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FIXED INCOME APPROACH

FIXED INCOME APPROACH. Ş enay A ğ ca George Washington University. Fixed Income Securities. Treasury securities Agency securities Corporate securities Municipal securities Securitized assets. Fixed Income Securities. Treasury securities: - Treasury bills, notes, bonds - STRIPS

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FIXED INCOME APPROACH

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  1. FIXED INCOME APPROACH Şenay Ağca George Washington University

  2. Fixed Income Securities • Treasury securities • Agency securities • Corporate securities • Municipal securities • Securitized assets

  3. Fixed Income Securities • Treasury securities: - Treasury bills, notes, bonds - STRIPS - TIPs - on-the-run/off-the-run • Agency securities: - GSEs - FHLB, FNMA, FHLMC

  4. Fixed Income Securities • Corporate Securities - Call feature - Credit Risk - Liquidity - Commercial Paper (30 days to 270 days maturity, discount bonds) - Corporate Bond - Shelf registration

  5. Fixed Income Securities • Municipal Securities General obligation bonds Revenue bonds Tax issues • Securitized Assets Prepayment risk Pass-through securities Collateralized Mortgage Obligations (CMOs) Collateralized Debt Obligations (CDOs)

  6. Risk Exposure of Fixed Income Securities • Interest rate risk All fixed income securities • Credit risk Corporate bonds, municipal bonds, low at agency securities, none at Treasury securities • Liquidity risk Corporate bonds, municipal bonds, low at Treasury and agency securities

  7. Risk Exposure of Fixed Income Securities • Call risk Corporate bonds, munis • Prepayment risk Mortgage backed securities

  8. Bond Return Measures • Current Yield Problems: no time value of money, good approximation for bonds close to par and long maturity • Yield to Maturity Problems: Assumes that all coupons will be reinvested at the same rate

  9. Yield Curve

  10. Quantifying Interest Rate Risk • Price risk Change in the bond price for an instantaneous change in the yield curve Price risk =

  11. Price-Yield Relation

  12. Quantifying Interest Rate Risk • First order risk measures: Duration Modified Duration =

  13. Quantifying Interest Rate Risk • Second order risk measures: Convexity Convexity =

  14. Portfolio risk measures • Portfolio duration • Portfolio convexity Portfolio duration (convexity) is weighted average duration (convexity) of assets in the portfolio.

  15. Portfolio Management Techniques • Portfolio dedication - Buy minimum cost portfolio subject to restrictions on callability, credit quality, reinvestment risk, etc. such that cash flows from the assets will match the cash flows needed for the liability.

  16. Portfolio Management Techniques • Immunization 1. Duration Matching Strategy: PV(Asset portfolio) = PV (Liability portfolio) Duration(Asset Portfolio) = Duration(Liability Portfolio)

  17. Portfolio Management Techniques 2. Duration and Convexity Matching Strategy: PV(Asset portfolio) = PV (Liability portfolio) Duration(Asset Portfolio) = Duration(Liability Portfolio) Convexity(Asset Portfolio) = Convexity(Liability Portfolio)

  18. Portfolio Management Techniques • Horizon matching - A hybrid of portfolio dedication and immunization - Divide horizon into 2. Manage first half with portfolio dedication and second half with immunization. Idea is that short-term cash flows are more predictable and in long term there is more price risk.

  19. Credit Risk • Credit Spread: Yield of R rated bond – Yield of Treasury with same maturity Depends on: • Probability of default • Recovery rate (loss given default)

  20. r% on notional N CDS Seller (B) CDS Buyer (A) In default, pay notional - recovery Credit Derivatives • Credit Default Swap (CDS)

  21. Total return on bond Total Return Receiver Total Return Payer LIBOR + x basis points Credit Derivatives • Total Return Swap

  22. Credit Derivatives • Credit Spread Options Call payoff = max {Credit sensitive asset price - Strike,0} Put payoff = max {Strike – Credit sensitive asset price, 0} Examples of this type options are: - To cap the spread over LIBOR in a floating rate loan - Right to enter (or terminate) a CDS.

  23. Securitized Assets • Mortgage backed securities • Collateralized Mortgage Obligations (CMOs) • Collateralized Debt Obligations (CDOs)

  24. Securitized Assets • Mortgage Backed Securities Prepayment risk: - Extension risk - Contraction risk

  25. Securitized Assets • Collateralized Mortgage Obligations (CMOs) Bond classes (tranches) are created to reduce prepayment risk - Sequential Pay Tranches - Accrual Tranche (Z-bond) - Floating Rate Tranches - Planned Amortization Class (PAC) Bonds

  26. Securitized Assets • Collateralized Debt Obligations (CDOs) • A stand-alone special purpose vehicle (SPV) that raises capital through issuance of “shares” and debt • Proceeds are used to buy debt securities • There is credit risk • Risk depends on the class of seniority (tranches)

  27. Securitized Assets • Collateralized Debt Obligations (CDOs) Standardized Index Tranches: - CDX.NA.IG – 125 names - CDX.NA.HY – 100 names Tranches for CDX.NA.IG: 0-3 (Equity tranche); 3-7 (Mezanine tranche) 7-10 10-15 15-30 30-100

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