FixedIncome Lect 3

Fixed Income Securities and Derivatives
Introduction to the Valuation of Fixed-Icome Securities
Vladimir Sokolov
ICEF, Higher School of Economics
Fall 2021
Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 1 / 24

Sources of Return
1 The coupon interest payments

Sources of Return

2 Capital gain/loss

Sources of Return

2 Capital gain/loss
Realized when the security matures

Sources of Return

2 Capital gain/loss
Realized when the security is called

Sources of Return

2 Capital gain/loss
Realized when the security is sold prior to maturity

Sources of Return

2 Capital gain/loss
3 Income from reinvestment of interim cash-‡ows

Sources of Return

2 Capital gain/loss
Interest payments

Sources of Return

2 Capital gain/loss
Interest payments
Principal payments prior to stated maturity

Traditional principle of valuation
Step 1. Estimate the expected cash ‡ows

Holding aside the possibility of default it is relatively simple to project
the future cash-‡ows in the case of simple …xed-income bonds

For callable bonds, ‡oating-rate bonds, or mortgage-backed securities it
is necessary to incorporate into analysis how future changes in other
factors may a¤ect future cash ‡ows

Step 2. Determine the appropriate interest rate that should be used to
discount future cash ‡ows

The minimum interest rate that investor should require is the rate
available on the default-free cash-‡ows

The interest rate applied to the discounting should incorporate the
additional risk-premium over the default-free assets which re‡ects risks
associated with a given bond

The interest rate applied to the discounting should incorporate the
additional risk-premium over the default-free assets which re‡ects risks
associated with a given bond
Step 3. Calculate the present value of the expected cash ‡ows to be received
ta time t found in Step 1 using the interest rate determined in Step 2
Expected Cash Flow t
PVt =
(1 + Y )t
Russia 18 valuation with CDS premium 09/28/2015

Russia 18 valuation with CDS premium 11/05/2009

Russia 5-Year CDS price dynamics

The Yield to Maturity Model. Part 1: Market Conventions
Valuing Semiannual Cash ‡ows


For most bonds in the US and Russia the coupon payments are
semiannual. The tricky part is that the bond market convention is to
quote annual interest rates. We can express this in the following
formula which assumes semiannual compounding:
2n
Ci /2 Pp
Pm = ∑ (1 + Y /2)t +
(1 + Y /2)2n
t =1


For most bonds in the US and Russia the coupon payments are
semiannual. The tricky part is that the bond market convention is to
quote annual interest rates. We can express this in the following
formula which assumes semiannual compounding:
2n
Ci /2 Pp
Pm = ∑ (1 + Y /2)t +
(1 + Y /2)2n
t =1
Pm is the current market price; Ci is the annual coupon; Y is the

yield to maturity for this bond issue; Pp is the par value of the bond;
n - number of years to maturity

Market Conventions (cont.)
To illustrate consider a 7% coupon 8-year bond with the current

market price $94.17. The semiannual discount rate for this bond is 4%
16
$3.5 $100
$94.17 = ∑ (1 + 0.04)t +
(1 + 0.04)16
t =1

Market Conventions (cont.)
To illustrate consider a 7% coupon 8-year bond with the current

market price $94.17. The semiannual discount rate for this bond is 4%
16
$3.5 $100
$94.17 = ∑ (1 + 0.04)t +
(1 + 0.04)16
t =1
The market convention adopted to annualize the semiannual yield is

to double it and call it yield to maturity (Y-to-M). Thus the Y-to-M
above is 8%. Doubling the semiannual yield is called a
bond-equivalent yield.

The Bond-Equivalent Yield Convention
Two questions are most commonly asked:

Why the practice of simply doubling the semiannual yield is followed?


Wouldn’t it be more appropriate to compute the e¤ective annual yield
by compounding the semiannual yield as follows:
e¤ective annual yield = (1 + semiannual yield )2 1



First answer: this is just the convention. Once you are given the
quoted bond-equivalent of 6% you can get the semiannual yield of 3%
and compute any other measures desired



First answer: this is just the convention. Once you are given the
quoted bond-equivalent of 6% you can get the semiannual yield of 3%
and compute any other measures desired
Second answer: the traditional valuation approach of having a single
interest rate for discounting is very limited, hence it’s not good for
investment decisions. The bond-equivalent yield is convenient for
quoting

Valuing a Bond Between Coupon Payments
A complication arises when we try to price a bond between coupon

payments.

Valuing a Bond Between Coupon Payments
A complication arises when we try to price a bond between coupon

payments.
The interest earned by the seller is called accrued interest. At the

time of purchase the buyer must compensate the seller. If price of the
bond includes the accrued interest it is called the full price. If the
accrued interest is deducted it is called the clean price

Valuing a Bond Between Coupon Payments (cont.
In order to compute the full price it is necessary to determine the

fractional periods between the settlement date and the next coupon
payment date
days between settlement date and next coupon payment date

w=
days in coupon period

Valuing a Bond Between Coupon Payments (cont.
In order to compute the full price it is necessary to determine the

fractional periods between the settlement date and the next coupon
payment date
days between settlement date and next coupon payment date

w=
days in coupon period
The present value of a cash-‡ow to be received at time t assuming
that the …rst coupon payment is w periods from now is calculated
following the so-called "street method":
expected cash ‡owt

PVt =
( 1 + Y ) t 1 +w

Example of full and clean price calculations
We have 10% coupon bond with 5 semiannual coupons remaining. Assume
that there are 78 days between the settlement date and the next coupon
payment date; there are 182 days in the coupon period. Also assume the 8%
annual discount rate:

78
We can get w = 182 = 0.4286 And obtain the full price:
$5 $5 $105
Pm = 0.4286
+ 1.4286
+...+ = $106.8192
(1.04) (1.04) (1.04)4.4286

78
$5 $5 $105
Pm = 0.4286
+ 1.4286
+...+ = $106.8192
(1.04) (1.04) (1.04)4.4286
The accrued interest is calculated:
AI =semiannual coupon payment x (1-w)
$5 x (1 0.4286) = $2.8570

78
$5 $5 $105
Pm = 0.4286
+ 1.4286
+...+ = $106.8192
(1.04) (1.04) (1.04)4.4286
The accrued interest is calculated:
AI =semiannual coupon payment x (1-w)
$5 x (1 0.4286) = $2.8570
The clean price is:
$106.8192 $2.8570 = $103.9622

Russia 18 Yield Screen 09/28/2015

Russia 18 Bloomberg Yield Screen 11/05/2009

The Yield to Maturity Model. Part 2: Limitations of the
Y-to-M measure.
The yield to maturity model considers all 3 sources of income
speci…ed above, however, it assumes that the coupon payments
received are reinvested at an interest rate equal to the yield to
maturity. Some authors call it Y-to-M a Promised Yield to Maturity.
For example if Y-to-M of a bond is quoted at 8% but in order to
actually realize such yield investor must reinvest all future coupons
received at 8%. If this is not the case then the Realized Yield to
Maturity at the end of your investment will di¤er from the Promised
Yield to Maturity at the beginning

The Yield to Maturity Model. Part 2: Limitations of the
Y-to-M measure.
The yield to maturity model considers all 3 sources of income
speci…ed above, however, it assumes that the coupon payments
received are reinvested at an interest rate equal to the yield to
maturity. Some authors call it Y-to-M a Promised Yield to Maturity.
For example if Y-to-M of a bond is quoted at 8% but in order to
actually realize such yield investor must reinvest all future coupons
received at 8%. If this is not the case then the Realized Yield to
Maturity at the end of your investment will di¤er from the Promised
Yield to Maturity at the beginning
The model assumes 2 things:
1). All future coupons are reinvested at quoted Y-to-M. However,
investor will reinvest coupons at the prevailing future interest rates
2). The bond is held to maturity. However, investor can sell the bond
prior to maturity and realize the capital gain or loss. As a result the
realized return will di¤er from the promised return
Zeroes
For the analytics of …xed income valuation and risk management, it is

convenient to unpack the original government coupon bonds into
individual zero-coupon bonds, or zeroes— bonds with a single cash
‡ow equal to face value at maturity.

Zeroes

Let dt denote the price today of the t-year zero, the asset that pays
o¤ $1 in t years.

Zeroes

o¤ $1 in t years.
I.e., dt is the price of a t-year zero as a fraction of par value.

Zeroes

o¤ $1 in t years.
I.e., dt is the price of a t-year zero as a fraction of par value.
This is also called the t-year “discount factor.”

The Arbitrage-free Valuation Approach
The fundamental ‡aw of the traditional approach is that it views each

security as the same package of cash ‡ows and discounts them at the same
discount rate


discount rate
The proper way to view the coupon bond as a package of zero-coupon
bonds whose maturity value is equal to the amount of the cash ‡ow and
whose maturity date is equal to each ‡ow’s payment. For example one 10
year 10% coupon bond can be viewed as 20 zero coupon bonds


discount rate
The reason this is a proper way to value bonds is that this does not allow to
make arbitrage pro…ts by "striping" a bond and selling securities at a higher
aggregate value. On the opposite side one could collect existing zero-coupon
bonds and "reconstitute" a coupon-bearing bond


discount rate
The reason this is a proper way to value bonds is that this does not allow to
make arbitrage pro…ts by "striping" a bond and selling securities at a higher
aggregate value. On the opposite side one could collect existing zero-coupon
bonds and "reconstitute" a coupon-bearing bond
This is called the arbitrage-free valuation approach. In order to implement
this approach one needs to determine the theoretical rates on zero-coupon
bonds of all maturities. For the US Treasury market this rate is called the
Treasury Spot Rate
Valuation Using Treasury Spot Rates
For the purpose of illustration consider the hypothetical spot rate curve for 5
years. It is assumed that for each period there exists traded zero-coupon
bond which rate of return is represented by the spot rate in the table. Dollar
value of cash ‡ow is arbitrary (60 $ is an example here)
Spot Cash Discount
Period Years PV ($)
Rate (%) Flow ($) Factor dt
1 0.5 5 60 0.9756 58.536
2 1 5.2 60 0.9499 56.994
3 1.5 5.5 60 0.9218 55.308
4 2 5.7 60 0.8937 53.622
5 2.5 5.8 60 0.8668 52.008
6 3 5.9 60 0.8399 50.394
7 3.5 6.1 60 0.8103 48.618
8 4 6.3 60 0.7803 46.818
9 4.5 6.4 60 0.7532 45.192
10 5 6.5 1060 0.7270 770.620
Total $1238.11
Comparing the Yield to Maturity and Spot Rates
Mathematically:
Pm = (C /2) d0.5 + (C /2) d1 + ... + (Pp + C /2) dn =

Mathematically:
Pm = (C /2) d0.5 + (C /2) d1 + ... + (Pp + C /2) dn =
C /2 C /2 Pp + C /2
= + 2
+ ... + =
(1 + r0.5 /2) (1 + r1 /2) (1 + rn /2)n

Mathematically:
Pm = (C /2) d0.5 + (C /2) d1 + ... + (Pp + C /2) dn =
C /2 C /2 Pp + C /2
= + 2
+ ... + =
(1 + r0.5 /2) (1 + r1 /2) (1 + rn /2)n
This equation demonstrates that in order to receive the current
market value of the bond Pm one must use the spot rate curve

Mathematically:
Pm = (C /2) d0.5 + (C /2) d1 + ... + (Pp + C /2) dn =
C /2 C /2 Pp + C /2
= + 2
+ ... + =
(1 + r0.5 /2) (1 + r1 /2) (1 + rn /2)n
In the following step one can use the obtained current prices Pm and
the …xed coupon values in order to calculate the quoted
yield-to-maturity Y

Mathematically:
Pm = (C /2) d0.5 + (C /2) d1 + ... + (Pp + C /2) dn =
C /2 C /2 Pp + C /2
= + 2
+ ... + =
(1 + r0.5 /2) (1 + r1 /2) (1 + rn /2)n
In the following step one can use the obtained current prices Pm and
the …xed coupon values in order to calculate the quoted
yield-to-maturity Y
C /2 C /2 Pp + C /2
= + + ... +
(1 + Y /2) (1 + Y /2)2 (1 + Y /2)n

Comparing the Yield to Maturity and Spot Rates (cont.)
Notice that there exists an in…nite number of spot rate curves that
can generate the given bond price and therefore the given yield to
maturity

maturity
In this context Y-to-M serves two purposes:

maturity
1) Rather than quoting the price of the bond Pm we can quote Y as
there is one-to-one correspondence between them

maturity
1) Rather than quoting the price of the bond Pm we can quote Y as
there is one-to-one correspondence between them
2) Although Y-to-M is an inappropriate measure to value bonds since it
provides a summary of all spot rates that enter the bond price equation

Deriving the Theoretical Spot Rate Curve
The default-free spot rate curve can be constructed from the observed
Treasury Yield curve. The approach used is called bootstrapping
Maturity Coupon Rate Price Y-to-M
0.5 0 96.15 0.08
1 0 92.19 0.083
1.5 0.085 99.45 0.089
2. 0.09 99.64 0.092
2.5 0.11 103.49 0.094
3 0.095 99.49 0.097

Deriving the Theoretical Spot Rate Curve
The default-free spot rate curve can be constructed from the observed
Treasury Yield curve. The approach used is called bootstrapping
Maturity Coupon Rate Price Y-to-M
0.5 0 96.15 0.08
1 0 92.19 0.083
1.5 0.085 99.45 0.089
2. 0.09 99.64 0.092
2.5 0.11 103.49 0.094
3 0.095 99.49 0.097
The 6 month and 1 year T-bills are zero coupon securities. The spot
rates for them are: 0.08 and 0.083 correspondingly. Given these two
rates we can compute the spot rate for a theoretical 1.5 year zero
coupon bond:
4.25 4.25 104.25
+ 2
+ = 99.45
1 + 0.04 (1 + 0.0415) (1 + r3 )3
Deriving the Theoretical Spot Rate Curve (cont.)
Solving we get r3 = 0.04465 or 8.93% on a bond equivalent basis.

Using the same idea we can calculate spot rates for all other future
maturities:
Maturity Y-to-M Theoretical Spot Rate
0.5 0.08 0.08
1 0.083 0.083
1.5 0.089 0.0893
2. 0.092 0.09247
2.5 0.094 0.09468
3 0.097 0.09787


maturities:
0.5 0.08 0.08
1 0.083 0.083
1.5 0.089 0.0893
2. 0.092 0.09247
2.5 0.094 0.09468
3 0.097 0.09787
As shown with a rising YTM curve the theoretical spot rate will
increase at a faster rate


maturities:
0.5 0.08 0.08
1 0.083 0.083
1.5 0.089 0.0893
2. 0.092 0.09247
2.5 0.094 0.09468
3 0.097 0.09787
As shown with a rising YTM curve the theoretical spot rate will
increase at a faster rate
The value of a bond which is priced using the spot rates is called the
arbitrarge-free value

The Market Friction
In practice, prices of Treasury STRIPS and Treasury bonds don’t …t

the pricing relationship exactly

The Market Friction

transaction costs and search costs in stripping and reconstituting

The Market Friction

bid/ask spreads

The Market Friction

bid/ask spreads
Liquidity premium

The Market Friction

bid/ask spreads
Liquidity premium
Note: The terms “bid” and “ask” are from the viewpoint of the
dealer:

The Market Friction

bid/ask spreads
Liquidity premium
dealer:
The dealer buys at the bid and sells at the ask, so the bid price is
always less than the ask.

The Market Friction

bid/ask spreads
Liquidity premium
dealer:
The dealer buys at the bid and sells at the ask, so the bid price is
always less than the ask.
The customer sells at the bid and buys at the ask.

Yield Curve of US Treasury Zero Rates
A “yield curve” summarizes the pricing of bonds of di¤erent maturity

by plotting yields or zero rates for di¤erent maturities. It depicts the
“term structure of interest rates.”

Yield Curve of US Treasury Zero Rates
A “yield curve” summarizes the pricing of bonds of di¤erent maturity

by plotting yields or zero rates for di¤erent maturities. It depicts the
“term structure of interest rates.”
This graph plots the zero rates implied by Treasury coupon bond
prices (line), and the actual traded Treasury STRIPS rates (dots).

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Fixed Income Securities and Derivatives

Introduction to the Valuation of Fixed-Icome Securities

ICEF, Higher School of Economics

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 1 / 24

1 The coupon interest payments

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 2 / 24

1 The coupon interest payments

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 2 / 24

1 The coupon interest payments

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 2 / 24

1 The coupon interest payments

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 2 / 24

1 The coupon interest payments

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 2 / 24

1 The coupon interest payments

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 2 / 24

1 The coupon interest payments

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 2 / 24

1 The coupon interest payments

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 2 / 24

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 3 / 24

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 3 / 24

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 3 / 24

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 3 / 24

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 3 / 24

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 3 / 24

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 4 / 24

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 5 / 24

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 6 / 24

Valuing Semiannual Cash ‡ows

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 7 / 24

Valuing Semiannual Cash ‡ows

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 7 / 24

Valuing Semiannual Cash ‡ows

Pm is the current market price; Ci is the annual coupon; Y is the

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 7 / 24

To illustrate consider a 7% coupon 8-year bond with the current

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 8 / 24

To illustrate consider a 7% coupon 8-year bond with the current

The market convention adopted to annualize the semiannual yield is

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 8 / 24

Two questions are most commonly asked:

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 9 / 24

Two questions are most commonly asked:

e¤ective annual yield = (1 + semiannual yield )2 1

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 9 / 24

Two questions are most commonly asked:

e¤ective annual yield = (1 + semiannual yield )2 1

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 9 / 24

Two questions are most commonly asked:

e¤ective annual yield = (1 + semiannual yield )2 1

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 9 / 24

A complication arises when we try to price a bond between coupon

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 10 / 24

A complication arises when we try to price a bond between coupon

The interest earned by the seller is called accrued interest. At the

Vladimir Sokolov (ICEF) Fixed Income Securities 1/11 10 / 24

In order to compute the full price it is necessary to determine the