Fixed income securities

Debt Financing In practice, debt financing covers a variety of fixed-income securities, both long-term and short-term. The most common forms of long-term debt are bonds, mortgages, and debentures. 

Jarrow, R., 1996. ModeUmg Fixed Income Securities and Interest Rate Options. McGraw-Hill, New York. 

Introduction to European Fixed Income Securities and Markets... 

The cash flows of a fixed-income security can be denominated in any currency. For bonds issued by countries within the European Union, the issuer typically makes both coupon payments and maturity value payments in euros. However, there is nothing that prohibits the issuer from making payments in other currencies. The bond s indenture can specify that the issuer may make payments in some other specified currency. There are some issues whose coupon payments are in one currency and whose maturity value is in another currency. An issue with this feature is called a dual-currency issue. 

RISKS ASSOCIATED WITH INVESTING IN FIXED INCOME SECURITIES... 

Risk can thought of as the possibility of unpleasant surprise. Fixed-income securities expose the investor to one or more of the following types of risk (1) interest rate risk (2) credit risk (3) call and prepayment risk (4) exchange rate risk (5) liquidity risk and (6) inflation or purchasing power risk. 

A fundamental property is that an upward change in a bond s price results in a downward move in the yield and vice versa. This result makes sense because the bond s price is the present value of the expected future cash flows. As the required yield decreases, the present value of the bond s cash flows will increase. The price/yield relationship for an option-free bond is depicted in Exhibit 1.9. This inverse relationship embodies the major risk faced by investors in fixed-income securities—interest rate risk. Interest rate risk is the possibility that the value of a bond or bond portfolio will decline due to an adverse movement in interest rates. 

Cash flow is simply the cash that is expected to be received in the future from owning a financial asset. For a fixed-income security, it does not matter whether the cash flow is interest income or repayment of principal. A security s cash flows represent the sum of each period s expected cash flow. Even if we disregard default, the cash flows for some fixed-income securities are simple to forecast accurately. Noncallable benchmark government securities possess this feature since they have known cash flows. For benchmark government securities, the cash flows consist of the coupon interest payments every year up to and including the maturity date and the principal repayment at the maturity date. 

Many fixed-income securities have features that make estimating their cash flows problematic. These features may include one or more of the following ... 

Once we estimate the cash flows for a fixed-income security, the next step is to determine the appropriate interest rate for discounting each cash flow. Before proceeding, we pause here to note that we will once again use the terms interest rate, discount rate, and required yield interchangeably throughout the chapter. The interest rate used to discount a particular security s cash flows will depend on three basic factors (1) the level of benchmark interest rates (2) the risks that the market perceives the securityholder is exposed to and (3) the compensation the market expects to receive for these risks. 

The source of dollar return called reinvestment income represents the interest earned from reinvesting the bond s interim cash flows (interest and/or principal payments) until the bond is removed from the investor s portfolio. With the exception of zero-coupon bonds, fixed income securities deliver coupon payments that can be reinvested. Moreover, amortizing securities (e.g., mortgage-backed and asset-backed securities) make periodic principal repayments which can also be invested. 

It is a fact that bond yields and bond prices possess predictable behaviour patterns. Several well-documented rules have been established that can assist a fixed income security analyst/portfolio manager in deciding which bonds to hold in a portfolio given a future potential interest rate scenario and the goal of the portfolio. 

This chapter explores interest rate options—a vitat part of the European fixed income securities market. The first section tooks at exchange-traded options, where 20 bittion worth of bond options and over 250 billion of options on short-term rates change hands every day. Next, we ll look at the flexible OTC markets for interest rate options, including caps, collars, swaptions, and structured products. Finally, having explained the products themselves, we ll move on to explore how they can be used to hedge interest rate risk. 

Source Robert F. Kopprasch, John Macfarlane, Daniel R. Ross, and Janet Showers, The Interest Rate Swap Market Yield Mathematics, Terminology, and Conventions, Chapter 58 in Frank J. Fabozzi and Irving M. Pollack (eds.). The Handbook of Fixed Income Securities (Fiomewood, IL Dow Jones-Irwin, 1987). 

The first section describes the motivation for using the swap term structure as a benchmark for pricing and hedging fixed-income securities. The second section examines the factors that affect swap spreads and swap market flows. The third section describes a swap term structure derivation technique designed to mark to market fixed-income products. Finally, different aspects of the derived term structure are discussed. 

The complete term structure is formed by joining together the different parts of the swap term structnre using the chosen interpolation methodology. The resnlt is a complete swap term structure that is a fundamental tool in marking to market fixed-income securities. 

For more details, see Lionel Martellini, Stephane Priaulet, and Philippe Priaulet, Fixed-Income Securities Valuation, Risk Management and Portfolio Strategies (Hoboken, NJ John Wiley C Sons, Inc., 2003). 

L. Martellini and P. Priaulet, Fixed-Income Securities Dynamic Methods for Interest Rate Risk Pricing and Hedging (New York John Wiley 8c Sons, 2000). France (1995-98)—Spot ZC IM-lOY 3 66.64/20.52/6.96... 

The Monte Carlo method, however, is prone to model risk. If the stochastic process chosen for the underlying variable is unrealistic, so will be the estimate of VaR. This is why the choice of the underlying model is particularly important. The geometric Brownian motion model described above adequately describes the behavior of some financial variables, but certainly not that of short-term fixed-income securities. In the Brownian motion, shocks on prices are never reversed. This does not represent the price process for default-free bonds, which must converge to their face value at expiration. 

Fixed Income Securities, Second Edition by Frank J. Fabozzi Focus on Value A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate... 

Introduction to European Fixed Income Securities and Markets Moorad Choudhry, Frank J. Fabozzi, and Steven V. Mann... 

As discussed in chapter 1, there are two types of fixed-income securities zero-coupon bonds, also known as discount bonds or strips, and coupon bonds. A zero-coupon bond makes a single payment on its maturity date, while a coupon bond makes interest payments at regular dates up to and including its maturity date. A coupon bond may be regarded as a set of strips, with the payment on each coupon date and at maturity being equivalent to a zeto-coupon bond maturing on that date. This equivalence is not purely academic. Before the advent of the formal market in U.S. Treasury strips, a number of investment banks traded the cash flows of Treasury securities as separate zero-coupon securities. 

A zero-coupon bond is the simplest fixed-income security. It makes no coupon payments during its lifetime. Instead, it is a discount instrument, issued at a price that is below the face, or principal, amount. The rate earned on a zero-coupon bond is also referred to as the spot interest rate. The notation P t, T) denotes the price at time r of a discount bond that matures at time T, where T >t - The bond s term to maturity, T - t, is... 

Tuckman, B. 1996. Fixed Income Securities. New York John Wiley Sons, chap. 17. 

Ames, L. 1997. Mortgage Backed Securities Analysis, in Fabozzi, E, Handbook of Fixed Income Securities, 4th ed. New York McGraw Hill. 

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