Fixed Income Securities
A fixed income security is a security for which the rule determining future cash flows is set, when the security is issued. The classical example of a fixed income security is a treasury bond, with fixed coupon payments. As long as the government can be trusted to avoid default, there is no cash-flow uncertainty for the bond. That simplifies analysis of sovereign bonds: there is only one major source of uncertainty, future interest rates.
While pricing of some fixed-income instruments is simpler, it is never simple. This course and jobs in fixed income are some of the most technically demanding within finance. While learning about fixed income may seem dry, at times, good understanding is paramount. Indeed, the fixed income market dwarfs the equity market. Knowledge of fixed income is in high demand in the job market.
Due to its complexity, detailed analysis of fixed income securities is often nearly omitted from academic programs. Yet fixed-income instruments (and their derivatives) form the majority of the capital markets in the developed economies. Importance of understanding fixed-income instruments by a wider audience of investors/households has been repeatedly brought to light in the recent years of financial turmoil.
The recent global crisis was brought about by troubles in the fixed-income markets. The words on everyone's tongue were "mortgages" and "mortgage-backed securities", both "fixed-income instruments". More close to home, the Terra Securities scandal of 2007 has hopefully taught us, that investing in fixed-income instruments without proper analysis and knowledge is a bad idea.
The following list gives an overview of the key topics to be covered in the course. The required textbook is good in some aspects, but is not detailed enough in others. It will therefore be supplemented by a number of articles and/or teaching materials.
The following topics will be covered:
- Institutional details: An overview of debt securities markets
- Tools: Bond pricing and arbitrage
- Tools: Measures of price sensitivity: Duration and convexity
- Institutional details: bond auctions
- Tools: Forwards and swaps; Options and futures
- Institutional details and Tools: Central Banks, Inflation, Monetary Policy
- Tools: Term Structure of Interest Rates in discrete time
- Tools: Binomial trees (term structure and pricing, European and American options, Monte Carlo simulation)
- Mortgage backed securities
Additional topics may be covered as time permits, including:
- Agency debt market
- Institutional details and Tools: Corporate debt and fixed income options
Quantitative methods applied within the context of the course include:
- Probability distributions (discrete and continuous)
- Regression analysis (time series and cross section, hypothesis testing)
- Binomial trees and Monte Carlo simulation
Learning outcome knowledge
By the end of the course, the students will gain understanding of the major institutional characteristics and some key technical know-how of the design and the valuation of fixed-income instruments. To that end, in addition to understanding the economic intuition, the students will be expected to solve problems, which will go into the formal modeling issues, including interest rate modeling.
Acquired Knowledge includes:
1. Ability to identify the determinants of risk and return of debt securities. The emphasis is on pricing of fixed-income securities, including fixed income derivatives.
2. Fixed income portfolio management techniques
3. The role of fixed-income securities in risk management.
- Class participation: 10%
- Home exam: 25%
- Written exam: 65%