An Overview

Course Description Materials Requirements Description of important fixedincome securities Topics

Course Description
Study important fixed-income securities and markets Develop and apply tools for

Valuation of interest rate contracts - Bonds, futures, swaps, derivatives etc. Measure interest rate risk
Duration Convexity Management of interest rate risk - immunization Scenario Analysis and Active Portfolio Management

Materials
Lecture Notes Other readings Recommended: Fabozzi

Course Requirements
Mid-Term Exams
40%

Final Exam
40% - University schedule

Problem Sets and Term paper

20% - Work in groups

What is a Fixed-Income Security?

Traditionally, securities with fixed cash-flows at known points in time T-Bonds and T-Bills Any security whose value is primarily determined by interest rates, such as interest rate futures and options

Types of Fixed-Income Securities

Fixed Cash Flows
U.S.Treasury. Bonds and Bills Corporate Bonds Municipal Bonds

Interest-rate dependent cash flows

Floating rate bonds Futures Options (exchange traded) Caps and Floors (OTC traded) Mortgage Backed Securities(MBS) and Collateralized Mortgage Obligations (CMOs)

US Treasury Bills, Notes and Bonds

Issued by the US Treasury - Default free Bills pay face value at maturity and sell at discount - maturities at issue range from 3 to 12 months Notes pay coupon semi-annually; maturities at issue are 2, 3, 5 and 10 years Bonds - Same as notes except 30 year maturity at the time of issue no longer issued TIPS Treasury Inflation Protected Securities; adjust payouts for inflation.

Agency and Corporate Debt

Agency bonds are issued by federal government agencies such as Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Bank. Typically very little default risk Corporate Bonds are Issued by Private Corporations Default risks vary widely Bonds with high default risk are called ``Junk Bonds May include call and sinking fund provisions Commercial Paper issued by corporations are short term debt like T-Bills

Floaters and Inverse Floaters

Floating rate bonds pay coupons that rise with interest rates e.g. Pay 6month LIBOR every six months. Inverse Floaters pay coupons that fall with interest rates e.g. Pay a fixed number, say 16, minus 6-month LIBOR every six months.

Municipal Bonds
Issued by state and local governments Default risk varies widely Coupon income exempt from federal taxes and issuing state taxes subject to limitations

Interest Rate Futures

Contracts to buy or sell bonds or bills at a future point in time at a price specified today T-Bond Futures Eurodollar futures - The settlement price for this futures is tied to the 3-month LIBOR (London Interbank Offered Rate) which is the rate charged by highest rated London banks on dollar denominated 3-month interbank deposits Futures Contracts are exchange traded

Interest Rate Swaps

One party to a swap typically pays a fixed rate and receives a variable payment tied to an interest rate index Very large volumes of swaps are issued and traded on the over the counter (OTC)

Interest Rate Options

Call and Put options to buy bonds and bills and futures contracts - Exchange traded Caps - pay if interest rate exceeds the strike rate Floors - pay if interest rate falls below the strike rate Caps and Floors are OTC traded

Mortgage Backed Security

Residential Mortgages are home loans taken by individuals These mortgages are pooled by agencies such as Fannie Mae and sold to capital market investors Home owners can prepay the mortgages at any time which is passed through to MBS holders prepayment risk is critical for MBS valuation and risk management

Largest Taxable Bond Funds (2000)

Fund Assets ($ Bil.) 29.0 10.7 9.2 4.0 3.7 Returns(%) 1 Year 12.09 11.39 6.17 10.76 11.23 5 Years 41.46 36.03 33.21 38.37 32.75

PIMCO Vanguard Bond Fd. America MAS Fds MSDW

Bond fund returns are typically smaller than stock fund returns The variation in returns across funds is also small - Small outperformance improves ranking significantly

Debt Markets (2003: Q3)

Municipal Marketable Treasuries Federal Agency Debt MortgageRelated Securities Money Market Corporate Asset Backed Instruments Debt Total

New Issue Volume $289.7 B Daily Trading Volume* $12.5 B Volume of Securities Outstanding* $1.9 T

$530.0 B $438.6 B $4.5 T

$1009.9 B $84.9 B $2.6 T

$2584.2 B $219.2 B $5.1 T

$423.4 B NA $1.7 T

NA NA $2.5 T

$583.2 B $5420.4 B $19.5 B $4.3 T NA $22.6 T

Source: The Bond Market Association (http://www.bondmarkets.com)

Course Topics
Introduction - This is it Valuation of cash flows and interest rate conventions Duration, Convexity and Hedging Interest Rate Risk Term structure of interest rates Active Portfolio Management, Repo Markets Futures Contracts and Eurodollar Futures Contracts T-Bond Futures Contracts Mid-term exam

Course Topics (contd.)

Interest Rate Swaps Interest rate dynamics and valuation of derivatives Corporate Debt Securities Municipal securities Mortgage-backed securities and derivatives Final Exam

Risk Exposures and Course Structure

Risk/ Characteristic Treasury Derivative Corporate Munis Mortgage Backed Securities X

Interest rate risk Cash Flow timing

Default Risk
Tax Exemption Prepayment

X
-

X
X -

y
X

X :Very Important, y : Maybe important in some cases, - : Not particularly important