Fixed Income Securities

1
Fixed Income Securities and their Derivatives
2
Introduction
3
Course Introduction

• Goal To provide participants with a working
  knowledge of
• Fixed income markets
• Interest rates
• Interest rate derivatives

4
Course Introduction

• Method Focus on practice
• Lectures
• Examples
• Reviews
• Quick-checks
• Exams

5
Course Overview

• Part I Fixed income markets
• Money markets
• Bond markets and bond pricing
• Bond price volatility
• Interest rates and the term structure
• Bond portfolio management
• Exam I

6
Course Overview

• Part II Derivatives
• Asset-backed securities
• Option pricing
• Pricing bonds with embedded options
• Interest rate futures
• Interest rate options
• Interest rate swaps and FRAs
• Exam II

7
Course Materials

• Textbook
• Bonds and Bond Derivatives, by Miles Livingston
• Software
• Microsoft Excel spreadsheets
• How to contact me
• Email spindt_at_mailhost.tcs.tulane.edu
• Web http//elvis.sob.tulane.edu

8
Objectives for Session 1

• To understand what are fixed income securities
• To see how fixed income securities are traded
• To identify the important players in fixed
  income markets
• To understand what are fixed income derivatives

9
Whats Fixed Income?

• Fixed income securities
• Financial claims
• Principle and possibly coupons
• Contractually defined cash flows
• Default provisions
• Covenants

10
Whats Fixed Income?

• In other words

Fixed income securities are debt contracts
11
Example

• Commercial paper
• Unsecured promissory note
• Specific maturity short-term
• Pays the face amount at maturity
• Sold at a discount
• Issued by corporations

12
Example

• Coupon bond
• Specifies periodic payments (coupons) until
  maturity
• At maturity, principal amount is repaid
• Sold at or near par
• May be secured or unsecured
• Governed by an indenture
• Issued by various agencies

13
Bond Example

• 11.75 Republic of Columbia dollar bond of
  02-25-20
• Issued 750 million principal 02-25-00
• Pays 11.75/2 5.875 semi-annually
• Matures 02-25-20
• Repays principal at maturity
• Is not callable

14
Example

• Amortizing bond
• Periodic payments include interest and principal
• Principal is repaid over time
• Payments may be level or variable
• Mortgage loans are typically amortizing

15
Review

• Types of cash flows

16
Review

• Types of cash flows

17
Review

• Types of cash flows

A 180-month level pay amortizing bond
18
Risks

• Fixed income securities involve risk as well as
  return
• Credit risk
• Interest rate risk
• Liquidity risk
• Other risks

19
Bond Ratings
20
Quick Check

• What are fixed income securities?
• Describe three types of fixed income cash flows.
• Identify the key risks associated with fixed
  income securities.
• What are bond ratings?

21
Fixed Income Markets

• The money market
• Short-term, highly liquid, low risk
• Wholesale trading
• The bond market
• Long term, varied liquidity, varied risk
• Wholesale and retail trading

22
New Issues

• New issues are sold in the primary market
• Issuers sell FI securities to raise money
• Debt v. Equity (cost flexibility purpose)
• Sellers include
• Sovereign governments
• Other governmental units
• Quasi-government agencies
• Corporations

23
New Issues

• New issues are sold in the primary market
• Purchasers buy FI securities to invest money
• Debt v. Equity (risk/return cash flow timing)
• Investors include
• Institutions
• Financial corporations
• Non-financial corporations
• Wealthy individuals

24
Placing New Issues

• Some new issues are sold directly to investors
• Auctions US government bonds or CETES
• Negotiated sale Federal funds, Eurodollars
• Most bond issues are sold indirectly to investors
• Firm commitment underwriting
• Best efforts sale
• Private placements
• Rule 144a

25
Auctions

• Call auctions
• Values and information
• Open outcry
• English (ascending price)
• Dutch (descending price)
• Sealed bid
• first or second price
• discriminatory
• Winners curse

26
Example T-Bill Auction

• Schedule
• Tenders
• Noncompetitive
• Competitive
• Allocation rule
• top price
• stop-out price
• average price
• Tail and cover

27
Example T-Bill Auction
28
Example T-Bill Auction
29
Example T-Bill Auction
30
Underwritten Offerings

• Presale activities
• SEC registration
• The road show
• Pricing
• At the offering date
• Purchase by underwriter
• Distribution to investors

31
Seasoned Issues

• Traded in the secondary market
• Organized exchanges
• Centralized trading post members only
• Listing rules
• NYSE specialist system
• OTC market
• Dealers
• Automated quoting systems

32
Market Making

• Price quotes
• inside market
• outside market
• Dealer inventories
• trading needs
• informational problems
• financing considerations
• The bid-ask spread
• depth

33
Quick Check

• Who are the main players in the fixed income
  market?
• Describe the US Treasury bill auction process.
• What role do underwriters play in the primary
  market for fixed income securities?
• How is the secondary market for fixed income
  securities organized?

34
Derivatives

• Whats a derivative?
• A security whose value derives from the value of
  some other security
• Examples
• Asset-backed securities (cash-flow derivatives)
• Options
• Forwards, Futures, Swaps

35
Next Money Markets