Fixed Income Final- Lecture 5

Convertibility

Holder has the option to exchange bond for equity at a preset price.

Puttability

Holder has the option to sell the bond back to the issuer prior to maturity at a preset price.

Inflation

(IP) is defined as the (percentage) increase in the price of a standardized basket of goods and services over a given period of time.

In US, IP is measured using.....

-CPI (Consumer Price index) or PCE (Personal consumption expend. -Headline(all items) or Core (excluding food& Energy)

Inverted Yield Curve

-Higher Short term rates and lower expected future inflation. -Always followed by economic slowdown. Or outright recession- as well as lower interest rates across the board. -E.X. August 1981, (Followed by the great recession)

Positive Yield Curve (Normal)

-Normal Slope under preferred natural habitat -Most Closely associated with the middle, salad days of an economic and stock market expansion -E.X. December 1984 (middle of the longest postwar expansion)

Flat (or humped) Yield Curve

-Likely ( but not always) followed by economic slowdown and lower interest rates.

Steep Yield Curve

-Very low short term rates and higher long term yields. - Typical at the beginning of an economic expansion, just after the end of a recession. - April 1992 (Followed by stock market expansion when Russell 3000 index gained 20% over the next two years.

Interest Rates Compensate Investors for the following

1)Delaying Consumption (real rate) 2)Loss of purchasing power (inflation) 3)Risks (Not all mutually exclusive)

Equation for Inflation

CPI(t+1)- CPI (t) / CPI (t)

Tax Free

MUNI

Real Interest Rates

Measures society's relative time preference for consuming today rather than tomorrow

Special Provisions (Holder)

Provide Benefits to the security holder are associated with LOWER interest rates

Special Provisions (Issuer)

Provide benefits to the security issuer and are associated with HIGHER interest rates

Nominal Interest Rate=

Real Rate +Expected Inflation

Term Structure of Interest Rates

Relationship among interest rates on bonds with DIFFERENT terms to maturity but with the SAME risk structure

Risk Structure of Interest Rates

Relationship among the different interest rates on bonds with the SAME term to maturity. -Default Risk -Liquidity Risk -Special Provisions

Fisher Effect

Relationship between interest rates and expected inflation is often referred to as the Fisher effect.

Spot Rate Curve depicts the relationship between

Spot Rates and Maturity

Nominal Interest Rates

The interest rate actually observed in financial markets. - Contain premiums for 1) Forgoing present consumption 2) Expected inflation

Callability

The issuer has the option to retire a security prior to maturity at a preset price.

Risk's

a) Default Risk b) Liquidity Risk c) Special Provisions-Risk Premium d) Term to Maturity