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CourseIntroduction

Goal:Toprovideparticipantswitha
workingknowledgeof
Fixedincomemarkets
Interestrates
Interestratederivatives

CourseIntroduction
Method:Focusonpractice

Lectures
Examples
Reviews
Quickchecks
Exams

CourseOverview
PartI:Fixedincomemarkets

Moneymarkets
Bondmarketsandbondpricing
Bondpricevolatility
Interestratesandthetermstructure
Bondportfoliomanagement
ExamI

CourseOverview
PartII:Derivatives

Assetbackedsecurities
Optionpricing
Pricingbondswithembeddedoptions
Interestratefutures
Interestrateoptions
InterestrateswapsandFRAs
ExamII

CourseMaterials
Textbook
BondsandBondDerivatives,byMiles
Livingston

Software
MicrosoftExcelspreadsheets

Howtocontactme
Email:spindt@mailhost.tcs.tulane.edu
Web:http//:elvis.sob.tulane.edu

ObjectivesforSession1
Tounderstandwhatarefixedincomesecurities
Toseehowfixedincomesecuritiesaretraded
Toidentifytheimportantplayersinfixed
incomemarkets
Tounderstandwhatarefixedincome
derivatives

WhatsFixedIncome?
Fixedincomesecurities

Financialclaims
Principleandpossiblycoupons
Contractuallydefinedcashflows
Defaultprovisions
Covenants

WhatsFixedIncome?
Inotherwords:
Fixedincomesecuritiesare
debtcontracts

Example
Commercialpaper

Unsecuredpromissorynote
Specificmaturity;shortterm
Paysthefaceamountatmaturity
Soldatadiscount
Issuedbycorporations

Example
Couponbond
Specifiesperiodicpayments(coupons)until
maturity
Atmaturity,principalamountisrepaid
Soldatornearpar
Maybesecuredorunsecured
Governedbyanindenture
Issuedbyvariousagencies

BondExample
11.75%RepublicofColumbiadollarbond
of022520

Issued$750millionprincipal022500
Pays11.75%/2=5.875%semiannually
Matures022520
Repaysprincipalatmaturity
Isnotcallable

Example
Amortizingbond
Periodicpaymentsincludeinterestand
principal
Principalisrepaidovertime
Paymentsmaybelevelorvariable
Mortgageloansaretypicallyamortizing

Review
Typesofcashflows:
$15,000

$10,000

$5,000

$Mar-00

Apr-00

May-00

Jun-00

Jul-00

Aug-00

Sep-00

Oct-00

$10,000.00
cash outflow
to repay debt
at maturity

$(5,000)

$(10,000)

$(15,000)

Nov-00

Review
Typesofcashflows:
$15,000

$10,000

$5,000

$3/2/00
$(5,000)

9/2/00

3/2/01

9/2/01

3/2/02

$500 cash
outflow at
each coupon
date

$(10,000)

$(15,000)

9/2/02

Review
Typesofcashflows:
A180monthlevelpayamortizingbond
$2,500.00
$2,000.00
$1,500.00

Principal
Interest

$1,000.00
$500.00
$0.00

Risks
Fixedincomesecuritiesinvolveriskaswell
asreturn

Creditrisk
Interestraterisk
Liquidityrisk
Otherrisks

BondRatings
Rating
Highestquality
Highquality
Uppermediumquality
Mediumgrade
Somewhatspeculative
Lowgrade,speculative
Lowgrade,default
possible
Lowgrade,partial
recovery
Default,recovery
unlikely

S&P
AAA
AA
A
BBB
BB
B
CCC

Moodys
Aaa
Aa
A
Baa
Ba
B
Caa

CC

Ca

QuickCheck
Whatarefixedincomesecurities?
Describethreetypesoffixedincomecash
flows.
Identifythekeyrisksassociatedwithfixed
incomesecurities.
Whatarebondratings?

FixedIncomeMarkets
Themoneymarket
Shortterm,highlyliquid,lowrisk
Wholesaletrading

Thebondmarket
Longterm,variedliquidity,variedrisk
Wholesaleandretailtrading

NewIssues
Newissuesaresoldintheprimarymarket
IssuerssellFIsecuritiestoraisemoney
Debtv.Equity(cost;flexibility;purpose)

Sellersinclude
Sovereigngovernments
Othergovernmentalunits
Quasigovernmentagencies
Corporations

NewIssues
Newissuesaresoldintheprimarymarket
PurchasersbuyFIsecuritiestoinvestmoney
Debtv.Equity(risk/return;cashflowtiming)

Investorsinclude
Institutions
Financialcorporations
Nonfinancialcorporations
Wealthyindividuals

PlacingNewIssues
Somenewissuesaresolddirectlytoinvestors
Auctions:USgovernmentbondsorCETES
Negotiatedsale:Federalfunds,Eurodollars

Mostbondissuesaresoldindirectlyto
investors
Firmcommitmentunderwriting
Besteffortssale
Privateplacements
Rule144a

Auctions
Callauctions
Valuesandinformation
Openoutcry
English(ascendingprice)
Dutch(descendingprice)

Sealedbid
firstorsecondprice
discriminatory

Winnerscurse

Example:TBillAuction
Schedule
Tenders
Noncompetitive
Competitive

Allocationrule
topprice
stopoutprice
averageprice

Tailandcover

Example:TBillAuction
Tenders and Awards for the 91-day Tbill Issued
May 11, 1989 (CUSIP No. 912794 TD 6)
Dollar amounts in thousands
Issue Size
Noncompetitive Bids
Competitive Allocation
Competitive Tenders
Competitive Cover
Total Cover
Auction Tail (lower)
Auction Tail (upper)

$8,483,509
$3,120,100
$5,363,409
$15,094,215
2.81
2.15
0.02%
0.04%

37%
63%

Example:TBillAuction

Discount
7.90%
7.91%
7.92%
7.93%
7.94%
7.95%
7.96%
7.97%

Price
98.003
98.001
97.998
97.995
97.993
97.990
97.988
97.985

Tenders
$2,025
$25,355
$66,835
$810,000
$1,505,000
$2,835,000
$3,252,000
$6,598,000
$15,094,215

Awarded
$2,025
$25,355
$66,835
$810,000
$1,505,000
$2,835,000
$119,194
$0

Remaining
$5,361,384
$5,336,029
$5,269,194
$4,459,194
$2,954,194
$119,194
$0
$0

% Awarded
100.00%
100.00%
100.00%
100.00%
100.00%
100.00%
3.67%
0.00%

Weight
0.04%
0.47%
1.25%
15.10%
28.06%
52.86%
2.22%
0.00%
7.94%

Example:TBillAuction
$0

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

7.90%
7.91%
7.92%
Tenders

7.93%

Awarded

7.94%
7.95%
7.96%
7.97%

$6,000,000

$7,000,000

UnderwrittenOfferings
Presaleactivities
SECregistration
Theroadshow
Pricing

Attheofferingdate
Purchasebyunderwriter
Distributiontoinvestors

SeasonedIssues
Tradedinthesecondarymarket
Organizedexchanges
Centralizedtradingpost;membersonly
Listingrules
NYSEspecialistsystem

OTCmarket
Dealers
Automatedquotingsystems

MarketMaking
Pricequotes
insidemarket
outsidemarket

Dealerinventories
tradingneeds
informationalproblems
financingconsiderations

Thebidaskspread
depth

QuickCheck
Whoarethemainplayersinthefixedincome
market?
DescribetheUSTreasurybillauctionprocess.
Whatroledounderwritersplayintheprimary
marketforfixedincomesecurities?
Howisthesecondarymarketforfixedincome
securitiesorganized?

Derivatives
Whatsaderivative?
Asecuritywhosevaluederivesfromthevalue
ofsomeothersecurity

Examples
Assetbackedsecurities(cashflowderivatives)
Options
Forwards,Futures,Swaps