Fixed Income Markets and Their Derivatives / Edition 2 available in Hardcover
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Thethird editionof this well-respected textbook continues the tradition of providing clear and concise explanations for fixed income securities, pricing, and markets.Fixed Income Markets and Their Derivativesmatches well with fixed income securities courses. The book's organization emphasizes institutions in the first part, analytics in the second, selected segments of fixed income markets in the third, and fixed income derivatives in the fourth. This enables instructors to customize the material to suit their course structure and the mathematical ability of their students.
- New material on Credit Default Swaps, Collateralized Debt Obligations, and an intergrated discussion of the Credit Crisis have been added
- Online Resources for instructors on password protected website provides worked out examples for each chapter
- A detailed description of all key financial terms is provided in a glossary at the back of the book
About the Author
Suresh Sundaresan is the Chase Manhattan Bank Professor of Economics and Finance at Columbia University. He is currently the Chairman of the Finance subdivision. He has published in the areas of Treasury auctions, bidding, default risk, habit formation, term structure of interest rates, asset pricing, pension asset allocation, swaps, options, forwards, fixed-income securities markets and risk management. His research papers have appeared in major journals such as the Journal of Finance, Review of Financial Studies, Journal of Business, Journal of Financial and Quantitative Analysis, European Economics Review, Journal of Banking and Finance, Journal of Political Economy, etc. He has also contributed articles in Financial Times, and in World Bank conferences. He is an associate editor of Journal of Finance and Review of Derivatives Research. His current research focus is on default risk and how it affects asset pricing and sovereign debt securities. He has consulted for Morgan Stanley Asset management and Ernst and Young. His consulting work focuses on term structure models, swap pricing models, credit risk models, valuation, and risk management. He has conducted training programs for leading investment banks including Goldman Sachs, Morgan Stanley, CSFB and Lehman Brothers. He is the author of Fixed Income Markets and Their Derivatives. He has served on the Treasury Bond Markets Advisory Committee.
Read an Excerpt
Fixed Income Markets and Their Derivatives
By Suresh Sundaresan
Academic PressCopyright © 2009 Elsevier Inc.
All right reserved.
Chapter OneOverview of fixed income markets
This chapter introduces debt securities and the markets in which they trade. Key players in debt markets and their objectives are described. A classification of debt securities is then provided. Various sources of risk (interest rate risk, credit risk, liquidity risk, call risk, event risk, and so on) that are present in debt securities are identified, with examples of how such risks could affect their prices and returns. Finally, the risk-return performance of the aggregate debt market is provided for a 10-year period and contrasted with other asset classes such as equity.
1.1 OVERVIEW OF DEBT CONTRACTS
Debt securities are issued by borrowers to obtain liquidity (cash) or capital for either short-term or long-term needs. Such securities are contractual obligations of the issuers (borrowers) to make certain promised stream-of-cash flows in future. Promises made by borrowers may be secured by specific assets of the borrowers, or they can be unsecured. Markets in which debt securities trade are known as either debt markets or fixed-income markets. As of mid-2008, the Securities Industry and Financial Markets Association (SIFMA) estimated the market value of all outstanding debt securities at $30 trillion. In contrast, the market capitalization of the New York Stock Exchange was about $25 trillion as of 2006.
Debt securities have several defining characteristics, including (a) coupon rate, (b) maturity date, (c) issued amount, (d) outstanding amount, (e) issuer, (f) issue date, (g) market price, (h) market yield, (i) contractual features, and (j) credit-rating category. In the context of two real-life examples of debt securities, here we describe such defining features to better understand the sources of risks and returns of debt securities. The first example is a debt security issued by the United States Treasury. The second example pertains to a debt security issued by General Motors. These two examples will help us appreciate the significant diversity associated with debt securities and the way they contribute to cross-sectional variations in risk and return.
Take a look at Table 1.1, which features a 10-year Treasury note, a debt security issued by the U.S. Treasury with a maturity of 10 years.
Several aspects of debt securities can be better understood in the context of this Treasury debt obligation: First, note that the issuer (or the borrower) is the United States Treasury; the obligations are backed by the federal government. The security has an annualized coupon of 4.125% and matures on May 15, 2015. The periodic compensation is referred to as the coupon, and the remaining life of the claim is referred to as the time to maturity.
The frequency of coupon is twice a year, or semiannual. The coupon is computed on the par value or the face value of debt security. Assuming a par value of 100, the semiannual coupon is 100 x (4.125%/2) = 2.0625. Typically debt securities tend to trade in million dollars of par value. On a million-dollar par value, the semiannual coupon (in this example) will be $20,625, which is fixed throughout the life of the debt contract. The security has a unique identifier known as Cusip, which is 912828DV9. The issued amount was about $24.27 billion, and the amount outstanding as of July 22, 2005, was approximately $22 billion. (The remaining $2.27 billion has been "stripped"—a practice that is described later in this book.) The first coupon date is November 15, 2005, and the coupon started to accrue from the dated date, which is May 15, 2005. The market price of the debt security is quoted at $99.213997 on a $100 par value. The yield is quoted at 4.223%.
The yield of a debt security is its internal rate of return (IRR): It is the discount rate at which the present value of all future promised cash flows is exactly equal to its market price.
The quotations are given by Solomon Smith Barney, one of the many dealers in debt markets. This debt security is denominated in U.S. dollars. The date on which the prices are quoted is July 22, 2005, but the transactions will settle on the settlement date, which is July 24, 2005. On the settlement date, the buyer and seller will exchange cash and security as per the terms agreed to on the pricing date. Therefore, the settlement date is the relevant date for valuation and computing prices. A Treasury note is not callable by the issuer, nor can it be put back to the issuer by investors. Debt securities such as the Treasury note in this example, which just pay coupons and mature on a specific date, are known as bullet securities.
The T-note described in Table 1.1 is an example of a default-free security, because there is no doubt that the promised payments will be made; thus, investors face no credit risk. This is not to say that such an instrument has no risk. Indeed, investors who take a position in this Treasury bond are exposed to a significant interest rate risk. This risk is due to the fact that the coupon is fixed: If interest rates in the market were to increase, the price of this bond would decline, reflecting the relatively low coupon of this T-note in a higher interest rate setting where similar debt securities will be issued with a higher coupon reflecting the current market conditions. Moreover, the security may have inflation risk: If inflation rates become unexpectedly high in the future, the market price of the security could fall.
The size of this specific T-note outstanding in the market is over $20 billion. This rather large size, coupled with the fact that there are dozens of dealers who stand ready to participate in a two-way market, is indicative that such a security is liquid. High liquidity means that investors can buy or sell large amounts easily at a narrow bid-offer spread without an adverse price reaction. (Bid is the price at which the market maker is prepared to buy the security; offer or ask is the price at which the market maker is prepared to sell the security.) This implies that the Treasury security has a low liquidity risk. The fact that this T-bond was not callable by the Treasury means that the investor has no uncertainty about the timing of the cash flows. Thus, the security has no timing risk. If the issuer can call the security, the investor will face timing risk because the issuer is likely to call the bonds when interest rates decline or when the credit quality of the issuer improves. Some securities are also subject to event risk. This risk arises if the issuer's credit risk suddenly deteriorates or if a major recapitalization (such as a leveraged buyout) occurs, adversely affecting the risk of the bond. Note that the T-note has no such event risk, since it is the direct obligation of the U.S. Treasury.
Now let's turn to the second example described in Table 1.2, which summarizes the features of a debt security that was issued by the General Motors Corporation. The GM corporate bond also has features such as coupon rate, maturity, and issue date that are very similar to the Treasury bond example in Table 1.1. But there are important ways in which the GM debt issue differs from the Treasury debt described in the first example. Note that the issue size is $1.25 billion, which is significantly smaller than the Treasury bond issue size. This small issue size is fairly typical of corporate debt issues. This size contributes to lower liquidity of corporate debt in the secondary markets. This lower liquidity may cause the investors to demand a higher return for holding GM debt.
There is another important dimension on which GM debt is more risk; it has to do with GM's credit quality. Rating agencies rate debt issued by companies and classify them into two broad categories: investment grade and noninvestment (junk) grade. There are currently three major rating agencies: Moody's, Standard & Poor's (S&P), and Fitch. The fact that GM debt is noninvestment grade implies that investors will perceive GM debt to have a high credit risk. This is in sharp contrast to Treasury debt in the first example: Treasury debt is viewed as being free from default risk and hence typically not even rated. When T-bills are rated, rating agencies accord them the highest rating, which is AAA. On the other hand, GM debt is rated and is classified as being below investment grade; this implies that investors will demand a higher coupon at issue to compensate them for being exposed to GM's credit risk. Note also that the settlement conventions differ from Treasury and corporate debt securities.
GM has the right to call the bond back prior to maturity date; the company is likely to do this if its credit reputation improves and the ratings move to a higher level. This way, GM can refinance its existing debt with a new debt that can be issued with a lower coupon. This is an additional risk to investors because the bond may be called away from them, which will cause them to require a higher coupon at issue date or higher return at the time of purchase.
Our analysis of Treasury debt and GM debt clearly illustrates that investors will want a higher compensation to hold GM debt as opposed to Treasury debt due to increased credit risk, liquidity risk, and timing risk.
At-issue coupon of GM debt, which had 20 years to maturity on issue date, was 8.25%. On the same issue date, the Fed estimated the 20-year constant maturity Treasury yield at 4.60%. So, investors demanded an extra compensation of 8.25% - 4.60% = 3.65% for holding GM debt instead of Treasury debt. In addition, GM debt was selling at 66.00 as of December 29, 2005 (see Table 1.2), which is a discount to the par value of 100, whereas a Treasury note with a coupon of 4.50% was selling close to par on the same date. This implies that investors want a higher compensation than the promised coupon in order to invest and hold GM debt. By purchasing GM debt at a discount, they can get this additional return.
1.1.1 Cash-flow rights of debt securities
Debt contracts typically have precedence over residual claims such as equity. When there are multiple issues of debt securities by the same issuing entity (as is typical), priorities and relative seniorities are clearly stated by the issuer in bond covenants. This leads to some important types of debt contracts: secured and unsecured debt. Secured debt, such as a mortgage bond, is backed by tangible assets of the issuing company. In the event of financial distress, such assets may be sold to satisfy the obligations of debt holders. Unsecured debt, known as debentures in the United States, is not secured by any assets. Debt securities sold by issuers such as banks and corporations are subject to a positive probability of default, and they typically contain two important contingency provisions.
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Table of Contents
1. Overview of Fixed Income Markets
2. Price-Yield Conventions
3. Federal Reserve (Central Bank) & Fixed Income Markets
4. Organization and Transparency of Fixed Income Markets
5. Financing Debt Securities Repurchase (Repo) Agreements
6. Actions of Treasury Debt Securities
7. Bond Mathematics-DV01, Duration and Convexity
8. Yield Curve and the Term Structure
9. Models of Yield Curve and the Term Structure
10. Modeling Credit Risk and Corporate Debt Securities
11. Mortgages, Federal Agencies & Agency Debt
12. Mortgage-Backed Securities (MBS)
13. Inflation-Linked Debt Treasury Inflation Protected Securities (TIPS)
14. Derivatives on Overnight Interest Rates
15. Eurodollar Futures Contracts
16. Interest-Rate Swaps
17. Treasury Futures Contracts
18. Credit Default Swaps Single Name, Portfolio and Indexes
19. Structured Credit Products Collateralized Debt Obligations