2015 Study Session # 15, Reading # 53

INTRODUCTION TO FIXED-INCOME VALUATION

MMI = Money Market Instruments
1. INTRODUCTION

2. BOND PRICES AND THE TIME VALUE OF MONEY

2.1 Bond Pricing with a Market Discount Rate

Bond price PV of the promised future cash flows.

Market rate or required yield rate of return required by investors
given the risk of investment in bonds.

Bond is described as trading at discount (premium) if price is < (>) par
value.

When the coupon rate is > (<) market rate, bond is trading at premium
(discount).

If coupon rate = market discount rate bond is priced at par.
2.2 Yield-to-Maturity

YTM internal rate of return that makes present value of future cash
flow equal to market price.

Assumptions regarding YTM.

Investor holds the bond to maturity.

Issuer does not default on any of the payments.

Reinvestment of coupon payments on same rate.
2.3 Relationships between the Bond Price and Bond Characteristics

Inverse relationship b/w bond price & market rate.

Convexity effect when market discount rate goes down, % price is
greater than when the same goes up (given same maturity & coupon
rate).

Coupon effect lower coupon bond has
% price than a

coupon bond when market rate (given same time to maturity).

Maturity effect longer term bond has a greater % price than a
shorter term bond when market rate (given same coupon).

3. PRICES AND YIELDS: CONVENTIONS FOR QUOTES AND CALCULATIONS

3.1 Flat Price, Accrued Interest, and the Full Price

Full or dirty price sum of the parts price.

Flat price full price accrued interest (usually quoted by dealers).

Settlement date date on which the bond buyer makes cash
payment & the seller delivers the security.

Day-count conventions vary from market to market.

Copyright FinQuiz.com. All rights reserved.

2015 Study Session # 15, Reading # 53

3.2 Matrix Pricing

Matrix pricing mechanism used to calculate market discount rate &

prices of thinly traded bonds.

Features of frequently traded comparable bonds are used in matrix
pricing (e.g. time-to- maturity, coupon rates & credit quality).

Matrix pricing is also used in underwriting new bonds to get an
estimate of the required yield spread over benchmark.

Benchmark rate YTM on a Govt. bond having same maturity.

Term structure of credit spreads relationship b/w the spreads over
the risk fee rates & time to maturity.

3.3 Yield Measures for Fixed-Rate Bonds

Effective annual rate rate with just one compounding period in the year.

Semiannual bond basis yield annual rate having a periodicity (no. of
periods) of two or yield per semiannual period times two.

Street convention yield measures that neglect weekends & holidays.

Current yield sum of the coupon payments received over the year divided
by the flat price.

Bonds with embedded option:

Yield-to-worst the lowest of the sequence of yield-to-call & YTM is
called YTM.

Option-adjusted-yield required market rate whereby price is adjusted
for the value of the embedded option.

3.4 Yield Measures for Floating-Rate Notes

Interest payments on a floater are not fixed.

Relatively immune to interest rate risk.
Interest rate = reference rate + quoted margin.
Quoted margin compensate the investor for the difference in the
issuers credit risk.

Valuation of a FRN needs a pricing model.

3.5 Yield Measures for Money Market Instruments

Differences in yield measures of money market & bond market

include:

Rate of return on MMI is stated on a simple interest basis & not
compounded as the case with bond YTM.

Standard time-value-of money analysis cant be used in MMI.

MMI have no common periodicity for all time-to-maturity.

Pricing formula for MMI quoted on discount rate basis.


 =  1

 = 













Pricing formula for MMI quoted on an add-on-rate.

 = 

 

 =





Copyright FinQuiz.com. All rights reserved.

2015 Study Session # 15, Reading # 53

4. THE MATURITY STRUCTURE OF INTEREST RATES

Analysis of Term structure Involves the analysis of yield curve (relationship b/w YTM & timeto-maturity).

Maturity structure should be analyzed for bonds that have the same properties except timeto-maturity.

Spot curve is ideal data set for a series of zero coupon govt. bonds.

Par curve sequence of YTM such that each bond is priced at par value.

Forward market market for future delivery.

Forward rate interest rate on a bond or MMI traded in a forward market.

Implied forward rate (forward yields) breakeven reinvestment rate calculated from spot rates.

Forward curve series of forward rates each having the same time frame.

Forward curve implication:

Forward rates are used to make maturity choice decisions.

They are used to identify arbitrage opportunities.

Important in derivative valuation.

Forward & spot rates are interconnected (used to value a fixed income security in the same
manner).

5. YIELD SPREADS

5.1 Yield Spreads over Benchmark Rates

Components of YTM.

Benchmark yield (often a govt. bond yield).

Spread (difference b/w YTM & benchmark).

Benchmark captures macroeconomics factor (e.g. inflation business cycle etc.) while spread capture
microeconomic factors (credit quality & liquidity etc.).
Spread

Risk Premium

Taxation
Liquidity
Credit Risk

Benchmark

Risk-Free" Rate of
Return

Expected Inflation
Rate
Expected Real
Rate

Reference: Level I Curriculum, Volume 5, Reading 54, Page 437

Benchmark spread is usually measured in basis points.

G spread yield spread in basis points over a govt. bond.

I spread yield spread of a bond over the standard swap rate in that currency of the same tenor.

5.2 Yield Spreads over the Benchmark Yield Curve

Z-spread constant spread that is added to each spot rate such that
the present value of cash flows matches the price of the bond.

Option adjusted spread (callable bond) z spread call option value.

Copyright FinQuiz.com. All rights reserved.