The Fixed Income Market (Part 1)

15.433 INVESTMENTS Class 13: The Fixed Income Market Part 1: Introduction Bonds. 9/6/1993 -7% -12% SBTSY10 CCMP 8% 3% -2% -7% -12% 9/6/1993 3/6/1998 1/6/1998 11/6/1997 9/6/1997 7/6/1997 5/6/1997 3/6/1997 1/6/1997 11/6/1996 9/6/1996 7/6/1996 5/6/1996 3/6/1996 1/6/1996 11/6/1995 9/6/1995 7/6/1995 5/6/1995 3/6/1995 1/6/1995 11/6/1994 9/6/1994 7/6/1994 5/6/1994 3/6/1994 1/6/1994 11/6/1993 1/6/1999 3/6/2000 3/6/2000 9/12/2001 7/12/2001 5/12/2001 3/12/2001 1/12/2001 3/6/2001 5/6/2001 3/6/2001 5/6/2001 9/6/2001 9/6/2001 7/6/2001 1/6/2001 1/6/2001 7/6/2001 9/6/2000 11/6/2000 11/6/2000 7/6/2000 11/12/2000 9/6/2000 7/6/2000 5/6/2000 1/6/2000 1/6/2000 5/6/2000 9/6/1999 9/12/2000 7/12/2000 5/12/2000 3/12/2000 7/6/1999 11/6/1999 1/12/2000 11/6/1999 5/6/1999 9/6/1999 7/6/1999 11/12/1999 3/6/1999 1/6/1999 11/6/1998 3/6/1999 9/6/1998 11/6/1998 9/6/1998 5/6/1999 9/12/1999 7/12/1999 5/12/1999 3/12/1999 7/6/1998 -2% 5/6/1998 3% 7/6/1998 8% 1/12/1999 CCMP 5/6/1998 3/6/1998 1/6/1998 11/6/1997 9/6/1997 7/6/1997 5/6/1997 3/6/1997 1/6/1997 11/6/1996 9/6/1996 7/6/1996 5/6/1996 3/6/1996 1/6/1996 11/6/1995 9/6/1995 7/6/1995 5/6/1995 3/6/1995 1/6/1995 11/6/1994 9/6/1994 7/6/1994 5/6/1994 3/6/1994 1/6/1994 11/6/1993 SPX 11/12/1998 9/12/1998 7/12/1998 5/12/1998 3/12/1998 1/12/1998 11/12/1997 9/12/1997 7/12/1997 5/12/1997 3/12/1997 1/12/1997 11/12/1996 9/12/1996 7/12/1996 5/12/1996 3/12/1996 1/12/1996 11/12/1995 9/12/1995 7/12/1995 5/12/1995 3/12/1995 1/12/1995 Stocks and Bonds SPX 8% 3% -2% -7% -12% SBTSY10 Figure 1: Returns from July 1985 to October 2001 for the S&P 500 index, Nasdaq-index and 10 year Treasury 12% 10% Probability 8% 6% 4% 2% 0% -2% -0.080 0.020 0.120 0.220 0.320 0.420 0.520 0.620 0.720 0.820 0.920 Monthly Returns Current Distribution Normal-Distribution Figure 4: Return-distribution of 1-month Libor rates from 1985 to 2001. 7% 6% Probability 5% 4% 3% 2% 1% 0% -1% -0.080 -0.060 -0.040 -0.020 - 0.020 0.040 Monthly Returns Current Distribution Normal-Distribution Figure 5: Return-distribution of 10-year US treasury bonds from 1985 to 2001. Data source for Figures 1, 4, and 5: Bloomberg Professional. 0.060 0.080 Zero-Coupon Rates n-year zero rt,t+n : the interest rate, determined at time t, of a deposit that starts at time t and lasts for n years. All the interest and principal is realized at the end of n years. There are no intermediate payments. Suppose the five-year Treasury zero rate is quoted as 5% per annum. Consider a five-year investment of a dollar: compounding annual $ 1 grows into (1+0.05)5 = 1.276 semiannual (1+0.05/2)10 = 1.280 continuous e0.05·5 = 1.284 Zero Coupon Yield-Curve For any fixed time t, the zero coupon yield curve is a plot of the zero-coupon rate rt+n , with varying maturities n: r t,n 5 10 15 20 Maturity n (years) Figure 6: Zero-coupon yield curve. Treasury Bills T-bills are quoted as bank discount percent rBD . For a $10’000 par value T-bill sold at P with n days to maturity: rBD = 10
000 − P 360 · 10
000 n (1) Conversely, the market price of the T-bill is � n �
P = 10 000 · 1 − rBD · 360 (2) Treasury Bond and Notes Figure 8: Cash flow representation of a simple bond, Source: RiskM etrics T M , p. 109. Maturity at issue date: T-notes are up to 10 years; T-bonds are from 10 to (30) years. Coupon payments with rate c%: semiannual (November and May). Face (par) value: $1,000 or more. Prices are quoted as a percentage of par value. If purchased between coupon payments, the buyer must pay, in addition to the quoted (ask) price, accrued interest (the prorated share of the upcoming semiannual coupon). Some T-bonds are callable, usually during the last five years of the bond’s life. U.S. Government Bonds and Notes Footnote1 1 Footnote: Treasury bond, note and bill quotes are from midafternoon. Colons in bond and note bid-and-asked quotes represent 32nds; 101:01 means 101 1/32. Net change in 32nds. n-Treasury Note. i-Inflation-indexed issue. Treasury bill quotes in hundredths, quoted in terms of a rate of discount. Days to maturity calculated from settlement date. All yields are to maturity and based on the asked quote. For bonds callable prior to maturity, yields are computed to the earliest call date for issues quoted above par and to the maturity date for issues quoted below par. Bond Pricing with Constant Interest Rate Assume constant interest rate r with semiannual compounding. All future cash flows should be discounted using the same interest rate r. (Why?) 1 1 1 0 0 0 1 2 3 4 5 n 5 n Zero Rate r t,n 12 10 8 6 4 2 0 1 2 3 4 Figure 11: Bond pricing with constant interest rate. The bond price as a percentage of par value: P = 10 � i=1 � c 2 1+ � r t 2 +� 100 1+ � r t 2 (3) Time-Varying Interest Rates In practice, interest rates do not stay constant over time. If that is the case, then the short- and long-term cash flows could be discounted at different rates. That is, rt,t+n varies over n. 1 2 3 4 5 n Zero Rate r t,n Figure 12: Bond pricing with time varying interest rates. The time-t bond price as a percentage of par: P = 10 � i=1 � 1 Where n1 = 0.5, n2 = 1, . . . , n10 = 5 c 2 r i �t + 0,n 2 +� 100 1+ r0,ni �10 2 (4) Yield to Maturity The yield to maturity (YTM) is the interest rate that makes the present value of a bond’s payment equal to its price: P = 10 � i=1 � 1+ c 2 � Y TM t 2 +� 100 1+ � Y T M 10 2 (5) where bond has T-year to maturity and pays semiannual coupon with rate c%: If the interest rate is a constant r, then the YTM equals r; In practice, the interest rate is not a constant; The time-t n-year zero-coupon rate rt,t+n varies over time t, and across maturity n; Intuitively, the YTM for a T-year bond is a weighted average of all zero-coupon rate rt,t+n between n = 0 and n = T ; What is the difference between the YTM and the holding period return for the same bond? Duration Duration = T � P V (CFt ) t=1 P ·t (6) T 1 � t · (CFt ) = P t=1 (1 + r)t � � 1 1 · CF1 2 · CF2 T · CFT + = + + ··· + P (1 + r)1 (1 + r)2 (1 + r)T �T Duration = t·(CFt ) t=1 (1+r)t P M odif ied Duration = (7) (8) �T t·CFt t=1 (1+r)t CFt t=1 (1+r)t = �T M acaulay Duration 1 + mr (9) (10) where m represents the number of interest payments per year and r the interest rate. Ef f ective Duration = − 1 dB · B dy Dollar Duration = D · B (11) (12) where B stands for bond value. Foonote2 2 If nothing else mentioned, we assume that a duration is defined as a modified duration! Example: An obligation with a redemption price of 100 and an current market-price of 95.27 has a coupon of 6% (annual coupon payments) and has a remaining maturity of 5 years with a yield of 7%. Calculate the Macaulay-Duration. t cash flow pv-factor pv of cf cf weight pv time -weighted with t #1 #2 #3 1 6.00 0.9346 5.6075 0.05886 0.05886 2 6.00 0.8734 5.2401 0.05501 0.11002 3 6.00 0.8163 4.8978 0.05141 0.15423 4 6.00 0.7629 4.5774 0.04805 0.19219 5 106.00 0.71299 75.5765 0.79329 3.96644 Duration #4#=#2·#3 #5=#4/price #6=#1*#5 4.48 Duration Hedge Recall, that the price change (dP) from a change in yields (dy) is: dP = −D · P · dy (13) [if you have to think twice why D is negative → don’t select fixed income portfolio manager as a career option!] ∆S = −DS · S · ∆y (14) ∆F = −DF · F · ∆y (15) Where DS is the duration of the spot position and DF is the duration of the Futuresposition. 2 σS2 = (DS · S)2 · σ∆y (16) 2 σF2 = (DF · F )2 · σ∆y (17) 2 σSF = (DF · F ) · (DS · S) · σ∆y (18) The number of futures contracts is: N =− DS · S σSF =− 2 DF · F σF (19) If we have a target duration DT , we can get it by using: N =− σSF DS · S =− DF · F σF2 (20) Example 1: A portfolio manager has a bond portfolio worth $10 mio. with a modified duration of 6.8 years, to be hedged for 3 months. The current futures price is 93-02, with a notional of $100’000. We assume that the duration can be measured by CTD, which is 9.2 years. Compute: 1. The notional of the futures contract; 2. The number of contracts to buy/sell for optimal protection. Solution: 1. The notional of the futures contract is: (93 + 2/32)/100 · $100
000 = $93
062.5 (21) 2. The number of contracts to buy/sell for optimal protection. N∗ = − 6.8 · $10
000
000 DS · S =− DF · F 9.2 · $93
062.5 (22) Note that DVBP of the futures is 9.2 · $93
062.5 · 0.01% = $85 Example 2: On February 2, a corporate treasurer wants to hege a July 17 issue of $ 5 mio. of CP with a maturity of 180 days, leading to anticipated proceeds of $ 4.52 mio. The September Eurodollar futures trades at 92, and has a notional amount of $ 1 mio. Compute: 1. The current dollar value of the of the futures contract; 2. The number of contracts to buy/sell for optimal protection. Solution: 1. The current dollar value is given by: $10
000 · (100 − 0.25 · (100 − 92)) = $980
000 (23) Note that the duration of futures is 3 months, since this contract refers to 3-month LIBOR. 2. If rates increase, the cost of borrowing will be higher. We need to offset this by a gain, or a short position in the futures. The optimal number of contracts is: N∗ = − DS · S 180 · $4
520
000
000 =− = −9.2 90 · $980
000 DF · F Note that DVBP of the futures is 0.25 · $1
000
000 · 0.01% = $25 (24) Convexity The duration should not be used for big swings in the term structure. The accuracy of the estimation of the duration-coefficient depends on the convexity. Duration is an approximate estimate of a convex form with a linear function. The stronger the yield-curve is ”curved”, the more the real value deviates from the estimated values. We receive a better estimate applying the first two moments of a Taylor-expansion to estimate the price changes: dP = dP 1 d2 P · dr + · 2 dr2 + ε dr 2 dr ε is the residual part of the Taylor expansion and d2 P dr 2 (25) is the second derivative of the bond price relative to the yield. Dividing both parts by the price we obtain: dP dP 1 1 d2 P = · · dr + +ε P dr P 2 dr2 (26) Replacing the second derivative of the price equation and reformulating the notation of the Taylor-expansion, we get: � � �� T � 1 dP 1 t · CFt 1 dP = · − · t P 2 dr 1 + r t=1 (1 + rt ) � � 1 1 1 1 · 2 · CF1 2 · 3 · CF2 T · (T + 1) · CFt = · · + + ··· + 2 P (1 + r)2 (1 + r) (1 + r)2 (1 + r)T T � 1 1 1 t · (t + 1) · CFt = · · (27) · 2 2 P (1 + r) t=1 (1 + r)t The notation of the price-convexity results from the Taylor-expansion. The first part is the approximation based on the duration. The second part is an approximation based on the convexity of the price/yield-relationship. The percent-approximation results from the duration and the convexity by summing up the individual components. The convexity is defined as: convexity = 1 d2 P 1 · · 2 dr2 P (28) dP dP 1 1 d2 P 1 = · · dr + · 2 · (dr)2 + ε P dr P 2 dr P (29) ∆P ∆r = −D · + convexity · (∆r)2 1+r P (30) Based on duration and convexity the price change for small changes in the market return can be expressed as price change instead a percentage number: ∆P = −Duration · ∆r + convexity · (∆r)2 1+r (31) Building Zero Curves The coupon-bearing T-notes and bonds can be thought of as packages of zero-coupon securities. For any time t, a zero-curve builder uses all such coupon-bearing securities traded in the market at time t to calculate the zero-coupon rates rt,t+n for all possible maturities n. A sophisticated procedure will take into account of the illiquidity and mis-pricing of bonds, as well as tax-related issues. In recent years coupon-bearing securities have been ”stripped” into simpler packages of zero-coupon securities. For example, a 5-year T-note can be divided up and sold as 10 separate zero-coupon bonds, or as a ”strip” of coupon payments and a five-year zero-coupon bond. Focus: BKM Chapter 14 • All pages except p. 434 after-tax returns Style of potential questions: Concept checks 1, 2, 3, 4, 6, 8, 9, p. 443 ff question 1, 5, 14, 15 Preparation for Next Class Please read: • BKM Chapter 15, and • Kao (1993).