BOND VALUATION

For a Treasury bond, the appropriate rate used to value the promised cash flows is the risk-free rate.

For non-Treasury securities, we must add a risk premium to the risk-free (Treasury) rate to determine the appropriate
discount rate.

Price-Yield Curve

 Bond values and bond yields are inversely related.

 An increase in the discount rate will decrease the present value of a bond’s expected cash flows;
 The change in bond value in response to a change in the discount rate can be calculated as the difference between the
present values of the cash flows at the two different discount rates.

Discount Factors and Arbitrage

 Discount factors are used to determine present values.

 The discount function is expressed as d(n), where n denotes the number of coupon periods until the next payment.
 Treasury bills are securities that mature within one year and are issued by governments to finance their short-term
funding needs.
 If the Treasury bill matures in one year and n = 360, then the price paid by a buyer would be 100 – Q.
o Treasury bill is a function of the:
 maturity price (e.g., 100),
 quoted price (Q), and
 number of calendar days until maturity (n).

This can be expressed as:

o The quoted price: clean price and does not include accrued interest.
o The cash price: dirty price and includes accrued interest

 Cash price is based on both the bid and ask quotes for the bill. The midpoint of these two values is the discount factor.
For example, if the cash price based on the bid for a security that matures in 80 days is calculated as
99.60 and the cash price based on the ask is 99.65, the midpoint is 99.625, or 0.99625. A security worth
$100,000 in 80 days would be priced at $99,625 today.

Therefore, the 0.99625 is the discount factor for this maturity date. If a security was priced at $100,000
today, it would be worth $100,000 / 0.99625 = $100,376.41 in 80 days based on the midmarket discount
factor.
Determining Bond Value from Discount function:

 Law of one price: Instruments with identical future cash flows should sell for the same price.
 Arbitrage opportunity: Exploiting a mispricing because of the law of one price.
BOND COMPONENTS AND PRICING:

 Zero-coupon bonds issued by the Treasury are called STRIPS (which stands for Separate Trading of Registered Interest and
Principal Securities).
 The bond is “stripped” into two components: principal (P-STRIPS, TPs, or Ps) and coupons (C-STRIPS, TINTs, or INTs).
 Arbitrage opportunities exist when the price of C-STRIPS relative to P-STRIPS diverges.
 Short-term (long-term) C-STRIPS often trade rich(cheap). Recent issues tend to trade at higher prices than otherwise similar
issues. Some of this premium is due to the demand for shorts and the resulting financing advantage, that is, the ability to
borrow money at less than GC rates when using these bonds as collateral

 The dirty price is the price that the seller of the bond must be paid to give up ownership. It includes the present value of the
bond plus the accrued interest.

Clean price = Dirty price – Accrued interest

The dirty price or full price or invoice price.

The clean price or flat price or quoted price.

Question: Consider a $100 par value bond that pays 3% coupon semi-annually. This means a coupon of $1.50 is paid every six
months.

If the bond is sold (and settles) 41 days after the last coupon, the buyer will need to pay the seller:

for every $100 purchased.

 Several day count conventions are used in practice in the bond markets:
o Actual/actual (in period): U.S. government bonds
o Actual/360: money markets – discount securities and floating legs of interest rate swaps,
o 30/360: U.S. corporate and municipal bonds, fixed leg of interest rate swaps
o Actual/365: money market securities in Canada, New Zealand, and Australia

Spot Rates

 The spot rate (also known as the zero-coupon interest rate or the zero) is the rate earned on an investment when it is received
at a single point in the future.
 The spot rate and the discount factor, d(t), provide the same information.

Forward rates
 These are future spot rates that are based on current spot rates.
 In theory, an investor should be indifferent and earn the same return for an investment that spans two years versus one that
lasts one year and then requires reinvestment in the second year.

Forward rate agreement (FRA)

 It is a financial instrument that guarantees a specific rate to be paid or earned during a future period.
 The FRA is worth zero when the current forward rate (F) is equal to the guaranteed rate (R).
 Assuming there is a difference, the PV of that difference between R and F, applied to the principal amount, equals the value of
the FRA.
 When R > F, the value of the FRA is positive;
 When R < F, the value of the FRA is negative.

Par Rates:

The par rate at maturity is the rate at which the present value of a bond equals its par value.

Bond Valuation with Par rate:

 R>F and FRA is positive: The value of a bond will fall if its coupon rate exceeds the forward rate for the final payment period.

R<F and FRA is negative: The value of a bond will rise when the forward rate for the last period is greater than the coupon rate,
which tends to happen in an upward-sloping term structure.

Derivative Swap:

 A swap is a derivatives transaction where two parties agree to exchange payments based on the movement of an underlying
asset.
 A fixed rate for floating rate swap involves one party making payments based on fixed rate and receiving payments based on a
floating rate, while the counterparty has the opposite position. E

1. Yield curve twists: are yield curve changes when the slope becomes either latter or steeper.

 With an upward-sloping yield curve, a flattening of the yield curve means that the spread between short- and long-term rates
has narrowed.
 Conversely, a steepening of the yield curve occurs when spreads widen.
 The curve will flatten when long-term rates fall by more than short-term rates (a bull flattener)
 When short-term rates rise by more than long-term rates (a bear flattener).
 The curve will steepen when long-term rates rise by more than short-term rates (a bear steepener)
 When short-term rates fall by more than long-term rates (a bull steepener).

Bullish environment: As bond prices rise (driven by falling yields), it’s typically considered a positive or
"bullish" bond market.

Flattening curve: Long-term yields drop more than short-term yields, reducing the spread between them and
"flattening" the curve

2. Yield curve butterfly shifts: are changes in the degree of curvature.

 A positive butterfly means the yield curve has become less curved.
For example, if rates increase, the short and long maturity yields increase by more than the intermediate maturity yields.

 A negative butterfly means there is more curvature to the yield curve.

EXAMPLE:

Investor A expects an upward-sloping term structure to flatten in the coming months, with long-term rates falling and short-term rates
rising.

Strategy A: Investor A will take a long position in longer-term bonds and a short position in shorter-term bonds.

 A flattening curve means longer-term bonds will see lower rates, which will increase their value and produce a profit on the long
position.
 Short-term bonds will see relatively higher rates, lowering their value and benefitting the short position
Investor B expects the same term structure to go in the opposite direction.

Strategy B: Investor B will take a short position in longer-term bonds and a long position in short-term bonds.

 A steepening curve means the longer-term bonds will see higher rates, which will lower the price of the bonds and allow the
investor to cover his short position at a lower price.
 The shorter-term bonds will have lower rates, which will increase the price of these bonds and improve the investor’s long
position

Realized gross return:

Net Realised Return:

Reinvestment risk: occurs in-

- Callable bonds because the principal can be prematurely retired.

- The higher the coupon, the higher the reinvestment risk, holding all else constant.
- A bond being issued at par has nothing to do with reinvestment risk.
- Zero-coupon bond has no re-investment risk.

Bond Price of Semi-annual coupon bond with maturity at time T:

Bond Spread: Difference between bond market price and bond price according to the term structure of interest rates.

Bond Valuation using forward rates:

Thus, the total price of the bond is 103.440.

The yield to maturity (YTM):

- YTM of a fixed-income security is equivalent to its internal rate of return.

- It is the single discount rate that equates the present value of all cash flows associated with the instrument to its price.
 YTM < coupon rate: the bond will trade at a premium. (MP>BP)
 YTM > coupon rate: the bond will trade at a discount. (MP<BP)
 YTM = coupon rate: the bond trades at par. (MP=BP)

Annuity: Remember, FV=0 in calculator. (only the cash flows)

Perpetuity:
Relationship Between YTM, Coupon Rate, and Price:

The coupon effect describes a scenario where two bonds with identical maturities but different coupons will have different yields to
maturity.

Coupon rate is, inversely proportional to interest rate risk

Spot Rates and YTM

1. In an upward-sloping curve, the bond's price tends to be higher, and the YTM is lower than the final spot rate.
2. In a flat curve, the YTM matches the spot rates
3. In a downward-sloping curve, bond prices are higher, and the YTM is lower than the short-term rates due to lower discounting of the
final large cash flow.
Japanese Yields:

Simple yields only require the coupon (c), principal (p), and maturity (T):

Carry-roll down Scenario:

The decomposition of return for a bond involves analyzing the profit and loss (P&L) by breaking down how various factors contribute to
changes in a bond’s price and cash flow. This is helpful for investors seeking to understand what drives the profitability or losses on a
bond. Here’s a breakdown of the key components and concepts involved:

1. Price Effect Components

The bond price effect can be broken down into three primary components:

 Carry Roll-Down: This represents the return expected from bond price movements and coupon payments if interest rate
expectations remain unchanged. In this context, it assumes that expected forward rates are realized and match the spot rates
when they materialize. Carry roll-down doesn’t account for changes in credit spread, making it a "rate-neutral" component.
Different carry roll-down scenarios include:

o Realized Forward Scenario: This assumes that forward rates set for future periods are realized as expected, meaning the
forward rate at the beginning of each period becomes the spot rate as time progresses.

o Unchanged Term Structure: Here, term structures are assumed to remain the same over time.

o Unchanged Yields: Assumes that yield levels do not shift, providing a straightforward scenario for rate-neutral analysis.

 Rate Change: This component reflects the difference in realized returns compared to what was assumed in the carry roll-down.
Essentially, it captures deviations in rates from expectations, focusing purely on interest rate movement without considering
spread changes.

 Spread Change: This captures price changes due to shifts in the bond’s spread relative to other bonds. Spread changes often
reflect changes in perceived credit risk or market sentiment, and traders frequently target bonds they believe are “cheap” or
“rich” in relation to these spreads.

2. Gross Return Calculation

By dividing each of these components (carry roll-down, rate change, and spread change) by the bond’s price, investors can obtain the
percentage return attributed to each source of P&L, helping to analyze gross return comprehensively.
 Dividing each component return by the bond’s price will give us components of the gross return.

P&L is generated by price appreciation plus cash-carry, which consists of explicit cash flows like coupon payments and financing costs.
The P&L due to the passage of time excluding cash-carry is called carry-roll-down.

P&L due to carry is meant to convey how much a position earns due to the passage of time, holding everything else constant. P&L due
to roll-down is meant to convey how much a position earns due to the fact that. as a security matures, its cash flows are priced at
earlier points on the term structure.

There are two extensions to P&L analysis:

1. Consider the impact of financing: If financing is considered, the cost of financing should be added as a fourth component of the
P&L, and both gross and net returns would be calculated.
2. Consider accrued interest on both the initial and final valuation dates. So far, we looked at returns simply between two coupon
dates. However, both the initial and final bond valuations could be between coupon dates. In this case, it is necessary to add a
fourth component for the impact of accrued interest.

APPLYING DURATION, CONVEXITY, AND DV01

A. DV01

The dollar value of a basis point (DV01) is the dollar value change in a fixed-income security’s price for a one basis point
change in interest rates. The 01 refers to one basis point (i.e., 0.0001)

The DV01 formula is preceded by a negative sign, so when rates decline and prices increase, DV01 will be positive

Convexity: Since bond prices exhibit convexity to changes in interest rates, the bond price increase will be larger when rates
decline compared to the bond price decline when rates increase by the same percentage

Analysts may also distinguish between the following definitions of DV01:

 Yield-based DV01: The change in bond price from a one basis point change in yield.
 DVDZ or DPDZ: The change in bond price from a one basis point change in spot (zero) rates.
 DVDF or DPDF: The change in bond price from a one basis point change in forward rates

DV01 Application to Hedging:

 A hedge ratio of 1 means that the hedging instrument and the position have the same interest rate sensitivity.
 The goal of a hedge is to produce a combined position that will not change in value for a small change in yield.
 The hedge ratio (HR) is expressed as:
How Does DV01 Hedging Work?

Suppose an investor holds a long position in a bond with a DV01 of $0.065 and wants to hedge using another bond (say, a 20-
year bond) with a DV01 of $0.085. The investor can use the hedging ratio to determine how much of the 20-year bond they
need to buy or sell to offset the interest rate exposure. (HR = 0.065/0.085 = 0.765)

1. If the investor has a long position:

 They are exposed to falling interest rates, which will cause the bond’s price to rise. If they want to hedge against this,
they would sell the hedging instrument.

 They are at risk if interest rates rise (which would cause bond prices to fall), so they might want to hedge by selling
bonds with higher DV01 to offset potential losses.

2. If the investor has a short position:

 They are exposed to rising interest rates, which cause bond prices to fall. To hedge, they would buy the hedging
instrument to protect against rising interest rates.

3. To properly hedge, you must take opposite positions (one long and one short):

If You Have a Long Position in the 10-Year Bond:

 To hedge against rising interest rates (which would cause the bond's price to fall), you need to take the opposite
position in the hedging instrument.
 In this case, with HR = 0.765, you would short the 20-year bond.
 So, the action is: Sell $76.50 of the 20-year bond for every $100 of the 10-year bond.

If You Have a Short Position in the 10-Year Bond:

 To hedge against falling interest rates (which would cause the bond's price to rise, creating losses in a short position), you
need to take a long position in the 20-year bond.
 In this case, with HR = 0.765, you would buy the 20-year bond.
 So, the action is: Buy $76.50 of the 20-year bond for every $100 of the 10-year bond.

B. Bond Duration:

 It is the most widely used measure of bond price volatility.

 A bond’s price volatility is a function of its coupon, maturity, and initial yield. Duration captures the impact of all three of
these variables in a single measure.
 The impact of interest rate change in a bond portfolio is measured by the duration of the portfolio. The bond with the
higher coupon has a smaller duration compared to the bond with the lower coupon. Hence, if the fund manager wants
to limit the impact of the interest rate changes on his portfolio, he must invest in the bond with the higher coupon.
 Effective duration measures the percentage change in a bond’s price, P, for a given small change in rates (Δy). It is
commonly interpreted as the percentage change in a bond’s price for a 100-basis point change in rates.
 or

 When yields are continuously compounded, the provided duration measure is known as Macaulay duration.

 Modified duration is used when the yield given is something other than a continuously compounded rate. When the
yield is expressed as a semi-annually compounded rate, for example, modified duration = duration / (1 + y/2).

In general, we can express this relation as:

Note: When a position doubles or becomes “x” times, DV01 also becomes “x” times or doubles. However, Duration and
Convexity remain constant as they are % changes.

 Callable Bond:
1. A bond that gives its issuer the right to buy back the bond from investors at a predetermined price in the future.
2. The issuer will typically want to buy back the bond when interest rates have declined and it can refinance at lower,
more beneficial rates.
3. As a result, the upside price appreciation in response to decreasing rates is limited and capped at the call price.

4. A zero-coupon bond will always trade below par, and the call should never be exercised. Hence, its duration is the
maturity of the bond. (D=T)

5. Effective duration is the weighted duration of the bond, with the weights as the probability that the bond would not
be called and the probability that it would be called.

Deff = (Pcalled * Dcalled) + (Pnot called * Dnot called), where Dnot called > Dcalled

6. A putable bond gives the bondholder the right to sell the bond back to the issuer at a predetermined price in the
future. Typically used, when interest rates rise.

Limitations of DV01 vs Duration:

1. Convexity not considered as it assumes linear curve

2. Both of them are not good for large yield changes.
3. DV01 measures the change in dollar value of a security for every basis point change in rates, duration measures the
percentage change in a security’s value for a unit change in rates.
4. Price calculated using duration will always underestimate the actual price change in the bond, which will always be
above the duration-calculated price.
5. Duration measures assume a parallel shift in the yield curve. Duration is not a good measure of nonparallel shifts.

C. Convexity

 It measures the sensitivity of duration to changes in interest rates.

 It is a measure of the curvature in the relationship between changes in interest rates and the change in bond price.
 As duration will always result in a price below the bond’s true price change, convexity will help adjust (lift) the price
calculated by duration.
 It is always a positive adjustment. Generally, the higher the convexity number, the higher the price volatility
 The convexity value means nothing in isolation.

The fund manager must invest in such a bond/portfolio which has the highest convexity, as higher convexity will help the
fund manager to maximize return due to interest rate volatility.

Question: What is the value of the portfolio’s DV01 (dollar value of a basis point)?

DV01 = Bond value * Effective duration * 0.0001

Portfolio Duration and Portfolio Convexity:

Calculate the DV01, duration, and convexity of a fixed income securities portfolio:

1. Portfolio DV01 = Sum of DV01 of all securities

2. Portfolio Duration = Weighted sum of durations of all securities

3. Portfolio Convexity = Value-weighted average of the individual bond convexities within a portfolio.

4. Hedging using Duration:

5. Hedging using Duration + Convexity:

This could be done by using two bonds with prices P1 and P2, durations D1 and D2, and convexities C1 and C2.

For the investment to be fully hedged, both durations and convexities must be zero.

 Negative sign of P1 or P2 = short hedge

 Positive sign of P1 or P2 = long hedge

Constructing a Barbell Portfolio

 A barbell investment is typically used when an investor invests in bonds with short and long maturities, thus forgoing
any intermediate-term bonds.
 A bullet investment is used when an investor buys a single bond, typically concentrated in the intermediate maturity
range.
 If the manager believes that rates will be especially volatile, the barbell portfolio would be preferred over the bullet
portfolio.
 However, for nonparallel changes in interest rates, the bullet strategy often outperforms. For example, in a typical
upward sloping yield curve scenario, the yield of the bullet investment would be greater than the yield of the barbell
strategy.

Question: Assume that an investor is looking to construct a $100,000 portfolio with a duration of 7.65.

Case 1: The investor could buy $100,000 of the 10-year bond (Bond 2) with a duration of 7.65. As only one bond is purchased
that matches the desired duration, this is a bullet investment.

Case 2: Investor could construct a portfolio using a shorter and longer maturity bond (using the 5-year and 30-year bonds)
with a weighted duration of 7.65. This is a barbell investment, which would have the same duration as the individual bullet
investment:

4.12 w1 + 14.93 (1 – w1) = 7.65, where w1 is the weight in Bond 1 w1 = 0.6735 (where w1 derived by calculating the equation)
Therefore, the investor could construct a portfolio with a duration of 7.65 by investing 67.35% of funds in the 5-year Bond 1
and investing (1 – 67.35%) = 32.65% in the 30-year Bond 3.

The barbell portfolio will have a combined convexity of:

Barbell Convexity: (0.6735 × 21.9) + (0.3265 × 310.5) = 116.1 > bullet portfolio with convexity of 59.8

Note: Although durations are same, the barbell portfolio’s convexity of 116.1 is greater than the bullet portfolio’s convexity
of 59.8. Higher convexity is beneficial because it improves the investor’s position for parallel changes in interest rates.

 Strategy A: If interest rates are expected to increase in a parallel way, the barbell strategy would typically outperform
because of the higher convexity.
 Strategy B: For nonparallel changes in interest rates, the bullet strategy often outperforms.
 For example, in a typical upward sloping yield curve scenario, the yield of the bullet investment would be greater than
the yield of the barbell strategy.

MODELING NON-PARALLEL TERM STRUCTURE SHIFTS AND HEDGING

Parallel shifts occur due to single factors as assumed by simple hedging approaches.

Non-parallel shifts however, occur due to multiple factors therefore, multi-factor models are used.

 Principal components analysis (PCA) is a technique used to analyze term structure movements in historical data.
o Based on daily movements in rates across maturities, the technique identifies uncorrelated factors which,
combined linearly, are used to create the daily term structure of rate movements.
o Multiple factors impact the movements in the term structure (with PC1, PC2 and PC3 having the biggest impact).
o Factor scores are variable values relating to a specific data point covering daily changes, with their standard
deviations aligned with the relative importance of each factor.
o The variance of all of the factor scores, when summed, equal the total variance of all rate movements.

The total variance is equal to the following: (12.96)2 + (5.82)2 + (2.14)2 + (1.79)2 = 209.62.

For instance, Relative importance of Factor 1’s variance of 167.96 (which is 12.96 squared) represents 80.13% of the total.

Non-Parallel Shifts:

1. Key Rate Shift Analysis:

 Assumptions:

o The rates can be determined as a function of a relatively small number of key rates.
o The key rates also assume that there is a parallel shift/linear shift of rates across the term structure.
o It also assumes that the rate of the given term is affected by its neighbouring key rates. For instance, it assumes
that the 5-year rate is a function of 2-year and 3-year rates.

 Key rate exposures describe how the risk of a bond portfolio is distributed along the term structure, and they assist in
setting up a proper hedge for a bond portfolio
 Key rates used for the U.S. Treasury and related markets are par yield bonds—2-, 5-,10-, and 30-year par yields.
 If one of these key rates shifts by one basis point, it is called a key rate shift.
 Assumption that all rates can be determined as a function of a few key rates. When in reality, shifts are not always
perfectly linear.
2. Partial ‘01s: They are used for measuring and hedging risk in swap portfolios (or a portfolio with a combination of bonds
and swaps).
 They are derived from the most liquid money market and swap instruments for which a swap curve is usually
constructed
3. Forward-bucket ‘01s: It represents the decrease in portfolio value for a one basis point increase in all forward rates
within a bucket.
 They are also used in swap and combination bond/swap contexts.
 But instead of measuring risk based on other securities, they measure risk based on changes in the shape of the
yield curve.
 Help to understand a portfolio’s yield curve risk.

Partial ‘01s and forward-bucket ‘01s are similar to key rate approaches but use more rates, which divide the term structure
into many more regions.

A. Key rate ’01:

 The effect of a dollar-change of a one basis point shift around each key rate on the value of the security.
 They are expressed as KR011, KR012, …, KR01N, with each key rate representing the reduction in portfolio value for a
one basis point increase in that particular spot rate.
o Interest rates and portfolio values move in opposite directions. For a 2-year spot rate, a key rate KR01 will
represent the increase in portfolio value from a one basis point decrease in the 2-year spot rate.
 DV01 is equal to the sum of all of the individual KR01s.
 So, while DV01 can be used to hedge against parallel shifts in the interest rate term structure, using a similar process
to hedge against KR01s, the hedge covers a wider range of structure movements.

 Key rate duration: In effect, it is the percentage change in the value of the portfolio resulting from 100-basis point
change interest rate.

Key rate ‘01 with respect to the 5-year shift is calculated as follows: (delta p / delta y)

This implies that the C-STRIP increases in price by $0.0040 per $100 face value for a positive one basis point five-year
shift.

Key rate Duration: ((delta P) / P * (delta y))

Or (KR01 / Initial Value)*10,000

Key rate effective duration: Completing Column (3) in Figure 59.3 and summing all key rate durations would give us
the effective duration of the 30-year C-STRIP. (-0.633, -1.59, -9.555, 41.129), sum is 29.6.
 X values are -2, -5, -10 hence short positions. If positive, long position.

FORWARD BUCKETS AND VOLATILITY

Instead of using individual key rates, buckets can be used as segments of interest rates covering the term structure. The
dollar impact on the portfolio value is then derived from changing every spot rate in each bucket by one basis point.

Forward rates can also be used in buckets. Assume three buckets are covering a 30-year term, and are divided as follows:
0–3 years, 3–15 years, and 15–30 years. If forward rates are calculated in six-month periods, each six-month rate will be
increased by one basis point. As an example, a portfolio contains a 3-year bond (face value of $100) and a coupon rate of
4.5% per year. Compounding is semi-annual, and the term structure is a flat 3.5%. using calc, PV = 102.8245

If all buckets increased together:

If each bucket increased separately:

If the standard deviation of the factor score of the i th factor is σi and ƒi is the change in portfolio value, then given the
significant relative impact of the first three factors, the standard deviation of the first three factors is calculated using the
following formula:

Portfolio duration using forward rate buckets: (same as KR01 formula)

T-bond futures:
1. The conversion factor defines the price received by the short position of the contract (i.e., the short position is
delivering the contract to the long).

2. Specifically, the cash received by the short position is computed as follows:

3. Conversion factors are supplied by the CBOT on a daily basis.

4. Conversion factors for 10-year Treasury notes or longer are calculated as the time to maturity from Day 1 of the delivery
month to the maturity of the bond. That amount is then rounded down to the nearest three months.

5. Finally, the rounded-down time to maturity is used to calculate the clean price per dollar of face value on the
assumption of a 6% annual yield, compounded semi-annually.

6. For shorter periods, such as for 2-year or 5-year Treasury notes, the rounding down is to the nearest month (not three
months).

Cheapest-to-Deliver Bond

1. The conversion factor system is not perfect and often results in one bond that is the cheapest (or most profitable) to
deliver.
2. The procedure to determine which bond is the cheapest to deliver (CTD) is as follows:

3. The CTD bond minimizes the following: quoted bond price − (QFP × CF).

4. Indication of what type of bonds tend to be the cheapest to deliver under different circumstances:

a. When yields > 6%, CTD bonds tend to be low-coupon, long-maturity bonds.
b. When yields < 6%, CTD bonds tend to be high-coupon, short-maturity bonds.
c. When the yield curve is upward sloping, CTD bonds tend to have longer maturities.
d. When the yield curve is downward sloping, CTD bonds tend to have shorter maturities.

5. Short position advantage

 Settlement Price: This is the price at which the futures contract is settled at a specific time (2:00 PM Chicago time). It
reflects the trading price at that moment.
 Short Position: An investor with a short position in a futures contract agrees to deliver the underlying asset (e.g.,
bonds) at a future date. The short position benefits from falling prices because they can deliver the asset at a lower
cost.
 Delivery Flexibility: The investor who is short has the advantage of choosing when to deliver the asset within the
delivery month. This flexibility allows them to wait for potentially better market conditions (e.g., lower bond prices)
before deciding to deliver.
 Wild Card Play: This term refers to the strategic benefit that the short position gains by having the option to deliver
after the settlement time. If bond prices drop after 2:00 PM, the short seller can deliver at a lower price, reducing
their costs.
 Impact on Futures Prices: Because of these advantages, including the ability to deliver at the most favorable time,
the short position is willing to accept a lower delivery price. This willingness to accept a lower price translates into a
lower futures price overall. Essentially, the market recognizes that the short position has certain benefits that
decrease their risk, which can lead to lower futures prices compared to where they might be without those
advantages.
Eurodollar futures:

Difference between Eurodollar futures and FRA:

1. Assuming a three-month contract, the interest on the FRA is paid at the end of the three months, while for
Eurodollar futures the interest is paid at the beginning.
2. FRAs are settled only at the very end, while Eurodollar futures have daily settlement.

Swaps
 A payer swaption gives the owner of the swaption the right to enter into a swap where they pay the fixed leg and
receive the floating leg.
 A receiver swaption gives the owner of the swaption the right to enter into a swap in which they will receive the
fixed leg, and pay the floating leg.

The most common interest rate swap is a plain vanilla interest rate swap.

1. In this swap arrangement, Company X agrees to pay Company Y a periodic fixed rate on a notional principal over the
tenor of the swap.
2. In return, Company Y agrees to pay Company X a periodic floating rate on the same notional principal.
3. Both payments are in the same currency. Therefore, only the net payment is exchanged.
4. Most interest rate swaps use overnight interest rates ex, SOFR.
5. Finally, because the payments are based in the same currency, there is no need for the exchange of principal at the
inception of the swap.

Financial Intermediaries:

1. There are swap intermediaries who bring together parties with needs for the opposite side of a swap.
2. Dealers, large banks, and brokerage firms act as principals or market makers in trades.
 3. Financial intermediaries, such as banks, will typically earn a spread for bringing two non-financial companies together
in a swap agreement.
4. This fee is charged to compensate the intermediary for the risk involved. If one of the parties defaults on its swap
payments, the intermediary is responsible for making the other party whole.
5. Confirmations, as drafted by the International Swaps and Derivatives Association (ISDA), outline the details of each
swap agreement.

Currency Swaps

1. A currency swap exchanges both principal and interest rate payments with payments in different currencies.
2. The exchange rate used in currency swaps is the spot exchange rate.
3. The valuation and application of currency swaps is similar to the interest rate swap. However, because the
principals in a currency swap are not the same currency, they are exchanged at the inception of the currency
swap so that they have equal value using the spot exchange rate.
4. Also, the periodic cash flows throughout the swap are not netted as they are in the interest rate swap.

Refer study notes for currency swap value calc using spot rates.
Equity Swap:

 In an equity swap, one party agrees to pay the return on an equity asset, such as a stock, portfolio, or index, in
exchange for receiving either a fixed or floating rate payment.

 The return on the equity asset can be based on capital appreciation alone or total return, including dividends.

 Equity swaps allow parties to gain or hedge equity exposure without directly holding the equity.

Credit Default Swap (CDS):

 A CDS provides insurance against the default of a specified company (known as the reference entity).

 The buyer of the CDS makes periodic payments to the seller. If the reference entity defaults, the seller compensates
the buyer with a predetermined amount.

 Index CDS: Similar to a regular CDS but based on multiple reference entities (e.g., a credit index). It allows for
diversification and hedging across multiple companies rather than a single one.

Commodity Swap:

 In a commodity swap, one party agrees to pay a fixed rate for the delivery of a commodity over multiple periods,
while the other party pays a floating rate based on spot prices.

 Commonly used to manage price risks associated with commodities, particularly in energy markets (e.g., oil and
electricity).

 Commodity swaps stabilize costs for firms reliant on these resources, shielding them from volatile spot prices.

Volatility Swap:

 A volatility swap involves the exchange of payments based on volatility, calculated over a specified period, rather
than price or yield.

 One party pays based on a predefined (implied) volatility level, and the other pays based on the realized (historical)
volatility.

 Volatility swaps allow investors to hedge or speculate on the volatility of an asset independently from its price
movements.

Exotic Swap:

 Exotic swaps are custom-made swaps with complex structures, often tailored to specific needs or market views.

 Example: The Procter & Gamble and Banker's Trust swap, where P&G’s payments were based on a combination of
different interest rates (commercial paper rate, medium-term and long-term Treasury rates).

 Exotic swaps are used for bespoke risk management or speculative purposes, and they can involve a combination of
market variables or unique payout structures.
Valuing an interest rate swap in terms of bond positions involves understanding that the value of a floating-rate bond will
be equal to the notional amount at any of its periodic settlement dates when the next payment is set to the market
(floating) rate.

Because Vswap = Bondfixed − Bondfloating, we can value the fixed-rate bond using the spot rate curve and then discount the next
(known) floating-rate payment plus the notional amount at the current discount rate.

The following example illustrates this method.

Bond Methodology:

Note that if are at a (semi-annual) reset date, so the floating-rate portion has a value equal to the notional amount.

Mortgage-Backed Securities

The weighted average maturity (WAM) is determined by weighting the remaining number of months to maturity for each
mortgage loan by the amount of the outstanding mortgage balance.

The Public Securities Association (PSA) prepayment benchmark assumes that the monthly prepayment rate for a mortgage
pool increases as it ages (becomes seasoned). The PSA is expressed as a monthly series of Conditional Prepayment Rates
(CPRs).

The model assumes that:

 CPR = 0.2% for the first month after origination, increasing by 0.2% every month up to 30 months;
 And, CPR = 6% for months 30 to 360

The risks to which MBS is exposed are:

1. Interest rate risk: An increase in interest rate increases the probability of default as the interest burden on the borrower
increases
2. Prepayment risk: If the interest rate decreases, the borrower may refinance its mortgage and prepay the existing
mortgage
3. Default risk: The borrower may not repay for various reasons
4. Credit risk: The borrower may default on the debt

Key Concepts of CMOs

1. Collateralized Mortgage Obligations (CMOs)

o CMOs are structured securities that redistribute cash flows from a pool of mortgage loans. They are created
from pass-through securities, allowing investors to have different risk profiles and cash flow characteristics
based on their needs.

o Each CMO is divided into tranches, which represent different levels of risk and return. This segmentation
allows investors to choose tranches that align with their appetite for prepayment risk (contraction or
extension risk).

2. Prepayment Risk

o Extension Risk: This risk occurs when interest rates rise, leading to lower prepayment rates. Investors in
these tranches may face longer-than-expected average lives for their investments.

o Contraction Risk: This occurs when interest rates decline, resulting in higher prepayment rates. Here, the
average life of the investment is shortened as borrowers refinance their mortgages.

o Servicing fee decline as the mortgage approaches the maturity.

Types of Tranches

1. Planned Amortization Class (PAC) Tranches

o PACs are designed to provide more predictable cash flows. They have a defined sinking fund amortization
schedule and are protected from prepayment risk by companion or support tranches.

o Support Tranches: These tranches absorb excess prepayments or delays in principal payments. The
relationship between PAC and support tranches is critical; as PACs gain prepayment protection, the risk
associated with support tranches increases.

o The stability of cash flows for PACs comes at the cost of increased variability in average life for support
tranches. If a PAC tranche cannot maintain its schedule due to prepayment speed fluctuations, it can lead to
a scenario termed as "broken PAC," where it starts behaving like an ordinary sequential-pay structure.

2. Principal-Only (PO) and Interest-Only (IO) Securities or Strips:

Strips enable the investor to separately purchase the principal portion and interest portion of the mortgage
payments on the mortgage pool. The principal-only strips (PO) are conventionally sold at a discount.

o PO Securities: These tranches receive only principal payments. The cash flow stream typically starts small but
grows over time as the principal portion of mortgage payments increases. POs are highly sensitive to
prepayment rates—faster prepayments enhance yields but reduce average life.

o IO Securities: These tranches receive only interest payments. Their cash flow starts high and diminishes over
time. IOs face the risk that their expected cash flows may be significantly reduced if the mortgage pool pays
off faster than anticipated. Falling interest rates lead to higher prepayment speeds, which negatively impact
IO holders since they may receive less interest than initially expected.

Cash Flow Dynamics

  The structure of CMOs and the specific types of tranches allow for nuanced cash flow management. Investors can
tailor their investment strategies based on anticipated interest rate movements and prepayment behavior.

 The effective life of PO and IO securities diverges significantly due to their respective cash flow characteristics. Higher
uncertainty around interest and prepayment rates leads to varying values—generally lower values for IOs and
higher values for POs.

Conclusion

CMOs provide investors with a flexible way to manage mortgage-related investments, allowing them to mitigate prepayment
risks through the strategic design of tranches. Understanding the dynamics between PACs, support tranches, and stripped
securities (POs and IOs) is crucial for effectively navigating the MBS market and aligning investment strategies with risk
tolerance and market conditions.

1. Collateralized Mortgage Obligations (CMOs)

 Definition: CMOs are structured securities that are created from pools of mortgage loans. They distribute the cash
flows from these pools into different classes of bonds, known as tranches, each with distinct risk and return
characteristics.

 Tranche Structure: Each tranche has a different claim on cash flows, allowing investors to choose securities that
match their risk preferences regarding prepayment risks—either contraction risk (due to falling interest rates) or
extension risk (due to rising interest rates).

 Planned Amortization Class (PAC) Tranches: PAC tranches are designed to provide more predictable cash flows
within a range of prepayment speeds, supported by companion or support tranches that absorb excess prepayments
or provide liquidity during periods of slower prepayments.

 Prepayment Risks: The relationship between PAC and support tranches creates a balance of risk—PACs tend to have
lower prepayment risk due to their structure, while support tranches face higher risk as they absorb the variability in
cash flows.

2. Mortgage Prepayment Behavior

 Borrower's Prepayment Option: Borrowers have the option to prepay mortgages, which can be likened to a call
option. This feature is advantageous to borrowers, especially when interest rates fall.

 Forms of Prepayment: Common forms include increasing payment amounts, refinancing, and selling the property.
Prepayments tend to increase when market interest rates decline.

 Lender Perspective: For lenders, prepayments can be detrimental as they lose the high-interest income and must
reinvest the received principal at lower rates. Consequently, lenders often price mortgages higher to account for this
prepayment risk.

 Investors’ Perspective: With agency MBSs, prepayments and defaults have the same impact on investors.
Prepayments result in the investors actually receiving cash from the borrowers, whereas with defaults, the borrower
does not pay the outstanding mortgage balances, but the GSE does, thereby causing a prepayment

3. Refinancing Motives

 Cash-out refinancing: Given a substantial increase in property value, a borrower may take out a new mortgage with a
higher balance that not only pays off the existing mortgage but also has extra cash for other purposes. Also called
extracting home equity.

 Incentives for Refinancing: Borrowers may refinance to secure lower interest rates, improve credit ratings, or extract
home equity through cash-out refinancing. Incentive functions can be used to model these refinancing activities,
focusing on the difference between the weighted average coupon (WAC) and current mortgage rates. (I = WAC - R)

o The incentive function essentially considers how much interest the borrowers will save by refinancing
 At the bottom of the curve when interest rates are high (when WAC − R is negative), there is much less prepayment
activity occurring. However, as interest rates fall (and WAC − R becomes positive), more prepayment activity will
occur

 Burnout Effect: This phenomenon occurs when many borrowers refinance during periods of falling rates, leaving
fewer opportunities for refinancing when rates fall again.

4. Turnover Modeling

 Turnover Factors: Various factors affect borrower turnover, including mortgage age, borrower age, and housing
location. The lock-in effect can slow turnover as borrowers may hesitate to incur the costs associated with new
mortgages.

5. Default Dynamics

 Defaults and Prepayments: Defaults create prepayments as mortgage guarantors cover the outstanding balances.
Analyzing loan-to-value ratios and borrower credit scores is critical for modeling these prepayments.

6. Valuation Using Monte Carlo Simulation

 Purpose of Monte Carlo Simulation: This method values MBS with embedded prepayment options by simulating
various interest rate paths and their effects on prepayment rates, reflecting the complex, path-dependent nature of
prepayments.

 Monte Carlo simulation can easily take into account path dependence, which is not as easy to do with other tools
such as binomial trees.

 Simulation Steps:

1. Simulate interest rates and housing prices.

2. Determine prepayment rates.

3. Project cash flows based on prepayment rates.

4. Compute present values of cash flows.

5. Repeat to gather a distribution of values.

 Result Interpretation: The average of the present values from these simulations provides an estimate for the MBS
value.

7. Option-Adjusted Spread (OAS)

 Definition and Calculation: OAS measures the return of an MBS after adjusting for prepayment risk, representing the
excess return over Treasuries. It is determined iteratively through simulations.

OAS = Expected MBS return – Return on Treasury Securities

 o Assuming the model is sound, then in theory, it should allow for interest rate hedging (using Treasury
futures). However, it would not be a perfect hedge because there is not a perfect correlation between
mortgage rates and Treasury rates

 Challenges: The OAS is sensitive to model assumptions, particularly around prepayment behavior. Modeling errors
can arise from incorrect assumptions about borrower behavior and interest rate correlations.

o Interest rate paths must be adjusted to ensure that securities or rates making up the benchmark curve are
properly valued when using Monte Carlo methods. This process of adjusting interest rate paths is subject to
modeling error.

o If there is a term structure to the OAS, then this is not reflected in the Monte Carlo process because the OAS
methodology assumes a constant OAS