FIN 4120- Fixed Income Securities Analysis

Lecture Notes

Professor Changhyun Ahn

CUHK Business School
Department of Finance

Fall 2022

FINA 4120 – Fixed Income 1

 Instructor

• PROFESSOR: Changhyun Ahn

• PhD in Finance from UF
• Teaching Fixed income securities since 2019

• Office: Room 1048, 10/F, Cheng Yu Tung Building

• E-mail: [email protected]
• Office Hour: By appointment

FINA 4120 – Fixed Income 2

 TA

• TA: Siyuan Wu
• PhD Student (CUHK)

• Office: Room 1157, 11/F, Cheng Yu Tung Building

• E-mail: [email protected]
• Office Hour: 10:00 – 11:30 AM (Wed)

FINA 4120 – Fixed Income 3

 Topic 1

Course Overview

FINA 4120 – Fixed Income 4

 Topic 1 - Outline

• Course overview and logistics

– Why fixed income/what will we cover?
– Course style
– Class logistics

• Review
– Interest rate quotations and conversions
– Basic PV calculation (annuity, car loan, mortgage)
– Basic bond valuation
– Basic yield curve
FINA 4120 – Fixed Income 5
Course Overview and Logistics

FINA 4120 – Fixed Income 6

 Why Fixed Income?

• Equity Market: Cash flow is uncertain

• Fixed income: Cash flow fixed…
• So simple so boring…

FINA 4120 – Fixed Income 7

 Simple is Power (1)

• Simple is good if there is asymmetric information

• Townsend (1979)
• It is costly to verify information
• Example: Gangs

FINA 4120 – Fixed Income 8

 Costly Information Verification

• Why gangs extort fixed contribution fees?

• The income flows of local shops are owner’s
private information
• Owner does not want to tell the truth
• It is costly for gangs to verify
• Gangs do not need to verify if the debt is
repaid

FINA 4120 – Fixed Income 9

 Simple is Power (2)

• No uncertainty
• Accepted and preferred by people without
financial knowledge or underdeveloped financial
system

FINA 4120 – Fixed Income 10

 Simple is Power (3)

• No uncertainty
• Idea Policy tool
• Central bank monetary market operation
• HKD:

FINA 4120 – Fixed Income 11

 1997 Asian Financial Crisis

• Soros Fund:

1. Borrow money from banks in country A

2. Sell it for USD
3. Central Bank does not have enough USD
4. Currency A depreciates
5. Repay loans at much cheaper price

FINA 4120 – Fixed Income 12

 1997 Asian Financial Crisis

Exchange rate
Currency (per US$1) Change
June 1997 July 1998
Thai baht 24.5 41 40.2%
Indonesian rupiah 2,380 14,150 83.2%
Philippine peso 26.3 42 37.4%
Malaysian ringgit 2.48 4.88 45.0%
South Korean won 850 1,290 34.1%

FINA 4120 – Fixed Income 13

 1997 Asian Financial Crisis

GNP (US$1 billion)

Country Change
June 1997 July 1998
Thailand 170 102 -40.0%
Indonesia 205 34 -83.4%
Philippines 75 47 -37.3%
Malaysia 90 55 -38.9%
South Korea 430 283 -34.2%

FINA 4120 – Fixed Income 14

 1997 Asian Financial Crisis

• One solution: increase interest rate

• Too costly
• Housing price, loans rates, stock market etc.

FINA 4120 – Fixed Income 15

 1997 Asian Financial Crisis

• Another way: Trade against speculators

• Need huge reserved money (USD)
• In the final trading day for HS stock:
– 3 billion HKD in first 5 mins
– 79 billion HKD for the whole day
– HK gov. used 120 billion HKD
– Averaged trading volume in 1997: 2 billion HKD

FINA 4120 – Fixed Income 16

 1997 Asian Financial Crisis

Foreign Currency
Rank Country Reserves (USD billions)
1 China $3,480
2 Japan $1,376
3 Switzerland $1,033
4 Russia $630
5 India $599
6 Taiwan $548
7 Hong Kong $504
8 Saudi Arabia $451
9 South Korea $449
10 Singapore $365
From IMF and *Central Bank of the Republic of China (Taiwan) as of June 2022

FINA 4120 – Fixed Income 17

Pandemic Reaction

FINA 4120 – Fixed Income 18

 US Fixed Income Market
• Very large!
– The U.S. bond market is more than twice the size of the combined
market capitalization of all U.S. stock markets
– It amounts to almost $44.9 trillion (as of Q4, 2019)—making it by far
the largest securities marketplace in the world
– Current Amount: http://www.usdebtclock.org/index.html
Money
Markets, Asset-Backed, 3%
6%
Federal Agency
Securities, 5% Municipal
, 9%

Corporate Debt, Treasury, 33%

21%

Mortgage Related,
22%

FINA 4120 – Fixed Income 19

US Fixed Income Market

Bond Market Dynamic

FINA 4120 – Fixed Income 20
Similar in Global Markets

FINA 4120 – Fixed Income 21

HK Fixed Income Market

FINA 4120 – Fixed Income 22

 Where are we?

Investment Analysis & Portfolio Management

( FINA 3080 )

Derivatives
Others
FINA 4150
…
Options & Futures Fixed Income
FINA 4110 FINA 4120

FINA 4120 – Fixed Income 23

 Why fixed income course?

• You may want to take the course if…

1. Not the worst one among major elective courses…
2. Considering a career related to the fixed income
market
3. Heard grades are not bad

FINA 4120 – Fixed Income 24

 This class is useful to students who are
interested in
• Sales and Trading

• Portfolio Management

• Commercial and Investment Banking

• Corporate Treasury

• Planning to take the CFA exams

FINA 4120 – Fixed Income 25

 We will cover

• Basic Bond Math

– Pricing
– Hedging
– Arbitrage
• Various Debt Instruments
– Convertible, ARS, MBS, ABS, CDS, CMO, CDO…
• Current Market Development

FINA 4120 – Fixed Income 26

 Examples of questions that will be answered

• What are PIK / TIPS / Reverse Convertible / Yankee /

Bulldog / Dim sum bonds?
• Is there free lunch in fixed income market?
• Are yield curves better than tea leaves in predicting the future?
• Why do firms issue convertible bonds?
• How do I protect my bond investments from future interest
rate movements?
• What fixed income investment strategies do IBs recommend to
their clients and why?

FINA 4120 – Fixed Income 27

 Course Style: General

• Not technically challenging

– We won’t touch fancy stuff like stochastic processes,
simulations and numerical solutions
– Almost all contents are based on basic financial
concepts and calculations
• It is indeed quite challenging
– Lots of application and modifications
– Emphasis on the ability to apply basic concepts to new
products (out of your comfort zone!)

FINA 4120 – Fixed Income 28

 Course Style: Emphasis

• Applying fundamental ideas

– Not repeating homework/basic questions
– Mainly new products/issues haven’t touched in class
– Applying what we learnt to understand them
• May have more in-depth analysis that beyond the
scope of the class
– Curiosity
– A little bit disorganized…

FINA 4120 – Fixed Income 29

 Course Style: Examples

• We focus on US market
• US market:
– The most efficient market, good to understand basic
facts/concepts
– The largest market
– Most new products emerge here

FINA 4120 – Fixed Income 30

 Course Style: Notes and Exams

• Class note
– You still need to take some notes
– Commitment device to force you to digest and
reorganize content
• Emphasis on why AND how
– Why we need the product/feature? Implicit assumption?
– Can we have free lunch? How does it work?
– Pros and Cons?

FINA 4120 – Fixed Income 31

 Course Style

• Polarized teaching evaluations

– Love/hate “no pain no gain” style
– Love/hate non-standard products and applying the basic
concepts to understand them
– Love/hate the emphasis on application of basic stuff
– Very fast pace and (maybe) too much stuff
– Not interested in mainland market

FINA 4120 – Fixed Income 32

 Course Logistics

• Class
– Attendance will NOT be taken
– Show up on time
– Check Blackboard for supplementary materials
– Self-test questions are provided

FINA 4120 – Fixed Income 33

 Course Logistics

• Homework
– Can be solved in groups of no more than THREE students
– 2 in total
• In-class Questions
– Some from past exams
– Won’t be accounted for grades

• Exams
– Two in-class: mid-term and Final

• Grade
– Class participation: 10%, HW: 20%, Mid-term: 25%, Final: 45%

FINA 4120 – Fixed Income 34

 Course Logistics

• Suggested Textbook (Not Required):

– Fixed Income Analysis, 3rd Edition
– Handbook of Fixed Income Securities
– Good practice and end-of-chapter questions
– WSJ/Economists

• Computation
– A financial calculator is needed for taking exams
– I am using HP10bII+

FINA 4120 – Fixed Income 35

 Grades

Grade Percentage
A 10%
A- 10~15%
B+ 20~30%
B- The rest

FINA 4120 – Fixed Income 36

• Next, Let’s review some basic concepts:
– Different interest rate quotations
– Annuity valuation
– Basic bond valuation
– Yield curve

FINA 4120 – Fixed Income 37

 Investment Decision
• Cash Flows
– Sequence of money flows
– Can be positive (income) or negative (cost, payment)
– At t=0, the initial cash outflow (-$10,000) can be interpreted as an
initial cost to start the project or security price that you pay to
purchase it.
$15,000
$5,000 $5,000 $5,000

-$10,000

– Then, is this project profitable? How do we judge it?

FINA 4120 – Fixed Income 38

 Investment Decision
• To make an investment decision, we need to know the concept of the
present value (PV) of future cash flow

• How much 1 dollar in the future is worth today?

• To compute PV, we should know the interest rate that we use to

“discount” future cash flows

• Then, how to discount them?

FINA 4120 – Fixed Income 39

 Compounding
• Suppose you put 1 dollar in a bank account and the bank pays 8%
interest per year. How much will it be after one year?

• Simple interest: 1 dollar grows linearly for a year.

– After 1 year: 1 + 0.08 = 1.08 dollar
– After 2 years: 1.08 + 0.08 = 1.16 dollar.
– After 3 years: 1.16 + 0.08 = 1.24 dollar.

• Compounded interest: 1 dollar grows geometrically for a year.

– After 1 year: 1 * (1 + 0.08) = 1.08 dollar
– After 2 years: 1.08 * (1 + 0.08) = 1.1664 dollar.
– After 3 years: 1.1664 * (1 + 0.08) = 1.2597 dollar.

FINA 4120 – Fixed Income 40

 Compounding
• Semi-annually, quarterly, and continuously compounded
interest
• After 1 year,
– Semi-annually compounded interest: (1+0.08/2)^2=1.0816
– Quarterly compounded interest: (1+0.08/4)^4=1.0824
𝑟 𝑚
– Do you see a pattern? 1 +
𝑚
– What if compounding frequency m goes infinity (m→∞)?
𝑟 𝑚
– We know lim 1 + = 𝑒𝑟.
𝑚→∞ 𝑚
– We say this as continuously compounded interest rate.
– After 2 years? 𝑒 𝑟∗2

FINA 4120 – Fixed Income 41

 Discounting
• Discounting=1/Compounding
• Inverse concept to the Future Value (FV) => Present Value (PV)

• How much do you need to put in a bank to receive 1 dollar after 1 year?
– If we assume semi-annually compounded interest rate, it is 1 /
(1+0.08/2)^2 = 1/1.0816 =0.9245 today.

• “Present Value (PV)” of 1-dollar in the future typically cannot exceed

1-dollar. => This is the concept for time-value-of-money.

FINA 4120 – Fixed Income 42

 Net Present Value (NPV)
• Assume that annual interest of 10% with annual compounding

$15,000
$5,000 $5,000 $5,000

-$10,000
• PV of the 1st cash flow: 5,000 / (1+0.1)= 4,545
• PV of the 2nd cash flow: 5,000 / (1+0.1)^2= 4,132
• PV of the 3rd cash flow: 5,000 / (1+0.1)^3= 3,757
• PV of the 4th cash flow: 15,000 / (1+0.1)^4= 10,245

• NPV of the cash flows: -10,000+4,545+4,132+3,757+10,245 = 12,679

• Since NPV is positive, this project is profitable!

FINA 4120 – Fixed Income 43

 Internal Rate of Return (IRR)
• Suppose we don’t know the interest rate. What are we supposed to do?

• IRR: The interest rate that makes the NPV of the project cash flow
zero.

• Solve
5,000 5,000 5,000 15,000
0 = −10,000 + + 2
+ 3
+
1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 1 + 𝐼𝑅𝑅 (1 + 𝐼𝑅𝑅)4

• IRR: 50%

• Since IRR is greater than the (expected) interest rate (e.g. 10%), this
project is profitable!

FINA 4120 – Fixed Income 44

 Interest Rate Quotations
• Effect interest rate vs. Annual Percentage Rate
• Effective n-month interest rate is the actual rate of return over n months
– If the effective n-month interest rate is x%, what is the effective one-month
interest rate?
– Answer: (1 + x%)1/n -1
– Effective 12-month interest rate is also known as EAY (effective annual
yield)

• Annual Percentage Rate (APR) is a way of quoting the effective interest

rate
– APR with monthly compounding of y% implies the effective monthly
interest rate is y%/12
– APR with quarterly compounding of y% implies the effective quarterly
interest rate is y%/4
– APR with semi-annual compounding of y% implies the effective semi-
annual interest rate is y%/2

FINA 4120 – Fixed Income 45

 Rule of 72

• If you were to invest $100 with compounding interest at a

rate of 9% EAY, how many years does it take to double
your investment?
• Approximately, 72/9 = 8 years.
• What happens, if interest rate becomes 2%, 3%, 8%, or
12%?
• If you have 12 years to make the double of your
investment, how much rate do you want the investment to
generate?

FINA 4120 – Fixed Income 46

 Simple Annuity

• An annuity is a stream of cash flows C received at the end of

each period for n periods

• Cash flows are the same over time

• There is no cash flow today (i.e. the first cash flow is received
one period from now)

FINA 4120 – Fixed Income 47

 Valuing a Simple Annuity

The PV of an annuity for n years is:

r is the one-period effective interest rate

FINA 4120 – Fixed Income 48

 Car Loan
• You need to buy a $20,000 car but you have only $4,000.
You have two options:
– a) You can borrow from a bank at 9% A.P.R compounded monthly
with a rebate of $1,000
– b) “South Bend Dealers” offers financing at 6% A.P.R. compounded
monthly but then you forego a $1,000 rebate.

• Both loans are for 30 months. What should you do?

FINA 4120 – Fixed Income 49

• Monthly payment to bank:
X  1 
$15,000 = 1 −   X = $560
30 
0.09/12  (1+ 0.09/12) 

• Monthly payment to dealer:

X  1 
$16,000 = 1 −   X = $576
30 
0.06/12  (1+ 0.06/12) 

FINA 4120 – Fixed Income 50

 Mortgage
• You have managed to save $50,000 and are buying your first
house for $250,000. You are offered a 9% APR
(compounded monthly) 30-year mortgage.

– What is your monthly payment?

– How long would it take you to pay back the mortgage if you are
willing to increase the monthly payment by $200?

FINA 4120 – Fixed Income 51

a) Monthly payment
monthly interest rate 9%/12=0.75%
1 1
$200,000 = X ∗ − = 𝑋 ∗ 124.28
0.75% 0.75%(1 + 0.75%)30×12
⇒ X = $1,609

b) New monthly payment: $1,809

1 1
$200,000 = 1,809 ∗ −
0.75% 0.75%(1 + 0.75%)𝑛
200,000 ∗ 0.75% 1
⇒ =1−
1,809 (1 + 0.75%)𝑛
200,000 ∗ 0.75%
⇒ (1 + 0.75%)−𝑛 = 1 − = 0.1708
1,809
ln( 0.1708)
⇒𝑛=− = 236.5𝑚𝑜𝑛𝑡ℎ𝑠
ln( 1 + 0.75%)

FINA 4120 – Fixed Income 52

 Mortgage: Composition of mortgage
payments
• Break the monthly payments into “interest” and “principal”.
time Loan outstanding Payment Interest Principal
(beginning month) (end (end month) (end month)
month)
1 200,000 1,609 200,000(0.09/12)=1,500 109

2 200,000-109 = 1,609 199,891(0.09/12)=1,499 110

199,891
3 199,781 1,609 199,781(0.09/12)=1,498 111

… … … … …

360 1,597 1,609 12 1,597

FINA 4120 – Fixed Income 53

 Mortgage: Composition of mortgage
payments
$1,800

$1,600
Interest
$1,400

$1,200

$1,000

$800

$600

$400
principal
$200

$0
1 37 73 109 145 181 217 253 289 325

FINA 4120 – Fixed Income 54

 Coupon Bond
$50 $50
New Issue March 1, 2010 $50 $50
$50 $50
$50 $50
$1000 $50 $50
$50 $50
$50 $50
ABC Corporation $50 $50
$50
$50
$50 $50
10% Subordinated Note due 2030 $50 $50
$50 $50
$50 $50
$50 $50
$50 $50
(Coupons Redeemed Semiannually) $50 $50
$50 $50
$50 $50
$50 $50
$50 $50
FINA 4120 – Fixed Income 55
Coupon Bond

$50 $50
FINA 4120 – Fixed Income 56
 ABC Corp Bond

• This simple bond is characterized by:

– Maturity, "T" --- 20 years
– Face value, "F" (also called par value) --- $1000
– Coupon rate, "c" --- $100 or 10% per year
– Payment frequency --- semi-annual

• Valuing the bond is easier than valuing equity

– It has a maturity date
– Cash flows are fixed and paid at pre-determined dates (hence the
name fixed income security)

FINA 4120 – Fixed Income 57

 Pricing --- Discounted Cash Flow

C1 C2 C3 CT −1 CT
P = "Value" = "Price" = + + + + +
1 + r1 (1 + r2 ) 2 (1 + r3 )3 (1 + rT −1 )T −1 (1 + rT )T
T
Ct
=
t =1 (1 + rt )t
where:

P = present value or price

T = time to maturity
Ct = periodic cash payment (coupon/interest)
r = discount rate or spot rate
t = time period when a payment is received
FINA 4120 – Fixed Income 58
 Yield to Maturity (YTM)

• A bond’s yield answers the question: “What is the

constant rate of return that makes the bond price equal
to the present value of promised future payments?” –
recall Internal Rate of Return (IRR)
C1 C2 C3 CT −1 CT
P = "Value" = "Price" = + + + + +
1 + y (1 + y )2 (1 + y )3 (1 + y )T −1 (1 + y )T
T
Ct
=
t =1 (1 + y )t

• Given the other information, you can solve for the yield
using a financial calculator or spreadsheet program

FINA 4120 – Fixed Income 59

 ABC Corporation Bond Example (1)

• Assume price P = $919.77, what is the YTM?

 40 50  1000
919.77 =   t 
+
 t =1 (1 + y )  (1 + y )
40

y = 5.5% = semi − annual YTM

or, with calculator:
PMT = 50, PV = −919.77, N = 40, FV = 1000, I = ?
I = 5.5%

FINA 4120 – Fixed Income 60

 ABC Corporation Bond Example (2)

• Assume a semi-annual YTM of 4.5%, what’s the Price?

 40 50  1000
P =  t 
+ 40
 t =1 (1.045)  (1.045)
= 1092.01
or, with calculator:
PMT = 50, I = 4.5%, N = 40, FV = 1000, PV = ?
PV = −1092.01

FINA 4120 – Fixed Income 61

 Price-YTM Graph
Price

YTM

FINA 4120 – Fixed Income 62

 Price-YTM Relationship
• Price  YTM
– Given one, you can get the other
• Premiums, discounts and yield
– coupon rate < YTM => price < face (discount)
– coupon rate = YTM => price = face (par)
– coupon rate > YTM => price > face (premium)

FINA 4120 – Fixed Income 63

 Practice Question

Issue Coupon (%) Maturity Yield (%) Price

(year)
A 7 3/8 16 6 114.02
B 6 3/4 4 7 99.14
C 0 10 5 102.1
D 5 1/2 20 5.9 104.15
E 8 1/2 18 8.5 100.00
F 4 1/2 6 4 96.5
G 6 1/4 25 6.25 103.45

Which prices are wrong?

FINA 4120 – Fixed Income 64

 Answer

C, D, F and G

FINA 4120 – Fixed Income 65

 Quotation Conventions

• Bond yields are quoted in many different ways. To turn a yield quotation
into a price or vice versa, you have to know which convention you are
working with!

• To compare the yields on alternative investments quoted differently, you

need to convert all of the yields to the same convention or “basis”.

• You do not need to memorize the myriad bond market quotation

conventions for this class. But you do need to learn to work with several
common conventions.

FINA 4120 – Fixed Income 66

 Bond Equivalent Yield (BEY) --- Coupon Bond

• Similar to YTM but assumes semi-annual compounding:

C1 C2 C3 CT −1 CT
P= + + + + +
y y 2 y 3 y y
1+ (1 + ) (1 + ) (1 + )T −1 (1 + )T
2 2 2 2 2
T
Ct
=
t =1 (1 +
y t
)
2
– In the previous example, BEY = 2 ∙ semi-annual YTM = 11%
– Basically, it is the annual percentage rate (APR) with
semiannual compounding
• BEY is the most common way coupon bond yields are
quoted in financial press

FINA 4120 – Fixed Income 67

 Effective Annual Yields
• EAY is the effective 12-month interest rate

• If “Y” is the quoted BEY, investors earn Y/2 every six months. The
equivalent effective annual yield is:

(1 + Y/2)2 – 1

• Comprehension Check Question:

A bond equivalent yield is 10.5%

What is the effective annual rate?

.105 2
(1 + ) − 1 = 10.776%
2
What is the effective 6- month rate?
10.5%/2 = 5.25%

FINA 4120 – Fixed Income 68

 Yield Curve

• Interest rates are unlikely to be constant across horizon

• Likewise, bond yields varies with maturities
• Yield Curve plots the yields as a function of maturities
– There are many types of yield curves (Treasury yield curve, spot
rate curve, LIBOR Curve)
– All depict yield-maturity relationship
– aka Term Structure of Interest Rates

FINA 4120 – Fixed Income 69

U.S. Treasury Yield Curve

FINA 4120 – Fixed Income 70

 Key Points

• It is important to understand fixed income

instruments

• Bond price is determined by discounted cash

flows and is therefore a function of two things:
– Cash Flows
– Discount Rates

FINA 4120 – Fixed Income 71