PAPER NO.13 FIXED INCOME INVESTMENTS ANALYSIS
UNIT DESCRIPTION
This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable him/her to value and analyse fixed income securities and assess associated risk.
LEARNING OUTCOMES
A candidate who passes this paper should be able to:
• Identify various types of fixed income instruments
• Assess various types of risks associated with fixed income instruments
• Analyse interest rate volatility using the term structure of interest rate approach
• Model interest rate yield curves
• Value and analyse fixed income instruments
• Value bonds using interest rate models
CONTENT
1. Overview of fixed income securities
1.1 Basic features of fixed income securities
1.2 Types of fixed income securities
1.3 Bond indenture; affirmative and negative covenants; effect of legal, regulatory and tax considerations on the issuance and trading of fixed income securities; bonds with embedded options
1.4 Structure of cash flows of fixed income securities; contingency provisions affecting the timing and/or nature of cash flows of fixed income securities
2. Markets of fixed income securities: Issuance, trading and funding
2.1 Classifications of global fixed income markets
2.2 Issue process; market participants; issuers; intermediaries; investors borrowing parties; underwriting; fees and expenses
2.3 Fixed income trading platforms; OTC; multi user electronic trading platforms; market and regulatory factors
2.4 Interbank offered rates as reference rates in floating-rate debt; mechanisms available for issuing bonds in primary markets; secondary markets for bonds; securities issued by sovereign governments, non-sovereign governments, government agencies and supranational entities; debt securities issued by corporations; Credit risk and credit-related risks affecting corporate bonds; seniority rankings of corporate bonds; potential violation of the priority of claims in a bankruptcy proceeding; corporate issuer credit ratings; issue credit ratings; rating agency practice of “notching”; risks in relying on ratings from credit rating agencies; components of traditional credit analysis; short-term funding alternatives available to banks; repurchase agreements (repos)
2.5 Fixed income risk and return
2.5.1 Risks associated with fixed income securities (Interest rate risk, Reinvestment risk, Call risk, inflation risk, liquidity risk, Currency risk, Volatility risk and other risks
2.5.2 Return; potential sources of bond’s total return; coupon interest; capital gain; reinvestment income; assumptions of total return; hold to maturity; reinvestment; horizon analysis; factors affecting treasury security total returns; shifts in interest rate level; slope of yield curve; curvature and butterfly shifts; computing the total return; Option Adjusted Spread(OAS)
total return; total return to maturity; Return from investing in a fixed-rate bond; total return for mortgage-backed security; portfolio return
2.5.3 Risk/return characteristics
2.5.4 Bond yield measures: current yield; yield to maturity; yield to call; other yields; yield curves and yield spread analysis; the full valuation approach; price volatility characteristics of bonds
3. Fundamentals of fixed income valuation
3.1 Determination of price of the bond given a market discount rate
3.2 Relationships among a bond’s price, coupon rate, maturity and market discount rate (yield-to-maturity)
3.3 Bonds price quotation: spot rates; flat price (clean price), accrued interest and the full price of a bond (dirty price)
3.4 Matrix pricing of a bond
3.5 Yield measures for fixed-rate bonds, floating-rate notes and money market instruments
3.6 Bond refinancing/refunding
4. Interest rate risk
4.1 Measures of interest rate risk; Bond duration measures: Macaulay duration, modified duration and effective durations, portfolio duration; money duration of a bond and price value of a basis point (PVBP)
4.2 Effective duration as a measure of interest rate risk for bonds with embedded options
4.3 Key rate duration as a measure of sensitivity of bonds to changes in the shape of the benchmark yield curve
4.4 Effect of a bond’s maturity, coupon, embedded options and yield level to its interest rate risk
4.5 Bond convexity: approximate convexity; effective convexity; determination of percentage price change of a bond for a specified change in yield, given the bond’s approximate duration and convexity
4.6 Effect of term structure of yield volatility on the interest rate risk of a bond; relationships among a bond’s holding period return, its duration and the investment horizon; importance of yield volatility
4.7 Effect of changes in credit spread and liquidity on yield-to-maturity of a bond and how duration and convexity can be used to estimate the price effect of the changes
4.8 Inflation and default risk
5. The arbitrage-free valuation framework
5.1 Overview of arbitrage-free valuation of a fixed-income instrument
5.2 Computation of the arbitrage-free value of an option-free, fixed-rate coupon bond
5.3 Binomial interest rate tree framework: the backward induction valuation methodology and computation of the value of a fixed-income instrument given its cash flow at each node; process of calibrating a binomial interest rate tree to match a specific term structure
5.4 Pricing using the zero-coupon yield curve and pricing using an arbitrage-free binomial lattice; path wise valuation in a binomial interest rate framework and computation of the value of a fixed-income instrument given its cash flows along each path
5.5 Monte Carlo forward-rate simulation and its application
6. Valuation and analysis of bonds with embedded options
6.1 Overview of fixed-income securities with embedded options
6.2 Relationships between the values of a callable or putable bond, the underlying option-free (straight) bond and the embedded option; Use of the arbitrage-free framework to value a bond with embedded options
6.3 Effect of interest rate volatility on the value of a callable or putable bond
6.4 Effect of changes in the level and shape of the yield curve on the value of a callable bond
6.5 Determination of the value of a callable or putable bond from an interest rate tree; option-adjusted spreads (OAS); effect of interest rate volatility on option- adjusted spreads
6.6 Effective duration of callable, putable and straight bonds; use of one-sided durations and key rate durations to evaluate the interest rate sensitivity of bonds with embedded options
6.7 Effective convexities of callable, putable and straight bonds
6.8 Determination of the value of a capped or floored floating-rate bond
6.9 Defining features of a convertible bond; components of a convertible bond’s value; valuation of convertible bond in an arbitrage-free framework; risk–return characteristics of a convertible bond, straight bond and underlying common stock.
7. The term structure and interest rate dynamics
7.1 Determinants of the nominal yield curve; different shapes of a yield curve; normal, flat and inverted yield curves; Yield curve shifts; parallel; non-parallel shift; yield curve twist and curvature change; butterfly shift
7.2 Term structure of interest rate theories: pure expectation theory, liquidity preference theory, market segmentation theory; implications of the yield curve for the yield-curve theories; interpretation of yield curve shape and implied forward rates in the context of the term structure theories.
7.3 Spot rate curves, constructing theoretical spot rate curve for treasury securities using bootstrapping; on-the-run treasury securities; coupon treasury securities; zero coupon treasury securities; treasury strips; yield curve on coupon bonds, par curve and forward curve
7.4 Forward rates; determination of spot rates from forward rates, forward rates from spot rates and the price of a bond using forward rates; yield spread measures
7.5 Relationships among spot rates, forward rates, yield to maturity, expected and realised returns on bonds and the shape of the yield curve
7.6 Forward pricing and forward rate models: determination of forward and spot prices and rates using those models
7.7 Assumptions concerning the evolution of spot rates in relation to forward rates implicit in active bond portfolio management; the strategy of riding the yield curve
7.8 Swap rate curve: its use in valuation by market participants; determination and interpretation of the swap spread for a default-free bond; the Z-spread; treasury and Euro dollar (TED) spread and London interbank offer rate (LIBOR) – OIS spreads
7.9 Review of traditional theories of the term structure of interest rates; the implications of each theory to forward rates and the shape of the yield curve
7.10 Modern term structure models and their use; measuring the bond’s exposure to each of the factors driving the yield curve and how these exposures can be used to manage yield curve risks; computation and interpretation of yield risk using key rate duration; maturity structure of yield volatilities and their effect on price volatility
Sample reading and reference material
1. Fabozzi, F., Mann, S., & Fabozzi, F. (2021). The Handbook of Fixed Income Securities (9th edition). New York: McGraw-Hill.
2. Tuckman, B., & Serrat, A. (2012). Fixed Income Securities: Tools for Today’s Markets. New Jersey: John Wiley & Sons.
3. Veronesi, P. (2016). Handbook of Fixed-Income Securities. New Jersey: John Wiley & Sons.
4. Kasneb e-learning resources (link on the Kasneb website).
5. Kasneb approved study packs.