Computational Finance

Lecture 2 Part 1 Fixed Income Securities: Bonds

Main Contents

Interest theory:

Simple and compounding interests Discount

Bond Details:

Pricing and yields Default Risk and Credit Ratings Credit Default Swaps

2.1 Interest Theory

Time Value of Money

$1 today is worth more than $1 in 1 year Interest () as a measure of time value of money:

simple interest () compounding interest ()

Simple Interests

Suppose that you invest $1 for years with interest per annum. After years, under the rule of simple interest you will have:

Discretely Compounding Interests

Compound interest means interest on interest.

Suppose that you invest $1 for years with interest per annum, but under a compound scheme

After 1 year, you will have: After 2 years, you will have After years:

Compounding at Various Intervals

The compounding periods of interest rates may not be the same as the periods that they are quoted. e.g., compounding frequency is semiannually and the interest rate is 10% per year.

After 1 year,
After 2 years,

Compounding at Various Intervals

In general, if an interest rate is per year and the rate is compounded times per year, the total amount will be

after n years if we invest $1 now.

Nominal interests () and effective interests ()

Continuously Compounded Interests

As compounding more and more frequent, i.e., as , where Continuously compounded interest: Suppose that you invest $1 with continuously compounded interest rate. After years, you will have
We use continuously compounded interests only in the class

Present Values

Interest rates facilitate the comparison of (deterministic) cash flow at different time.

$1000
Discounting

$1100

Now

1 year

Present Values of Cash flow Streams

If an amount interest rate is

is to be received in 1 year and the , then the present value is

A cash flow stream:

2.2 Bond Pricing and Yields

Fixed Income Securities

Fixed income securities are financial instruments that promise to the holder a fixed stream of income or a stream of income that is determined according to a specified formula over a span of time. They are an important fund-raising tool for governments, corporations, and even individuals. Bonds are a typical example of such securities.

U.S. Credit Market Instruments as of 2008 Quarter 3

U.S. Stock Market (Common): $19,648 billion U.S. Credit Market Debt: $51,796bn
Debt by Selected Major Borrowers (Not Exhaustive List):

U.S. Government Securities (Includes Agency & GSE):

$13,850bn (27%) Corporate & foreign bonds: $11,262bn (22%) Municipal bonds: $2,669bn (5%) Mortgage: $14,720bn (28%)

%s are percent of Total U.S. Credit Market Debt, source is Federal Reserve Flow of Funds

Bond Characteristics

Bonds () are a kind of financial instruments issued by government or corporations to borrow money from the public. Bonds usually obligates the issuer to make periodic interest payments to the bondholder, called coupon () payments. At the maturity () of a bond, the issuer repays the principal, called the par value or the face value (), to the bondholder.

Bond Example

To illustrate, suppose that you bought a 2-year HK government bond with a par value of $1, 000 and a coupon rate of 8%. It costs you $1,000. That means, you just lent $1,000 to HK government for 2 years. In return, the government is obligated to repay you $80 per year for the stated life of the bond. At the end of the 2-year life of the bond, the government needs to repay $1,000 to you.

Another Example

HK government started to issue 3-year inflationindex bonds () in July 2011. The par value of one bond is $10,000. It pays coupons semiannually and the coupon rate depends on the inflation rate of the latest six month.

Bond Pricing

For investors, bonds are an important investment vehicle because they are traded frequently in the market. We need to know how to determine its value when trading.

Bond Pricing

Interest rate: Face Value: Coupon rate:

per annum

Principal Coupons Coupon

Example

Suppose that a 2-year bond with a par value of $100 provides coupon at the rate of 6% per annum semiannually. The interest rate is 5% per year. What should the bond be sold at? See attached excel file.

Bond Prices, Interest Rates, and Time-toMaturity

Bond price and market interest rate is inversely related. Keeping all other factors the same,

the bond price will rise when interest rate falls bond price will fall when interest rate rises.

The longer the maturity of the bond, the greater the sensitivity of its price to fluctuations in the interest rate.

Bond Prices at Different Interest Rates

Use one numerical example to illustrate the previous slide: 8% coupon bond, coupon paid semiannually, face value $1,000
Time-to-maturity
1 Year 10 Years 20 Years 30 Years

2%
$1059.11 1541.37 1985.04 2348.65

4%
$1038.83 1327.03 1547.11 1695.22

6%
$1019.13 1148.77 1231.15 1276.76

8%
$1000 1000 1000 1000

10%
$981.41 875.38 828.41 810.71

Bond Yields

The yield to maturity () of a bond is defined as the discount rate that makes the present value of the bonds payments equal to its price. In other words, find such that For example, find YTM to the following bond: Bond A: 2-year, sold at $101.76, paying 6% coupon semiannually, face value = $100

Bond Yields

Bond A: Therefore, the yield is 5% per year. This equation can be solved using a trial and error procedure.

2.3 Default Risk

Default Risk and Bond Pricing

Although bonds generally promise a fixed flow of income, that income stream is not riskless. If the issuing company or government goes bankrupt, the bondholder will not receive all the payments they have been promised. We refer this uncertainty as the default risk.

Default Risk and Bond Pricing

This default risk affects the price of a bond (or equally, the YTM of a bond).
Price Coupon Rate Maturity 2016 2016 YTM 4.846% 5.035%

Treasury Note 105.74 5.125% Emerson Elec co. 101.80 5.125% (Yahoo! Finance, Sept. 16, 2007)

Default Risk and Bond Pricing

YTM difference in the US bond market:

Default Risk and Bond Pricing

YTM difference in the Canadian bond market:

Default Risk Premium

To compensate for the possibility of default, corporate bonds are usually sold at a YTM higher than Treasury bonds. The difference is known as default premium.

If the firm remains solvent and actually pays the investor all of the promised cash flows, the investor will realize a higher yield. If, however, the firm goes bankrupt, the corporate bond is likely to provide a lower return than the government bond.

Credit-Rating Agencies

In the financial world, some investment advisory firms provide credit quality information of corporate and municipal bonds to the public. They are known as credit-rating agencies. Several famous agencies:

Standard & Poors () Moodys () Fitch Rating ()

Credit-Rating Agencies

Some grades used by credit rating agencies:

Moodys Aaa Aa A Baa Ba B Caa C -

2.4 Credit Default Swaps

Credit Default Swaps

The seller of the swap collects an annual premium (and sometimes an upfront fee) from the swap buyer. The buyer of the swap collects nothing unless the bond issuer or loan borrower defaults, in which case the seller of the swap essentially pays the drop in value from par to the swap buyer.

Credit Default Swaps

Cash flow illustration:

Pricing of CDS

CDS was originally designed to allow lenders to buy protection against losses on sizable loans. The natural buyers would be large bondholders or banks that had made large loans. An investor holding a bond with a BB rating could in principle raise the effective quality of the debt to AAA by buying a CDS. Therefore, the fair CDS premium should be the yield spread between BB and AAA-rated bonds.

CDS Premium in the Crisis

CDS as a Speculation Tool

CDSs can be used to speculate on financial health of firms.

Swap buyer need not hold the underlying bond or loan. Someone in August 2008 wishing to bet against the financial sector might have purchased CDS and have profited as CDS premium spiked in September. At their peak there were reportedly $63 trillion worth of CDS; US GDP is about $14 trillion.

CDS, Systemic Risk, and The Credit Crisis of 2008

Transactions of CDSs are accomplished largely in the Over-the-Counter (OTC, ) market. Therefore, this product lacks of transparency. As the subprime-mortgage market collapsed in 2008, the potential obligations on these contracts ballooned to such levels that the ability of CDS sellers to honor their commitments was in doubt. AIG, counterparty risk and systemic risk.

New Regulations on CDS

New regulations on CDS will be implemented

CDS contracts will be required to be traded on an exchange with collateral requirements to limit risk. Exchange trading will increase transparency of positions of institutions.