Introduction to fixed income market Flashcards
What is a Fixed Income Market?
- The name “fixed” often be misleading its underlying complexity.
- Trading FI doesn’t necessarily guarantee a gain.
- The size of the fixed income market is quite larger than stock market.
What securities can be traded on debt market?
- Treasury (Sovereign) Securities: Issued by governments (USA, Japan, UK, etc.);
Government that are in surplus also issue bonds to keep liquid market favorable for them and make the base rate.
- Agency Securities: (particularly in US) Debt securities issued by government agencies, such as the Federal Home Loan Bank (FHLB), the Tennessee Valley Authority (TVA), the Federal National Mortgage Association (FNMA) and Government National Mortgage
Association (GNMA). - Corporate Securities: Debt securities issued by corporations
(both investment grade and non-investment grade ie junk) - Mortgage-Backed Securities: Debt securities backed by pools
of mortgages. - Asset-Backed Securities: Securities backed by a portfolio of
assets, such as credit card receivables. - Municipal issues: Debt securities issued by state governments
and municipalities. for instance particular state government issue it to finance infrastructure development.
What is worth to highlight from Fixed Income market in 2008?
There are 2 things to highlight.
- The size of the MBS > size of the US treasury market.
- OTC interest rate swaps derivative market > underlying primary market ie US treasury market.
What is credit derivative?
In plain english it is like insurance policy on your neighbor’s house such that in the event of fire or loss you will get paid. In other words insurance policy against default on assets that you don’t own. CDS is a credit derivative instrument. AIG issued CDSs prior to credit crisis, which resulted them to be bailed out.
What are the key concepts in trading fixed income market?
No arbitrage and the Law of one price.
The key concept for understanding the relationship among these different Fixed Income Markets is No Arbitrage
▫ An Arbitrage Opportunity is a feasible trading strategy involving two or more securities with either of the following characteristics:
It does not cost anything at initiation and it generates a sure positive profit by a certain date in the future
It generates a positive payoff at initiation, and it has a sure non-negative payoff by a certain date in the future
▫ The No Arbitrage condition requires that no arbitrage opportunities exist
What are the trading instruments in government debt market?
• Zero Coupon Bonds: securities that only pay the principal at maturity
• Fixed Rate Coupon Bonds: securities that pay a fixed coupon over a given period (semiannually) plus the principal at maturity
• Floating Rate Coupon Bonds: securities that have the coupon indexed to some other short term interest rate, varying over time
• The Municipal Debt Market
• Separate Trading of Registered Interest and Principal of Securities (STRIPS): Artificial zero coupon bonds constructed by stripping off separate interest and principal payments from a coupon bond
• Treasury Inflation Protected Securities (TIPS):
securities with the principal indexed to inflation, so that coupon payments move accordingly
What is Money market?
The Money Market refers to the market for short term borrowing and lending, usually undertaken by
banks
•Federal Funds Rate: rate for borrowing / lending balances kept at the Federal Reserve
• Eurodollar Rate: rate of interest of dollar deposits at a European bank
• LIBOR: average interest rate the banks charge to each other for short term uncollateralized borrowing / lending
• Repo Rate: interest rate charged for short term borrowing / lending with collateral
What is REPO market?
- A Repurchase Agreement (Repo) is an agreement to sell some securities to another party and buy them back at a fixed date and for a fixed amount. The price at which the security is bought back is greater than the selling price and the difference implies an interest called Repo Rate
- A Reverse Repo is the opposite transaction, namely, it is the purchase of the security for cash with the agreement to sell it back to the original owner at a predetermined price, determined, once again, by the Repo Rate
The Repo Market - example
• Profit = PT – Pt – Repo rate x (Pt – haircut) x n/360
• Capital at risk = haircut (very small)
▫ Return = [PT – Pt – Repo rate x (Pt – haircut) x n/360] / haircut
▫ Very highly levered position.
• The trader earns the accrued interest between t and T.
• The repo rate for most Treasury securities is called the General Collateral Rate.
• At times, a particular bond is hard to find. Rate on such a bond is called a special repo rate.
▫ Dealers often short on-the-run Treasuries to hedge other securities.
▫ Purchased via reverse repo, causing repo rate to fall.
▫ (Lower repo rate is an additional benefit of owning the security, causing its price to rise).
What if the T-bond is not
delivered to dealer in the repo Market scenario?
• In a reverse repo at time T trader must return bond to dealer
• in exchange for cash amount Pt x (1+repo rate x n/360)
• What happens if the trader does not return the security?
• This is called a fail and up to May 2009 repo dealer just kept cash and cost to trader is to forgo repo rate.
• In crisis of 2007-2009 Fed Funds rates fell to essentially zero
• Repo rates also fell to essentially zero so cost of a fail to a trader was minimal
▫ Crisis generated flight to quality – strong demand for US Treasuries.
▫ Costly for traders who are short to buy back bonds to return to repo dealer.
▫ Small cost of failure to deliver meant number of fails spiked in last quarter of 2008.
MORTGAGE BACKED SECURITIES
MARKET AND ASSET-BACKED SECURITIES
• The Mortgage Backed Securities (MBS) market has grown significantly over the past years
▫ These securities allow local banks, which issue mortgages to individuals, to diversify their risk
A bank issues mortgages to individuals living nearby. These mortgages are susceptible to local events (e.g. a local company goes bankrupt leaving many mortgage holders without a job)
▫ By pooling its mortgages and buying into a mortgage backed security, the bank reduces the effect of a local event affecting its balance sheet
• Asset Backed Securities (ABS) are similar to MBS, but instead they are collateralized by other types of loans (auto loans, credit cards, etc.)
About Swaps - Derivative Market
to be completed
About Futures and Forwards - Derivative Market
• Futures and forward contracts are contracts according to which two counterparties decide to exchange a security, or cash, or a commodity, at
a prespecified time in the future for a price agreed upon today
Futures are traded on regulated exchanges
Forwards are traded on the over-the-counter (OTC) market
What is a financial Options?
• Intuitively, an option is the financial equivalent of an insurance contract:
▫ It is a contract according to which the option buyer, who purchases the insurance, receives a
payment from the option’s seller, who sold the insurance, only if some interest rate scenario occurs in the future
