Last Revised: 06/02/2023

2024 Level 1 - Fixed Income

Learning Modules Page

Fixed-Income Instrument Features 2

Fixed-Income Cash Flows and Types 6

Fixed-Income Issuance and Trading 12

Fixed-Income Markets for Corporate Issuers 16

Fixed-Income Markets for Government Issuers 23

Fixed-Income Bond Valuation: Prices and Yields 27

Yield and Yield Spread Measures for Fixed-Rate Bonds 33

Yield and Yield Spread Measures for Floating-Rate Instruments 38

The Term Structure of Interest Rates: Spot, Par, and Forward Curves 43

Interest Rate Risk and Return 47

Yield-Based Bond Duration Measures and Properties 51

Yield-Based Bond Convexity and Portfolio Properties 55

Curve-Based and Empirical Fixed-Income Risk Measures 58

Credit Risk 62

Credit Analysis for Government Issuers 68

Credit Analysis for Corporate Issuers 73

Fixed-Income Securitization 77

Asset-Backed Security (ABS) Instrument and Market Features 81

Mortgage-Backed Security (MBS) Instrument and Market Features 87

This document should be used in conjunction with the corresponding learning modules in the 2024 Level 1 CFA® Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with
permission from CFA Institute. All rights reserved.

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1
 Last Revised: 06/02/2023

Fixed-Income Instrument Features

a. describe the features of a fixed-income security

b. describe the contents of a bond indenture and contrast affirmative and

negative covenants

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Fixed-Income Instrument Features

Page 1

Fixed-income ➞ debt such as loans and bonds

private agreements public securities
(borrower - lender) (many lenders, one borrower)
individuals banks investors corporation
corporations funds government

- all involve periodic interest payments plus principal

$ $ $ $ + FV - last payment
includes principal
investor 𝐜𝐨𝐮𝐩𝐨𝐧 𝐫𝐚𝐭𝐞 × 𝐅𝐕 (e.g. bullet bond)
lends ! 0
𝐦
periodicity
Bond Features/
government - national, local, supranational, quasi-gov’t.
Issuer
state, muni. agencies
private sector
- financial/non-financial
- SPE (e.g. ABS/MBS)

Page 2
Bond Features/
Maturity - date of final payment + principal repayment
tenor - time remaining to maturity
< 1 yr. to maturity at issuance - money market security
> 1 yr. to maturity at issuance - capital market security
perpetual bonds - no stated maturity (not very common)
Principal - par value, face value, amount repaid at maturity
- amortizing bond - some principal is repaid each payment
(e.g. mortgage, MBS)
Coupon Rate and Frequency
fixed - constant amount - monthly, quarterly, semi-annual, annual
floating - variable with some MRR - market reference rate
+
(FRN) spread - issuer specific (credit
constant over the life spread)
of the bond (higher quality ➞ lower spread)

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Page 3
Coupon Rate and Frequency
zero - buy at a discount, mature at par (pure discount bond)
(ZCB)

Seniority - position in the capital structure (priority of claim on

assets)
Senior secured
Senior unsecured - pari passu - all sen. unsec. rank equally
Junior debt (subordinated)
Contingency Provisions - a clause that allows for an action if an
event or circumstance happen
- most common - calls, puts, convertibility (to equity)
Yield measures - current yield = annual coupon price
premium bonds price > par yield < coupon
discount bonds price < par yield > coupon
par bonds price = par yield = coupon

Page 4
Yield measures
yield to maturity - the bond’s IRR (mwrr) PMTs
- rate of return = YTM if: 𝐁𝐏𝟎 𝐁𝐏𝐓
1/ no default
𝐁𝐏
2/ held to maturity 1 𝐓4𝐁𝐏 5 - 1 = YTM
𝟎
3/ coupon reinvested at YTM rate
(if CFs are reinvested)

Yield curves - yields on all bonds with same features by

same issuer
typically upward sloping
government par curve
G-spread - a measure of credit risk

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Page 5
Bond Indenture - legal contract
- contains: form of the bond, obligations of issuer, rights of
bondholders, sources of repayment
sovereign government - taxation, print currency
local/regional gov’t. - taxes, project cash flows
credit analysis corporate - operating cash flows for int./prin.
- evaluate OCF plus unsecured
value of collateral + pledge of specific assets
secured
ABS/MBS
tranche A senior
assets
loans ➞ CFs int. + prin. on tranche B
mortgages bonds
tranche C junior

Page 6
Bond Covenants
affirmative - typically impose no cost or restriction on operating
the business
- states what the issuer is required to do - typically
administrative
- pari passu clause - equal footing
- cross-default clause - a default on one is a default
on all
negative - what the issuer will not do
- limitations on liens (pledged assets)
- limitations on sales/leaseback (can’t sell the collateral)
- restrictions on issuance of debt more senior (negative
pledge clause)
- restriction on share buybacks/dividend/dividend increases
unless certain ratios are met (incurrence tests)
- limitations on additional debt

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Fixed-Income Cash Flows and Types

a. describe common cash flow structures of fixed-income instruments and

contrast cash flow contingency provisions that benefit issuers and investors

b. describe how legal, regulatory, and tax considerations affect the issuance and
trading of fixed-income securities

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Fixed-Income Cash Flows and Types

Page 1
Bullet bond - most common
- interest payments on coupon dates + principal at maturity
Fully amortizing bond - each payment is 𝒊 + 𝐏 (e.g. mortage)
5 yr., semi-annual, 3.2% issued at 300
e.g./ PV = -300 FV = 0 N = 10 𝐈#𝐘 = 1.6 CPT PMT = 32.70
Balance PMT 𝒊 𝐏
1. 300 32.70 4.8 27.90
2. 272.10 32.70 4.35 28.35 etc.
- credit risk declines over time as 𝐏 is repaid
- investors/lenders face higher reinvestment risk
Partially amortizing bond - each payment is 𝒊 + 𝐏, but not all 𝐏 is
repaid
- balloon payment at maturity
PV = -300 FV = 150 N = 10 𝐈#𝐘 = 1.6 CPT PMT = 18.75
Balance PMT 𝒊 𝐏
1. 300 18.75 4.80 13.95
2. 286.05 18.75 4.58 14.17 etc.

Page 2
e.g. mortgage Price = 500k
Loan = 400k 30 yr. FRM @ 3.50%
PV = -400,000 FV = 0 N = 12 × 30 = 360 𝐈# = 𝟑. 𝟓𝟎#
𝐘 𝟏𝟐 = . 𝟐𝟗𝟏𝟔
̇ CPT PMT = 1796.18

Sinking Funds - periodically retire a bond’s principal over time

Waterfall Structure
- 𝐢 paid to all classes of bonds
𝐏 flows to senior class first

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Page 3
Variable Interest Debt - MRR + spread constant
less interest rate risk credit quality ↓
(i.e. price risk) since rate adjusts yield ↑ , price ↓
fixed rate - rates ↑, price ↓, coupon fixed
floating rate - rates ↑, price unch., coupon ↑

Step-up bonds - coupon rate steps up over time or is related to

same event
common credit quality ↓, coupon ↑ (less price risk)
with
e.g. credit-linked notes (tied to a credit rating)
- issuer may be able to issue at a lower yield initially
leveraged loans - loans to issuers of lower credit quality

PIK (payment in kind) bonds - payment of 𝒊 can be made by

increasing the principal
- will offer a higher yield

Page 4

Index-linked bonds - 𝒊 or 𝐏 linked to a specific index

e.g. inflation-linked (TIPS) most common
issued by gov’t.
- coupon is a real rate, 𝐏 adjusts by %∆CPI

e.g. 1000 @ 2% %∆CPI = 4% 1. 𝐢 = 20 FV = 1040

%∆CPI = 3% 2. 𝐢 = 20.80 FV = 1071.20
- called ‘capital-indexed’ ➞ protects the real value of 𝐏
- deflation won’t hurt however
max of par or inflation-adjusted amount
- ‘interest-indexed’ bonds ➞ commonly issued by companies
𝒊 = MRR + %∆CPI , fixed 𝐏
Zero coupon bonds - no 𝒊 , just 𝐏 ➞ purchased at discount
- all return is interest

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Page 5
Zero coupon bonds
- common type ➞ Strips ➞ dealer buys capital market bonds
- sells each CF as a ZCB
- no reinvestment risk ➞ rate of return = YTM if held to maturity
Deferred coupon bonds - no 𝒊 for first few years, then higher 𝒊
thereafter
- typically issued at par, typically for construction projects
(do not generate CFs until
complete)

Page 6

Contingency Provisions
Callable bonds - issuer has the right to call all or part of the
bond prior to maturity
- the bond will have a higher yield vs. a non-callable bond
(straight)
- allows the issuer to refinance debt if interest rates fall
- calls are set at fixed prices at fixed times
103% 102% 101% 100%

issue first second last maturity

call call call

- if YTM > coupon (discount bond), call is OTM ➞ no value in

calling bond
- as YTM drops below coupon, price is capped at call price
- investor now faces call risk

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Page 7
Callable bonds - may be a ‘make-whole’ call
- bonds called at a sov. bond YTM of similar maturity
Putable bonds - bondholder has the right to redeem the bond at
pre-determined prices on pre-determined dates
- typically at par
- issued at lower yields
- if YTM < coupon , put has no value
YTM > coupon , company faces put risk
Convertible bonds - convertible into equity at a conversion price/sh.
- will have a lower yield
𝐩𝐚𝐫 𝐯𝐚𝐥𝐮𝐞
4𝐜𝐨𝐧𝐯𝐞𝐫𝐬𝐢𝐨𝐧 𝐩𝐫𝐢𝐜𝐞 = conversion ratio

conversion value = conversion ratio × current share price

- if 𝐏𝟎 < con. price - bond trades like a bond
𝐏𝟎 > con. price - bond trades off the stock

Page 8
Convertible bonds
- often used by growth companies
- will also have a ‘forced conversion’ provision
- if 𝐏𝟎 > conv. price for a # of days, company calls
bonds at a lower price
Attached warrants (not embedded) - can trade separately
a right to buy stock at a predetermined price
Contingent convertible bond (CoCo) - typically issued by banks
e.g. if Tier 1 capital falls below a regulatory level,
CoCo s automatically convert to equity
- will have a higher yield

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Page 9
Domestic bonds - issued in same country as company
US company issues a USD bond in the US
Foreign bond - issued in a different country than the issuer
US company issues a CAD bond in Canada
Euro bond - issued outside the jurisdiction of any single country,
usually unsecured, and can be denominated in any currency
- usually named for the currency they are denominated in
e.g. Euro-dollar , Euro-yen
US company issues EUR bonds, not registered in any
country
Global bond - issued in Euro bond market plus at least
one domestic market
- all 4 are subject to different legal, regulatory, and tax requirements

- the currency of issue has a stronger effect on price than where it

USD issued in Canada ➞ US yield curve matters is issued

Page 10

tax considerations
issuers - interest is tax-deductible
investors - taxable at marginal tax rate (interest)
- specific types of bonds may have some tax exempt qualities
i.e. cap-gains or interest exempt
e.g. UST - federal tax only
munis - tax exempt
- capital gains - may be a distinction between s.t./L.T. gains

ZCB - no coupon - but all discount amount is interest

- may be all taxable when received or
amortized each year

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Fixed-Income Issuance and Trading

a. describe fixed-income market segments and their issuer and investor

participants

b. describe types of fixed-income indexes

c. compare primary and secondary fixed-income markets to equity markets

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Fixed-Income Issuance and Trading

Page 1
Fixed Income markets can be
categorized along 3 dimensions
sov.
1/ issuer type (sector) corporate
issuers
2/ credit quality
corp. have many
SPE/SPV
3/ time to maturity fixed-income
instruments
- others ➞ geography, currency, ESG etc.

Credit Quality/ measured by credit

rating ➞ letter grade qualitative
measure of the ability to meet investors

debt obligations (captures both

POD and LGD) HY typically
probability loss given issued with
of default default 7-9 yr. mat.

Page 2

Credit Quality/
- both the issuer and the issues have ratings
same as senior unsecured
- 2 largest credit rating agencies ➞ Moody’s and S&P
- many institutional investors are restricted to instruments with
credit ratings and oftentimes some minimum
(must be rated) (IG only)
AAA, AA, A
BBB - or higher BBB, BBB -
fallen angels
HY - high yield ➞ speculative, junk ➞ BB+ or lower

sovereign government debt typically lowest risk in each market

- developed government bonds widely held for safety and income
- also a useful tool for central banks conducting monetary
policy

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Page 3
Fixed Income Indexes/
- perform the same function as equity indexes
1/ track broad risk/return of different markets
2/ enable evaluation of market performance
3/ benchmarks for portfolios and investment managers
4/ form the basis for indexed investment strategies and products
differ: many more constituents than equity indexes bond funds
far more changes (issuance, maturity) rarely hold
- monthly rebalancing all bonds
market value of debt weighted - sampling

classified as aggregate indexes e.g. Bloomberg Barclay’s Global Agg.

(also have sub-indexes) (sov. gov’t., corporate, securitized, DM and EM)
sector, credit quality, time-to-maturity, etc...
HYG TLT

- all bonds are priced once a day to determine index value

Page 4

Primary FI markets/
- issuer sells a new bond to raise capital
- may be sold via public offering or private placement
for both
debut and may be underwritten non-underwritten
seasoned - underwriter and issuer agree unregistered
issuers on price, underwriter assumes small size or less well
risk of issuance known

- debut issuers typically replacing private debt with public debt

bonds are typically priced (i.e. yield) to sell at par

‘Re-opening of an existing bond’ - less common, a previous issue is added
to a current market price
IG issuance typically very quick, HY a longer process
typically brokered on a best efforts basis
- commission only

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Page 5
Primary FI markets/
- for sovereign debt - typically sold by auction led by the
Treasury or Ministry of Finance
Secondary FI markets/
- mostly quote driven, OTC markets (i.e. dealer markets)
- some electronic trading (Treasury Direct)
- liquidity varies across segments (gov’t., IG, HY)
- bid-offer quoted in bps (more liquid = tighter)
- DM sov. gov’t. ‘on-the-run’ bonds are the most liquid
most recently issued
- IG - on-the-run of frequent issuers most liquid (dealers have
inventory)
- remaining ➞ very low liquidity
Distressed debt - bonds from issuers believed to be very close to, or in,
- trades well below par bankruptcy
- will trade until issuer liquidates or restructures

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Fixed-Income Markets for Corporate Issuers

a. compare short-term funding alternatives available to corporations and

financial institutions

b. describe repurchase agreements (repos), their uses, and their benefits and
risks

c. contrast the long-term funding of investment-grade versus high-yield

corporate issuers

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FI Markets for Corporate Issuers

Page 1
Short-term funding ➞ Non-financial/
Lines of credit
- uncommitted - banks can cancel at any time
- least reliable source of financing
up to a certain amount (credit line) for a maximum
period of time ( < 1 yr.)
floating rate + spread
no costs other than interest payments
- committed (regular) - a formal written commitment from the bank
- max term < 365 days - then must ‘rest the line’
- will involve a commitment fee on the full
or unused amount
- borrower does face renewal risk
- revolving credit agreements (revolvers)
- multi-year revolver agreements
- bank will add covenants (lender protections)

Page 2
Short-term funding ➞ Non-financial/
Secured loans - asset-backed loans (fixed assets, high-quality
receivables, marketable securities)
Factoring - selling AR - typically at a discount
- factor collects the AR
External, security-based:
Commercial paper ( ≤ 3 mos.) - issued by large, highly-rated companies
- unsecured notes to fund wc or as bridge financing
- typically rolled over (introduces rollover risk)
- usually requires a backup line of credit (committed)
➞ Financials/
Deposits - household/commercial (operational) deposits
- checking accounts, demand deposits that pay little to
no interest
- no duration or maturity, but they do have
a behavioral maturity (fee rebates, min. balances)

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Page 3
Short-term funding ➞ Financials/
Savings deposits - non-transactional, usually a stated term
i.e. certificate of deposit (CD, term deposit)
< 1 yr. maturity, pays interest at maturity (add-on)
- non-negotiable CD ➞ 𝐏 + 𝐢 at maturity, penalty for
early withdrawal
- negotiable CD ➞ can be sold in the market
retail - small denomination ~ 1000+
institutional - large denomination ~ 100k
Interbank market - short term lending/borrowing among financial
institutions as either secured or unsecured
- overnight to 1 yr. @ MRR (interbank rate)
- banks hold funds with central bank - reserves
- excess reserves can be lent in the central bank
funds market

Page 4
Short-term funding ➞ Financials/
Interbank market
- lend/borrow at the central bank funds rate
upper bound - will lend at
- CB targets the rate
lower bound - will borrow at
- if a bank can’t borrow in the interbank market, they can
borrow from CB at the discount window
- collateral required, borrowing rate higher than CB funds
rate
- often invites greater oversight
Commercial paper - dominated by large financial institutions
- unsecured ( ~ 60% of issuance/annum.)
Short-term
ABCP - asset-backed loans
commercial paper Bank SPE ABCP
off balance sheet guarantee ➞ back-up credit facility
- less capital required for banks, investors get access to bank loan
returns

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Page 5
Repurchase Agreements/
secured short-term funding source
- sale of a security with agreement to repurchase it
(sov. bonds usually)

- seller retains ownership of the

Security over the repo term
- gets the yield, buyer gets the repo
rate
- range from overnight to term repos
( > 1 day)
- repo may reference a group of securities
i.e. general (vs. specific) collateral

- seller pays the ‘general collateral’ repo

rate
- repos generally overcollateralized

Page 6
Repurchase Agreements/
e.g./ 30-day repo, Security value $100M, 102% initial margin, repo rate = .25%
𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐩𝐫𝐢𝐜𝐞 𝟏𝟎𝟎𝐌
102% = 1.02 = X = 98,039,216
𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞 𝐩𝐫𝐢𝐜𝐞 𝐗

‘haircut’ = 𝟏𝟎𝟎𝐌 − 𝟗𝟖, 𝟎𝟑𝟗, 𝟐𝟏𝟔

= 1.96%
𝟏𝟎𝟎𝐌

Repurchase price = 98,039,216 × (1 + .0025#𝟑𝟎&𝟑𝟔𝟎') = 98,059,641

- if collateral value changes, margin may change
5 days later, collateral value = 103M.
amount due = 98,039,216 × (1 + .0025(𝟓&𝟑𝟔𝟎*) = 98,042,620
𝐗
102% = X = 100,003,472
𝟗𝟖, 𝟎𝟒𝟐, 𝟔𝟐𝟎
➞ overcollateralized by 2,996,527 ∴ release 2.996M in MV

variation or 𝟐, 𝟗𝟗𝟔, 𝟓𝟐𝟕

= 𝟐. 𝟗𝟏𝐌 𝐅𝐕
margin 𝟏. 𝟎𝟑

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Page 7
Repurchase Agreements/
- used for 3 specific purposes
1/ finance ownership of a security
2/ earn short-term income by lending funds on a secured basis
3/ borrow a security in order to short it (reverse repo)

e.g. buy a bond for 1000 with a yield of 3% and sell it in a repo for
980
repo rate 1%
term 30 days
yield amortized 3%
int. exp. = .867 ➞ min. default or liquidity risk
amortized gain = 𝟐. 𝟓𝟎.
𝐍𝐈𝐈 = 1.683
ROI = 𝟏. 𝟔𝟖𝟑1𝟐𝟎 = 8.415% for 30d (100.98% annualized)
- the longer the term, the higher the repo rate
- the lower the collateral quality/liquidity - the higher the repo rate

Page 8

Repurchase Agreements/ - short a security

1) borrow security (reverse repo) - typically very specific securities
(called specials or ‘on special’)
- negative repo rates typically - sec. buyer pays interest
2) sell security - get cash (earn cash rate)
3) buy security back (hopefully at a lower price)
4) return security - get cash back less reverse repo rate
- repos also used by central banks to affect the money supply
- repo rates are affected by
1/ money market interest rates
2/ collateral quality
3/ repo term
4/ collateral uniqueness - more unique, lower the repo rate
5/ collateral delivery - higher rates if collateral is not delivered

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Page 9
Risks/ Default risk - counterparty may not repurchase
Collateral risk - with low quality collateral
Margining risk - counterparty may not meet margin calls if
collateral drops in value
Legal risk
Netting/settlement risk - money and collateral actually transfer
- risks can be reduced by using a triparty repo

a heavy reliance on the repo market

can create rollover and liquidity risks
under adverse market conditions

Page 10

Long-term corporate debt/ more stable funding

higher yields over time
= maturity premium
wider spreads at longer maturities
(more credit risk)
OAS
higher cost
debt but
more stable
lower cost but rollover risk ∴ less stable
funding
ability rate
uncertainty

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Page 11

HY
IG spread
spread
- more concern about
default

𝐫𝐟 𝐫𝐟

more concern
about credit
migration

IG - relatively standardized, often sen. unsecured

- laddered debt maturity schedules (reduces rollover risk)
- typically > 15 yrs. at issuance
- can issue across the economic cycle, so can be interest rate
strategic
HY - < 10 yrs., lower overall issuance vs. IG
- difficult to issue in some economic environments, so must be
timing strategic ➞ interest rate taker

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Fixed-Income Markets for Government Issuers

a. describe funding choices by sovereign and non-sovereign governments,

quasi-government entities, and supranational agencies

b. contrast the issuance and trading of government and corporate fixed-income

instruments

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FI Markets for Government Issuers

Page 1
DM - developed market issuers
- strong, stable, well-developed domestic economy
- stable and transparent fiscal policy
EM - emerging market issuers
- higher growth but less stable and less well-diversified economies
- typically a dominant domestic industry (usually commodity-based)
- many more state-owned or state controlled enterprises
- bonds possibly denominated in a ‘restricted’ domestic currency
(limited convertibility due to illiquidity)
issued in domestic currency issued in a major foreign currency
- typically held by domestic (USD, EUR)
investors - external debt ➞ held by foreigners
- or debt from IMF/World Bank
- a nation’s fiscal policy determines the level of sovereign debt
required

Page 2
composition of debt
Short-term (1 - 12 months) T-Bills (ZCB)
medium term - long-term Notes, Bonds - fixed rate generally
- limited issuance of FRNs, TIPS
gov’t. guarantees - gov’t. agency debt (Ginnie Mae) - agency MBS
Ricardian equivalence
IF:/ taxpayers smooth consumption (i.e. save expected future taxes)
taxpayers form rational expectations that a tax cut today = higher
future taxes
capital markets are perfect with no transaction costs
taxpayers are altruistic on an intergenerational basis (i.e. pass on
tax savings to descendants)

then:/ taxpayer expects gov’t. debt to be offset by higher future taxes,

then a sov. gov’t. should be indifferent between collecting tax
today or raising debt of any maturity

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Page 3
then:/ - governments should fund themselves with the shortest
possible maturity to minimize borrowing costs
(low rates due to liquidity premium and lack
But/ Conditions do not hold of maturity premium)
∴ debt maturity terms matter
- longer maturity = higher borrowing costs but greater fiscal
stability
Benefits of a maturity spectrum/
establishment of a 𝐫𝐟 benchmark for all other debt
- gov’t. issues benchmark securities (i.e. 2 yr., 5 yr., 10 yr., 30 yr.)
- increases market efficiency and transparency
use in managing and hedging interest rate risk
- bonds to hedge liability interest rate risk
- futures to hedge asset interest rate risk
use as collateral
use in monetary policy and forex reserves

Page 4

issuance of gov’t. debt usually by public auction

- investors submit competitive and non-competitive bids
yield and gets yield determined
amount at auction
Single price auction: highest yield (lowest price)
bids ranked
issue filled - ‘cut off’
lowest yield - all bond sold at this
multiple price
price
- everybody pays their bid
- all non-competitive bids
filled at this price

- bidders are mostly ‘primary dealers’ - must participate

- individual investors can use Treasury Direct to participate
- trade in secondary markets, either OTC (dealers) or exchange-traded
- on-the-run ➞ most recent issue - used as a benchmark yield
(closest to par)

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Page 5

off-the-run - previous issues ➞ mostly owned by buy-and-hold investors

- less liquid, slightly higher yield
Treasuries have a number of ‘non-economic’ buyers
price insensitive
central banks - reserves, monetary policy
banks, insurance companies - regulatory requirement
(LOS 1)
government agencies - quasi-government entities
- have their own cash flows but also a
government guarantee
local/regional (state, provincial, municipal) - issue debt for general
purposes or a specific project general
obligation bonds
revenue bonds
- repaid by tax
- repaid by project’s
receipts
revenue stream

Page 6

Supranational Organizations e.g. IMF, World Bank

- typically provide financing to emerging economies

fund lend
members org. EM
- backup
finance issue
bonds

26
 Last Revised: 06/02/2023

Fixed-Income Bond Valuation: Prices and Yields

a. calculate a bond’s price given a yield-to-maturity on or between coupon dates

b. identify the relationships among a bond’s prices, coupon rate, maturity, and
yield-to-maturity

c. describe matrix pricing

27
 Last Revised: 06/02/2023

FI Bond Valuation: Prices and Yields

Page 1
market discount rate ➞ required yield ➞ required rate of return
(mdr)
𝐏𝐌𝐓𝟏 𝐏𝐌𝐓𝟐 𝐏𝐌𝐓𝐍 + 𝐅𝐕
𝐏𝐕 = + +⋯ +
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫)𝐍
discount rate or yield
𝐍
𝐏𝐌𝐓𝐢 (IRR)
=; + 𝐅𝐕1(𝟏
(𝟏 + 𝐫)𝐢 + 𝐫)𝐍
𝐢%𝟏

e.g./ 3.2% 5-yr. semi at par ➞ market discount rate = coupon rate

- if market discount rate = 2.4%

N = 10 𝐈# = 1.2 PMT = 1.6 FV = 100 CPT PV = -103.75
𝐘
mdr < coupon ➞ premium bond
- if mdr = 4% N = 10 𝐈# = 2
𝐘 PMT = 1.6 FV = 100 CPT PV = -96.41
mdr > coupon ➞ discount bond
in Excel: = PV(rate, n per, pmt, FV, type)
𝐈# 0 = end - most common
𝐘 N PMT FV
1 = beg.

Page 2

yield-to-maturity (YTM)
- given 𝐏𝟎 , can always calculate YTM (IRR)
➞ 3.2% 5 yr. semi @ 108.15
N = 10 PV = -108.15 FV = 100 PMT = 1.6 CPT 𝐈#𝐘 = .7509
× 2 = 1.5019
excel: = YIELD(settlement, maturity, rate, pr, redemption, frequency, [basis]

DATE(YR, mo., d.) PMT PV FV PMTs/yr. day count

convention
ytm typically > 0
0 = 30/360
- may be 0 or < 0 if rates = 0 or < 0 respectively
typically sov. bonds e.g. ZCB issued at premium
ytm(ZCB) :
𝟏#
PV = 𝐅𝐕1(𝟏 + 𝐫)𝐍 1 + r = 8𝐅𝐕1𝐏𝐕9 𝐍
e.g./ 5 yr. ZCB @ 100.763
𝟏# 𝟏#
PV(𝟏 + 𝐫)𝐍 = FV r = 8𝐅𝐕1𝐏𝐕9 𝐍
-1 r = B𝟏𝟎𝟎#𝟏𝟎𝟎. 𝟕𝟔𝟑C 𝟓
-1

(𝟏 + 𝐫)𝐍 = 𝐅𝐕4𝐏𝐕 = - .15%

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Page 3
when a bond is priced between coupon dates, it is quoted as
a flat price ➞ 𝐏𝐕 𝐟𝐥𝐚𝐭
- also has AI (accrued interest)

𝐏𝐕 𝐟𝐮𝐥𝐥 = 𝐏𝐕 𝐟𝐥𝐚𝐭 + 𝐀𝐈
dirty price quoted or clean price

- paid on trade settlement date

AI = 𝐭/𝐓 × PMT quoting flat price avoids volatility

associated with just the
𝐭 = days since last coupon (settlement date passage of time
- coupon date)
𝐓 = days between coupons

Day count convention ➞ 𝟑𝟎1𝟑𝟔𝟎 corporate bonds

𝐚𝐜𝐭1 government bonds
𝐚𝐜𝐭

Page 4

e.g./ 4.375% semi , coupon dates 15th of May/Nov.

1/ act/act AI for Jun. 27 settlement

𝐭 = 16 + 27 = 43 T = 16 + 30 + 31 + 31 + 30 + 31 + 15 = 184
M J M J J A S O N

AI = D𝟒𝟑4𝟏𝟖𝟒H × 1𝟒. 𝟑𝟕𝟓4𝟐5 = .5112/100 of par

2/ 30/360 𝐭 = 15 + 27 = 42 AI = B𝟒𝟐#𝟏𝟖𝟎C × D𝟒. 𝟑𝟕𝟓#𝟐E = .5104/100 of par

M J

➞ algebra: 𝟖𝟐1 = 𝟏
𝟖𝟒
𝟖𝟒,𝟐
𝐏𝐌𝐓𝟏 𝐏𝐌𝐓𝟐 𝐏𝐌𝐓𝐍 + 𝐅𝐕 𝐭
𝐏𝐕 𝐟𝐮𝐥𝐥 =1 + + ⋯+ : (𝟏 + 𝐫) *𝐓
(𝟏 + 𝐫) (𝟏 + 𝐫) 𝟐 (𝟏 + 𝐫)𝐍

𝐏𝐌𝐓𝟏 𝐏𝐌𝐓𝟐 𝐏𝐌𝐓𝐍 + 𝐅𝐕

= 𝟏+𝐭*
+ 𝟐+𝐭*
+ ⋯+ 𝐍+𝐭*
(𝟏 + 𝐫) 𝐓 (𝟏 + 𝐫) 𝐓 (𝟏 + 𝐫) 𝐓

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Page 5
calculate PV here (N = remaining PMTs)

PMT PMT

𝐭
- then × (𝟏 + 𝐫) *𝐓 to get 𝐏𝐕 𝐟𝐮𝐥𝐥 then 𝐏𝐕 𝐟𝐮𝐥𝐥 - AI = 𝐏𝐕 𝐟𝐥𝐚𝐭

e.g./ 3.2% 5-yr. semi @ 100 , 𝟑𝟎#𝟑𝟔𝟎 ➞ mdr = 4%

- 𝐏𝐕 𝐟𝐥𝐚𝐭 and 𝐏𝐕 𝐟𝐮𝐥𝐥 90 days after first coupon date
𝐏𝐕 𝐭𝐞𝐦𝐩 ➞ N = 9, FV = 100, 𝐈#𝐘 = 2, PMT = 1.6 CPT PV = -96.735
𝐏𝐕 𝐟𝐮𝐥𝐥 = 96.375 × (𝟏. 𝟎𝟐)𝟗𝟎/𝟏𝟖𝟎 = 97.698
𝐏𝐕 𝐟𝐥𝐚𝐭 = 97.698 - (𝟏. 𝟔𝟎)B𝟗𝟎#𝟏𝟖𝟎C
= 96.898

Page 6

Coupon effect/
- lower coupon bonds ➞ higher proportion of total cash flows
occur at maturity
∴ higher discount rate ➞ lower PV than if coupon were higher

e.g. 30 yr. ZCB vs. 30 yr., 4.625% annual bond

if YTM = 4.625% PV = 25.759 PV = 100

-24.83% -14.34%
YTM ↑ 100 bps +33.39% PV = 19.364 +18.11%
PV = 85.665
YTM ↓ 100 bps PV = 34.361 PV = 118.107

Maturity effect/ - longer the tenor of the bond, the greater the
%∆PV for a ∆yield
(exception - low yield, long-term bonds at a discount)

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Page 7
Constant yield-price trajectory/
pr.
- bond prices change with the passage of time
- premium or discount bonds are ‘pulled’ to par
disc.
- holding all else constant

Convexity effect/
%∆PV for a - ∆y > %∆PV for a + ∆y
P

inverse relationship
+ ∆y ➞ - ∆P
- ∆y ➞ + ∆P

- ∆y + ∆y 𝐲

Page 8

Matrix pricing/ - for bonds with no current market price

- illiquid or not yet issued
e.g. 3 yr., 4% semi corporate not actively traded
1/ Identify comparable bonds ➞ time to maturity, credit rating
2/ calculate YTM for each, and avg. YTM by maturity
3/ use linear interpolation
4/ use estimate YTM to calculate price

2 yr.
➞ avg. YTM = 3.8035
➞ 3 yr. ➞ 3.93183 3 yrs.

➞ avg. YTM = 4.1885

5 yr.

N=6 𝐈# = 1.965915 PMT = 2 FV = 100 (4.1885 - 3.8035)/3 = .12833

𝐘
CPT PV = - 100.191

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 Last Revised: 06/02/2023

Page 9
- linear interpolation can also be used to estimate required
yield spread (over benchmark rate)
e.g. 5 yr. bond yield for a new corporate issue?

- company has:
4 y, 3% annual at 102.40 (N = 4, PMT = 3, FV = 100, PV = -102.40)
CPT 𝐈#𝐘 = 2.364%

- no 4 yr. gov’t. bonds 3 yr. @ .75% 4 yr. = (.75% + 1.45%)/2 = 1.1%

5 yr. @ 1.45%
∴ required spread = 2.364% - 1.1% = 1.264%

yield spread

5 yr. yield = 1.45% + 1.264% = 2.714%

32
 Last Revised: 06/02/2023

Yield and Yield Spread Measures for Fixed-Rate Bonds

a. calculate annual yield on a bond for varying compounding periods in a year

b. compare, calculate, and interpret yield and yield spread measures for fixed-
rate bonds

33
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Yield & Spread Measures: Fixed Rate Bonds

Page 1
- yield measures (capital market securities) stated as annualized
and compounded
- depends on periodicity (# of interest payments/yr.)
e.g./ 5% stated annual rate
annual 1.05 5%
effective
semi-annual (𝟏. 𝟎𝟐𝟓) 𝟐
= 1.050625 5.0625% annual
quarterly (𝟏. 𝟎𝟏𝟐𝟓) 𝟒
= 1.050945 5.0945% yield
𝟏𝟐
monthly ̇
8𝟏. 𝟎𝟎𝟒𝟏𝟔9 = 1.051162 5.1162% (EAY)
continuous 𝐞.𝟎𝟓 = 1.051271 5.1271%

ZCB - no coupon, so periodicity is arbitrary

e.g. 5 yr. ZCB @ 80 B𝐫#𝟐C
annual 80 = 100/(𝟏 + 𝐫)𝟓 r = 4.564% (𝟏. 𝟎𝟐𝟓𝟔𝟓)𝟐 - 1
𝟏𝟎
semi-annual 800 = 100/B𝟏 + 𝐫#𝟐C r = 4.513% - yield per
quarterly 80 = 100/B𝟏 + 𝐫#𝟒C
𝟐𝟎
r = 4.4879% semi-annual period × 2
𝟔𝟎 (semi-annual bond basis
monthly 80 = 100/B𝟏 + 𝐫#𝟏𝟐C r = 4.4712%
yield or bond equivalent
continuous 80 = 100𝐞(𝐫𝐓 r = 4.4629% yield)

Page 2
- comparing periodicities:
𝐀𝐏𝐑 𝐦 𝐦 𝐀𝐏𝐑 𝐧 𝐧
E𝟏 + I = E𝟏 + I
𝐦 𝐧
e.g. 3.582% semi-annual bond basis
quarterly: . 𝟎𝟑𝟓𝟖𝟐 𝟐 𝐀𝐏𝐑 𝟒 𝟒
E𝟏 + I = E𝟏 + I
𝟐 𝟒
𝟏*
<(𝟏. 𝟎𝟑𝟔𝟏𝟒𝟏) 𝟒 − 𝟏C × 𝟒 = 𝐀𝐏𝐑 𝟒 = 𝟑. 𝟓𝟔𝟔%
𝟏*
monthly <(𝟏. 𝟎𝟑𝟔𝟏𝟒𝟏) 𝟏𝟐 − 𝟏C × 𝟏𝟐 = 𝐀𝐏𝐑 𝟏𝟐 = 𝟑. 𝟓𝟓𝟓𝟔%
compounding more frequently
3.582% ➞ 3.566% ➞ 3.5556% at a lower rate corresponds to
(2) (4) (12)
less frequently at a higher rate

e.g./ 20 yr. ZCB @ 69.43 vs. 20 yr. 4% semi @ 101.99

69.43 = 𝟏𝟎𝟎. N = 40 PMT = 2 PV = -101.99 FV = 100
𝟒𝟎
*𝟏 + 𝐫#𝟐- 𝐈# × 2 = 1.928
𝐘
r = 1.833

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Page 3
- negative yields 5 yr. ZCB @ 103.72
𝟏#
annual B𝟏𝟎𝟎#𝟏𝟎𝟑. 𝟕𝟐C 𝟓
- 1 = -.7278%
𝟏#
semi IB𝟏𝟎𝟎#𝟏𝟎𝟑. 𝟕𝟐C 𝟏𝟎
− 𝟏K × 2 = -.7291%
𝟏#
monthly IB𝟏𝟎𝟎#𝟏𝟎𝟑. 𝟕𝟐C 𝟔𝟎
− 𝟏K × 12 = -.7303%

Street convention - yield quoted assuming payments are made

on scheduled dates (does not account for weekends
and holidays)
true yield - uses actual payment dates
- never higher than street convention since weekends and
holidays delay time to payment

government equivalent yield - restating a 𝟑𝟎1𝟑𝟔𝟎 as 𝐚𝐜𝐭1𝐚𝐜𝐭

𝐘𝐢𝐞𝐥𝐝𝟑𝟎* × 𝟑𝟔𝟓#𝟑𝟔𝟎
𝟑𝟔𝟎

Page 4

Simple yield = 𝐜𝐨𝐮𝐩𝐨𝐧 𝐩𝐚𝐲𝐦𝐞𝐧𝐭 + 𝐬𝐭𝐫𝐚𝐢𝐠𝐡𝐭 𝐥𝐢𝐧𝐞 𝐚𝐦𝐨𝐫𝐭. 𝐨𝐟 𝐩𝐫./𝐝𝐢𝐬𝐜.

𝐏𝐕 𝐟𝐥𝐚𝐭
(most common with Japanese government bonds)

Bonds with embedded options - calculate yield to call (first, second...)

e.g. 6.5% 7 yr. semi @ 106.25
call schedule
end of: yield to first call

1. 103.25 yr. 3 N= 6 FV = 103.25 PMT = 3.25 PV = -106.25 5.1496%

2. 102.50 yr. 4 N= 8 FV = 102.50 yield to 5.2472%
3. 101.75 yr. 5 N = 10 FV = 101.75 second call 5.3128%
4. 101 yr. 6 N = 12 FV = 101 5.3622%
100 yr. 7 N = 14 FV = 100 5.3736%

- lowest is called yield-to-worst (first call) ytm

- more precise way uses an option pricing model to get an option

adjusted price

35
 Last Revised: 06/02/2023

Page 5

microeconomic factors
- issuer and the bond
In bps itself
can affect credit risk as
well
macroeconomic factors
- general economic growth,
business cycle, fiscal and
monetary policy

varies across financial markets

- fixed rate bonds often use gov’t. benchmark security (the most
recently issued ‘on the run’ security) ➞ G-spread

- floating - typically an interbank rate (e.g. SOFR)

Page 6
e.g./ 24 yr. 5.25% semi 𝟑𝟎&
𝟑𝟔𝟎 @ 123.50
issuer curve
20 yr. UST 2%
30 yr. UST 2.25% YTM
N = 48
(. 𝟎𝟐𝟐𝟓 − . 𝟎𝟐)
× 𝟒 = .𝟏 PMT = 2.625
𝟏𝟎
PV = -123.50
benchmark curve 2% + .1 = 2.1% FV = 100
(gov’t. or swap curve)
*𝐈#𝐘 × 𝟐- = 3.756%
20 24 30

G-spread = 3.756% - 2.1% = 165.5 bps

I-spread: same method but using swap rates (interbank rates)

- same currency, same tenor
Z-spread - zero volatility spread - constant spread over each spot rate
𝐏𝐌𝐓𝟏 𝐏𝐌𝐓𝟐 𝐏𝐌𝐓𝐍 + 𝐅𝐕
𝐏𝐕 = + + ⋯+
(𝟏 + 𝐳𝟏 + 𝐙) (𝟏 + 𝐳𝟐 + 𝐙)𝟐 (𝟏 + 𝐳𝐍 + 𝐙)
spot rates - derived from par curve

36
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Page 7
OAS - option adjusted spread (non zero-volatility)
- requires a pricing model + estimate of interest rate volatility

OAS = Z spread + option value in bps (putable bond ➞ long the put)
callable bond ➞ short the call
z-spread - option value in bps

37
 Last Revised: 06/02/2023

Yield and Yield Spread Measures for Floating-Rate Instruments

a. calculate and interpret yield spread measures for floating-rate instruments

b. calculate and interpret yield measures for money market instruments

38
 Last Revised: 06/02/2023

Yield & Spread Measures: Floating Rate Bonds

Page 1
⇒ Yield Measures
1/ Floating rate instruments

- floating rate bonds, bank loans ➞ reference rate is usually a

short-term money market rate (SOFR)

- typically stated as MRR + spread

(1, 3, 6 months) quoted margin

- determined at beginning of the period, paid at the end

(in arrears)

Fixed Coupon Stable price

variable variable
price coupon

Page 2
⇒ Yield Measures/
1/ Floating rate bonds - common day count conventions
𝐚𝐜𝐭.. 𝐚𝐜𝐭..
𝟑𝟔𝟓 𝟑𝟔𝟎
yield spread over the reference rate ➞ quoted margin ➞ credit related
required margin ➞ spread required by investors to ➞ may even be

reflect changes in credit quality negative (sub-Libor)

- changes usually come from changes in the issuer’s credit

risk
∴ FRN with quoted margin = 50 bps with no changes in
credit risk, required margin = 50bps
PMT PMT premium between PMT dates for a
PV = 100 PV = 100
PV change in the reference
discount rate ➞ but PV pulled to
QM - quoted margin par as PMT date nears

DM - discount margin if QM = DM ➞ PV = 100 on reset date

QM > DM ➞ PV > 100 and QM < DM ➞ PV < 100

39
 Last Revised: 06/02/2023

Page 3
⇒ Yield Measures/
1/ Floating rate bonds
(𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕
+ 𝐅𝐕
𝐏𝐕 = 𝐦 + 𝐦 + ⋯ + 𝐦
𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝟐
𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝐍
C𝟏 + F C𝟏 + 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌F C𝟏 + F
𝐦 𝐦 𝐦

e.g./ 2 yr. FRN, pays 6-mos. Libor + 50 bps, required spread = 40 bps
1.25%
Index = .0125
N= 4
QM = .005
DM = .004 PMT = (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 = (. 𝟎𝟏𝟐𝟓 + . 𝟎𝟎𝟓) × 𝟏𝟎𝟎 = . 𝟎𝟏𝟕𝟓 = . 𝟖𝟕𝟓
𝐦 𝟐 𝟐
𝐈4 = 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 . 𝟎𝟏𝟐𝟓 + . 𝟎𝟎𝟒 . 𝟎𝟏𝟔𝟓
𝐘 = = = . 𝟖𝟐𝟓%
𝐦 𝟐 𝟐
FV = 100

CPT PV = 100.196 QM > DM ∴ PV > 100

Page 4
⇒ Yield Measures/
1/ Floating rate bonds
e.g./ 5 yr. FRN, pays 3-mos. Libor, QM = 75 bps, PV = 95.50 (DM = ?)
1.10%
N = 20, FV = 100, PV = -95.50, PMT = !𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌0 × 𝐏𝐕 = 𝟏. 𝟖𝟓% × 𝟏𝟎𝟎 = . 𝟒𝟔𝟐𝟓
𝟒 𝟒
CPT 𝐈1𝐘 = .7045% ➞ (.007045 × 4) - .0110 = DM
DM = 171.8 bps

e.g./ 4 yr. FRN pays 3-mos. Euribor + 125 bps @ 98 (DM = ?)

N = 16 2%
PMT = 𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌 × 𝐏𝐕 = (. 𝟎𝟐 + . 𝟎𝟏𝟐𝟓) × 𝟏𝟎𝟎 = . 𝟖𝟏𝟐𝟓
FV = 100 𝐦 𝟒
CPT 𝐈#𝐘 = .009478 ⇒ (.009478 × 4) - Index = DM
PMT = .8125
PV = -98 = .017912
or/ 179.12 bps

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Page 5
⇒ Yield Measures/
1/ Floating rate bonds assumes MRR is the same
for all cash flows

Z-DM - a constant DM added to each spot rate

forward rates e.g. 𝐟𝟑,𝟑 , 𝐟𝟔,𝟑 , 𝐟𝟗,𝟑 , 𝐟𝟏𝟐,𝟑 ...

(𝐌𝐑𝐑 + 𝐐𝐌) × 𝐅𝐕 (𝐟𝐌𝐑𝐑 + 𝐐𝐌) × 𝐅𝐕 (𝐟𝐌𝐑𝐑 + 𝐐𝐌) × 𝐅𝐕

+ 𝐏𝐕
𝐏𝐕 = 𝐦 + 𝐦 + ⋯+ 𝐦
-
𝐙 + 𝐙 𝐃𝐌
1𝟏 + 𝟏 5 𝐙𝟐 + 𝐙-𝐃𝐌 𝟐
𝐙𝐧 + 𝐙-𝐃𝐌 𝐍𝐦
𝐦 1𝟏 + 5 1𝟏 + 5
𝐦 𝐦

spot rates constant amount

and not MRR added to each spot rate

Page 6
⇒ Yield Measures/
2/ Money market instruments
annualized, but not compounded ⇒ instead
rates of return are stated on a simple interest basis
either discount rates or add-on rates
(T-bills, CP, BA) (CDs, repos)

Discount rates interest

𝐝𝐚𝐲𝐬 𝐲𝐫. 𝐅𝐕 − 𝐏𝐕 earned
PV = FV × I𝟏 − × 𝐃𝐑O ⇒ 𝐃𝐑 = I OI O
𝐲𝐫. 𝐝𝐚𝐲𝐬 𝐅𝐕
91-day T-bill, $10M, DR = 2.25% periodicity FV, not PV
360-day yr. ∴ DR will
𝐏𝐕 = $𝟏𝟎𝐌 × D𝟏 − 𝟗𝟏4𝟑𝟔𝟎 × . 𝟎𝟐𝟐𝟓H understate the rate of
return to the investor and
= $𝟗, 𝟗𝟒𝟑, 𝟏𝟐𝟓
the cost of funds to the
borrower

41
 Last Revised: 06/02/2023

Page 7
⇒ Yield Measures/
2/ Money market instruments
Add-on rates PV = 𝐅𝐕
𝐝𝐚𝐲𝐬1 ⇒ AOR = ! 𝐲𝐫. 0 !𝐅𝐕 − 𝐏𝐕0
Q𝟏 + 𝐲𝐫. × 𝐀𝐎𝐑T 𝐝𝐚𝐲𝐬 𝐏𝐕

e.g./ 180-day BA, AOR = 4.38, 365-day yr., $10M periodicity 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐞𝐚𝐫𝐧𝐞𝐝
𝐩𝐫𝐢𝐜𝐞 𝐩𝐚𝐢𝐝
FV = PV(1 + 𝐝𝐚𝐲𝐬#𝐲𝐫. × AOR)
= $10M(1 + 𝟏𝟖𝟎#𝟑𝟔𝟓 × .0438) = $10,216,000

Note: FV = PV(𝟏 + 𝐫)𝐧 ➞ compounded interest

FV = PVQ𝟏 + 𝐝𝐚𝐲𝐬1𝐲𝐫. 𝐫T ➞ simple interest (money market yields)

➞ Sell after 45 days when AOR = 4.17%

𝟏𝟎, 𝟐𝟏𝟔, 𝟎𝟎𝟎
𝐏𝐕 = = $𝟏𝟎, 𝟎𝟔𝟎, 𝟖𝟐𝟗 ⇒ implies AOR = M𝟑𝟔𝟓N M𝟏𝟎, 𝟎𝟔𝟎, 𝟖𝟐𝟗 − 𝟏𝟎N
Q𝟏 + 𝟏𝟑𝟓1𝟑𝟔𝟓 ×. 𝟎𝟒𝟏𝟕T 𝟒𝟓 𝟏𝟎

= 4.934%

Page 8
⇒ Yield Measures/ ⇒ DR vs. AOR
2/ Money market instruments
⇒ 360 vs. 365
- convert all to AOR with 365d to compare:
e.g./ 90-day CP, DR = 5.76%, 360-day yr. vs. 90-day CD, AOR = 5.9%, 365d/yr.
PV = 100 × (1 - 𝟗𝟎#𝟑𝟔𝟎 × .0576) = 98.56
𝟏𝟎𝟎 − 𝟗𝟖. 𝟓𝟔
AOR = Q𝟑𝟔𝟓1 T E I = . 𝟎𝟓𝟗𝟐𝟓 vs. 5.9%
𝟗𝟎 𝟗𝟖. 𝟓𝟔
BEY - bond equivalent yield ➞ AOR for 365d.
- all 180 day A. PV = 100 × (1 - 𝟏𝟖𝟎#𝟑𝟔𝟎 × .0433) = 97.835
𝟏𝟎𝟎 − 𝟗𝟕. 𝟖𝟑𝟓
A - DR = 4.33, 360d AOR = D𝟑𝟔𝟓#𝟏𝟖𝟎E M N = 𝟒. 𝟒𝟖𝟕%
𝟗𝟕. 𝟖𝟑𝟓
B - DR = 4.36, 365d B. PV = 100 × (1 - 𝟏𝟖𝟎#𝟑𝟔𝟓 × .0436) = 97.84986
𝟏𝟎𝟎 − 𝟗𝟕. 𝟖𝟒𝟗𝟖𝟔
C - AOR = 4.35, 360d AOR = D𝟑𝟔𝟓#𝟏𝟖𝟎E M N = 𝟒. 𝟒𝟓𝟔%
𝟗𝟕. 𝟖𝟒𝟗𝟖𝟔
D - AOR = 4.45, 365d C. FV = 100 × (1 + 𝟏𝟖𝟎#𝟑𝟔𝟎 × .0435) = 102.175
ok! AOR = D𝟑𝟔𝟓#𝟏𝟖𝟎E M
𝟏𝟎𝟐. 𝟏𝟕𝟓 − 𝟏𝟎𝟎
N = 𝟒. 𝟒𝟏%
𝟏𝟎𝟎

42
 Last Revised: 06/02/2023

The Term Structure of Interest Rates: Spot, Par, and Foward Curves

a. define spot rates and the spot curve, and calculate the price of a bond using
spot rates

b. define par and forward rates, and calculate par rates, forward rates from spot
rates, spot rates from forward rates, and the price of a bond using forward
rates

c. compare the spot curve, par curve, and forward curve

43
 Last Revised: 06/02/2023

Term Structure of Rates: Par/Spot/Forward

Page 1
⇒ Maturity structure of interest rates/
yield
for bonds with the
maturity structure
same currency credit risk
or
term structure liquidity tax status
yield
curve same coupon (reinvestment
time to risk held constant)
maturity
government bond spot curve ➞ YTMs for zero-coupon bonds for a
(a.k.a. zero or strip curve) full range of maturities
upward sloping ➞ normal ➞ longer maturities have higher YTMs
downward sloping ➞ inverted
- no coupon ➞ no reinvestment risk, but/ most bonds have coupons
∴ need a term structure for coupon paying bonds, but/ older bonds
may have different tax/liquidity status ∴ use on-the-run bonds,
but/ there is limited data for the full range of maturities
∴ interpolate between dates

Page 2
⇒ Maturity structure of interest rates/
- typically stated on
a semi-annual bond basis
- observed yields on recently issued ‘on-the-run’
coupon paying bonds
- gov’t. bond yield - 1 mos., 3 mos., 6 mos. ➞ money market, all converted
curve, coupon bonds to BEY (semi-annual basis)
⇒ Par Curve - sequence of YTMs such that each
bond is priced at par
- par rates are derived from spot rates
spots 𝐏𝐌𝐓 + 𝟏𝟎𝟎
𝟏𝟎𝟎 = PMT = 5.263%
1 yr. - 5.263% 𝟏. 𝟎𝟓𝟐𝟔𝟑
2 yr. - 5.616% 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝟏𝟎𝟎
𝟏𝟎𝟎 = + PMT = 5.606
𝟏. 𝟎𝟓𝟐𝟔𝟑 (𝟏. 𝟎𝟓𝟔𝟏𝟔)𝟐
3 yr. - 6.359%
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝟏𝟎𝟎
4 yr. - 7.008% 𝟏𝟎𝟎 = + + PMT = 6.306
𝟏. 𝟎𝟓𝟐𝟔𝟑 (𝟏. 𝟎𝟓𝟔𝟏𝟔) 𝟐 (𝟏. 𝟎𝟔𝟑𝟓𝟗)𝟑
etc…

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 Last Revised: 06/02/2023

Page 3
e.g./ spot rates: 3 yr. 5% annual bond
𝟓 𝟓 𝟏𝟎𝟓
1 yr. 2% (𝐙𝟏 ) 𝐏𝐕 = 𝟏. 𝟎𝟐 + 𝟏. 𝟎𝟑𝟐 + (𝟏. 𝟎𝟒)𝟑 = 𝟏𝟎𝟐. 𝟗𝟔
2 yr. 3% (𝐙𝟐 ) YTM: N= 3 PMT = 5 FV = 100 PV = -102.96
3 yr. 4% (𝐙𝟑 ) CPT 𝐈&
𝐘 = 3.935%
pulled towards r(3) since the
weight of the CFs are at T = 3.

e.g./ spot rates 𝟏=

𝐏𝐌𝐓
+
𝐏𝐌𝐓
…+
𝐏𝐌𝐓
+
𝐅𝐕
DF 𝟏 + 𝐫𝟏 (𝟏 + 𝐫𝟐 )𝟐 (𝟏 + 𝐫𝐍 )𝐍 (𝟏 + 𝐫𝐍 )𝐍
r(1) = .31% .9969
𝟏 𝟏 𝟏 𝟏
r(2) = .57% .9887 = 𝐏𝐌𝐓 + 𝐏𝐌𝐓 + ⋯ + 𝐏𝐌𝐓 + 𝐅𝐕
(𝟏 + 𝐫𝟏 ) (𝟏 + 𝐫𝟐 )𝟐 (𝟏 + 𝐫𝐍) 𝐍 (𝟏 + 𝐫𝐍 )𝐍
r(3) = .80% .9764
2.9620 = PMT 𝐃𝐅𝟏 + PMT 𝐃𝐅𝟐 + ... + PMT 𝐃𝐅𝐍 + FV 𝐃𝐅𝐧
calculate PMT 1 = PMT 𝚺DF + PV 𝐃𝐅𝐍
i.e. 3 yr. par rate PMT 𝚺DF = 1 - 𝐃𝐅𝐍 𝟏 − . 𝟗𝟕𝟔𝟒
PMT = (1 - 𝐃𝐅𝐍 ) 𝐏𝐌𝐓 = = . 𝟕𝟗𝟔𝟕%
𝟐. 𝟗𝟔𝟐𝟎
𝚺DF

Page 4
⇒ Maturity structure of interest rates/
Forward curve ➞ based on forward rates
➞ agreed on today, received/paid in the future
➞ quoted as ‘when, what’

e.g./ 2y5y ➞ an agreement on a rate, when ➞ in 2 years

f(2,5) more common what ➞ a 5 yr. rate
- implied forward rates are calculated from spot rates
spots f(3,1) 3.65%
f(3,1)
3 yr. = 3.65%
4 yr. = 4.18% 4.18%
. 𝟎𝟒𝟏𝟖 𝟖
. 𝟎𝟑𝟔𝟓 𝟔 𝐟(𝟑, 𝟏) 𝟐
E𝟏 + I = E𝟏 + I E𝟏 + I
𝟐 𝟐 𝟐
semi-annual
𝟏;
bond basis (𝟏. 𝟎𝟐𝟎𝟗)𝟖 𝟐
ab c − 𝟏d = 𝐟(𝟑, 𝟏) = . 𝟎𝟐𝟖𝟖𝟗𝟏𝟒𝟓𝟐 × 𝟐
(𝟏. 𝟎𝟏𝟖𝟐𝟓)𝟔
= . 𝟎𝟓𝟕𝟕𝟖𝟐𝟗

45
 Last Revised: 06/02/2023

Page 5
- deriving spot rates from forward rates:
𝟏;
r(1) = 1.88% r(2) = [(𝟏. 𝟎𝟏𝟖𝟖) × (𝟏. 𝟎𝟐𝟕𝟕)] 𝟐 - 1 = 2.324%
𝐟𝟏,𝟏 = 2.77% 𝟏;
r(3) = [(𝟏. 𝟎𝟏𝟖𝟖)(𝟏. 𝟎𝟐𝟕𝟕)(𝟏. 𝟎𝟑𝟓𝟒)] 𝟑 - 1 = 2.728%
𝐟𝟐,𝟏 = 3.54% 𝟏;
or g(𝟏. 𝟎𝟐𝟑𝟐𝟒)𝟐 (𝟏. 𝟎𝟑𝟓𝟒)h 𝟑 - 1 = 2.728%
𝐟𝟑,𝟏 = 4.12%
𝟏;
r(4) = [(𝟏. 𝟎𝟏𝟖𝟖)(𝟏. 𝟎𝟐𝟕𝟕)(𝟏. 𝟎𝟑𝟓𝟒)(𝟏. 𝟎𝟒𝟏𝟐)] 𝟒 - 1 = 3.074%
𝟏;
or g(𝟏. 𝟎𝟐𝟕𝟐𝟖)𝟑 (𝟏. 𝟎𝟒𝟏𝟐)h 𝟒
- 1 = 3.074

Page 6
⇒ Maturity structure of interest rates/

forward
spot
par par
spot
forward

- forward curve is a series of 1 yr. forward rates ➞ f(1,1), f(2,1), f(3,1)

- forward rates are also referred to as break-even etc…
rate or no-arbitrage rates

Pricing/ - using spots 𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕

+ +
(𝟏 + 𝐫𝟏 ) (𝟏 + 𝐫𝟐 )𝟐 (𝟏 + 𝐫𝟑 )𝟑
- 3 yr. annual
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕
- using forwards + +
(𝟏 + 𝐫𝟏 ) (𝟏 + 𝐫𝟏 )(𝟏 + 𝐟(𝟏, 𝟏)) (𝟏 + 𝐫𝟏 )(𝟏 + 𝐟(𝟏, 𝟏))(𝟏 + 𝐟(𝟐, 𝟏))

46
 Last Revised: 06/02/2023

Interest Rate Risk and Return

a. calculate and interpret the sources of return from investing in a fixed-rate

bond;

b. describe the relationships among a bond’s holding period return, its

Macaulay duration, and the investment horizon;

c. define, calculate, and interpret Macaulay duration.

47
 Last Revised: 06/02/2023

Interest Rate Risk and Return

Page 1
- fixed rate bonds: 3 sources of return
1/ receipt of promised coupon and principal payments
on scheduled dates
2/ reinvestment of coupon payments
interest
rate risk 3/ potential capital gains/losses on sale of bond prior
to maturity
e.g./ 10 yr. 6.2% annual bond @ 100, no change in rates

1/ Buy and hold: 2/ 4 yr. investment horizon

𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 82.49256 𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 27.2032
(N = 10, PMT = 6.2, PV = 0, 𝐈&𝐘 = 6.2) (N = 4, PMT = 6.2, PV = 0, 𝐈&𝐘 = 6.2)
interest-on-interest = 20.49256 interest-on-interest = 2.4032
(82.49256 - 62) (27.2032 - 24.80)
Total FV = 182.49256 Total FV = 127.2032
horizon yield = 6.2% horizon yield = 6.2%

Page 2
premium
bond each point = bond’s carrying
100 value
= 𝐏𝟎 +⁄− amort. of disc./pr.
constant-yield price trajectory
discount
bond
T
- what if r ↑ 100 bps before first coupon
1/ Buy and hold: 2/ 4 yr. inv. horizon (T = 0 par bond)
𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 86.4754 𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 27.6092
(N = 10, PMT = 6.2, PV = 0, 𝐈&𝐘 = 7.2) (N = 4, PV = 0, PMT = 6.2, 𝐈&𝐘 = 7.2)
Total PV = 186.4754
𝟏#
𝐏𝐕𝐛𝐨𝐧𝐝 = 95.2627 (T = 4 discount
(N = 6, FV = 100, PMT = 6.2, 𝐈&𝐘 = 7.2) bond
)
horizon yield = 8𝐅𝐕1𝐏𝐕9 𝐓
- 1 𝟏'
horizon yield = 𝟏𝟐𝟐. 𝟖𝟕𝟏𝟗 𝟒
- 1 = 5.28%
𝟏' : =
= :𝟏𝟖𝟔. 𝟒𝟕𝟓𝟒= 𝟏𝟎𝟎
𝟏𝟎
- 1 = 6.4295% (vs. 6.2%)
𝟏𝟎𝟎
(vs. 6.2%)

48
 Last Revised: 06/02/2023

Page 3
- 2 offsetting types of risk:
reinvestment risk - buy and hold only has this
price risk
𝐏𝐓 ↑ if r ↓ inverse price/yield
𝐏𝐓 ↓ if r ↑ relationship

- now assume 8 yr. investment horizon/ r ↑ 100 bps

𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 64.0707 (vs. 61.80656 @ r = 6.2)
(N = 8, PMT = 6.2, 𝐈*𝐘 = 7.2, PV = 0) if r ↓ 100 bps
𝐏𝐕𝟖 = 98.19698 𝐅𝐕𝐜𝐨𝐮𝐩𝐨𝐧𝐬 = 59.6296 (↓ 2.1769)
(N = 2, PMT = 6.2, FV = 100, 𝐈*𝐘 = 7.2)
𝟏'
𝐏𝐕𝟖 = 101.854 (↑ 1.854)
horizon yield = 𝟏𝟔𝟐. 𝟐𝟔𝟕𝟔𝟖 𝟖 - 1 = 6.23778 (N = 2, PMT = 6.2, FV = 100, 𝐈*𝐘 = 5.2)
: =
𝟏𝟎𝟎
(vs. 6.2%) 𝟏'
horizon yield = <𝟏𝟔𝟏. 𝟒𝟖𝟑𝟔@ 𝟖
- 1 = 6.173%
coupon reinv. + 2.264 𝟏𝟎𝟎
(vs. 6.2%)
cap. loss - 1.803

Page 4

Macaulay duration (MacDur) - the point in time where

any reinvestment gain/loss is offset by any
capital loss/gain for a one-time instantaneous parallel
shift in the yield curve

neg.
gap

Duration gap = MacDur - Investment horizon

pos. gap negative gap ➞ risk = lower rates

positive gap ➞ risk = higher rates

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 Last Revised: 06/02/2023

Page 5

MacDur ➞ the weighted average of the time to receipt

of cash flows based on 𝐏𝐕 𝐟𝐮𝐥𝐥 ➞ quoted as a measure of
𝐏𝐕 𝐟𝐮𝐥𝐥 using bond’s time
IRR

quoted as an
= IRR (array) 𝐂𝐅𝟏 annualized stat
r = 6.2 (in years)
𝚺𝐂𝐅
- also called the bond’s or
portfolio’s cash flow yield

Page 6

𝐏𝐌𝐓 𝐏𝐌𝐓 weight 𝐏𝐌𝐓

PV of weight
(𝟏 + 𝐫)𝐭 1 × (𝟏 + 𝐫)𝐭
(𝟏 + 𝐫)𝐭 CF of ×
𝐏𝐕 𝐟𝐮𝐥𝐥 CF 𝐏𝐕 𝐟𝐮𝐥𝐥 time
𝐏𝐌𝐓 Z𝟏 − 𝐭/𝐓[
𝟏,𝐭;
(𝟏 + 𝐫) 𝐓
between coupon dates

closed form formula

50
 Last Revised: 06/02/2023

Yield-Based Bond Duration Measures and Properties

a. define, calculate, and interpret modified duration, money duration, and the
price value of a basis point (PVBP)

b. explain how a bond’s maturity, coupon, and yield level affect its interest rate
risk

51
 Last Revised: 06/02/2023

Yield-Based Bond Duration: Measures and Properties

Page 1
assumes underlying bond cash flows are certain
price 𝚺 of all future cash flows (e.g. 5 yr., 4% annual bond, r = 0%)
PV = 120
par price sensitivity ➞ first derivative of price/yield
curve at a certain point
yield 𝐝𝐌𝐚𝐜𝐃𝐮𝐫
= ModDur = 𝐌𝐚𝐜𝐃𝐮𝐫
𝐝𝐏𝐕 𝐝𝐫 𝟏+𝐫
➞ $∆ in PV for a ∆yield
𝐝𝐫 yield/period

𝐝𝐏𝐕
I O
𝐝𝐫 = %∆𝐏𝐕 𝐟𝐮𝐥𝐥 for a ∆yield ⇒ %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = -ModDur × ∆yield
𝐏𝐕
calibrated for
100 bps change in yield

Page 2

e.g./ ModDur = 5 ⇒ 𝐏𝐕 𝐟𝐮𝐥𝐥 ↑ 5% for 100 bps ↓ in yield

%∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-5 × - .0100) = + 5%

- higher ModDur ➞ steeper the price-yield curve, the more sensitive

the bond to ∆yield (∆r)

e.g./ 5 yr., 3.2% semi @ 100

if ∆yield = 80 bps ↑
MacDur = 9.3203 (in semi annual periods)
ModDur = 𝟗. 𝟑𝟐𝟎𝟑 %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = -4.58676 × .008
= 9.17352
𝟏. 𝟎𝟏𝟔
= -3.6694%
AnnModDur = 9.17352/2 = 4.58676
(yields up, price down)
ApproxModDur/
S𝐫𝐢𝐬𝐞.𝐫𝐮𝐧T ➞ slope of tangent line
𝐏𝐕𝟎 - divide by 𝐏𝐕𝟎 ➞ sensitivity at a
point

52
 Last Revised: 06/02/2023

Page 3
ApproxModDur/ ∆y = 100 bps ↑ ➞ 𝐏𝐕2
↓ ➞ 𝐏𝐕+
rise = 𝐏𝐕, - 𝐏𝐕A
𝐏𝐕( run = 2 ∆yield

𝐏𝐕𝟎 𝐏𝐕, − 𝐏𝐕A 𝟏 𝐏𝐕, − 𝐏𝐕A

ApproxModDur ≈ I O× =
𝐏𝐕0 𝟐 ∆𝐲𝐢𝐞𝐥𝐝 𝐏𝐕𝟎 𝟐 ∆𝐲𝐢𝐞𝐥𝐝 𝐏𝐕𝟎
𝐏𝐕𝟎 𝟏
ytm × will need a
∆y ∆y 𝟏 𝐏𝐕𝟎 convexity
yield/period adjustment
AnnMacDur ≈ AnnModDur (1 + r)
e.g./ 5 yr., 3.2% semi @ 100 𝟏𝟎𝟒. 𝟕𝟏𝟎𝟑 − 𝟗𝟓. 𝟓𝟑𝟐𝟏
ApproxModDur ≈
𝐏𝐕( = (N = 10, PMT = 1.6, 𝐈&𝐘 = 1.1, FV = 100) 𝟐 × . 𝟎𝟏 × 𝟏𝟎𝟎

CPT PV = 104.7103 ≈ 4.5891

𝐏𝐕0 = (N = 10, PMT = 1.6, 𝐈&𝐘 = 2.1, FV = 100)
CPT PV = 95.5321

Page 4

Money Duration ➞ $∆𝐏𝐕 𝐟𝐮𝐥𝐥 for a ∆yield

(dollar duration in US) DD = AnnModDur × 𝐏𝐕 𝐟𝐮𝐥𝐥
DD
and $∆𝐏𝐕 𝐟𝐮𝐥𝐥 = - DD × ∆yield

PVBP ➞ price value of a basis point ➞ $∆𝐏𝐕 𝐟𝐮𝐥𝐥 for a 1 bps

(or PV01/DV01) ∆yield
= 𝐏𝐕, − 𝐏𝐕A
𝟐

BPV = -ModDur × 𝐏𝐕 𝐟𝐮𝐥𝐥 × .0001

- DD

e.g./ 5 yr., 3.2% semi

𝐏𝐕( (N = 10, PMT = 1.6, 𝐈&𝐘 = 1.595, FV = 100)
CPT PV = 100.5396
PVBP = 𝟏𝟎𝟎. 𝟓𝟑𝟗𝟔 − 𝟗𝟗. 𝟗𝟓𝟒𝟏
𝐏𝐕0 (N = 10, PMT = 1.6, 𝐈&𝐘 = 1.605, FV = 100) 𝟐
CPT PV = 99.9541 = .044556

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Page 5

ZCB - MacDur = time to maturity (100% of CF weight on last pmt.)

ModDur = MacDur (1 + r)
Perpetuity - MacDur = 𝟏 + 𝐫
𝐫
FRNs - 𝐌𝐚𝐜𝐃𝐮𝐫𝐟𝟏 = 𝐓 − 𝐭 fraction of time remaining until
𝐓 next reset date
e.g. 𝟓𝟔# ➞ 𝟏𝟖𝟎 − 𝟓𝟔 = 𝟏𝟐𝟒#
𝟏𝟖𝟎 ̇
𝟏𝟖𝟎 𝟏𝟖𝟎 = . 𝟔𝟖
Properties of Duration/ MacDur
ZCB

discount
bond
perpetuity
premium
bond

time to maturity

Page 6

- duration ↓ as time passes

MacDur
coupon payment ➞ nearest CF falls off
➞ weight shifts to further
cash flows
time to maturity

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 Last Revised: 06/02/2023

Yield-Based Bond Convexity and Portfolio Properties

a. calculate and interpret convexity and describe the convexity adjustment

b. calculate the percentage price change of a bond for a specified change in

yield, given the bond’s duration and convexity

c. calculate portfolio duration and convexity and explain the limitations of these
measures

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Yield-Based Bond Convexity

Page 1

ModDur - first order effect (linear)

Convexity - second order effect (option-free bond)
- results in:
%∆𝐏𝐕 𝐟𝐮𝐥𝐥 for ↓ ∆y > %∆𝐏𝐕 𝐟𝐮𝐥𝐥 for ↑ ∆y

%∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (- ModDur × ∆y)

+ (𝟏&𝟐 × AnnConv. × ∆𝐲 𝟐 )

convexity adjustment

ApproxModDur = 𝐏𝐕, − 𝐏𝐕A ApproxConvexity = 𝐏𝐕, + 𝐏𝐕A − 𝟐 𝐏𝐕𝟎

𝟐 × ∆𝐲 × 𝐏𝐕𝟎 ∆𝐲 𝟐 𝐏𝐕𝟎

Page 2
5 yr., 3.2% semi @ 100

W.
𝟏 × 𝟐 × . 𝟎𝟏𝟓𝟕
(𝟏. 𝟎𝟏𝟔)𝟐

non-linearity

𝟕 × 𝟖 × . 𝟎𝟏𝟒𝟑
(𝟏. 𝟎𝟏𝟔)𝟐

𝐭𝐢𝐦𝐞𝐭 × 𝐭𝐢𝐦𝐞𝐭A𝟏 × 𝐖
fixed rate bond will have greater convexity: (𝟏 + 𝐈𝐑𝐑)𝟐
per period
the longer the time-to-maturity i.e. anything
÷
the lower the coupon that leads to
(𝐩𝐞𝐫𝐢𝐨𝐝𝐬/𝐲𝐫. )𝟐
the lower its ytm higher ModDur for
fixed rate bonds

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 Last Revised: 06/02/2023

Page 3
another factor is dispersion of cash flows
- for 2 bonds with the same duration, the one with the
greater dispersion of cash flows will have the greater convexity

e.g./ 30 yr., 4.625% annual @ 4.75% ytm

N = 30 PMT = 4.625 FV = 100 𝐈# = 4.75

𝐘 𝐏𝐕𝟎 = -98.02244
= 4.80 𝐏𝐕A = -97.24738
= 4.70 𝐏𝐕, = -98.80656
ApproxModDur = 𝟗𝟖. 𝟖𝟎𝟔𝟓𝟔 − 𝟗𝟕. 𝟐𝟒𝟕𝟑𝟖
= 𝟏𝟓. 𝟗𝟎𝟔𝟑𝟔
𝟐 × . 𝟎𝟎𝟎𝟓 × 𝟗𝟖. 𝟎𝟐𝟐𝟒𝟒
ApproxConvexity = 𝟗𝟖. 𝟖𝟎𝟔𝟓𝟔 + 𝟗𝟕. 𝟐𝟒𝟕𝟑𝟖 − 𝟐 × 𝟗𝟖. 𝟎𝟐𝟐𝟒𝟒
= 𝟑𝟔𝟗. 𝟔𝟒
. 𝟎𝟎𝟎𝟓𝟐 × 𝟗𝟖. 𝟎𝟐𝟐𝟒𝟒

∆ 50 bps ↓ %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-15.90636 × -.005) + (𝟏#𝟐 × 369.64 × -. 𝟎𝟎𝟓𝟐 )

= 0.0841 or + 8.41%

Page 4

DD = ModDur × 𝐏𝐕 𝐟𝐮𝐥𝐥 DC = AnnConvexity × 𝐏𝐕 𝐟𝐮𝐥𝐥

(money duration) (money Convexity)

$∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (- DD × ∆y) + (𝟏#𝟐 × DC × ∆𝐲 𝟐 )

e.g./ 100M (using previous example)

∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-15.90636 × 100M × .005) + (𝟏#𝟐 × 369.64 × 100M × . 𝟎𝟎𝟓𝟐 )

= 7.95318M + .46205M
= 8.41523 M
Portfolio Duration/Convexity
1/ calculate portfolio statistics ➞ i.e. weighted-average time to
correct
closer if YC is flat receipt of aggregate cash flows

2/ use weighted-average of each bond

approx.
using MV

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 Last Revised: 06/02/2023

Curve-Based and Empirical Fixed-Income Risk Measures

a. explain why effective duration and effective convexity are the most
appropriate measures of interest rate risk for bonds with embedded options

b. calculate the percentage price change of a bond for a specified change in

benchmark yield, given the bond’s effective duration and convexity

c. define key rate duration and describe its use to measure price sensitivity of
fixed-income instruments to benchmark yield curve changes

d. describe the difference between empirical duration and analytical duration

58
 Last Revised: 06/02/2023

Curve-Based and Empirical Duration

Page 1
yield-based duration/convexity assumes a bond’s cash flows
do not change as interest rates change
contingency features (options, convertibility) make cash flows
rate dependent
- the appropriate measure of interest rate risk is the
sensitivity of 𝐏𝐕 𝐟𝐮𝐥𝐥 to ∆curve (not ∆yield)
par curve

Effective Duration (EffDur) and Effective Convexity

callable bond
negative MBS
convexity

positive
convexity

EffDur < ModDur EffDur ~ ModDur

Page 2

➞ positive convexity
throughout

even more convex

EffDur ~ ModDur EffDur < ModDur

EffDur ≈ 𝐏𝐕, − 𝐏𝐕A EffConvexity ≈ 𝐏𝐕, + 𝐏𝐕A − 𝟐𝐏𝐕𝟎
𝟐 ∆𝐜𝐮𝐫𝐯𝐞 𝐏𝐕𝟎 ∆𝐜𝐮𝐫𝐯𝐞𝟐 𝐏𝐕𝟎
change in par curve (parallel)
calculate spot rates, then calculate PV

(not quite parallel) ➞ ∆yield ➞ parallel shift in spot

∴ ModDur ≠ EffDur even for option-free bonds curve)

- ModDur = EffDur for a flat YC (par), or tenor is shorter, or bond

is priced close to par

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 Last Revised: 06/02/2023

Page 3

%∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (- EffDur × ∆curve) + (𝟏#𝟐 EffConv. ∆𝐜𝐮𝐫𝐯𝐞𝟐 )

with ∆yield, accuracy is improved by choosing

smaller ∆y to est. ModDur & ModConv.
- with ∆curve, larger moves has more accuracy
- small moves may not capture cash flow changes
from optionality
KRD - key rate duration (or partial duration)
- bond’s price sensitivity to a change in a specific par
rate
𝐊𝐑𝐃𝐫𝐤 = 𝟏 ∆𝐏𝐕 - helps identify shaping risk
−
𝐏𝐕 ∆𝐫𝐤
𝐧

b 𝐊𝐑𝐃𝐫𝐤 = 𝐄𝐟𝐟𝐃𝐮𝐫
𝐤6𝟏

- 𝐊𝐑𝐃𝐫𝐤 = ∆𝐏𝐕 𝟏
➞ (- 𝐊𝐑𝐃𝐫𝐤 × ∆𝐫𝐤 ) = ∆𝐏𝐕 = %∆𝐏𝐕 𝐟𝐮𝐥𝐥
𝐏𝐕 ∆𝐫𝐤 𝐏𝐕

Page 4
e.g./

𝐏𝐕𝟐 𝐏𝐕 𝐏𝐕
! × 𝟏. 𝟗𝟗0 + ! 𝟓 × 𝟒. 𝟗𝟑𝟖0 + ! 𝟏𝟎 × 𝟗. 𝟖𝟐𝟖0 = 5.36741
𝚺𝐏𝐕 𝚺𝐏𝐕 𝚺𝐏𝐕
0.711335 + 1.675139 + 2.980938 = 5.36741
(𝐊𝐑𝐃𝟐 ) (𝐊𝐑𝐃𝟓 ) (𝐊𝐑𝐃𝟏𝟎 )
e.g./

A: %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-.645 × -.0023) = .14835%

B: %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-1.483 × -.0025) = .37075%

C: %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-2.158 × -.0018) = .38844%

D: %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (-2.982 × -.0010) = .2982%

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 Last Revised: 06/02/2023

Page 5
EffDur/ModDur ➞ analytical duration ➞ theoretical change
in 𝐏𝐕 𝐟𝐮𝐥𝐥 for ∆yield or ∆curve

Empirical duration ➞ observed ∆𝐏𝐕 𝐟𝐮𝐥𝐥 for actual ∆yield or ∆curve

➞ use historical data
- for gov’t. bonds, EffDur ~ EmpDur
- matters more for credit risky bonds since
𝛒𝐜𝐫𝐞𝐝𝐢𝐭 𝐬𝐩𝐫𝐞𝐚𝐝,𝐛𝐞𝐧𝐜𝐡𝐦𝐚𝐫𝐤 𝐲𝐢𝐞𝐥𝐝𝐬 < 𝟎

➞ curve ↑, spreads ↓
curve ↓, spread ↑

- the larger the component of yield is the credit spread,

the lower EmpDur vs. EffDur

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 Last Revised: 06/02/2023

Credit Risk

a. describe credit risk and its components, probability of default and loss given
default

b. describe the uses of ratings from credit rating agencies and their limitations

c. describe macroeconomic, market, and issuer-specific factors that influence

the level and volatility of yield spreads

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Credit Risk
Page 1
- credit risk - risk of loss due to default

issuer specific factors failure to meet debt

general economic conditions obligations

Top-down
(macro)
Country Conditions Currency
- geopolitical - macro - domestic vs. foreign
- legal/political environment

Credit Risk
Bottom-up/
Capacity Capital Character Covenants Collateral
- ability to - level of - quality of - legal terms - quality and
service debt equity management of debt value of
agreement assets
quantitative
qualitative

Page 2
Sources of credit risk/

illiquidity risk

illiquidity - inability to raise funds

vs.
insolvent - A < L

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 Last Revised: 06/02/2023

Page 3

Measuring Credit Risk/

➞ principal + accrued - when LGD and POD are stated in %:
interest
credit spread ≈ LGD × POD
seniority of
claim e.g./ LGD = 80% POD = 1%: CS = .8% or 80 bps
value of
collateral (lower) profitability

(lower) coverage POD (higher)

annualized measure (higher) leverage

positive relationships
- positive
negative relationship
relationship

Page 4

3 majors - Moody’s provide credit ratings for

- Standard and Poors issuers/issues and monitor
- Fitch ongoing performance
- issuer pays (potential conflict of
interest)
credit ratings - letter-based - encapsulates LGD and POD
introduces credit migration risk - downgrade risk

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 Last Revised: 06/02/2023

Page 5

credit ratings tend to be sticky and lag market pricing

of credit risk
- rating outlook ➞ positive or negative ➞ more timely with
market conditions
- rating changes ➞ lagging

- some risks are difficult to capture in credit ratings

(litigation, environmental risk, natural disasters)
- may result in split ratings - different ratings by the 3
agencies
- ratings may involve miscalculation or unforeseen
changes not fully captured in a rating agency’s
forward-looking analysis

Page 6

credit spread risk - the risk of greater expected loss due

to changes in credit conditions
Factors affecting yield spread:
Macro factors - spread correlation with business cycle is negative

narrowest
expansion
- business/credit
- spreads contraction - spreads
cycle:
contract widen
widest
- addition of credit risk (i.e. HY)
portfolio diversification - in a bond portfolio
- lower 𝛒 with IG and sovereign yields
capital appreciation - equity-like performance over the business
cycle
equity-like returns with lower volatility

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 Last Revised: 06/02/2023

Page 7
Factors affecting yield spread:
higher credit rating ➞ lower yield
longer maturity, higher yield (within each credit rating)
IG - OAS < (𝐇𝐘𝐎𝐀𝐒 − 𝐈𝐆𝐎𝐀𝐒 )

low spreads and

upward sloping

HY inversion
- reflects near-term
credit market anticipating
tightness credit cycle
contraction

Page 8

Factors affecting yield spread:

Market factors
liquidity - wider spreads for more illiquid bonds
spread issuer size
tax lower = wider
credit quality
credit
financial conditions
- stressed = wider spreads
Issuer specific
- issuer financial performance
debt coverage and leverage levels
𝐂𝐅𝐲𝐫
`𝐨𝐛𝐥𝐢𝐠𝐚𝐭𝐢𝐨𝐧𝐬 B𝐀#𝐄C
𝐲𝐫

- relative spreads - compare issuer with similar industry and

credit quality comparables
e.g./ Industry A ➞ BBB rating 𝐎𝐀𝐒𝐚𝐯𝐠. ~ 220 bps
Company XYZ ➞ OAS = 300 bps estimated 80 bps issuer specific

66