# Chapter 7 | Fixed-Income Securities: Pricing and Trading

1. CALCULATING PRICE AND YIELD OF A BOND

PV=Cn+FV/(1+r)n

THE DISCOUNT RATE

The discount rate is the rate at which you would discount a future value to determine the present value.

CALCULATING THE FAIR PRICE OF A BOND

The fair price of a bond is the present value of the bond’s principal and the present value of all coupon payments to be received over the life of the bond.

Yield to maturity (YTM)

REINVESTMENT RISK

Because interest rates fluctuate, the interest rate prevailing at the time of purchase is unlikely to be the same as the interest rate prevailing at the time the investor reinvests cash flows from each coupon payment.

2. TERM STRUCTURE OF INTEREST RATES

• The general level of interest rates at any particular time

• The level of interest rates at different terms to maturity

Fisher Effect:

• The real rate of return

• The inflation rate

Because inflation reduces the value of a dollar, the return that is received, called the nominal rate, must be reduced by the inflation rate to arrive at the real rate of return.

Nominal Rate = Real Rate + Inflation Rate

THE YIELD CURVE

Yield curve is a curve showing several yields to maturity or interest rates across different contract lengths for a similar debt contract.

-Expectations theory : The expectations theory says that current long-term interest rates foreshadow future short-term rates.

-Liquidity preference theory : Investors prefer short-term bonds because they are more liquid and less volatile in price.

-Market segmentation theory : Yield curve represents the supply of and demand for bonds of various terms, which are primarily influenced by the bigger players in each sector.

3. FUNDAMENTAL BOND PRICING PROPERTIES

THE RELATIONSHIP BETWEEN BOND PRICES AND INTEREST RATES

When interest rates rise, bond yields also rise but bond prices fall; when interest rates fall, bond yields also fall but bond prices rise.

THE IMPACT OF MATURITY

The next important relationship to recognize is that longer-term bonds are more volatile in price than shorter-term bonds.

THE IMPACT OF THE COUPON

Lower-coupon bonds are more volatile in price percentage change than high-coupon bonds.

THE IMPACT OF YIELD CHANGES

The relative yield change is more important than the absolute yield change.

DURATION AS A MEASURE OF BOND PRICE VOLATILITY

• The value of a bond changes in the opposite direction to a change in interest rates: as interest rates rise, bond prices fall; as interest rates fall, bond prices rise.

• Given two bonds with the same term to maturity and the same yield, the bond with the higher coupon is usually less volatile in price than the bond with the lower coupon.

• Given two bonds with the same coupon rate and same yield, the bond with the longer term to maturity is usually more volatile in price than the bond with the shorter term to maturity.

THE SELL SIDE

• Investment banker

• Sales representative

• Portfolio manager

ROLE OF INTER-DEALER BROKERS

These brokers act solely as agents, bringing together institutional buyers and sellers in matching trades.

• Specific details of the counterparties to the trade

• Full identification of the bond

• The bond’s Committee on Uniform Security Identification Procedure (CUSIP)

• The nominal

• The price

• The settlement date

• The name of the custodian

• The total settlement amount

CLEARING AND SETTLEMENT

Bearer bonds

Registered bonds

Bonds registered in book-based format

CALCULATING ACCRUED INTEREST

Accrued Interest = par amount X (coupon rate/100) X (Time Period/365)

5. BOND INDEXES

• As a guide to the performance of the overall bond market or a segment of that market

• As a performance measurement tool, to assess the performance of bond portfolio managers

• To construct bond index funds

FTSE Global Debt Capital Markets offers a comprehensive set of Canadian bond indexes.

GLOBAL INDEXES

• Global bond indexes

• U.S. bonds

• Government bonds

• Emerging market bonds

• High-yield bonds