Week 1 (Part I)

Features of Debt
Securities
1

Plan of the lecture

Some basic features of a bond

Coupon rate structures
Floating rate securities
Accrued interest
Options embedded in a bond
Borrow funds to purchase bonds (repo)
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Basic features of a bond

Bonds can have any par value

The market practice is to quote the price of a
bond as a percentage of its par value
Example: Suppose a bond has a par value of
$1,000

If the bond sells at $1,000, the bond price is

quoted as 100, i.e., 100% of par value
If the bond price is $950, the bond is said to be
selling at 95, i.e., 95% of par value
And if the bond price is $1,050, the bond is trading
at 105, i.e., 105% of par value

Basic features of a bond

A bond is said to be trading at a discount
if it sells below its par value, e.g., at 95
A bond is trading at par if it sells at its par
value, i.e., at 100
A bond is said to be trading at a premium
if it sells above its par value, e.g., at 105
A bond sells above or below its par value
depending on the levels of interest rates

Basic features of a bond

In the United States, when computing the

dollar price of a bond, we first compute the
price per US$1 of par value, which is then
multiplied by the bond par value to get the
dollar price of the bond

Quoted price Price per US$1 of par value Par value Dollar price
(1)
(2)
(3) (4) = (2) (3)
86 1/4
0.86250
$50,000 $43,125
110 3/8
1.10375
$200,000 $220,750
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Coupon rate structures

Coupon is the annual interest payment made to a

bondholder
Coupon coupon rate par value
Example : coupon rate 5%, par value $2,500
coupon 5% $2,500 $125

Coupon rate (also known as nominal rate) is an

annual rate
The coupon rate is specified for a bond, along with its
maturity date

Example: 5s of 12/16/2015 means the coupon rate is 5%

In both Canada and the U.S., bonds typically pay coupons in
two equal semiannual installments

Coupon rate structures

Step up notes
Securities where the coupon rate increases
(or steps up) over time
Single step up note: where there is only
one increase (or step up) in the coupon rate

Example: A four year step up note, the coupon

rate is 4.5% for Year 1 and 5.5% annually for the
remaining 3 years of the life of this note

Coupon rate structures

Step up notes (continued)

Multiple step up note: where there are

multiple (i.e., more than one) increases in the
coupon rate

Example: A three year bond has the following

coupon schedule

5%
5.25%
5.60%

from 1/1/2012 to 12/31/2012

from 1/1/2013 to 12/31/2013
from 1/1/2014 to 12/31/2014
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Coupon rate structures

Deferred coupon bonds

Bonds whose interest payments are deferred
for several years, i.e., no interest payment
during the deferred period
At the end of the deferred period, the issuer
pays higher periodic interests (than that
would otherwise have been paid) to the
bondholder as a compensation

Floating rate securities

Floating rate securities (or variable rate

securities, floaters) have a coupon rate reset
periodically according to the coupon formula:

Coupon rate = reference rate + quoted margin

The reference rate could be an interest rate (e.g., U.S.

Treasury bill rate), a stock index (e.g., the S&P 500), a
foreign exchange rate, the price of crude oil, and the
inflation rate etc.
For example, the Consumer Price Index (CPI) is the
reference rate for inflation linked (or inflation
indexed) bonds
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Floating rate securities

The quoted margin is the additional

amount paid above the reference rate

Example: The coupon formula is

Coupon rate = U.S. Treasury bill rate + 120 basis
points

A basis point is 0.01% or 0.0001

So 100 basis points = 1%, 120 basis points = 1.2%

etc.

Suppose the U.S. Treasury bill rate is 4%, then

the coupon rate = 4% + 1.2% = 5.2%
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Floating rate securities

The quoted margin could be a negative

value

Example: The coupon formula is

Coupon rate = U.S. AAA rate - 60 basis
points

Suppose the U.S. AAA rate is 5%, then the

coupon rate = 5% - 0.6% = 4.4%

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Floating rate securities

Caps and floors

A cap is the maximum coupon rate paid on a
floater
Example: The coupon formula is

Coupon rate = reference rate + 200 basis points

and the cap is 10%

Suppose the reference rate is 8.5%, then the

coupon rate is 10%, not 10.5% (= 8.5% + 2%)

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Floating rate securities

Caps and floors (continued)

A floor is the minimum coupon rate paid on a
floater
Example: The coupon formula is

Coupon rate = reference rate - 50 basis points

and the floor is 3%

Suppose the reference rate is 3.25%, then the

coupon rate is 3%, not 2.75% (= 3.25% - 0.5%)

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In-class exercise 1

Fill in the table below. The coupon

formula is: reference rate + 60 basis points
with a cap of 5.50%
Reference rate Coupon rate
First reset date
4.50%
?
Second reset date
5.00%
?
Third reset date
4.85%
?

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In-class exercise 2

Fill in the table below. The coupon

formula is: reference rate + 25 basis points
with a floor of 2.75%

Reference rate Coupon rate

First reset date
3.00%
?
Second reset date
2.80%
?
Third reset date
2.25%
?

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Floating rate securities

Inverse floater (or reverse floater)

Floating rate securities where the coupon rate
moves in the opposite direction from the
reference rate
The coupon formula is:

Coupon rate = K L (reference rate)

where K and L are fixed values
Example: Suppose K is 25%, L is 2.5, the reference
rate is 8%, then the coupon rate is 25% - 2.5 8% =
5%
A cap and/or floor can be imposed on an inverse
floater
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Accrued interest
Accrued interest is the interest earned by the
bond seller between the last coupon payment
date and the bond settlement date

Accrued interest earned

by the seller

Last
coupon
payment
date
(A)

Interest earned by the buyer

Settlement date
(B)

Next
coupon
payment
date
(C)
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Accrued interest
Full price (or dirty price) is the agreed upon
price for the bond plus the accrued interest

Example: Agreed upon price for the bond is

$960, accrued interest is $15, so the full price
paid by the buyer is ($960 + $15) = $975

Clean price (or simply price) is the agreed

upon price only, without the accrued interest

Example: In our example above, the clean price

is $960

We will see in Week 3 how to calculate

accrued interest

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Embedded options

Options beneficial to issuers include:

The right to call (i.e., repurchase) a bond at a

specified call price

The right to prepay principal above the

scheduled principal payment on, e.g., mortgage
backed securities

Call risk

Prepayment risk

And the cap on a floater

Bondholders do not like these options. So

what would happen to the bond price?

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Embedded options

Options beneficial to lenders include:

The right to put (i.e., sell back) a bond at a
specified put price
The right to convert or exchange a bond for a
number of common shares

Convertible bonds

And the floor on a floater

Embedded options can significantly impact

the bond prices, as we will see in later
chapters

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Borrow funds to
purchase bonds
Repurchase agreement (repo)
The
Buyer
(B)

Buys back the

same securities

Sells
securities
The investor
(A)
Receives
cash

Time 0

The
Buyer
Pays (a higher) (B)
repurchase price
including repo
rate
Time 1
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Repo

Repo is a collateralized loan between the

investor (A) and the buyer (B): A effectively
uses securities as collateral to borrow
funds from B to finance her purchase of
some other assets
Overnight repo: the term of the loan is one
day
Term repo: the term of the loan is more than
one day
The interest rate on the loan is called the
repo rate

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Repo

General collateral repo rate

Special repo rate

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Repo
Repo (from the investor (A)s perspective):
agrees to sell the securities and buy them
back, i.e., borrow funds
Reverse repo (from the buyer (B)s
perspective): agrees to buy the securities
first and sell them back later, i.e., make a
loan
Repo is primarily for institutional investors
to meet their short term financing needs

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Repo

Example: How much does a mutual fund

need to pay back an investment bank on a
14 day $94.8 million 3% repo loan?
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$94.8 million (1 3%
) $94.9106 million
360

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