OverviewofFixedIncome Markets

ImportanceofMarkets
Marketstructureisimportanttoriskmanagers mainlythroughitsimpactonliquidity. Asuccessfulmarketbringstogethermany buyersandsellers,reducestransacBonscosts. Marketstructurecanimpactrisk:
OTCtradeshavegreatercreditriskbutlowerbasis risk.

Liquidity
LiquidityistheabilitytotransactquicklywithoutaecBng prices. Liquidityisenhancedwhen: contractsarehomogeneous marketsareeecBvelylinkedtogether posiBonsaresmall LiquidityisapotenBalproblemwhen: productsarediverse marketsarefragmented posiBonsarelarge
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FinancialExchangesvs.OTCMarkets
FinancialExchanges: righttotradelimitedtomembers detailedandexplicitrulesregardingconductoftrade contractsarestandardized exchangesprovidepriceinformaBon,facilitatetrade seLlement OTC:AnynonexchangetradeiscalledOTC(Overthecounter) BuyerandsellercannegoBatetradedetails InvestorsdonothaveprotecBonofexchangerulesand procedures.
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ServicesOeredbyExchangesvs.OTC Equivalents
1. SeTngstandardsfortradednancialproducts.(OTCmarkets oVenuseISDAmasteragreementsastemplates). 2. ProvidingpriceinformaBon.(OnOTCmarkets,mustgetprice quotesfromdierentdealers). 3. ProtecBngagainstcounterpartyrisk.(Clearinghouseis counterpartyforalltransacBons).(OTCmarketsaLemptto reducecounterpartyriskbyrestricBngparBcipaBontohigh creditqualityinvestors,e.g.AAorabove). 4. Matchingbuyersandsellers(electroniconallexchanges exceptNYSE).(OTCmarketscompetewithindependent ElectronicCrossingNetworks,whichneithersetpricesnor carryinventory,tomatchbuyersandsellers).

OTCvs.ExchangeMarkets Tradeo:Increasedliquidityoeredby standardizedcontractsonexchanges.Basis riskisalsoincreased. Basisriskisthemismatchbetweenthehedge andtheposiBonbeinghedged.

OTCMarkets:TradiBonal Structure
DealersquotebidandaskpricestoprospecBve buyersandsellers. Normalmarketsizeisthemaximumsizeof transacBonatwhichadealerispreparedto transactatthestatedbid/askprices. Dealersmakeprotfromorderow,both throughbidaskspreadandfromanBcipaBng shorttermpricemovesbasedontheir privilegedaccesstoorders. Dealersalsobearriskfromholdinginventory, andfromthepossibilityofbeing"pickedo" byinvestorswithsuperiorinformaBon. MajorOTCmarketsincludethosefordebt, FOREX,somederivaBves,andtheNASDAQ.
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MeasuresofLiquidityinaDealerMarket
Stock Market Cap $mill. 1 NMS Bid $thous. 200.0 1 9.43 2.50 Ask Spread % 0.21 33%

A - liquid 10,000 Billiquid

9.45 3.50

Bidistheamountthedealeriswillingtopayforthestock. Askisthepriceforwhichthedealerwillsellthestock. NormalMarketSizeisthetransacBonsizefortheseprices.

FundingandLiquidity
ManyderivaBvesecuriBes(e.g.swaps,forwards) requirenoexchangeofprincipalandthereforeno (orliLle)moneyupfront(nothingbeyondan iniBalmargin). TakinganequivalentposiBoninacashmarket wouldrequirealargeamountoffunding. ThistendstopushtradingacBvityandprice formaBonontoderivaBvesmarkets.
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FinancialMarkets
Commonlydividedintothefollowingtwo components. MoneyMarkets:Maturity<1year. CapitalMarkets
EquityMarket DebtMarket(FixedIncomeInstruments) DerivaBveSecuriBes

Bonds Abondisanancialclaimbywhichtheissuer (borrower)iscommiLedtopayingbacktothe bondholder(lender)thecashamount borrowed(principal)plusperiodicinterest calculatedonthatamountoveraperiodof Bme.

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BasicTerminology
Term:periodofBmeoverwhichborrowingoccurs.Endofthetermiscalled thematuritydate. Principal:Amountrepaidonmaturitydate.Principal=FaceValue=ParValue InterestRate:Amountborrowerpaysthelenderfortheuseofthemoney, usuallyexpressedasanannualpercentage. Yield:eecBveinterestrateofthebond Issuer:government,localgovernment,corporaBons,supranaBonal organizaBon Marketability:Whetherornotownershipcanbetransferred. Security:Collateralthatcanbeseizedintheeventoffailuretopay. CallorPutFeatures:Provisionsthatallowtheborrowertorepay(call)orthe lendertodemandpayment(put)beforematurity.

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Sometypesofbonds
Bulletbonds:payregularinterestatxedrate Zerocouponbonds:dontpayregularinterest FloaBngRatenotes:interestratelinkedtoanexternalreference IndexLinkedbonds:couponpayments(andpossiblyprincipal repayment)linkedtoanexternalreferenceasinaBon,prices SecuriBzedbonds BondswithembeddedopBons

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ExampleofaBondanditsAssociatedCash Flows
ConsideranEurobondoffacevalue1millionUSDwith maturityin5yearspaying4%attheendofeachyear,itscash owis:
Cash flow (mill. us $) Issuer receives bond price ($1m if issued at par)

Time (years) 0

$40000 (each year)

Holder receives 1m 3 4 5 (maturity time)

BondCharacterisBcs
Issuer'sname,type,countryoforigin. Bondmarket,denominaBon. Collateral(bondsvs.debentures). Couponrate,type,frequency. Yield,Price(issuanceoraVer),RaBng (Moody's,S&P). PricequoBngmethod(cleanvs.dirty). Announcementdate,interestaccrual date,seLlementdate.
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RisksAssociatedwithBonds CreditRisk LiquidityRisk CurrencyRisk ReinvestmentRisk CallRisk PoliBcal/LegalRisk

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Markets MoneyMarket:shorttermborrowingand lending(maturiBes1year). CapitalMarket:Maturity>1year. PrimaryMarket:IniBalissueofthebond(for corporates,typicallybyaninvestmentbank underwriBngtheissuefortheborrower). SecondaryMarket:TradingaVeriniBalissue.

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MoneyMarketInstruments

Deposits DemandDeposits:NopriornoBceneedbe givenbeforefundsarewithdrawn.Verylow interest. NoBceDeposit:NoBcaBonmustbegiven beforefundsarewithdrawn(thisprovision rarelyenforced).VerylowoaBngrate interest. FixedTermDeposits:FixedoroaBng.

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CreditFaciliBes
Creditlinesmadeavailabletocorporateclients,methodsof borrowingtailoredtosuitclientneeds. Amountborrowedisexible(belowsomepresetlimit),but corporaBonpaysasmallcommitmentfeeonunusedporBon offunds. Othermethodsofshorttermcorporateborrowing:

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oneoloans syndicatedloans commercialpaper(marketable) bankers'acceptances(marketable)

RepoMarkets
"Repo"isshortforasaleandrepurchaseagreement. Itisausefulwayofremovingcreditriskfromshortterm funding. Onepartysellsasecurity(e.g.agov'tbond)toanother party,withanagreementtobuyitbackinthenearfuture ataslightlyhigherprice. ThedealhasliLlecreditriskbecauseifthereisadefault, thelendersimplykeepsthesecuriBes. BecauseoftheeliminaBonofcreditrisk,theinterestrate chargedisclosetotheriskfreerate.
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RepoMarkets:Terminology
Ifyouborrow$100,andpledgesecuriBeswitha currentmarketpriceof$110,your"haircut"is10%. TheoppositesideofaRepocontractiscalledareverse repo.Inthiscase,youbuyaparBcularsecurity,andsell itbackintheverynearfutureforahigherprice. Overnightrepo:termofoneday Termrepo:Term>1day.

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Example

Acompanyneedstoborrow$10,000.Thebank quotesthema3%haircut.Whatisvalueofliquid securiBes(e.g.governmentbonds)mustthe companyprovidetothebankassecurityonthe loan? Answer: AmountPledged=AmountBorrowed(1+Haircut) =10,000(1.03) =10,300

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TBills Shorttermzerocouponbondsissuedby (naBonal)governments. Creditriskistypicallyverylow,andliquidityin thesecondarymarketistypicallyveryhigh. OwingtomarketconvenBons,thereare dierentwaysofexpressingtheyieldonT Bills.

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U.S.GovtTBills
IssuedinweeklyaucBons 3maturiBes:4,13and26weeks PricequoBngconvenBon:%ofpar(in32nds ofapercent). YieldquoBngconvenBon:discountyields basedona360dayyear.

U.S.GovtTBills
Generalformulaforbondpricewithagiven quotedyield:
n P = F 1 y 360

F:FaceValue y:Quotedyield n:Timetomaturity(indays).

Example
AU.S.govtTBillquotedat5.25%yieldwith 61daysunBlmaturityandafacevalueof 100,000hasthefollowingprice:
61 P = 100,000 1 0.0527 = 99,107 360

EecBveAnnualYield
Theyieldthatwouldbeobtainedoverayearif thereturnobtainedovertheholdingperiod wouldconBnue(andbecompounded)overa wholeyear. Itisthevalueofrsuchthat:
F 365 / n = 1+ r P

CanadianGovtTBills
MaturiBes1,3,6,12months. Usessimpleinterestanda365dayyearfor quoBngyields. QuoBngconvenBonforyieldsisdierent:
P= F n 1 + y 365

Example
ACanadiangovtTBillquotedat5.25%yield with61daysunBlmaturityandafacevalueof 100,000hasthefollowingprice:
P= 100,000 61 1 + 0.0527 360 = 99,127

Bankers'Acceptances ShorttermdebtissuedbyacorporaBonand guaranteedbyabank. Thebankispaidastampingfee(inadvance) forassumingthecreditrisk.

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Bonds

BondIssuers PublicIssuers:Sovereigns,agencies, provinces/municipaliBes CorporateBonds:DomesBc,internaBonal, foreign.

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SovereignBonds IssuedbynaBonalgovernments. UsuallyinregularaucBons. U.S.Treasuriesarebyfarthemostliquid. Ontherunvs.Otherun:Recentlyissued bondsarereferredtoas"ontherun"(tendto bemoreliquid,tradeatapremium),other bondsare"otherun".

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USAgencyBonds
FederalNaBonalMortgageAssociaBon(FannieMae) FederalHomeLoanBankSystem FederalHomeLoanMortgageCorporaBon(Freddie Mac) FarmCreditSystem ResoluBonFundingCorporaBon StudentLoanMarkeBngAssociaBon(SallieMae) TennesseeValleyAuthority Debtisnotnecessarilyguaranteedbythegovernment. Containsacreditpremium.

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MunicipalBonds IssuedbymunicipaliBes. OVentaxexemptintheUS. GeneralObligaBonBonds:Backedbythefull faithandcreditoftheissuinggovernment. RevenueBonds:Backedbytherevenues generatedbytheoperaBngprojectsnanced withtheproceedsofthebondissue.

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PricingQuotaBons
Bondscanbequotedby: Price:
CleanPrice:DirtyPriceAccruedInterest Usuallyquotedintermsof%ofparvalue.

USTreasurybondsandsomeotherbonds quotedin32ndsofcents. Yield:Interestrateatwhichallcashowsshould bepresentvaluedtoproducecurrentprice. Spread:BondYield=BenchmarkRate+Spread

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Example
HowmuchwouldyoupayforUSTreasurybonds withtotalnoBonal$1,000,000quotedat9914? Answer: 9914means99+14/32=99.4375. Totalprice=$1,000,000(0.994375)=$994,375.00

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STRIPS
STRIPS(SeparateTradingofRegisteredInterest andPrincipal) SeparaBonoftheinterestandprincipal repaymentofabondthattypicallypayscoupons (i.e.USgovernmentbonds). Canbuyeithertheinterestcomponent(principal strips)ortheprincipalrepayment(couponstrips). Notasliquidascouponbearingbonds.
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CorporateBonds FourMajorMarkets:US,UK,EURO,JP Sectors:Financial,UBliBes,Industrial USisbyfarthemostmature,largest,and mostdiversied(bothintermsofsectorsand creditquality).

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CorporateBonds
Typically<20yearsinlength. Corporateborrowerstendtopreferlongerborrowing periods. ShorterbondsareoVenpreferredbyinvestors. LongerbondshavehigherinterestratepricesensiBvity thandootherwiseidenBcalshortertermbonds. Mostcorporatebondshavecall/putfeatureswhich meanthattheymay'expire'beforethematuritydate.

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SinkingFunds
Highcreditqualityborrowersmaynotneedtospecifyhowabondissue willberepaid. Lowerqualityborrowersmaymakeexplicitprovisions. Asinkingfundisaringfencedamountofcashusedtobuybacka proporBonofthebondissueeachyear. Ittendstoreducecreditrisk,becausefundshavebeenputasidefor repaymentofthedebt. Typically,bondsareredeemedbyloLery,andatpar(i.e.facevalue). Sinkingfundalso:
Createsliquidityinsecondarymarket Reducescreditrisk(smallerpaymentatbondmaturity)

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CallProvision
Inmanycorporatebonds,theissuerhastherightto'call'thebond, exchangingthebondforaxedredempBonprice. Frequently,thebondscanbecalledaVeraxedcoolingoperiod(say 510years),onaxedsetofdates. CallSchedule:Givesthecallpriceateachdate(oVenthecallpriceisthe parvalue). Thismightenablethecompanytorenanceatcheaperrates. ItrepresentsanegaBvefeatureforthebondholder.

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OtherEmbeddedOpBons
Putablebonds:investorhastherighttosellback thebondtotheissueratparatspecieddates. ConverBbleBonds:Canbeexchangedforaxed numberofsharesofthebondissuer.
ConversionraBo:numberofsharesthebondcanbe exchangedfor. Conversionprice:FaceValue/ConversionRaBo Representsanadvantagetoinvestorsifratesrise.

Exchangeablebond:Canbeexchangedforthe commonstockofacompanyotherthanthebond issuer.

FloaBngRateNotes
CouponpaymentsdependonaoaBnginterestrate. FloaBngRateBonds:Indexedtoashorttermreference withmaturitylessthanoneyear. VariableRateBonds(AdjustableRateBonds):Indexed toalongertermreference(e.g.yieldon10yearUS TreasuryBonds). Usually,resetfrequency=couponpaymentfrequency. InverseFloaters:Couponmovesintheopposite direcBonofthereferenceindex.
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LIBOR
LONDON INTER BANK OFFER RATE

At11am,BriBshBankers'AssociaBonsurveystheratesoeredby8 banksintheLondonmarket.Dropslowestandhighest25%,andtakes averageofremaining50%.TheresultistheBBALIBORforthegiven maturityandcurrency. LIBORistheprimarybenchmarkrateforoaBngrateloans(parBcularly USD).

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Example Aninvestorbuysaninverseoaterthat enBtleshimtoreceivemax(18%2*LIBOR,0) ona$100,000noBonaleveryyear.IfLIBORis currently5%,howmuchdoeshereceive? Answer:Rate=max(0.182(0.05),0)=0.08 $100,000(0.08)=$80,000.

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InaBonIndexedBonds
IssuedbygovernmentstypicallytargeBnglow inaBonrates. Usefulfor: HedgesagainstinaBonrates. DiversicaBonofpor}olios(indexlinkedbonds tendtobeweaklycorrelatedwithotherassets suchasstocks,xedcouponbondsandcash). Insurancecompaniesandpensionfundswishing tohedgeinaBonlinkedliabiliBes.
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Yield
Theyield(tomaturity)ofabondistheinterestrate thatwillmakethepresentvalueofthecashows fromthebondequaltoitscurrentprice. Itisdeterminedby:
gov'tyields creditspread liquidity supplyanddemandfactors

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PricingBulletBonds
Onacoupondate:

1 F P = cF + k n (1 + y ) k =1 (1 + y )
P:Price c:couponrate y:yield F:Facevalue n:numberofperiods

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PricingBulletBonds,cont
AlternaBveformula:

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Example
Priceatreasurybondwithfacevalue $1000whichpaysa10%coupon, redempBonin10yearsfromnow,which payssemiannualcoupons.Assumethe interestratewithsemiannual compoundingisequalto5%perannum.

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Example
SoluBon:Couponpaymentsare$50every6 months.Thereare20ofthem.Theinterest rateperperiodis2.5%.

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PricingBondsinBetweenCouponDates Thepreviousformulaassumedthebondwas beingpricedonacoupondate.

i= Days from value date to next coupon date d = Days in the interest period D

1 F P = cF + k i n i (1 + y ) k =1 (1 + y )

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CleanandDirtyPrices CleanPrice:Withoutaccruedinterest.Normal methodforquoBngbondpricesinmost markets. DirtyPrice:Grosspricepaidforthebond. Includesaccruedinterest.

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Cleanvs.DirtyPrices
Forabondbetweencoupondates,(FacevalueF,perperiodcoupon ratec) y:yield(expressedasaperperiodrate D:#ofdaysbetweencouponpayments d:#ofdayssincelastcouponpayment n:numberofremainingcouponpayments DirtyPrice: n
cF F d PD = (1 + y ) D + k n (1 + y ) (1 + y ) k =1

CleanPrice:

d PC = PD AI = PD cF D

CleanpricequotesareoVenpreferredastheyaremorestable.

MoreTerminology Trading/Pricedatadiscount:Price<Par Trading/Pricedatapremium:Price>Par

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Forcouponbearingbonds: IfYield<CouponRate,PricedataPremium IfYield>CouponRate,PricedataDiscount IfYield=CouponRate,PricedatPar.

Perpetuals Nomaturitydate,justaninnitestreamof couponpayments.Alsocalledirredeemable bonds.ExamplesincludeUKgovernment consols. Fromsummingtheinniteseries: P=C/r

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Example AUKgovernmentconsolprovidescoupon paymentsof100perannuminperpetuity.If theconsolispricedtoyield10%,whatisits currentprice? Answer:100/0.1=1000

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