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All About Fixed Income Instruments


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All About Fixed Income Instruments

  1. 1. Understanding Fixed Income Instruments
  2. 2. <ul><li>Welcome To The World Of Risk Free rather Lower Risk and moderate returns </li></ul><ul><li>You are safe but no assurance on that safety </li></ul><ul><li>Quite a pickle – Isn’t It? </li></ul><ul><li>We see why????? </li></ul>Understanding Fixed Income Instruments
  3. 3. Conventions <ul><li>Debt securities – Issued by borrowers to obtain liquidity or capital for their short term or long term needs </li></ul><ul><li>Promised payment events – Interest payment & Repayment of fixed amount </li></ul><ul><li>Secured & Unsecured </li></ul><ul><li>Risk prone – Not absolute risk free </li></ul><ul><li>Mid 2009 Debt market valued at $30 Trillion </li></ul>Understanding Fixed Income Instruments
  4. 4. Types Of Bonds Understanding Fixed Income Instruments
  5. 5. Features Of Bonds <ul><li>Coupon Rate </li></ul><ul><ul><li>“ 6s of 12/10/2009” – 6% Coupon maturing @... </li></ul></ul><ul><ul><li>Monthly (MBS & ABS), Semi-Annually </li></ul></ul><ul><ul><li>Zero-Coupon Bonds </li></ul></ul><ul><ul><li>Accrual Securities </li></ul></ul><ul><ul><li>Deferred Coupon Bonds </li></ul></ul><ul><ul><li>Floating Rate Securities </li></ul></ul><ul><ul><ul><li>Reference Rate + Quoted Margin </li></ul></ul></ul><ul><ul><ul><li>1-month LIBOR+100 basis points </li></ul></ul></ul>Understanding Fixed Income Instruments
  6. 6. Accrual Securities Buyer Seller Jan 09 Jan 10 Jun 10 Jan 11 Jun 11 Jun 09 $ 5 $ 5 $ 5 $ 5 $ 5 Accrued Interest Par Value of $100 - Semi Annual Interest Of 5% Dirty Price – Trading Cum-Coupon Clean Price – Trading Ex-Coupon Understanding Fixed Income Instruments
  7. 7. Calculating Accrued Interest <ul><li>Three pieces info needed: </li></ul><ul><ul><li>No of days in the accrued interest period </li></ul></ul><ul><ul><li>No Of days in the coupon period </li></ul></ul><ul><ul><li>Dollar amount of the coupon payment </li></ul></ul><ul><li>AI is calculated as </li></ul><ul><li>Day count conventions </li></ul>Understanding Fixed Income Instruments
  8. 8. Features Of Bonds – Contd’ <ul><li>Maturity Date </li></ul><ul><ul><li>Time period over receipt of interest payments </li></ul></ul><ul><ul><li>Yield on a Bond </li></ul></ul><ul><ul><li>Price Of the Bond </li></ul></ul><ul><li>Price Of the Bond is calculated as </li></ul><ul><li>Sum Of the Present values of all expected coupon payments & Principal @ Par </li></ul>C = coupon payment n = number of payments i = interest rate, or required yield M = value at maturity, or par value  Understanding Fixed Income Instruments
  9. 9. Features Of Bonds – Contd’ <ul><li>Yield – returns which investor gets by holding the bond till maturity </li></ul><ul><li>Current Yield Vs Adjusted Current Yield </li></ul><ul><li>A bond with a par value of $100 for $95.92 and it paid a coupon rate of 5% </li></ul>Understanding Fixed Income Instruments
  10. 10. Price Vs Yield <ul><li>Price of a Bond & Yield of a Bond are inversely related </li></ul><ul><ul><li>When the Coupon rate is less than the required Yield, the price is less than the par value </li></ul></ul><ul><ul><li>When price is greater than the par value, the coupon rate is greater than the required yield </li></ul></ul><ul><li>YTM - The discount rate that equates a bond’s price with the present value of its future cash flows. </li></ul>Understanding Fixed Income Instruments
  11. 11. Risk Associated With Bonds <ul><li>Interest Rate Risk </li></ul><ul><ul><li>Price Of a bond falls when interest rates rise </li></ul></ul><ul><ul><li>Floating Rate Securities </li></ul></ul><ul><li>Credit Risk </li></ul><ul><ul><li>Default, Downgrade </li></ul></ul><ul><li>Contractual Risk </li></ul><ul><ul><li>Callable Bonds </li></ul></ul><ul><li>Inflation Risk </li></ul><ul><ul><li>Increase in inflation – Purchasing power </li></ul></ul>Understanding Fixed Income Instruments
  12. 12. Types Of Bonds <ul><li>Callable Bonds - A bond that can be redeemed by the issuer prior to its maturity. </li></ul><ul><ul><li>main cause of a call is a decline in interest rates </li></ul></ul><ul><li>Convertible Bonds – A bond that can be converted into a predetermined amount of the company's equity at certain times during its life </li></ul><ul><li>Eurodollar Bonds - U.S.-dollar denominated bond issued by an overseas company and held in a foreign institution outside both the U.S. and the issuer's home nation </li></ul><ul><ul><li>Chinese bank held dollar-denominated bonds issued by a Japanese company, this would be considered a eurodollar bond. </li></ul></ul>Understanding Fixed Income Instruments
  13. 13. Types Of Bonds <ul><li>Eurobond is an international bond that is denominated in a currency not native to the country where it is issued </li></ul><ul><li>Yankee Bond - A bond denominated in U.S. dollars that is publicly issued in the U.S. by foreign banks and corporations </li></ul><ul><li>Bulldog Bond - A sterling denominated bond that is issued in London by a company that is not British </li></ul>Understanding Fixed Income Instruments
  14. 14. Types Of Bonds <ul><li>Maple Bond - A bond denominated in Canadian dollars that is sold in Canada by foreign financial institutions </li></ul><ul><li>  Matilda/Kangaroo Bond - An bond denominated in the Australian dollar and issued on the Australian market by a foreign entity </li></ul><ul><li>Samurai Bond - Yen-denominated bond issued in Tokyo by a non-Japanese company </li></ul>Understanding Fixed Income Instruments
  15. 15. Fixed Income Products <ul><li>Treasury Bills – Maturities with 6,12 & 18 months duration </li></ul><ul><ul><li>Issued by the Treasury of the state </li></ul></ul><ul><ul><li>Always issued at discount </li></ul></ul><ul><li>Government Bonds - Medium & long term bonds – known as bonos & obligaciones </li></ul><ul><ul><li>Maturities of 10, 15 & 30 Years </li></ul></ul><ul><ul><li>Fixed Interest rate through annual coupons </li></ul></ul>Understanding Fixed Income Instruments
  16. 16. Fixed Income Products <ul><li>Commercial Paper - An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. </li></ul><ul><ul><li>Maturities on commercial paper rarely range any longer than 270 days </li></ul></ul><ul><li>Certificate of deposit or CD is a time deposit, a financial product commonly offered to consumers by banks, thrift institutions, and credit unions </li></ul><ul><ul><li>Held until maturity </li></ul></ul>Understanding Fixed Income Instruments
  17. 17. Fixed Income Products <ul><li>Repo – Repurchase Agreements (Not necessarily FI product) </li></ul><ul><li>Is a contract in which a security is sold with an agreement to repurchase the security at a higher price </li></ul>Understanding Fixed Income Instruments
  18. 18. Fixed Income Products <ul><li>Reverse Repo is a contract in which a security is borrowed with an agreement to replace the security at a higher price </li></ul><ul><li>Secured lending and borrowing </li></ul>Repo Understanding Fixed Income Instruments
  19. 19. Fixed Income Products <ul><li>Commercial Paper – Zero Coupon bonds issued at discount </li></ul><ul><ul><li>Short term with maturities 1,3,6,12 & 18 months </li></ul></ul><ul><ul><li>Placed in the primary market through competitive auctions </li></ul></ul><ul><li>Convertible/Exchangeable Bonds </li></ul><ul><ul><li>Enables a financial asset to be transformed into other </li></ul></ul>Understanding Fixed Income Instruments
  20. 20. Fixed Income Derivatives Understanding Fixed Income Instruments
  21. 21. MBS <ul><li>A mortgage-backed security ( MBS ) is an asset-backed security or debt obligation that represents a claim on the cash flows from mortgage loans, most commonly on residential property. </li></ul><ul><ul><li>Residential mortgage-backed security (RMBS) </li></ul></ul><ul><ul><li>Commercial mortgage-backed security </li></ul></ul><ul><ul><li>Collateralized mortgage obligation </li></ul></ul><ul><ul><li>Stripped mortgage-backed securities </li></ul></ul><ul><ul><li>Interest-only stripped mortgage-backed securities </li></ul></ul><ul><ul><li>Principal-only stripped mortgage-backed securities </li></ul></ul>Understanding Fixed Income Instruments
  22. 22. Weapons Of Financial Destruction <ul><li>Collateralized Debt Obligation </li></ul><ul><li>Process Of Securitization </li></ul>Understanding Fixed Income Instruments
  23. 23. Interest Rate Swap <ul><li>Interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows </li></ul><ul><li>Fixed for floating/Vanilla Interest Rate Swaps </li></ul><ul><li>Often use LIBOR as reference rates </li></ul><ul><li>Hedging/Speculation on interest & FX rates </li></ul>Understanding Fixed Income Instruments
  24. 24. Interest Swaps – I llustrated Understanding Fixed Income Instruments Time 6-Month Fixed Rate Floating Rate Swap 0 2.80% – 100.0 – 100.0 0 0.5 3.40% 2.3 1.4 0.9 1 4.40% 2.3 1.7 0.6 1.5 4.20% 2.3 2.2 0.1 2 5.00% 2.3 2.1 0.2 2.5 5.60% 2.3 2.5 – 0.2 3 5.20% 2.3 2.8 – 0.5 3.5 4.40% 2.3 2.6 – 0.3 4 3.80% 102.3 102.2 0.1 Cash Flows During the Life of a Hypothetical USD 100MM 4.6% Four-Year Swap
  25. 25. Interest Rate Caps <ul><li>An interest-rate cap is an OTC derivative in which the buyer receives payments at the end of each period in which the interest rate (reference rate/LIBOR) exceeds the agreed strike rate (Cap rate) </li></ul><ul><li>3-year, USD 200MM notional cap </li></ul><ul><li>6-month Libor - index rate, struck at 7.5%. </li></ul><ul><li>Protects from int. rate rises </li></ul>Understanding Fixed Income Instruments
  26. 26. Interest Rate Floors <ul><li>An interest rate floor is a derivative in which the buyer of the floor receives money if on the maturity the reference rate fixed is below the agreed strike price of the floor </li></ul><ul><li>Protects holder from declines in short-term interest </li></ul><ul><li>3-year, USD 200MM notional cap </li></ul><ul><li>6-month Libor - index rate, struck at 7.5%. </li></ul>Understanding Fixed Income Instruments
  27. 27. Swaption <ul><li>A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap </li></ul><ul><li>the term &quot;swaption&quot; typically refers to options on interest rate swaps </li></ul><ul><ul><li>A payer swaption gives the owner of the swaption the right to enter into a swap where they pay the fixed leg and receive the floating leg. </li></ul></ul><ul><ul><li>A receiver swaption gives the owner of the swaption the right to enter into a swap where they will receive the fixed leg, and pay the floating leg. </li></ul></ul>Understanding Fixed Income Instruments
  28. 28. Swaption <ul><li>designed to give the holder the benefit of the agreed-upon strike rate if the market rates are higher </li></ul><ul><ul><li>American swaption, in which the owner is allowed to enter the swap on any day that falls within a range of two dates. </li></ul></ul><ul><ul><li>European swaption, in which the owner is allowed to enter the swap only on the maturity date. </li></ul></ul><ul><ul><li>Bermudan swaption, in which the owner is allowed to enter the swap only on certain dates that fall within a range of the start (roll) date and end date. </li></ul></ul>Understanding Fixed Income Instruments