabilities. This approach is called risk-neutral
pricing, a masterpiece of option pricing theory.
 E.g. 4.3: (continued with e.g. 4.2) First, compute the risk-neutral
probabilities 𝑃𝑟𝑜𝑏(1, 𝑢) and 𝑃𝑟𝑜𝑏(1, 𝑑) for states at time t=1.
Then compute option price.
Interest rate options: risk-neutral pricing
30
 Answer to E.g. 4.3: We find the risk-neutral probabilities based on the two-
period bond price today and next period, and the one-period risk-free rate.
𝑃𝑟𝑜𝑏 1,𝑢 ×𝑃𝐵 1,𝑢 +𝑃𝑟𝑜𝑏 1,𝑑 ×𝑃𝐵 1,𝑑
𝑃𝐵 0 =
1+𝑟(0)
𝑃𝑟𝑜𝑏 1,𝑢 ×94.79+[1−𝑃𝑟𝑜𝑏 1,𝑢 ]×95.69
or 90.53 =
1+5%
which implies 𝑃𝑟𝑜𝑏 1, 𝑢 = 0.7; 𝑃𝑟𝑜𝑏 1, 𝑑 = 0.3;
 Then the price of option is the discounted value of its expected value
(using the above risk-neutral probabilities)
𝑃𝑟𝑜𝑏 1,𝑢 ×𝑉 1,𝑢 +𝑃𝑟𝑜𝑏 1,𝑑 ×𝑉 1,𝑑 0.70×0+0.3×0.69
𝑉 0 = = = 𝟎. 𝟐𝟎
1+𝑟(0) 1+5%
(These are risk-neutral probabilities because we use risk-free rate 𝑟(0) as discount rate! )
IR option: the non-applicability of Black-Scholes
31
 Black-Scholes formula is extremely popular in pricing option on stock. A

natural question is that: Does Back-Scholes formula apply to pricing
option on fixed-income securities?
 The short answer is NO! To see this in action, consider the following
counterexample (this e.g. is made up to illustrate the points, it is not entirely consistent).
 E.g. 4.4: What is the price of a 3-yr European call option on a 3-yr zero
coupon bond with exercise price $110 (per $100 face value)? Assuming flat
yield of r=10% and bond price’s volatility of 𝜎=4%
 Answer to e.g. 4.4:
 At t=3 (maturity), bond price will be par ($100) with certainty, and thus
the option will surely (and always) not be exercised. In other words, this
option is always worthless (price is zero) at t=3, and thus also at t=0.
 In contrast, the Black-Scholes formula (using given data) gives the option
price of $7.78! What went wrong?
IR option: the non-applicability of Black-Scholes
32
 What went wrong? The assumptions underlying the traditional

Black-Scholes option pricing model do not apply to bond prices:
 positive probability of any future price (in contrast, zero-coupon
bond price at maturity must be the par, that is, 100% probability)
 constant short-term rate assumed over life of option (in contrast,
spot yields generally are not constant for fixed-income securities)
 constant return volatility on the underlying security (in contrast,
return volatilities generally are not constant for fixed-income
securities)
 For this reason, fixed income options are usually priced on the
interest rate evolution, but not of bond price evolution. (thus, yields,
not bond price, are fundamentals in FI option modeling)
Callable and Puttable Bonds
33
 Bonds can be embedded with some option features.

 Callable bonds
 Callable bonds are bonds for which the bond issuer has the right
to buy back (i.e., call) the bonds from bond buyer at pre-specified
(strike) price upon (or after) some pre-specified (exercise) date
 So, when the exercise date comes, bond issuer will call (buy back) the
bond if its market price is higher than strike price. Thus, bond issuer
has the long position in the call option on the bond.
 This feature is an disadvantage to the bond buyer, thus it must be
reflected in a cheaper callable bond price 𝑃𝐵,𝑐𝑎𝑙𝑙𝑎𝑏𝑙𝑒 compared to
price 𝑃𝐵 of a plain bond of identical cash flows
𝑷𝑩,𝒄𝒂𝒍𝒍𝒂𝒃𝒍𝒆 = 𝑷𝑩 − 𝑽𝒄𝒂𝒍𝒍 𝒐𝒑𝒕𝒊𝒐𝒏 ≤ 𝑷𝑩
 Hence, callable bond must offer higher yield to compensate bond
buyers 𝒚𝑩,𝒄𝒂𝒍𝒍𝒂𝒃𝒍𝒆 ≥ 𝒚𝑩
Callable and Puttable Bonds
34
 Puttable bonds
 Puttable bonds are bonds for which the bond buyer has the right
to sell back (i.e. put) to the bond issuer at pre-specified (strike)
price upon (or after) some pre-specified (exercise) date.
 So, when the exercise date comes, bond buyer will sell back (put) the
bond to bond issuer if its strike price is higher than its market value.
Thus, bond buyer holds the put option on the bond.
 This feature is an disadvantage to the bond seller, thus it must be
reflected in higher puttable bond price 𝑃𝐵,𝑝𝑢𝑡𝑡𝑎𝑏𝑙𝑒 compared to price
𝑃𝐵 of a plain bond of identical cash flows
𝑷𝑩,𝒑𝒖𝒕𝒕𝒂𝒃𝒍𝒆 = 𝑷𝑩 + 𝑽𝒑𝒖𝒕 𝒐𝒑𝒕𝒊𝒐𝒏 ≥ 𝑷𝑩
 Hence, puttable bond must offer lower yield to compensate bond
seller 𝒚𝑩,𝒑𝒖𝒕𝒕𝒂𝒃𝒍𝒆 ≤ 𝒚𝑩
Pricing Callable and Puttable Bonds
35
 Pricing strategy
 Use interest rate model to price the plain bond (of identical CFs).
 Use same interest rate model to price embedded call (or put) option.
 E.g. 4.5: Assume the following annual binomial tree for one-period interest
rate evolution with: 𝑃𝑟𝑜𝑏 𝑢 = 𝑃𝑟𝑜𝑏 𝑑 = 0.5 at every node.
 Compute the price of a plain 3yr 5.25%-coupon bond (annual coupon
payment)
 Assume that this 3yr 5.25%-coupon bond is callable at the end of two
years for $99.50. What is the value of the call option? What is the value of
the callable bond?
36
 Answer to e.g. 4.5:

 Compute the price of a plain 3yr 5.25%-coupon bond
 Denote plain bond price P, coupon C at each node. We find bond price is
$102.08 at t=0.
0.5× 100+5.25 +0.5× 100+5.25

For e.g. 99.73 =
1+5.53%
0.5× 99.73+5.25 +0.5× 100.69+5.25
101.33 =
1+4.07%
37
 Answer to e.g. 4.5 (cont):

 Compute the value of the embedded option and price of callable bond
 Denote option price V at each node. We find option price is $0.38 at t=0.
0.5× 0 +0.5× 0.23 0.5× 0.11 +0.5× 0.68

For e.g. 0.11 = ; 0.38 =
1+4.98% 1+3.50%
 Then follow the price of callable bond at time t=0
𝑃𝑐𝑎𝑙𝑙𝑎𝑏𝑙𝑒 = 𝑃 − 𝑉𝑐𝑎𝑙𝑙 𝑜𝑝𝑡𝑖𝑜𝑛 = 102.08 − 0.38 = 𝟏𝟎𝟏. 𝟕𝟎
American Callable Bond
38
 E.g. 4.6: All assumptions are as in e.g. 4.5, except now that the
bond can be called in years 1 and 2 (but not in year 0) at $99.50
(thus the call option is of American style). What is the value of
the (American) call option? What is the value of the callable
bond?
 Answer to e.g. 4.6:

 To compute the value of call option, we also proceed
backward in time from the option’s value (i.e., payoff) at t=2.
 But in the difference with European option pricing, we also

need to compare the option value if continuation with
option value if exercise at t=1 (because American option can
also be exercise at that time)
American Callable Bond
39
 Answer to e.g. 4.6 (cont.):

0.5×0+0.5×0.23
 At node (𝑡 = 1, 𝑢): continuation value = = 0.11;
1+4.98%
exercise value = 𝑚𝑎𝑥 99.46 − 99.5 , 0 = 0.
0.5×0.23+0.5×1.19
 At node (𝑡 = 1, 𝑑): continuation value = 1+4.07%
= 0.68;
exercise value = 𝑚𝑎𝑥 101.33 − 99.5 , 0 = 1.83.
0.5×0.11+0.5×1.83
 At initial node (𝑡 = 0): 0.94 = 1+3.5%
 Thus option value (at t=0) is $𝟎. 𝟗𝟒, and value of callable bond is 102.08 − 0.94 =
𝟏𝟎𝟏. 𝟏𝟒
Caps, Floors and Collars
40
 An interest rate cap is a derivative that (1) specified a cap rate and (ii)
allows the holder (i.e., buyer) to receive payment at the end of each period
in which a floating interest rate (e.g., LIBOR or Treasury yield) exceeds the
cap (or, strike) rate. Cap’s payoff at the end of period t is
𝐶𝐹𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑃𝑒𝑟𝑖𝑜𝑑 𝐿𝑒𝑛𝑔𝑡ℎ × 𝑚𝑎𝑥 𝑟𝑡 − 𝑟𝑐𝑎𝑝 , 0

41
 An interest rate floor is a derivative that (1) specified a floor rate and (ii)
allows the holder (i.e., buyer) to receive payment at the end of each period
in which a floating interest rate (e.g., LIBOR or Treasury yield) falls below
the floor (or, strike) rate. Floor’s payoff at the end of period t is
𝐶𝐹𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑃𝑒𝑟𝑖𝑜𝑑 𝐿𝑒𝑛𝑔𝑡ℎ × 𝑚𝑎𝑥 𝑟𝑓𝑙𝑜𝑜𝑟 − 𝑟𝑡 , 0

42
 An interest rate collar a derivative that specify both cap and floor rates.
Collar allows the holder (i.e., buyer) to receive payment at the end of each
period in which a floating interest rate (e.g., LIBOR or Treasury yield) falls
below the floor rate or exceeds above the cap rate. Collar’s payoff at the end
of period t is
𝐶𝐹𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑃𝑒𝑟𝑖𝑜𝑑 𝐿𝑒𝑛𝑔𝑡ℎ × 𝑚𝑎𝑥 𝑟𝑡 − 𝑟𝑐𝑎𝑝 , 0 + 𝑚𝑎𝑥 𝑟𝑓𝑙𝑜𝑜𝑟 − 𝑟𝑡 , 0
 So collar is simply a portfolio of a cap and a floor
Valuing an interest rate cap
43
 E.g. 4.7: Consider a interest rate cap contract associated with a 3-year
floating rate loan for $100,000 indexed to the 1-yr LIBOR. The cap has annual
reset frequency and cap rate is 4.75%. Assume 1-yr LIBOR follows the
binomial evolution depicted below (same as in e.g. 4.5), and
Prob(u)=Prob(d)=0.5 at every node. What is the price of this cap at t=0.
44
 First caplet: at node (1,u), cap will payoff because 𝑟𝑢 = 4.98% > 𝑟𝑐𝑎𝑝 =
4.75%. The payoff is 100𝐾 × 4.98% − 4.75% at end of year 2, so after
discounting it back to end of year 1 (node (1,u)), its value is
100𝐾 × (4.98% − 4.75%)
𝑉𝑢 = = 219.1
1 + 4.98%
The (expected and discounted) value of this first caplet at t=0 is

0.5 × 𝑉𝑢 + 0.5 × 0
𝑉𝑐𝑎𝑝𝑙𝑒𝑡1 = = 105.8
1 + 3.50%
45
 Answer to E.g. 4.7 (cont.):
 Second caplet: Similarly, at node uu, and ud this cap will also pay off because interest rates at
these nodes are above 𝑟𝑐𝑎𝑝 = 4.75%.
100𝐾 × (6.76% − 4.75%) 100𝐾 × (5.53% − 4.75%)
𝑉𝑢𝑢 = = 1882.7; 𝑉𝑢𝑑 = = 739.1
1 + 6.76% 1 + 5.53%
 The (expected and discounted) value of this second caplet at t=0 is
𝑉𝑐𝑎𝑝𝑙𝑒𝑡2
0.25 × 𝑉𝑢𝑢 0.25 × 𝑉𝑢𝑑 0.25 × 𝑉𝑢𝑑
= + +
(1 + 3.50%)(1 + 4.98%) (1 + 3.50%)(1 + 4.98%) (1 + 3.50%)(1 + 4.07%)
0.25 × 𝑉𝑑𝑑
+ = 433.2 + 170.1 + 171.5 + 0 = 774.8
(1 + 3.50%)(1 + 4.07%)
Thus, the total value of this cap contract at t=0 is
𝑉𝑐𝑎𝑝 = 𝑉𝑐𝑎𝑝𝑙𝑒𝑡1 + 𝑉𝑐𝑎𝑝𝑙𝑒𝑡2 = 105.8 + 774.8 = 𝟖𝟖𝟎. 𝟔
Valuing a swaption
46
 Recall: in swaptions, fixed or floating payors have option to exit

the swap early
 E.g. 4.8: Consider a swap with notional principal of $1000 and 3
years until maturity. The fixed rate payor pays 10.1% annually.
The payor has a swaption that releases him from the swap at
any time. What is the initial value of the swaption, assuming
interest rate follows a binomial evolution depicted below, and
Prob(u)=Prob(d)=0.5 at every node.
Valuing a swaption
47
 Answer to E.g. 4.8: Solution approach

 The value of the swaption depends on the exercise policy of the fixed rate payor
(who has the right to keep paying fixed rate or quit the swap contract at any
node). In case he chooses to exercise (i.e., he quits the swap): no further
payments are made by any counterparties
 We go backward in time from t=2 to find first the optimal exercise policy for the
fixed-rate payor, then we price the swaption accordingly. The pricing is similar to
that of American option: but with swaption, when exercise, (from that
moment on) payoff is actually zero! (with American option: exercise early
because it generates best profits in expectation)
 For convenience, we proceed as if the principal is also exchanged in the final

payment: An equal amount is paid and received, hence this does not affect the
estimated option value:
PV(face + fixed interest)-PV(face + floating interest)
= PV(fixed interest)-PV(floating interest)
Valuing a swaption
48
 Answer to E.g. 4.8 (cont.): At t=2

 Node uu (rate =12%)
 PV of final fixed rate payment is $1000(1+10.1%)/(1+12%) = $983.04
 PV of final floating payment is $1000(1+12%)/(1+12%) = $1000.00
 Fixed-rate payor receives more than what he pays (1000> 983.04), so he doesn’t
need to exercise option. Denote V2(12%) the option value at time 2 at 12%,
then V2(12%) = 0
Valuing a swaption
49

 Node ud (rate =10%)
 Fixed-rate payor receives less than what he pays (1000< 1000.91), so he
exercises option. Then option value V2(10%) = $1000.91-$1000.00=$0.91
Valuing a swaption
50

 Node dd (rate =8%)
 Fixed-rate payor receives less than what he pays (1000<1019.44), so he exercises
option. Then option value V2(8%) = $1019.44-$1000.00=$19.44
Valuing a swaption
51

 Node u (rate =11%)
 PV of remaining fixed rate payment is
1000 × (1 + 10.1%)
1000 × 10.1% 0.5 × + 0.5 × 𝟎
+ 1 + 12% = 533.8
1 + 11% 1 + 11%
where 𝟎 is the payment value when fixed-rate payor exercises at node ud at t=2 (recall
that when he exercises, he quits the swap and pays nothing at that node).
Valuing a swaption
52

 PV of remaining floating payment is
1000 × (1 + 12%)
1000 × 11% 0.5 × + 0.5 × 𝟎
+ 1 + 12% = 549.5
1 + 11% 1 + 11%
where 𝟎 is the payment value when fixed-rate payor exercises at node ud at t=2 (recall
that when he exercises, he quits the swap, the floating-rate payor also quits and thus pays
nothing at that node).
Valuing a swaption
53

 (Expectedly,) Fixed-rate payor receives more than what he pays (549.5 > 533.8), so he
doesn’t need to exercise option, and the swap contract will proceed to t=2.
 The value of option (swaption) to fixed-rate payor is thus 𝑽𝟏 𝟏𝟏% = 𝟎 at node u, at
t=1: NO Exercise
Valuing a swaption
54

 Node d (rate =9%)
1000 × 10.1% 0.5 × 𝟎 + 0.5 × 𝟎
+ = 92.7
1 + 9% 1 + 9%
where 𝟎 and 𝟎 are the payment values when fixed-rate payor exercises at node ud and
node dd at t=2 (when he exercises, no payments will be made by either counterparties).
Valuing a swaption
55

1000 × 9% 0.5 × 𝟎 + 0.5 × 𝟎
+ = 82.6
1 + 9% 1 + 9%
where 𝟎 and 𝟎 are the payment values when fixed-rate payor exercises at node ud and
node dd at t=2 (when fixed-rate payor exercises, no payments will be made by either
counterparties).
Valuing a swaption
56

 (Expectedly,) at node d at t=1, Fixed-rate payor receives less than what he pays (82.6. <
92.7), so he will exercise option in node d at t=1.
 The value of option (swaption) to fixed-rate payor is thus 𝑽𝟏 𝟗% = 𝟗𝟐. 𝟕 − 𝟖𝟔. 𝟔 =
$𝟔. 𝟏 at node d, at t=1
Valuing a swaption
57

 Initial Node (rate =10%)
1000 × 10.1%
1000 × 10.1% 0.5 × 1 + 11%
+ 0.5 × 𝟎
+
1 + 10% 1 + 10%
1000 × (1 + 10.1%)
0.25 × + 0.25 × 𝟎 + 0.25 × 𝟎 + 0.25 × 𝟎
(1 + 11%)(1 + 12%)
+ = 334.5
1 + 10%
where 𝟎’s are payments at the nodes in which fixed-rate payor chooses to exercise.
Valuing a swaption
58

1000 × 11%
1000 × 10% 0.5 × 1 + 11%
+ 0.5 × 𝟎
+
1 + 10% 1 + 10%
1000 × (1 + 12%)
0.25 × + 0.25 × 𝟎 + 0.25 × 𝟎 + 0.25 × 𝟎
(1 + 11%)(1 + 12%)
+ = 340.7
1 + 10%
where 𝟎’s are payments at the nodes in which fixed-rate payor chooses to exercise.
Valuing a swaption
59

 (Expectedly,) at initial node at t=0, Fixed-rate payor receives more than what he
pays (340.7 > 334.5), so he doesn’t need to exercise option, and the swap
contract will proceed to t=1. At initial node at t=0, the net present value to fixed
rate payor then is 𝟑𝟒𝟎. 𝟕 − 𝟑𝟑𝟒. 𝟓 = $𝟔. 𝟐, this is also the price of the swaption at
t=0.
Week 5: CORPORATE DEBTS, CREDIT RISK &

CREDIT DEFAULT SWAPS (CDS)
NGOC-KHANH TRAN
SPRING 2018

by Profs. D. Lucas and J. Pan (MIT)
2 Topic 5-1: CORPORATE DEBTS & DEFAULT
 Corporate debt market: overview

 Corporate debt default: the risk (credit risk)
 Simplified pricing model of risky bond
Corporate debts
3
 Corporate debts (also known as corporate bonds) are debt

instruments issued by corporations
 Corporate debts are an important category of securities with
significant credit risk (risk of default on the creditors, i.e.,
corporate bond holders)
 Classification: Corporate debts can be classified as financial
(banks, investment companies, etc.) or non-financial.
 Credit rating: Corporate debts can also be classified based on
their credit rating. Broadly, corporate bonds belong to either of
 Investment grade
 Non-investment (or speculative, or “junk”) grade

Corporate debts
4
Corporate debts: New Issuance (Volume)
5
Corporate debts: credit rating
6
Corporate debts: Returns
7
Sovereign debts: Returns
8
Corporate debts: Default and Prevalence of Junk Bonds
9
Corporate debts: credit change
10
Corporate debt index return
11
 FINRA-Bloomberg Active US Corporate Bond Indices
Investment grade index: total return High-yield index: total return
Source: http://finra-markets.morningstar.com/BondCenter/ActiveUSCorpBond.jsp
Corporate debts: Default
12
What is a default in corporate debt? Moody’s definition of corporate

debt default includes three types of credit events:
 A missed or delayed disbursement of interest and/or principal,
including delayed payments made within a grace period;
 Bankruptcy (e.g., chapter 11), administration, legal receivership, or
other legal blocks (perhaps by regulators) to the timely payment of
interest and/or principal;
 A distressed exchange occurs where:
 the issuer offers debt holders a new security or package of
securities that amount to a diminished financial obligation (such
as debt with a lower coupon, lower seniority, or longer maturity);
 the exchange had the apparent purpose of helping the borrower
avoid default.
Corporate debts: the risks
13
 Interest rate risk (or yield curve risk): values of corporate bonds change
with market yields, in the same way as T-bond prices changes with yields.
 This risk can be hedged using Treasuries or Swaps (recall: immunization,
duration (delta) hedging, convexity (gamma) hedging)
 Default risk is the number one risk factor (aside from the “standard”
interest rate risk) in corporate bonds
 Default risk is the key difference between corporate bonds and
government (T-) bonds. There is (safely assumed) no default in (US) T-
bonds, yet there is non-zero (market-perceived) possibility of default
even for the corporate bonds of highest ratings
 Thus default risk is a key driver behind the (price and) yield spread
between corporate bonds and T-bonds.
 Additionally, illiquidity risk has also emerged as an important risk factor.

14
Corporate default in 2008, by Industry Distribution
FIRE stands for Finance, Insurance, and Real Estate sectors

15
Corporate default in 2008, by Financial Institutions
The bankruptcy of Lehman was the largest default in history ($120.2 billion debt).
16
Corporate debts: Default vs. credit risk
17
 Credit risk crucially contributes/influences to the chance of default in

corporate debt, and vice versa. So for corporate debts, credit risk is highly
related to default risk, even though a credit event is not necessarily outright
default.
 What affect credit risk?
 Collateralization: is firm’s debt backed by some collateral (apart from
firm’s own assets), for e.g. by other bank/underwriter?
 Priority to receive payment/settlement: is the corporate debt under
consideration senior or subordinated?
 Indentures and covenants: is the corporate debt contract under
consideration bound to some extra legal agreements concerning interest
and principal payment schedule?
 Sinking funds: firms commit to put aside every year some money
preparing for the repurchase of the debts. Thus sinking fund reduces the
chance of default for corporate bonds.
18
 Recall: Debt vs. Equity in case of corporate default

 Creditors (debt holders) has first claim over corporate assets
(usually up to the book value of the debt). Residual assets then
belong to equity holders (but there exist forms of limited legal
protection to the rescue of equity holders).
 Thus, practically and simplistically, default may happen when
firm’s asset value A falls below that of (face) value of the firm’s
debt (or more specifically, the book value of liability) K.
 Two key measures in assessing credit risk are
 Default rate: (Annual) probability (likeliness) of a default event
 Recovery rate: Amount recovered as a fraction of what is owed in
case of default.
Corporate debt default: variation in default rates
19
Default rates vary enormously: Over time, by credit rating, and

with the business cycle. Why?
Corporate debt default: variation in recovery rates
20
Recovery rates vary sizably over types and seniorities of debts

Corporate debt default: default rates vs. recovery rates
21
Recovery rates tend to be low when default rates are high. Why?
Corporate bonds: the payoff claim
22
 The simplified picture of payoff to corporate debt holder (i.e., firm’s creditor) at
debt’s maturity T (omitting interests for now):
 Solvency: If firm’s asset value A is higher than the face value of debt (or more
specifically, the book value of liability) K, debt holder gets K
 Default: If firm’s asset value A is lower than the face value of debt K, debt
holder gets only A
 A risky zero coupon corporate debt (bond) is equivalent to a portfolio that includes:
 a risk-free zero coupon debt
 a short position in a put option on firm’s assets, with strike price equal to the
face value of the debt
 This put option is key feature in all risky debt pricing models
23
 From the perspective of firm’s equity holders (i.e., firm owner), at debt’s
maturity T:
 Solvency: If firm’s asset value A is higher than the face value of debt K,
the firm is solvent, equity holders get: A-K
 Default: If firm’s asset value A is lower than the face value of debt K,
equity holders get zero (limited liability!)
 Thus equity holders’ payoff is 𝐦𝐚𝐱 𝑨 − 𝑲, 𝟎 , or equity holders have a
long position in a call option on firm’s asset, with strike price equal to
the face value of the debt
24
 Regardless of default, total claim of debt and equity holders

must be the total value of the firm (i.e., firm’s asset value) in all
cases:
𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐴𝑠𝑠𝑒𝑡
Risky debts: Loan guarantees
25
 Loan guaranteeing is a process to help risky firms raise corporate debts

 It can be very costly (or even, impossible) for a high-risk firm to issue
debts on its own (firms’ bonds would be very cheap, thus firms have
to pay high interests for their borrowing) .
 A way out is to issue loan guarantees (instead of standard stand-
alone corporate debts): bad-credit firms find a co-signer (a.k.a.,
guarantor) issuing the debt (i.e., bond, or loan).
 Guarantor supposedly has good credits, and can be banks or
government
 In case the firm defaults (its asset value falls below the face of debt),
the guarantor will step in to pay the debt on behalf of firm
 In exchange, firm periodically pays guarantor fee for guaranteeing its
bond/debt/loan
26
 Note that in case of default, firm’s owner (equity holders) still loses all (zero
payoff). But just because of the backing of guarantor, firm is able to raise debt
(that it was not able to otherwise)
 In case of default, guarantor has to make up (ie., pay) for any debt loss to the
creditor: Debt loss = Debt Face – Firm’s Asset value
 (omitting fee), payoff to the guarantor
equals short position of a put option on
firm’s asset: i.e., guarantor writes put
option on firm’s asset.
27
 With loan guarantees, all the risk will be taken by guarantor, while other
creditors enjoy holding a safe bond
Pricing loan guarantees
28
 E.g. 5.1: Today XYZ Co. has a market value of $100 million, and next
year the company’s assets will take on one of two values: $140 million
or $70 million. XYZ also has a guaranteed debt with a face value of
$90 million (covering principal and interest), coming due next year.
One-year T-note is currently traded at $95 per $100 face. What is the
lump-sum fee that XYZ has to pay (now) to have this guarantee?
 Answer to E.g. 5.1: solution approach
 First we compute the payoff to the loan guarantor
 Then, as guarantor’s position is equivalent to writing a put

option on firm’s asset, we need to use both a risk-free asset (T-
note) and the underlying asset (firm’s asset) to construct a
portfolio replicating the payoff of this put.
 Finally, we compute the current value of this replicating portfolio.
By no arbitrage, this is the value of the guarantee.
29

 When firm defaults (𝐴1 < 90 mil), guarantor has to pay to make up
for any debt loss for the creditor.
 When firm stays solvent (𝐴1 > 90 mil), guarantor doesn’t need to pay
anything
 Thus, (omitting fees) payoff 𝐺1 to guarantor is payoff to short
position in a put on firm’s asset with exercise price K = 90 mil
30

 To replicating the payoff 𝐺1 to guarantor, we use 𝑥𝑁 units of T-
note (which invariably has face value of 100) and 𝑥𝐴 units of
firm’s total asset. The payoff matching in two states is
𝑥𝑁 × 100 + 𝑥𝐴 × 𝐴1,𝑢 = 𝐺1,𝑢 or 𝑥𝑁 × 100 + 𝑥𝐴 × 140 = 0
𝑥𝑁 × 100 + 𝑥𝐴 × 𝐴1,𝑑 = 𝐺1,𝑑 or 𝑥𝑁 × 100 + 𝑥𝐴 × 70 = −20
which implies 𝑥𝑁 = −0.4; 𝑥𝐴 = 0.286
 Thus, the initial value (at t=0) of the guarantor’s position is
𝑥𝑁 × 95 + 𝑥𝐴 × 100 = −0.4 × 95 + 0.286 × 100 = −𝟗. 𝟒 𝒎𝒊𝒍
 Thus, in expectation, it makes a loss (of −9.4 𝑚𝑖𝑙) to be the
guarantor to cosign the loan for XYZ. Then, XYZ needs to pay
the guarantor 𝟗. 𝟒 𝒎𝒊𝒍 now (at t=0) to compensate the
guarantor for this expected loss.
31
Topic 5-2: PRICING MODELS OF
CORPORATE DEBT/CREDIT RISK
 Reduced-form models
 Structural models
Pricing models of credit risk
32
 Credit risk pricing models center around modeling chance of

corporate default and institutional details (who - creditor vs. equity
holders - gets what), given default did happen.
 Models are classified into Reduced-form models and Structural
models
 Reduced-form models take ad-hoc approach: they attempt to
mimic the default patterns/data closely using math/stat process
with or without necessary economic intuitions. The fit with data is
good, because model’s parameters are tuned to the data (best-fit
approach)
 Structural models start with economic reasoning (first-principle
approach). But usually requires simplifications to make models
tractable. While intuitively beautiful, fit power of structural
models can be limited.
A reduced-form model of credit risk
33
 Formal model presentation (we will look at numerical example later)

 Current time is t=0. Let 𝜏 be the random time of default
 Thus, probability that firm survives beyond time t is Prob(𝜏 > t)
 Probability that firm defaults sometime before t is 1-Prob(𝜏 > t)
 The survival chance is modeled
(reduced-form) to decrease
exponentially with time (age)
Prob(𝜏 > t)=𝑒 −𝜆𝑡 ,
where 𝜆 ≡intensity of default
(Larger intensity 𝜆 means
higher chance of default).
Typically, 𝜆 is small (few % at most)
Technical note: the corresponding
probability density of default is
𝜌 𝑡 = 𝜆𝑒 −𝜆𝑡 (see graph), meaning the probability that firm defaults within interval from t to t+dt is
𝑡
𝜌 𝑡 𝑑𝑡 = 𝜆𝑒 −𝜆𝑡 𝑑𝑡. Then the probability that firms defaults before t is 0 𝜌 𝑠 𝑑𝑠 =
𝑡
0
𝜆𝑒 −𝜆𝑠 𝑑𝑠=1 − 𝑒 −𝜆𝑡 . Thus indeed the probability of survival beyond time t is
𝑡
1− 0
𝜌 𝑠 𝑑𝑠=𝑒 −𝜆𝑡
A reduced-form model of credit risk (100% loss)
34
 Formal presentation (cont.): within a year

survival: Prob(𝜏 > 1)=𝑒 −𝜆 ≈ 1 − 𝜆 default: 1 − Prob(𝜏 > 1)≈ 𝜆
Let 𝐷0 be price of firm’s one-year zero-coupon bond (debt) per notional

$1 face
 Assuming zero recovery (100% loss given default)
𝑃𝑟𝑜𝑏 𝜏>1 ×1+𝑃𝑟𝑜𝑏 𝜏<1 ×0 1−𝜆 1
𝐷0 = ≈ ≈
1+𝑟 1+𝑟 1+𝑟+𝜆
 The bond yield thus is (approximately) 𝑟 + 𝜆
 𝑟 is risk-free rate (which implies 𝑒 −𝜆 is risk-neutral probability),
then the credit spread is
𝑠 = 𝑟+𝜆 −𝑟 =𝜆
 In words: due to chance of default, the cost of debt to firm is
higher than the cost of non-defautable debt by 𝜆 (the intensity of
default)
A reduced-form model of credit risk (partial loss)
35
 Formal presentation (cont.): within a year

survival: Prob(𝜏 > 1)=𝑒 −𝜆 ≈ 1 − 𝜆 default: 1 − Prob(𝜏 > 1)≈ 𝜆
Price of firm’s one-year zero-coupon debt (bond) per notional $1 face

 Assume constant recovery (loss 𝐿, recovery 1 − 𝐿 per $1 face, given
default). (For simplicity), also assume small loss fraction 𝐿
𝑃𝑟𝑜𝑏 𝜏>1 ×1+𝑃𝑟𝑜𝑏 𝜏<1 ×(1−L) 1−𝜆 ×1+𝜆× 1−L 1−𝜆×𝐿 1
𝐷0 = ≈ ≈ ≈
1+𝑟 1+𝑟 1+𝑟 1+𝑟+𝜆×𝐿
 The bond yield thus is (approximately) 𝑟 + 𝜆 × 𝐿
 the credit spread is
𝒔= 𝑟+𝜆×𝐿 −𝑟 =𝜆×𝐿
 In words: due to chance of default and loss given default, the cost
of debt to firm is higher than the cost of non-defautable debt by
𝜆 × 𝐿 (the intensity of default multiplied by the loss fraction)
 credit spread s increases with both chance of default 𝜆 and loss
give default 𝐿 (both make sense)
A reduced-form model: example
36
 E.g. 5-2: Let’s consider a risky debt with intensity of default 𝜆 = 10%. In case
of default, the debt holder will lose 𝐿 = 40% of the face value of the debt.
 What is the probability the debt will default within next year?
 The current 1-year T-bond is currently priced at $95 per $100 face. What is
the price of this risky debt (per $100 face)?
 The probability the debt will survive through next year is Prob(𝜏 > 1) =
𝑒 −𝜆 = 𝑒 −10% = 90.5% and the probability the debt will default within
next year is Prob(𝜏 < 1) = 1 − 𝑒 −𝜆 = 1 − 𝑒 −10% = 9.5%
 The current 1-year risk free rate can be computed from price of T-bond
100 100
95 = ⟹𝑟= − 1 = 5.3%
1+𝑟 95
 The bond’s credit spread is 𝑠 = 𝐿 × 𝜆 = 0.4 × 10% = 4%,
and the yield on this risky bond is y = 𝑠 + 𝑟 = 4% + 5.3% = 9.3%
100
 Current price of the risky bond (per $100 face) is = $𝟗𝟏. 𝟓
1+9.3%
Structural (Merton’s) model of credit risk
37
 This structural model stems from the payoff claim to firm’s asset given the
prospect of firm’s default.
 Recall that debt holder’s position is sum of [long position in non-
defaultable debt plus short position in put option on firm’s asset]
 Thus current (at t=0) price of risky debt is

𝑷𝟎 = 𝑲𝒆−𝒓𝑻 − 𝑷𝒖𝒕𝟎
 K is face value of debt,
 𝑃𝑢𝑡0 is the put option price on firm’s asset,
 r is risk-free rate,
 T is time to maturity of debt.
38
𝑷𝟎 = 𝑲𝒆−𝒓𝑻 − 𝑷𝒖𝒕𝟎
 Idea: Merton’s structural model employs Black-Scholes option pricing to
compute put price 𝑃𝑢𝑡0 , then follows risky bond price 𝑃0
 Assuming firm’s asset value 𝐴𝑡 follows random log-normal process
1 2
𝑙𝑜𝑔(𝐴𝑡 ) = log(𝐴0 ) + 𝜇 − 𝜎 𝑡 + 𝜎 𝑡 × 𝑁 0,1
2
where 𝑁 0,1 is a standard normal random variable (like in Black-Scholes).
𝜇 = mean growth of asset value; 𝜎 = volatility of asset value
 At debt’s maturity date T, if 𝐴 𝑇 < 𝐾 (or equivalently log(𝐴 𝑇 ) < log(𝐾)),
firm defaults (because the put ends up in the money, and as bond’s holder
writes the put, he loses money)
 At t=0, given the current asset value 𝐴0 , and parameters 𝜇, 𝜎, risk-free rate
𝑟, we know only the distribution of 𝐴 𝑇 (the asset’s random value 𝐴 𝑇 will be
realized only at T)
39
1
 𝑙𝑜𝑔(𝐴 𝑇 ) = log(𝐴0 ) + 𝜇 − 𝜎 2 𝑇 + 𝜎 𝑇𝑁 0,1 is normal variable with
2
1
mean m = log(𝐴0 ) + 𝜇 − 𝜎2 𝑇 and stddev= 𝜎 𝑇
2
 distance-to-default (DD): how far is 𝑙𝑜𝑔(𝐴 𝑇 ) from default value log(𝐾)?

1 1
𝒎−log(𝐾) log(𝐴0 )+ 𝜇−2𝜎 2 𝑇−log(𝐾) 𝜇−2𝜎 2 𝑇−log(𝐾/𝐴0 )
𝐷𝐷 ≡ = =
𝒔𝒕𝒅𝒅𝒆𝒗 𝜎 𝑇 𝜎 𝑇
Clearly, DD decreases (default’s
likelihood increases) with firm’s
leverage 𝐾/𝐴0 , and with
asset’s volatility 𝜎.
(Both of these relationships are
plausible! )
40
 From distance-to-default (DD) to probability of default :
Assuming normal distribution for firm’s asset value, the probability of

default (i.e. chance that 𝐴 𝑇 < 𝐾 at T) is Φ −𝐷𝐷 where Φ(… ) is the
cumulative distribution function (cdf ) for standard normal variable.
Technical note: If x is non-standard normal variable with mean m, and stddev,
𝑥−𝑚
then is standard normal variable with mean=0, and stddev=1,
𝑠𝑡𝑑𝑑𝑒𝑣
𝑥−𝑚 𝐾−𝑚 𝐾−𝑚
then the prob(x<K)=prob( < ) = 𝛷( )
𝑠𝑡𝑑𝑑𝑒𝑣 𝑠𝑡𝑑𝑑𝑒𝑣 𝑠𝑡𝑑𝑑𝑒𝑣
41
 Calibration in Merton’s model:

1
𝜇 − 𝜎 2 𝑇 − log(𝐾/𝐴0 )
𝐷𝐷 = 2
𝜎 𝑇
Leverage Asset growth Asset Time to Distance to Default Prob
(𝐾/𝐴0 ) (𝝁) vola. (𝝈) maturity (T) default (DD) at T
𝚽(−𝑫𝑫)
15% 10% 40% 1 yr 4.79 𝟖𝟑 × 𝟏𝟎−𝟖
15% 10% 40% 10 yr 1.66 𝟒. 𝟖%
50% 10% 40% 1 yr 1.78 3.8%
15% 10% 20% 1 yr 9.89 0
15% 10% 20% 10 yr 4.26 𝟏𝟎 × 𝟏𝟎−𝟔
15% 20% 40% 1 yr 5.04 𝟐𝟑 × 𝟏𝟎−𝟖
Drawback of original Merton’s model: Apparently, (log) normal distribution
for asset value gives too small (i.e., underestimates) chance of default 𝚽(−𝑫𝑫)
42
Defaultable bond price and associated yield:

𝑃0 = 𝐾𝑒 −𝑟𝑇 − 𝑃𝑢𝑡0 𝑃0 = K 𝑒 −𝑦𝑇
defaultable yield
1 𝑃𝑢𝑡0
𝑦=𝑟− 𝑙𝑜𝑔 1 −
𝑇 𝐾𝑒 −𝑟𝑇
and credit spread
1 𝑃𝑢𝑡0
𝐬 = 𝑦 − 𝑟 = − 𝑙𝑜𝑔 1 −
𝑇 𝐾𝑒 −𝑟𝑇
(Technical derivation: Starting with the price of daultable bond 𝑃0 =K 𝑒 −𝑦𝑇 = 𝐾𝑒 −𝑟𝑇 − 𝑃𝑢𝑡0
𝑃𝑢𝑡0
Which implies: K 𝑒 −𝑦𝑇 = 𝐾𝑒 −𝑟𝑇 1 −
𝐾𝑒 −𝑟𝑇
𝑃𝑢𝑡0 −1
Or 𝑒 𝑦𝑇 = 𝑒 𝑟𝑇 1 −
𝑃𝑢𝑡0
Taking log of both sides: 𝑦𝑇 = 𝑟𝑇 − 𝑙𝑜𝑔 1 −
From this follows the above expressions for yield and credit spread)
43
 Merton’s model gives specific expression for credit spread, because it

employs Black-Scholes option pricing technology
 Recall that firm’s asset value 𝐴𝑡 follows random log-normal process
1
𝑙𝑜𝑔(𝐴𝑡 ) = log(𝐴0 ) + 𝜇 − 𝜎 2 𝑡 + 𝜎 𝑡𝑁 0,1 , then Put price at current
2
time (t=0) has Black-Scholes formula
𝑃𝑢𝑡0 = 𝐾𝑒 −𝑟𝑇 𝛷 −𝑑2 − 𝐴0 𝛷 −𝑑1
𝐴0 𝜎2 𝐴0 𝜎2
log 𝐾
+ 𝑟+ 2 𝑇 log 𝐾
+ 𝑟− 2 𝑇
where 𝑑1 = 𝑑2 =
𝜎 𝑇 𝜎 𝑇
 Thus for defaultable bond, the credit spread in Merton’s model is

1 𝑟𝑇
𝐴0
𝑠 = 𝑦 − 𝑟 = − 𝑙𝑜𝑔 1 − 𝛷 −𝑑2 + 𝑒 𝛷 −𝑑1
𝑇 𝐾
(note: 𝑑2 is very much like distance to default DD, with 𝑟 replaced by 𝜇)
44
1 𝐴0
Credit spread 𝒔 = 𝑦 − 𝑟 = − 𝑙𝑜𝑔 1 − 𝛷 −𝑑2 + 𝑒 𝑟𝑇 𝛷 −𝑑1
𝑇 𝐾
 Credit spread 𝒔 increases with firm’s asset volatility 𝜎: why?
 larger 𝜎 increases chance of default
 larger 𝜎 also make put more expensive, giving bond holder (put writer)
higher risk & higher premium since put will more likely be exercised
𝐾
 Credit spread 𝒔 increases leverage ratio : why?
𝐴0
 larger leverage decreases distance to default, and thus higher chance of
default
 Depending on the parameters, credit spread 𝒔 might increase or decrease
with time to maturity T: why?
 Larger T increases both stddev 𝜎 𝑇 and asset value’s mean
1
𝜇−2𝜎2 𝑇−log(𝐾/𝐴0 )
 Thus, effect on distance to default (DD) in inconclusive 𝐷𝐷 = 𝜎 𝑇
(but when T is large enough, DD increases with T, less default chance, and spread s decreases
with T).
45 Topic 5-3: CREDIT DERIVATIVES
 Credit default swaps (CDS)

 CDS Pricing
 Basis trading
Credit default swaps (CDS)
46
 Credit default swap (CDS) is a insurance contract with reference to a risky

asset (usually, corporate bond or foreign sovereign bond), between two
counterparties
 The protection buyer periodically pays fee to the protection seller.
 In case the reference bond default, the protection seller pays the recovery
(usually, face value of bond) to the protection buyer
 Notably, the protection buyer does not necessarily has any claims on the
reference bond (it just speculates on the bond’s default): this is naked
CDS
Credit default swaps (CDS): reduced-form pricing
47
 E.g. 5-3: Consider a 1-year CDS contract on a risky bond of $100

face . Suppose that:
 Bond survives (i.e., does not default) through next year with
probability 𝑒 −𝜆 = 𝑒 −10% = 90.5% (and defaults with
probability 1 − 𝑒 −𝜆 = 9.5%)
 If bond defaults: the holder loses a fraction 𝐿 = 0.4 of bond’s
face value, but the CDS protection contract will cover this
loss
 CDS transactions (fee or recovery payments) are made at the
end of year. Assume that fee is paid only when bond is
solvent.
What is the (fair-value) fee (also called, CDS spread) s of this CDS
contract?
48
 Answer to e.g. 5-3: Let’s consider the CDS contract from the prospect of
the protection seller
 The expected and discounted value of his payment (to the protection
buyer, in case the bond defaults) is
𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑃𝑟𝑜𝑏 × (𝐿 × 100) 1 − 𝑒 −𝜆 × (𝐿 × 100)
=
1+𝑟 1+𝑟
 The expected and discounted value of the payment to him (from the
protection buyer, in case the bond does not default) is (recall: 𝒔 is the fee
seller receives)
𝑆𝑢𝑟𝑣𝑖𝑣𝑎𝑙 𝑃𝑟𝑜𝑏 × (𝒔 × 100) 𝑒 −𝜆 × (𝒔 × 100)
=
1+𝑟 1+𝑟
 Fair-value of spread (or CDS fee) 𝒔 is obtained when protection seller
makes even in the CDs contract:
1 − 𝑒 −𝜆 × (𝐿 × 100) 𝑒 −𝜆 × (𝒔 × 100)
=
1+𝑟 1+𝑟
1−𝑒 −𝜆 ×𝐿
⟹𝒔= ≈ 𝝀 × 𝑳 = 10% × 0.4 = 4%
𝑒 −𝜆
49
 Answer to e.g. 5-3 (cont.): CDS spread (or fee)

𝒔=𝝀×𝑳
is very intuitive
 CDS Fee increases (linearly) with loss fraction L: higher loss

requires higher insurance premium
 CDS Fee increases (linearly) with loss probability 𝜆: higher

chance of loss requires higher insurance premium
 However, this is only an approximate formula, which holds

for small default intensity (risk) 𝜆
Credit default swaps (CDS): Basis trading
50
 CDS spread is just the fee paid by protection buyer in CDS contract.
 CDS spread characterizes the bond’s riskiness
 Bond spread is the difference between the (risky) reference bond’s yield
and riskless T-bond’s yield
 so bond spread also quantifies the riskiness of the reference bond
 What is relation between CDS spread and Bond spread?

Basis ≡ CDS spread – Bond spread
Assuming no default in CDS contract itself : basis should be around zero!
Why?
 This because two strategies,
 A: buying risky bond and buying CDS protection on this bond, and
 B: buying riskless T-bond
should be (in principle) equally safe. (Indeed, in case risky bond defaults, CDS
protection will pay the face value of the risky bond: Nothing is lost)
51
Thus, returns on these two riskless strategies should be roughly equal

𝑟𝐴 = 𝑟𝐵 ; where 𝑟𝐴 = 𝑟𝑟𝑖𝑠𝑘𝑦 − 𝐶𝐷𝑆𝑠𝑝𝑟𝑒𝑎𝑑; 𝑟𝐵 = 𝑟𝑇𝑏𝑜𝑛𝑑
⟹ 𝑟𝑟𝑖𝑠𝑘𝑦 − 𝑟𝑇𝑏𝑜𝑛𝑑 = 𝐶𝐷𝑆𝑠𝑝𝑟𝑒𝑎𝑑 ⟹Bond spread= CDS spread ⟹ Basis= 𝟎
52
 But is basis = 0 in the market? No, basis can be either negative or

posititve in the market (depending on market condition and event risk),
which leads to negative basis trading or positive basis trading.
Before looking at the data, here is the general basis trading strategy:
 Negative basis trading: If Basis = CDS spread-Bond spread< 0

buy CDS protection and buy reference bond
(earns high bond yield, pays low CDS protection fee, while stays safe)
 Positive basis trading: but if Basis = CDS spread-Bond spread> 0
sell CDS protection and sell reference bond
(earns high CDS fee, pays low interest on bond, while stays safe)
53
 Basis tends to be negative in the market in/around bad time

 Firm-specific picture
54
 Basis tends to be negative in the market in/around bad time

 Market-wide picture
55
 When/why basis is negative (CDS spread < bond spread):

 Heavy issuance of bonds: this makes bonds tend to be cheaper
 Buying bond (lending money and earning interests) is non-zero investment,
while selling CDS (another way to earning interests) does not necessary require a
lot of hard-cash investment upfront. This makes investors to require higher
interest payments in holding (buying) bond than in selling CDS
 Heavy issuance of synthetic CDO (collateralized debt obligations): as CDO is a
portfolio of CDS, this pushes CDS spread (fee) lower
56
 Negative basis trading (CDS spread < Bond spread): CDS protection tends to be
cheap, it is good to buy bonds (to receive high yields) and buy cheap insurance
(CDS) on it
 But is it truly that good? One for e.g. can bet on the convergence of the basis (back
to zero):
 If basis indeed gets back to zero,
meaning bond’s yield drop, bond become
more valuable, this is good (because we are
longing bond)
 If bonds defaults, it is fine too (because
CDS protection will fully cover the loss)
 But if basis continues to drop (but bond does not default), then bond just loses
more and more value and it is not good for long position (specially if one cannot
keep up with the strategy until convergence, i.e. liquidity constraint-remember
LTCM): many firms lost money in convergence bet after 2008.
 Thus, sometime, incentive of basis traders is the default of the reference
firm (bond)
Credit derivatives: the dark side
57
 Speculative trading on credit derivatives (i.e. when investors have no direct claims
on reference bonds-remember naked CDS) may have important (self-fulfilling)
consequences on reference firm/bond’s fate.
 Buying CDS is like buying fire insurance on your neighbor’s house (which may lead
to vile incentive to burn that house to collect insurance payment)
 Even when traders have direct claims on the reference bond (for e.g., negative basis
traders indeed also long the reference bond), their ultimate incentive may be the
default of the firm (bond).
 When basis traders are also bond holders, they have voting rights in and may
interfere with debt restructuring deals of the firm under distress, with the
ultimate purpose not to rescue firm but make it default
 Credit derivative victims:
 Richard Fuld (last and long-time serving CEO of Lehman) claims that credit
derivatives destabilized and led Lehman to the its final collapse in 2008
 JP Morgan’s Bruno Iksil (London Whale) lost 6 billions in aggressive credit
derivative trades in 2011/2012

Fixed Income Combined Notes Week 1 To 5

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Fixed Income Combined Notes Week 1 To 5

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FIN 525: FIXED-INCOME SECURITIES

Week 1: INTRODUCTION, BONDS, YIELD,

Acknowledgement: Slides are based on class notes

 Objectives: Become familiar with fixed-income

 Get to know major fixed income markets and standard

 Acquire tools to value fixed income securities & their

 Acquire tools to understand, manage & speculate on the

 Most efficient way to learn in this class is to study

 Do homework either by yourself or actively

 Ask questions in class or in office hours.

 Two problem sets, 15% each.

 Instructor’s e-mail: ntran@wustl.edu

 Instructor’s office hours: 10:30am-12:00 (noon)

 TAs/office hours: Thao Vuong,

 Lecture slides, Psets, supplemental notes and

 Textbooks are optional:

First topical class on FI security: tradeoff b/w

 Topic 2: Yield curve and its leading theories.

 Topic 3: Futures, Forwards and Swap contracts.

 Topic 4: Option on fixed-income (FI) securities.

 Topic 5: Credit risks.

 Topic 6: Mortgages and Securitization.

 Week 7: Final exam (Tue, Feb 27, 2018).

Fixed-income (FI) securities promise a series of pre-specified

 Treasury inflation protected securities (TIPS).

 Muni’s (Municipal bonds)

 Agencies, government sponsored enterprises (GSE)

 Emerging market bonds

 LIBOR and swaps

 Fixed income derivatives

Average Daily Trading Volume ($ Billions)

The most fundamental fixed-income (FI) securities are

Bond cash flows (CF) are determined by:

 Face value, “F” (also called par), paid at maturity T

 Annual coupon rate “c”  annual coupon = cF

 Coupon frequency “k”  per-period coupon =cF/k

 Attached options, covenants, amortization schedules, etc.

 E.g.: “… a zero-coupon bond maturing in 3 years

 Payment Frequency (or coupon period)

 Price quoted as a fraction of face value

 E.g. 1-1: What are CFs associated with buying a 7.2%

 Answer: c=7.2%; F=$1000; T=2 yr; P=$980; k=2;

Long position Short position

 Issuer: to finance the national debt of the U.S.

 Lenders (who buy Treasuries):

Great Info Resource: https://www.treasurydirect.gov/

 Current US National Debt (as of Jan/11/2018)

 Current US National Debt (as of Jan/11/2018)

Additional sources: http://data.worldbank.org/indicator/FI.RES.TOTL.CD?end=2015&locations=US&start=1960

Q: Why national debt has increased so much lately?

With respect to Inflation

 TIPS (Treasury Inflation-Protected Securities).

 The principal of a TIPS increases with inflation, and

With respect to On-the-run vs. off-the-run

somewhat less liquid.

Primary (New Issue) market

Treasury (called “Treasury Auction”).

 The Fed uses about 23 "primary dealers" to carry out

“open market operations.” Many other securities firms

Treasury Auction (2017: 277 auctions, 8,522,000 $ Billions issued)

quantity of 91 and 182 day bills in a sealed auction.

bidders, at the lowest market clearing yield, in the order of

 Individual investors can buy Bills, Notes, Bonds,