Basic Pricing Concepts and Methodology

1. Basic Pricing Concepts and Methodology September 5, 2002

2. Discussion Topics • Overview of Treasury Security Market • Common Risk and Return Measures • Characteristics of available Agency Investments • Pricing Methodology • Things to consider when choosing investments

3. Primary and Secondary Treasury Security Markets • Treasury auctions new securities periodically to finance government deficits • Treasury auctions its securities competitively in the “primary market” • Once auctioned, Treasury securities are traded between investors in the “secondary market”

4. The Treasury Security Market • Highly-liquid primary and secondary markets • Treasury securities are regarded as credit-risk free • Interest-rate risk is major risk facing investors in Treasuries • Reinvestment risk also exists • Prices on Treasury instruments fluctuate continuously depending on the level of interest rates • Variety of investment vehicles available to investing agencies • Overnight investments • bills • notes and bonds • inflation indexed notes and bonds • zero coupon bonds

5. Investment Prices and Yields • Prices and yields are inversely related • Prices are determined by discounting the cash flow from a security to its present value using current market rate as discount • Bid and Ask prices - narrow spreads • Prices are quoted “flat”, w/o accrued interest, accrued interest added to settlement price • Yield to Maturity (YTM) is standard yield measure

6. The Main Risk: Interest Rate Risk • As the level of interest rates change, the price of fixed-income investments change - this is a continuous process based on economic activity • Inverse relationship between prices and interest rates - as rates rise, prices fall and vice-versa • Longer-maturity instruments are more price sensitive to interest rate movements • Lower-coupon instruments are more price sensitive than Higher coupon instruments

7. Re-investment risk • Arises when considering investment alternatives • Must be considered if purchasing an asset that has a maturity shorter than the liability • E.g. Investing for a liability arising in 4 years. • Can purchase an asset with 4 years to maturity (exact maturity match - no reinvestment risk) • Can purchase a shorter-dated maturity - e.g., a 2-yr security and reinvest in another 2-yr security when the first instrument matures (this option has some reinvestment risk)

8. Return Basics • Generally, three components of return on Treasuries • coupon • price appreciation or depreciation • reinvestment of coupons (depends of reinvestment rate) • The sum of these three components constitute the “total return” • TIIS have an additional return component tied to the CPI

9. Basic Risk-Return Rules of Thumb • The more risk, the greater the return • Absent credit risk, risk in fixed-income securities generally increases as the maturity of the investment increases • Portfolio management theory prescribes that the maturity of liabilities should be matched to the maturity of assets. The greater the maturity “gap” between, assets and liabilities, the greater the risk

10. Categories of Market-Based Investments available to Investing Agencies • Mirror image market-based specials • T-bills • T-notes • T-bonds • TIIS • Additional market-based specials • O/N investments • Treasury Zeros coupon bonds

11. Investment Instrument Characteristics • T-Bills - short maturity - discount instruments • T-Notes and T-bonds- short to long maturity- semi annual coupon paid • TIIS- medium to long maturity - semi annual coupon and indexed for inflation • O/N Investments - very short maturity - overnight • Zeros - medium to long maturity - deep discount instruments

12. Treasury Bills • Issued w/ maturities of 1-, 3-, & 6-months • Identified by maturity date, e.g. “10/31/02” • Bills trade at discounts to maturity price of 100 • Bills are quoted on a bank-discount rate basis BDR = [[(100 - Price)/100] x (360/DTM)] • (Must convert to coupon equivalent (CE) to compare to other investments • CE = [ [(100 - Price)/Price] x (365/DTM) ] • Difference between the purchase price and maturity price represents the interest earned by bill investor

13. Fixed-Rate Treasury Notes and Bonds • Issued with maturities of 2-, 5-, and 10 years. • Notes are between 1 and 10 years; bonds are greater than 10 years. Bonds no longer issued. • Longer dated bonds are still outstanding and available as investments ( longest maturity is 2/15/31) • Note and bonds are Identified by coupon and maturity date, e.g. “6% of 9/30/02” • Unlike bills, notes and bonds have a coupon associated with them and interest is paid semi-annually • Longer-maturity notes and bonds carry significant interest rate risk

14. Treasury Inflation-Indexed Securities (TIIS) • TIIS are floating rate instruments designed to protect investors from inflation. • Principal is indexed to the CPI (nsa) • Coupons on IIS are real-rate coupons, lower than comparable nominal rate instruments • Indexing is based on the ratio of the current CPI divided by the CPI at issuance. (Index Ratio x Principal ) Coupon is a fixed-real coupon times indexed principal • As inflation increases, principal increases as well as coupon • Be aware - TIIS yields and prices quotes are based on real rates and real prices - settlement prices account for inflation and can be significantly higher

15. Overnight Investments • Issued with a stated rate of interest applied to the par amount of the investment. • Mature on business day following investment. Interest credited at maturity • Rate determined by FRB-NY survey of O/N repurchase agreement (repo) rates. • O/N repurchase agreements are one-day loans collateralized by Treasury securities

16. Zero Coupon Bonds (Zeros) • Zeros are not issued by Treasury - they are created by market participants through STRIPs • Zeros carry no coupon - instead they are a single payment at some future date - can be short or long maturities • Zeros are identified by just a maturity date. • the price of a zero is the PV of the single future payment - often quoted in market on yield basis • long zeros are extremely sensitive to interest rate movements - carry great deal of interest-rate risk

17. Zero Pricing Formula

18. Pricing Methodology • O/N Rates come from FRB-NY repo rate survey • Bills, Notes, Bonds, & IIS prices come from trading desk at FRB-NY (survey of dealers) • Zero prices are determined by OMF - via a survey of dealer quotes - averaged; quotes that deviate more than 1 Std Dev from average are eliminated • Mean of the bid-ask prices are used for investments, while ask prices for investment redemptions • Timing- Pricing occurs between 11:15 AM and 11:45 AM for O/Ns, bills, notes, bonds, and IIS and 12:00 noon for zeros.

19. Things to consider before investing • Horizon: When do you need the money? • What is the nature of the liability? • What alternatives investment are there? • What is the outlook for interest rates? • Fed Policy • Rate Forecasts (public, private, model-based) • Inflation and Inflation Expectations • Federal Budget Deficits and Surpluses

20. Sources of Investor Information • Financial Newspapers - e.g.,WSJ, Financial Times, etc. • Fixed-Income Newsletters - e.g. Wrightson, Grant’s Interest Rate Observer, etc. • Newswire/Analytic Services - e.g. Reuters, Bloomberg, Dow Jones Capital Markets, etc. • Federal Reserve publications - press releases, statistical releases, economic reports, etc. • Treasury publications - Daily Treasury Statement, Monthly Statement of Public Debt, auction data, etc. • OMB releases - Annual Budget, Mid-Session Review • Price-yield conversion formulas along with related examples can be found in the Uniform Offering Circular Pt 356, Appendix B at http://www.publicdebt.treas.gov/gsr/gsruocam.htm