Fixed Income Flashcards
Spot rates / zero-coupon rates
Effective annual rates which pay no interim interest. Geometric averages of forward rates. Not fully observable but required to fully disocunt the cashflows of any bond.
Spot curve
Annualized return on a risk-free zero coupon bond with a single payment of principal at maturity
YTM
Annual return an investor would achieve by investing in a particular coupon-paying bond to maturity and reinvesting all cash flows at the yield itself. Weighted average of spot rates.
YTM will only be expected return if:
- Bond is held to maturity 2. Cash flows are made in full and on time 3. All cash flows are reinvested at the original YTM
Forward rates
Spot rates starting in the future. They can be derived from Spot rates.
Price of a bond is
PV of all cash flows discounted at each cash flow’s zero coupon rate aka spot rate
Bootstrapping a yield curve
In reality we cannot observe zero rates directly. We need to extract them from bond yields = bootstrapping. We generally look at par yield curves where there is no tax distortion.
On-the-run bonds
Most recently issued! Similar to par yield curves (Y=C // P=Par).
Par Yield Curve
A par yield curve is a graphical representation of the yields of hypothetical Treasury securities with prices at par. On the par yield curve, the coupon rate will equal the yield to maturity (YTM) of the security, which is why the Treasury bond will trade at par.
Valuing a bond / discounting the cash flows with YTM when
Coupon = YTM (par) yield
Valuing a bond / discounting the cash flows with Spot rates and forward rates when
If coupon doesn’t equal YTM (par) yield
Forwards haben keine Potenzen
Maturity / Tenor
refers to the length of time remaining before a financial contract expires
Riding the Yield Curve
Purchase long-term bonds with a maturity date longer than their investment time horizon. Sell at the end of their time horizon, profiting from the declining yield that occurs over the life of the bond (profits from the higher six-month yield altough he is only holding 3 months)
Works best in a stable interest rate environment where interest rates are not increasing. Additionally, the strategy only produces excess gains when longer-term interest rates are higher than shorter-term rates (upward sloping yield curve)
Swap
Derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments
Like all derivatives the value of an interest rate swap at inception is zero
Swap curve
Is the yield curve of swap rates
Why use a swap curve as a benchmark?
- Liquidity – if the swap market is more liquid than the government bond market
- It contains more maturities than the government spot curve
- If a bank or client of a bank uses swaps to hedge interest rate risk then it makessense (for hedging purposes) to value their assets and liabilities using the swap curve
Par yield
The yield on a bond priced at par
(Par) Swap Rate
Swap spread
Is defined as the spread paid by the fixed-rate payer of an interest rate swap over the rate of the on-the-run (most recently issued) government security with the same maturity as the swap
It It represents the extra return above the equivalent equivalentrisk -free return which compensates the investor for additional time value, credit and liquidity risk. It is conceptually equivalent to a Z-spread.
The Z-spread, ZSPRD
Spread over the default-free spot curve
The static spread required to be added to each implied government spot rate such that the present value of cash flows equals the bond price. Reflects compensation for credit, liquidity and option risk. Reflects compensation for credit, liquidity and option risk.
TED spread
Difference between the interest rates on interbank loans and on short-term U.S. government debt (“T-bills”). TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract.
Indicator of perceived credit risk in the general economy. A widening of the TED spread indicates higher concerns about the wider wider economy (T-Bills Flight to safety > Prices up > Yields go down = ED Yields go up as people sell)
Credit (G) spread
A credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality
G-spread (also called nominal spread) is the difference between yield on Treasury Bonds and yield on corporate bonds of same maturity
- Compensation to the investor for bearing the default risk of the issuer ( investors wants more RETURN)
- Considers the possibility that the issuer fails to make a scheduled payment in full on the due date // losses incurred in the event of default
LIBOR-OIS Spread
The spread between LIBOR for a given maturity (typically three months) and the
Overnight Indexed Swap (OIS) rate for the equivalent maturity.
A widening of the spread indicates higher concerns about banking default risk
and/or liquidity concerns in the money markets.
OIS in GBP: SONIA; OIS in EUR: EONIA; OIS in USD: FFER
Option adjusted spread (OAS)
[Option removed spread]
constant interest rate spread that must be added to all of the one period forward rates in a binomial tree so that the theoretical value of the callable bond is the same as the market price. The spread you would receive if the bond had no embedded option. Best thought of as ‘option removed spread
Reflects compensation for credit and liquidity risk (but not option risk)
decline in interest rate volatility corresponds with a higher OAS
Flight to safety
Investors buy bonds (safer investments) when they sell stocks (higher-risk investments) in order to reduce the losses that investors suffer in crises periods
Demand for T-Bills goes up, Prices go up, Yields go down