Fixed Income Securities

IMT Ghaziabad

7/19/2018 Lectures-Fixed Income Securities 1

Critical Concepts ( Session 5 , 6 & 7)

• Yield Curve
• Replication, Arbitrage and Pricing
• Zero rate, forward rate
• Construction of Zero Coupon Curve
• Forward Curve
• Term Structure theories
• Dynamic present values
• Yield curve arbitraging strategies ( case study)

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Yield Curve

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10yr-Govt Yield ( 2002 to 2017)
10-yr Govt Yield
10

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19-Apr-01 14-Jan-04 10-Oct-06 6-Jul-09 1-Apr-12 27-Dec-14 22-Sep-17 18-Jun-20

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Yield curve
• The term structure of interest rates—collective intelligence of the market
participants about the future economy

• Replication

• Pricing

• Arbitraging

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 Session 6

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ZCYC/Forward Curve
• Refer to excel exercise to get the zero coupon prices 𝜋(𝑡)

1
• 𝜋(𝑡) = (1+𝑟 where 𝑟 𝑡 = spot rate
𝑡 )𝑡

𝜋(𝑡)
• = 1 + 𝑓𝑡,𝑡+1 where 𝑓𝑡,𝑡+1 = forward rate between t and t+1
𝜋(𝑡+1)

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Common method

• Bootstrapping

- Refer the classroom exercise

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Bond values and arbitraging
𝑃1 = 𝜋1 𝐶11 + 𝜋2 𝐶12 + ⋯ + 𝜋 𝑇 𝐶1𝑇
𝑃2 = 𝜋1 𝐶21 + 𝜋2 𝐶22 + ⋯ + 𝜋 𝑇 𝐶2𝑇
…………..
………….
𝑃𝑛 = 𝜋1 𝐶𝑛1 + 𝜋2 𝐶𝑛2 + ⋯ + 𝜋 𝑇 𝐶𝑛𝑇

What if 𝑃𝑖𝑎𝑐𝑡𝑢𝑎𝑙 > 𝑃𝑖 = 𝜋1 𝐶𝑛1 + 𝜋2 𝐶𝑛2 + ⋯ + 𝜋 𝑇 𝐶𝑛𝑇 ?

-Short selling and institutional regulations

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Cont’d (Example)
Does arbitraging opportunity exits?

t 𝝅(𝒕) A B C D

1 0.981 105 4 7 9

2 0.943 0 104 107 109

Theoretical
Price
Market 103 102 107.77 112
price

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Yield Curve
.

When the spot curve is

upward sloping, the
forward curve will lie
above the spot curve.
Conversely, when the spot
curve is downward sloping,
the forward curve will lie
below the spot curve

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• An important observation about forward prices and the spot yield curve is
that the forward contract price remains unchanged as long as future spot
rates evolve as predicted by today’s forward curve.

• If one expects that the future spot rate will be lower/higher than what is
predicted by the prevailing forward rate, the forward contract value is
expected to increase/decrease.

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CCIL

• CCIL ZCYC

• Interpolation

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Traditional theories of the term structure of
interest rates

Pure expectations Liquidity preference

theory theory
There are four
traditional theories of
the term structure of
interest rates.
Segmented markets
theory Preferred habitat theory

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PURE EXPECTATIONS THEORY

The pure expectations theory says that the forward rate is

an unbiased predictor of the future spot rate.
• Its broadest interpretation suggests that investors expect
the return for any investment horizon to be the same.
• The narrower interpretation—referred to as the local
expectations theory—suggests that the return will be
the same over a short-term horizon starting today.

(1  zT )  (1  z1 )(1  f1, 2 )    (1  fT 1,T )

1/ T

Under pure expectations theory, the shape of the yield curve reflects
the expectation about future short-term rates.

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LIQUIDITY PREFERENCE THEORY

The liquidity preference theory makes the following

assertion:

• Liquidity premiums exist to compensate investors

for the added interest rate risk they face when
lending long term, and these premiums increase
with maturity.

(1  zT )  (1  z1 )(1  f1, 2  L2 )    (1  fT 1,T  LT ) 
1/ T

Thus, given an expectation of unchanging short-term spot rates,

liquidity preference theory predicts an upward-sloping yield curve.

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SEGMENTED MARKETS AND PREFERRED HABITAT THEORIES

The segmented markets theory assumes that market

participants are either unwilling or unable to invest in
anything other than securities of their preferred maturity.
• It follows that the yield of securities of a particular
maturity is determined entirely by the supply and
demand for funds of that particular maturity.
The preferred habitat theory also assumes that many
borrowers and lenders have strong preferences for
particular maturities.
• However, if the expected additional returns to be
gained become large enough, institutions will be
willing to deviate from their preferred maturities or
habitats.
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Modern term structure models
• Modern term structure models provide quantitatively precise
descriptions of how interest rates evolve.
• Interest rate models attempt to capture the statistical
properties of interest rate movements.

Two major types

of such models

General equilibrium, Arbitrage-free

including Vasicek and
Cox–Ingersoll–Ross models, including the
(CIR) models Ho–Lee model

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CIR MODEL

𝐝𝐫 = 𝒂 𝒃 − 𝒓 𝐝𝐭 + 𝛔 𝒓𝐝𝐳

where dr and dt = infinitely small increments of short-term interest rate

and time, respectively; 𝒂 𝒃 − 𝒓 𝐝𝐭 = a deterministic part, where b = a long-
run value of interest rate and a = a positive parameter; 𝝈 𝒓𝐝𝐳 = a
stochastic part, which models risk and follows the random normal
distribution with a mean of zero; 𝛔 𝒓 is the standard deviation factor.

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Exercise: Dynamic Present Value

• Value a bond 1 yr later ( considering no arbitrage)

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