Lecture 2

Fixed Income
FIN 411, Fall 2016

Prof. Dmitry Orlov
FIN 411: Fixed Income Prof. Dmitry Orlov 1

Lecture Plan
1. Overview of Bond Markets

2. Pricing Fixed Income Securities
3. Yield to Maturity
4. Yield Curve
5. Forward Rates
6. Expectations Hypothesis
7. Interest Rate Risk
8. Duration
9. Hedging (or Duration Matching)

Overview of Fixed Income
Markets: Treasury Bonds
n Treasury Notes and Treasury Bonds
q The U.S. government borrows money from you
q Maturities and naming conventions:
n T-Bills: less than one year (no coupons)
n T-Notes: from one to ten years
n T-Bonds: greater than ten years, up to 30 years
q Some T-Bonds include a call option (callable bond): the
issuer can buy the bond back from you at a
predetermined price
q Treasuries are safest of all Fixed Income instruments
n Only interest rate risk, no default risk. Why?

Overview of Fixed Income
Markets: Treasury Bonds
q Notes and bonds pay semiannual coupons and pay
the face value (normally $1,000) back at the maturity
n Coupons are expressed as percentages of the face value. If
the face value is $1,000
q and the 10% coupon is annual, each coupon is $100
q and the 10% coupon is semiannual, each coupon is $100/2=$50
n If the bonds market price = face value, we say that the
bond is trading at par (or call it a par bond)
q Example. Two year T-Note with semiannual coupons
and a 5% annual coupon rate makes the following
payments:
q $25 (0.5 yrs), $25 (1 yr), $25 (1.5 yrs), $1,025 (2 yrs).

Corporate Bonds
n Corporate bonds enable firms to borrow
money directly from the public
q Issued by large corporations
n Cheap alternative to bank financing
q Structure is similar to T-Bonds: semi-annual coupons
q Issued through an investment bank through an
underwriting process
q Traded primarily through a dealer market connected
by computers
n Credit risk makes corporate bonds riskier than
T-Bonds

How risky are corporates?
n Corporate bonds rated for credit worthiness
q Two big agencies: Moodys and Standard&Poors
n Moodys scheme: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, D[1,2,3]
n S&Ps scheme: AAA, AA, A, BBB, BB, B, CCC, CC, C, D[+,-]
q Investment grade: rated at least Baa / BBB
q Junk: rating lower than BBB / Baa
n The junk bond market has thrived since early 1980s, going
from $25 billion in 1980 to $750 billion in 2003
q Some financial institutions are not allowed to invest
in junk (pension funds, money market mutual funds)
n Default rates: AAA-rated bonds almost never default;
ten-year rate for CCC-rated bonds is almost 50%

Corporate Bonds Classification
1. Secured Bonds
n Specific collateral backing in the event of default
2. Debentures
n Unsecured bonds
3. Subordinated debentures
n Lower priority claim in the case of default than debentures
n A corporation defaults if it misses coupon payments
q A technical default is also possible: do not file financial statements in time
n This technical default was a sideshow in the options backdating scandal
n In default, bond holders can force bankruptcy procedures:

q Subordinated debenture holders do worst, secured bond holders the best
n Definition of Leverage: amount of debt relative to equity
q Higher leverage (more debt) increases debt service burden, bonds risk

Options Commonly Attached to
Bonds
1. Callability
q Allows issuing firm to retire bonds before maturity
n Exercised when financing gets cheaper
q Callable bonds sell at a discount to non-callable bonds
n Nearly all long-term corporate bonds used to be callable
q Now few are (only the least credit worthy)
2. Convertibility
q Gives bondholder option to convert the bond, typically into
stock
n Convertibles sell at a premium relative to non-convertible bonds
3. Putability
q Allows bondholder to sell the bond back to the firm
n An option to the bondholder: putable bonds sell at a premium
relative to non-putable bonds

Mortgage-Backed Securities
n Mortgage securitization (bond creation)
q Collect many mortgages into a pool
n In normal times, people default on their loans for idiosyncratic
reasons
n If so, default are rates very predictable in large pools lower
risk
q Issue securities that are claims on the pools cash flows
n Different tiers determine who gets the money first if
individuals start refinancing and who loses the first when
defaults occur
q Converts illiquid loans into liquid securities that may be
held by more investors
n Lower borrowing costs to consumers
n Securitization has been applied to other loan types.

Mortgage-Backed Securities
n Government agencies introduced securitization

in response to the Savings & Loans collapse
q In 1970, 70% of mortgages were originated by local
banks and thrifts
n Costs of collecting information made long-distance lending difficult
n System constrained by local supply-demand imbalances: who wants
to borrow, who wants to lend
q Now 80% of mortgages are securitized
n Mortgage-backed securities are a three-trillion dollar market (22% of
fixed income)
n Mortgage system no longer constrained by local imbalances
n Ratings agencies, regulation, arbitrage

Collateralized debt obligations
n Slicing and repackaging CDOs
q Put pieces of different MBS together
q Split the CDO into another set of tiers and sell these
pieces
q Idea: if defaults are idiosyncratic, the CDO is less
risky than the individual MBS pieces
n The models predicted that even if housing prices were to fall
considerably, default rates would increase only slightly
n Agency problems in securitization
q If a bank can sell its loan to someone else, it doesnt
care about the quality of the loan low approval
standards

Bond Cash Flow Patterns
1. Straight Coupon Bond
n Semiannual coupon with a fixed rate, principal repaid only at
maturity
2. Zero Coupon Bond
n No periodic (coupon) payments, makes a single payment at maturity
q Also known as: (Pure) Discount Bond, Strip
3. Deferred Coupon Bond

n Interest (coupons) is deferred for some time, so that cash-
constrained firms can fund other projects
4. Consol (Perpetuity) Bonds
n Bonds that pay only interest, last forever
5. Annuity Bonds
n Bonds that pay a mix of interest and principal for a finite amount of
time

Pricing F.I. Securities
n Recall our basic asset pricing formula:
E [D1] E [D2] E [D3]
P = + 2
+ 3
+ ...
(1 + r ) (1 + r ) (1 + r )
t
n For fixed
F Vt income
= P V0 securities without default risk
(1 + r )
(Treasuries), cash flows are certain:
3 E(Di) = Di:
= $10, 000 (1 + 0.05) = $11, 576.25
D1 D2 D3
P = + 2
+ 3
+ ...
(1 + r ) (1 + r ) (1 + r )
q We discount all future casht flows to present at a constant
P V0 (1 + r )
F Vt =rate
discount
3
= $10, 000 (1 + 0.05) = $11, 576.25

n Discount rates are not constant in reality

q For example, long term investors may have higher discount
rates than short term investors due to interest rate risk
q Long term interest rate (per year) is usually higher than the
short term interest rate
n Allowing for rates to differ from date to date, the asset

pricing formula becomes:
D1 D2 D3
P = + 2
+ 3
+ ...
(1 + r1) (1 + r2) (1 + r3)
F Vt = P V0 (1 + r )t
FIN 411: Fixed Income = $10, 000 Prof.
(1Dmitry
+ 0.05)
Orlov
3 = $11, 576.25 14
n Fixed income security valuation is simple: its just
discounting
q Only need to worry about using the correct discount rate
n Note: from now on, unless specified otherwise, assume that all rates (i.e.,
coupons and discount rates) are annual.
n Example. A two-year T-Note

q face value of $1,000
q 10% annual coupon rate.
n Coupons paid semi-annually.
q What is the price of the bond if the 0.5, 1, 1.5 and 2-

year annual rates are 4%, 4.5%, 4.8%, and 5%
n Compounded semi-annually

n This bond makes the following payments:
q $50 at t = , 1 and 1
q $1,050 at t = 2
n The appropriate semiannual discount rates are 2%,
2.25%, 2.4%,
P = and
D1 2.5% D2
+ +
D3
+ ...
2 3
n The price of(1 + bond
the r1) (1
is + r2)
then (1 + r3)
C1 C2 C3 F + C4
P = + 2
+ 3
+
(1 + r1) (1 + r2) (1 + r3) (1 + r4)4
$50 $50 $50 $1, 000 + $50
= + 2
+ 3
+
1 + 0.02 (1 + 0.0225) (1 + 0.024) (1 + 0.025)4
1
= $49.02 + $47.82 + $46.57 + $951.25 = $1, 094.66

Spot Rates
n We call the different discount rates spot rates
q If the 3-year spot rate is 5%, we discount a year 3 cash flow to today at 5%
n We use this to our advantage to compute the spot rates:
q Lets look at the simplest possible bond to calculate the spot rates!
q The simplest method is to look at zero-coupon bonds:
n They make just one payment, so the discount rate is easy to back out:
1
F F F t
P = ) (1 + r )t = ) r= 1
(1 + r )t P P
n Example.CA1 three-yearCzero
2 couponCbond
3 withFa+face
C4 value of $1,000
=
P trading
is +
at $868.79. What2is+the three-year
3
+ spot rate?
(1 + r1) (1 + r2) (1 + r3) (1 + r4)4
1 1
$50 F t $50 $1, 000 3 $50 $1, 000 + $50
= r= + 1= 2
+ 1 = 34.8%
+
$868.79
1 + 0.02P (1 + 0.0225) (1 + 0.024) (1 + 0.025)4
1
= $49.02
C1 + $47.82
C2 + $46.57 C3 + $951.25 F +=
C4$1, 094.66
PFIN=
411: Fixed Income +
2
+ Prof. Dmitry Orlov
3
+ 4
17
Treasury Strips. Notation
n The convention is to report the zero coupon bond (or

strip) prices in price per 100 units of face value
q You can think of this as follows: no matter what the true face
value of the bond is, we scale the price by the face value and
multiply the result by $100
q This makes the price comparable to a bond with a face value of
$100
n The price is reported as [dollars]:[seconds]

q Note: seconds = 32nds (e.g., 1/32, 2/32, )

Treasury Strips. Notation
n For example, in November 1999 a U.S. Treasury Strip
with a face value of $100 and maturity November 2004
had a bid price of 73:22 and an ask price of 73:26
q Note: Bid = the price at which you can sell; Ask = the price at
which you can buy
n This means that the bid price was $73 + $22/32 =

$73.6875 and the ask price was $73 + $26/32 =
$73.8125
n We use B to denote prices of strips/zero-coupon

bonds
q For example, we might write B5 = $73.8125

Valuing a Bond: Example
$80 $80
Example. Suppose youre offered a 5-year coupon
$1, 0
90 =
n
+ 2
bond with a face of F = $1,000. An
+
8%

coupon
+
is paid
1 + y (1 + y )
annually. (1 +
q Suppose that $100 face zero-coupon bond prices up to 5 years
cost
Years to Maturity 1 2 3 4 5
Price $98 $95 $92 $89 $85
q Annual spot rates are
n r1 = 2.04%,
n r2 = 2.60%,
n r3 = 2.82%,
n r4 = 2.96%,
n
Interval
r5 = 3.30% Equation E
What price should you pay for the 5-year coupon bond?
1
(m = 1) (1.12) 1 12
Valuation Example Continued
n Remember what the zero-coupon prices say:
q If the 2-year zero-coupon bond has a price of $95, it means that
$1 received in two years is worth $95 / $100 = $0.95 today
We just compute what is the value of getting $1 inX
n T
Byear
1 t, and use B2these as weights: BT Bt
= C1 + C2 + + CTT =
$100 B1 $100B2 BT$100 X Bt t=1 $100
P = C1 + C2 + + CT = Ct
$100 $100 $100 $100
t=1
where Ct is the cash flow in period t
C1 C2 C3 F + C4
P = + 2
+ +
98
(1 + r1) 95 (1 + r2) 92 (1 + r3) 89(1 + r4)485
3
P = $80 + $80 + $80 + $80 + ($1, 000 + $80)
100 $50 100 $50 100 100
$50 100
$1, 000 + $50
= + + +
1
1+
= $1, 0.02 (1 + 0.0225)
217.35 2 (1 + 0.024) 3 (1 + 0.025)4
= $49.02 + $47.82 + $46.57 + $951.25 = $1, 094.66
Spot Rates Revisited
n We could also get the spot rates from coupon bonds
q Need to iterate: compute the 1-year spot rate, look at the 2-
year coupon bond to get the 2-year spot rate, look at the 3-
year
q This is known as bootstrapping
n Not the same meaning as in statistics
n Example. We see prices of 1- and 2-year coupon

bonds
q Face values are $1,000
q The one-year has an annual coupon of 5%
q The two-year has an annual coupon of 8%
q Prices are $997.50 (1-year) and $1,048.00 (2-year)
q What are the 1- and 2-year spot rates?

B1 B2 BT X B
C1 + Spot CRates
2 + Revisited
+ CT =
$100 $100 $100 $1
t=1
n Let B1 and B2 to denote zero-coupon bond prices
q Then bond pricing equations are
B1
$997.50 = $1, 050
$100
B1 B2
$1, 048.00 = $80 + $1, 080
$100 $100
n Solve B1 from the first equation: B1 = $95

q So the one-year spot rate is $100 / $95 1 = 5.26%
n Plug B1 into the second, solve for B2 = $90
q And the two-year spot rate is ($100 / $90)1/2 1 = 5.41%

Synthesizing Bonds
n Could also synthesize a two-year
q Work this out backwards: to get $100 in two years, need to buy
$100 / $1,080 = 0.09259

of the 2-year coupon bond
q Problem: gives a year-1 flow of 0.09259 * $80 = $7.407
q To get rid of this, sell some 1-year bonds
n The 1-year coupon bond gives $1,050 in a year, so need to sell
$7.407 / $1,050.00 = 0.00705

units of the 1-year coupon bond
q Cost of this synthetic 2-year zero-coupon bond:
0.09259 * $1,048 0.00705 * $997.5 = $90

Yield to Maturity (YTM)
n In the previous example we used different rates
to discount each payment
$80 $80 $1, 080

P = + 2
+ + 5
= $1, 217.35
1.0204 (1.0260) (1.0330)
n Yield-to-maturity answers the following

question: $997.50 =
B1
$100
$1, 050
B1 B2
What one discount rate, used for all dates,
$1, 048.00 = $80 + $1, 080
1
$100 $100
gives the correct price?

Yield to Maturity (YTM)
n If we picked, say, r = 3%, would we get the same result?
$80 $80 $1, 080

P = + 2
+ + 5
= $1, 228.99
1.03 (1.03) (1.03)
n Pretty close to $1,217.35, but not quite.
q New price is too high, we need to increasing the rate a bit
B1
n When we find the rate=that
$997.50
$100 gives the correct answerthe
$1, 050
true pricewe$1,have found
048.00 =
B1 the yield-to-maturity
$80 +
B2
$1, 080
$100 $100
q The average yield you get if you buy the bond
q Formally: YTM = rate realized over life of the bond if coupons

are reinvested at the YTM.

Yield to Maturity
n How do we find yield-to-maturity?
q Usually by trial and error
q No closed-form solution when we have more than four distinct
payment dates
n Can use Goal Seek (under ToolsGoal Seek)
n Write a valuation spreadsheet:
n Difference is the difference between the actual bond price and the
price we get with our yield-to-maturity (YTM) guess

Yield to Maturity: Using Excel
n Lets pull up Goal Seek and define the problem:
n Clicking Ok, we get:
This bond s yield-to-

maturity is 3.22%
Note: YTM is unique to
each bond!

Yield to Maturity
n There is a special case when YTM is easy to compute:
C1 C2 CT
Pactual = + 2
+ +
(1 + y ) (1 + y ) (1 + y )T
q If the bond is trading at par, YTM is the same as the coupon rate
q Example. A 5-year bond with a coupon rate of 7.25% is trading at par,
what is the bonds yield to maturity?
B1
n Answer: YTM = $997.50
7.25% = $1, 050
$100
n This observation also gives us B1another tool:
B2 even if a bond is not
trading at par, we $1,know
048.00if=the YTM $80is+higher
$1, 080
$100 $100 or lower than the
coupon rate
1
q Bond price higher than face, then bonds YTM is lower than the coupon
rate
n Why? Future dollars must be more valuable, i.e., the discount rate lower, to
get a higher present value
q Bond price lower than face, then bonds YTM is higher than the coupon
rate

YTM and Semiannual
Coupons
n Real world treasuries pay semiannual coupons
q Hence, the actual yield-to-maturity is the six-month rate
multiplied by 2 (i.e., we want to report the APR)
n Example. A five-year bond with a face value of $1,000 and 8% per

year coupons (coupons paid semiannually) trades at $1,090. What
is the yield-to-maturity per year?
$40 $40 $1, 040
$1, 090 = y + 2
+ + T
y
1+ 2 1+ 2 1 + y2
q Using Excels solver (where T = 10), we find y = 5.895%
Years to Maturity 1 2 3 4 5
Price $98 $95 $92 $89 $85
FIN 411: Fixed Income

Compounding Interval Prof. Dmitry Orlov
Equation Eective Rate 30
1
Yield Curve
n The yield curve is a graphical presentation of spot

rates
q It plots spot rates from 3-month T-bills out to 30-year Treasury
bonds
q Normal yield curve is upward sloping: short-term bonds carry
lower yields than long-term bonds
q In the absence of economic disruptions, investors who risk their money
for longer periods expect to get a bigger reward than those who risk
their money for shorter time periods
q Inverted yield curve is downward sloping: short-term bonds
carry higher yields than long-term bonds
n Discussion in the media: inverted yield curve has historically predicted
recessions

Yield Curve

Yield Curve: Example
Maturity
n Example: Suppose zero (in years) Price
coupon bonds (faces of $1,000) 1 $952.38
2 $898.45
are trading at: 3 $843.59
4 $790.44
5 $740.12
6 $693.01
7 $649.10
a) What are the spot rates? 8 $608.23
9 $570.17
b) Draw the yield curve 10 $534.68
n Answer: The 1-year spot rate is $1,000 / $952.38 1 = 5.00%

q The 2-year spot rate is ($1,000 / $898.45)1/2 1 = 5.50%
q The rest, using (F/B0,T)1/T 1:
Maturity (in years)
1 2 3 4 5 6 7 8 9 10
5.00% 5.50% 5.83% 6.06% 6.20% 6.30% 6.37% 6.41% 6.44% 6.46%

Yield Curve: Example
Continued
n Now that we have the spot rates, we plot them against maturity:
Yield Curve Example
7%
6%
5%
Spot Rate
4%
3%
2%
1%
0%
0 1 2 3 4 5 6 7 8 9 10
Maturity (in years)

Forward Rates
n Spot rates vs. forward rates

q Spot rates are average rates from today
n I.e., the rates you get when you walk into the bank today and
put your money away for t years
q Forward rates are the future rates you can lock in
today
n I.e., the rates you get when you walk into the bank today and
agree to put your money away for t years at some time in the
future
q I am getting $100,000 in one year, and I want to put the money
in a bank account at that time. I am afraid about whats going to
happen to the rates before that. So, can I lock in a 5-year rate,
starting in one year?

Forward Rates
n Good news: if you know spot rates, also know forward
rates
q Spot rates imply forward rates (same info)
n If spot rates and forward rates did not satisfy a certain relationship,
you could create a strategy that generated positive profits with no
risk
q This is the first example of no-arbitrage condition
n Definition of arbitrage: a risk-free, zero-net investment
strategy that generates a profit (a free lunch)
n NA is one of the most celebrated concepts in finance
q General assumption: if there were an arbitrage opportunity,
someone would trade aggressively on it, making it go away
n NA is used to price all kinds of assets,
q And in particular, derivative securities (Black-Scholes)

Forward Rate Example
n Suppose 1-year spot rate is 5% and 2-year spot rate is 6%.
n Question: Whats the forward rate from year 1 to year 2?
q I.e., the rate that you can lock in today for 1-year loans in one year
n Let r1 and r2 denote the spot rates and f1,2 denote the forward rate from year 1
to 2
n Answer: Can loan $10,000 risk-free for two years two ways:
1. Invest the money for two years at the 2-year spot rate
2. Invest the money for one year at the 1-year spot rate,
and lock in the forward rate from year 1 to year 2
n As soon as you get the money back after one year, you roll it
over
n Note: All the rates are locked in today. No matter what
happens next year, the forward rate is already fixed

Forward Rate Example
n The payoffs from these strategies must be the

same:
$40 $40
q Otherwise we could make free money!
$1, 040
$1, 090 = y + 2
+ + T
1 + y y
n Payoff from Strategy 1 + 2 * (1 + r )
2 1: $10,000 1+ 2 2
2
n Payoff from Strategy 2: $10,000 * (1 + r1) * (1 + f1,2)
n So
$10, 000(1 + r2)2 = $10, 000(1 + r1)(1 + f1,2)
(1 + r2)2
) (1 + f1,2) =
1 + r1
B1
) f1,2 = 1
B2

2
f1,2 = 1 = 1 = 7.01
(1 +Forward
r1) Rates: Example
1.05
n So (1 + r2)2 1.06 2
f1,2 =$10, 000(1 + r2)21==$10, 000(1 +1r1)(1
= 7.01%
+ f1,2)
(1 + r1) 1.05
2
The same
(1 + r2 )
n ) approach
(1 + f1,2can
) =be used to solve ALL forward
rates 1 + r1
(1 + rn )n (1 + fn,n+1
B)1= (1 + rn+1)n+1
) f1,2 = 1
B2 (1 + rn+1)n+1
) (1 + fn,n+1) =
(1 + rn )n
Bn
) fn,n+1 = 1
Bn+1

Forward Rates and
Expectations Hypothesis
n Expectations hypothesis:
q Forward rates are expectations of future spot rates
n I.e., f1,2 = E1 (r1)
n If the current 1-year spot rate is 5.25%, and the forward rate from year 1 to
year 2 is 5.5%, we expect the 1-year spot rate to increase by 25 bps to 5.5%
(1 + r2)2 1 + r2
in a year
1n + f1,2 =
Yield curve upward
=
sloping
(1 + r
expectation 2 ) > 1 +
hypothesis
r2
1 + r1 1 + r1
says that spot rates are expected to rise
q Why? Assume that r2 > r1 (upward sloping yield curve):
(1 + r2)2 1 + r2
1 + f1,2 = = (1 + r2) > 1 + r2
1 + r1 1 + r1
) f1,2 > r2 and r2 > r1
Alternative Hypotheses
Why might f1,2 be different expected spot rates?
n Liquidity preference theory:
q Most investors dont want to tie their capital for long periods of
time (need liquidity), so long term rates must compensate for
lack of liquidity
q If so,
forward rate = E[spot rate] + liquidity premium
n Market segmentation theory:

q Short and long term instruments are traded in separate
markets, with different types of investors,
n This theory imposes less structure on the yield curve.

Interest Rate Risk
n Suppose you buy 10-year bonds with 5% annual

coupons
q Face value of each bond is $1,000
q Trade at par
n What happens if rates increase by 5 basis points?
q We know that before the rates increase, the following must be
true:
$50 $50 $1, 050

P = + + + = $1, 000.00
1.05 (1.05)2 (1.05)10
n Reason: a bond trading at par has YTM = coupon rate
(1 + r2)2 1 + r2
1 + f1,2 = = (1 + r2) > 1 + r2
1 + r1 1 + r1
) f1,2 > r2 and r2 > r1
Interest Rate Risk
n When the rates increase by 0.05%, we just recompute the price
q We use the old YTM (5%) + price increase (0.05%) = 5.05%
q We get the new price:
$50 $50 $1, 050
Pnew = + 2
+ + 10
= $996.15
1.0505 (1.0505) (1.0505)
n A loss of $3.85 per bond
n This is IR risk: when the rates change, the bond prices change
(1 + r2)2 1 + r2
q We are going to
1 +learn
f1,2 =two things:
= (1 + r2) > 1 + r2
1 + r1 1 + r1
1. How to measure interest rate risk, and
) f1,2 > r2 and r2 > r1
2. How to protect (hedge) against interest rate risk
n Important: yields and prices move in the opposite directions
q If yields go up, bond prices go down
q If yields go down, bond prices go up

Simple example
n More IR risk, long or short dated bonds?

q Suppose yield curve is flat, rises from 5% to 6%
n 1-year bond price goes:

q From: $100/(1.05) = $95.24
q To: $100/(1.06) = $94.34
n About a 1% drop
n 10-year bond price goes:

q From: $100/(1.05)10 = $61.39
q To: $100 /(1.06)10 = $55.84
n About a 10% drop

Maturity vs. Duration
n Maturity: time until a bond makes its last payment
n Duration: when, on average, a bond makes payments
q For example, if we buy a 5-year zero-coupon bond, we
get all the money back in year 5, so the duration is
exactly 5
q Coupon bonds return some cash earlier, have shorter
durations
n The value-weighted average of the durations of the individual CFs
n I.e., weights take the form: (PV of payment / bond price)
q These weights sum up to one by construction
q The present values are computed using YTM, not spot rates

Duration
n This weighted average is known as Macaulays Duration
q Or just duration
X P V (Ct ) T
P V (C1) P V (C2) P V (CT )
D= + 2+ + T = t
P P P P
t=1
n Duration is important for understanding interest rate risk
n But first, lets do an example
1 + f1,2 =
(1 + r2)2 about
=
1 + r2 how to compute
(1 + r2) > 1 + r2
duration 1 + r1 1 + r1
q Suppose a )
5-yearf1,2
bond> r2 and r2 > r1
with annual 8% coupons is trading at
1
$1,090. The bond s face value is $1,000.

What is the bonds duration?

Duration: Example
n First, need the YTM
q The yield-to-maturity is the y that solves the following equation:
$80 $80 $1, 080
$1, 090 = + 2
+ +
1 + y (1 + y ) (1 + y )5
q Excels solver yields y = 5.871%
n The next step is to find the present values of each payment. These
present values are$997.50
$75.56,=
$71.37,
B1 $67.42, $63.68, and $811.97.
$1, 050
q You can verify that they sum$100
up to $1,090as they should, because the
price of a bond$1,
is the B
sum=of the B2
present
$80 + value
$1,of080
the cash flow stream
1
048.00
$100 $100
Imply PV weights are 0.0693, 0.0655, , 0.7449.
1
n These weights imply the following duration:

q Duration = 0.0693 * 1 + 0.0655 * 2 + + 0.7449 * 5
= 4.34 years

Duration and IR risk
C C F +C
n Remember: P = + + +
1 + y (1 + y )2 (1 + y )T
n Differentiating both sides with 2respect to y gives
(1 + r2) 1 + r2
1 + f1,2 = = (1 + r2) > 1 + r2
1 + r1 1 + r1
dP C C F +C
= )2 f21,2 > r2 and r2 > r1 T
dy (1 + y ) (1 + y )3 (1 + y )T +1
Taking -1 / (1+y) as the common factor, we get
1
n
(1 + r2)2 1 + r2
1 + f1,2 = = (1 + r2) > 1 + r2
1 + r1 1+2 r1 T

dP 1 C/(1 + y ) C(1 + y ) (F + C)/(1 + y )
= ) f1,2 >+r22 and r2 > r1+ + T P
dy 1+y P P P
1
q You can see that Macaulays2Duration appears here!

(1 + r2) 1 + r2
1 + f1,2 = = (1 + r2) > 1 + r2
FIN 411: Fixed Income
1+Prof. 1
1 + r1
r Dmitry Orlov 48
Duration and IR risk
n That is, the percent change in price is given by
dP D
= dy
P 1+y
q Remember:
n The 1-year bond price fell about 1% when rates rose 1%
2
n (1 + r ) 1+r
The 10-year bond price2fell about 10% when
2 rates rose 1%
1 + f1,2 = = (1 + r2) > 1 + r2
1 + r1 1 + r1
n Longer duration prices more sensitive to rates
) f1,2 > r2 and r2 > r1

Duration-Based
Approximation versus Exact
Price Change
(Source: BKM, 10th edition, p. 526)

Duration and Price Change
n Can calculate the approximate change in a bonds price
when rates change using
D
P P y
1+y
q A linear approximation
n Good approximation when yield change is small
n Worse approximation as yield
2 change gets bigger
(1 + r2) 1 + r2
n Example.
1 +10-year
f1,2 = par bond= with 8%(1 annual
+ r2) > coupons
1 + r2
1 + r1 1 + r1
q Question 1: What is the approximate price change (using
duration)
) when ther2yield
f1,2 > goesr2up
and >byr1(a) 5 basis points or by (b)
50 basis points?
q Question 2: What is the exact price change when the yield goes
up by the same amount?

Duration: Example Continued
n Spreadsheet that computes the duration:
1 1
P Dur P y = 7.2469 $1, 000 0.05% = 3.36
1+y 1.08
n Approximate changes in price of bonds from 5 (50) basis point move

1 1
P Dur P y = 7.2469 $1, 000 0.05% = $3.36
1+y 1.08
1 1
P Dur P y = 7.2469 $1, 000 0.5% = $33.55
1+y 1.08

Duration: Example Continued
n Compute exact changes by modifying the
spreadsheet to include a change to YTM:
q Thus, the exact price changes are -$3.35 and -$32.81.

n The approximations were -$3.36 and -$33.55

Properties of Duration
n The duration of a bond portfolio is the weighted
average duration of the individual bonds
q For example, if bond 1 has a duration Dur1 and price P1, and
bond 2 has a duration Dur2 and price P2, the portfolio has a
duration of
P1 P2
Portfolio Duration = Dur1 + Dur2
P1 + P2 P1 + P2
n Durations are shorter when YTM is higher

1 q Duration is the value-weighted
1 average of payment dates
YTM increase
n Dur P theypresent
= value of the short term
7.2469 payments
$1, 000 relative
0.05% =
1+y to the long term payment1.08
(face value), decreasing duration
1 1
Dur P y = 7.2469 $1, 000 0.5% =
1+y 1.08
Immunization
n Immunization refers to strategies used to shield a
portfolio from exposure to interest rate fluctuations
n Example. Suppose the yield curve is flat at 6%, and
You bought 100 5-year, 4% coupon bonds with faces of
$1,000, exposing you to IR risk.
n Q: If you have access to 10-year ZCBs (F=$1,000), how
many should you buy or sell to hedge the interest rate
risk?
q Given that the yield curve is flat, the price of our bond is easy to
compute, using the annuity formula
P = ($40 / 0.06) * (1 1 / 1.065) + $1,000 / 1.065 = $915.75
q The duration of this bond is 4.611 years
n The duration of the 10-year zero is of course 10 years

Immunization
q Now, remember the (approximate) price change

formula:
1
P 1
Dur P y
P 1 + y Dur P y
q Want to buy Phedge worth
1 + y of 10-year zeros so that the
sum of the price changes is zero:
1 1
P + Phedge Dur P y Durhedge Phedge y
1 1+y 1 1+y
Dur =
P y y =
(D P 1.08
7.2469 $1, 000 0.05%
+ Dhedge Phedge ) = 0
1+y 1+y
1) P =
D
P
1
hedge P
Dur Dhedge y = 7.2469 $1, 000 0.5%
1+y 1.08

"Duration Matching Example
n market value of the hedge position has to equal that
of the old position, scaled by the ratio of the durations:
D
Phedge = P
Dhedge
n Market value of existing position is 100 * $915.75 =
$91,575, durations are 4.611 (5-year coupon) and 10
1 zero)
(10-year 1
Phedge Dur P y Durhedge P
1 +tells
n Formula y us to sell 10-year zeros1 worth
+y
y (4.611 / 10) * $91,575 = $42,222
= (D P + Dhedge Phedge ) = 0
n
1+y
This corresponds to selling 75.61 of ZCB.
D
Phedge = P
Dhedge
Duration Matching Example
n Are we hedged?
q Suppose that rates increase by 1%:
n Value of the old portfolio changes
approximately
(4.611 / 1.06) * $91,575 * 1% = -$3,983.18.
n Value of the new portfolio changes
approximately by
(10 / 1.06) * (-$42,222) * 1% = $3,983.18.
n These approximate changes exactly offset each
other this is what we wanted

Duration Matching Example
n Bond falls more than your hedge

q You lose 38.76 37.84 = $0.98.
n Unhedged position loses $38.76

Convexity
n Our price change approximation was linear
q In mathematics, this is the first-order Taylor
expansion
n Works well for small changes; less well for large changes
q One solution: use a higher-order approximation
n The second-order expansion would look like this:
P 1 dP 1 1 d 2P 2
= y+ 2
y
P P dy 2 P dy
n 1st-order term is modified duration

n 2nd-order 1 term convexity 1
Phedge Dur P y Durhedge Phe
1+y 1+y
y
1
Convexity
P
1+y
P y
T
X
Denote 1 Ct /(1 + y )t
n C t(t + 1)
(1 + y )2 t=1
P
n Then
P C
= D y+ y2
P 2
P5 = 915.75 D5 = 4.61
n Bond holders like convexity.
P7 = 665.06 D7 = 7
n You 1 could also use convexity 1 to hedge better:
ge q Hedgefor Dur PPrate
bigger
=changes
y558.39 D Dur = hedge Phedge
10
1+y 10 1 + y 10
q Need y two bonds to match both duration and
= convexity (D P + Dhedge Phedge ) = 0
1+y
D
ge =FIN 411: Fixed Income P Prof. Dmitry Orlov 61
D
Simple example
n Remember, the 5-year coupon bond fell

$38.76 when rates rose from 6% to 7%
q Less than the predicted
1
P Dur P y
1+y
4.61
= 915.75 0.01 = 39.83
1.06
n What
$40if we had
$40accounted
$40for convexity?
$40 $10
63.83 = + 2
+ 3
+ 4
+
1 + y (1 + y ) (1 + y ) (1 + y ) (1 +
1+y
Simple
1
T
X CExample
t /(1 + y )t
C 2
t(t + 1)
(1 + y ) t=1 P
n Bond convexity C = 23.9472.
Dur P y C P y 2
P +
1+y 2
23.9472 915.75 0.0001
= 39.83 +
2
= 39.83 + 1.10 = 38.73
n Very close to the observed $38.76 price drop

Hedging example
n How can we hedge the 5-year coupon

bonds duration and convexity?
q What happens with the 1% yield change?
n Need one more bond

q Assume its a zero coupon seven year bond.

T
X
1 Ci /(1 + y )i
C t(t + 1)
(1 + y )2 P
i =1
n Need to buy n7 and n10 such that:

Duration
P5D5 + n7P7D7 + n10P10D10 = 0 matching
condition
Convexity
P5C5 + n7P7C7 + n10P10C10 = 0 matching
condition
q Have
P5 = 915.75 D5 = 4.61 C5 = 23.95
P7 = 665.06 D7 = 7 C7 = 49.84
P10 = 558.39 D10 = 10 C10 = 97.9

T
X
1 Ct /(1 + y )t
C 1 t(t + 1)
(1 + y )2 P
t=1
P P y
1+y
n Substitution yields:
T
X
1 Ct /(1 + y )t
n7 + 5, 2584 n10 = 4, 222
C4, 665 t(t +matching
1)
Duration
(1 + y ) t=1 P condition
Convexity
37, 243 n7 + 61, 423 n10 = 24, 640 matching
condition
q Solving gives
n7 = 1.561
n10 = 0.545

T
X
1 Ct /(1 + y )t
C t(t + 1)
(1 + y )2 t=1
P
1
P P y
n Now what happens if1 +
rates
y rise 1%?
P5 = 876.99
XT 915.75 = 38.76
1 Ct /(1 + y )t
C 2
t(t + 1)
P(1
7 =+622.75
y ) t=1 665.06P = 42.31
P10 = 508.35 558.39 = 50.05
n So
P5 + n7 P7 + n10 P10
= 38.76 + 1.561 42.31 0.545 50.05
= 0.006 Much better than the

$0.98 we lost with
duration matching
alone
Real Life Immunization
n Banks need to insulate their portfolios from IR
fluctuations
q Banks assets have long durations: mainly long-term loans
q Banks liabilities have short durations: mainly short-term deposits
n When rates increase, asset values fall more than liabilities
q Balance sheet could be wiped out, if duration discrepancy big
enough
n Pension funds, opposite is true: liabilities (promised
payments ) have longer maturities than assets
n To decrease IR exposure, an institution needs to
1. figure out the durations of the (existing) assets and liabilities, and
2. buy or sell some other bonds to hedge the risk
n Can accomplish this many different ways, using different instruments
n Most commonly IR swaps

Grand Example
n Suppose the ZCB prices of bonds paying $100 at

maturity from year 1 to year 5 are:
q B0,1 = $97.09
q B0,2 = $92.46
q B0,3 = $87.63
q B0,4 = $83.06
q B0,5 = $78.82
n Answer the following questions for a 5-year bond that

q Pays annual 4% coupons
q Has a face of $1,000

Grand Example
1. What is the price of the bond?
2. What is its YTM?
3. What is its duration?
4. Use the duration to compute the approximate price
change if yield rise 50 bps
q And what would the exact price change be?
5. Under the expectations hypothesis, what bond price
do we expect in two years?
n Note: In two years, two coupons payment will have been
made, and the bond will mature in only 3 years.

Grand
P Example,
1
1+y
P y Continued
T
X Ct /(1 + y )t
1
C 2
t(t + 1)
(1 + y ) t=1 P
n Bonds price:
B0,1 B0,2 B0,3 B0,4 B0,5

P = C1 + C1 + C1 + C1 + (F + C1)
100 100 100 100 100
97.09 92.46 87.63 83.06 78.82
= 40 + 40 + 40 + 40 + 1040
100 100 100 100 100
= 38.83 + 36.98 + 35.05 + 33.22 + 819.73
= 963.83

Grand Example, Continued
n For YTM, need to findPrate y 1 satisfies the following
that
P y
equation: 1+y
$40 $40 $40 $40 $1040
$963.83 = + 2
+ 3
+ 4
+
1 + y (1 + y ) (1 + y ) (1 + y ) (1 + y )5
n We can pick some trial y, say 3%, and set this up as a problem
in Excel:
B0,1 B0,2 B0,3 B0,4 B0,5
P = C1 + C1 + C1 + C1 + (F + C1)
100 100 100 100 100
97.09 92.46 87.63 83.06 78.82
= 40 + 40 + 40 + 40 + 1040
100 100 100 100 100
= 38.83 + 36.98 + 35.05 + 33.22 + 819.73
= 963.83
q Yields too high a price YTM > 3%

n Telling Excels solver to set the objective (Difference) to $0 by

changing y, we find y = 4.83%:

n We can compute duration of this bond almost immediately

n Approximate price change comes from duration formula:
1
P Dur P y
1+y
1
= 4.622 $963.83 0.005 = $21.25
1 + 0.0483
q Price would drop by approximately $21.25 if the yield went up 0.5%
$40 $40 $40 $40 $1040
n Can find exact
$963.83 = change+ by recomputing
2
+ price
3
+ with the4
+new yield,
5
y
1 + y= 5.33%:
= 4.83% + 0.50% (1 + y ) (1 + y ) (1 + y ) (1 + y )
B0,1 B0,2 B0,3 B0,4 B0,5

P = C1 + C1 + C1 + C1 + (F + C1)
100 100 100 100 100
97.09 92.46 87.63 83.06 78.82
= 40 + 40 + 40 + 40 + 1040
100 100 100 100 100
= 38.83 + 36.98 + 35.05 + 33.22 + 819.73
= 963.83
n Last question: what price do we expect in two

years?
q This requires that we compute some forward rates:
n Under the expectations hypothesis, these are the expected spot
rates
q Need three forward rates:
n From year 2 to year 3
q These are our expectations of future 1-, 2-, and 3-
year spot rates

n Can compute these rates as before
q Or get them directly from the ZCB price!
q The 2-year bond price is $92.46
q The 3-year bond price was $87.63
n So the forward rate from year 2 to year 3 is
f2,3 = $92.46 / $87.63 - 1 = 5.507%

q The 4-year bond had a price of $83.06
n So the forward rate from year 2 to year 3 is
f2,4 = ($92.46 / $83.06) - 1 = 5.505%
q Finally, the forward rate from year 2 to year 5 is f2,5 = 5.462%
n Exercise: use the standard method of computing

forward rates to verify that this method indeed works!

n Two years from now well own a three year bond that
will make three more payments, of $40, $40, and
$1,040.
n We expect the 1-, 2-, and 3-year spot rates to be
5.507%, 5.505%, and 5.462%, respectively.
n The expected bond price by using these as the spot
rates:
40 40 1040
P = + 2
+ 3
= 960.48
1.05507 1.05505 1.05462
n Expect the
$40bond to cost $960.47
$40 $40 $40 $1040
$963.83 = + + holds, this3 is+a low estimate
q If liquidity preference theory
2 4
+ for the 5
1 + y (1 + y ) (1 + y ) (1 + y ) (1 + y )
price

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Fixed Income

FIN 411, Fall 2016

FIN 411: Fixed Income Prof. Dmitry Orlov 1

1. Overview of Bond Markets

FIN 411: Fixed Income Prof. Dmitry Orlov 2

FIN 411: Fixed Income Prof. Dmitry Orlov 3

FIN 411: Fixed Income Prof. Dmitry Orlov 4

FIN 411: Fixed Income Prof. Dmitry Orlov 5

FIN 411: Fixed Income Prof. Dmitry Orlov 6

n In default, bond holders can force bankruptcy procedures:

FIN 411: Fixed Income Prof. Dmitry Orlov 7

FIN 411: Fixed Income Prof. Dmitry Orlov 8

FIN 411: Fixed Income Prof. Dmitry Orlov 9

n Government agencies introduced securitization

FIN 411: Fixed Income Prof. Dmitry Orlov 10

FIN 411: Fixed Income Prof. Dmitry Orlov 11

3. Deferred Coupon Bond

FIN 411: Fixed Income Prof. Dmitry Orlov 12

FIN 411: Fixed Income Prof. Dmitry Orlov 13

n Discount rates are not constant in reality

n Allowing for rates to differ from date to date, the asset

n Example. A two-year T-Note

q What is the price of the bond if the 0.5, 1, 1.5 and 2-

FIN 411: Fixed Income Prof. Dmitry Orlov 15

= $49.02 + $47.82 + $46.57 + $951.25 = $1, 094.66

FIN 411: Fixed Income Prof. Dmitry Orlov 16

n The convention is to report the zero coupon bond (or

n The price is reported as [dollars]:[seconds]

FIN 411: Fixed Income Prof. Dmitry Orlov 18

n This means that the bid price was $73 + $22/32 =

n We use B to denote prices of strips/zero-coupon

FIN 411: Fixed Income Prof. Dmitry Orlov 19

n Example. We see prices of 1- and 2-year coupon

FIN 411: Fixed Income Prof. Dmitry Orlov 22

n Solve B1 from the first equation: B1 = $95

FIN 411: Fixed Income Prof. Dmitry Orlov 23

$100 / $1,080 = 0.09259

$7.407 / $1,050.00 = 0.00705

0.09259 * $1,048 0.00705 * $997.5 = $90

FIN 411: Fixed Income Prof. Dmitry Orlov 24

$80 $80 $1, 080

n Yield-to-maturity answers the following

FIN 411: Fixed Income Prof. Dmitry Orlov 25

$80 $80 $1, 080

q Formally: YTM = rate realized over life of the bond if coupons

FIN 411: Fixed Income Prof. Dmitry Orlov 26

FIN 411: Fixed Income Prof. Dmitry Orlov 27

n Clicking Ok, we get:

This bond s yield-to-

FIN 411: Fixed Income Prof. Dmitry Orlov 28

FIN 411: Fixed Income Prof. Dmitry Orlov 29

multiplied by 2 (i.e., we want to report the APR)

n Example. A five-year bond with a face value of $1,000 and 8% per

FIN 411: Fixed Income

n The yield curve is a graphical presentation of spot

FIN 411: Fixed Income Prof. Dmitry Orlov 31

FIN 411: Fixed Income Prof. Dmitry Orlov 32

n Answer: The 1-year spot rate is $1,000 / $952.38 1 = 5.00%

FIN 411: Fixed Income Prof. Dmitry Orlov 33

FIN 411: Fixed Income Prof. Dmitry Orlov 34

n Spot rates vs. forward rates

FIN 411: Fixed Income Prof. Dmitry Orlov 35

FIN 411: Fixed Income Prof. Dmitry Orlov 36

FIN 411: Fixed Income Prof. Dmitry Orlov 37