2023 L1 FixedIncome

Last Revised: 05/10/2022
2023 Level 1 - Fixed Income

Readings Page
Fixed-Income Securities: Defining Elements 2
Fixed-Income Markets: Issuance, Trading, and Funding 15
Introduction to Fixed-Income Valuation 26
Introduction to Asset-Backed Securities 42
Understanding Fixed-Income Risk and Return 64
Fundamentals of Credit Analysis 80
Review 91
M.M128348126.
This document should be used in conjunction with the corresponding readings in the 2023 Level 1 CFA® Program curriculum.
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1
Fixed-Income Securities: Defining Elements
a. describe basic features of a fixed-income security
b. describe content of a bond indenture
c. compare affirmative and negative covenants and identify examples of each
d. describe how legal, regulatory, and tax considerations affect the issuance
and trading of fixed-income securities
e. describe how cash flows of fixed-income securities are structured
f. describe contingency provisions affecting the timing and/or nature of cash

flows of fixed-income securities and whether such provisions benefit the
borrower or the lender
M.M128348126.
2
Fixed-Income Securities: Defining Elements

Page 1
➞ any borrowing of money is debt (fixed income security)
LOS a
- promised payments are contractual obligations - describe
- payment of interest and principal are a prior claim on
the company’s earnings and assets versus equity
Bond ➞ a contractual agreement between the issuer & bondholders
⇒ Basic Features/
1/ Issuer
Supranational organizations
dfdf (World Bank)
gov’t. Governments ➞ sovereign (national)
sector ➞ non-sovereign (state, provincial, municipal)
➞ quasi-government (government owned or
corporate sponsored agencies)
sector Companies (corporate, either financial or non-financial)
Structured special purpose entities (securitization ➞ ABS, MBS)

finance
sector
Page 2
⇒ Basic Features/
LOS a
2/ Maturity - maturity date ➞ principal due - describe
- tenor ➞ time remaining to maturity date
M.M128348126. - range ➞ from overnight to 30 years (or longer)
money market securities - maturities, at issuance, < 1 yr.

(e.g. commercial paper, CDs, T-Bills)
capital market securities - maturities, at issuance, > 1 yr.
perpetual bonds - no maturity (consols)
3/ Par Value a.k.a. principal amount, principal value, future value,

maturity value, face value, nominal value,
redemption value
- bonds can have any par value 100 - par bond

- bonds are typically quoted as a percentage of par 98 - discount bond
104 - premium bond
3
Page 3
⇒ Basic Features/
LOS a
4/ Coupon Rate & Frequency - describe
coupon ➞ annual amount of interest payments made
(coupon rate × par value)
e.g./ 6%, $1000 bond ⇒ $60 annually typically gov’t., corporate
$30 semi-annually
QUIBS - quarterly interest
$15 quarterly
QUIDS bonds
$5 monthly quarterly interest
MBS
debt securities
plain vanilla or conventional bond – fixed coupon
floating rate notes (FRNs, floaters) - a reference rate + a spread
London pays pays pays fluctuates constant
Interbank 4.75% 4.65% 4.50% (e.g. Libor) (in bps)
offered Dec June Dec June
e.g. Libor + 150 bps
rate (Libor)
3.25 3.15 3.00 2.95
Page 4
⇒ Basic Features/ LOS a
4/ Coupon Rate & Frequency - describe
no coupon payments - sold at a discount
zero-coupon bond
all income = interest
most money market securities = zero coupon
5/ Currency Denomination - can be issued in any currency
EM countries typically opt to issue either USD or EUR
M.M128348126.
- makes it easier to place the bond denominated bonds
- dual-currency bonds ➞ coupon payments in one currency

➞ principal payments in another
- currency-option bonds ➞ single currency bond bondholders choose
+ the currency of each
foreign currency option interest payment
& principal
4
Page 5
⇒ Yield Measures/ current or running yield 𝐚𝐧𝐧𝐮𝐚𝐥 𝐜𝐨𝐮𝐩𝐨𝐧 LOS a
𝐩𝐫𝐢𝐜𝐞 - describe
yield-to-maturity (yield-to-redemption, redemption yield)

- the IRR of the bond’s expected cash flows
➞ an estimate of the bond’s expected return
➞ inverse relationship between price and YTM

➞ higher price, lower YTM
➞ lower price, higher YTM
par bond ➞ coupon rate = YTM

premium bond ➞ coupon rate > YTM
discount bond ➞ coupon rate < YTM
Page 6
⇒ Bond Indenture LOS b
- trust deed ➞ legal contract form of the bond - describe
obligations of the issuer
guided by
rights of the bondholder
issuer appoints trustee ➞ typically a financial institution with

trust powers
acts as a
monitors fiduciary for
M.M128348126. for compliance bondholders
trust deed includes/
1/ Legal identity of the bond issuer and its legal form
Holding Co. Securitization
credit transfers
Co. A Co. B Co. C quality & assets to
recourse bankruptcy
Subs. of
to assets Co. A SPE ➞ remoteness
Co. A from Co. A
bondholders
5
Page 7
2/ Sources of repayment proceeds - describe
Supranational ➞ repayment of previous loans
➞ paid-in capital from its members
tax revenues
Government ➞ Sovereign ➞ full ‘faith and credit’
print money
➞ Non-sovereign ➞ taxes
➞ project cash flows
➞ special taxes/fees specific to the
Corporate ➞ CFO funding
Securitized ➞ periodic payments of principle + interest
from securities held
3/ Asset or Collateral Backing
A/ Senior Ranking ➞ secured bond ➞ backed by assets (less risky)
➞ unsecured bond ➞ general pledge
senior
junior
Debenture - can be secured or unsecured
Page 8
⇒ Bond Indenture
LOS b
3/ Asset or Collateral Backing - describe
B/ Types of Collateral Backing
Collateral Trust Bond - backed by other financial assets (held by a
M.M128348126.
Equipment Trust Certificate - backed by specific equipment trustee)
- typically used to engineer a lease
➃ pays issues ➀
Airline Trustee Certificate
leases $
➂ buys
assets ➁
MBS - backed by a pool of mortgages
Covered bonds - backed by a segregated pool of assets
that are not transferred to a SPE
- if the assets become non-performing, must be
replaced by other assets
6
Page 9
4/ Credit Enhancements - reduce the credit risk of a bond - describe
a) Internal subordination or credit tranching junior – last
overcollateralization paid
senior 2
- posting more collateral senior 1
than is needed ‘waterfall structure’
reserve accounts or reserve funds
• cash reserve fund➁ - a deposit of cash that can
be used to absorb losses
• excess spread account e.g. 8% in, 6.5% out
b) External Bank guarantee and surety bonds ➞ up to some %’age
(Bank) (Insurance Co.)
called the
Letter of credit - a credit line to ‘penal sum’
reimburse any cash flow shortfalls from
the assets backing the issue
Page 10
LOS b, c
⇒ Bond Indenture - describe
4/ Credit Enhancements - compare
b) External cash collateral account - does not rely on 3rd party
creditworthiness
M.M128348126. 5/ Covenants - legally enforceable rules
Affirmative - typically administrative in nature
- what issuers are required to do
➁
e.g./ What the issuer will do with the proceeds, promise to comply
with all laws and regulations, maintain its current line of
business, insure/maintain its assets, pay taxes
Negative - what an issuer will not do

- purpose is to protect bondholders
Restrictions on debt ➞ max debt ratios, min. Interest Coverage Ratios

Negative pledges ➞ no debt senior to this issue
7
Page 11
⇒ Bond Indenture LOS b, c
5/ Covenants · Negative - describe
· Restrictions on prior claims (for unsecured bonds) - cannot use - compare
unsecured assets for future collateral

· Restrictions on distributions to shareholders - dividends and
Share buybacks out of earnings above some threshold profit only
· Restrictions on asset disposal - set a limit on asset disposal
➁
during bond’s life (%’age of gross assets)
· Restrictions on investment - blocks speculative investment
(i.e. stay in its current line of business)
· Restrictions on M&A - unless bond/collateral survive
- common element ➞ ensure issuer will not take any actions

that would reduce its ability to make interest
payments and repay the principal
Page 12
➞ Legal/Regulatory Considerations/ LOS d
- describe
· Domestic bonds - issued in issuer’s home country in the currency
of that country (e.g. Can. Co. issues in Canada in CAD)
· Foreign bonds - issuing entity not of the target country
(e.g. U.S. Co. issues in Canada in CAD)
M.M128348126. - regulated by the market the bonds are issued in
➁
· Euro bonds - originally created to bypass legal/regulatory/tax constraints
imposed on issuers
- named after the currency in which they are denominated
e.g. Eurodollar, Euroyen
- less regulated since they are issued outside the jurisdiction of
any single country
- usually unsecured - can be issued in any currency
8
Page 13
➞ Legal/Regulatory Considerations/ LOS d
- global bonds ➞ bonds issued simultaneously in the Eurobond - describe
market and in at least one domestic market
- ensures sufficient demand for large bond issues
- domestic, foreign, Eurobond & global bonds are subject to different
legal, regulatory & tax requirements
- the market rate that affects a bond’s price is the currency
in which the bond is denominated ➁
⇒ Tax Considerations/
· Interest - typically taxed as ordinary income (unless tax-exempt)
· Capital gains/losses - long-term vs. short-term
favourable ordinary income

· Discount bonds - discount is amortized over life of bond and
treated as implied interest (opposite effect for
premium bond) - but not always
Page 14
⇒ Bullet, Fully-amortizing, Partially amortizing bonds
LOS e
- describe
- most common
- almost all gov’t.
M.M128348126. & corporate bonds
➁
(N = 5, PV = -1000, FV = 0, I/Y = 6) CPT PMT ➞ 237.3964
- MBS ➞ each payment

is fixed ‘interest +
principal’ until paid
in full
- reduces credit risk

over time
9
Page 15
⇒ Bullet, Fully-amortizing, Partially amortizing bonds LOS e
- describe
N = 5, I/Y = 6, PV = -1000,
FV = 200
CPT PMT = 201.917
balloon payment required = $200

⇒ Sinking Fund arrangements/ - issuer sets aside funds over time to
retire the bond
- specifies the portion (e.g. 5%) of the bond’s principal outstanding
that must be repaid each year throughout the bond’s life
(or after a specified date)
Page 16
⇒ Sinking fund arrangement/ LOS e
issuer trustee redeems bonds in open - describe
$
market or serial #
- also may involve redeeming some lottery
increasing %’age each year
- lowers default (i.e. credit) risk, but raises re-investment risk or
call risk (called at par but trading at a premium)
M.M128348126.
⇒ Coupon payment structure/ ➁ annual

· Fixed coupon (conventional bond) semi-annual certain
- price volatility quarterly cash-flows
monthly
· Floating rate notes - little price volatility since coupons are
reset at market rates on each coupon date
coupon = reference rate + spread (margin) uncertain cash

flows
typically quarterly
10
Page 17
⇒ Coupon payment structure/ LOS e
- describe
cap - maximum rate
· Floating rate notes - may have if both, called
floor - minimum rate
a collared FRN
· inverse or reverse FRN (inverse floater) - if the
reference rate ↓, coupon ↑ instead
· Step-up coupons - may be fixed or floating
- coupon increases by specified margins at specified dates
- offer bondholders some➁ protection against rising rates
· Credit-linked coupon bonds - coupon changes when bond’s credit
rating changes (↓/↑ by some margin with every ↑/↓
in credit rating)
· PIK (payment-in-kind) bonds - interest paid with more amounts
of the bond (or with common shares)
PIK toggle ➞ issuer has the option to pay coupon
in cash or in kind (or some mix)
· usually tied to a cash flow trigger
Page 18
LOS e
⇒ Coupon payment structure/ - describe
· Deferred coupon bonds (split coupon bonds) - no coupon payments
for the first few years followed by higher coupon
than otherwise
- common in project financing (delay payments until the project
M.M128348126.
is complete)
· Index-Linked bonds - coupons are linked to some index
(e.g. inflation-linked
➁ bonds tied to CPI)
with
without Inf.
Inf.
Inf.
real real real
real rate nominal nominal rate
decreases rate increases
· inflation adjustment can be made to either coupon

payments or principal
11
Page 19
⇒ Coupon payment structure/ LOS e
· Index-Linked bonds - describe
· zero-coupon indexed bond ➞ inflation adjustment via principal only
e.g./ $1000 face value ➞ principal payment = $1,050
5% inflation
· interest-indexed bonds ➞ fixed nominal principal + index-linked coupon
$1000 face value, 4% semi-annual coupon, 5% inflation
𝟏𝟎𝟎𝟎 × . 𝟎𝟒
➞ principal = $1,000 coupon = - 4 (𝟏. 𝟎𝟓) = $𝟐𝟏
➁ 𝟐
· capital-indexed bonds ➞ fixed coupon + index-linked principal
∴ PMT ↑ as principal ↑
$1000 face value, 4% semi-annual coupon, 5% inflation
➞ principal = $1000(1.05) = $1,050 𝐜𝐨𝐮𝐩𝐨𝐧 = 𝟏𝟎𝟓𝟎 × 𝟒%.𝟐 = $𝟐𝟏
· Indexed-annuity bonds ➞ fully amortizing
➞ interest + principal payments ↑ as CPI ↑
$1000 face value, 4% semi-annual coupon, 20 yr. bond, 5% inflation
(N = 40, I/Y = 2, FV = 0, PV = -1000) PMT = 36.56 ➞ new PMT = 36.56(1.05) = 38.38
Page 20
⇒ Bonds with contingency provisions/ LOS f
- describe
some future event or circumstance that is possible
but not certain
- contingency provision gives issuer or bondholder a right to some
M.M128348126.
action
1/ Callable Bonds - issuer has the right to embedded
redeem all or part of the bond before maturity ‘option’
- issuer is protected from a decline
➁ in interest rates
- can re-issue at lower rates
- call option has value to the issuer ∴ higher coupon or lower price
- detailed in the bond indenture: compensates for higher
· call price · call dates reinvestment risk
· call premium (shrinks as time passes)
· call protection period (lockout period) ⇒ cannot be called until
some future date
12
Page 21
1/ Callable bonds - describe
𝐚𝐥𝐥 𝐈𝐧𝐭. + 𝐏𝐫𝐢𝐧𝐜𝐢𝐩𝐚𝐥 - results in a
- make whole call ➞ PV of
𝐠𝐨𝐯 ! 𝐭. 𝐘𝐓𝐌 + 𝐬𝐩𝐫𝐞𝐚𝐝 call price > current
market price
- calls can be: American - continuously callable
European - only on call date (1 date)
Bermuda - only on call
➁ dates after the lockout period
- usually on coupon dates
2/ Putable bonds - bondholder can put bond back to issuer on
certain dates @ specific prices (value for bondholder)
- lower yield or higher prices
- protects against a rise in rates
➞ one-time put bonds - European
➞ multiple put bonds - Bermuda
Page 22
⇒ Bonds with contingency provisions/
LOS f
3/ Convertible bonds - hybrid security, 5-10 yr. maturities - describe
- bondholder has the right to exchange the bond for a
specified number of shares
- if share price ↓, get bond principal (downside protection)
- if share price ↑, get share price (upside participation)
- lower yield or higher price (yield higher than dividend yield however)
M.M128348126. - issuer pays lower interest, plus may➁avoid principal repayment
· Key Terms e.g.
· Conversion Price - price/share $20
· Conversion Ratio # of shares/bond 50
· Conversion Value P0 × conv. ratio P0 = 19 , CV = 950
· Conversion Premium $Bond - Con. Value $1000 - 950 = 50
· Conversion Parity $Bond = Con. Value below par
13
Page 23
3/ Convertible bonds - describe
- typically also have call provisions to force conversations
- avoids ‘overhanging convertibles’ when above parity
- bonds with warrants ➞ attached warrants

➞ not really ➁
a contingency provision, more of a
yield enhancement
- contingent-convertible bonds ➞ contingent write-down provisions
e.g./ if core Tier 1 capital falls below some

minimum level (min. Basel 3 requirement), bond
converts to equity ➞ raises Tier 1 capital amount
- conversion happens automatically (not discretionary)
M.M128348126.
14
Fixed-Income Markets: Issuance, Trading, and Funding
a. describe classifications of global fixed-income markets
b. describe the use of interbank offered rates as reference rates in floating-rate

debt
c. describe mechanisms available for issuing bonds in primary markets
d. describe secondary markets for bonds
e. describe securities issued by sovereign governments
f. describe securities issued by non-sovereign governments, quasi-government

entities, and supranational agencies
g. describe types of debt issued by corporations
h. describe structured financial instruments
i. describe short-term funding alternatives available to banks
j. describe repurchase agreements (repos) and the risks associated with them
M.M128348126.
15
Issuance, Trading, Funding

Page 1
⇒ Classification of Fixed-Income Markets/ LOS a
1/ by issuer gov’t. & gov’t. related – supranational orgs. - describe
fin. - sovereign & non-sovereign
corporate
non-fin. - quasi-gov’t.
structured finance – securitization (MBS, ABS)
2/ by credit quality Investment grade (Baa3 or BBB – and up)
Non-Investment grade (high yield, speculative,
junk)
- certain types of investors may be restricted from
holding non-investment grade debt
3/ by maturity money market < 1 yr. original maturity at
capital market > 1 yr. issuance
4/ by currency – currency of a bond’s cash flows determine what
country’s interest rate affects price
5/ by coupon – fixed
- floating ➞ reference rate + spread
Page 2
⇒ Classification of Fixed-Income Markets/ LOS a, b
5/ by coupon – floating rate = reference rate + spread - describe
resets
typically constant
periodically
Libor – reflects the rate at set at issuance
typically Libor
which unsecured loans can f(credit risk)
M.M128348126.
be obtained between banks in the

Interbank Money Market ➞ is actually a collection of rates
ranging from overnight up to one year
Process/ 8-16 banks submit daily rates they believe they could
borrow at for 5 currencies and 7 time periods (35 rates)
USD, EUR, JPY, GBP, CHF 1 day, 1 wk., 1-2-3-6-12 months
- highest/lowest 25% discarded

LIBOR = mean of mid 50% of bids
- alternatives: Euribor, Tibor, Sibor, Hibor, Mibor

EUR JPY SGD HKD INR
16
Page 3
⇒ Classification of Fixed-Income Markets/ LOS a
6/ by Geography Domestic legal, regulatory and tax - describe
Foreign issues of ‘issued-in’ country
Eurobond - issued internationally
also by developed market
local currency
emerging market
foreign currency
⇒ Primary bond markets/ - issuers initially sell bonds LOS c

to investors - describe
Public Offerings
a) underwritten offerings (firm commitment offering)
Phases: 1. Issuer determines funding need
buys from
Spread 2. Select underwriter - typically an investment bank
= revenue (or syndicate)
lead
sells to syndicated
dealers/investors offering
Page 4
⇒ Primary bond markets/ LOS c
Public Offerings a) underwritten offerings - describe
3. Investment bank structures the offering

bond terms regulatory filings circulars/prospectus
M.M128348126. selects trustee
4. Announcement date to end of subscription period
- underwriter gauges demand + price
- marketing efforts
- anchors (large inst. investors)
pricing date - grey market (forward mkt.)
- last day to commit
- final terms solidified
next day = offering
5. Issuing phase ⇒ money changes hands
6. Closing date ⇒ about 14 days from issue date
17
Page 5
⇒ Primary bond markets/ LOS c
Public Offerings a) underwritten offerings - describe
Shelf registration ➞ certain issuers can offer additional bonds
to the public without having to prepare a new
and separate offering
- may be used to cover multiple bond issues
b) best-efforts offering – investment bank/syndicate serve
only as a broker for a commission
c) auction – single price auction ➞ all the winning bidders pay
the same price and receive the same coupon
rate (U.S. Treasuries)
- competitive + non-competitive bids
primary dealers accepts the rate determined
- final price = yield at which the issue clears
multiple price auction ➞ each bidder pays their price
(Canada, Germany)
Page 6
⇒ Primary bond markets/ LOS c, d
Public Offerings - describe
d) Private Placements non-underwritten
unregistered
M.M128348126.
one/few investors (pension fund, insurance)
- typically no active secondary markets low need for liquidity
higher yield
⇒ Secondary bond markets/
investor investor Central Banks & large
investor dealer investor
institutional investors
exchange-listed ➞ very limited - very small retail
OTC (over-the-counter) ➞ vast majority of bonds presence
- dealers act as market makers
post bid - offer < 5 bps – very liquid
spread ➞ lower = more liquid 10-12 – reasonable
> 50 - illiquid
- no bid/offer = completely illiquid
18
Page 7
⇒ Secondary bond markets/ LOS c, d
Settlement – bonds passed to buyer and payment made - describe
gov’t./quasi-gov’t. ➞ cash or T + 1
corporate ➞ T + 2 or T + 3, maybe even T + 7
(some jurisdictions)
⇒ Sovereign bonds/ LOS e
- usually called Treasuries (even though they - describe
have different names by country)
- name may also denote original maturity
e.g. U.S. Treasury - bill (T-Bill) < 1 yr. (zero coupon)
- Note (T-Note) 1 yr. ≤ T-Note < 10 yrs.
coupon –
bearing - Bond (T-bond) > 10 yrs.
- most recently issued ➞ ‘on the run’ or benchmark issue

- most active in secondary market
- as sovereigns age, they trade less frequency
Page 8
⇒ Sovereign bonds/ LOS e
Credit Quality ➞ typically unsecured obligations - describe
➞ paid out of budget surplus
➞ deficits require ‘rolling over’ the principal + interest
- risk-free (theoretically) ➞ AAA or Aaa (only a few)
M.M128348126. local currency ➞ higher credit rating than foreign currency
- strong domestic savings base ➞ solid domestic demand
- liquid and freely traded currency ➞ strong international demand
Types/ 1/ Fixed-rate bonds – by far the most common
2/ Floating-rate bonds – lower interest rate risk (i.e. price risk)
than fixed rate bonds
(Germany, Spain, US) (Japan, UK – never)
3/ Inflation-linked bonds – US ➞ TIPS (Treasury Inflation
- tied to CPI Protected Securities)
not a perfect proxy for inflation
19
Page 9
⇒ Non-Sovereign/Quasi-government/Supranational/ LOS f
Non-Sovereign: state, province, municipality - describe
- not guaranteed by the national government schools
- typically issued to finance public projects roads
- ranging tax treatment depending on type & jurisdiction hospitals
- credit ratings differ widely, but generally high

- higher yield/lower price than comparable sovereigns
Quasi-government: agency bonds
- rarely guaranteed by the sovereign (implied however)
- repaid from the cash flows of the entity
- typically high credit rating
Supranational: supranational bonds ➞ highly rated
- some may be used as a benchmark for non-liquid
sovereign bonds
Page 10
⇒ Corporate Debt/ LOS g
- companies have a choice: Debt or Equity - describe
public private
Private debt: 1/ Bi-lateral loans – single lender to single borrower
floating-rate usually bank typically
2/ Syndicated loans – a group of lenders to a single
M.M128348126.
borrower
can be packaged not all will be banks
and securitized
- private debt can be customized to the borrowers need, can be
interest only or fully amortizing, usually more expensive than public
Public debt: 1/ Commercial paper – short-term, unsecured debt
- working capital, seasonal needs, bridge financing
- largest issues are financial institutions
- maturity can range from overnight ➞ 1 yr. (3 mos. is typical)
20
Page 11
Public debt: 1/ Commercial paper ➞ Credit quality - describe
prime paper ➞ IG
- maturing CP is usually met by ‘rolling over the paper’

introduces ‘rollover risk’
∴ credit rating agencies usually require issuers to secure
‘backup lines of credit’ – referred to as a ‘liquidity
enhancement’
- investors typically hold CP to maturity ∴ very low
secondary market
- yield on CP > yield on same maturity
trading
credit risk sovereign debt
illiquidity
Page 12
Public debt: 1/ Commercial paper US vs. Eurocommercial - describe
Paper
issued
M.M128348126. internationally
also: smaller issue

sizes and less
liquidity
e.g.: issue $50M @ 5% for 180 days
- interest = $1.25M - interest = $1.25M
- proceeds = $48.75M - proceeds = $50M
repay ➞ $50M repay ➞ $51.25M
2/ Corporate Notes and Bonds (range from 1 to 30 years, typically)
short < 5 yrs.
notes fixed or floating
5 yr. ≤ medium < 12 yrs.
long > 12 yrs. – bonds ➞ primarily fixed
21
Page 13
Public debt: 2/ Corporate Notes and Bonds - describe
quarterly
Coupon payment structures fixed or inflation
semi-annual
floating market
annual
credit
- also ➞ zero coupon, deferred coupon, PIK bonds quality
Principal repayment structures
- serial maturity – maturity dates are spread out over the bond’s life
- a stated # of bonds mature each year
- term maturity – principal all paid on one date (more credit risk)
Asset or collateral backing – seniority ranking, secured vs.
unsecured
Contingency provisions – calls, puts, conversions
Issuance, Trading, Settlement
underwritten OTC T + 2 or T + 3, longer for new issues
best efforts
Page 14
⇒ Structured Financial Instruments/ LOS h
1/ Capital protected instruments - describe
➞ buy a zero coupon bond + call options
equity
discount security on an index commodity
M.M128348126.
pays principal + option payoff
2/ Yield enhancement instruments e.g./ credit-linked note

- a bond that pays regular coupons but whose principal value
depends on specific credit events - ratings downgrade
default of an underlying
no credit event ➞ pays par
asset
credit event ➞ pays a recovery rate
Note: protects the issuer

- pays higher coupon in return, plus issued at a discount
22
Page 15
⇒ Structured Financial Instruments/ LOS h
3/ Participation instruments – participate in the return of - describe
an underlying asset
- offer exposure to a particular index or asset price
4/ Leveraged instruments e.g./ inverse floater
coupon rate = C – (L × R) - if reference rate (R) = 0
leverage factor C is maxed out
e.g./ C = 9.5% 9.5% - (3 × 2.5%) = 2% R ↓ 1.5%
L = 3
9.5% - (3 × 1.0%) = 6.5% C ↑ 4.5%
Libor ➞ 2.5% ➞ 1%
- if L < 1 , called a ‘deleveraged inverse floater’
L > 1 ➞ ‘leveraged inverse floater’
- often have floors (C is the cap)
Page 16
⇒ Short-term funding alternatives for banks LOS i
1/ Retail Deposits – individual and commercial depositors - describe
demand deposits ➞ pay no interest
savings accounts ➞ pay interest but lack service levels of
demand deposits
money market accounts ➞ money market rates of return
M.M128348126.
2/ Short-term wholesale funds
a) Reserve funds ➞ central bank funds
- banks place minimum level of funds with the central bank
- called reserves
- help ensure sufficient liquidity should depositors withdraw funds
- some banks have surplus reserves, others deficits
can lend extra reserves to other banks for
interest is maturities of one day up to one year
called the central bank overnight funds term funds
funds rate
23
Page 17
⇒ Short-term funding alternatives for banks LOS i
2/ Short-term wholesale funds - describe
b) Interbank funds ➞ loans/deposits between banks (unsecured)
➞ term: overnight to one year
rate ➞ interbank offered rate bank will typically quote 2 rates
➞ fixed rate ① rate at which it will lend
② rate at which it will accept a
c) Large denomination negotiable CDs deposit
allows depositor to sell CD in open market
before maturity
usually issued in denominations of $1M or more (U.S.)
typically traded among institutional investors
have maturities < 1 yr., pay interest at maturity
yields are driven primarily by the credit risk of the issuing bank
Page 18
⇒ Short-term funding alternatives for banks LOS j
3/ Repurchase and reverse repurchase agreements - describe
repo ➞ the sale of a security with funds

an agreement to buy it back at an Bank Bank
agreed on price at some future date A B
security
M.M128348126.
repurchase price repurchase date - basically a collateralized
- term = one day ➞ called an overnight repo loan
= longer ➞ term repo
Interest rate ➞ repo rate ➞ affected by
1/ risk associated with the collateral – higher quality = lower
rate
2/ term of the repo – longer = higher
3/ physical delivery ➞ lower rate
4/ supply/demand of collateral ➞ the more scarce, the lower the
5/ other market rates rate (on special)
24
Page 19
⇒ Short-term funding alternatives for banks LOS j
3/ Repurchase and reverse repurchase agreements - describe
interest is paid at the end of the repo term
if the collateral pays interest, belongs to the borrower
- from the lender’s perspective ➞ called a reverse repo

often used to purchase
each side in a repo is exposed securities to cover a
to counterparty credit risk short position
- however the repo is structured in favour of the lender
of cash
- the amount lent is lower than the collateral’s
market value
- difference is called the ‘repo margin’ or ‘haircut’
M.M128348126.
25
Introduction to Fixed-Income Valuation
a. calculate a bond’s price given a market discount rate
b. identify the relationships among a bond’s price, coupon rate, maturity, and
market discount rate (yield-to-maturity)
c. define spot rates and calculate the price of a bond using spot rates
d. describe and calculate the flat price, accrued interest, and the full price of a
bond
e. describe matrix pricing
f. calculate annual yield on a bond for varying compounding periods in a year
g. calculate and interpret yield measures for fixed-rate bonds and floating-rate
notes
h. calculate and interpret yield measures for money market instruments
i. define and compare the spot curve, yield curve on coupon bonds, par curve,
and forward curve
M.M128348126. j. define forward rates and calculate spot rates from forward rates, forward
rates from spot rates, and the price of a bond using forward rates
k. compare, calculate, and interpret yield spread measures
26
Introduction to Fixed Income Valuation

Page 1
⇒ Bond Prices/ LOS a, b
a) using a single ‘market discount factor’ - a.k.a. - calculate
- price of bond = PV(future cash flows) - required yield - identify
- required rate of
e.g./ 5 yr., 4% annual bond, r = 6% ➞ r = market discount rate return
𝟒 𝟒 𝟒 𝟒 𝟏𝟎𝟒 ➞ coupon + principal
+ + + +
𝟏. 𝟎𝟔 (𝟏. 𝟎𝟔) 𝟐 (𝟏. 𝟎𝟔)𝟑 (𝟏. 𝟎𝟔)𝟒 (𝟏. 𝟎𝟔)𝟓 Note: bonds are
quoted as a %’age
= 𝟑. 𝟕𝟒 + 𝟑. 𝟓𝟔 + 𝟑. 𝟑𝟓𝟖 + 𝟑. 𝟏𝟔𝟖 + 𝟕𝟕. 𝟕𝟏𝟓 = 𝟗𝟏. 𝟓𝟕𝟓 of par (i.e. 100 = par)
calculator: N = 5, FV = 100, PMT = 4, 𝐈.𝐘 = 6, CPT PV
if coupon rate = market rate - par bond
coupon rate < market rate - discount bond
coupon rate > market rate - premium bond
e.g./ 5 yr., 8% annual bond, r = 6% (N = 5, 𝐈.𝐘 = 6, PMT = 8, FV = 100) CPT PV
= 108.425
⇒ Inverse relationship between bond prices and interest rates
(discount rates)
Page 2
a) using a single ‘market discount factor’ - calculate
- identify
- semi-annual: 5 yr., 4% semi-annual bond, r = 6%
M.M128348126.
(N = 10, 𝐈.𝐘 = 3, PMT = 2, FV = 100) CPT PV = 91.46979
(vs. 91.575 for annual)
5 yr., 8% semi-annual bond, r = 6%
(N = 10, 𝐈.𝐘 = 3, PMT = 4, FV = 100) CPT PV = 108.5302
(vs. 108.425 for annual)
- quarterly: (N = 20, 𝐈.𝐘 = 1.5, PMT = 1, FV = 100) CPT PV = 91.4156
(N = 20, 𝐈.𝐘 = 1.5, PMT = 2, FV = 100) CPT PV = 108.5843
Note: discount bonds PV ↓ as periodicity ↑

premium bonds PV ↑ as periodicity ↑
➞ Yield-to-Maturity - if PV is known (i.e. bond’s market price),
YTM can be calculated
- YTM is the IRR of the bond’s cash flows
27
investor holds the Page 3

bond to maturity
➞ Yield-to-Maturity - assumes - calculate
all cash flows are
- identify
e.g./ 4 yr., 5% annual bond @ 105 received on the specified
N = 4, PMT = 5, PV = -105, FV = 100 all coupon payments can dates
CPT 𝐈#𝐘 = 3.634% be reinvested at the same rate
- if semi-annual
N = 8, PMT = 2.5, PV = -105, FV = 100
CPT I/Y = 1.82265 /semi-annual period × 2 = 3.645315%
- if quarterly the greater the
N = 16, PMT = 1.25, PV = -105, FV = 100 periodicity, the
CPT I/Y = .912705 × 4 = 3.6508 higher the YTM
- if monthly
N = 48, PMT = 𝟓.𝟏𝟐, PV = -105, FV = 100
CPT 𝐈#𝐘 = .30454 × 12 = 3.6545
Page 4
4 relationships 1/ PV inversely related to $𝐘𝐈 - calculate
- identify
- bond price is inversely related to the market
discount rate
2/ given the same coupon & time to maturity: (inverse effect)
%’age 𝚫price when market rates increase is less than
M.M128348126.
price
- called a ‘convexity effect’ when rates decrease
- in other words, bond prices increase by

more when rates drop than they drop
in price when rates rise
market rate
3/ for the same time to maturity:
lower coupon bond is more price sensitive than a higher
coupon bond when rates change
(coupon effect)
28
Page 5
4 relationships 4/ for the same coupon rate: - calculate
longer-term bond is more price sensitive than a - identify
(maturity effect) shorter-term
- generally bond
4.95% ↑ as r ↓ 1%
4.60% ↓ as r ↑ 1%
convexity effect
all rise all drop
coupon effect
longer term bonds = higher price vol. lower coupon = higher note: maturity effect
price vol. does not hold for low
coupon, LT-bonds @
maturity effect a discount
Page 6
- calculate
- identify
M.M128348126.
pulled to par
constant yield-price
over time
trajectory
- bond prices change as

time passes even if
nothing else changes
10 yr., annual bonds, r = 8%
29
Page 7
⇒ Bond Prices/ LOS c
b) using multiple discount rates - define
- calculate
- spot rates ➞ rates that correspond to a bond’s cash flow
dates
∴ rather than using the same discount rate, each cash flow
is discounted by its associated spot rate
yields-to-maturity on zero-
PV ➞ referred to as the bond’s
coupon bonds maturing at
‘no arbitrage value’
the date of each cash flow
e.g./ 𝟓 𝟓 𝟏𝟎𝟓
PV = + (𝟏.𝟎𝟑)𝟐 + (𝟏.𝟎𝟒)𝟑 = 102.96 3 yr., 5% annual bond
(𝟏.𝟎𝟐)
r(1) = 2% r(2) = 3% r(3) = 4%
(N = 3, PMT = 5, PV = -102.96, FV = 100) CPT 𝐈.𝐘 = 3.935% (YTM)
(N = 3, PMT = 5, FV = 100, 𝐈.𝐘 = 3.935) CPT PV = 102.96
Page 8
⇒ Prices and Yields/ LOS d
- when a bond is between coupon dates, its price has - calculate
2 parts ① the flat price - PVflat
sum = PVfull
② accrued interest - AI
dirty price
- dealers quote PV flat
(a.k.a. - the clean price)
M.M128348126. - AI ➞ the proportional share of the next coupon payment belonging
= 𝐭J𝐓 where T = # of days between PMT to the seller
𝐭 = # of days since last PMT to the settlement
date
- 2 conventions to count days:
𝐚𝐜𝐭𝐮𝐚𝐥$ 𝟑𝟎.
𝐚𝐜𝐭𝐮𝐚𝐥 𝟑𝟔𝟎
- most common for gov’t. bonds - typically corporate bonds
e.g./ May 15 & Nov. 15 ➞ coupon dates, settlement on June 27

𝟏𝟔 + 𝟐𝟕 𝟏𝟓 + 𝟐𝟕
= 𝟒𝟑.𝟏𝟖𝟒 = 𝟒𝟐.𝟏𝟖𝟎
𝟏𝟔 + 𝟑𝟎 + 𝟑𝟏 + 𝟑𝟏 𝟏𝟓 + 𝟑𝟎 + 𝟑𝟎 + 𝟑𝟎
+ 𝟑𝟎 + 𝟑𝟏 + 𝟏𝟓 + 𝟑𝟎 + 𝟑𝟎 + 𝟏𝟓
30
Page 9
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕 - calculate
𝐏𝐕 𝐟𝐮𝐥𝐥 = 𝐭 + 𝐭 +⋯ + 𝐭
(𝟏 + 𝐫)𝟏* -𝐓 (𝟏 + 𝐫)𝟐* -𝐓 (𝟏 + 𝐫)𝐍* -𝐓
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕 𝐭
= 7 + + ⋯+ 8 × (𝟏 + 𝐫) -𝐓
(𝟏 + 𝐫) (𝟏 + 𝐫)𝟐 (𝟏 + 𝐫) 𝐍
𝐭
= 𝐏𝐕 × (𝟏 + 𝐫) -𝐓
this is not PVflat
e.g./ 5% semi, maturity date = Feb. 15, 2024, act./act., settles May 14/2015
r = 4.8% Feb. 15 Aug. 15 Feb. 15 Feb. 15 - Aug. 15
T = 181 T = 184 13 + 31 + 30 + 31
𝐭 = 𝟏𝟑 + 𝟑𝟏 + 𝟑𝟎 + 𝟏𝟒 = 𝟖𝟖 + 30 + 31 + 15 = 181
N = 18 𝐏𝐕 𝐟𝐮𝐥𝐥 = 𝟏𝟎𝟏. 𝟒𝟒𝟕𝟗
𝐭# = 𝟖𝟖# Aug. 15 - Feb. 15
𝐓 𝟏𝟖𝟏 PMT = 2.5 𝟖𝟖
× (𝟏. 𝟎𝟐𝟒) &𝟏𝟖𝟏 16 + 30 + 31 + 30
I/Y = 2.4
𝐀𝐈 = 𝟖𝟖#𝟏𝟖𝟏 × 𝟐. 𝟓 = 𝟏𝟎𝟐. 𝟔𝟐𝟒𝟑𝟐𝟑
+ 31 + 31 + 15 = 184
FV = 100 𝐏𝐕 𝐟𝐥𝐚𝐭 = 𝟏𝟎𝟐. 𝟔𝟐𝟒𝟑𝟐𝟑
= 𝟏. 𝟐𝟏𝟓𝟒𝟕 CPT PV = 101.4479 - 1.21547
= 101.408853
Page 10
e.g./ 6% corporate semi, settles June 18/2015 - calculate
June 18
coupon dates ➞ Mar./Sept. 19 Mar. 19 Sept. 19 Mar. 19
matures ➞ Sept. 19/2026 x
M.M128348126.
r = 6.2%
Step #3. Calculate PV Sep. 19/15
Step #1. 30/360 day count N = 23 2 × (16 - 26)
T = 11 + 30 + 30 + 30 + 30 + 30 + 19 = 180 PMT = 3 11 yrs.
𝐭 = 11 + 30 + 30 + 18 = 89 FV = 100 CPT PV = 98.372607
𝐈# = 3.1
Step #2. AI 𝐘
AI = 𝐭.𝐓 × 𝐏𝐌𝐓 Step #4. Calculate PVfull
𝟖𝟗-
= 𝟖𝟗.𝟏𝟖𝟎 × 𝟑 = 𝟏. 𝟒𝟖𝟑̇ 𝐏𝐕 𝐟𝐮𝐥𝐥 = 𝟗𝟖. 𝟑𝟕𝟐𝟔𝟎𝟕 × (𝟏. 𝟎𝟑𝟏) 𝟏𝟖𝟎
= 𝟗𝟗. 𝟖𝟔𝟖𝟖𝟎𝟓
Step #5. Calculate PVflat
𝐏𝐕 𝐟𝐥𝐚𝐭 = 𝟗𝟗. 𝟖𝟔𝟖𝟖𝟎𝟓 − 𝟏. 𝟒𝟖𝟑̇
= 𝟗𝟖. 𝟑𝟖𝟓𝟒𝟕𝟐
31
Page 11
⇒ Prices and Yields/ LOS e
Matrix Pricing - for fixed rate bonds without an active - describe
market, or not yet issued ➞ ∴ no market price to calculate

- estimate PV and r based on prices of more frequently YTM
traded comparable bonds (i.e. similar tenor, coupons, credit quality)
e.g./ 3 yr., 4% semi corporate
Step #1: find comparable
2% 3% 4% 5% Coupon
bonds
2 98.50 102.25 Step #2. Calculate YTM for
term 3.786% 3.821% 3.8035% each
to 3 (N = 4, PMT = 1.50, PV = -98.50,
turity
ma FV = 100) CPT 𝐈,𝐘 etc…
4
Step #3: find avg. YTM/term
5 90.25 99.125
4.181% 4.196% 4.1885% Step #4: Interpolate the
yield
Page 12
⇒ Prices and Yields/ LOS e
e.g./ 3 yr., 4% semi corporate - describe
2% 3% 4% 5% Coupon
98.50 102.25
2
term 3.786% 3.821% 3.8035%
to y 3
urit 3 yrs. 𝟑. 𝟖𝟎𝟑𝟓 + 𝟏.𝟑 (𝟒. 𝟏𝟖𝟖𝟓% −
mat
M.M128348126. 4 𝟑. 𝟖𝟎𝟑𝟓%)
5 90.25 99.125 = 𝟑. 𝟗𝟑𝟏𝟖𝟑 ̇
4.181% 4.196% 4.1885%
Step #5: Find PV
Note: if the bond were floating instead: (N = 6, I/Y = 𝟑. 𝟗𝟑𝟏𝟖𝟑̇2𝟐, FV = 100,
spread = 3.93183 - YTM on gov’t. 3 yr.-semi PMT = 2)
if gov’t. YTM = 2.75% CPT PV = 100.191
spread = 118.183 bps
⇒ usually a different yield spread for each maturity & credit rating
term structure of credit spreads
32
Page 13
⇒ Yield Measures/ LOS f, g, h
1/ Fixed rate bonds - yield measures typically are - calculate
annualized and compounded (if > 1 yr.) - interpret
e.g./ 5-yr. zero @ 80 Periodicity
annual 80 = 100/(1 + r) 5
1 ➞ r = 0.04564
semi-annual 80 = 100/(1 + r)10 2 ➞ r = 0.022565 × 2 = 0.04513
quarterly 80 = 100/(1 + r)20 4 ➞ r = 0.011220 × 4 = 0.04488
monthly 80 = 100/(1 + r)60
12 ➞ r = 0.003726 × 12 = 0.044712
Note: 4.564% = 2.2565 compounded semi-annually

= 1.1220 compounded quarterly
= .3726 compounded monthly
the effective annual rate
Semi-annual bond basis yield or semi-annual bond equivalent yield
= yield/semi-annual period × 2
2.2565 × 2 = 4.513%
Page 14
1/ Fixed rate bonds - calculate
𝐀𝐏𝐑 𝐦 𝐦 𝐀𝐏𝐑 𝐧 𝐧 - interpret
➞ periodicity conversions: 9𝟏 + = = 9𝟏 + =
𝐦 𝐧
e.g./ 3 yr., 5% semi @ 104 (BEY)
M.M128348126.
𝐈
(N = 6, PMT = 2.5, PV = -104, FV = 100) CPT #𝐘 = .01791 × 𝟐 = 𝟑. 𝟓𝟖𝟐%
(𝟏. 𝟎𝟏𝟕𝟗𝟏)𝟐 − 𝟏 = 𝟑. 𝟔𝟏𝟒𝟏
. 𝟎𝟑𝟓𝟖𝟐 𝟐 𝐀𝐏𝐑 𝟒 𝟒
quarterly equivalent C𝟏 + D = C𝟏 + D (EAY)
𝟐 𝟒
𝟏-
?(𝟏. 𝟎𝟑𝟔𝟏𝟒𝟏) 𝟒 − 𝟏F × 𝟒 = 𝟑. 𝟓𝟔𝟔%
𝟐 𝟏𝟐
monthly equivalent C𝟏 + . 𝟎𝟑𝟓𝟖𝟐D = C𝟏 + 𝐀𝐏𝐑 𝟏𝟐 D
𝟐 𝟏𝟐
𝟏
?(𝟏. 𝟎𝟑𝟔𝟏𝟒𝟏) -𝟏𝟐 − 𝟏F × 𝟏𝟐 = 𝟑. 𝟓𝟓𝟔%
3.582% ➞ 3.566% ➞ 3.556% compounding more frequently at a

(2) (4) (12) lower rate = compounding less
frequently at a higher rate
33
Page 15
e.g./ 5 yr., 4.5% semi @ 98
① annual YTM ? (N = 10, PMT = 2.25, PV = -98, FV = 100) - interpret
CPT 𝐈#𝐘 = .0247826 × 2 = 4.95652%
(semi-annual bond basis)
② convert to quarterly . 𝟎𝟒𝟗𝟓𝟔𝟓𝟐 𝟐
𝐀𝐏𝐑 𝟒 𝟒
C𝟏 + D = C𝟏 + D
𝟐 𝟒
𝟏-
?(𝟏. 𝟎𝟓𝟎𝟏𝟕𝟗) 𝟒 − 𝟏F × 𝟒 = 𝐀𝐏𝐑 𝟒 = 𝟒. 𝟗𝟐𝟔𝟏𝟖%
② convert to annual . 𝟎𝟒𝟗𝟓𝟔𝟓𝟐 𝟐 𝐀𝐏𝐑 𝟏 𝟏

C𝟏 + D = C𝟏 + D
𝟐 𝟏
[(𝟏. 𝟎𝟓𝟎𝟏𝟕𝟗) − 𝟏] × 𝟏 = 𝐀𝐏𝐑 𝟏 = 𝟓. 𝟎𝟏𝟕𝟗% - effective
annual
Street convention ➞ YTM that ignores the possibility that yield
a PMT date could be a weekend or holiday
True yield ➞ takes any delayed PMT into consideration
Page 16
- interpret
government equivalent yield ➞ quoted for a corporate bond
➞ restates 𝟑𝟎.𝟑𝟔𝟎 to 𝐚𝐜𝐭𝐮𝐚𝐥.𝐚𝐜𝐭𝐮𝐚𝐥
M.M128348126.
➞ results in a more accurate ‘spread over
benchmark’ measure
current yield (income or running yield) = ∑𝐜𝐨𝐮𝐩𝐨𝐧 𝐏𝐌𝐓𝐬 𝐟𝐨𝐫 𝐲𝐫.
𝐏𝐕 𝐟𝐥𝐚𝐭
simple yield = 𝐏𝐌𝐓/𝐲𝐫. + 𝐒. 𝐋. 𝐚𝐦𝐨𝐫𝐭. 𝐨𝐟 𝐠𝐚𝐢𝐧/𝐥𝐨𝐬𝐬
𝐏𝐕 𝐟𝐥𝐚𝐭
➞ Embedded options/ 7 yr., 8% annual @ 105, callable after 4 years
yield measures:
102 in 4 years
yield to first call (FV = 102, PV = -105, PMT = 8, N = 4)
yield to second call (FV = 101, N = 5)
101 in 5 years
yield to third call (FV = 100, N = 6) 100 in 6 years
YTM (FV = 100, N = 7) call schedule
lowest = yield to worst
34
Page 17
➞ Embedded options/ - pricing involves an option pricing - interpret
model + assumption about future interest rate volatility
Option-adjusted price = Option free bond - value of call option
used to calculate the or/ (+ value of put option)
option-adjusted yield
2/ Floating rate bonds
- reference rate is usually a short-term money market
rate (i.e. Libor)
- determined at the beginning of the period, paid at the end
(in arrears)
Fixed-Coupon price
price Floating Coupon
Page 18
2/ Floating rate bonds - common day count conventions - calculate
𝐚𝐜𝐭.$ 𝐚𝐜𝐭.$ - interpret
𝟑𝟔𝟓 𝟑𝟔𝟎
yield spread over the reference rate ➞ quoted margin ➞ credit related
➞ may even be
required margin ➞ spread required by investors to
M.M128348126.
negative (sub-Libor)
reflect changes in credit quality
- changes usually come from changes in the issuer’s credit
risk
∴ FRN with quoted margin = 50 bps with no changes in
credit risk, required margin = 50bps
PMT PMT between PMT dates for a
premium
PV change in the reference
PV = 100 PV = 100
discount rate ➞ but PV pulled to
QM - quoted margin par as PMT date nears
DM - discount margin if QM = DM ➞ PV = 100 on reset date
QM > DM ➞ PV > 100 and QM < DM ➞ PV < 100
35
Page 19
LOS f, g, h
⇒ Yield Measures/
- calculate
2/ Floating rate bonds - interpret
(𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕
+ 𝐅𝐕
𝐏𝐕 = 𝐦 + 𝐦 + ⋯+ 𝐦
𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝟐
𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝐍
^𝟏 + ` ^𝟏 + 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌` ^𝟏 + `
𝐦 𝐦 𝐦
e.g./ 2 yr. FRN, pays 6-mos. Libor + 50 bps, required spread = 40 bps
1.25%
Index = .0125
N= 4
QM = .005
DM = .004 PMT = (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 = (. 𝟎𝟏𝟐𝟓 + . 𝟎𝟎𝟓) × 𝟏𝟎𝟎 = . 𝟎𝟏𝟕𝟓 = . 𝟖𝟕𝟓
𝐦 𝟐 𝟐
𝐈. = 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 . 𝟎𝟏𝟐𝟓 + . 𝟎𝟎𝟒 . 𝟎𝟏𝟔𝟓
𝐘 = = = . 𝟖𝟐𝟓%
𝐦 𝟐 𝟐
FV = 100
CPT PV = 100.196 QM > DM ∴ PV > 100
Page 20
LOS f, g, h
⇒ Yield Measures/ - calculate
2/ Floating rate bonds - interpret
e.g./ 5 yr. FRN, pays 3-mos. Libor, QM = 75 bps, PV = 95.50 (DM = ?)
1.10%
M.M128348126. N = 20, FV = 100, PV = -95.50, PMT = C𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌D × 𝐅𝐕 = 𝟏. 𝟖𝟓% × 𝟏𝟎𝟎 = . 𝟒𝟔𝟐𝟓
𝟒 𝟒
CPT #𝐘 = .7045% ➞ (.007045 × 4) - .0110 = DM
𝐈
DM = 171.8 bps
e.g./ 4 yr. FRN pays 3-mos. Euribor + 125 bps @ 98 (DM = ?)
N = 16 2% PMT = 𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌 × 𝐅𝐕 = (. 𝟎𝟐 + . 𝟎𝟏𝟐𝟓) × 𝟏𝟎𝟎 = . 𝟖𝟏𝟐𝟓

FV = 100 𝐦 𝟒
CPT 𝐈#𝐘 = .009478 ⇒ (.009478 × 4) - Index = DM
PMT = .8125
PV = -98 = .017912
or/ 179.12 bps
36
Page 21
3/ Money market instruments - calculate
annualized, but not compounded ⇒ instead - interpret
rates of return are stated on a simple interest basis
either discount rates or add-on rates
(T-bills, CP, BA) (CDs, repos)
Discount rates interest

𝐝𝐚𝐲𝐬 𝐲𝐫. 𝐅𝐕 − 𝐏𝐕 earned
PV = FV × 9𝟏 − × 𝐃𝐑= ⇒ 𝐃𝐑 = 9 =9 =
𝐲𝐫. 𝐝𝐚𝐲𝐬 𝐅𝐕
91-day T-bill, $10M, DR = 2.25% periodicity FV, not PV
360-day yr. ∴ DR will
𝐏𝐕 = $𝟏𝟎𝐌 × c𝟏 − 𝟗𝟏$𝟑𝟔𝟎 × . 𝟎𝟐𝟐𝟓d understate the rate of
= $𝟗, 𝟗𝟒𝟑, 𝟏𝟐𝟓 return to the investor and
the cost of funds to the
borrower
Page 22
LOS f, g, h
⇒ Yield Measures/ - calculate
3/ Money market instruments - interpret
𝐅𝐕 𝐲𝐫. 𝐅𝐕 − 𝐏𝐕
Add-on rates 𝐏𝐕 = ⇒ 𝐀𝐎𝐑 = 9 =9 =
𝐝𝐚𝐲𝐬$ 𝐝𝐚𝐲𝐬 𝐏𝐕
^𝟏 + 𝐲𝐫. × 𝐀𝐎𝐑`
e.g./ 180-day BA, AOR = 4.38, 365-day yr., $10M periodicity 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐞𝐚𝐫𝐧𝐞𝐝
𝐩𝐫𝐢𝐜𝐞 𝐩𝐚𝐢𝐝
M.M128348126.
𝐝𝐚𝐲𝐬.
𝐅𝐕 = 𝐏𝐕 R𝟏 + 𝐲𝐫. × 𝐀𝐎𝐑W
= $𝟏𝟎𝐌R𝟏 + 𝟏𝟖𝟎.𝟑𝟔𝟓 × . 𝟎𝟒𝟑𝟖W = $𝟏𝟎, 𝟐𝟏𝟔, 𝟎𝟎𝟎
Note: FV = 𝐏𝐕(𝟏 + 𝐫)𝐧 ➞ compounded interest

𝐝𝐚𝐲𝐬$
FV = 𝐏𝐕 ^𝟏 + 𝐲𝐫. 𝐫` ➞ simple interest (money market yields)
➞ Sell after 45 days when AOR = 4.17%
𝟏𝟎, 𝟐𝟏𝟔, 𝟎𝟎𝟎 𝟑𝟔𝟓 𝟏𝟎. 𝟎𝟔𝟎𝟖𝟐𝟗 − 𝟏𝟎
𝐏𝐕 = = $𝟏𝟎, 𝟎𝟔𝟎, 𝟖𝟐𝟗 ⇒ implies AOR = L ML M
H𝟏 + 𝟏𝟑𝟓#𝟑𝟔𝟓 × . 𝟎𝟒𝟏𝟕I 𝟒𝟓 𝟏𝟎
= 𝟒. 𝟗𝟑𝟒%
37
Page 23
⇒ DR vs. AOR
3/ Money market instruments ⇒ 360 vs. 365 - calculate
- interpret
- convert all to AOR with 365d to compare:
e.g./ 90-day CP, DR = 5.76%, 360-day yr. vs. 90-day CD, AOR = 5.9%, 365 d/yr.
𝐏𝐕 = 𝟏𝟎𝟎 × Z𝟏 − 𝟗𝟎.𝟑𝟔𝟎 × . 𝟎𝟓𝟕𝟔[ = 𝟗𝟖. 𝟓𝟔

𝟏𝟎𝟎 − 𝟗𝟖. 𝟓𝟔
𝐀𝐎𝐑 = R𝟑𝟔𝟓.𝟗𝟎W C D = . 𝟎𝟓𝟗𝟐𝟓 𝐯𝐬. 𝟓. 𝟗%
𝟗𝟖. 𝟓𝟔
BEY - bond equivalent yield ➞ AOR for 365d
- all 180 day A. 𝐏𝐕 = 𝟏𝟎𝟎 × O𝟏 − 𝟏𝟖𝟎#𝟑𝟔𝟎 × . 𝟎𝟒𝟑𝟑P = 𝟗𝟕. 𝟖𝟑𝟓

A - DR = 4.33, 360d 𝟏𝟎𝟎 − 𝟗𝟕. 𝟖𝟑𝟓
𝐀𝐎𝐑 = H𝟑𝟔𝟓#𝟏𝟖𝟎I L M = 𝟒. 𝟒𝟖𝟕%
𝟗𝟕. 𝟖𝟑𝟓
B - DR = 4.36, 365d
C - AOR = 4.35, 360d B. 𝐏𝐕 = 𝟏𝟎𝟎 × H𝟏 − 𝟏𝟖𝟎#𝟑𝟔𝟓 × . 𝟎𝟒𝟑𝟔I = 𝟗𝟕. 𝟖𝟒𝟗𝟖𝟔
D - AOR = 4.45, 365d 𝟏𝟎𝟎 − 𝟗𝟕. 𝟖𝟒𝟗𝟖𝟔

𝐀𝐎𝐑 = H𝟑𝟔𝟓#𝟏𝟖𝟎I L M = 𝟒. 𝟒𝟓𝟔%
𝟗𝟕. 𝟖𝟒𝟗𝟖𝟔
ok!
C. 𝐅𝐕 = 𝟏𝟎𝟎 × O𝟏 + 𝟏𝟖𝟎#𝟑𝟔𝟎 × . 𝟎𝟒𝟑𝟓P = 𝟏𝟎𝟐. 𝟏𝟕𝟓
𝟏𝟎𝟐. 𝟏𝟕𝟓 − 𝟏𝟎𝟎
𝐀𝐎𝐑 = H𝟑𝟔𝟓#𝟏𝟖𝟎I L M = 𝟒. 𝟒𝟏%
𝟏𝟎𝟎
Page 24
⇒ Maturity structure of interest rates/ LOS i
yield - define
maturity structure for bonds with the
- compare
or same currency credit risk
M.M128348126.
yield term structure liquidity tax status

curve same coupon (reinvestment
time to risk held constant)
maturity
government bond spot curve ➞ YTMs for zero-coupon bonds for a
(a.k.a. zero or strip curve) full range of maturities
upward sloping ➞ normal ➞ longer maturities have higher YTMs
downward sloping ➞ inverted
- no coupon ➞ no reinvestment risk, but/ most bonds have coupons
∴ need a term structure for coupon paying bonds, but/ older bonds
may have different tax/liquidity status ∴ use on-the-run bonds,
but/ there is limited data for the full range of maturities
∴ interpolate between dates
38
Page 25
⇒ Maturity structure of interest rates/ LOS i
- typically stated on - define
a semi-annual bond basis - compare
- observed yields on recently issued ‘on-the-run’

coupon paying bonds
- gov’t. bond yield - 1 mos., 3 mos., 6 mos. ➞ money market, all converted
curve, coupon bonds to BEY (semi-annual basis)
⇒ Par Curve - sequence of YTMs such that each
bond is priced at par
- par rates are derived from spot rates
spots 𝐏𝐌𝐓 + 𝟏𝟎𝟎
𝟏𝟎𝟎 = PMT = 5.263%
1 yr. - 5.263% 𝟏. 𝟎𝟓𝟐𝟔𝟑
2 yr. - 5.616% 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝟏𝟎𝟎
𝟏𝟎𝟎 = + PMT = 5.606
𝟏. 𝟎𝟓𝟐𝟔𝟑 (𝟏. 𝟎𝟓𝟔𝟏𝟔)𝟐
3 yr. - 6.359%
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝟏𝟎𝟎
4 yr. - 7.008% 𝟏𝟎𝟎 = + + PMT = 6.306
𝟏. 𝟎𝟓𝟐𝟔𝟑 (𝟏. 𝟎𝟓𝟔𝟏𝟔)𝟐 (𝟏. 𝟎𝟔𝟑𝟓𝟗)𝟑
etc…
Page 26
⇒ Maturity structure of interest rates/ LOS j
Forward curve ➞ based on forward rates - define
- calculate
➞ agreed on today, received/paid in the future
➞ quoted as ‘when, what’
e.g./ 2y5y ➞ an agreement on a rate, when ➞ in 2 years
f(2,5) more common what ➞ a 5 yr. rate
M.M128348126.
- implied forward rates are calculated from spot rates

spots f(3,1) 3.65% f(3,1)
3 yr. = 3.615%
4 yr. = 4.18%
4.18%
. 𝟎𝟒𝟏𝟖 𝟖 . 𝟎𝟑𝟔𝟓 𝟔 𝐟(𝟑, 𝟏) 𝟐
semi-annual L𝟏 + M = L𝟏 + M L𝟏 + M
𝟐 𝟐 𝟐
bond basis 𝟏-
(𝟏. 𝟎𝟐𝟎𝟗)𝟖 𝟐
\] ^ − 𝟏_ = 𝐟(𝟑, 𝟏) = . 𝟎𝟐𝟖𝟖𝟗𝟏𝟒𝟓𝟐 × 𝟐
(𝟏. 𝟎𝟏𝟖𝟐𝟓)𝟔
= . 𝟎𝟓𝟕𝟕𝟖𝟐𝟗
39
Page 27
⇒ Maturity structure of interest rates/ LOS j
- define
forward
- calculate
spot
par
par
spot
forward
- forward curve is a series of 1 yr. forward rates ➞ f(1,1), f(2,1), f(3,1)

- forward rates are also referred to as break-even etc…
rate or no-arbitrage rates
Pricing/ - using spots 𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕
+ +
- 3 yr. annual (𝟏 + 𝐫𝟏 ) (𝟏 + 𝐫𝟐 )𝟐 (𝟏 + 𝐫𝟑 )𝟑
𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕
- using forwards (𝟏 + 𝐫 ) + (𝟏 + 𝐫 )(𝟏 + 𝐟(𝟏, 𝟏)) + (𝟏 + 𝐫 )(𝟏 + 𝐟(𝟏, 𝟏))(𝟏 + 𝐟(𝟐, 𝟏))
𝟏 𝟏 𝟏
Page 28
⇒ Yield Spreads/ LOS k
- compare
microeconomic - calculate
factors - interpret
in bps - issuer and the bond
itself
can affect credit risk
as well
M.M128348126.
macroeconomic
factors
- general economic growth,
business cycle, fiscal and
varies across financial markets monetary policy
➞ fixed rate bonds often use gov’t. benchmark security (usually the
most recently issued ‘on the run’ security) ⇒ G-spread
➞ floating ➞ typically an interbank rate (e.g. Libor)
40
Page 29
US, UK, Japan ➞ spread over the benchmark for fixed - compare
rate securities is the G-spread (risk free) - calculate
- interpret
EUR ➞ benchmark is EUR interest swap rates ➞ I-spread
➞ spread over the standard swap rate in any currency
fixed Libor swap rates (risky)
- for both the G-spread & I-spread, all cash flows are discounted
at the same rate
- Z-spread ➞ a constant spread over a government spot curve (or
swap
zero volatility spread ➞ zero interest rate volatility curve)
𝐏𝐕 = + + ⋯+
(𝟏 + 𝐫𝟏 + 𝐳) (𝟏 + 𝐫𝟐 + 𝐳)𝟐 (𝟏 + 𝐫𝐧 + 𝐳)
option adjusted spread = Z-spread - option value (in bps)
Page 30
- compare
e.g./ 6% annual corporate, 2 yrs. to maturity @ 100.125
- calculate
2 yr., 4% annual gov’t. bond @ 100.750 - interpret
r(1) = 2.10% r(2) = 3.635%
1. G-spread: corporate bond YTM = 5.932%
M.M128348126. (N = 2, PMT = 6, FV = 100, PV = -100.125)
gov’t. bond YTM = 3.605
(N = 2, PMT = 4, FV = 100, PV = -100.175)
G-spread = 5.932% - 3.605% = 2.327% or 232.7 bps
2. Z-spread ➞ demonstrate that Z-spread = 234.22 bps
𝟔 𝟏𝟎𝟔
+ = 𝟏𝟎𝟎. 𝟏𝟐𝟓
(𝟏 + . 𝟎𝟐𝟏 + . 𝟎𝟐𝟑𝟒𝟐𝟐) (𝟏 + . 𝟎𝟑𝟔𝟑𝟓 + . 𝟎𝟐𝟑𝟒𝟐𝟐)𝟐
41
Introduction to Asset-Backed Securities
a. explain benefits of securitization for economies and financial markets
b. describe securitization, including the parties involved in the process and the
roles they play
c. describe typical structures of securitizations, including credit tranching and

time tranching
d. describe types and characteristics of residential mortgage loans that are

typically securitized
e. describe types and characteristics of residential mortgage-backed securities,

including mortgage pass-through securities and collateralized mortgage
obligations, and explain the cash flows and risks for each type
f. define prepayment risk and describe the prepayment risk of mortgage-

backed securities
g. describe characteristics and risks of commercial mortgage-backed securities
h. describe types and characteristics of non-mortgage asset-backed securities,

including the cash flows and risks of each type
M.M128348126.
i. describe collateralized debt obligations, including their cash flows and risks
j. describe characteristics and risks of covered bonds and how they differ from
other asset-backed securities
42
Benefits of Securitization
Regulated Institutions Economy Financial Markets

cost savings greater credit access to liquid
⇒ avoid capital availability investment &
maintenance req. (banks are not payment streams
⇒ lower reserve limited by capital or otherwise unavailable
requirements risk concentration) assets of SPV have
⇒ lower deposit less concentration bankruptcy remoteness
insurance premiums risk - will carry
additional source of higher credit rating
funding (lower cost) than originator
Investors
⇒ SPV typically rated
higher risk-adjusted wide choice of
higher than originator
returns investment profiles
increased loan
origination diversification
Securitization
Page 1
Physical
Bond
asset
Investors
General Debenture
M.M128348126. claim
Auto
pool Asset-Backed
Home Investors
of Security
assets
Credit Card
Receivables
Student Loans
credit sensitive
43
Page 2
buy a
Customer product Consumer Co. ⇒ originator
⇒ may also be
makes a flow through
credit criteria servicer
loan (- fee)
(underwriting standards) collecting
sells cash repossessing
loans liquidating
sell
securities Consumer Asset
Investor (ABS)
⇒ special
Trust (SPV)
interest purpose
+ cash vehicle
principal
Page 3
Seller ⇒ originator of the loans (Consumer Co.)
Issuer/Trust ⇒ SPV (Consumer Asset Trust)
Servicer ⇒ Collections, etc. (Consumer Co.)

Others ⇒ Lawyers, Underwriters, Accountants, Rating Agencies,
Trustees
Documents
Prospectus ⇒ ‘waterfall’ – priority and amounts of
M.M128348126.
payments
service fees admin. fees
principal interest
Purchase Agreement (Seller ➞ SPV)
Waterfall Structure
Servicing Agreement (Servicer & SPV)
44
Bonds Issued
Page 1
Asset1 Senior tranche

$80M
Asset2
Libor + 60 bps
Asset3
SPV
Mezzanine tranche credit
Assetn $15M tranching
Principal Libor + 250 bps
$100M
Equity tranche
$5M
Libor + 1000 bps
⇒ redistributes credit risk
Page 2
Assets Senior tranche (80%) – easy to sell

an ABS of an ABS
Mezzanine tranche (15%)
Senior tranche (65%)
- hard to sell
‘AAA’
M.M128348126. Equity tranche (5%) Mezzanine tranche (25%)
retained by originator ‘BB’
or sold to hedge fund Equity tranche (10%)
‘C’
End Result: ⇒ the mezzanine tranche is
80% + 65%(15%) repackaged with other mezzanine
= 89.75% of asset tranches
‘AAA’ - easy to
pool is rated ‘AAA’ sell
45
Page 3
e.g./ Bond Class Par Value
A1 $ 40M
n each would have different
io A2 30M
o nat
n d i A3 20M terms to maturity and yields
bor
su A4 10M
Sequential–pay
- each bond class receives periodic interest
- However: principal is repaid as follows:
- all principal to A1 until paid in full
- next is A2 until paid in full
etc…
Redistributes prepayment risk ⇒ Called ‘Time Trancing’
or
‘Prepayment Trancing’`
Page 4
e.g./ Bond Class Par Value
A1 $35M
A2 28M time
AAA
A3 15M
+ credit tranching
M.M128348126.
A4 12M
BB B (subordinate) 7M
C C (subordinate) 3M
$100M
Class (or tranche) A suffers no loss if defaults < $10M

- Class C absorbs losses first
referred to as ‘first piece loss’
46
SPV vs. Originator
Originator Co. ⇒ Balance Sheet Loans stay on

to Cash… Originator Co.’s
finance
sells bonds Balance Sheet
Loans
Versus
Originator Co.
SPV sells securities
Balance Sheet Loans ⇒ lower cost
Cash… ⇒ higher rating
Loans - loans leave Originator Co.’s

Balance Sheet (legally segregated)
Residential Mortgage Loans

Page 1
Property maturity ∼ 30 yrs.

Conventional
Lender
Credit of Mortgage
Borrower + morg. insurance Loan-to-Value (LTV)
M.M128348126.
perhaps
payments to Ratio = 𝐦𝐨𝐫𝐭𝐠𝐚𝐠𝐞
lender principal 𝐩𝐫𝐨𝐩𝐞𝐫𝐭𝐲 𝐯𝐚𝐥𝐮𝐞
interest
May include prepayments:
payment in full
payments made in
excess of regular partial payments ⇒ curtailments
payments
47
Page 2
Prepayments ⇒ amount & timing of cash flows is not known
with certainty (prepayment risk)
𝐭=0 𝐭 = 30
if repaid in full or if
lockout period
prepayment > some certain amt.
penalty period
= penalty
(usually X months interest)
Interest Rate Determination
Fixed Rate, Level Payment, Fully Amortizing
ceiling
Adjustable Rate Mortgages (ARMs)
floor
Others: Initial Period Fixed Rate, then floating
: Teaser + Reset
: Convertible (Fixed ➞ Floating) or reverse
Page 3
Amortization Schedule
e.g. Fixed Rate, Level Payment, Fully Amortizing
⇒
6% equal payments last payment,

of interest + balance = $0
Principal
i.e. 30-yr., $200K @ 6%

Balance Principal Int. Amortized
M.M128348126.
N = 30 × 12 = 360 $200,000 199.10 1000 $199,800.90

FV = 0 199,800.90 200.10 999 199,600.80
PV = 200,000 etc…
𝐈# = .5%
𝐘
CPT PMT = -1,199.10
1,193.10 1193.10 6 Ø
48
Page 4
𝒊 Principal
Interest-service fee
security holder
par value of gets net interest or
collateral net coupon
𝐭=0 30 yrs.
Rights of Lender in a Foreclosure
recourse non-recourse
all assets of the - borrowers walk away
borrower can be used
to make the lender
whole
Residential MBS
3 ‘credit guarantee’ sectors: MBS guaranteed by -

1) federal agency
- Government National Mortgage Association
(Ginnie Mae or GNMA)
M.M128348126.
2) government sponsored agencies

agency MBS
- Federal National Mortgage Association
(Fannie Mae or FNMA)
- Federal Home Loan Mortgage Corporation
(Freddie Mae or FHLMC)
3) private entities
- Banks non-agency MBS
49
Mortgage Pass-Through Securities

Page 1
mortgage rate – fees = passthrough rate
mortgage1
pool securities sold to investors
mortgagen principal pass through
+
monthly payments interest
less servicing
and other fees
principal
interest To be included in the pool, each
prepayments mortgage must meet certain
penalties underwriting standards
size
not all mortgages have docs required
the same rate conforming
max. LTV
insured versus non-conforming
Page 2
Not all mortgages have the same rate or time left
e.g. Mortgage Balance Weight Rate Time Left
1 $125k 22.12% 7.5% 275
2 85k 15.04% 7.2% 260
M.M128348126. 3 175k 30.97% 7% 290
4 110k 19.47% 7.8% 285
5 70k 12.39% 6.9% 270
$565k 100% 7.28% 279 months
Weighted-average coupon rate (WAC)
WAC = .2212(7.5%) + .1504(7.2%) + .3097(7%) + .1947(7.8%)
+ .1239(6.9%) = 7.28%
Weighted average maturity (WAM)
WAM = .2212(275) + .1504(260) + .3097(290) + .1947(285)
+ .1239(270) = 279 months
50
Page 3
Measuring the Prepayment Rate (Speed)
- Single Monthly Mortality Rate (SMM)
𝐩𝐫𝐞𝐩𝐚𝐲𝐦𝐞𝐧𝐭 𝐢𝐧 𝐦𝐨𝐧𝐭𝐡 𝐭
𝐒𝐌𝐌𝐭 =
𝐁𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠 𝐦𝐨𝐧𝐭𝐡𝐥𝐲 𝐛𝐚𝐥𝐚𝐧𝐜𝐞 𝐟𝐨𝐫 𝐦𝐨𝐧𝐭𝐡 𝐭 − 𝐬𝐜𝐡𝐞𝐝𝐮𝐥𝐞𝐝
𝐩𝐫𝐢𝐧𝐜𝐢𝐩𝐚𝐥 𝐩𝐚𝐲𝐦𝐞𝐧𝐭𝐬 𝐟𝐨𝐫 𝐦𝐨𝐧𝐭𝐡 𝐭
e.g. 𝟏, 𝟖𝟒𝟏, 𝟑𝟒𝟕
Beg. Bal.33 = $358,326,766 𝐒𝐌𝐌𝟑𝟑 =
𝟑𝟓𝟖, 𝟑𝟐𝟔, 𝟕𝟔𝟔 − 𝟐𝟗𝟕, 𝟖𝟐𝟓
Sched. Prin.33 297,825
= . 𝟓𝟏𝟒𝟑%
Prepay33 1,841,347
⇒ if SMM is assumed, the
- based on historical observations
Prepay Amt.33 = SMM33 × (Beg. Bal.33
of actual activity in month 33
– Sched. Prin.33)
Page 4
Conditional Pre Payment Rate (CPR)
⇒ the annualized SMM
1 – SMM ⇒ what is
CPR = 1 – (1 - SMM)12
NOT being
1 – what is NOT being prepaid
prepaid for the year (1 – SMM)12 – for the
= what is being prepaid for year
the year
M.M128348126.
i.e. SMM = .005143 ∴ 6% of beg. yr. principal
CPR = 1 – (1 - .005143)12 will be prepaid during
the year over and
= 1 – (.994857)12
above regular principal
= .06 or 6%
payments
51
Page 5
PSA Prepayment Rate referred to as 100% PSA
or 100 PSA
Public
Securities
Association
6%
𝐭=0 30
assumes CPR of .2% in month 1 + .2% each additional
month
up to 6% (30 months) ⇒ 6% thereafter
0 PSA = no prepayments
100 PSA = prepayments at the same speed as the benchmark
⇒ less than 100 = slower more than 100 = faster
Page 6
Cash Flow Construction
if 𝐭 < 30, then CPR = 6% c𝐭$𝟑𝟎d
𝐭 ≥ 30, then CPR = 6%
∴ for month 5, CPR = .06R𝟓.𝟑𝟎W = .01 or 1% annual
and CPR = 1 - (1 – SMM)12
M.M128348126. (𝟏 − 𝐒𝐌𝐌)𝟏𝟐 = 𝟏 − 𝐂𝐏𝐑
𝟏
𝟏 − 𝐒𝐌𝐌 = (𝟏 − 𝐂𝐏𝐑) -𝟏𝟐 𝟏-
𝟏 = 𝟏 − (𝟏 − . 𝟎𝟏) 𝟏𝟐
𝐒𝐌𝐌 = 𝟏 − (𝟏 − 𝐂𝐏𝐑) -𝟏𝟐
− . 𝟎𝟎𝟎𝟖𝟑𝟕
for month 5, PSA = 165
Note: Applied to CPR, not SMM
CPR = .06R𝟓.𝟑𝟎W = .01
165 PSA = 1.65(.01) = .0165
𝟏& 𝟏&
𝐒𝐌𝐌𝟓 = 𝟏 − (𝟏 −. 𝟎𝟏𝟓𝟓) 𝟏𝟐 = 𝟏 − ( . 𝟗𝟖𝟑𝟓) 𝟏𝟐 = . 𝟎𝟎𝟏𝟑𝟖𝟔
52
Page 7
e.g. $400M, 7.5% Pass-through, WAC of 8.125%, WAM = 357 months
100PSA 165PSA MH SPV SH
Months from Months Beg.

now Seasoned Balance SMM PMT 𝐢 Principal
.000669 2,975,868 $2.5M 267,535
1 4 $400,000,000
N = 357
.001106
2 5 399,464,995 PV = 400M
399,290,077 FV = 0
𝐈3 = 𝟖. 𝟏𝟐𝟓3
𝐘 𝟏𝟐
Total Cash 𝐂𝐏𝐑 = 𝟔%Z𝟒.𝟑𝟎[ = . 𝟖%

Prepayment Principal Flow 𝟏
𝐒𝐌𝐌𝟒 = 𝟏 − (𝟏 − . 𝟎𝟎𝟖) -𝟏𝟐
267,470 535,005 3,035,005 = . 𝟎𝟎𝟎𝟔𝟔𝟗
442,389 709,923 3,209,923 𝟏𝟔𝟓 𝐏𝐒𝐀 = 𝟏. 𝟔𝟓(. 𝟎𝟎𝟖) = . 𝟎𝟏𝟑𝟐
𝟏
𝐒𝐌𝐌𝟒 = 𝟏 − (𝟏 − . 𝟎𝟏𝟑𝟐) -𝟏𝟐
= . 𝟎𝟎𝟏𝟏𝟎𝟔
Page 8
Weighted Average Life 𝐓
𝐭 × 𝐏𝐫𝐨𝐣𝐞𝐜𝐭𝐞𝐝 𝐩𝐫𝐢𝐧𝐜𝐢𝐩𝐚𝐥 𝐫𝐞𝐜𝐞𝐢𝐯𝐞𝐝 @ 𝐭
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐋𝐢𝐟𝐞 = Z
𝟏𝟐 × 𝐓𝐨𝐭𝐚𝐥 𝐏𝐫𝐢𝐧𝐜𝐢𝐩𝐚𝐥
𝐢*𝟏
PSA Speed 50 100 165 200 300 400 500 600

Average Life 15.11 11.66 8.76 7.68 5.63 4.44 3.68 2.78
M.M128348126.
depends on prepayment assumption

= if mortgage rate drop, refinancing ↑, Prepayments ↑
∴
PSA Speed ↑, Average Life ↓
➞ Called Contraction Risk
= if mortgage rates rise, refinancing ↓, Prepayments ↓
∴
PSA Speed ↓, Average Life ↑
⇒ Called Extension Risk
53
Page 9
Pre-payment Risk
Contraction Risk Extension Risk
arises
decreasing rates from
increasing rates
shorter average life results longer average life

greater cash flows in minimum cash flows
price will not rise by Adverse price will fall at

as much as an Condition #1 about the same rate
option-free bond as an option-free bond
lower re-investment Adverse lower cash flow for
of cash flow Condition #2 reinvestment
Collateralized Mortgage Obligation – CMO

Page 1
Note: Prepayment
Pool of Bond Class 1 risk is not eliminated,
time
Pass-through only redistributed
Bond Class 2 tranches
Mortgage
Securities Bond Class 3
collateral different maturities
different yields
M.M128348126. Sequential-Pay Tranches
⇒ all Principal payments ⇒ Bond Class 1
⇒ when fully paid, then Bond Class 2
etc…
⇒ each Bond Class will get paid interest as per
contractual agreement
54
Page 2
$400M, 7.5% pass-through, WAC = 8.125%, WAM = 357 months
Principal Paydown Window

A month 1 ➞ month 81
B month 81 ➞ month 100 @ 165 PSA
C month 100 ➞ month 178
D month 178 ➞ month 357
Original average life was 8.76 years @ 165 PSA

(of the collateral)
A ⇒ 3.42 average life shorter than average life of

- protection from extension risk collateral
B ⇒ 7.54
(provided by C&D)
C ⇒ 11.58 average life longer
D ⇒ 22.29 - protection from contraction risk
(provided by A&B)
Page 3
Planned Amortization Class (PAC) & Support Tranches
e.g. $400M 7.5% Pass-Through, WAC = 8.125%, WAM = 357 months
- assumptions of an
Min.
upper & lower PSA Month @ 90PSA @ 300PSA Pr. PMT
1 508,169 1,075,391 508,169
M.M128348126. lower PSA – 90 2 569,843 1,279,412 569,843
3 631,377 1,482,194 631,377
initial PAC collar/bond
upper PSA – 300 211 949,482 213,309 213,309

213 946,083 209,409 209,409
offers both contraction
etc…
& extension risk support tranches get
(two-sided prepayment $ over min. Pr. PMT
protection)
55
Page 4
Floating-rate tranches - collateral pays a fixed rate
Solution: the CMO still gets a fixed-$ interest amount
➞ split into a floating & inverse floating portion
e.g. $96.5M @ 7.5% (Total int. = 95.5 × .075 = $7,237,500)

FL – 72,375,000 (75%) 1-month Libor + 50bps
IFL – 24,125,000 (25%) K – L × (1–month Libor)
leverage 𝟕𝟓%#
max. int. occurs when Libor = 0% 𝟐𝟓% = 3
FL ⇒ $361,875 So, Libor @ 3.75%
IFL ⇒ 6,875,625 FL ⇒ 4.25%
= 28.5% (k)
24,125,000 IFL ⇒ 28.5 – 3(3.75) = 17.25%
𝟕, 𝟐𝟑𝟕, 𝟎𝟎𝟎
IFL floor = 0%, FL cap rate = = 10% 9.5%
𝟕𝟐, 𝟑𝟕𝟓, 𝟎𝟎𝟎
Page 5
Which tranche in a CMO structure is most suitable for:
1. Investor concerned about contraction risk
sequential pay ⇒ last tranche
2. Investor looking for stable average life

PAC tranche slow
M.M128348126. fast
3. Investor expecting rates to fall
Inverse floater
4. Investor ok with prepayment risk for high expected

return support tranche (of PAC)
56
Non-Agency Residential MBS

Page 1
Agency ⇒ Prepayment risk – conforming mortgages
- Explicit/Implicit Gov’t. guarantee
Non-agency ⇒ Credit + Prepayment risk
- can include non-conforming loans
Cash flows ⇒ waterfall (credit tranching)
⇒ realized losses (priority of claims)
subordinate before senior
forecasting requires assumptions about default rates as well
as prepayment rates
Credit Rating ⇒ usually require credit enhancements
Internal: senior/subordinate structure
i.e. A - senior $ 90M
B - sub. 7M - provides credit support for A
C - sub. 3M - provides credit support for B & A
Page 2
Internal Credit Enhancements Cont.
Reserve Funds
cash reserve funds ⇒ part of underwriting profits deposited
in a fund
excess spread accounts ⇒ WAC = 8%, service = .25%
M.M128348126. net passthrough = 7.25% 50 bps excess spread
Overcollateralization $105M ➞ SPV ➞ sells $100M
External Credit Enhancements
Financial guarantee by a third party
- typically monoline insurance co. - securities said
up to a specified amt. to be ‘wrapped’
i.e. $100M security issue, 5% guarantee
⇒ Covers first $5M in losses
57
Commercial MBS
Page 1
Income pool of
producing commercial CMBS
assets mortgages
apt. buildings
non-recourse loans
office prop.
∴ credit analysis involves
malls
analysis of cash flows
industrial parks
etc…
on a long-by-loan basis
debt-to-service coverage ratio loan-to-value ratio
𝐍𝐎𝐈 𝐋𝐨𝐚𝐧
higher = better
𝐝𝐞𝐛𝐭 𝐬𝐞𝐫𝐯𝐢𝐜𝐞 𝐀𝐩𝐩𝐫𝐚𝐢𝐬𝐞𝐝 𝐕𝐚𝐥𝐮𝐞
can be
𝐜𝐨𝐬𝐭𝐬
‘gamed’
Page 2
⇒ if DSC & LTV ratios are not sufficient for a rating,
subordination is used
⇒ rating agencies will require sequential retirement
∴ losses from defaults will be charged
against lowest priority tranche
M.M128348126.
(first loss piece, equity tranche,

Call Protection ⇒ at loan level residual tranche)
1) prepayment lockout 2-5 yrs.

2) defeasance ⇒ borrower purchases securities as
collateral to cover remaining principal balance + an
amount to substitute for what the yield would have been
(Defeasance premium)
58
Page 3
Call Protection – con’t.
3) Prepayment penalty points i.e. 5 - 4 - 3 - 2 - 1
⇒ if borrower wishes to prepay in Year 1, must pay 105%
2 104%
4) Yield maintenance charges etc…
a.k.a. – make whole charge ⇒ if refinanced to get lower rate,
borrower must make ‘yield’ whole
at structure level ⇒ Credit Tranching
Balloon Maturity Provisions – at end of term of loan
- borrower may not be able to - refinance
balloon risk
- lender will most likely - sell
- pay ‘extension risk’
extend the loan
Auto-Loan Backed Securities

Page 1
typically issued by: - financial subsidiaries of auto manufactures
- commercial banks often below
market rates
- independent finance companies
Prime
high credit quality ⇒ secured Moody’s
⇒ begin to repay Pr. + 𝒊 immediately < 3%
⇒ short-term in nature losses
M.M128348126.
⇒ originated by fin. subs. of auto man. cos.
Sub-Prime > 7%
- not as clear as home loans (near prime 3-7%)
Cash Flows – Principal + interest + prepayments (amortizing loans)
sale & trade-ins
repossession and sale (business cycle related)
Prepayments loss or destruction (insurance)
early retirement
refinancing ⇒ minimal
59
Page 2
⇒ all ALB Securities have some form of credit
enhancement
A - senior
⇒ Credit tranching B - mezzanine
C - equity (subordinate)
⇒ Reserve Account $5M on $100M
⇒ Overcollateralization $100M issued against $105M
⇒ Excess Interest - 8.5% - 1% = 7.5% but pays

WAC - servicing 6.75%
⇒
.75% excess
spread
Credit-Card Receivable-Backed Securities

Page 1
Visa/MC/Amex
SPV Securities
Sears/Target
receivables interest (monthly, quarterly)
finance charges fixed or floating
cash flow fee (50% - uncapped)
to SPV principal
M.M128348126.
Note: Non-Amortizing finance charges

(18 mos. - 10 yrs.)
lockout period fees
principal
revolving period
𝐭=0 𝐭*
any principal payments received are retained by the trustee
and re-invested in additional receivables to maintain the size
of the pool
60
Page 2
Payment Structure:
① Pass-through ⇒ principal paid to security holders on a
pro-rata basis
② Controlled Amortization ⇒ PAC structure
③ Bullet payment ⇒ entire amount of FV
Gross Portfolio yield – chargeoffs = Net Portfolio yield

(finance charges + fees) (bad debts)
Early Amortization Triggers

⇒ 3 month average excess spread ≤ 0 - the AAA first
- no more reinvestment AA next
etc…
Collateralized Debt Obligations (CDO)

asset (collateral) Page 1
US high yield corporates manager
structured financials (MBS/ABS) senior
asset securities mezzanine
emerging market bonds
pool equity
bank loans
distressed debt if only
if only
loans (CLO)
M.M128348126. bonds (CBO)
Asset Manager: buys/sells assets to generate cash flows

(cap. gains, interest)
⇒ has restrictive covenants
⇒ ability to pay interest pmts. to tranches depends
on the performance of the assets
interest payments
cash flows come from maturing assets
sale of assets
61
Page 2
fixed-rate
bonds SPV floating rate payments
some floating (one or more tranches)
rate bonds interest rate
swaps (fixed-for floating)
e.g. $100M CDO, fixed @ 11%, mgmt. fee = $640k
Senior $80M Libor + 70 bps 8% Libor

Collateral 6.4M Swap
Mezzanine 10M 9%
$11M
Equity 10M 4.6M
In Out 640k ⇒ Mgmt. Fee

Libor + 4.6M Libor + 560k ⇒ Senior
900k ⇒ Mezzanine
2.5M ⇒ Equity
assumes no
defaults.
Page 3
ramp-up period – mgr. buys assets
𝐭=0 𝐭 = 1 yr. 5 yr. . . . . n

assets sold
securities retired
M.M128348126. reinvestment period
(revolving) – proceeds are reinvested
capture
spread
CDO
cash CDO remove assets synthetic CDO
from sponsor BS.
Arbitrage * Balance * Arbitrage * Balance *
Driven Sheet Driven Driven Sheet Driven
Cash Flow Market Cash Flow

CDO Value CDO CDO * motivation ⇒ active
mgmt.
62
Covered Bonds
Page 1
- senior debt obligations issued by a financial institution and
backed by a segregated pool of assets
(commercial or residential mortgages)
- offer dual recourse asset pool (remains on issuer’s balance sheet)
financial institution
- one bond class per cover pool
- issuer must replace any prepaid or non-performing asset until
maturity of the covered bonds
- usually carry lower risk and lower yields than ABS
3 major redemption regimes
1/ hard bullet covered bonds - payments have to be made according
to the covered bonds original schedule
- if not paid on the Standard Maturity Date (SMD), investors
gain access to the cover pool
Page 2
3 major redemption regimes
2/ soft bullet covered bonds - pmts. must also be made according
to the covered bond’s original schedule
- if not, does not trigger default - extension period of
M.M128348126.
typically 12 months granted, creates a new
Final Maturity Date (FMD)
- if not paid then, investors gain access to the cover pool
3/ Conditional pass-through covered bonds (CPT) - pmts. must
also be made according to the original schedule
- if not, does not trigger default - covered bonds go
into pass-through mode
- cash flows and sales of assets are then
passed through to the covered bond investors as
they occur
63
Understanding Fixed-Income Risk and Return
a. calculate and interpret the sources of return from investing in a fixed-rate bond
b. define, calculate, and interpret Macaulay, modified, and effective durations
c. explain why effective duration is the most appropriate measure of interest rate
risk for bonds with embedded options
d. define key rate duration and describe the use of key rate durations in measuring
the sensitivity of bonds to changes in the shape of the benchmark yield curve
e. explain how a bond’s maturity, coupon, and yield level affect its interest rate
risk
f. calculate the duration of a portfolio and explain the limitations of portfolio

duration
g. calculate and interpret the money duration of a bond and price value of a basis
point (PVBP)
h. calculate and interpret approximate convexity and compare approximate and

effective convexity
i. calculate the percentage price change of a bond for a specified change in yield,
M.M128348126. given the bond’s approximate duration and convexity
j. describe how the term structure of yield volatility affects the interest rate risk of
a bond
k. describe the relationships among a bond’s holding period return, its duration,
and the investment horizon
l. explain how changes in credit spread and liquidity affect yield-to-maturity of a

bond and how duration and convexity can be used to estimate the price effect of
the changes
m. describe the difference between empirical duration and analytical duration
64
Sources of Return - Fixed Rate Bond
dit Page 1
cre ① Coupon payments + principal (on scheduled dates)
risk
② Reinvestment of coupon
rest
inte
rate ③ Capital gain/loss
risk
Example: 10-year, 8% annual @ 85.503075

YTM = 10.40%
𝟖 𝟖 𝟏𝟎𝟖
(PV) 𝟖𝟓. 𝟓𝟎𝟑𝟎𝟕𝟓 = + + ⋯+ r = 0.104
(𝟏 + 𝐫) (𝟏 + 𝐫) 𝟐 (𝟏 + 𝐫)𝟏𝟎
8 8(1.104)9 Total coupons $80

Interest-on
t=0 t=1 t=2 t=10 interest 49.970678
8 8(1.104)8 Principal 100
229.970678
8 85.503075 = (1.104)10
129.970678
Page 2
YTM assumes 1) held to maturity
2) No default
M.M128348126. 3) Coupons re-invested at same rate of interest
Now assume same bond ⇒ But sold after 4-years
t=0 t=4 t=10

FV(coupons) = 8(1.104)3 + 8(1.104)2 + 8(1.104) + 8 = 37.347111
PV of 6-year, 8% annual with YTM = 10.40% = 89.668770

𝟏𝟐𝟕. 𝟎𝟏𝟓𝟖𝟖𝟏
Total Return = = 85.503075 r = 10.40%
(𝟏 + 𝐫)𝟒
horizon yield.
Assumes ① coupons re-invested at 10.40%
② Bond is sold on the constant-yield price curve.
65
Page 3
100 -
carrying value ⇒ purchase price + amortized amt.
of the bond (85.503075) of the discount
Capital gain
Capital loss OR
“ “
89.668770
“ “ premium
80 -
𝐭
-
-
5 10
Now: Assume interest rates rise 100 bps (10.40% ⇒ 11.40%)
9 yrs.
8 11.4%
-
-
.
t = 0 t = 1 t = 10 .
.
.
(85.503075) .
.
136.380195
100
𝟐𝟑𝟔. 𝟑𝟖𝟎𝟏𝟗𝟓
𝟖𝟓. 𝟓𝟎𝟑𝟎𝟕𝟓 − r = 10.7%
(𝟏 + 𝐫)𝟏𝟎
Now: Assume interest rates rise 100 bps (10.40% ⇒ 11.40%) Page 4
Sold after 4 years FV of coupons at t = 4 37.899724 (+)
PV of 6-yr. bond at t = 4 85.780408 (-)
M.M128348126.
𝟏𝟐𝟑. 𝟔𝟖𝟎𝟏𝟑𝟐
𝟖𝟓. 𝟓𝟎𝟑𝟎𝟕𝟓 = = 𝟎. 𝟎𝟗𝟔𝟕
(𝟏 + 𝐫)𝟒
89.668770 – 85.780408 = 3.888362
Capital loss
4
Now: Assume interest rates fall 100 bps (10.40% ⇒ 9.40%)
Buy-and-Hold. Sold after 4-years
r = 10.10% r = 0.1117
· lower re-investment · lower re-investment of coupon

of coupon · Capital gain on sale of bond
interest rate risk interest rate risk
66
Interest Rate Risk
Duration ⇒ measures the sensitivity of the bond’s full Page 1
price to changes in the bond’s own yield

or, more generally, changes in the
benchmark rate
- assumes all other variables are held constant
⇒ represents approx. amount of time a

➞
PV bond would have to be held for the
market discount rate to be realized
e.g. 10-yr. 8% annual @ 85.503075, YTM = 10.4%
r ➞ Duration = 7.0029 ⇒ if rates ↑ (+) 𝐫𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐨𝐟
𝐜𝐨𝐮𝐩𝐨𝐧
(−) 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐥𝐨𝐬𝐬
= ∅ 𝐢𝐟 𝐡𝐞𝐥𝐝 𝐟𝐨𝐫 𝟕. 𝟎𝟎𝟐𝟗 𝐲𝐫𝐬.
- several types of bond duration/ Page 2
yield duration curve duration

- sensitivity of price to - sensitivity of price to
own YTM benchmark yield
gov’t. yield curve

e.g./ Macauley spot curve
modified forward curve
M.M128348126.
money ➞ par curve (often used)

price value for a (PVBP) - used with complex bonds
basis point and also with financial
assets/liabilities that
will require an have int. rate risk but are
option pricing model not bonds
e.g./ effective
67
Macaulay Duration/ Page 3
c𝟏 − 𝐭J𝐓d𝐏𝐌𝐓 c𝟐 − 𝐭J𝐓d𝐏𝐌𝐓 c𝐍 − 𝐭J𝐓d(𝐏𝐌𝐓 + 𝐅𝐕)

𝐭 + 𝐭 + ⋯+ 𝐭
(𝟏 + 𝐫)𝟏0 &𝐓 (𝟏 + 𝐫)𝟐0 &𝐓 (𝟏 + 𝐫)𝐍0 &𝐓
𝟏0𝐭&𝐓
+ 𝟐0𝐭&𝐓
+ ⋯+ 𝐭
(𝟏 + 𝐫) (𝟏 + 𝐫) (𝟏 + 𝐫)𝐍0 &𝐓
➞
𝐏𝐕 𝐟𝐮𝐥𝐥
closed-form/ 𝟏 + 𝐫 𝟏 + 𝐫 + [𝐍 × (𝐜 − 𝐫)] c = coupon

g − j − c𝐭J𝐓d
𝐫 𝐜 × [(𝟏 + 𝐫)𝐍 − 𝟏] + 𝐫
Page 4
annualized
modified duration/ e.g./ (AnnModDur)
𝐌𝐚𝐜𝐃𝐮𝐫 𝟕. 𝟎𝟎𝟐𝟗
𝐌𝐨𝐝𝐃𝐮𝐫 = = 𝟔. 𝟑𝟒𝟑𝟐
𝟏+𝐫 𝟏. 𝟏𝟎𝟒
interpretation/ - provides an estimate of the %’age

price change for a bond given a change
in its YTM (linear estimate)
➞
𝐟𝐮𝐥𝐥 annual yield
M.M128348126.
%𝚫𝐏𝐕 ≈ −𝐀𝐧𝐧𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐲𝐢𝐞𝐥𝐝
e.g./ if r = 11.4% instead of 10.4%

%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ −𝟔. 𝟑𝟒𝟑𝟐 × . 𝟎𝟏𝟎𝟎 = −𝟔. 𝟑𝟒𝟑𝟐% requires
a
r = 9.4% instead of 10.4%
convexity
%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ −𝟔. 𝟑𝟒𝟑𝟐 × −𝟎. 𝟎𝟏𝟎𝟎 = 𝟔. 𝟑𝟒𝟑𝟐% adjustment
68
𝐌𝐚𝐜𝐃𝐮𝐫 Page 5
So… if MacDur is known, 𝐌𝐨𝐝𝐃𝐮𝐫 =
(𝟏 + 𝐫)
- if MacDur is not known, we can approximate ModDur
(𝐏𝐕0 ) − (𝐏𝐕2 ) 𝐫𝐢𝐬𝐞
𝐀𝐩𝐩𝐫𝐨𝐱. 𝐌𝐨𝐝𝐃𝐮𝐫 = =
𝟐 × 𝚫𝐲𝐢𝐞𝐥𝐝 × 𝐏𝐕𝟎 𝐫𝐮𝐧
PV
Price-Yield Curve for small 𝚫yield
PV- ➞
ApproxModDur
PV0 =
AnnModDur
PVt -
ApproxMacDur
line tangent to
Price-Yield Curve = ApproxModDur
YTM
r + × (1+r)
Page 6
e.g./ 10-year, 8% annual @ 85.503075, YTM = 10.4%
(𝐏𝐕0 ) − (𝐏𝐕2 ) 𝟖𝟔. 𝟖𝟕𝟑𝟖𝟖 − 𝟖𝟒. 𝟏𝟔𝟏𝟖𝟏𝟗
𝐀𝐩𝐩𝐫𝐨𝐱𝐌𝐨𝐝𝐃𝐮𝐫 = =
𝟐 × 𝚫𝐲𝐢𝐞𝐥𝐝 × 𝐏𝐕𝟎 𝟐 × (. 𝟎𝟎𝟐𝟓) × 𝟖𝟓. 𝟓𝟎𝟑𝟎𝟕𝟓
𝟐. 𝟕𝟏𝟐𝟎𝟔𝟐𝟑
up 25 bps down 25 bps =
. 𝟒𝟐𝟕𝟓𝟏𝟓
10 N 10
M.M128348126.
8 PMT ➞ 8 = 𝟔. 𝟑𝟒𝟑𝟕𝟕
100 FV 100 vs.
10.65 I/Y 10.15
84.161819 + PV - 86.87388 6.3432
∴ if rates ↑ 50bps
%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ −𝐀𝐩𝐩𝐫𝐨𝐱𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐲𝐢𝐞𝐥𝐝 = −𝟔. 𝟑𝟒𝟑𝟕𝟕 × . 𝟎𝟎𝟓 = −𝟑. 𝟏𝟕%
69
Page 7
Effective Duration/ (𝐏𝐕0 ) − (𝐏𝐕2 )
𝐄𝐟𝐟𝐃𝐮𝐫 =
𝟐 × 𝚫𝐜𝐮𝐫𝐯𝐞 × 𝐏𝐕𝟎
- used for complex bonds with embedded options
Value of the embedded - requires on option

PV- Call option pricing model for
➞
(PV-)
PV0
Non-Callable Bond (thus, Macaulay &

PVt modified duration are
useless)
Callable Bond
- r +
Effective Duration/ (𝐏𝐕0 ) − (𝐏𝐕2 ) Page 8

- for a callable bond/ may be called if
credit
decreases 𝚫credit duration
spread
or
M.M128348126.
➞
benchmark decreases 𝚫curve duration
yield
- also used for FRNs, MBS, DBPP (retirement obligations)
homeowner’s have a
call option
70
Q: Does a 𝚫curve = 𝚫yield? Page 9
i.e./ EffDur = ModDur on a fixed-rate, non-callable

bond?
𝚫curve is
ModDur vs. EffDur
based on
6.3492 6.0046
spot curve par curve
- when par curve is shifted, spot curve is

also shifted, but not in a parallel
manner
- flatter the par curve

- shorter the bond EffDur ≈ ModDur.
- close price is to par
Key Rate Duration

Page 1
EffDur ⇒ assumes a parallel shift in LOS d
the yield curve - define
M.M128348126.
- if the yield curve shifts in a non-parallel manner, - describe
a portfolio’s EffDur cannot be used to estimate %𝚫𝐏𝐨𝐫𝐭. 𝐕𝐚𝐥𝐮𝐞
r
2 < 𝚫𝐜𝐮𝐫𝐯𝐞 × 𝐏𝟎
key-rate duration is the duration
at a specific maturity on the yield
➞
curve
∴ for a non-parallel shift in
r- the yield curve, key-rate
bps ⇒ 𝚫𝐜𝐮𝐫𝐯𝐞 duration must be used to
estimate %𝚫𝐏𝐨𝐫𝐭. 𝐕𝐚𝐥𝐮𝐞
r-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
Maturity
71
Page 2
r LOS d
- define
- describe
r-
Key Rate Duration
(𝐏𝐕0 ) − (𝐏𝐕2 )
r- =
➞ 𝟐 × 𝚫𝐫𝐚𝐭𝐞 × 𝐏𝟎
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
Maturity 𝚫yield
𝚫curve
11 maturities
𝟏𝟏
- a key rate durationi is
g=
calculated for each = EffDur
𝐢7𝟏
EffDur ∑=𝟏
maturity
𝐌𝐚𝐭 𝟏 𝐌𝐚𝐭 𝟐 𝐌𝐚𝐭 𝟏𝟏

%𝚫𝐏𝐨𝐫𝐭𝐕𝐚𝐥𝐮𝐞 = 𝐊𝐞𝐲𝐑𝐚𝐭𝐞𝐃𝐮𝐫𝟏 q r + 𝐊𝐑𝐃𝟐 q r + ⋯ + 𝐊𝐑𝐃𝟏𝟏 q r
𝐏𝐨𝐫𝐭. 𝐕. 𝐏𝐨𝐫𝐭. 𝐕. 𝐏𝐨𝐫𝐭. 𝐕.
Page 3
𝐌𝐚𝐜𝐃𝐮𝐫 𝟏+𝐫 𝟏 + 𝐫 + [𝐍 − (𝐂𝐜 − 𝐫)] 𝐭
(𝐃𝐦𝐚𝐜 ) = h 𝐫 − i 𝐜 × [(𝟏 + 𝐫)𝐍 − 𝟏] + 𝐫 mn − Z .𝐓[
Dmac = f(c, r, N, t)
① 𝚫𝐭 ⇒ c, r, N - constant
M.M128348126.
D D zero coupon
bond
𝟏7𝐫 Discount
(N – 1) each date Perpetuity
𝐫
➞ Premium
45° time–to
time–to
-
-
coupon
-
-
-
maturity maturity
payment
Z𝐭.𝐓 = 𝟎[
dates 𝐏𝐌𝐓 D↑
𝐏𝐌𝐓 + 𝐅𝐕
⇒ low coupon bond ⇒ higher D (𝟏 + 𝐫)
∴ more interest rate risk
⇒ low YTM = higher D
➞ larger weights
72
Example/ Page 4
C PV YTM
A 10 yr. 58.075279
-
annual
B 20 yr. 10% 51.304203 20%
C 30 yr. 50.210636
-
⇒ +/- 1 bps
A B C
PV0 = 58.075279 PV0 = 51.304203 5.063
PVt = N = 10 PMT = 10 ➞ PVt = N = 20 PMT = 10
FV = 100 I/Y = 20.01 FV = 100 I/Y = 20.01
CPT PV = 58.047598 CPT PV = 51.277694
PV_ = N = 10 PMT = 10 PV_ = N = 20 PMT = 10
FV = 100 I/Y = 19.99 FV = 100 I/Y = 19.99
CPT PV = 58.102981 CPT PV = 51.330739
𝟓𝟖. 𝟏𝟎𝟐𝟗𝟖𝟏 − 𝟓𝟖. 𝟎𝟒𝟕𝟓𝟗𝟖

𝐀𝐩𝐩𝐫𝐨𝐱𝐌𝐨𝐝𝐃𝐮𝐫 = ApproxModDur = 5.169
𝟐 × . 𝟎𝟎𝟎𝟏 × 𝟓𝟖. 𝟎𝟕𝟓𝟐𝟕𝟗
= 𝟒. 𝟕𝟔𝟖
Page 5
PV
𝐌𝐚𝐜𝐃𝐮𝐫
= 𝐌𝐨𝐝𝐃𝐮𝐫
PV_ (𝟏 + 𝐫)
～option-pricing
model
M.M128348126.
𝐀𝐩𝐩𝐫𝐨𝐱𝐌𝐨𝐝𝐃𝐮𝐫
(𝐏𝐕0 ) − (𝐏𝐕2 )
PV_ 𝟐 × 𝚫𝐲𝐢𝐞𝐥𝐝 × 𝐏𝐕𝟎
PV ➞
Non-Callable Bond
𝐄𝐟𝐟𝐃𝐮𝐫
r = (𝐏𝐕0 ) − (𝐏𝐕2 )
Benchmark
Yield
73
Duration of a Bond Portfolio
2 ways to calculate: Page 1

1) weighted average of time to receipt of the
aggregate cash flows
2) weighted average of the individual bond durations
in the portfolio
𝐁𝐕𝟏 𝐁𝐕 𝐁𝐕
𝐀𝐯𝐠. 𝐌𝐨𝐝𝐃𝐮𝐫 = 𝐌𝐨𝐝𝐃𝐮𝐫 t u + 𝐌𝐨𝐝𝐃𝐮𝐫
➞ t 𝟐 u + ⋯ + 𝐌𝐨𝐝𝐃𝐮𝐫 t 𝐧 u
𝐁𝐩 𝐁𝐩 𝐁𝐩
𝐧
such that Z 𝐁𝐕𝐢 = 𝐁𝐩
𝐢*𝟏
and 𝐌𝐨𝐝𝐃𝐮𝐫 = where m = periodicity
𝐘𝐓𝐌
𝟏+ 𝐦
Page 2
e.g. A B C 𝐁𝐕
$25M $25M $50M 𝐌𝐨𝐝𝐃𝐮𝐫 t 𝐢 u + ⋯ 𝐞𝐭𝐜.
𝐁𝐩
Coupon 9% 11% 8%
TTM 6 yrs. 8 yrs. 12 yrs. 𝐌𝐚𝐜𝐃𝐮𝐫
YTM 9.1% 9.38% 9.62% 𝐘𝐓𝐌
𝟏+ 𝐦
MV $24,886,343 $27,243,887 $44,306,787
M.M128348126.
MacDur 4.761 5.633 7.652
Bp = $96,437,017 𝟒. 𝟕𝟔𝟏 𝟐𝟒, 𝟖𝟖𝟔, 𝟑𝟒𝟑

Avg.ModDur➞= v × x+
semi-annual coupons 𝟎. 𝟎𝟗𝟏 𝟗𝟔, 𝟒𝟑𝟕, 𝟎𝟏𝟕
𝟏+ 𝟐
MacDur – annualized
so… if YTM ↑ 20bps 𝟓. 𝟔𝟑𝟑 𝟐𝟕, 𝟐𝟒𝟑, 𝟖𝟖𝟕

v × x+
𝟎. 𝟎𝟗𝟑𝟖 𝟗𝟔, 𝟒𝟑𝟕, 𝟎𝟏𝟕
6.0495 × 0.002 = 0.0121 𝟏+ 𝟐
or 1.21% decline
𝟕. 𝟔𝟓𝟐 𝟒𝟒, 𝟑𝟎𝟔, 𝟕𝟖𝟕
v × x = 𝟔. 𝟎𝟒𝟗𝟓
𝟎. 𝟎𝟗𝟔𝟐 𝟗𝟔, 𝟒𝟑𝟕, 𝟎𝟏𝟕
𝟏+ 𝟐
74
Page 3
Money Duration ⇒ measure of price change in
currency terms
Money Dur. = Ann.ModDur × PV full
per 100 of versus actual
𝚫PVfull
≈ -MoneyDur × 𝚫yield par value face value
e.g. PVfull = 100.940243

∴ if YTM ↑ 100 bps
Ann.ModDur = 6.1268
𝚫PVfull = -(618.44178 × 0.01)
MoneyDur. = 6.1268 (100.940243)
➞ = 6.184417 ≈ 6.1268%
= 618.44178
Price Value of a Basis Point (PVBP)

𝚫PVfull for 𝚫1bp
(𝐏𝐕0 ) − (𝐏𝐕2 ) a.k.a. PVO1
𝐏𝐕𝐁𝐏 =
𝟐 DVO1 (U.S.)
or
basis point value BVP = MoneyDur × 0.0001
Page 4
e.g. FV = $10M 1. Calculate money duration
coupon = 4.5%
MoneyDur. = Ann.ModDur × PVfull
PVfull = 99.65
= 𝟐. 𝟒𝟗𝟖𝟖
M.M128348126. YTM = 5.2617% o p × 𝟗𝟗. 𝟔𝟓 = 𝟐𝟒𝟐. 𝟔𝟐
𝟎. 𝟎𝟓𝟐𝟔𝟏𝟕
MacDur = 2.4988 𝟏+
𝟐
➞
2. Calculate 𝚫PVfull for 1bp ↑ in YTM
BPV = MoneyDur. × 0.0001
= 242.62 × 0.0001 = 0.024262 /100 of par value

$𝟏𝟎𝐌
∴ × 0.024262 = $2,426.20 drop in MV for
𝟏𝟎𝟎
𝚫1bp.
75
Page 5
Price 𝚫PV due to duration – primary effect
𝚫PV due to convexity – secondary effect ⇒ for
large 𝚫bps
𝐏𝐕𝟎
∆𝐛𝐩# ∆𝐛𝐩$ Convexity

YTM Adjustment
𝟏
%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ (−𝐀𝐧𝐧𝐌𝐨𝐝𝐃𝐮𝐫 ×
➞𝚫𝐲𝐢𝐞𝐥𝐝) + y𝟐 𝐀𝐧𝐧. 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 {
due to duration due to convexity

first-order effect second-order effect
if 𝚫bp+ (neg.) + (pos.)
if 𝚫bp- (pos.) + (pos.)
Closed Form - |𝐍 − c𝐭J𝐓d} × |𝐍 + 𝟏 − c𝐭J𝐓d} Approx.Con. = (𝐏𝐕0 ) + (𝐏𝐕2 ) − (𝟐𝐏𝐕𝟎 )

(𝟏 + 𝐫)𝟐 𝐏𝐕𝟎 (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐
𝐦𝟐
Page 6
e.g. 7.25% annual, YTM = 7.44% Recall: pg. 410, R54, Eq. (6)
Maturity Apr. 4/2029 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕 𝐭
𝐏𝐕 𝐟𝐮𝐥𝐥 = - + ⋯+ 4 × (𝟏 + 𝐫) &𝐓
Settles Jun. 27/2014 𝟏+𝐫 (𝟏 + 𝐫)𝐧
M.M128348126. 𝐭J = 𝟖𝟑J
𝐓 𝟑𝟔𝟎
1. Calculate PVfull: PMT = 7.25, r = 0.0744, 𝐭J𝐓 = 𝟖𝟑J𝟑𝟔𝟎, PV0 = 99.95678

2. Calcuate Approx.ModDur & Approx.Con. for 𝚫1bp ⇒ 0.0001
PV+ ⇒ 1.0744 ➞ 1.0745➞= 99.869964
PV- ⇒ 1.0744 ➞ 1.0743 = 100.043703
−(𝐏𝐕, ) − (𝐏𝐕- ) (𝐏𝐕, ) + (𝐏𝐕- ) − (𝟐𝐏𝐕𝟎 )
𝐀𝐩𝐩𝐫𝐨𝐱. 𝐌𝐨𝐝𝐃𝐮𝐫 = = 𝟖. 𝟔𝟗𝟎𝟕 𝐀𝐩𝐩𝐫𝐨𝐱. 𝐂𝐨𝐧. = = 𝟏𝟎𝟕. 𝟎𝟒𝟔
𝟐𝚫𝐲𝐢𝐞𝐥𝐝 (𝐏𝐕𝟎 ) (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 𝐏𝐕𝟎
3. Calculate %𝚫PVfull for 𝚫yield = +100 bps.

%𝚫PVfull = (−𝟖. 𝟔𝟗𝟎𝟕 × 𝟎. 𝟎𝟏) + |𝟏J𝟐 (𝟏𝟎𝟕. 𝟎𝟒𝟔) × (𝟎. 𝟎𝟏)𝟐 }
= −𝟎. 𝟎𝟖𝟔𝟗𝟎𝟕 + 𝟎. 𝟎𝟎𝟓𝟑𝟓𝟐
= −𝟎. 𝟎𝟖𝟏𝟓𝟓𝟓
76
Page 7
4. Compare est. %𝚫PVfull with actual %𝚫PVfull if YTM ⇒ 8.44%
𝟕. 𝟐𝟓 𝟏𝟎𝟕. 𝟐𝟓 𝟖𝟑
𝐚𝐜𝐭𝐮𝐚𝐥 𝐏𝐕 𝐟𝐮𝐥𝐥 = - + ⋯+ 4 × (𝟏. 𝟎𝟖𝟒𝟒) &𝟑𝟔𝟎 = 𝟗𝟏. 𝟕𝟖𝟎𝟗𝟐𝟏
(𝟏. 𝟎𝟖𝟒𝟒) (𝟏. 𝟎𝟖𝟒𝟒) 𝟏𝟓
𝟗𝟏. 𝟕𝟖𝟎𝟗𝟐𝟏 − 𝟗𝟗. 𝟗𝟓𝟔𝟕𝟖

𝐀𝐜𝐭𝐮𝐚𝐥 %𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 = = −𝟎. 𝟎𝟖𝟏𝟕𝟗𝟒
𝟗𝟗. 𝟗𝟓𝟔𝟕𝟖
➞
𝐄𝐬𝐭. %𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 = −𝟎. 𝟎𝟖𝟏𝟓𝟓 [−𝟎. 𝟎𝟖𝟔𝟗𝟎𝟕 + 𝟎. 𝟎𝟎𝟓𝟑𝟓𝟐]
Actual -8.1794%
Est. -8.155% 2.44 bps off
vs. ModDur only of –8.6907%
Page 8
Recall: MoneyDur. = 𝐀𝐧𝐧. 𝐃𝐮𝐫. × 𝐏𝐕 𝐟𝐮𝐥𝐥
𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ −𝐌𝐨𝐧𝐞𝐲 𝐃𝐮𝐫. × 𝚫𝐲𝐢𝐞𝐥𝐝
Well, money convexity results in,
𝟏
𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ (−𝐌𝐨𝐧𝐞𝐲𝐃𝐮𝐫. × 𝚫𝐲𝐢𝐞𝐥𝐝) + y𝟐 𝐌𝐨𝐧𝐞𝐲𝐂𝐨𝐧. × (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 {
first-order second-order effect
M.M128348126. effect
𝐏𝐕0 + 𝐏𝐕2 − (𝟐𝐏𝐕𝟎 )
➞ ⇐ 𝐀𝐩𝐩𝐫𝐨𝐱. 𝐂𝐨𝐧. =
when bond’s cash
(𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 𝐏𝐕𝟎
flows do not change
𝐏𝐕0 + 𝐏𝐕2 − (𝟐𝐏𝐕𝟎 )
when bond’s cash ⇐ 𝐄𝐟𝐟. 𝐂𝐨𝐧. =
(𝚫𝐜𝐮𝐫𝐯𝐞)𝟐 𝐏𝐕𝟎
flows change
both pos.
neg. convexity
convexity callable
77
Yield Volatility Page 9
𝚫YTM 𝟏
%𝚫𝐏𝐕 𝐟𝐮𝐥𝐥 ≈ (−𝐀𝐧𝐧. 𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐲𝐢𝐞𝐥𝐝) + \ 𝐀𝐧𝐧. 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 _
𝟐
≈ Duration + Convexity
25 bps
impact/ basis point change
Yield Volatility = # of ‘basis points’ change

time-to-
maturity
· non-parallel ➞
shifts Investment Horizon
Duration gap = MacDur – Investment horizon
if: duration gap < 0 ⇒ coupon re-investment risk
dominates market price risk
- risk is to lower rates
> 0 ⇒ market price risk dominates
coupon re-investment risk
- risk is to higher rates
Credit & Liquidity Risk

Corporate Bonds Page 10
Benchmark + Spread
M.M128348126.
rate
Inflation real credit

liquidity
expectations rate risk
➞
Inflation Real Rate Credit Liquidity
Duration Duration Duration Duration
typically interaction effects

i.e.
𝚫credit quality
Conditions leading to a 𝚫benchmark rate
𝚫liquidity
may lead
to a…
78
Empirical Duration
Page 1
➞ Analytical duration ➞ arrived at by mathematical formulas
- assume yields and spreads are uncorrelated
➞ Empirical duration ➞ determined from market data

𝐑 𝐁𝐩 = 𝐛𝟎 + 𝐛𝟏 𝐢 where 𝐢 = benchmark
interest rate
e.g./
10 yr. EUR bond returns = 𝐛𝟎 + 𝐛𝟏 (10 yr. bond)
or 𝐛𝟏 (10 yr. Eurobor swap rate)
IG ➞ largely driven by interest rate

movements
HY - wide spreads ➞ behave like equities

- narrow spreads ➞ behave like IG
M.M128348126.
79
Fundamentals of Credit Analysis
a. describe credit risk and credit-related risks affecting corporate bonds
b. describe default probability and loss severity as components of credit risk
c. describe seniority rankings of corporate debt and explain the potential

violation of the priority of claims in a bankruptcy proceeding
d. compare and contrast corporate issuer credit ratings and issue credit ratings
and describe the rating agency practice of “notching”
e. explain risks in relying on ratings from credit rating agencies
f. explain the four Cs (Capacity, Collateral, Covenants, and Character) of

traditional credit analysis
g. calculate and interpret financial ratios used in credit analysis
h. evaluate the credit quality of a corporate bond issuer and a bond of that
issuer, given key financial ratios of the issuer and the industry
i. describe macroeconomic, market, and issuer-specific factors that influence

the level and volatility of yield spreads
M.M128348126.
j. explain special considerations when evaluating the credit of high-yield,

sovereign, and non-sovereign government debt issuers and issues
80
Fundamentals of Credit Analysis
LOS a, b (3p) Credit Risk (describe)
LOS c (5.5p) Capital Structure, Seniority Ranking, Recovery Rates (describe,

explain)
LOS d, e (9p) Rating Agencies, Credit Ratings (compare, contrast, describe)
LOS f (7p) Credit Analysis: Corporate Debt (explain)
LOS g, h (10.5p) Ratio Analysis (calculate, interpret, evaluate)
LOS i (8p) Risk v Return: Yields and Spreads (describe)
LOS j (14p) High Yield, Sovereign, Non-Sovereign (explain)
2 1 Page 1
credit risk ➞ risk of loss from non-payment LOS a, b
- describe
1 default risk (default probability - POD) - risk of non-payment
- issuer fails to make full and timely payments of
M.M128348126.
principal + interest
2 loss severity (loss given default - LGD) - the amount of the

loss given that the issuer has defaulted
(principal + any accrued interest)
($ or %)
∴ 𝐄(𝐥𝐨𝐬𝐬) = 𝐏𝐎𝐃 × 𝐋𝐆𝐃
% or $ (1 - Recovery Rate)
% of principal recovered
for IG (investment grade) bonds ➞ investors focus on POD

for HY (high yield) bonds ➞ investors focus on LGD
81
Page 2
Credit-related risks:
LOS a, b
1) Spread risk ➞ spread above risk-free rate - describe
credit
2) Credit migration risk (downgrade risk)
spread
lower credit rating = wider spread = lower price illiquidity
premium
higher POD = higher 𝐄(𝐥𝐨𝐬𝐬)
𝐑𝐟
3) market liquidity risk ➞ illiquidity = wider spread
higher risk for smaller issuers whose debt trades
infrequently
LOS c
Issuer’s debt may not all have the same seniority - describe
ranking (i.e. priority of payments) - explain
- rank of seniority will affect recovery rates in default
Page 3
mortgage (first, second…) LOS c
Secured ➞ Senior Secured - pledge of specific property - describe
- explain
liens (first, second, etc…)
- pledge of specific assets
M.M128348126.
Unsecured ➞ Senior Unsecured - most common
(general claim ➞ Senior Subordinated
on assets after ➞ Subordinated
all senior ranks)➞ Junior Subordinated
even low ranking debt may be cheaper than issuing equity, prevents
dilution of existing shareholders, less restrictive than issuing
senior debt, and may be adequate market demand
82
Page 4
Recovery Rates ➞ all creditors at the same level of the
LOS c
capital structure are treated as one class - describe
30 yr. - explain
i.e. senior unsecured all equal in claim
10 yr.
(pari passu - on equal footing)
3 yr.
- recovery rates vary by seniority class (ranking)

- also vary significantly by industry and by when they occur in the credit
top - higher recovery rates + lower POD
cycle
- recovery rates
are averages (bus. cycle)
bottom - lower recovery rates + higher POD

Typical priority of claims:
secured paid out from specific property/assets
- if that is not enough, balance becomes senior unsecured
unsecured (in order of ranking) before equity (priority may not always
be followed)
Page 5
Rating agencies: Moody’s, S&P, Fitch
LOS d
- compare
- contrast
all public debt is rated - describe
underwriters won’t issue, and
investors won’t buy, debt that is
M.M128348126.
not rated
ratings provide comparability of the
relative credit riskiness of all
bond issuers and issues
IG issuers are better able to access

debt markets at lower rates
- may add: positive, stable, negative

and/or ‘On Review for Downgrade’
‘On Credit Watch for Upgrade’
83
Page 6
Issuer vs. Issue Ratings:
LOS d
- compare
corporate family rating addresses an issuer’s overall - contrast
corporate credit rating creditworthiness - describe
issuer credit rating - typically applies to senior unsecured
Notching senior secured (issuer rating +1 or 2 notches)
Issuer senior unsecured
subordinated (issuer rating -1 or 2 notches)
higher the issuer rating, the smaller the notching
- issuers can have debt with different ratings and LGD

- may even be structurally subordinated
2 Parent - debt
SnP clause sub. 1 sub. 1 cash flows service this debt first
debt debt before 2 flowing to the parent
Page 7
1/ Credit ratings can change over time LOS e
upgrades/downgrades ➞ credit migration - explain
2/ Credit ratings tend to lag the market’s pricing of credit risk
M.M128348126. bond investors must anticipate changes rather than
wait for a credit rating change
HY ➞ credit rating assesses POD, but LGD may indicate other pricing
3/ Rating agencies may make mistakes (MBS, CDOs in 2007/08)
4/ Some risks are too difficult to capture in credit ratings
- environmental, social risks
LOS f
4 Cs of credit analysis/ - explain
- assessment of an issuer’s ability to pay ➞ sources, predictability
credit quality of the company and sustainability of cash flows
fundamentals of the industry
84
Page 8
LOS f
1/ Capacity - ability to make debt payments on time - explain
begin with industry structure analysis ➞ Porter’s 5 forces model
➞ an industry is more profitable and thus has lower
credit risk when the following are in place:
i/ threat of entry ➞ higher entry barriers
ii/ power of suppliers ➞ multiple suppliers
iii) power of buyers ➞ many buyers
iv) threat of substitutes ➞ no good or cost competitive substitutes
v) rivalry among competitors ➞ few competitors, high industry growth
low barriers to exit
Industry fundamentals
i) cyclical or non-cyclical - cyclical is more economically sensitive
- more volatile revenues and cash flows
Page 9
1/ Capacity Industry fundamentals LOS f
i) cyclical ➞ inherently risker (e.g. auto, steel, cons. discret.) - explain
➞ cyclical companies should carry lower debt than non-cyclicals
ii) growth prospects - better prospects, more sustainable cash flows

M.M128348126.
- better recovery rates
iii) published industry research - secondary research/statistics
Company fundamentals
a) competitive position - market share, cost structure
b) track record/operating history
c) management’s strategy and execution
2/ Collateral - refers to the quality and value of the assets

- typically emphasized more with lower credit quality issuers
85
Page 10
LOS f
2/ Collateral - when POD rises to a sufficient level, asset - explain
values are considered
- financial statement signals ➞ mix of tangible vs. intangible
➞ Dep. vs. CAPEX
- market-based signals ➞ MVequity vs. BVequity
3/ Covenants - terms and conditions of the debt issue
- what mgmt. must do and is limited from doing
affirmative negative or restrictive

- in the trust deed or bond indenture
- violations are a breach of the contract and may be considered default
- during weak economic/market conditions, new corporate bond issues
tend to have stronger covenants
4/ Character - mgmt. strategy ➞ track record of executing
- use of aggressive accounting/tax policies
- history of fraud
- previous poor treatment of bondholders (past credit downgrades)
Page 11
LOS g, h
Profitability and cash flow measures/ - calculate
(operating profit) - interpret
M.M128348126.
EBITDA ➞ op. income + Dep./Amort. - evaluate
FFO ➞ NI from cont. ops. + Dep./Amort. + Deferred taxes + NCC
FCF before dividends ➞ NI + NCC - WCInv - CAPEX
FCF after dividends
Leverage measures/
Debt = interest bearing liabilities + underfunded PO (has an implied
+ operating leases interest cost)
Debt/Capital Debt + Sh. Equity

- lower = lower credit risk
- generally used for IG issuers
Debt/EBITDA - higher = higher leverage
∴ more credit risk
86
Page 12
Leverage measures/
LOS g, h
FFO/Debt ➞ higher = better ability to pay debt - calculate
(FCF after dividends)/Debt ➞ higher = better - interpret
- evaluate
Coverage measures/ - measures ability to cover interest payments
EBITDA/Interest expense
EBIT/Interest expense or payments
- higher coverage = better
Issuer liquidity/ assessment of access to liquidity

- cash on B.S.
- net WC. (positive)
- operating cash flow example #6
- committed bank lines (untapped)
- Debt coming due and committed CAPEX (over next 12-24 months)
Page 13
LOS i
Yields and Spreads/ - describe
M.M128348126.
macro
level and
market volatility
of spreads
issuer
Corp. yield - nominal 𝐑 𝐟 = credit spread
real 𝐑 𝐟 credit risk

𝐄(𝐢𝐧𝐟𝐥. ) liquidity
maturity pr.
tax issues
87
spreads narrow Page 14

Spreads affected by: LOS i
1/ Credit cycle - describe
2/ Broader economic conditions spreads widen
3/ funding availability in the financial sector
dealers unwilling to hold inventories will decrease liquidity and
widen spreads
4/ general market supply and demand
demand > supply = narrower spreads
5/ financial performance of issuer
better (higher FCF, higher coverage) = narrower spreads
Price Impact/ spread risk ➞ the effect on prices for a ∆spread

𝟏
%∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (−𝐀𝐧𝐧𝐌𝐨𝐝𝐃𝐮𝐫 × ∆𝐬𝐩𝐫𝐞𝐚𝐝) × y 𝐀𝐧𝐧𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × (∆𝐬𝐩𝐫𝐞𝐚𝐝)𝟐 {
𝟐
Ex. #9 PV = 100 YTM = 4.75% ModDur = 7.9 Convexity = 74.9

𝟏
Spreads ↑ 50 bps %∆𝐏𝐕 𝐟𝐮𝐥𝐥 = (−𝟕. 𝟗 × . 𝟎𝟎𝟓) × t𝟐 𝟕𝟒. 𝟗 (. 𝟎𝟎𝟓)𝟐 u = −𝟑. 𝟖𝟔%
High Yield/ typically due to: Page 15

LOS j
higher leverage levels
- explain
weak/limited operating history
limited or negative free cash flow greater risk of
M.M128348126.
highly cyclical business default
poor mgmt.
more attention paid
lack of scale or competitive advantages
to recovery analysis
declining industry
Special considerations/
1/ Issuer liquidity - far more critical for HY
- may not have the ability to roll over debt when it comes
due
- may not be able to issue equity if a private company
2/ financial projections - forecasts under multiple scenarios
- use of stress testing
88
Page 16
High Yield/ Special considerations LOS j
3/ Debt Structure - secured down to junior subordinated - explain
(typically convertible bonds)

- lower the ranking, lower the recovery rate, and the
lower the credit rating
- calculate leverage at each level of the capital structure
- HY with a lot of secured debt referred to as having
a ‘top-heavy’ capital structure ➞ less capacity to add bank
(example #10) debt
4/ Corporate Structure - parent vs. subsidiary

- any structurally subordinated debt?
- leverage ratios should be calculated at each
debt-issuing entity level as well as on a consolidated
basis
High Yield/ Special considerations Page 17

LOS j
5/ Covenant analysis - explain
change of control put - in the event of an acquisition,
bondholders have the right to require the issuer to buy
M.M128348126. back their debt at par (or slight premium)
- for IG ➞ requires not just acquisition, but credit downgrade after the
fact
Restricted payments - limits how much cash can be
paid to shareholders over time
Limitations on liens and additional indebtedness
- limits how much secured debt an issuer can take on
- protects unsecured bondholders
Restricted vs. Unrestricted subsidiaries
offers guarantees to parent level debt - parent debt on equal

- eliminates structural subordination standing with
subsidiary’s debt.
89
Page 18
High Yield/ Special considerations LOS j
5/ Covenant analysis - explain
maintenance covenants - typical of bank credit agreements
e.g. debt/EBITDA < x times
6/ Equity-like approach to high yield analysis

HY has a higher correlation to equity than IG
HY has less interest rate sensitivity to rate hikes
IG ↓
- as economy improves, rates ↑
HY ↑ since spreads tend to
Sovereign Debt/ contract by more
external offerings (USD or EUR)
internal offerings (issued in local currency)
- easier to service
- defaults do occur
Page 19
Sovereign Debt/ should assess:
LOS j
1) ability to pay - explain
2) willingness to pay - sovereign immunity ➞ generally cannot force
a sovereign to pay since immunity prevents them from being sued
M.M128348126.
Institutional assessment
Economic assessment - growth prospects
Fiscal soundness
Monetary policy - mandates, credibility, flexibility
Non-Sovereign Debt/ - municipalities

- general obligation bonds (unsecured)
- revenue bonds - issued for specific project financing (DSCR)
- municipalities must balance their budgets
- analysis focuses on regional employment, tax base, population growth,
business attractiveness
90
REVIEW
M.M128348126.
91
Defining Elements
Review - 1
Features/ Issuer · supranational orgs.
sovereign
· government non-sov.
state
· corporate prov.
quasi
GSEs
Maturity vs. Term to Maturity (tenor)

- overnight to 30+ years
< 1 yr. - money market
at time of issuance
> 1 yr. - capital market
par
Par value · face/maturity value
discount < 100
premium > 100
Coupon rate/frequency - stated rate paid annually

- plain vanilla/conventional - fixed rate
- FRNs - floating rate notes - reference rate + spread
- zero-coupon - issued at a discount, matures at par
Review - 2
Features/ coupon in one
Currency - dual currency bonds
- principal in another
- currency option bonds
- bondholder chooses currency of each
coupon PMT
M.M128348126.
Credit Enhancement
subordination (senior 85%, junior 15%)
Internal
over-collateralization
excess spread
External Surety Bond/Guarantee

Letter of Credit
Covenants - affirmative - what an issuer must do

- negative - what an issuer will not do
- limits on debt, restrictions on dividends, restrictions on M & A,

negative pledges (i.e. nothing senior)
92
Review - 3
Bond - legally binding contract form of bond
- need Bond Indenture (a.k.a. trust deed) obligation of
- trustee - fiduciary for Bondholders issuer
- legal identity of issuer, legal form rights of
bondholders
Source of repayment proceeds/
· supranational - repayment of previous loans
· government - full faith & credit (taxes usually)
· corporate - cash flows (CFO)
· securitized - principal + interest PMTs of
securities held
Asset/Collateral Backing/
secured (bonds)
· Senior ranking
unsecured (debentures)
Review - 4
Asset/Collateral Backing/ collateral trust bond
· collateral quality equipment trust certificate
MBS/ABS
like
covered bonds securitization
Legal/Regulatory/Tax/
M.M128348126.
· Domestic - issuer, country, currency all match
· Foreign - country & currency match, issuer does not
· Eurobond - issued outside jurisdiction of any
country
- named after currency of denomination

(Eurodollar, Euroyen)
93
Review - 5
Legal/Regulatory/Tax/
Tax · Interest normal income
· Capital gain long-term - cap. gains tax rate
short-term - usually income
· Zero-coupon - all interest (implied each yr.)
at
issuanc
e Discount Bond - implied interest each yr.
only Premium Bond - implied capital loss each yr.
⇒ Structure of Cash Flows/

· plain vanilla - interest + principal (bullet bond)
at end
fully - interest + pr. each PMT

· amortizing bond
partially - interest + pr. each PMT +
balloon PMT at maturity
Review - 6
⇒ Structure of Cash Flows/
· Sinking Fund - some %’age of bond put aside each yr.
annual
· Fixed rate semi-annual · Floating rate
quarterly - reference + spread
· Step-up coupon variable (margin)
M.M128348126. - coupon increases over time
· Credit-linked coupons · may have · cap - no higher
↓↑ with credit quality · floor - no lower
· PIK bonds - payment in kind
(w/toggle) (e.g. shares) · may be inverse floater
· Deferred Coupons - no PMTs for first - if Libor ↑, coupon ↓
few years, higher PMT after
· Index-Linked Bonds
e.g. equity index/inflation
94
Review - 7
⇒ Structure of Cash Flows/ coupon
· inflation adjustments or
principal (zeros)
⇒ Contingency Provisions/ PMT ↑ as principal increases
- embedded options (capital indexed bonds)
call risk
① Callable bond - benefits issuer, holder
reinvestment risk
(higher coupon/lower price)
· Make whole call = PV of 𝐢𝐧𝐭. + 𝐅𝐕
𝐠𝐨𝐯 ! 𝐭. 𝐘𝐓𝐌
② Putable bond - benefits holder + 𝐬𝐩𝐫𝐞𝐚𝐝
· American - always callable/putable
· European - 1 call/pull date
· Bermuda - many call/put dates
Review - 8
⇒ Contingency Provisions/
③ Convertible Bonds/ into common shares (call option)
- benefits holder
e.g./ $20/sh.
conversion price = $/share
ratio = FV/conv. pr. = 𝟏𝟎𝟎𝟎#𝟐𝟎 = 𝟓𝟎 shares
value = Pt × ratio
if Pt < $20
premium = Bt - (Pt × ratio)
M.M128348126.
- below parity
parity Bt = (Pt × ratio)
if Pt > $20 - above
- forced conversion - if Pt > $20 for a parity
specified # of days, company calls bonds
at a lower price
④ Warrants
- not an embedded option
95
Issuance, Trading, Funding

Review - 1
Markets/ gov’t./gov’t. related supranational
Issuer financials sov./non-sov.
corporate non-financials
quasi. largest
structured products
(securitized) smallest
Credit Quality investment grade (Baa3 or BBB – or higher)

non-investment grade – high yield, speculative
(more risk)
< 1 yr. - money market
Maturity at issuance
> 1 yr. - capital market
Currency – determines what county’s interest rate determines price

Domestic
Geography legal, regulatory, tax regime of ‘issued-in’
Foreign
country
Eurobond
Review - 2
Markets/
emerging
Geography developed
5 currencies
fixed 35 rates 7 time
Coupon
floating ➞ LIBOR - London Interbank Offered Rate periods
- unsecured loans between banks
M.M128348126. for up to 1 yr.
Primary Market (first time issuance)
① Public Offering - underwritten offering (firm commitment)
- buys whole issue, assumes inventory risk
issuer determines funding
- typically Investment Bank or syndicate
needs
Selects underwriter
Structures the offering marketing
announcement date end of subscription obtain ‘anchors’
period grey market (forward mkt.
gauge demand for upcoming issues)
96
Review - 3
Pricing Day - last day to commit
Issuing Phase - sales made, money transfers
Closing Date - about 14 days later
② Best efforts Offering - investment bank acts as agent/broker
- commission only
- no risk of ownership
Issuance/ Auctions - typically Descending price auction for gov’t.
bonds
bids solicited price then ranked
quantity
e.g./ Sell $50M - each pay their bid until issue is
cuml.
.1560 12 12 sold
.1565 8 20 or/ Modified Dutch - each bidder pays
.1570 16 36 the same price at which the
.1575 18 50 all pay this
issue clears
only 14 filled price
non-competitive bids - pay the clearing
or avg. $
Review - 4
Primary Market (Con’t.) (first time issuance)
Private Placement non-underwritten one/few
unregistered buyers
M.M128348126. Secondary Market/ (already issued)
- dealer market - can act as principal/agent
(OTC)
very
- dealer acts as market maker
little retail
- exchange listed: very limited
trading
Settlement/
T +1 - gov’t./quasi gov’t. (capital market)
T +3 - corporate
same day - all money market
97
Review - 5
Sovereign Bonds/ Treasuries Bill - money market (pure
Note < 10 yr. discount)
coupon
Bond > 10 yr. bearing
- most recently issued - on the run
- most actively traded
- unsecured - full faith and credit only
- risk-free AAA (Fitch, S&P) Aaa (Moody’s)
(local currency)
- fixed rate (most common) - some floating (country
- may be inflation-linked (Linkers) specific)
Non-Sovereign Bonds/ - higher yields

- lower credit rating
- perhaps favourable tax treatment
Review - 6
Supranational Bonds/ typically plain vanilla
- must act as benchmark for countries w/
non-liquid bond markets
Quasi-gov’t./ - agency bonds
- not repaid by the gov’t. but by the GSE itself
Corporate/ Private - typically floating ⇒ may be securitized at

some point
M.M128348126.
Public
Commercial Paper - short term, unsecured
- usually issued by financial companies (or very large
- overnight to 1 yr. - EuroCP non-fin.)
to 270 days - US CP
1
prime paper - P/A/F
Ratings 2
non-prime
3
98
Review - 7
Commercial Paper
- retired by rolling over - issuer usually maintains
backup LOC
US CP/ EuroCP/ (issued internationally)
discount basis (par) interest bearing (par + interest)
settles same day settles T + 2
Corporate Notes/ 1 yr. < short ≤ 5 yrs.
notes
5 yrs. < med. ≤ 12 yrs.
long > 12 yrs. - bonds
fixed or floating
coupons Contingency Provisions
- annual, semi, quarterly
callable
- secured, unsecured
putable
1-30 yrs. convertible
Serial maturity - portion matures
Principal each yr.
term maturity
Review - 8
Short-Term Funding/ Deposits demand
Banks Retail savings
Wholesale money market savings
(short-term)
Central Bank Funds
M.M128348126. - overnight lending/borrowing
Interbank Market
overnight funds
- banks lending to each other
term funds
+25 bps
target
central bank
funds rate
-25 bps
non-negotiable
Certificates of Deposit
negotiable
99
Review - 9
Repurchase Agreement/
- sale of a security w/ agreement to buy back
$ repurchase
A B A B $ < value of
term security
securities $(1 + repo rate)
1 day
repo margin
- overnight repo
more - term repo
to maturity - repo to maturity (of the security)
Reverse Repurchase Agreement/

- the above, seem from B’s perspective
M.M128348126.
100
Fixed Income Valuation

Review - 1
N PMT 𝐈# PV FV
𝐘
- all bonds priced on 100 point system (i.e. 100%)
100 - par coupon = mkt. rate
greater than 100 - premium coupon > mkt. rate
Less than 100 - discount coupon < mkt. rate
① inverse relationship ⇒ as r ↑, prices ↓, as r ↓, prices ↑
② for the same coupon & TTM, |%𝚫𝐏| as r ↓ > |%𝚫𝐏| as r ↑

- prices are more volatile to the upside
③ for the same TTM, the lower coupon bond will be more
price volatile than a higher coupon bond
④ for the same coupon, longer-term will be more price volatile
Review - 2
Spot Rates/ rather than using one r for all PMTs
(𝐙𝐧 )
- also called 𝐏𝐌𝐓 𝐏𝐌𝐓 𝐏𝐌𝐓 + 𝐅𝐕
𝐏𝐕 = + + ⋯+
zero rates (𝟏 + 𝐙𝟏 ) (𝟏 + 𝐙𝟐 )𝟐 (𝟏 + 𝐙𝐧 )𝐧
will be the period 1 period 2 period n
no-arbitrage price spot spot spot
M.M128348126. Flat, Accrued & Full Price/ pricing bonds between coupon dates
𝐏𝐕𝐟𝐮𝐥𝐥 = 𝐏𝐕𝐟𝐥𝐚𝐭 + 𝐀𝐈 n = # of PMTs

PMT PMT PMT
N𝐭2𝐓 × 𝐏𝐌𝐓P x
𝟑𝟎2 PV
𝟑𝟔𝟎 − 𝐜𝐨𝐫𝐩𝐨𝐫𝐚𝐭𝐞 𝐭
(𝟏 + 𝐫) ,𝐓
𝐚𝐜𝐭𝐮𝐚𝐥2 /
𝐚𝐜𝐭𝐮𝐚𝐥 − 𝐠𝐨𝐯 𝐭.
𝐭
∴ 𝐏𝐕𝐟𝐮𝐥𝐥 = 𝐏𝐕(𝟏 + 𝐫) &𝐓
& 𝐏𝐕𝐟𝐥𝐚𝐭 = 𝐏𝐕𝐟𝐮𝐥𝐥 − 𝐀𝐈
101
Review - 3
Matrix Pricing/ for fixed rate bonds w/ no/little
secondary market (or not yet issued)
- use liquid comparables (credit quality)
e.g. 3 yr., 4%
Coupon
3% 4% 5%
2 x x - avg. YTM 2 yr.
TTM 3 X - 3 yr.
Interpolate for
4
3 yr. YTM
5 x x - avg. YTM 5 yr. - then calculate PV
estimated 3 yr. YTM - 3 yr. Treasury rate = required yield spread

maturity
- will be a different yield spread for each
credit rating
Review - 4
Yield Measures/ periodicity - # of coupon payments/yr.
e.g./ 6% coupons/yr.
60 1 annual - effective annual rate
2 × 30 2 semi - semi annual bond basis yield
4 × 15 4 quarterly (bond equivalent yield)
12 × 5 12 monthly
M.M128348126.
𝐀𝐏𝐑 𝐦 𝐦 𝐀𝐏𝐑 𝐧 𝐧
9𝟏 + = = 9𝟏 + =
𝐦 𝐧
e.g./ 3 yr., 5% semi @ 104 , r = 3.582%

. 𝟎𝟑𝟓𝟖𝟐 𝟐 𝐀𝐏𝐑 𝐧 𝟒
9𝟏 + = = 9𝟏 + = APR4 = 3.566%
𝟐 𝟒
as m ↑ , APRm ↓ APR - annual percentage
rate
102
Review - 5
Yield Measures/
street convention – yield measure that neglects
lower weekends/holidays
than
true yield – accounts for delays in PMTs caused by
(1-2 bps)
weekends/holidays
government equivalent yield – restates a 𝟑𝟎.𝟑𝟔𝟎 YTM to an
𝐚𝐜𝐭𝐮𝐚𝐥.
𝐚𝐜𝐭𝐮𝐚𝐥 YTM
current yield – 𝐚𝐧𝐧𝐮𝐚𝐥 𝐏𝐌𝐓$𝐏𝐕

𝐟𝐥𝐚𝐭
not on
m simple yield (𝐚𝐧𝐧𝐮𝐚𝐥 𝐏𝐌𝐓 + 𝐬. 𝐭. 𝐚𝐦𝐨𝐫𝐭. 𝐨𝐟 𝐠𝐚𝐢𝐧/𝐥𝐨𝐬𝐬)
com
𝐏𝐕𝐟𝐥𝐚𝐭
⇒ Embedded Options
Callable yield to first (second, third) call
yield to worst
YTM
Review - 6
⇒ Embedded Options/ typically require an options pricing
model (Level2)
PV = option adjusted price + value of embedded option
- call
+ put
M.M128348126. ⇒ Floating Rate Notes/ coupon tied to short-term rate (Libor)

paid ‘in arrears’ quarterly or
semi-annual
reference rate + quoted margin (QM)
(spread) PV = 100 if QM = DM
PV > 100 if QM > DM
required rate ➞ discount margin (DM)
PV < 100 if QM < DM
𝚫credit risk ⇒ 𝚫DM
on a PMT
date
103
PMT Review - 7
⇒ Floating Rate Notes/ (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕 (𝐈𝐧𝐝𝐞𝐱 + 𝐐𝐌) × 𝐅𝐕
PV = 𝐦 + 𝐦 + …
𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌 𝟐
R𝟏 + W R𝟏 + W
𝐦 𝐦
(1 + r) (1 + r)2
e.g./
4-yr. quarterly, Libor + 125 bps @ 98
find DM if Libor = 2%
CPT 𝐈#𝐘 = .009478
N = 16 PV = -98 FV = 100
.009478 = 𝐈𝐧𝐝𝐞𝐱 + 𝐃𝐌
PMT = 𝟐 + 𝟏. 𝟐𝟓 = 𝟑. 𝟐𝟓. = . 𝟖𝟏𝟐𝟓 𝟒
𝟒 𝟒
DM = 0.017912 or 179 bps
⇒ Money Market Securities/
𝐝𝐚𝐲𝐬.
discount basis 𝐏𝐕 = 𝐅𝐕 × R𝟏 − 𝐲𝐫. × 𝐃𝐑W
Simple interest basis
add-on basis 𝐅𝐕
𝐏𝐕 =
𝐝𝐚𝐲𝐬.
DR = discount rate AOR – add-on rate R𝟏 + 𝐲𝐫. 𝐀𝐎𝐑W
Review - 8
⇒ Money Market Securities/ 𝐅𝐕
𝐏𝐕 =
𝐝𝐚𝐲𝐬. 𝐝𝐚𝐲𝐬#
𝐏𝐕 = 𝐅𝐕 × R𝟏 − H𝟏 + 𝐲𝐫. 𝐀𝐎𝐑I
𝐲𝐫. 𝐃𝐑W
rearrange/ 𝐝𝐚𝐲𝐬#
𝐲𝐞𝐚𝐫 𝐅𝐕 − 𝐏𝐕 𝐅𝐕 = 𝐏𝐕 H𝟏 + 𝐲𝐫. 𝐀𝐎𝐑I
𝐃𝐑 = .𝐝𝐚𝐲𝐬 C D
𝐅𝐕
(1 + r)
hence DR is understated 𝐲𝐞𝐚𝐫 𝐅𝐕 − 𝐏𝐕
𝐀𝐎𝐑 = #𝐝𝐚𝐲𝐬 L M
M.M128348126. 𝐏𝐕
e.g./ 90-day, 360 DCC, DR = 5.76% ⇒ AOR = 5.925%
[w/365 DCC]
⇒ Term Structures/ a) gov’t. bond spot curve ( YTM on zeros)
YTM
(one issuer, same credit Q, same currency)
upward flat inverted
all else
constant
TTM normal
104
Review - 9
⇒ Term Structures/
b) gov’t. bond yield curve – coupon paying
Note: short end of curve ⇒ 1 mos., 3 mos., 1 yr. …
money mkt.
c) Par Curve – obtained from the - converted to BEY
spot curve
- each maturity is priced to par
d) Forward Curve 1y1y – 1 yr. from now, one yr. rate
2y1y – 2 yrs. from now, one yr. rate
(1 + r1)(1 + IFR1,1) 1 yr. rate implied forward rate

IFR1,1
- given a spot curve,
= (1 + r2)2
a forward curve can be
2 yr. rate
derived
taxation Review - 10
⇒ Yield Spreads/ Benchmark + Spread liquidity
Fixed macro factors credit risk
Rate
typically some gov’t. yield (most recently issued)
G-Spread – spread above gov’t. I-Spread - spread above swap rate
corp. YTM rate
Z-Spread - spread over gov’t. spot
- gov’t. YTM rate
M.M128348126. e.g./ 6% annual corporate, 2 yrs. TTM
@ 100.125
2 yr., 4% annual gov’t. @ 100.75
1 yr. spot = 2.10% 2 yr. spot = 3.65%
TTM
Term Structure of G-spread/ corporate YTM = 5.932%
(2.327%)
Credit Spreads gov’t. YTM = 3.605
(N = 2, PMT = 4, F = 100, PV = -100.75)
𝟔 𝟏𝟎𝟔
Z-Spread = 𝟏𝟎𝟎. 𝟏𝟐𝟓 = + = 𝟐. 𝟑𝟒𝟐𝟐%
(𝟏. 𝟎𝟐𝟏 + 𝐙) 𝟏 (𝟏. 𝟎𝟑𝟔𝟓 + 𝐙)𝟐
105
Asset-Backed Securities
SPV will typically have higher credit Review - 1

⇒ Benefits
rating than originator
(of Securitization) source of funding
greater credit
increased loan origination
availability
bankruptcy remoteness less concentration risk
higher risk-adjusted returns
Mortgages
Pool
Auto Loans
of ABS/MBS Investors
CC Receivables Assets
Student Loans have a claim
has a claim
originator
Customer Consumer Co.
sells loans
Investor SPV - separate legal entity
AAA Review - 2
senior tranche
mortgages SPV BB $80M
$100M mezzanine tranche credit
C 15M tranching
equity tranche
losses occur from 5M
the bottom up - all principal goes to senior tranche
first, then mezzanine, then equity
M.M128348126.
equity tranche
- usually retained by originator
senior 65%
mezzanine tranche ➞ pooled with other
mezzanine 25%
mezzanine tranches
(an ABS of ABS) equity 10%
⇒ Sequential Pay ABS/
A1
- each receives interest, but all principal
senior A2 different
TTM & goes to A1, then A2, then A3
A3
A4 YTM - time tranching – redistributes prepay. risk
106
Review - 3
Rating
A1
A2 time tranching
C absorbs all losses
AAA
A3 credit first
B B tranching “first piece loss”
C C
- if no credit risk, there would be no subordination (agency debt

- gov’t. guarantee)
⇒ Residential MBS (RMBS)
- payments = principal + interest + prepayments
Loan-to-Value Ratio = 𝐦𝐨𝐫𝐭𝐠𝐚𝐠𝐞 PMT in partial PMTs

𝐩𝐫𝐨𝐩𝐞𝐫𝐭𝐲 𝐯𝐚𝐥𝐮𝐞 full (curtailment)
prepayment risk
credit quality of borrower important
mortgage holder
· lockout period Review - 4

⇒ Pre-payment Risk/ · penalty period
5 yrs. 50 yrs.
⇒ Interest Rate/ fixed rate, level payment, fully amortizing

ceiling
adjustable rate mortgage (ARM)
M.M128348126. e.g./ floor
30-yr., 200K, 6%
N = 360 FV = 0 PV = 200,00 𝐈. = .5
𝐘
CPT PMT = -1199.10
(P) 𝒊 Principal
Amortization PMT 1 1199.10 199.10 1000 199,800.90
schedule PMT 2 1199.10 200.10 999 199,600.80
➞ recourse mortgage – lender can go after assets of borrower

for any short fall
➞ non-recourse – lender’s claim ends at the property backing
the mortgage
107
Review - 5
agency MBS
⇒ Guarantees/ 1) federal agency
- no credit risk
2) government sponsored agencies - prepayment risk
3) private entities – non-agency MBS (credit + prepay.
risk)
conforming – size, LTV, documentation, insured
non-conforming 𝐧 w – weight
r – interest rate
- weighted average coupon rate (WAC) = Q 𝐰𝐢 𝐫𝐢
𝐓
𝐢0 on mortgage
- weighted average maturity (WAM) = Q 𝐰 𝐓 n - # of mortgages
𝐢 𝐢
T - months
⇒ Prepayment Rate (speed)
𝐢0𝟏
remaining
𝐩𝐫𝐞𝐩𝐚𝐲𝐦𝐞𝐧𝐭 𝐢𝐧 𝐦𝐨𝐧𝐭𝐡 𝐭
𝐒𝐌𝐌𝐭 = · prepayments/month
𝐁𝐞𝐠. 𝐦𝐨𝐧𝐭𝐡𝐥𝐲 𝐁𝐚𝐥. 𝐭 − 𝐬𝐜𝐡𝐞𝐝𝐮𝐥𝐞𝐝 𝐏𝐌𝐓𝐬
based on historical
𝐏𝐫𝐞𝐩𝐚𝐲𝐀𝐦𝐭.𝐭 = 𝐒𝐌𝐌𝐭 × (𝐁𝐞𝐠. 𝐁𝐚𝐥.𝐭 – 𝐒𝐜𝐡𝐞𝐝. 𝐏𝐌𝐓𝐬)
observations
Conditional Prepayment Rate: CPR = 1 – (1 – SMM)12- annualized SMM
Review - 6
0 no prepayments
PSA Prepayment Rate
100 same speed as benchmark
e.g./month 5 ➞ CPR = 1% CPR of .2%/month up to 6%
(PSA = 100) 6%, month 30 onwards
& CPR = 𝟏 − (𝟏 − 𝐒𝐌𝐌)𝟏𝟐
𝟏,
M.M128348126. SMM = 𝟏 − (𝟏 − 𝐂𝐏𝐑) 𝟏𝟐
⇒ Weighted Average Life/ how long an MBS lasts assuming

interest rates stay at current levels
- if r ↓, refinancing ↑, Pre payments ↑, PSA Speed ↑, Avg. Life ↓

- contraction risk: lower reinvestment of CF
- if r ↑, refinancing ↓, Prepayment ↓, PSA Speed ↓, Avg. Life ↑
- extension risk: lower CF for reinvestment
108
Review - 7
CMO/Collateralized Mortgage Obligation/
pool of Bond Class 1 time tranching
MBS Bond Class 2 different maturities
does not eliminate etc. different yields
prepayment risk
protection from
‘waterfall’
extension risk
(principal distribution)
protection from
contraction risk
⇒ Planned Amortization Class (PAC) + Support tranches/

offers both contraction & get $ over minimum
extension risk Principal payments
⇒ Non-Agency Credit Risk/ credit tranching

- internal credit enhancements reserve funds
overcollateralization
Review - 8
⇒ Non-Agency Credit Risk/
external credit enhancement - Guarantee - Ins. Co.
(wrapped)
⇒ Commercial MBS (CMBS)/ income producing assets ➞ pool of
M.M128348126.
CMBS
credit analysis of cash
flows of each loan non-recourse
⇒ Auto Loan Backed Securities/ - short-term, pr. + 𝒊 + prepayments
- all have some form of credit enhancement
⇒ Credit Card Receivable Backed Securities/
- finance charges + interest + Principal
Principal
lockout/revolving period - all Pr. reinvested in new loans
109
Review - 9
Collateralized Debt Securities/
asset mgr.
selects
senior
asset
Debt mezzanine
pool
Securities
equity
ramp-up (buy assets)
0 1 yr. Principal
revolving
repayment
period
Review - 10
⇒ Call Protection/ results in CMBS trading more like a
corporate bond
1) prepayment lockout 2-5 yrs.
2) defeasance – borrower purchases securities as collateral

to cover remaining principal balance + an
amount to substitute for what yield would have
M.M128348126. been (defeasance premium)
3) prepayment penalty points YR.

5 4 3 2 1
105% 104% etc…
of prepayment amt.
4) yield maintenance charge
- make whole charge (yield) if refinanced
110
Fixed-Income Risk & Return

Review - 1
⇒ Sources of Return 1) Coupon Payments - credit risk
2) Reinvestment of Coupon
interest rate
3) Capital gain/loss
risk
- YTM assumes/ · held to maturity
· no default
· coupons reinvested at YTM rate
Constant-yield Price Curve
100 - if r ↓:
carrying value ⇒ purchase price - lower reinvestment
Cap. gain of bond + amortized discount of coupon BUT cap.
gain
(or - amort. of if r ↑: - higher
Cap. loss premium) reinvestment of coupon
𝒕
-
T BUT cap. loss
Review - 2
⇒ Duration/ measures the sensitivity of the bond’s full
price to changes in r
· represents approx. amt. of time a bond would

have to be held for the YTM to be realized
PV
M.M128348126. e.g. Duration = 5 yrs. if r ↑, (+)𝐫𝐞𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐨𝐟
𝐜𝐨𝐮𝐩𝐨𝐧
r (−) 𝐂𝐚𝐩. 𝐥𝐨𝐬𝐬
Macauley = ∅ 𝐢𝐟 𝐡𝐞𝐥𝐝 𝐟𝐨𝐫
· yield duration 𝟓 𝐲𝐫𝐬.
modified
𝚫YTM
money
PVBP
gov’t. yield curve used with
· curve duration - effective 𝚫benchmark spot yield curve complex
yield forward curve bonds
par yield curve · financial
assets/liab.
111
Review - 3
⇒ Duration/ 𝐰𝐞𝐢𝐠𝐡𝐭𝐞𝐝
𝐧 𝟏 × 𝐏𝐌𝐓 𝟐 × 𝐏𝐌𝐓 𝑵 × (𝐏𝐌𝐓 + 𝐅𝐕)
- + + ⋯+ 4
𝐌𝐚𝐜𝐃𝐮𝐫 = Z 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬 (𝟏 + 𝒓) (𝟏 + 𝒓)𝟐 (𝟏 + 𝒓)𝒏
𝐏𝐕𝐟𝐮𝐥𝐥
𝐢*𝟏
𝐌𝐚𝐜𝐃𝐮𝐫 i.e. if semi annual

𝐌𝐨𝐝𝐃𝐮𝐫 = must be annualized
(𝟏 + 𝒓) then ÷ 2
%𝚫𝐏𝐕𝐟𝐮𝐥𝐥 ≈ − 𝐀𝐧𝐧. 𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐲𝐢𝐞𝐥𝐝 - linear estimate

if 𝚫𝐲𝐢𝐞𝐥𝐝 r ↓ ➞ PV ↑ (requires a convexity
r ↑ ➞ PV ↓ adjustment)
(𝐏𝐕0 ) − (𝐏𝐕2 ) - for small 𝚫yield:
𝐀𝐩𝐩𝐫𝐨𝐱. 𝐌𝐨𝐝𝐃𝐮𝐫 =
𝟐 × 𝚫𝐲𝐢𝐞𝐥𝐝 × 𝐏𝐕𝟎 Approx.ModDur ≈ Ann.ModDur
(𝐏𝐕0 ) − (𝐏𝐕2 ) Approx.MacDur = Approx.ModDur (1 + r)
for complex bonds – requires an option pricing model
Review - 4
⇒ Duration/ assumes a parallel shift in yield curve
· EffDur - for a callable bond, may be called if
· credit spread decreases (credit duration)
also used for · benchmark yield decreases (curve duration)
FRNs, MBS, DBPP
· 𝚫yield is based on spot curve
M.M128348126.
· 𝚫curve is based on par curve, so…
- flatter the par curve
- shorter the bond EffDur ≈ ModDur
- closer the price is to par
⇒ Key Rate Duration/
- duration at a specific maturity on the

- a key rate dur. can yield curve
be calculated for each · to get %𝚫𝐏𝐨𝐫𝐭. 𝐕𝐚𝐥𝐮𝐞, must use
maturity Key Rate Duration
maturities
-
-
-
-
-
-
-
-
-
-
112
Review - 5
⇒ Key Rate Duration/ (𝐏𝐕0 ) − (𝐏𝐕2 ) - each key
𝐊𝐞𝐲𝐑𝐚𝐭𝐞𝐃𝐮𝐫 =
𝟐 × 𝚫𝐫𝐚𝐭𝐞 × 𝐏𝟎 rate may
have a
different 𝚫rate
11 of 𝟏𝟏
these ⇒ Z 𝐊𝐑𝐃 = 𝐄𝐟𝐟𝐃𝐮𝐫

maturities 𝐢*𝟏
-
-
-
-
-
-
-
-
11 maturities 𝐌𝐚𝐭 𝟏 𝐌𝐚𝐭 𝟐
%𝚫𝐏𝐨𝐫𝐭. 𝐕. = 𝐊𝐑𝐃𝟏 q r + 𝐊𝐑𝐃𝟐 q r
𝐏𝐕 𝐏𝐕
𝐌𝐚𝐭 𝟏𝟏
+ ⋯ + 𝐊𝐑𝐃𝟏𝟏 q r
𝐏𝐕
⇒ Properties of Duration/
D
D 𝚫𝒕 c, r, N constant zero coupon bond (D=TTM)
discount bond
𝟏-𝐫
S 𝐫
T perpetuity
premium bond
TTM
PMT PMT
Review - 6
⇒ Properties of Duration/
D - as TTM ↑, Duration ↑
- as coupon ↓, Duration ↑ more interest
M.M128348126.
- as YTM ↓, Duration ↑ rate risk
TTM
⇒ Duration of a Bond Portfolio/
1) weighted average of time to receipt of the
aggregate cash flows (requires CF yield
– not practical)
2) weighted average on individual
bond Durations
𝐁𝟏 𝐁𝟐 𝐁𝐧
𝐀𝐯𝐠. 𝐌𝐨𝐝𝐃𝐮𝐫 = 𝐌𝐨𝐝𝐃𝐮𝐫𝟏 t u + 𝐌𝐨𝐝𝐃𝐮𝐫𝟐 t u + ⋯ + 𝐌𝐨𝐝𝐃𝐮𝐫𝐧 t u
𝐁𝐩 𝐁𝐩 𝐁𝐩
𝐧
Z 𝐁 𝐢 = 𝐁𝐩 & 𝐌𝐨𝐝𝐃𝐮𝐫 =
𝐢*𝟏 𝟏 + 𝐘𝐓𝐌J𝐦
113
Review - 7
⇒ Money Duration/ MoneyDur. = Ann.ModDur × PVfull
𝚫PVfull = -MoneyDur. × 𝚫yield
e.g./ PVfull = 100.940243 MoneyDur. = 618.44178

Ann.ModDur = 6.1268 if YTM ↑ 100 bps, 𝚫PVfull = -618.44178 × .01
= -6.1844178/100
⇒ Price Value of a Basis Point (PVBP)/
(𝐏𝐕* ) − (𝐏𝐕: ) of par
𝐏𝐕𝐁𝐏 = ⇒ 𝚫PVfull for 𝚫1 bp value
𝟐
⇒ Convexity Adjustment/
first order effect second order effect

𝟏
%𝚫𝐏𝐕𝐟𝐮𝐥𝐥 = (−𝐀𝐧𝐧. 𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐲𝐢𝐞𝐥𝐝) + - 𝐀𝐧𝐧. 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 4
𝟐
1 order
st
2 order
nd
(𝐏𝐕0 ) + (𝐏𝐕2 ) − 𝟐𝐏𝐕𝟎

if 𝚫bp +
neg. pos. =
𝐏𝐕𝟎 (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐
𝚫bp- pos. pos.
Review - 8
⇒ Money Convexity/
𝟏
%𝚫𝐏𝐕𝐟𝐮𝐥𝐥 ≈ (−𝐌𝐨𝐧𝐞𝐲𝐃𝐮𝐫. × 𝚫𝐲𝐢𝐞𝐥𝐝) + - 𝐌𝐨𝐧𝐞𝐲𝐂𝐨𝐧𝐯𝐞𝐱. × (𝚫𝐲𝐢𝐞𝐥𝐝)𝟐 4
𝟐
first order second order
effect effect
⇒ Duration GAP/
M.M128348126. (MacDur. – Investment Horizon)
< 0 - coupon reinvestment risk dominates market price risk
- risk is to lower rates
> 0 - market price risk dominates coupon reinvestment risk
- risk is to higher rates
⇒ Yield Volatility/ 𝚫YTM
25 bps -
TTM
114
Credit Analysis
Review - 1
Default Risk E(loss) = P(default)
⇒ Credit Risk
loss severity ×
(1 - Recovery Rate)
- spread credit quality
liquidity = x%
+ size of debt
benchmark default (credit migration risk) i.e. downgrades
⇒ Priority of Claims/ first lien/mortgage

all become
2nd
senior unsecured
secured 3rd
senior secured
if not paid in full
senior unsecured
unsecured senior subordinated all rank
subordinated ‘pari passu’
junior subordinated
⇒ Recovery Rates vary by/ seniority

industry
stage of business cycle
Review - 2
high quality AAA to AA-
⇒ Ratings/ · investment grade
upper medium A+ to A-
(default premium & low medium BBB+ to BBB-
M.M128348126.
liquidity premium small)
· non-investment grade low grade BB+ to C

default D
- also/ Positive – Stable – Negative
⇒ Notching/ company rating ⇒ on senior unsecured

⇒ each debt issue will also have a rating
· Investment grade · issue rating +/- 1 notch the issuer rating
· Non-investment grade · issue rating -up to 2 notches the issuer
rating
2 bonds with equal ratings
different outlook
may have very different prices
different recovery rates
115
⇒ 4 C’s of Credit/ an assessment of ability to pay Review - 3

- credit quality + industry fundamentals
① Capacity/ – ability to pay on time

A. Industry analysis (e.g. Porter’s 5-forces)
high credit risk ⇒ few buyers/suppliers, low barriers, many
substitutes, fragmented
B. cyclical vs. non-cyclical, growth prospects
C. Company Fundamentals – leverage, solvency
Profit & Cash Flow Leverage Coverage

- EBITDA Debt/Capital EBITDA/Int. Exp.
- FFO Debt/EBITDA
EBIT/Int. Exp.
- FCF – before Div. FFO/Debt
⇒ 4 C’s of Credit/ Review - 4

② Collateral/ (1 - Recovery Rate)
estimates of MV of assets
③ Covenants/ affirmative
negative
④ Character/ mgmt. track record, soundness of strategy
⇒ Credit Risk/ liquidity premium + risk spread

M.M128348126.
spread + benchmark
affected by/ · credit cycle
· economic conditions
· market performance
· supply and demand
return impact from ≈ (−𝐌𝐨𝐝𝐃𝐮𝐫 × 𝚫𝐒𝐩𝐫𝐞𝐚𝐝) + •𝟏. 𝐂𝐨𝐧𝐯𝐞𝐱𝐢𝐭𝐲 × (𝚫𝐒𝐩𝐫𝐞𝐚𝐝)𝟐 €

𝟐
spread changes
116
Review - 5
⇒ Special Considerations in Credit Analysis/
1) High Yield – more interested in loss severity
(1 - Recovery Rate)
- greater focus on liquidity
- ‘top-heavy’ cap. structure loss given
= high % of debt as secured default
parent - debt
structural
debt
sub sub sub subordination restricted
Hold Co.
res. unres. vs.
debt debt debt res.
sub sub sub unrestricted
debt debt debt subsidiaries
restricted by
debt agreement at Hold Co. level
- covenant analysis
· restricted PMTs to shareholders, restrictions
on liens, etc…
Review - 6
⇒ Special Considerations in Credit Analysis/
2) Sovereign Debt - ability to pay
- willingness to pay (sovereign
immunity – investors can’t force PMT)
M.M128348126.
3) Municipal Debt · general obligation bonds
- unsecured
- municipalities must balance their
budgets
· revenue bonds (installment debentures)
- for specific projects
117

2023 L1 FixedIncome

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2023 L1 FixedIncome

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Last Revised: 05/10/2022

2023 Level 1 - Fixed Income

Fixed-Income Securities: Defining Elements 2

Fixed-Income Markets: Issuance, Trading, and Funding 15

Introduction to Fixed-Income Valuation 26

Introduction to Asset-Backed Securities 42

Understanding Fixed-Income Risk and Return 64

Fundamentals of Credit Analysis 80

© markmeldrum.com. All rights reserved.

Fixed-Income Securities: Defining Elements

a. describe basic features of a fixed-income security

b. describe content of a bond indenture

c. compare affirmative and negative covenants and identify examples of each

e. describe how cash flows of fixed-income securities are structured

f. describe contingency provisions affecting the timing and/or nature of cash

Fixed-Income Securities: Defining Elements

Bond ➞ a contractual agreement between the issuer & bondholders

Structured special purpose entities (securitization ➞ ABS, MBS)

money market securities - maturities, at issuance, < 1 yr.

3/ Par Value a.k.a. principal amount, principal value, future value,

- bonds can have any par value 100 - par bond

- makes it easier to place the bond denominated bonds

- dual-currency bonds ➞ coupon payments in one currency

yield-to-maturity (yield-to-redemption, redemption yield)

➞ inverse relationship between price and YTM

par bond ➞ coupon rate = YTM

issuer appoints trustee ➞ typically a financial institution with

Negative - what an issuer will not do

Restrictions on debt ➞ max debt ratios, min. Interest Coverage Ratios

unsecured assets for future collateral

- common element ➞ ensure issuer will not take any actions

favourable ordinary income

- MBS ➞ each payment

- reduces credit risk

balloon payment required = $200

⇒ Coupon payment structure/ ➁ annual

coupon = reference rate + spread (margin) uncertain cash

· inflation adjustment can be made to either coupon

- bonds with warrants ➞ attached warrants

e.g./ if core Tier 1 capital falls below some

Fixed-Income Markets: Issuance, Trading, and Funding

a. describe classifications of global fixed-income markets

b. describe the use of interbank offered rates as reference rates in floating-rate

c. describe mechanisms available for issuing bonds in primary markets

d. describe secondary markets for bonds

e. describe securities issued by sovereign governments

f. describe securities issued by non-sovereign governments, quasi-government

g. describe types of debt issued by corporations

h. describe structured financial instruments

i. describe short-term funding alternatives available to banks

Issuance, Trading, Funding

be obtained between banks in the

- highest/lowest 25% discarded

- alternatives: Euribor, Tibor, Sibor, Hibor, Mibor

⇒ Primary bond markets/ - issuers initially sell bonds LOS c

3. Investment bank structures the offering

- most recently issued ➞ ‘on the run’ or benchmark issue

- credit ratings differ widely, but generally high

- maturity can range from overnight ➞ 1 yr. (3 mos. is typical)

- maturing CP is usually met by ‘rolling over the paper’

also: smaller issue

2/ Yield enhancement instruments e.g./ credit-linked note

Note: protects the issuer