Fixed Income Markets

Fixed Income Markets

Fixed income markets comprising Government
securities, Money market instruments, Mortgagebacked
securities,
Asset-backed
securities,
Interest rate derivatives, Corporate bonds, and
Credit derivatives are very large and still growing.
All the interest rate instruments are tied together.
i.e. highly correlated due to no-arbitrage
conditions.

Government Securities
Government securities do not have any counterparty
risk.
Prices of these securities, however, fluctuate in the
short-run and are also subject to inflation risk.
Most recently issued Treasury securities are called
On-the-run securities while the others are called
Off-the-run securities.
On-the-run securities trade at a premium relative to
off-the-run securities because of their higher
liquidity.

Government Securities
Government securities include zero-coupon bonds
(Treasury bills), Coupon bonds (Treasury notes,
Treasury bonds) and Floating-rate coupon bonds.
Zero-coupon bonds enable investors to manage
risk and use effective investment strategies.

The Money Market

Instruments
The Money Market refers to the market for short term
borrowing and lending, usually undertaken by banks
Bank Rate: rate for borrowing / lending balances kept at
the Central Bank
Eurodollar Rate: rate of interest of dollar deposits at a
European bank. 90-day Eurodollar deposit rate is a
standard.
LIBOR: average interest rate the banks charge to each
other for short term uncollateralized borrowing / lending
Repo Rate: interest rate charged for short term borrowing
/ lending with collateral

The Repo Market

The Repo market is used by traders to borrow and lend cash
on collateralized basis.
A Repurchase Agreement (Repo) is an agreement to sell some
securities to another party and buy them back at a fixed date
and for a fixed amount.
The price at which the security is bought back is greater than
the selling price and the difference implies an interest called
Repo Rate
A Reverse Repo is the opposite transaction, namely, it is the
purchase of the security for cash with the agreement to sell it
back to the original owner at a
predetermined price,
determined, once again, by the Repo Rate

The Repo Market

example
At time t, a trader wants to take a long position until
time T

The Repo Market

Profit = PT Pt Repo rate x (Pt haircut)
Capital at risk = haircut (very small)
Return = [PT Pt Repo rate x (Pt haircut)] /
haircut
Very highly levered position.
The trader earns the accrued interest between t and
T.
Because the trader has to pay the repo rate during
this period, setting up the repo transaction tends to
generate a positive or negative stream of payments.
The trade implies a positive carry if the interest on
the bond is above the repo rate and a negative carry
if the interest on the bond is below the repo rate.

Problems
Whats the return on capital for a
trader who entered into a one-month
repo where Pt = 98.5, PT = 99.01,
Repo= 5% and haircut= 0.8?
Whats the profit for a trader who
entered into a one-week reverse repo
where Pt = 99.40, PT = 99.48 and
Repo= 6%

General Collateral and Special Repo

Rate
The repo rate for most Treasury securities is called the
General Collateral Rate. It is generally lower than
the borrowing rates available to banks such as LIBOR ,
because Repo transactions are collateralized
transactions.
At times, a particular bond is hard to find. Rate on such
a bond is called a special repo rate.
Dealers often short on-the-run Treasuries to hedge other
securities.
Purchased via reverse repo, causing repo rate to fall.
(Lower repo rate is an additional benefit of owning the
security, causing its price to rise).

Reverse Repo Transaction

MORTGAGE BACKED SECURITIES

MARKET AND ASSET-BACKED
SECURITIES
The Mortgage Backed Securities (MBS) market
has grown significantly over the past years
These securities allow local banks, which issue mortgages
to individuals, to diversify their risk
A bank issues mortgages to individuals living nearby
These mortgages are susceptible to local events (e.g. a local
company goes bankrupt leaving many mortgage holders without a
job)

By pooling its mortgages and buying into a mortgage

backed security, the bank reduces the effect of a local
event affecting its balance sheet

Asset Backed Securities (ABS) are similar to MBS,

but instead they are collateralized by other types of
loans (auto loans, credit cards, etc.)

THE DERIVATIVES
MARKET

Swaps were earlier used to arbitrage some

relative price discrepancy that existed between
floating rates and fixed rates.
The real growth in the swap market happened
because these are convenient means of cash and
risk management.
Financial institutions, corporations and even
Governments use swaps
To change the sensitivity of their cash flows to interest
rates
To alter the timing of their payments and revenues
For investment purposes within complex trading strategies.

THE DERIVATIVES
MARKET
Important Futures Contracts are the 90-day Eurodollar
futures, Eurodollar futures, Treasury note futures.
The quote in futures contracts is given by (100-futures
rate).
If a 90-day Eurodollar futures contract with December
maturity is quoted at 95, it establishes a rate of 5% today
at which the party long the futures contract can deposit
dollars in the Eurodollar market for the following 90 days.
Futures contracts allow to lock in a future interest rate and
to form expectations about future movements in interest
rates.

THE DERIVATIVES
MARKET
Interest rate options such as caps and floors are
a kind of insurance purchased by the option
buyer.
Some fixed-income options are embedded in
other instruments such as prepayment option in a
fixed-rate mortgage.