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Financial Options In Depth

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									Welcome to the Jungle:
 Fixed Income Topics
         November 21, 2004
            Zachary Emig
         MBA Class of 2005
 Ross School of Business Finance Club


                                        1
            Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products



                                       2
 What Is Fixed Income?
Technically, the word “fixed income” means
 a security that has a set payment on a set
 sequence of days; i.e. straight debt.
The way it is used today, it means “any
 financial security that is not related to
 equity (stocks).” This includes:
Treasury Bonds    Mortgage Backed Securities   Commodities
Corporate Bonds     Credit Derivatives     And much,
                                           much, more!
Interest Rate Options   Foreign Exchange
                                                         3
Fixed Income Covers a Lot!
As you can see, there are many product
  areas that fall under the fixed income
  umbrella. Which makes sense, because

…Fixed Income rules the world (or at least is
 where most of investor money is at).




                                            4
  Market Capitalization
The US is one of, if not the, most equity
 friendly country in the world.
That said, compare market capitalizations:
NYSE              $11.7 Trn      Nasdaq
                                 $3.1 Trn
ABS      Munis    Agency      Treasury*     Corporate       Mortgage             $8.7 T
$1.7 T   $1.9 T   $2.7 T      $3.7 T        $4.6 T


What about monthly trading volume:
Treasuries                                $9.6 T     Agency MBS     Agency
                                                                    Debt
                                                                             Corporates

                                                           $3.9 T            $0.4T
                                                                    $1.5 T

NYSE NASDAQ
NYSE                                                  Nasdaq
$0.8 T   $0.6 T


                                                                                          5
  Market Capitalization
•It is very hard to find official capitalization, volume
data on fixed income securities.
•For trading volume, took average daily volumes and
multiplied by 20 trading days in a month.
•Didn’t include: derivative trading volumes (both
equity and FI), foreign exchange, commodities (FI).
•The point: Both domestically and globally, FI
markets dwarf equity markets in capital and volume.
http://www.nyse.com/pdfs/movolume0410.pdf
http://www.nasdaq.com/newsroom/stats/Performance_Report.stm
http://www.bondmarkets.com/collection.asp?colid=191
http://www.bondmarkets.com/story.asp?id=296, ?id=96, ?id=1209, ?id=304, ?id=323
                                                                                  6
            Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products



                                       7
 Duration
One of the most important concepts to know is duration,
which is basically the sensitivity of a bond’s price to interest
rate movements.
•There are several closely related versions of duration, but it’s
usually defined as the % change in a bond’s value for a
percentage change in yield (measured in basis points).
•Duration also represents the weighted average of all
payments of the bond. For zero coupon bonds, duration=time
to maturity. For coupon paying bonds, duration will be less
than the time to maturity.


http://www.investorwords.com/1602/duration.html
                                                                   8
 Duration Example
5 year bond, non-callable, 4% annual coupons, $100 par.
                             T=                     1         2         3         4         5
Using                        Payment           $4.00     $4.00     $4.00     $4.00  $104.00
                             Interest Rate PV at T=1 PV at T=2 PV at T=3 PV at T=4 PV at T=5 Total PV
DCFs:                               4.00%       $3.85     $3.70     $3.56     $3.42    $85.48  $100.00

                             T=                     1         2         3         4         5
Vary the                     Payment           $4.00     $4.00     $4.00     $4.00  $104.00
                             Interest Rate PV at T=1 PV at T=2 PV at T=3 PV at T=4 PV at T=5 Total PV

interest                            3.90%
                                    4.00%
                                                $3.85
                                                $3.85
                                                          $3.71
                                                          $3.70
                                                                    $3.57
                                                                    $3.56
                                                                              $3.43
                                                                              $3.42
                                                                                       $85.89
                                                                                       $85.48
                                                                                               $100.45
                                                                                               $100.00

rates a bit:                        4.10%       $3.84     $3.69     $3.55     $3.41    $85.07    $99.56



 Divide the % change in price by the bp change in rates:
T=                     1         2         3         4         5
Payment           $4.00     $4.00     $4.00     $4.00  $104.00
Interest Rate PV at T=1 PV at T=2 PV at T=3 PV at T=4 PV at T=5 Total PV PV change Rate change Duration
       3.90%       $3.85     $3.71     $3.57     $3.43    $85.89  $100.45   -0.44%       0.10%       4.44
       4.00%       $3.85     $3.70     $3.56     $3.42    $85.48  $100.00   -0.44%       0.10%       4.44
       4.10%       $3.84     $3.69     $3.55     $3.41    $85.07    $99.56


                                                                                                       9
 Duration Example (cont.)
Often, a graph of a bond’s price versus yield is
helpful to understand duration.
                                                                              Duration Cash 30yr)
                                                                      PV of CashPV of(for theFlows 4% Bond
                                                                                 Flows        30yr
Duration is essentially   23.50$150

the slope at a point      21.50
                              $100
                          19.50
on the P/Y line.          17.50
                                  $50
                          15.50
                          13.50
                                   $0
Note that duration is     11.50




                                                   3%
                                                   4%
                                                                  6%
                                                                  7%
                                                                  8%
                                                                 10%
                                                                 11%
                                                                 12%
                                                                                                        14%
                                                                                                        15%




                                                                                                                                      20%
                                                                                                                                                  21%
                                                                                                                                                  23%
                                         1%
                                              2%
                                                   3%
                                                   4%
                                                                  5%
                                                                  7%
                                                                  8%
                                                                  9%
                                                                 10%
                                                                 11%
                                                                 13%
                                                                                                        14%
                                                                                                        15%
                                                                                                                      16%
                                                                                                                            17%
                                                                                                                                      19%
                                                                                                                                      20%
                                                                                                                                                  21%
                                                                                                                                                  22%
                           9.50   IRs
different for different    7.50


bonds.
                           5.50
                           3.50
                                  1%
                                        2%
                                             3%
                                                  4%
                                                       5%
                                                            6%
                                                                 7%
                                                                      8%
                                                                           9%
                                                                                10%
                                                                                      11%
                                                                                            12%
                                                                                                  13%
                                                                                                        14%
                                                                                                              15%
                                                                                                                    16%
                                                                                                                          17%
                                                                                                                                18%
                                                                                                                                      19%
                                                                                                                                            20%
                                                                                                                                                  21%
                                                                                                                                                        22%
                                                                                                                                                              23%
Also note that duration changes with interest rates;
this “2nd derivative” is called convexity; for large
swings in rates, it can play a factor in prices.     10
Real World Use: DV01
For convenience, most traders use DV01 (PVBP): the
dollar change in the bond price for a 1bp move in
yield (very similar to yield).




This is the Bloomberg Yield Analysis (YA) for the
10yr Treasury Note.                                 11
 DV01 in Action
On Nov. 16, at 8:30, the government published the
PPI numbers, which came in much hotter than
expected.
The yield on the 10yr
benchmark Treasury
immediately jumped
4.6bp
DV01 x 4.6bp = Price
0.08103 x 4.6bp =
$0.373
…=12/32nds.                                         12
DV01 in Action




As expected, the price dropped by 37¢ ($12/32).
…A trader long $50MM of 10 years just lost
      27¢ x 50,000 = $18,637. Ouch.               13
            Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products



                                       14
 Yield Curves
Generically, a “yield curve”, is simply a plot of the
current yields at different maturity points.
When speaking of
the yield curve, most
traders mean the US
Treasury yield curve,
since Treasuries are
the “riskfree”
benchmark for all
debt instruments.
                                    Bloomberg command: YCRV

                                                        15
Yield Question
By the way, what is yield?
I would answer that it is the periodic discount rate
that, when applied to every payment in a bond’s cash
flow, returns the exact same price as the current
market price.




                                                 16
 Credit Spread
In the FI world, many products are traded on a
“spread” off the Treasury yield curve.
The credit spread
is the difference in
AAA corporate debt
yields and Treasury
yields; it is a real-
time measurement
of the credit risk
tolerance of the
market.

                                                 17
Breakeven Inflation
Comparing the Treasury curve versus the TIPS
(Treasury Inflation Protected Securities) yield curve
reveals the breakeven inflation level expected by the
market.
A word of caution on TIPS:
they are a fairly new
product, and do have some
liquidity issues that could
lead to mispricing.



                                                   18
Swap Spread
Other interesting spreads to observe: Agency spread
and swap spread.




                                                 19
           Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products



                                       20
 Swaps: At their most basic
As their name implies, swaps are simply contractual
agreements between two counterparties to exchange
different cash flows.
The number of swaps are greatly expanding. A
truncated list:
                         ISDA:
•Currency swaps
                         For interest rate swaps, rate
•Interest rate swaps     options, and currency swaps, at
                         mid-year 2004, the notional
•Credit Default Swaps    amount outstanding was:
•Volatility Swaps
•Total Return Swaps      $164.49 Trillion
                         http://www.isda.org/statistics/recent.html#2004mid
                                                                              21
Interest Rate Swaps
Interest rate swaps (often called vanilla swaps) are
simply exchanges of a fixed rate of interest for a
floating rate, both paid on a fixed notional amount.
Things to remember:
•Buying (going long) a swap = paying fixed rate,
receiving floating
•Selling (going short) a swap = paying floating,
receiving fixed



                                                   22
            Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products



                                       23
 Securitization
•Securitization was one of the biggest financial
innovations of the last 40 years.
•Definition: transforming illiquid/non-financial
products into tradable financial securities.
•Two most common methods:
   •Pooling: using large pools of securities to
   diminish the illiquidity/risk of a single one.
   •Tranching: dividing cash flows into separate
   “tranches” that have different risk levels, in order
   to target differing investor appetites for risk.
                                                     24
 Mortgage Backed Securities
•The history of MBS is an excellent example of both
processes.
•Problems with investing in individual mortgages: small size
(to an institutional investor) and prepayment risk (at the
“whim” of the homeowner).
•In the late 70s and early 80s, Mortgage Pass-Thrus were
popularized: securities whose coupons were supported by
pools of [numerous] mortgage securities.
               Individua
      Individua
         Individual
            l l
    Individua
            Individual
       Mortgag   Mortgag
          Individua
                           MBS Pass-Thru               Pass-
       Individual e
          Mortgag
         Individua
          l e Individua
            Mortgage
    Individual
       Mortgage
     Mortgag
          e
               e
               l
             Individua
     Individuall l
          l Mortgag
      Individua
        Individua
          Mortgag
   Individua Mortgag            Issuer                 Thru
          Individua
     Mortgage
         l lIndividua
     Mortgage le
 Individua Mortgag
              Individua
    Individual l e
         Mortgag
       Mortgag
                                                      Investors
    Mortgag Individua
          e                (Fannie Mae, Freddie
              e el l
      l l Mortgag
         e eMortgag
  Mortgag Mortgag             Mac, I-Banks)
                 ee
     MortgagMortgag
     e e           ee
                                                           25
 CMOs
•The next step in securitization was tranching.
•CMOs = Collateralized Mortgage Obligations.
•Rather than divide all the pooled mortgage cash flows equally
among investors, CMOs divide them into separate “tranches” of
securities with different payment profiles.
•Commonly, the different tranches receive different timing of
payments.
                                                           Tranche A
                                                           Investors
              Individua
      Individua
         Individual
            l l
    Individua
       Mortgag  Mortgag
          Individua
                               CMO
       Individual e
            Pass-Thru
          Mortgag
         Individua
          l e Individua                                   Tranche B
    Individual
        Mortgage
              e
              l
                              Issuer
     MortgagIndividua                       18mos-36mos
     Individual l
          l Mortgag
      Individua
        Individua
          Mortgag
   Individua Mortgag
          e
                                                          Investors
             le l
          Individua
     Mortgage
         l lIndividua
     MortgageMortgag
 Individua Individua
       Mortgag l e
         Mortgagl
    Mortgag Individua
          e
      l Pass- e l l           (I-Banks)
            Mortgag
         e eeMortgag
  Mortgag Mortgag
                ee
        Thru Mortgag
     e            ee
                                                          Tranche C
                                                          Investors
                                                                  26
            Today’s Agenda
I. What is fixed income?
II. Duration
III. Yield Curves and Credit Spreads
IV. Swaps
V. Securitized Products

                  ~ Fin ~
                                       27

								
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