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2roup mmm

ilesh Jain (26)

azeel Kazi (29)
rashant Kokare (31)
umeet Kudal (32)
ilind Walke (55)
jay Patel (62)
xixed Income Market

D The bond market (also known as the debt, credit, or fixed income
market) is a financial market where participants buy and sell debt
securities, usually in the form of bonds.

D As of 2009, the size of the worldwide bond market (total debt

outstanding) is an estimated $82.2 trillion, of which the size of the
outstanding U.S. bond market debt was $31.2 trillion according to
BIS (or alternatively $34.3 trillion according to SIxMA).

D Nearly all of the $822 billion average daily trading volume in the
U.S. bond market takes place between broker-dealers and large
institutions in a decentralized, over-the-counter (OTC) market.
However, a small number of bonds, primarily corporate, are listed
on exchanges.
Indian xixed Income Market

D The Indian debt market is today one of the largest in Asia.

D Includes securities issued by the Government (Central & State

Governments), PSU·s, other government bodies, financial
institutions, banks and corporates.

D The Indian debt markets with an outstanding issue size of

Government securities (Central and state) close to Rs.13.4 billion
(or Rs. 1,34,7435 crore) and a secondary market turnover of
around Rs 56.03 billion is the largest segment of the Indian
financial markets.(Source RBI & CCIL).
xixed Income Securities

D Bonds (Govt, Agency, Muni, Corp ² Investment Grade/High-

Yield/Junk Bonds, Inflation/Index Linked)

D MBS

D CMO/CDO

D ABS (Student loan/Car loans/Home equity)

D SWAPS (IRS/x /TRSWAPS/CDSWAPS)

Important xeatures

D Issuer

D Coupon

D Maturity

D Coupon xrequency

D Rating

D Market Interest Rates

D Yield
Risk Associated

It is a common misconception among non-professional investors that

bonds and bond funds are risk free. They bear various risks, of which
the most important ones are :

D Credit Risk (Default)

D Interest Risk (Coupon vis-a-vis Market interest Rate)

Price ² Yield Relationship

D The understanding of relation between price and yield of a

security is of utmost importance in xixed income securities.

D There are three rates ² Coupon, Mkt Interest Rates and Yield
(Coupon/Price).

D The price of a security and yield of the security are inversely

related.

D If interest rates in the market increase, the demand for the

security goes down and thus lowers its price.

D As the changes in Market interest rates affect the price of a

security ² there is a need of some measure that would explicitly
state the sensitivity of these changes.
Duration
D Duration is a measure that helps to translate the risk associated with
fixed income securities in numerical terms.

D It helps in understanding the interest risk profile of a security.

D There are two approaches to look at Duration:

- How much time will it take for the bond to realize its initial
investment in present value terms of future expected cash flows
(Macaulay Duration).

- % change in price for 100 bp changes in yields (Modified Duration).

D Though the calculation of these goes in similar fashion ² these are two
main schools of thought for interpreting the numbers.
Duration
D Duration is a measure of the average (cash-weighted) term-to-
maturity of a bond. (Macaulay)

D Modified duration is an extension of Macaulay duration and is a useful

measure of the sensitivity of a bond's price (the present value of it's
cash flows) to interest rate movements

D Effective Duration: Cash flows from securities with embedded options

or redemption features will change when interest rates change. xor
calculating the duration of these types of bonds, effective duration is
the most appropriate.

D Key Rate Duration: Calculates the spot durations of each of the 11

´keyµ maturities along a spot rate curve. These 11 key maturities are
at the three-month and one, two, three, five, seven, 10, 15, 20, 25,
and 30-year portions of the curve.
Calculating Duration
Macaulay Duration ² A measure of Timing of
Cash xlows
È The red lever above represents the four-year time
period it takes for a zero-coupon bond to mature.

È The money bag balancing on the far right

represents the future value of the bond, the
amount that will be paid to the bondholder at
maturity.

È The fulcrum, or the point holding the lever,

represents duration, which must be positioned
where the red lever is balanced.

È The fulcrum balances the red lever at the point on

the time line at which the amount paid for the
bond and the cash flow received from the bond are
equal.

È The entire cash flow of a zero-coupon bond occurs

at maturity, so the fulcrum is located directly
below this one payment.
Duration

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Characteristics that influence Duration

D Duration is Higher if:

ö Longer the maturity
ö Lower the coupon
ö Lower the yield

D Small coupons increase duration while large coupons decrease duration.

D Holding coupon constant , duration increases with maturity.

D Duration decreases with calls and prepayments as calls and prepayments

shorten maturity.

D Duration indicates price sensitivity of bond. xor e.g.:

If Duration of bond is 5 years and price of my bond is 100$, 100bps change in
interest rate will change my price accordingly. If rates go down by 100bps
price of my bond is expected to rise by 5$ to 105$, and vice-versa.
Duration & Coupon payment

D As the bondholder receives a coupon payment, the amount of the

cash flow is no longer on the time line, which means it is no longer
counted as a future cash flow that goes towards repaying the
bondholder.

D Duration increases immediately on the day a coupon is paid, but

throughout the life of the bond, the duration is continually
decreasing as time to the bond's maturity decreases
Convexity

D xor a security bearing Duration 5, we know that a 100bps change

in interest rate will lead to a 5% change in price.

D But, this is not the case.

D This is because Duration assumes that price and interest rate have
a linear relationship.

D Interest rate do not exhibit constant change across the yield

curve.

D Thus the relationship between price and interest rate is

curvilinear.

D So, when a bond has a Duration of 5, the price may change by

more or less than 5%. This pricing error is defined by Convexity.
 Convexity

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Convexity

D Convexity measures the curvature

or the second order change in
price with respect to yields.

D A security has 

convexity
if its price increases 

than
duration would imply when yields
decrease (or vice versa).

D Conversely a security has



convexity if its price
increases 
than duration
would imply when yields decrease
(or vice versa).

D Graphically, positive convexity

can be observed if the price-yield
curve is convex (the curve smiles)
and negatively convex securities
have concave price-yield graphs
(the curve frowns).
Convexity of two bonds

è Convexity is also useful for

comparing bonds.

è If two bonds offer the same

duration and yield but one
exhibits greater convexity,
changes in interest rates will
affect the bond differently.

è A bond with greater convexity is

more affected by interest rates
than a bond with less convexity.

è Also, bonds with greater

convexity will have a higher
price than bonds with a lower
convexity, regardless of whether
interest rates rise or fall.
Duration and Convexity of Callable Bonds


  
 


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Duration and Convexity combined

D The idea behind duration is simple. Suppose a portfolio has a duration of 3

years. Then that portfolio's value will decline about 3% for each 1% increase in
interest rates³or rise about 3% for each 1% decrease in interest rates. Such a
portfolio is less risky than one which has a 10-year duration. That portfolio is
going to decline in value about 10% for each 1% rise in interest rates.
Convexity provides additional risk information.

D With a callable bond, as interest rates rally it becomes more likely that the
issuer will call the bond, thereby providing the investor with a set of cash
flows to the call date that are worth less than the cash flows to the maturity
date.

D This change in expected future cash flows limits the potential increase in the
bond's price as rates rally, causing the bond's price curve to display negative
convexity. If the call is deep in-the-money (i.e. virtually 100% certain to occur)
and the call date is near, a further decline in rates may produce almost no
increase in the bond's price and the price curve will be flat, i.e. with zero
convexity.

D Duration and Convexity are combined to asses price sensitivity

Rate Influence on Total Return

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Rising -ve +ve +ve -ve

Stable +ve -ve -ve +ve
Decline +ve -ve +ve -ve
Relationship between the rates and Price/Duration

Relationship between Price and Duration

D Positive Convexity : Price up- duration up (direct relation) and Price down ²
Duration down

D Negative Convexity : Price up - duration down (Indirect relation) and Price

Down ² Duration up

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D Treasury securities: Price up-Duration up and Price down ² Duration down

(direct relation between price and duration) as they bear +ve Convexity.

D Credits (investment grade): Price up-Duration up and Price Down ² Duration down (direct
relation between price and duration)

D Mortgage Backed Securities: Price up-Duration down (inverse relation between price and
duration) as they have ²ve Convexity.

D Agency (Callable): Price up-Duration down (inverse relation between price and duration)
as they have ²ve Convexity.
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 Learning·s

D Duration and Convexity are measures that depict the risk of a

security.

D Duration alone cannot be used in isolation.

D Convexity further makes the understanding more clear in regards

to effect of interest rate on prices.

D Securities are often used to hedge prices (xutures/Options for

Equities).

D In xixed income market, securities are used to hedge interest rate

risk.

D Portfolio managers use the Duration and Convexity profile of

securities to hedge the risk that are inherent in the portfolio.
 Learning·s

D Securities with +ve Duration and Convexity are used to hedge

against securities with ²ve Duration and Convexity (e.g.. TBA·s used
to hedge IO·s)

D Calculating duration for securities like CMO/MBS is further

complex. More than just looking at cash-flows, companies have
built Pre-payment models that predict the cash-flows of these
securities.

D Considering the current scenario post the sub-prime crisis,

Duration/Convexity are losing its importance as products like Home
Equity ABS do not have any values left ² so no point in calculating
their interest rate sensitivity.

D xunds are moreover judges on their actual returns and then these
returns being attributed to factors like ² bet taken by the Portfolio
manager, x changes, etc.
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