RSM332

Fixed Income Security

Instrument that pays off regular or fixed interest payments and repayments of the principal when the security reaches maturity

Bond

Legally binding contract between and borrower (bond issuer) and a lender (bondholder)

Zero-coupon bond

pays only one future CF, principal (FV) F on maturity date, pays no interim CF

Coupon Bond

Pays principal F at maturity (100% of principal, we assume F=$100), additionally it also pays coupons every 6 months, or as designated

Yield-to-Maturity (Yield)

'average discount rate' that accounts for all the r_t's

The required rate of return on the bond

can price a bond with either yield or spot rates

is the discount rate y that equate the observed price to the present value of cash flows

or the IRR

Spot Rates

r_t is the appropriate rate to discount any (risk-free) cash floe that happens at time t

each period should have a different discount rate

Nominal Bonds

most popular and promise nominal $, the yield compensates investors for both real (y^r )and nominal (pi) opportunity cost
y^$=y^r+E[pi]

Real (or indexed) Bonds

Growing in popularity, they promise real dollars, that is, they adjust for inflation, no need to compensate the investor for inflation y=y^r

Breakeven Inflation Rate

difference between the nominal and real bond, measure of what investor require as compensation for future inflation

market based measure of expected inflation

E[pi]=y^$-y^r

Bond Trades at Par

P=F
y=c

Bond Trades at Premium

P>F
y<c

Bond Trades at a Discount

P<F
y>c

Forward Rate

is the rate for some future period as expected today

is the rate you can lock into today for investing/borrowing in the future

short term

Term Structure

relation between time to maturity (horizontal axis) and spot rates (vertical axis)

once plotted this is a yield curve

Expectations Hypothesis

forward rates are unbiased estimates of expected future spot rates

forward rate = expected one period spot rate

Liquidity Preference Theory

investors prefer securities that pay off sooner rather than later

forward rate = expected spot rate + liquidity preference

Bid Price

price at which you sell

maximum price that the buyer is willing to pay for a security

Ask Price

is the price at which you buy

it is the minimum price that a seller is willing to receive

Short Sell

selling an asset you don't own

Accrued Interest

calculates the share of the interest payment that has accrued to the seller when a trade happens between two coupon payment dates

ie. what was its price right before the coupon was paid

Settlement Date

date at which the trade settles, actual day of the transfer of cash or assets

Dirty Price

actual price paid by the buyer

in the efficient market, it is equal to the present value of future cash-flows

Clean Price

is the price of the bond, excluding the accrued interest

clean price = dirty price - accrued interest

how bonds are typically quoted in North America

Arbitrage

practice of buying and selling equivalent goods or portfolios to take advantage of a price difference

Arbitrage Opportunity

is a situation in which it is possible to make a profit without taking any risk or making any investment

Law of one Price

in competitive markets, assets or portfolios with identical cash flows must have identical prices

Bootstrapping

solving a system of equations, where spot rates are unknown

assumes there is no arbitrage

Modified Duration

measures the percentage change in the value of a bond for a given change in yield

Macaulay Duration

effective maturity of a bond

considers early coupon payments

Mortgage

debt instrument secured by collateral of a specified real estate property

Credit Risk

risk associated with the corporation failing to pay the promised cash flows

in cases of bankruptcy how are creditors able to recover portions of their investment

- renegotiating with the firm for a new repayment schedule

- liquidating some of the firm assets

what does the price of a corporate bond depend on

- promised cash flows
- spot rates
- default risk
- recovery in default

Credit Ratings

companies are assigned rating to measure their risk, depending on various firm characteristics
ie. profitability, outstanding debt

Speculative/Junk Bonds

non-investment grade bonds

Derivative

financial instrument whose payoffs depends on an underlaying asset (e.g stocks, bonds) or a set of assets (index)

Forwards and Futures

agreement to buy or sell and asset at a certain future time for a certain price

Fowards

Traded over the counter
- less customizable
- less liquid
- usually between two parties thus it is customized and not usually universal
- counter party risk

Futures

Traded on exchanges
- standardized
- more liquid
- most contracts are unwound before maturity, seller buys or buyer sells
- is a tradable contract and you can sell it
- Mark-to-market daily - daily settlement process to make sure there is an inflow and outflow of money between the buyer and seller daily to make it hard to walk away
- no counter-party risk

Option

is a contract that gives one party (the option holder) the choice to buy or sell an asset at a specified price at or before a specified time

European Call Option

the right, but not the obligation, to buy the underlaying asset at a specified price and time

European Put Option

is the right but not the obligation to sell the underlaying asset at a specified price and time

American Option

is like a European option but but can be exercised at any time prior to maturity

Call Option

right to buy an asset (S) at maturity T, for a price of X

Put Option

is the right to sell an asset (S), at maturity T, for a price of X

Speculate

taking a risky position with the hope of generating high gains

Hedge

reduce/eliminate the risk of a position
- protect your portfolio against downside risk, you can buy a put for each share of the underlaying asset in your portfolio

Arbitrage

build a portfolio with an underlaying asset that replicated an option payoff and make it risk free

Spreads

constructed from the same type of option (call or puts)

Combinations

constructed by combining puts and calls

Straddle

buy a call and a put with the same strike price

Reverse Straddle

sell a call and a put with the same strike price

Bull Spread

buy a call and sell a call with a higher strike price

Bear Spread

Buy a put and sell a put with a lower strike price