CH 03

Chapter 3
Fixed Income Securities

Road Map
Part A Introduction to finance.

Part B Valuation of assets given discount rates.
• Fixed-Income securities.
• Stocks.
• Forward and futures.
• Options
Part C Determination of discount rates.
Part D Introduction to corporate finance.
Main Issues
• Fixed-Income Markets
• Term Structure of Interest Rates
• Interest Rate Risk
• Hedging Interest Rate Risk
• Inflation Risk
• Credit Risk
3-2 Fixed Income Securities Chapter 3
Contents
1 Motivating Examples . . . . . . . . . . . . . . . . . . . . . . 3-3
2 Fixed-Income Markets . . . . . . . . . . . . . . . . . . . . . 3-5
3 Term Structure of Interest Rates . . . . . . . . . . . . . . . . 3-9
3.1 Spot Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . 3-10
3.2 Discount Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-11
3.3 Coupon Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-12
3.4 Forward Interest Rates . . . . . . . . . . . . . . . . . . . . . . . 3-15
4 Market Conventions . . . . . . . . . . . . . . . . . . . . . . 3-19
4.1 Yield-to-Maturity (YTM) . . . . . . . . . . . . . . . . . . . . . . 3-19
4.2 Pitfalls of YTM. . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-23
5 Measuring Interest Rates . . . . . . . . . . . . . . . . . . . . 3-25
6 Interest Rate Risk and Its Measures . . . . . . . . . . . . . . 3-30
6.1 Duration and Modified Duration . . . . . . . . . . . . . . . . . . 3-32
6.2 Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-36
7 Hedging Interest Rate Risk . . . . . . . . . . . . . . . . . . . 3-39
8 Inflation Risk . . . . . . . . . . . . . . . . . . . . . . . . . . 3-41
9 Default Risk . . . . . . . . . . . . . . . . . . . . . . . . . . 3-42
9.1 Default Premium and Risk Premium . . . . . . . . . . . . . . . . 3-43
9.2 Factors in Determining Default Premium . . . . . . . . . . . . . . 3-45
9.3 Factors in Determining Risk Premium . . . . . . . . . . . . . . . . 3-47
10 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-49
15.407 Lecture Notes Fall 2003

c Jiang Wang
Chapter 3 Fixed Income Securities 3-3
1 Motivating Examples
Example 1. In the tobacco settlement, required payments by the
tobacco companies (in billion dollars):
Year 00 01 02-03 04-07 08 on

Payment 4.5 5.0 6.5 8.0 9.0
The payments total $216.5 billion by Year 2025. Companies

involved have the following capitalization:
Name Market Capitalization

Brooke Group 0.33
Philip Morris 130.16
RJR 9.46
British American Tobacco 27.03
Lowes 11.02
Total 178.00
How can these companies make the payments?
Assuming payments are certain, how do we value them?

c Jiang Wang Fall 2003 15.407 Lecture Notes
Example 2. Personal business – Pension benifits.
Heard Off the Street: For pension benefits, it’s a matter of

interest – as in rates
Ben Boselovic (Monday, April 07, 2003
(This article has been edited for class use.)
Workers worried about whether their how much money to set aside to cover
employers will be able to pay them the their expected obligations. That num-
pension benefits they’ve promised are ber is based on something called the dis-
painfully aware of what the debilitated count rate, basically a conservative esti-
stock market has done to the asset side mate of what a company’s pension fund
of the pension equation. assets will earn over a long period of time
But a lot less ink has been spilled on to cover its long-term retirement obliga-
the liability side of the problem, where tions.
major changes in the works could make For years, the discount rate was
a serious problem a lot less serious with based on 30-year U.S. Treasury bond
the stroke of a pen. rates. They are at historic lows because
A pension plan’s liabilities are based of efforts to jump-start the economy and
on assumptions about how long someone the Treasury’s decision to stop issuing
will work for a company, how much his 30-year bonds. The lower the discount
pay will increase over the course of his rate, the higher a pension fund’s liabili-
career, at what age he will retire and how ties and the more cash companies are re-
long he will live after retiring. Once pen- quired to set aside to cover their pension
sion plan sponsors make a stab at esti- obligations.
mating their liability, he has to figure out
What happens to corporate pension plans when interest rates

move? How to manage the risk?

c Jiang Wang
2 Fixed-Income Markets
Definition: Fixed-income securities are financial claims with
promised cash flows of fixed amount paid at fixed dates.
Classification of Fixed-Income Securities:
1. Treasury Securities
• U.S. Treasury securities (bills, notes, bonds)
• Bunds, JGBs, U.K. Gilts . . .
2. Federal Agency Securities

• Securities issued by federal agencies (FHLB, FNMA . . .)
3. Corporate Securities
• Commercial paper
• Medium-term notes (MTNs)
• Corporate bonds . . .
4. Municipal Securities
5. Mortgage-Backed Securities
6. . . .

Overview of Fixed-income Markets
Composition of U.S. Debt Markets (2001)

Market value %
(in trillion dollars)
Treasury 3.02 16.2
Corporate 3.82 20.5
Mortgage 4.13 22.2
Agency 2.14 11.5
Munies 1.69 9.1
Asset-Backed 1.28 6.9
Money Market 2.54 13.6
Current Trends
T. Corp. MBS Agency ABS Munies MM Total
1995 3.31 1.94 2.35 0.84 0.42 1.29 1.18 11.34
1996 3.46 2.12 2.49 0.93 0.57 1.30 1.39 12.25
1997 3.46 2.35 2.68 1.02 0.78 1.37 1.69 13.35
1998 3.36 2.67 2.96 1.30 1.04 1.46 1.98 14.76
1999 3.28 3.02 3.33 1.62 1.32 1.53 2.34 16.48
2000 2.97 3.37 3.56 1.85 1.61 1.57 2.66 17.60
2001 3.02 3.82 4.13 2.14 1.69 1.28 2.54 18.62

c Jiang Wang
Organization of Fixed Income Market
ISSUERS:
1. Government
2. Corporations
3. Commercial banks
4. States and municipalities
5. Special purpose vehicles
6. Foreign institutions
INTERMEDIARIES:
1. Primary dealers
2. Other dealers
3. Investment banks
4. Credit rating agencies
5. Credit and liquidity enhancers
INVESTORS:
1. Governments
2. Pension funds
3. Insurance companies
4. Commercial banks
5. Mutual funds
6. Foreign institutions
7. Individual investors

Cashflow and Valuation of Fixed-Income Securities
Cash flow:
1. Maturity
2. Principal
3. Coupon.
Example. A 3-year bond with principal of $1,000 and annual

coupon payment of 5% has the following cashflow:
50 50 50 + 1, 000
6 6
-
t=0 1 2 3 time
Valuation:
1. Time-Value
• Interest rates.
2. Risks
• Inflation.
• Credit.
• Timing (callability).
• Liquidity.
• Currency . . ..
c Jiang Wang
3 Term Structure of Interest Rates

Our objective here is to value riskless cash flows.
Given the rich set of fixed-income securities traded in the market,

their prices provide the information needed to value riskless cash
flows at hand.
In the market, this information on the time value of money is

given in several different forms:
1. Spot interest rates.
2. Prices of discount bonds (e.g., zero-coupon bonds and STRIPS).
3. Prices of coupon bonds.
4. Forward interest rates.
The form in which this information is expressed depends on the

particular market.

3.1 Spot Interest Rates
Definition: Spot interest rate, rt, is the (annualized) interest rate

for maturity date t.
• rt is for payments only on date t.
• rt is the “average” rate of interest between now and date t.
• rt is different for each different date t.
Example. On 2001.08.01, the spot interest rates for different
maturities are:
Maturity (year) 1/4 1/2 1 2 5 10 30
Interest Rate (%) 3.52 3.45 3.44 3.88 4.64 5.15 5.57
Definition: The set of spot interest rates for different dates
{r1, r2, . . . , rt, . . .}
gives the term structure of (spot) interest rates, which refers to

the relation between spot rates and their maturities.
Term Structure of Interest Rates
6
5.5
5
interest rate (%)
4.5
3.5
3
0 5 10 15 20 25 30
maturity (years)
2001.08.02 (WSJ)

c Jiang Wang
3.2 Discount Bonds
Discount bonds (zero coupon bonds) are the simplest fixed-income

securities.
Definition: A discount bond with maturity date t is a bond which

pays $1 only at t.
Example. On 2001.08.01, STRIPS are traded at the following

prices:
Maturity (year) 1/4 1/2 1 2 5 10 30

Price 0.991 0.983 0.967 0.927 0.797 0.605 0.187
For the 5-year STRIPS, we have

1 1
0.797 = ⇒ r5 = − 1 = 4.64%.
(1 + r5 )5 (0.797)1/5
Let Bt denote the current price (at date 0) of a discount bond

maturing at t. Then
1 1
Bt = or rt = 1/t
− 1.
(1+rt )t Bt
Prices of discount bonds provide information about spot inter-

est rates and vise versa.

3.3 Coupon Bonds
A coupon bond pays a stream of regular coupon payments and a

principal at maturity.
Observation: A coupon bond is a portfolio of discount bonds.
Example. A 3-year bond of $1,000 par and 5% annual coupon.
50 50 50 + 1, 000
6 6
-
t=0 1 2 3 time
=
50
6(50 1-year STRIPS)
-
t=0 1 2 3 time
+
50
6(50 2-year STRIPS)
-
t=0 1 2 3 time
+ 1050
6(1050 3-year STRIPS)
-
t=0 1 2 3 time

c Jiang Wang
Suppose that the discount bond prices are as follows
t 1 2 3 4 5
Bt 0.952 0.898 0.863 0.807 0.757
What should the price of the coupon bond be?
Price = (50)(0.952) + (50)(0.898) + (1050)(0.863)
= 998.65.
What if not?
Thus, a bond with coupon payments {C1, C2, . . . , CT } and a

principal P at maturity T is composed of
• Ct units of discount bonds maturing at t, t = 1, . . . , T
• P units of discount bond maturing at T .
The price of a coupon bond must be

T
B = (Ct × Bt) + (P × BT )
t=1
C1 CT −1 CT +P
= + ··· + + .
1+r1 (1+rT −1 )T −1 (1+rT )T

Example. Measuring term structure from coupon bond prices.
Years to Maturity 1 2
Face Value 1,000.0 1,000.0
Coupon Rate (%) 5.0 8.0
Current Price 997.5 1048.0
(a) Price of 1 year bond:
997.5 = B1 × (50 + 1000) ⇒

997.5
B1 = = 0.95
1050
r1 = = 5.26%.
(b) Price of 2 year bond:
1048 = (80)(0.95) + B2 × 1080 ⇒

972
B2 = = 0.90
1080
r2 = 5.41%.
How to replicate 1- and 2-year discount bonds from coupon

bonds?

c Jiang Wang
3.4 Forward Interest Rates
So far, we have focused on spot interest rates: rates for a

transaction between today, 0, and a future date, t.
Now, we study forward interest rates: rates for a transaction

between two future dates, for instance, t1 and t2.
For a forward transaction to borrow money in the future:
• Terms of transaction is agreed on today, t = 0
• Loan is received on a future date t1
• Repayment of the loan occurs on date t2.
Note:
Future spot rates can be different from current corresponding

forward rates.

Example. As the CFO of a U.S. multinational, you expect to

repatriate $10 M from a foreign subsidiary in 1 year, which will
be used to pay dividends 1 year later. Not knowing the interest
rates in 1 year, you would like to lock into a lending rate one year
from now for a period of one year. What should you do?
The current interest rates are

t 1 2
rt 0.05 0.07
Strategy:
1. Borrow $9.524 M now for one year at 5%
2. Invest the proceeds $9.524 M for two years at 7%.
Outcome (in million dollars):
Year 0 1 2
1-yr borrowing 9.524 −10.000 0
2-yr lending −9.524 0 10.904
Repatriation 0 10.000 0
Net 0 0 10.904
The locked-in 1-year lending rate 1 year from now is 9.04%, which
is the forward rate for year 2.

c Jiang Wang
Definition: The forward interest rate between time t − 1 and t is
(1 + rt)t = (1 + rt−1)t−1(1 + ft)
or
Bt−1 (1 + rt)t
ft = −1= − 1.
Bt (1 + rt−1)t−1
Spot and forward rates
6
r4 -
f5 -
r3 -
f4 -
r2 -
f3 -
r1 -
f2 -
r1 = f-1
1 2 3 4 5 year
Example. Suppose that discount bond prices are as follows:

t 1 2 3 4
Bt 0.9524 0.8900 0.8278 0.7629
Y T Mt 0.05 0.06 0.065 0.07
A customer would like to have a forward contract to borrow $20 M

three years from now for one year. Can you (a bank) quote a rate
for this forward loan?
f4 = 8.51%.

What should you do today to lock-in these cash flows?
Strategy:
1. Buy 20,000,000 of 3 year discount bonds, costing
(20, 000, 000)(0.8278) = $16, 556, 000.
2. Finance this by selling 4 year discount bonds of amount
16, 556, 000/0.7629 = $21, 701, 403.
3. This creates a liability in year 4 in the amount $21,701,403.
Cash flows from this strategy (in million dollars):
Year 0 1–2 3 4
Purchase of -16.556 0 20.000 0
3 year bonds
Sale of 4 16.556 0 0 -21.701
year bonds
Total 0 0 20.000 -21.701
The yield to maturity for the “bond” is given by:

21, 701, 403
− 1 = 8.51%.
20, 000, 000

c Jiang Wang
4 Market Conventions
4.1 Yield-to-Maturity (YTM)
Definition: Yield-to-maturity of a bond, denoted by y , is given by

T
Ct P
B= + .
t=1
(1+y) t (1+y) T
Given its maturity, the principle and the coupon rate, there is a
one to one mapping between the price of a bond and its YTM.
In the market, it is conventional to quote bond prices in YTM.

YTM of T-bills 2001.08.02 (WSJ)

The T-bill quotes on
2001.08.02 are given on
the right. Consider
the T-bill maturing on
2002.01.31. The ask
quote is 3.35. That is,
the bill is selling at a dis-
count of d = 3.35%.
There are n = 181 days
to maturity.
• Price you actually pay:

P = 10, 000 [1 − d × (n/360)]
= 10, 000[1 − 0.0335(181/360)] = 9, 831.57.
• Rate of return for 181 days:

10, 000 − 9, 831.57
= 0.0171.
9, 831.57
• Ask yield:
0.0171 × (365/181) = 3.45%.
• Annualized rate of return (spot interest rate)

r 181 = (1.0171)365/181 − 1 = 3.48%.
365

c Jiang Wang
2001.08.02 (WSJ) YTM of zeros (STRIPS).

Consider the Treasury STRIPS Aug 06.
The ask quote on 2001.08.02 is 79
08/32.
• Face value is $100
• Price is 79 + 08/32 = 79.25
• Time to maturity is 5 years
• Price and yield satisfy

100
79.25 = .
(1 + y/2)10
The convention is semi-annual com-
pounding for bond yields.
• Yield is
1/10
100
y = (2) −1
79.25
= 4.70%
• Quoted ask yield is 4.68% (actual

maturity slightly longer than 5 years).
• Spot interest rate:
r5 = (1 + 0.0470/2)2 − 1
= 4.76%.

2001.08.02 (WSJ) YTM of Treasury bonds.

Consider the Treasury note Jul 03 with
coupon rate 3 7/8% (semi-annual). The
ask quote is 100 00/32. The ask yield is
3.87%.
• This note is on-the-run.
• The price is 100 + 00/32 = $100.00
• Since coupon is semi-annual,

4
1.9375 100
B= +
(1 + y/2)t (1 + y/2)4
t=1
• Confirm that y = 3.87%:

4
1.9375 100
B = +
(1.01935)t (1.01935)4
t=1
= 100.0095 (very close).

c Jiang Wang
4.2 Pitfalls of YTM.
Example. Inconsistencies in YTM.

Years 1 2 3
Current spot interest rates for different maturities (%) 10.0 12.0 14.0
Future spot interest rates with one-year maturity 14.0 18.1
Bond Maturity (years) Coupon rate (%) Par value Price YTM (%)
A 2 8 100 93.4 11.9
B 3 10 100 91.3 13.7
1. Prices in terms of yields:

8 108
93.4 = +
1.119 (1.119)2
10 10 110
91.3 = + + .
1.137 (1.137)2 (1.137)3
• Cash flows at different dates from the same bond are dis-
counted at the same rate.
• Cash flows at the same date from different bonds are dis-
counted at different rates.
2. Prices in terms of spot interest rates:

8 108
93.4 = +
1.10 (1.12)2
10 10 110
91.3 = + + .
1.10 (1.12)2 (1.14)3
• Cash flows at the same date are discounted at the same rate.
• Cash flows at different dates are discounted at different rates.

Example. Making investment decisions using YTM.
In the example above, is B a better investment because it has

higher YTM?
Returns from investing in A and B for one year:
Year 0 1 2 3
1-year interest rate (%) 10.0 14.0 18.1
Bond A
Coupon + principal 0 8 108
Price 93.4 94.7 0 0
Return (%) 0 10.0 14.0
NPV 0.0 0.0 0.0
Bond B
Coupon + principal 0 10 10 110
Price 91.3 90.5 93.1 0
Return (%) 10.0 14.0 18.1
NPV 0.0 0.0 0.0 0.0
• Bond B has higher YTM than bond A.
• Both bonds give same returns.
• NPV of both bonds is zero.
Thus:
1. YTM is not a valid measure of “yield” for coupon bonds.
2. The NPV rule is always correct!

c Jiang Wang
5 Measuring Interest Rates

Often, we need to measure the term structure of interest rates
from market prices of coupon bonds.
Example. Measuring yield curve from coupon bond prices.
• No discount bonds traded with one- and two-year maturities
• Coupon bonds of these maturities traded
• Data on coupon bonds (with annual coupon):

Years to Maturity 1 2
Face Value 1,000 1,000
Coupon Rate 5% 8%
Current Price 997.5 1048
(a) Price of 1 year bond: B1 = 0.95.
(b) Price of 2 year bond: B2 = 0.90.

How to synthetically construct 1 and 2 year discount bonds?
1. 1-year discount bond (with face value $1,000):

- Buy 0.9523 one year coupon bonds. In one year, this gives
(0.9523)(1050) = 1, 000.
- The cost of this cash flow is

(0.9523)(997.5) = 950.
2. 2-year discount bond (with face value $1,000):

- A 2-year coupon bond yields $1,080 in two years. In order
to yield $1,000 in two years, buy the following units of the
2-year coupon bond:
1000/1080 = 0.9259
- This results in coupons at year 1 in the amount

(0.9259)(80) = 74.07.
- To eliminate these coupons, sell the following units of the

1-year bond
74.07/1050 = 0.0705.
- In net, this creates identical cash flow as a 2-year discount

bond.
- The cost of this cash flow is
(0.9259)(1048) − (0.0705)(997.5) = 900.

c Jiang Wang
In equilibrium, all treasuries are priced by the same spot rates.
Suppose the market gives the following prices for coupon bonds:
Bond Price CF 1 CF 2 CF 3 ···

A PA CF A1 0 0 ···
B PB CF B1 CF B2 0 ···
C PC CF C1 CF C2 CF C3 ···
.. .. .. .. .. ..
. . . . . .
Thus,
CF A1
PA =
1 + r1
CF B1 CF B2
PB = +
1 + r1 (1 + r2 )2
CF C1 CF C2 CF C3
PC = + +
1 + r1 (1 + r2 )2 (1 + r3 )3
..
.
Solving the set of equations gives the term structure of (spot)

interest rates.
In practice,
• For many maturities, there may not be bonds traded

• For some maturities, there may be more than one bond traded.
Spot rates derived from bond prices vary with bonds used.
• Liquidity.
• Other market imperfections.

Example. Bond arbitrage opportunities. Suppose you, as bond

trader, see the following bond prices:
Bond Price CF 1 CF 2 CF 3
A 870 100 100 1000
B 901 110 110 1020
C 813 85 85 955
D 830 90 90 980
E 819 70 70 1000
What should you do?
Consider the following transactions:
Transaction CF 0 CF 1 CF 2 CF 3
Sell 2 A 1740 -200 -200 -2000
Buy 1 B -901 110 110 1020
Buy 1 D -830 90 90 980
Total 9 0 0 0
• This is an arbitrage opportunity: you pocket $9 now without

paying anything later.
• There may be more than one way to arbitrage.
• In the absence of arbitrage opportunities, at least one set of

spot rates can price everything.
• Existence of arbitrage opportunities implies that there is no

set of spot rates that can price all bonds.

c Jiang Wang
Observation: Existence of arbitrage opportunities implies that

there is no set of spot rates that correctly prices all bonds.
Example. Continued from previous example. Suppose that A and

B are “correctly priced.” Consider the following bond portfolios:
Portfolio CF 0 CF 1 CF 2 CF 3
P1 = 1.1 A - B 56 0 0 80
A - (1000/80) P1 170 100 100 0
• From P1, we have r3 = 12.625%.

• A 2-year annuity of $1.00 is worth $1.70.
• We cannot extract r1 and r2.
• Parameters are sufficient to price all bonds:
PV(C) = (1.7)(85) + (0.7)(955) = 813
PV(D) = (1.7)(90) + (0.7)(980) = 839
PV(E) = (1.7)(70) + (0.7)(1000) = 819.
• They work for all except bond D, which is “underpriced.”
Summary:
• In the presence of arbitrage opportunities, no set of spot rates

can price everything.
• In the absence of arbitrage opportunities, at least one set of

spot rates can price everything.

6 Interest Rate Risk and Its Measures

As interest rates change (stochastically) over time, bond prices
also change. The value of a bond is subject to interest rate risk.
Price (in log)

6
100 ` ` ` ` ` ` ` ` ` ` ` ` ` ` ` r
`
`
`
`
`
`
`
`
`
` -
5.0 yield (%)
Interest rate risk of a 6%, 30-year T-bond

5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
-1.00%
-2.00%
-3.00%
-4.00%
-5.00%
-6.00%
1/1/1900
1/8/1900
1/15/1900
1/22/1900
1/29/1900
2/5/1900
2/12/1900
2/19/1900
2/26/1900
3/4/1900
3/11/1900
3/18/1900
3/25/1900
4/1/1900
4/8/1900
4/15/1900

c Jiang Wang
30yr 6% vs.5yr 6% B ond R eturn
6.00%
4.00%
2.00%
Return
0.00%
-2.00%
-4.00%
-6.00%
7-7-00 1-5-01 7-6-01 1-4-02 7-5-02
D ate
30 yr6% 5yr6%
30yr 6% vs.30yr 0% B ond R eturn
6.00%
4.00%
2.00%
Return
0.00%
-2.00%
-4.00%
-6.00%
7-7-00 1-5-01 7-6-01 1-4-02 7-5-02
D ate
30 yr6% 30yr0%

6.1 Duration and Modified Duration
A bond’s interest rate risk can be measured by its relative price

change with respect to a change in yield. This is called a bond’s
volatility or modified duration:
1 ∂B
MD = −
B ∂y
(Here, “volatility” does not mean standard deviation or variance.)
The term modified duration is partially due to its link with the
bond’s duration:
Definition: Duration of a bond is the weighted average of the ma-

turity of individual cash flows, with the weights being proportional
to their present values:

T
PV(CF t) 1 CF t
T
D= ×t= × t.
t=1
B B t=1 (1+y)t
Duration measures the average time taken by a bond, on a

discounted basis, to pay back the original investment.
Duration and MD satisfy the following relation:
D
MD = .
1+y

c Jiang Wang
Example. Consider a 4-year T-note with face value $100 and 7%

coupon, selling at $103.50, yielding 6%.
For T-notes, coupons are paid semi-annually. Using 6-month

intervals, the coupon rate is 3.5% and the yield is 3%.
t CF PV(CF ) t · PV(CF )
1 3.5 3.40 3.40
2 3.5 3.30 6.60
3 3.5 3.20 9.60
4 3.5 3.11 12.44
5 3.5 3.02 15.10
6 3.5 2.93 17.59
7 3.5 2.85 19.92
8 103.5 81.70 653.63
103.50 738.28
• Duration (in 1/2 year units) is

D = (738.28)/103.50 = 7.13.
• Modified duration (volatility) is

MD = D/(1 + y) = 7.13/1.03 = 6.92.
If the yield moves up by 0.1%, the bond price decreases by

0.6860%.

Properties of Duration:
• Duration decreases with coupon rate.
Bond Duration and Coupon Rate

30
maturity = 30 yrs, yield = 6%
28
26
24
22
duration
20
18
16
14
12
10
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2
coupon rate
• Duration decreases wit YTM.

Bond Duration and Yield
20
maturity = 30 yrs, coupon = 8%
18
16
14
12
duration
10
0
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2
yield

c Jiang Wang
• Duration usually increases with maturity.

- For bonds selling at par or at a premium, duration always
increases with maturity.
- For deep discount bonds, duration can decrease with maturity
- Empirically, duration usually increases with maturity.
Bond Duration and Maturity

14
yield = 12%
coupon = 2%
12
10
coupon = 12%
8
duration
0
0 5 10 15 20 25 30
maturity (in years)

6.2 Convexity
Example. (Continued.)
• Duration is D = 7.13.
• Volatility is MD = 6.92.
As the yield changes, the bond price also changes:
Yield Price Using MD Difference

0.040 96.63 96.30 0.33
0.035 100.00 99.90 0.10
0.031 102.79 102.78 0.01
0.030 103.50 - -
0.029 104.23 104.22 0.01
0.025 107.17 107.08 0.08
0.020 110.98 110.70 0.28
• For small yield changes, pricing by MD is accurate.
• For large yield changes, pricing by MD is inaccurate.

c Jiang Wang
Price (in log)

6
HH
HH
∆ gives the slope
103.5 ` ` ` ` ` ` ` ` ` ` ` ` ` H` H̀?
r Convexity gives curvature
`HH
` HH ?
` HH
`
`
`
`
`
`
` -
3.0 yield (%)
Bond price is not a linear function of the yield. For large

yield changes, the effect of curvature (i.e., nonlinearity) becomes
important.
∂B 1 ∂ 2B 2
(∆B) = (∆y) + (∆y) + ···
∂y 2 ∂y 2
Definition: Convexity is the curvature of the bond price (per $)

as a function of the yield:
1 1 ∂ 2B
CX = .
2 B ∂y 2
Thus,
∆B
≈ −MD × (∆y) + CX × (∆y)2 .
B

For a bond of par P , annual coupon C , maturity T and yield y :

T
C P
B= + .
t=1
(1+y) t (1+y) T
Thus,
∂ 2B t(t + 1)C
T
T (T +1)P
2
= + +2
>0
∂y t=1
(1+y) t (1+y) T
or

∂ 2B T (T +1)(P − Cy) 2CT 2C 1
= − + 1− .
∂y 2 (1 + y)T +2 y(1+y)T +1 y3 (1+y)T
Example. (Continued.) 4-year T-note as before (face value of

$100, 7% coupon, selling at $103.50, yielding 6%).
Yield Price Using MD Using MD & CX

0.040 96.63 96.30 96.60
0.035 100.00 99.90 99.98
0.031 102.79 102.78 102.79
0.030 103.50 - -
0.029 104.23 104.22 104.23
0.025 107.16 107.08 107.15
0.020 110.98 110.70 111.00

c Jiang Wang
7 Hedging Interest Rate Risk

Hedging is to take new positions to offset a given risk exposure.
Given a fixed-income position, we can take another fixed income

position to reduce the interest risk of the total position (the
portfolio).
A portfolio’s MD is the value-weighted average of its components’

MD.
Assume a flat term structure. Consider a bond portfolio consisting

of nA units of bond A and nB units of bond B, where
Bond Price Duration Volatility

A BA DA MDA
B BB DB MDB
The value of the portfolio is
VP = VA + VB = nABA + nB BB .
When interest rates change,
∆VP = ∆VA + ∆VB = nA∆PA + nB ∆PB .
Thus
VA VB
MDP = MDA + MDB .
VA + VB VA + VB

Example. Suppose that you are long in 4-year bonds and you
want to use 3-year bonds to hedge the interest rate risk. The
data on these bonds are
Bond Yield Duration Volatility (%)
3-year 0.10 2.75 2.50
4-year 0.10 3.52 3.20
To hedge the long position in 4-year bond, we need to sell 3-year

bond. How much to sell?
For each dollar worth 4-year bond, choose delta dollar worth of
3-year bond such that the total portfolio has zero volatility:
MD4 + (hedge ratio) × MD3 = 0.
Thus
MD4 3.20
hedge ratio = = = 1.28.
MD3 2.50
For the hedged portfolio, we have
Position Value change when yields ↑ 0.1%

Long $1000 4-year bond −(1000)(3.20)(0.001) = −3.20
Short $1280 3-year bond (1280)(2.50)(0.001) = 3.20
Net 0

c Jiang Wang
8 Inflation Risk
Most bonds give nominal payoffs. In the presence of inflation risk,
• Real payoffs are risky even when nominal payoffs are safe.
• Rolling over short-term investments may be less risky than a

long-term investment.
Example. Suppose that inflation in year 1 is uncertain ex ante

and inflation in year 2 is the same as in year 1. The expected
annual inflation rate is 8% ex ante while possible realizations of
inflation rate are 10%, 8% and 6%. The real rate is constant 2%.
Consider the payoffs of two strategies:
1. investing in 2-year bond
2. rolling over 1-year bonds
Year 0 Inflation Year 1 Reinvest Year 2 Final

value rate (t = 1) nom. payoff at nom. payoff real payoff
Strategy 1: Payoff from investing in 2-year bond

1000 0.10 — — 1210 1000
1000 0.08 — — 1210 1037
1000 0.06 — — 1210 1077
Strategy 2: Payoff from rolling over 1-year bonds

1000 0.10 1100 0.12 1232 1018
1000 0.08 1100 0.10 1210 1037
1000 0.06 1100 0.08 1188 1057

9 Default Risk
Fixed-income securities have promised payoffs of fixed amount
at fixed times. Excluding government bonds, other fixed-income
securities, such as corporate bonds, carry the risk of failing to pay
off as promised.
Definition: Default risk (credit risk) refers to the risk that a debt
issuer fails to make the promised payments (interest or principla).
Credit ratings by rating agencies (e.g., Moody’s and S&P) provide

indications of the likelihood of default by each issuer.
Description Moody’s S&P

Gilt-edge Aaa AAA
Very high grade Aa AA
Upper medium grade A A
Lower medium grade Baa BBB
Low grade Ba BB
• Investment grade bonds: Aaa – Baa by Moody’s or AAA –

BBB by S&P
• Speculative (junk) bonds: Ba and below by Moody’s or BB

and below by S&P.

c Jiang Wang
9.1 Default Premium and Risk Premium
Example. Suppose all bonds have par value $1,000 and
• 10-year Treasury STRIPS is selling at $463.19, yielding 8%

• 10-year zero issued by XYZ Inc. is selling at $321.97
• Expected payoff from XYZ’s 10-year zero is $762.22.
For the 10-year zero issued by XYZ:

1000.00 1/10
Promised YTM = − 1 = 12%
321.97

762.22 1/10
Expected YTM = − 1 = 9%
321.97
and
Default Premium = Promised YTM − Expected YTM

= 12% − 9% = 3%
Risk Premium = Expected YTM − Default-free YTM

= 9% − 8% = 1%.
• Promised YTM is the yield if default does not occur.

• Expected YTM is the probability-weighted average of all possible yields.
• Default premium is the difference between promised yield and expected yield.
• Risk premium (of a bond) is the difference between the expected yield on a risky bond
and the yield on a risk-free bond of similar maturity and coupon rate.

Yield-to-maturity for a risky bond
12% - Promised YTM

Default
Yield premium
spread
Risk 9% - Expected YTM
premium 8% - Default-free YTM
Default-free
rate

c Jiang Wang
9.2 Factors in Determining Default Premium

• Probabilities of default
• Financial loss in the event of default.
Example. Assume that a 1-year bond of par $1,000 has probability

of default p = 6% and only (1−λ) = 90% of the bond value
is paid in the case of default. Suppose that market expects
ȳ = 10% yield for bonds of similar risk. Let the promised yield
be y . Then,
ȳ = (1−p) × y + p × [(1−λ)y].
Thus
ȳ 0.1
y= = = 10.06%.
1 − pλ 1 − (0.06)(0.1)
The bond should be selling at $908.59.

One-year default rates

c Jiang Wang
9.3 Factors in Determining Risk Premium
Every bond that might default should offer a default premium,

but not necessarily a risk premium.
Example. A group of companies all face default risk, but from

totally unrelated causes. What should the risk premium on their
bonds be?
Note that in this case:
• A portfolio of these bonds should provide actual return close

to its expected return.
• Default premiums earned on bonds that did not default would

offset losses from bonds that did default.
• The expected return on the bond portfolio should be the same

as that of a default-free bond.
• Each bond should offer no risk premium.
In general:
• Risks associated with bonds are not unrelated.

• When business is bad, most firms are affected.
• Risk premium of a bond depends on how its default relates to
general business conditions.

Yields of corporates, treasury, and municipals

c Jiang Wang
10 Homework
Readings:
• BKM Chapters 14, 15, 16.
• BM Chapters 3, 24, 25.
Assignment:
• Problem Set 2.
• Project 1 on fixed income portfolio management.


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Chapter 3

Fixed Income Securities

Part A Introduction to ﬁnance.

• Term Structure of Interest Rates

• Interest Rate Risk

• Hedging Interest Rate Risk

15.407 Lecture Notes Fall 2003

Year 00 01 02-03 04-07 08 on

The payments total $216.5 billion by Year 2025. Companies

Name Market Capitalization

How can these companies make the payments?

Assuming payments are certain, how do we value them?

Example 2. Personal business – Pension beniﬁts.

Heard Oﬀ the Street: For pension beneﬁts, it’s a matter of

What happens to corporate pension plans when interest rates

15.407 Lecture Notes Fall 2003

Classification of Fixed-Income Securities:

2. Federal Agency Securities

Overview of Fixed-income Markets

Composition of U.S. Debt Markets (2001)

15.407 Lecture Notes Fall 2003

Organization of Fixed Income Market

Cashflow and Valuation of Fixed-Income Securities

Example. A 3-year bond with principal of $1,000 and annual

3 Term Structure of Interest Rates

Given the rich set of ﬁxed-income securities traded in the market,

In the market, this information on the time value of money is

1. Spot interest rates.

2. Prices of discount bonds (e.g., zero-coupon bonds and STRIPS).

3. Prices of coupon bonds.

4. Forward interest rates.

The form in which this information is expressed depends on the

3.1 Spot Interest Rates

Deﬁnition: Spot interest rate, rt, is the (annualized) interest rate

Deﬁnition: The set of spot interest rates for diﬀerent dates

{r1, r2, . . . , rt, . . .}

gives the term structure of (spot) interest rates, which refers to

15.407 Lecture Notes Fall 2003

3.2 Discount Bonds

Discount bonds (zero coupon bonds) are the simplest ﬁxed-income

Deﬁnition: A discount bond with maturity date t is a bond which

Example. On 2001.08.01, STRIPS are traded at the following

Maturity (year) 1/4 1/2 1 2 5 10 30

For the 5-year STRIPS, we have

Let Bt denote the current price (at date 0) of a discount bond

Prices of discount bonds provide information about spot inter-

3.3 Coupon Bonds

A coupon bond pays a stream of regular coupon payments and a

Observation: A coupon bond is a portfolio of discount bonds.

Example. A 3-year bond of $1,000 par and 5% annual coupon.

15.407 Lecture Notes Fall 2003

Suppose that the discount bond prices are as follows

What should the price of the coupon bond be?

Price = (50)(0.952) + (50)(0.898) + (1050)(0.863)

Thus, a bond with coupon payments {C1, C2, . . . , CT } and a

• Ct units of discount bonds maturing at t, t = 1, . . . , T

• P units of discount bond maturing at T .

The price of a coupon bond must be

Example. Measuring term structure from coupon bond prices.

(a) Price of 1 year bond:

997.5 = B1 × (50 + 1000) ⇒

(b) Price of 2 year bond: