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Introduction
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Learning Objectives
After reading this chapter, you will understand the fundamental features of bonds the types of issuers the importance of term to maturity of a bond floating rate and inverse-floating rate securities what is meant by a bond with an embedded option and the effect of an embedded option on a bonds cash flow the various types of embedded options
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall
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Learning Objectives
(continued)
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Bond Basics
Bond are debt instruments Issuers (debtors) promise to repay the amount borrowed from investors plus interest over a specified period of time
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Bond Sectors
Treasuries and agencies Municipals (includes states, cities and others) Corporates (includes asset-backed securities) Mortgages (commercial and residential) : passthroughs, collateralized mortgage obligations, stripped mortgage backed securities
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Bond Features
Types of issuers: Federal government and its agencies Municipal governments Corporations Term to maturity Short term: 1-5 years Intermediate: 5-12 years Long term: 13 years + The term to maturity tells investors how long they will receive coupon interest and how long before they are repaid; it also affects the yield as market rates change
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall
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Bond Risks
Credit risk: risk investor will not get principal back Interest rate risk: market risk of price changes Reinvestment risk: risk that coupon payments may be reinvested at a different rate than the coupon Inflation risk: purchasing power risk Call risk: shortened maturity Exchange rate risk (for non $ bonds) Liquidity risk: marking to market Volatility risk: greater volatility enhances value of embedded options Risk risk: uncertainty of bond market innovations
Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall
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Bond Trading
Original issue securities Secondary markets
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