Chapter 2: BASICS OF FIXED INCOME SECURITIES

Chapter 2: BASICS OF FIXED INCOME SECURITIES

2.1 DISCOUNT FACTORS 2.1.1 Discount Factors across Maturities 2.1.2 Discount Factors over Time

2.1 DISCOUNT FACTORS The discount factor between two dates, t and T, provides the term of exchange between a given amount of money at t versus a (certain) amount of money at a later date T: Z(t,T) On August 10, 2006 the Treasury issued 182-day Treasury bills. The issuance market price was $97.477 for $100 of face value That is, on August 10, 2006, investors were willing to buy for $97.477 a government security that would pay $100 on February 8, 2007 This Treasury bill would not make any other payment between the two dates Thus, the ratio between purchase price and the payoff, 0.97477 = $97.477/$100, can be considered the market-wide discount factor between the two dates August 10, 2006 and February 8, 2007 That is, market participants were willing to exchange 0.97477 dollars on the first date for 1 dollar six months later

2.1.1 Discount Factors across Maturities Z(t,T) records the time value of money between t and T At any given time t, the discount factor is lower, the longer the maturity T. That is given two dates T 1 and T 2, with T 1 < T 2, it is always the case that Z(t,T1 ) Z(t,T 2 ) It is always the case that market participants prefer a $1 sooner than later On August 10, 2006 the U.S. government also issued 91-day bills with a maturity date of November 9, 2006. The price was $98.739 for $100 of face value Thus, denoting again t = August 10, 2006, now T 1 = November 9, 2006, and T 2 = February 8, 2007, we find that the discount factor Z(t,T 1 ) = 0.98739, which is higher than Z(t,T 2 ) = 0.97477

2.1.1 Discount Factors across Time Discount factors give the current value (price) of receiving $1 at some point in the future These values are not constant over time One of the variables that determines this value is inflation: Higher expected inflation, makes less appealing money in the future so discounts go down Inflation is not the only variable that explains discount factors

2.2 INTEREST RATES 2.2.1 Discount Factors, Interest Rates, and Compounding Frequencies 2.2.1.1 Semi-annual Compounding 2.2.1.2 More Frequent Compounding 2.2.1.3 Continuous Compounding 2.2.2 The Relation between Discount Factors and Interest Rates

2.2.1 Discount Factors, Interest Rates, and Compounding Frequencies Interest rates are closely related to discount factors and are more similar to the concept of return on an investment Yet it is more complicated, because it depends on the compounding frequency The compounding frequency of interest accruals refers to the number of times within a year in which interests are paid on the invested capital For a given interest rate, a higher compounding frequency results in a higher payoff For a given payoff, a higher compounding frequency results in a lower interest rate

2.2.1.1 Semi-annual Compounding In semi-annual compounding bondholders receive a coupon payment twice a year To obtain the semi-annual compounding rate we have: rn t, T 2 1 1 Z t, T 2 where Z(t,T) is a discount factor T t Let t = August 10, 2006, and let T = August 10, 2007 (one year later) Consider a year investment of $100 at t with semi-annually compounded interest r = 5% This terminology means that after six months the investment grows to $102.5 = $100 (1 + 5%/2), which is then reinvested at the same rate for another six months, yielding at T: Payoff at T: $105.0625 = ($100) (1 + r/2) (1 + r/2) = ($100) (1 + r/2) 2 Given that the initial investment is $100, there are no cash flows to the investor during the period, and the payoff at T is risk free, the relation between money at t ($100) and money at T (= $105.0625 = payoff at T) establishes a discount factor between the two dates:. $100 1 Z( t, T ) payoff. at. T 1 r / 2 2 1

2.2.1.1 Semi-annual Compounding Another example: On March 1, 2001 (time t) the Treasury issued a 52-week Treasury bill, with maturity date T = February 28, 2002 The price of the Treasury bill was $95.713 As we have learned, this price defines a discount factor between the two dates of Z(t,T) = 0.95713 At the same time, it also defines a semi-annually compounded interest rate equal to r 2 (t,t) = 4.43% In fact, $95.713 (1 + 4.43% / 2) 2 = $100 The semi-annually compounded interest rate can be computed from Z(t,T) = 0.95713 by solving for r 2 (t,t). 1 1 r2 t, T 2 1 2 1 4.43% 1 1, 2 2 Z t T 0.95713

2.2.1.2 More Frequent Compounding Let the discount factor Z(t,T) be given, and let r n (t,t) denote the annualized n-times compounded interest rate. Then r n (t,t) is defined by the equation 1, 1 rn t T n 1, n T t Z t T Rearranging for Z(t,T), we obtain Z t, T r 1 n 1 t, T n n T t

2.2.1.3 Continuous Compounding The continuously compounded interest rate is obtained by increasing the compounding frequency n to infinity The continuously compounded interest rate r(t,t) is given by the formula: r t, T where ln(.) denotes the natural logarithm Solving for Z(t,T) we obtain: ln Z t, T T t, T t r t T Z t, T e

2.2.1.3 Continuous Compounding An example: Consider the earlier example in which at t we invest $100 to receive $105 one year later Recall that the annually compounded interest rate is r 1 (t,t+1) = 5%, the semi-annually compounded interest rate is r 2 (t,t+1) = 4.939%, and the monthly compounded interest rate is r 12 (t,t+1) = 4.889% The following table reports the n times compounded interest rate also for more frequent compounding As it can be seen, if we keep increasing n, the n times compounded interest rate r n (t,t+1) keeps decreasing, but at an increasingly lower rate Eventually, it converges to a number, namely, 4.879% This is the continuously compounded interest rate Note that in this example, there is no difference between the daily compounded interest rate (n = 252) and the one obtained with higher frequency (n > 252) That is, we can mentally think of continuous compounding as the daily compounding frequency

2.2.1.3 Continuous Compounding

2.2.2 The Relation between Discount Factors and Interest Rates Note that independently of the compounding frequency, discount factors are the same Thus some useful identities are: r t, T nln 1 rn t, T r t, T n rn t, T n e 1 n

2.3 THE TERM STRUCTURE OF INTEREST RATES 2.3.1 The Term Structure of Interest Rates over Time

2.3.1 The Term Structure of Interest Rates over Time The term structure of interest rates, or spot curve, or yield curve, at a certain time t defines the relation between the level of interest rates and their time to maturity T The term spread is the difference between long term interest rates (e.g. 10 year rate) and the short term interest rates (e.g. 3 month interest rate) The term spread depends on many variables: expected future inflation, expected growth of the economy, agents attitude towards risk, etc. The term structure varies over time, and may take different shapes

2.3.1 The Term Structure of Interest Rates over Time An example: On June 5, 2008, the Treasury issued 13-week, 26-week and 52-week bills at prices $99.5399, $99.0142, and $97.8716, respectively Denoting t = June 5, 2008, and T 1, T 2, and T 3 the three maturity dates, the implied discount factors are Z(t,T 1 ) = 0.995399, Z(t,T 2 ) = 0.990142, and Z(t,T 3 ) = 0.978716 The discount factor of longer maturities is lower than the one of shorter maturities The question is then: How much lower is Z(t,T 3 ), say, compared to Z(t,T 2 ) or Z(t,T 1 )? Translating the discount factors into annualized interest rates provides a better sense of the relative value of money across maturities In this case, the continuously compounded interest rates are: ln 0.995399 ln r t, T1 1.8444 % 0.990142 r t, T2 0.25 ln 0.978716 r t, T3 2.1514 % 1 0.5 1.9814 %

2.4 COUPON BONDS 2.4.1 From Zero Coupon Bonds to Coupon Bonds 2.4.1.1 A No Arbitrage Argument 2.4.2 From Coupon Bonds to Zero Coupon Bonds 2.4.3 Expected Return and the Yield to Maturity 2.4.4 Quoting Conventions 2.4.4.1 Treasury Bills 2.4.4.2 Treasury Coupon Notes and Bonds

2.4.1 From Zero Coupon Bonds to Coupon Bonds The price of zero coupon bonds (with a principal value of $100) issued by the government are equal to: z, 100 Z t, T P t T The subscript z is mnemonic of Zero coupon bond This means that from observed prices for zero coupon bonds we can compute the discount factors

2.4.1 From Zero Coupon Bonds to Coupon Bonds Consider a coupon bond at time t with coupon rate c, maturity T and payment dates T 1,T 2,,T n = T. Let there be discount factors Z(t,T i ) for each date T i. Then the value of the coupon bond can be computed as: also: n c100 P t T Z t T Z t T,, 100, c n i n 2 i1 n c P t T P t T P t T,,, c n z i z n 2 i1

2.4.1 From Zero Coupon Bonds to Coupon Bonds An example: Consider the 2-year note issued on t = January 3, 2006 discussed earlier On this date, the 6-month, 1-year, 1.5-years, and 2-year discounts were Z(t,t+0.5) = 0.97862, Z(t,t+1) = 0.95718, Z(t,t+1.5) = 0.936826 and Z(t,t+2) = 0.91707 Therefore, the price of the note on that date was 4 Pc t, Tn $2.1875 Zt, t 0.5i $100 0.91707 i1 which was indeed the issue price at t $99.997

2.4.1.1 A No Arbitrage Argument In well functioning markets in which both the coupon bond P c (t,t n ) and the zero coupon bond P z (t,t n ) are traded in the market, if the previous relation does not hold, an arbitrageur could make large risk-free profits. For instance, if n c P t T P t T P t T,,, c n z i z n 2 i1 then the arbitrageur can buy the bond for P c (t,t n ) and sell immediately c/2 units of zero coupon bond with maturities T 1,T 2,,T n-1 and (c/2+1) of the zero coupon with maturity T n This strategy leads instantly to a profit

2.4.2 From Coupon Bonds to Zero Coupon Bonds We can also go the other way around, with enough coupon bonds we can compute the implicit value of zero coupon bonds With sufficient data we can obtain the discount factors for every maturity This methodology is called bootstrap methodology

2.4.2 From Coupon Bonds to Zero Coupon Bonds Let t be a given date. Let there be n coupon bonds, with coupon c i and maturities T i. Assume that maturities are regular intervals of six months. Then, the bootstrap methodology to estimate discount factors, for every i = 1,,n is as follows: 1. The first discount factor Z(t,T 1 ) is given by: 2.Any other discount factor Z(t,T i ) for i = 2,,n is given by:. Z t, T i Z t, T 1 Pc t, T1 100 1 c / 2 i1, / 2100, j1 P t T c Z t T c i i j 100 1 c / 2 1 1

2.4.2 From Coupon Bonds to Zero Coupon Bonds An example: On t = June 30, 2005, the 6-month Treasury bill, expiring on T 1 = December 29, 2005, was trading at $98.3607 On the same date, the 1-year to maturity, 2.75% Treasury note, was trading at $99.2343 The maturity of the latter Treasury note is T 2 = June 30, 2006 We can write the value of the two securities as: P bill (t,t 1 ) = $98.3607 = $100 Z(t,T 1 ) P note (t,t 2 ) = $99.2343 = $1.375 Z(t,T 1 ) + $101.375 Z(t,T 2 ) We have two equations in two unknowns: Z(t,T 1 ) = $98.3607 / $100 = 0.983607. Z t $99.2343 $1.375 Z $101.375 t, T $99.2343 $1.375 0.983607 $101.375 1, T2 0.965542

2.4.2 From Coupon Bonds to Zero Coupon Bonds Another example: On the same date, t = June 30, 2005, the December 31, 2006 Treasury note, with coupon of 3%, was trading at $99.1093 Denoting by T 3 = December 31, 2006, the price of this note can be written as: P(t,T 3 ) = $1.5 Z(t,T 1 ) + $1.5 Z(t,T 2 ) + $101.5 Z(t,T 3 ) = $99.1093

2.4.3 Expected Return and the Yield to Maturity Yield to maturity is a kind of weighted average of the spot rates corresponding to the different cash flows paid by a bond The higher a specific cash flow, the higher the weight on that spot rate YTM is a convenient summary measure, but it has limitations: You can only calculate it after you know a bond s price. It only applies to a single bond IMPORTANT: Yield to maturity is often not a good way to compare investment decisions. If the yield curve is not flat, bonds with different maturities or coupon rates will almost always have different yields The YTMs of two fairly priced bonds will differ if they have different coupon rates or maturities

2.4.3 Expected Return and the Yield to Maturity Use the next table in the following example: Columns 1 to 6 display coupon rates, maturities, and quotes of the latest issued Treasury notes on February 15, 2008 Column 7 shows the discount curve Z(0,T) obtained from the bootstrap procedure, and Column 8 reports the continuously compounded spot rate curve r(0,t) On February 15, 2008, traders could buy or sell two Treasury securities with the same maturity T = 9.5 years, but with very different coupon rates In particular, a T-note with coupon c = 4.750% and a T-bond with coupon c = 8.875% were available Using the discount factors Z(0,T) we can determine the fair prices of the two securities P 9.5 4.750 Z0, T 100 Z0,9.5 107.8906 c4.750 2 T 0.5 9.5 8.875 Pc 8.875 0, 100 0,9.5 141. 5267 2 Z T Z T 0.5 The yield to maturity of the c = 4.75 T-note is 3.7548% and for the c = 8.875 T-bond is 3.6603% The bond with the higher coupon has lower yield to maturity y

2.4.3 Expected Return and the Yield to Maturity

2.4.4.1 Quoting Conventions - Treasury Bills Treasury bills are quoted on a discount basis; rather than quoting a price, Treasury dealers quote the following: 100 Pbill t, T 360 d 100 n where n is the number of calendar days between t and T

2.4.4.2 Quoting Conventions - Treasury Coupon Notes and Bonds Treasury notes and bonds present an additional complication: Between coupon dates an interest accrues on the bond, if a bond is purchased between the coupon dates, the buyer is entitled to the portion of the coupon that accrues between the purchase date and the next coupon date and the seller to the portion of the coupon that accrued between the last coupon and the purchase date It is market convention to quote these without any inclusion of accrued interests, so: Invoice (Dirty) Price = Quoted (Clean) Price + Accrued Interest Accrued Interest is given by: Accrued Interest = Interest Due in Full Period Number of Days Since Last Coupon Date Number of Days between Coupon Payments

2.5 FLOATING RATE BONDS 2.5.1 The Pricing of Floating Rate Bonds 2.5.2 Complications

2.5.1 The Pricing of Floating Rate Bonds A semi-annual Floating Rate Bond with maturity T is a bond whose coupon payments c(t i ) at dates T 1 = 0.5, T 2 = 1, T 3 = 1.5,, T n = T are determined by the formula: c Ti 100 r2 Ti 0.5 s where r 2 (t) is the 6-month Treasury rate at t, and s is a spread Each coupon date is also called reset date as it is the time when the new coupon is reset If the spread of a floating rate bond is equal to zero, the ex-coupon price of a floating rate bond on any coupon date is equal to the bond par value

2.5.1 The Pricing of Floating Rate Bonds Consider a one year, semi-annual floating rate bond, with zero spread: The coupon at t = 0.5 depends on today s interest rate r 2 (0) = 2%, then: c(0.5) = 100 2% / 2 = 1 Also c(1) depends on the interest rate in six months r 2 (0.5) which is unknown today, yet this doesn't matter since the cash flow at that time will be (100 + c(1)), which means that the present value will be: 100 100r2 0.5 / 2 1001r2 0.5 / 2 V 0.5 100 1r2 0.5 / 2 1r2 0.5 / 2 After the coupon is paid at t = 0.5 the value of the bond is the face value ($100), so the value at t = 0 is:. 100 1 V 1 100 1 2% / 2

2.5.1 The Pricing of Floating Rate Bonds An example: Consider a one year, semi-annual floating rate bond where the coupon at time t = 0.5 depends on today s interest rate r 2 (0), which is known If today r 2 (0) = 2%, then c(0.5) = 100 2%/2 = 1, what about the coupon c(1) at maturity T = 1? This coupon will depend on the 6-month rate at time t = 0.5, which we do not know today This implies that we do not know the value of the final cash flow at time T = 1, which is equal to 100 + c(1) Consider an investor who is evaluating this bond, this investor can project himself to time t = 0.5, six months before maturity, can the investor at time t = 0.5 guess what the cash flow will be at time T = 1? Yes, because at time t = 0.5 the investor will know the interest rate So, he can compute what the value is at time t = 0.5 Suppose that at time t = 0.5 the interest rate is r 2 (0.5) = 3%, then the coupon at time T = 1is c(1) = 100 r 2 (0.5)/2 = 1.5 This implies that the value of the bond at time t = 0.5 is equal to Present Value of (100 + c(1)) = (100 + 1.5) / (1 + 0.03 / 2) = 100 which is a round number, equal to par

2.5.1 The Pricing of Floating Rate Bonds Example (cont d): What if the interest rate at time t = 0.5 was r 2 (0.5) = 6%? In this case, the coupon rate at time T = 1 is c(1) = 100 r 2 (0.5)/2 = 103, and the value of the bond at t = 0.5 is Present Value of (100 + c(1)) = (100 + 3) / (1 + 0.06 / 2) = 100 still the same round number, equal to par Indeed, independently of the level of the interest rate r 2 (T 1 ), we find that the value of bond at t = 0.5 is always equal to 100: Present Value of (100 + c(1)) = (100 (1 + r 2 (0.5) / 2)) / (1 + r 2 (0.5) / 2) = 100 Even if the investor does not know the cash flow at time T = 1, because it depends on the future floating rate r 2 (0.5), the investor does know that at time t = 0.5 the ex-coupon value of the floating rate bond will be 100, independently of what the interest rate does But then, he can compute the value of the bond at time t = 0, because the coupon at time T 1 = 0.5 is known at time t = 0 as it is given by c(0.5) = 100 r 2 (0)/2 = 101; thus the value at time t = 0 is: Present Value of (100 + c(0.5)) = (100 + 1) / (1 + 0.02 / 2) = 100

2.5.2 Complications Complication #1: What if spread (s) isn t zero? Effectively the spread is a fixed payment on the bond so we can value it separately: n Price with spread = Price of no spread bond + s Z 0, t t0.5 Complication # 2: How do we value a floating rate bond outside of reset dates? We know that the bond will be worth 100(1+c(t i )/2) at the next reset date, note that c(t i ) is known All we need to do is to apply the appropriate discount This leads to the following general formula

2.5.2 Complications Let T 1,T 2,,T n be the floating rate reset dates and let the current date t be between time T i and T i+1 : T i < t < T i+1. The general formula for a semi-annual floating rate bond with zero spread s is: P FR t, T Z t, Ti 1 100 1 r2 Ti / 2 where Z(t,T i+1 ) is the discount factor from t to T i+1. * At reset dates, Z(T i,t i+1 ) = 1 + r 2 (T i ) / 2, which implies: P t, T 100 FR