Fixed Income Securities and

Financial Innovations
(MGT3132)
Module-1
 Security
A security in the finance world is defined as a
tradable financial asset, certificate, or instrument
that has monetary value and can be traded.
Example: Equity securities and Debt securities.
 Fixed Income Securities
• Fixed-income securities are debt instruments
issued by government or corporate
organizations that offer a fixed return on your
investments.
• Specific securities even provide periodic returns
to create a steady income stream. Due to the
fixed returns, many investors prefer these fixed-
income instruments in their investment
portfolio along with equity and other market-
linked instruments.
Equity Vs Fixed Income

Dr. Anurag Shukla

(PhD)
Equity Vs Fixed Income
 Bonds
• What is a Bond ?
bonds

• Definitions

• Types of Bonds

• Bond Analysis- The Risk

Perspective
 What is a Bond-?
•A debt investment in which an investor loans money to an
entity (corporate or governmental) that borrows the funds for
a defined period at a fixed interest rate.
• Bonds are used by companies, municipalities, states and
governments to finance a variety of projects and activities.
Bonds are commonly referred to as fixed-income securities.
• Bonds pay fixed coupon (interest) payments at fixed intervals
(usually every 6 months) and pay the par value at maturity.
• Agreement between borrowers and lenders
What is a Bond-?
 Definitions
• Par or Face Value : The amount of money that is paid to the
bondholders at maturity.
• Coupon Rate : The coupon rate, which is generally fixed, determines
the periodic coupon or interest payments. It is expressed as a
percentage of the bond's face value. It also represents the interest cost
of the bond to the issuer.
• Coupon Payments : The coupon payments represent the periodic
interest payments from the bond issuer to the bondholder. The annual
coupon payment is calculated by multiplying the coupon rate by the
bond's face value. Since most bonds pay interest semiannually,
generally one half of the annual coupon is paid to the bondholders
every six months.
• Maturity Date : The maturity date represents the date on which the
bond matures, i.e., the date on which the face value is repaid. The last
coupon payment is also paid on the maturity date.
 Definitions
• Market Value- A Bond may be traded in a stock exchange. The
price at which it is currently sold or bought is referred to as the
market value. Market value may be different from the Par value
or the maturity Value.
• Redemption Value-At the end of maturity the borrowed sum must
be refunded. The amount of money paid at the time of maturity is
referred to as redemption value. Normally bonds are redeemable
at par, but they can also be redeemed at premium or discount.
• Current yield is the annual interest divided by the bonds current
value. Current yield only considers the annual interest and
ignores any capital gain or loss .
• Yield to maturity : Yield to maturity is the total rate of return that
the bondholder stands to earn after earning all the interest
payments and principal repayment.
• Credit Rating: Creditworthiness of issuer
Bonds: Secondary Market
 Types of Bonds
• Based on Coupon & Interest
Fixed Rate Bonds
Floating Rate Bonds : Reference rate + Margin
Zero Coupon Bonds

• Based on Option
Call option and Put Option

• Based on Geography
Domestic Bonds
Foreign Bonds
Euro Bonds
Global Bonds
 Types of Bonds
• Based on Issuer
Sovereign Bonds/Government Bonds/
Treasury Bonds
Quasi-Government Bonds
Non-Sovereign
Supranational (IMF, World Bank)
Corporate Bonds
SPE (MBS, ABS, CMO, CDO)
• Other: Inflation Indexed Bonds, Sovereign Gold Bonds,
Convertible Bonds
 Bond Analysis-The Risk Perspective
• Inflation Rate Risk
• Interest Rate Risk
• Price Risk
• Reinvestment Rate Risk
• Call Risk
• Marketability Risk
• Credit Risk
 Time value of money
• The time value of money is a basic financial concept that holds
that money in the present is worth more than the same sum of
money to be received in the future.

• This is true because money that you have right now can be
invested and earn a return, thus creating a larger amount of
money in the future.

• Also, with future money, there is the additional risk that the
money may never actually be received, for one reason or another.
The time value of money is sometimes referred to as the net
present value (NPV) of money.
 How the Time Value of Money Works
• A simple example can be used to show the time value of money.
Assume that someone offers to pay you one of two ways for some
work you are doing for them: They will either pay you Rs.1,000
now or Rs.1,100 one year from now.
• Which pay option should you take? It depends on what kind
of investment return you can earn on the money at the present
time. Since Rs.1,100 is 110% of Rs.1,000, then if you believe you
can make more than a 10% return on the money by investing it
over the next year, you should opt to take the Rs.1,000 now.
• On the other hand, if you don’t think you could earn more than 9%
in the next year by investing the money, then you should take the
future payment of Rs.1,100 – as long as you trust the person to
pay you then.
 Time Value of Money Formula

• The time value of money is an important concept not just

for individuals, but also for making business decisions.
Companies consider the time value of money in making
decisions about investing in new product development,
acquiring new business equipment or facilities, and
establishing credit terms for the sale of their products or
services.
• A specific formula can be used for calculating
the future value of money so that it can be
compared to the present value:
• Using the formula above, let’s look at an
example where you have Rs.5,000 and can
expect to earn 5% interest on that sum each
year for the next two years. Assuming the
interest is only compounded annually, the future
value of your Rs.5,000 today can be calculated as
follows:
• FV = Rs.5,000 x (1 + (5% / 1) ^ (1 x 2) =
Rs.5,512.50
 Present Value of Future Money Formula

• The formula can also be used to calculate the present value of

money to be received in the future. You simply divide the future
value rather than multiplying the present value. This can be
helpful in considering two varying present and future amounts.
• In our original example, we considered the options of someone
paying your Rs.1,000 today versus Rs.1,100 a year from now. If
you could earn 5% on investing the money now, and wanted to
know what present value would equal the future value of Rs.
1,100 – or how much money you would need in hand now in
order to have Rs. 1,100 a year from now – the formula would be
as follows:
The calculation above shows you that, with an available return
of 5% annually, you would need to receive Rs.1,047 in the
present to equal the future value of Rs. 1,100 to be received a
year from now.
 Discount Factors
• For a particular term
• Present value of one unit of currency to be
received at the end of that term d(t)
• If d(.5) =.99925 ,the pv of 1 $ to be received
in six month is 99.925 cents
• Can be extracted from treasury bond prices
• Price of bond=PV of future cash flows
• Fall with term reflect time value of money
• Longer the payment of 1$ is delayed, the less
it is worth today
 Law of One Price
• How to price .75% coupon of Nov 30, 2025
• Apply the discount factors to this bond’s
cashflow
• Base bonds are all U.S. treasury bonds: Risk
uniform
• Value to investors of receiving $1 from treasury
on some future date should not depend on
which particular bond paid that $1
 Law of One Price
• If there are two sets of securities, which are giving
identical cash flows in future (In the absence of
liquidity, financing, taxes, credit risk).
• Identical sets of cashflows should sell for same
price.
• If there is difference in price, there would be an
arbitrage opportunity.
• If the market price of bond is 100.19, what to
infer?
• Deviations from Law of one price can lead to
arbitrage
 Arbitrage and Law of One Price
• Justification for law of one price sets on a
stronger foundation
• Deviation from law of one price –Existence of
an arbitrage opportunity
• Trade that generates profits without any
chance of losing money
• Arbitrageurs would rush to do any such
trade- Market prices quickly adjust to rule
out any such opportunities
 Arbitrage: Limitations
• Transaction Costs

• Only in theory US treasury bonds are fungible

collection of cash flows but in reality , bonds
have idiosyncratic differences recognized by
market and priced accordingly
 Replicating Portfolio
• Replicating portfolios in the context of bonds
refer to a financial strategy used to create a
portfolio of assets that mimics the performance
of a specific bond or a bond-related financial
instrument.
 Replicating Portfolio
• A replicating portfolio is a combination of different
financial instruments designed to reproduce the
cash flows, risk profile, or performance
characteristics of a target asset or liability. In the
case of bonds, a replicating portfolio aims to match
the bond’s cash flows and characteristics (such as
duration or convexity) using a set of other bonds or
financial instruments.
 Replicating Portfolio
• Cash Flow Matching
• Duration Matching
• Hedging Strategies
• Arbitrage Opportunities
Valuation of Bonds
Answer: 1043.29
Answer: Rs. 920.15
Answer: 1018.59
 Years and yearly coupon rates

Answer: Rs. 71.28

 Separate Trading of Registered Interest and
Principal of Securities (STRIPS)
• Zero coupon bonds: No payment until maturity
• Strips: ZCB issued by U.S. Treasury
- Created when a particular coupon bond is
delivered to the treasury in exchange for its
coupon and principal components
C Strips: Coupon or interest STRIPS
P Strips: Principal STRIPS
Face value of C strips on each date is coupon
 Separate Trading of Registered Interest and
Principal of Securities (STRIPS)
• Treasury creates and retires the STRIPS
• C strips are fungible while P strips are not
-Any C-strips maturing on a particular date
may be applied towards the coupon payment
of that bond on that date
- Only P strips that were stripped from a
particular bond may be used to reconstitute
the principal payment of that bond