Investment Basics I

Investment Actuary Symposium

Boston, Massachusetts
November 8, 2004
Charlie Ford, Dick Mattison

Objectives
• Review basics of interest rate and bond math
• Define terms in the fixed income markets
• Explain the major types of derivatives and how they’re
used for hedging
• Define the landscape faced by an investor with some
kind of financial obligation to meet
• Study how to construct a portfolio to do the job
Agenda
1. Interest rates, term structure
2. Rate Math
3. Measurement tools
4. LIBOR
5. Swap curve
6. Credit Default Swaps
7. Derivative Market Pricing
8. Interest Rate Options
– Caps, floors; Pricing
9. CAPM, Mean-Variance Efficient Frontier
10. Portfolio Design

Agenda - Investment Basics II

11. The liability-oriented investor
12. Investment Policy and Strategy
– portfolio design
– risk/reward tradeoff
13. Regulatory constraints
14. Economic Evaluation of assets and liabilities
15. Risk Analysis and Control (hedging)
16. Practical Issues
1. Interest Rates
• The rate at which one can discount a bond’s cash flows
to replicate its price
• Bonds in the US pay coupons semi-annually. Quoting
i(2) is the “bond-equivalent yield” (BEY)
i = (1+i(2)/2)2 - 1
• i is a constant, same for all cash flows
• US Treasury bonds trade in 1/32 increments of $100 par
value, or face amount.
• Issued at about $100, so the yield almost equals the
coupon
– $100.00 10 year Treasury note (=bond), $2 coupon
semiannually, yield 4.00% BEY = 4.04% Eff. Ann.

US Treasury Notes
• Issued at about $100, so the yield almost equals the
coupon
– $100.00 10 year Treasury note (=bond), $2 coupon
semiannually, yield 4.00% BEY = 4.04% Eff. Ann.
• US Treasury bonds trade in 1/32 increments of $100 par
value, or face amount.
• Currently the US Treasury issues
– 3, 6, 12 month T-bills
– 2, 5, 10 year notes
– TIPS
T-Bills
• Exception: 3 month and 6 month maturity Treasury
bonds are called “bills”, and are quoted on a discount
basis
– buy a $100 90 day T-bill for $99.00, discount rate
quoted would be:
– (100-99)/100 * 360/90 = 4.00%
• note the actual/360 day-count basis

Bond Yield
• After issue, yields and the price of our bond fluctuate.
– <$100 is a “discount”, >$100 is a “premium” bond.
– Yield moves in opposite direction to price
• Yield
– Given the price, maturity date, coupon, we can solve
for the yield (use Bloomberg YAS function).
– Callable bonds
• Yield to call
• Yield to maturity
• Yield to worst - assumes the option to call will be exercised
against you at the optimal time.
Term Structure
6.00%

5.00%

4.00%
12/31/2003
3.00%
9/30/2004
2.00%

1.00%

0.00%
3m 6m 1yr 2yr 5yr 7yr 10yr 20yr 30yr

• Graph of BEY yields for each maturity is the “yield

curve”
• Treasury yield curve is the benchmark for bonds in US
• Corporate bonds are priced at a spread off the Treasury
yield curve (in US)
– spread to comparable, spread to benchmark

Bond Accounting
• Accounting Bases
– Market Value
– Amortized cost “ “book value”
• Each month until maturity the book value is amortized
toward the $100 par value.
– The cash coupon plus accural of discount (or
amortization of premium) gives you net investment
income.
 Corporate Bonds
• Treasury yield curve is the benchmark for bonds in US
• Corporate bonds are priced at a spread off the Treasury
yield curve
– spread curve graphs the spread for a given credit
quality (A, BBB, etc)
– spread to comparable, spread to benchmark
• Ratings
– Assigned by Moody’s, Standard & Poors, Fitch
– Investment Grade: AAA to Baa3 = BBB-
– High Yield: Ba1=BB+ to D
– Investment policy, capital loads
– Covenants

Bond Trading
• Different from stock trading
– an issuer may have dozens of individual bond issues
• different maturity dates,
• coupon rates
• place in capital structure
• convertibility to common stock
– market dominated by institutions
– most bonds trade thinly from a few weeks after issue
• low price transparency and discovery
• need trading relationships with 10+ broker/dealers
• negotiating a price is a poker game
• Prices assume accrued interest until the next coupon date
is settled up.
– If not the trade is quoted “flat” - usually a default
situation.
2. Rate Math
• Coupon Rates
– The (bond equivalent) yield on a coupon bond
– one rate for all cash flows
– MV = c/(1+y/2) + c/(1+y/2)2 + (1+c)/(1+y/2)3
• Spot Rates
– If coupon is zero, the bond just has a principal
payment at maturity
– The yield is the discount rate for that one cash flow
– coupon bond ~ package of zeros
– MV = c/(1+z0.5/2) + c/(1+z1/2)2 + (1+c)/(1+ z1.5 /2)3

Forward Rates
• Forward Rates
– Fabozzi p. 120
– one period rates stepping into the future.
MV = c / (1+f0.5/2) + c / (1+f0.5 /2)(1+f1 /2) +
(1+c) / (1+f0.5/2)(1+f1/2)(1+f1.5/2)
• 9/30/2004 Rates
7.00%
6.00%
5.00% Coupon
4.00%
3.00% Spot
2.00% Forward
1.00%
0.00%
3m

6m

yr

yr

yr
r

r
1y

2y

5y

7y
10

20

30
Rate Math: Bootstrapping
• Bootstrapping = the algebra that connects y, z, and f
• For a 1 year semiannual bond,
c/(1+y/2) + c/(1+y/2)2 = c/(1+z0.5/2) + c/(1+z1/2)2

• Know y from observed prices (Bloomberg)

• For a 6 month coupon bond, know z0.5 = y(0.5)
• solve for z1
• Repeat for z1.5, etc. to z30
• Graph your spot rate curve
• Forwards: Algebra is similar: solve and repeat
MV = 100 / (1+z1)(1+f1)

3. Measurement Tools
Price

Yield

• Duration (slope, first derivative)

• Convexity (curvature, second derivative)
• Key Rate Duration
Duration
• Macaulay
D (in years) = 6 (t c (1+y)-t) + (1+y)-n
– primitive but easy to calc
• Modified
D* = D / (1 + .5y)
– ignore, an intermediate step
• Price Sensitivity
DPrice Sens’y = D* 'y
– Only works for non-interest sensitive cash flows
• Option Adjusted
DOA = (-1/P) (dP/di) # (P- - P +) / (2P 'y)
– use this one

Duration - limitations
• Assumes parallel yield curve shift
– exposed to nonparallel shifts
– measure with Key Rate Durations
• Shock individual yield curve points, calc duration

for each
• 6 KRD = DOA

• Works only for small 'y

– adjust for convexity
• ignores yield volatility component of bond price
• not intuitive for callable bonds, prepayable mortgages
– must model 'P with many interest rate paths
 Price Changes
Price

P0
Pc
Pd

y0 y1 Yield
Pd = P0 - D 'y
Pc = Pd + .5 C ('y)2

Convexity
• Convexity Measure
C = (1/P) (d2 P/di2) # (P+ + P- - 2P) / P ('y)2
– this is what PTS gives you
• % price change
%'Pcvxy = .5 C ('y)2
– use this one
• Noncallable bonds are positively convex
• MBS, callable bonds have negatively convex range
• What 'y ? Bloomberg uses .0025 (25 basis points)
 4. LIBOR
• London Inter-Bank Offered Rate
• Rate at which major commercial banks loan to each
other in the London market
• The benchmark for borrowing-type instruments:
– swaps
– floating rate notes
– bonds, in Europe
• Maturities one day to one year

LIBOR-Swap Curve
6.00%

5.00%

4.00%
12/31/2003
3.00%
9/30/2004
2.00%

1.00%

0.00%
3m 6m 1y 2y 3y 5y 7y 10y 15y 20y 30y

• LIBOR to 1 year, Swap rates from 2 years

• builds in a few bp over Treasuries for systemic risk
• Swap spread = swap rate - Treasury yield, same maturity
 5. Interest Rate Swaps
• Custom agreement to exchange cash flows
• Usually debt cash flows or currencies
• At inception, least one series of payments is uncertain
• One party wins financially, but both offset risk
exposures
• AA bank rates, with collateral if necessary
• ISDA agreement the standardized legal contract your
firm signs - see www.isda.org
• CSA = Credit Support Annex: lower rated (and often
both) firms must put up collateral
– T-notes, you get the interest on your collateral

Plain Vanilla Interest Rate Swap

Fixed 4.5%
Bank Swap Dealer
LIBOR+0%

LIBOR+0.5% 5.75% Fixed

Depositors Mortgagors

Bank’s net cash flow: Fixed +0.75%

Not exposed to interest rate changes
Markets
FUTURES & OPTIONS
• regulated by CFTC
• contracts standardized
• trade on exchanges
• major traders observed
• 1-2 years max to expiry
SWAPS
• ~ unregulated
• contracts customized
• trade OTC
• privacy retained
• can be 30+ years to expiry

6. Credit Default Swaps

• Not a swap
• separates default risk from a bond’s interest rate risk and
principal exchange, in return for a premium
• Example: buyer pays 50 bp annually for 5 years times
$10m notional, or $50,000 annually
• CDS premium close to bond’s spread over Treasuries
– affected by liquidity, bond or CDS market dynamics
• Default defined as a specific event:
– missed interest or principal
– debt extension
– Chapter 11 or 7 filing
• If default occurs:
– pays par less the current market value, or pays par
and receives the bond
– contract terminates
7. Derivative Market Pricing

8. Interest Rate Options

– Caps, floors; Pricing

9. CAPM, Mean-Variance Efficient Frontier

10. Portfolio Design

Questions