FixedIncome Lect 1

Fixed Income Securities and Derivatives
Bond Market Overview
Vladimir Sokolov
ICEF, Higher School of Economics
Fall 2021
Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 1 / 26

Course Outline
1 Introduction to the Valuation of Fixed Income Securities

Course Outline

Overview of the Bond Sectors and Instruments

Course Outline

Classical Measurement of Interest Rate Risk

Course Outline

The Term Structure of Interest Rates

Course Outline

2 Arbitrage-free Interest Rate Models

Course Outline

The Science of Interest Rate Models

Course Outline

Arbitrage-free Pricing in a Multi-period Setting

Course Outline

3 Valuation of Interest Rate Derivatives

Course Outline

Forwards and Futures, LIBOR products, Swaptions, Caps and Floors

Course Outline

Forwards and Futures, LIBOR products, Swaptions, Caps and Floors
Economics of Securitization, Mortgage Backed Securities, CDOs

Readings
Jarrow R. (2002), Modelling Fixed Income Securities and Interest

Rate Options (2nd Edition), Stanford Economics and Finance

Readings

Hull J. (2006), Options, Futures and Other Derivatives, Sixth Edition,
Pearson International Edition

Readings

Tuckman B. (2002), Fixed Income Securities: Tools for Today’s
Markets, Second Edition, University Edition, Wiley

Readings

Lecture Slides

Readings

Lecture Slides
Supplementary Electronic Materials

Readings

Lecture Slides
Extracts from the e-books, journal articles, major …nancial newspapers
(recommended week by week)

Readings

Lecture Slides
Extracts from the e-books, journal articles, major …nancial newspapers
(recommended week by week)
www.bloomberg.com; www.cbonds.ru; http://moex.ru/

Why study …xed-income securities?

Why study …xed-income securities? Investment Banks
1 Act as underwriters for new bond issuances

2 Create new interest rate derivative products

3 Act as market makers in secondary bond and interest rate product

markets


markets
4 Trade bonds and interest rate products for their own account


markets
4 Trade bonds and interest rate products for their own account
"Goldman Sacks last month reported $2.7bn in second-quarter pro…ts,
re‡ecting record revenues of $6.8bn from trading …xed-income
securities, commodities, currencies and interest rates. People close to
the bank attributed the record quarterly result, …led with the SEC, to a
boom in …xed-income and equity trading."

Value of di¤erent types of assets

Trading volume of di¤erent types of assets

Why study …xed-income securities? Corporate CFOs
“The credit crisis has triggered a permanent shift for companies to fund in
bond markets as opposed to relying on bank loans,” said head of debt
capital markets at Citigroup. “Companies have learnt that in some cases it’s
riskier to borrow from a bank than the bond markets.”

“The credit crisis has triggered a permanent shift for companies to fund in
bond markets as opposed to relying on bank loans,” said head of debt
capital markets at Citigroup. “Companies have learnt that in some cases it’s
riskier to borrow from a bank than the bond markets.”
During the crisis bank often cut the lines of credits to …rms or refused to
roll-over the credit. Borrowing through the bond market reduces possible
"banking relationship" problem for a …rm

Why study …xed-income securities? Bond funds
On a buy-side bonds constitute a signi…cant fraction of portfolios of

di¤erent types of funds


Portfolio managers of mutual funds view bonds as an attractive asset

class in terms of the risk-return pro…le



There are funds that speci…cally specialize in sovereign bonds



There are funds that speci…cally specialize in sovereign bonds
There are specialized funds that focus on distressed debt of …rms and
states

In 2017 open-end funds managed $43 trillion

By 2017 cumulative net open-end Bond funds in‡ow
reached $2.2 trillion

Portfolio Management
Portfolio managers maximize expected return for a given level of risk

and other portfolio constraints
ln order to maximize risk-adjusted return, managers need to

understand risks and returns on the securities they hold and how they
covary with each other and other market factors
For bonds this traditional portfolio analysis needs to be blended with

the understanding of the current and future macroeconomic
environment and central banks’monetary policy

(again)
In addition to raising the new capital corporations can use interest

rate products to:

(again)

rate products to:
1 Hedge interest rate risk (interest rate swaps, caps and ‡oors)

(again)

rate products to:
2 Hedge credit risk (Credit default swaps (CDS), credit linked notes)

(again)

rate products to:
2 Hedge credit risk (Credit default swaps (CDS), credit linked notes)
3 Hedge in‡ation risk (in‡ation swaps)

Notional amount of derivatives

Why study …xed-income securities? A viabrant academic
litreture
Choi, Jaewon and Mathias Kronlund (2018) "Reaching for Yield in

Corporate Bond Mutual Funds," The Review of Financial Studies,
Vol. 31, pp. 1930–1965.

litreture

Vol. 31, pp. 1930–1965.
Cruces, Juan J. and Christoph Trebesch (2013) "Sovereign Defaults:
The Price of Haircuts," American Economic Journal:
Macroeconomics, Vol. 5, pp. 85-117.

litreture

Vol. 31, pp. 1930–1965.
Fang Chuck, Julian Schumacher and Christoh Trebesch (2020)
"Restructuring sovereign bonds: holdouts, haircuts and the
e¤ectiveness of CACs," ECB Working Paper 2366.

litreture

Vol. 31, pp. 1930–1965.
Goldstein Itay, Hao Jiang and David Ng (2017) "Investor ‡ows and
fragility in corporate bond funds," Vol. 126, pp. 592-613.

litreture

Vol. 31, pp. 1930–1965.
Goldstein Itay, Hao Jiang and David Ng (2017) "Investor ‡ows and
fragility in corporate bond funds," Vol. 126, pp. 592-613.
Shek, Jimmy, Ilhyock Shim, and Hyun Song Shin (2018) "Investor
Redemptions and Fund Manager Sales of Emerging Market Bonds:
How Are They Related?" Review of Finance, Vol, 22, pp. 207-241.
De…nition of the Standard Bond
A debt security is a …nancial claim by which the issuer, or the

borrower, is committed to paying back to the bondholder, or the
lender, the cash amount, called principal, plus periodic interests
calculated on this amount during a given period of time
A standard bond is a …xed-coupon bond without any embedded
options, delivering its coupons on periodic dates and principal on the
maturity date
Nonstandard Bonds
Floating-rate bonds
Bonds with embedded options: callable/putable bonds

Terminology and Convention
A bond issue is characterized by the following components:

The issuer’s name and type


The bond currency denomination


The methodology used for the calculation of the bond price


The maturity date


The maturity date
The coupon type/rate/frequency


The maturity date
The day-count type
- Actual/Actual, actual/365, Actual/360


The maturity date
The day-count type
- Actual/Actual, actual/365, Actual/360
The rating

Market Quote conventions
The bond price and a coupon rate are always expresses in percentage
of the bond’s nominal amount

The quoted price is a clean price which means it does not include the
accrued interest on the bond which if it sold between coupon
payments

The quoted price is a clean price which means it does not include the
accrued interest on the bond which if it sold between coupon
payments
The numbers in the quoted price after the hyphen denote 32th . For
example if you see the quote 101-12 3/4 it means that the price is 101
12.75/32 %

Example of bond quoting

Overview of the Bond Market sectors

Bonds by Issuer in the US [Russia]
Government Bonds

Government Bonds
Treasury Securities and Federal Agency Securities [Yes - OFZ]

Government Bonds
Municipal Bonds: State and Local Governments [Yes]

Government Bonds
Corporate Bonds and Commercial Paper [Yes]

Government Bonds
Corporate Bonds and Commercial Paper [Yes]
Asset-Backed Securities [Yes]

Overview of the US Treasury Securities

Overview of the US Treasury Securities (cont.)
Fixed-principal Treasury Securities


T-Bills (maturity up to 12 months)


T-Notes (maturity up to 10 years)


T-Bonds (maturity greater then 10 years)


In‡ation-Index Treasury Securities (TIPS)


Coupons are …xed but the principal is in‡ation adjusted (which is taxed)


Treasury STRIPs


Treasury STRIPs
Until 1985 they were a creation of the private sector


Treasury STRIPs
Until 1985 they were a creation of the private sector
Coupon and principal STRIPS are distinguished due to the tax
consideration by the non-US entities

Overview of the US Federal Agency Securities
Federally-related institutions which are backed by the full faith and

the credit of the US government (Ex., GNMA -Ginnie Mae)

Overview of the US Federal Agency Securities
Federally-related institutions which are backed by the full faith and

the credit of the US government (Ex., GNMA -Ginnie Mae)
Government-sponsored enterprises which are privately owned and were
created by congress to reduce the costs of capital of the certain
sectors of the economy deemed to be important: farmers, students,
homeowners and their debt is not guaranteed by the US government.
They are alos called Quasi-Government Bonds. (Ex. Federal National
Mortgage Association (Fannie Mae)

Overview of the Corporate Debt Securities

Overview of the Corporate Debt Securities (cont.)
Secured Debt

Secured Debt
Mortgage debt bonds

Secured Debt
Mortgage debt bonds
Collateral trust bonds

Secured Debt
Mortgage debt bonds
Unsecured Debt (commonly called debenture bonds)
- Holders have the claim of general creditors on all assets of the issuer
not pledged speci…cally to secure other debt
- Credit enhancement: third-party guarantee, Letter of credit by the
bank

Secured Debt
Mortgage debt bonds
bank
Medium-Term Notes is a debt instrument which is issued continuously
to investors by the issuer. MTNs di¤er from bonds in the manner in
which they are initially sold

Secured Debt
Mortgage debt bonds
bank
Medium-Term Notes is a debt instrument which is issued continuously
to investors by the issuer. MTNs di¤er from bonds in the manner in
which they are initially sold
Commercial Paper is a short-term unsecured promissory note that is
issued on the open market and represents the obligation of the issuing
corporation. Usually it’s a zero-coupon instrument.

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Fixed Income Securities and Derivatives

Bond Market Overview

ICEF, Higher School of Economics

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 1 / 26

1 Introduction to the Valuation of Fixed Income Securities

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 2 / 26

1 Introduction to the Valuation of Fixed Income Securities

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 2 / 26

1 Introduction to the Valuation of Fixed Income Securities

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 2 / 26

1 Introduction to the Valuation of Fixed Income Securities

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 2 / 26

1 Introduction to the Valuation of Fixed Income Securities

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 2 / 26

1 Introduction to the Valuation of Fixed Income Securities

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 2 / 26

1 Introduction to the Valuation of Fixed Income Securities

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 2 / 26

1 Introduction to the Valuation of Fixed Income Securities

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 2 / 26

1 Introduction to the Valuation of Fixed Income Securities

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 2 / 26

1 Introduction to the Valuation of Fixed Income Securities

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 2 / 26

Jarrow R. (2002), Modelling Fixed Income Securities and Interest

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 3 / 26

Jarrow R. (2002), Modelling Fixed Income Securities and Interest

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 3 / 26

Jarrow R. (2002), Modelling Fixed Income Securities and Interest

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 3 / 26

Jarrow R. (2002), Modelling Fixed Income Securities and Interest

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 3 / 26

Jarrow R. (2002), Modelling Fixed Income Securities and Interest

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 3 / 26

Jarrow R. (2002), Modelling Fixed Income Securities and Interest

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 3 / 26

Jarrow R. (2002), Modelling Fixed Income Securities and Interest

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 3 / 26

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 4 / 26

1 Act as underwriters for new bond issuances

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 5 / 26

1 Act as underwriters for new bond issuances

2 Create new interest rate derivative products

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 5 / 26

1 Act as underwriters for new bond issuances

2 Create new interest rate derivative products

3 Act as market makers in secondary bond and interest rate product

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 5 / 26

1 Act as underwriters for new bond issuances

2 Create new interest rate derivative products

3 Act as market makers in secondary bond and interest rate product

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 5 / 26

1 Act as underwriters for new bond issuances

2 Create new interest rate derivative products

3 Act as market makers in secondary bond and interest rate product

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 5 / 26

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 6 / 26

Vladimir Sokolov (ICEF) Fixed Income Securities 10/25 7 / 26