1.CFA二级基础段固收 Cherie 标准版

Fixed Income
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CFA二级培训项目
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讲师：Cherie
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Cherie
➢ 工作职称：金程教育资深培训师，CFA FRM
➢ 教育背景：新南威尔士大学金融学硕士
➢ 工作背景：单晨玮老师毕业于新南威尔士大学金融学专业，学术功底深厚。单老
师曾亲自参与中国工商银行总行、中国银行总行、中国建设银行、民生银行总行、
杭州银行、杭州联合银行、国泰君安、南京审计学院、西安工业大学、西安外国
语大学等CFA培训项目。在金程讲授CFA培训课程，累计课时达6000小时，课程
清晰易懂，深受学员欢迎。
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➢ 讲授课程：CFA一、二、三级
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➢ 参与出版：曾参与出版了注册金融分析师系列丛书、金程教育CFA课堂笔记、CF
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A冲刺宝典、CFA中文NOTES等公开出版物及内部出版物。并参与翻译CFA协会
官方参考书《企业理财》，《国际财务报告分析》等书籍。
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Topic Weightings in CFA Level II
Content Weightings
Quantitative Methods 5-10
Economics 5-10
Financial Statement Analysis 10-15
Corporate Issuers 5-10

Equity 10-15
Fixed Income 10-15
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Derivatives 5-10
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Alternative Investments 5-10

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Portfolio Management 10-15
Ethical and Professional Standards 10-15

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Framework ➢ Fixed Income
• LM1 The Term Structure and

Interest Rates Dynamics
Fixed Income Analysis
• LM2 The Arbitrage-Free
Valuation Framework
• LM3 Valuation and Analysis

of Bonds with Embedded
Options
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• LM4 Credit Analysis Models

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• LM5 Credit Default Swaps

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Learning
Module
1
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The Term Structure and Interest Rates Dynamics

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1. Benchmark curve
Framework 2. Yield Spread
3. Traditional theories of the term structure

of interest rates
4. Yield curve factor models
5. Developing Interest Rate Views Using

Macroeconomic Variables
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1.1 Spot Rates
➢ Spot rate: the yield to maturity of the single payment.
➢ Discount factor ：the price today of 1 dollar face value, zero coupon bond
is known as the discount factor, DFN.
1
𝐷𝐹𝑁 = 𝑁
1 + 𝑍𝑁
➢ Spot yield curve (spot curve): the term structure of spot rates – the graph
of the spot rate 𝑆𝑇 versus the maturity T.
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⚫ The shape and level of the spot yield curve are dynamic.
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⚫ Each point on the spot yield curve reflects the spot interest rate with
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different maturities, which can also be interpreted as the yield to

maturity(YTM) of a zero-coupon bond with identical maturity.
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1.2 Forward Rates
➢ A Forward rate is an interest rate that is determined today for a loan that
will be initiated in a future time period.
➢ The term structure of forward rates is called the forwards curve.
➢ Discount Factor: DF(A,B-A)
1
𝐷𝐹𝐴,𝐵−𝐴 = 𝐵 _𝐴
1 + 𝑓𝐴,𝐵−𝐴
⚫ 𝑓𝐴,𝐵−𝐴 = the discount rate of a unit principal payment initiated A years
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from today with tenor of B-A years

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⚫ 𝐷𝐹𝐴,𝐵−𝐴 : a forward price at time A from today for a 1 dollar par zero-
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coupon bond maturing at time B

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➢ Forward rates model (the relationship between spot rate and forward rate):
𝐵 𝐴 𝐵−𝐴
1 + 𝑍𝐵 = 1 + 𝑍𝐴 1 + 𝑓𝐴 ,𝐵−𝐴
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Example
➢ The spot rates for three hypothetical zero-coupon bonds (zeros) with
maturities of one, two, and three years are given in the following table.
Maturity(T) 1 2 3
Spot rate r(1)=9% r(2)=10% r(3)=11%
⚫ Calculate the forward rate for a one-year zero issued one year from
today, f(1,1)
⚫ Calculate the forward rate for a one-year zero issued two years
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from today, f(2,1).

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⚫ Calculate the forward rate for a two-year zero issued one year from
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today, f(1,2).
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⚫ Based on your answers to 1 and 3, describe the relationship

between the spot rates and the implied one-year forward rates.
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Example
⚫ f(1,1) is calculated as follows
(1 + r (2) = 1 + r (1)1 + f (1,1) , (1 + 0.1) 2 = (1 + 0.09) 1 + f (1,1)

2
(1.10)2
f (1,1) = − 1 = 11.01%
1.09
1 + r (3) = 1 + r (2) 1 + f (2,1) , (1 + 0.11)3 = (1 + 0.10) 2 1 + f (2,1) 

3 2 1 1
(1.11)3
f (2,1) = − 1 = 13.03%
(1.10) 2
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1 + r (3) = 1 + r (1)1 + f (1, 2) , (1+0.11)3 = (1 + 0.09)1 1 + f (1, 2) 

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(1.11)3
f (1, 2) = − 1 = 12.01%
1.09
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Spot Rates and Forward Rates
➢ Relationship between spot rate and forward rate:
⚫ When the spot curve is upward sloping, the forward curve will lie
above the spot curve.
⚫ When the spot curve is downward sloping, the forward curve will lie
below the spot curve.
⚫ This relationship is a reflection of the basic mathematical truth that

when the average is rising (falling), the marginal data point must be
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above (below) the average. In this case, the spot curve represents an
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average over a whole time period and the forward rates represent the
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marginal changes between future time periods.
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Forward Rates
➢ Forward curve: The term structure of forward rates for a loan made on a
specific initiation date.
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➢ Reinvestment rate that would make an investor indifferent between buying
an eight-year zero-coupon bond or investing in a seven-year zero-coupon
bond and at maturity reinvesting the proceeds for one year. In this sense,
the forward rate can be viewed as a type of breakeven interest rate.
➢ One-year rate that can be locked in today by buying an eight-year zero-

coupon bond rather than investing in a seven-year zero-coupon bond and,
when it matures, reinvesting the proceeds in a zero-coupon instrument that
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matures in one year. In this sense, the forward rate can be viewed as a rate
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that can be locked in by extending maturity by one year.

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➢ Yield curve shapes:
⚫ In developed markets, yield curves are most commonly upward

sloping with diminishing marginal increases in yield for identical
changes in maturity; that is, the yield curve "flattens" at longer
maturities.
✓ Because nominal yields incorporate a premium for expected

inflation, an upward-sloping yield curve is generally interpreted as
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reflecting a market expectation of increasing or at least level future

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inflation (associated with relatively strong economic growth).

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✓ The existence of risk premiums (e.g., for the greater interest rate
risk of longer-maturity bonds) also contributes to a positive slope.
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⚫ An inverted yield curve is somewhat uncommon. Such a term structure
may reflect a market expectation of declining future inflation rates
(because a nominal yield incorporates a premium for expected inflation)
from a relatively high current level.
✓ Expectations of declining economic activity may be one reason
that inflation might be anticipated to decline. A downward-sloping
yield curve has frequently been observed before recessions.
⚫ A flat yield curve typically occurs briefly in the transition from an
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upward-sloping to a downward-sloping yield curve, or vice versa.

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⚫ A humped yield curve, which is relatively rare, occurs when

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intermediate-term interest rates are higher than short- and long-term

rates.
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Forward Pricing Model
➢ Forward pricing model:
⚫ Values forward contracts based on arbitrage-free pricing
✓ Tradable securities with identical cash flow payments must have the
same price. Otherwise, traders would be able to generate risk-free
arbitrage profits;
➢ Forward contract price that delivers a T-year-maturity zero-coupon bond

at time A using forward pricing model
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DF𝐵 = 𝐷𝐹𝐴 × 𝐹𝐴,𝐵−𝐴

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𝐷𝐹𝐵
𝐹𝐴,𝐵−𝐴 =
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𝐷𝐹𝐴
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Example
➢ Consider a two-year loan (T = 2) beginning in one year (T* = 1). The
one-year spot rate = 7%. The three-year spot rate = 9%.
⚫ Q1: Calculate the three-year discount factor DF(3).
⚫ Q2: Calculate the forward price of a two-year bond to be issued in

one year F(1,2).
➢ Correct Answer:
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⚫ Answer1: 𝐷𝐹3 = = 0.7722
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1+0.09 3
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⚫ Answer2: 𝐷𝐹1 = = 0.9346
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1+0.07
0.7722
𝐹(1,2) = = 0.8262
0.9346
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Active Bond Portfolio Management
➢ 1. Yield curve movement and the forward curve
⚫ An active portfolio manager will try to outperform the overall bond market by
predicting how the future spot rates will differ from those predicted by current
forward curve.
⚫ Forward contract price remains unchanged as long as future spot rates evolve
as predicted by today's forward curve.
⚫ a change in the forward price reflects a deviation of the spot curve from that
predicted by today's forward curve.
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✓ if a trader expects that the future spot rate will be lower than what is
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predicted by the prevailing forward rate, the forward contract value is

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expected to increase. The trader would buy the forward contract.

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✓ if the trader expects the future spot rate to be higher than what is
predicted by the existing forward rate, then the forward contract value
is expected to decrease. The trader would sell the forward contract.
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➢ If a portfolio manager’s projected spot curve is above (below) the forward
curve and his or her expectation turns out to be true, the return will be less
(more) than the one-period risk-free interest rate.
➢ 1. Assume a flat yield curve 8% and that a trader holds a three-year

bond paying annual coupons based on a 8% coupon rate. Assuming a
par value of 100, the current market price is also 100. If today’s forward
curve turns out to be the spot curve one year from today, the trader
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will earn an 8% return.

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8+ +
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1 + 0.08 (1 + 0.08) 2
− 1 = 8%
100
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➢ 2. If the trader projects that the spot curve one year from today is
above today’s forward curve – for example, a flat yield curve of 9% -
the trader’s expected rate of return is 6.24%, which is less than 8%:
8 108
8+ +
1 + 0.09 (1 + 0.09) 2
− 1 = 6.24%
100
➢ 3. If the trader predicts a flat yield curve of 7%, the trader’s expected
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return is 9.81%, which is greater than 8%:

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8 108
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8+ +
1 + 0.07 (1 + 0.07) 2
− 1 = 9.81%
100
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➢ 2. Riding the yield curve or rolling down the yield curve
⚫ When a yield curve is upward sloping, the forward curve is always

above the current spot curve.
⚫ If the trader does not believe that the yield curve will change its level
and shape over an investment horizon, then buying bonds with a
maturity longer than the investment horizon would provide a total
return greater than the return on a maturity-matching strategy.
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Example
➢ The following figure shows a hypothetical upward-sloping yield curve and
the price of a 5% annual-pay coupon bond.
Maturity Yield Price
5 5% 100
10 5.5% 96.23
15 6% 90.29
20 6.5% 83.47
25 7% 76.69
30 7.5% 70.47
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⚫ A bond investor with an investment horizon of five years could

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purchase a bond maturing in five years and earn the 5% coupon but
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no capital gains.
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⚫ However, assuming no change in the yield curve over the investment

horizon, the investor could instead purchase a 30-year bond for $70.47,
hold it for five years, and sell it for $76.69, earning an additional return
beyond the 5% coupon over the same period.
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Example
1. A forward contract price will increase if:
A. Future spot rates evolve as predicted by current forward rates.
B. Future spot rates are lower than what is predicted by current
forward rates.
C. Future spot rates are higher than what is predicted by current
forward rates.
➢ Correct answer: B
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A. Equal to the investor’s investment horizon.

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B. Longer than the investor’s investment horizon.

C. Shorter than the investor’s investment horizon.
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Example
3. Nguyen state that she has a two-year investment horizon and will purchase
Bond Z ($1,000 par bond with 6% coupon rate, 3 years to maturity) as part of a
strategy to ride the yield curve. The following Exhibit shows Nguyen’s yield
curve assumption implied by the spot rates.
Maturity Spot Rate

One year 2.50%
Two years 3.00%
Three years 3.50%
Four years 4.00%
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➢ By choosing to buy Bond Z, Nguyen is most likely making which of the following
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assumption?
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A. Bond Z will be held to maturity.

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B. The three-year forward curve is above the spot curve.

C. Future spot rates do not accurately reflect future inflation.
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1.3 Par Curve
➢ The par curve represents the yields to maturity on coupon-paying
government bonds, priced at par, over a range of maturities.
⚫ recently issued ("on the run") bonds are typically used to create the par
curve because new issues are typically priced at or close to par.
⚫ The zero-coupon rates are determined by using the par yields and
solving for the zero-coupon rates one by one, in order from earliest to
latest maturities, via a process of forward substitution known as
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Example
➢ One-year par rate = 5%, Two-year par rate = 5.97%, Three-year par
rate= 6.91%, Four-year par rate = 7.81%. From these we can bootstrap
zero-coupon rates.
⚫ Zero-Coupon Rates:
Two year zero coupon rate:
0.0597 1 + 0.0597
1= + , r (2) = 6%
(1.05) 1 + r (2)2
Three year zero coupon rate

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0.0691 0.0691 1 + 0.0691

1= + + , r(3)=7%
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(1.05) (1.06) 1 + r (3)

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Four year zero coupon rate

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0.0781 0.0781 0.0781 1 + 0.0781

1= + + + , r(4)=8%
1.05 (1.06) 2 (1.07)3 1 + r (4)4
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1.4 YTM, Spot Rate and Return on Bonds
➢ Relationship between YTM and Spot rate
⚫ The YTM of these bonds with maturity T would not be the same as the
spot rate at T.
✓ most bonds outstanding have coupon payments and many have

various options, such as a call provision.
⚫ The YTM of the bond should be some weighted average of spot rates
used in the valuation of the bond.
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✓ Because the principle of no arbitrage shows that a bond’s value is

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corresponding spot rates
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YTM, Spot Rate and Return on Bonds
➢ YTM and the expected return on a bond
⚫ The expected rate of return is the return one anticipates earning on an

investment.
⚫ The YTM is
✓ (1) the expected rate of return for a bond that is held until its
maturity
✓ (2) assuming that all coupon and principal payments are made in
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✓ (3) and that coupons are reinvested at the original YTM

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YTM, Spot Rate and Return on Bonds
➢ YTM is not the expected return on a bond in general.
⚫ The assumption regarding reinvestment of coupons at the original yield

to maturity typically does not hold
⚫ The YTM can provide a poor estimate of expected return if
✓ (1) interest rates are volatile;
✓ (2) the yield curve is steeply sloped, either upward or downward;
✓ (3) there is significant risk of default;

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✓ (4) the bond has one or more embedded options (e.g., put, call, or
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conversion).
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⚫ Implicit in the determination of the yield to maturity as a potentially

realistic estimate of expected return is a flat yield curve
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1.5 Swap Rate Curve in Valuation
➢ Swap rate: the interest rate for the fixed-rate leg of an interest rate swap.
⚫ Swap floating rates historically referenced short-term survey-based
interest rates, such as three- or six-month US dollar Libor and are slated
to transition to transaction-based market reference rates (MRR) based
on secured overnight funding transactions.
⚫ The level of the swap rate is such that the swap has zero value at the
initiation of the swap agreement.
➢ Determining swap rate
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T
s(T ) 1
 1 + r (t ) + =1
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  1 + r (T )
t T
t =1
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⚫ The right side: the value of the floating leg, which is 1 at origination
⚫ The swap rate is determined by equating the value of the fixed leg, on
the left-hand side to the value of the floating rate.
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Example
➢ Suppose a government spot curve implies the following discount
factors: P(1)=0.9524, P(2)=0.8900, P(3)=0.8163, P(4)=0.7350
➢ Determine the swap rate curve based on this information
➢ Correct Answer:
1/2
 1 
1/1
 1  r (2) =  − 1 = 6.00%
r (1) =   − 1 = 5.00% 
 0.9524   0.8900 
1/3 1/4
 1   1 
r (3) =   − 1 = 7.00% r (4) =   − 1 = 8.00%
 0.8163   0.7350 
s(1) 1 s(1) 1
+ = + =1
1 + r (1) 1 + r (1) + +
1 1 1 1
(1 0.05) (1 0.05)
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⚫ Therefore, s(1)=5%
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⚫ For T=2, s(2) + s(2) +

1
=
s(2)
+
s(2)
+
1
=1
1 + r (1) 1 + r (2) 1 + r (2) 1 + 0.05 1 + 0.06 1 + 0.06
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1 2 2 1 2 2
⚫ Therefore, s(2)=5.97%
⚫ Similarly, For T=3, s(3)=6.91%; For T=4, s(4)=7.81%
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The Swap Rate Curve
➢ The yield curve of swap rates is called the swap rate curve (swap curve)
⚫ Because it is based on so-called par swaps, in which the fixed rates are
set so that no money is exchanged at contract initiation—the present
values of the fixed-rate and benchmark floating-rate legs being equal—
the swap curve is a type of par curve.
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The Swap Rate Curve
➢ The swap market is a highly liquid market for two reasons. (liquidity)
⚫ First, unlike bonds, a swap does not have multiple borrowers or lenders, only
counterparties who exchange cash flows.
⚫ Swaps provide one of the most efficient ways to hedge interest rate risk.
➢ Many countries do not have a liquid government bond market with maturities
longer than one year. The swap market has more maturities with which to
construct a yield curve than do government bond markets. (different
maturities)
➢ In countries in which the private sector is much bigger than the public sector,
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swap curve is a far more relevant measure of the time value of money than is the
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government's cost of borrowing. (default risk)

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⚫ A Libor/swap curve is probably the most widely used interest rate curve
because it is often viewed as reflecting the default risk of private entities at a
rating of about A1/A+, roughly the equivalent of most commercial banks.
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The Swap Rate Curve
➢ Another reason for the popularity of the swap market is that is unregulated
(not controlled by governments), so swap rates are more comparable across
different countries. (unregulated)
➢ Swap rate curves VS government spot curves
⚫ The choice of a benchmark for the time value of money often depends
on the business operations of the institution using the benchmark in the
United States where there is both an active Treasury security market and
a swap market.
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✓ Wholesale banks frequently use the swap curve to value assets and
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liabilities because these organizations hedge many items on their

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✓ Retail banks with little exposure to the swap market are more likely
to use the government spot curve as their benchmark.
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2.1 Swap Spread
➢ Swap spread: 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.
⚫ Swap spreadt = swap ratet – Treasury yieldt
⚫ For example, if the fixed rate of a five-year fixed-for-float Libor swap is

2.00% and five-year Treasury is yielding 1.70%, the swap spread is
2.00% - 1.70% = 0.30%, or 30 bps

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Swap Spread
⚫ The Treasury rate can differ from the swap rate for the same term for
several reasons.
✓ Unlike the cash flows from US Treasury bonds, the cash flows from
swaps are subject to much higher default risk.
✓ Market liquidity for any specific maturity may differ.
◆For example, some parts of the term structure of interest rates

may be more actively treaded with swaps than with Treasury
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2.2 I-Spread
➢ I-spreads: bond rates net of the swap rates of the same maturities.
⚫ I-spread = bond rate – swap rate
⚫ I-spread only reflects compensation for credit and liquidity risks.
⚫ We used linear interpolation to construct the swap curve based on

data points.
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Example
➢ Bond A has a coupon rate of 5%, and matures in 3.2 years. Its current
yield is 2.85%. Compute the I-spread from the swap rate provided in
the following chart.
Tenor Swap rate
1 1.15%
2 1.59%
3 1.95%
4 2.40%
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➢ Correct Answer:
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⚫ Using linear interpolation to calculate the swap rate:

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0.20(2.4 - 1.95)
3.2 year swap rate = 3 year swap rate + = 2.04%
1.0
I - spread = yield on the bond − swap rate = 2.85 − 2.04 = 0.81%
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2.3 Z-Spread
➢ Z-spread: is the constant basis point spread that would need to be added
to the implied spot yield curve so that the discounted cash flows of a bond
are equal to its current market price.
⚫ Calculation: trial and error
⚫ Reflect compensation for credit, liquidity and option risk
⚫ Although swap spreads provide a convenient way to measure risk, a

more accurate measure of credit and liquidity is Z-spread.
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✓ Z-spread will be more accurate than a linearly interpolated yield,

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particularly with steep interest rate swap curves.

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⚫ Under the assumption of zero interest rate volatility, it is not appropriate

for bonds with embedded options; without any interest rate volatility
options are meaningless.
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Example
➢ Consider a 5% annual coupon bond with a maturity of 2 years and a
par value of US$100. The spot yield curve is r(1)=3%, r(2)=4%. The
bond price is US$101.55. Calculate the Z-spread.
➢ Correct Answer:
$5 $105
$101.55 = +
(1 + 0.03 + Z ) (1 + 0.04 + Z ) 2
⚫ Z-spread = 20 bps
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2.4 TED Spread
➢ Market participants often use interest rate spreads between short-term
government and risky rates as a barometer to evaluate relative credit
and liquidity risk.
⚫ For example, the difference between Libor and the yield on a
Treasury bill of the same maturity, or TED spread, has historically
been a key indicator of perceived credit and liquidity risk.
✓ TED = LIBOR – T-bill rate
⚫ It is an indicator of perceived credit and liquidity risk.
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⚫ In particular, because sovereign debt instruments are typically the

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benchmark for the lowest default risk instruments in a given market, and
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loans between banks (often at Libor) have some counterparty risk, the
TED spread is considered to at least in part reflect default (or
counterparty) risk in the banking sector.
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2.5 Libor–OIS Spread
➢ Another popular measure of such risk is the Libor–OIS spread, which is the
difference between Libor and the overnight indexed swap (OIS) rate.
⚫ An OIS is an interest rate swap in which the periodic floating rate of the
swap equals the geometric average of a daily unsecured overnight
rate (or overnight index rate).
✓ The index rate is typically the rate for overnight unsecured lending
between banks, such as the federal funds rate for US dollars.
⚫ As market participants transition away from survey-based Libor to
alternative benchmarks based on actual transaction data, the secured
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overnight financing rate (SOFR), or overnight cash borrowing rate

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expected to replace Libor in the future.

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✓ It is a barometer of the US Treasury repurchase (or repo) market.

SOFR is a volume-weighted index of all qualified repo market
transactions on a given day and is influenced by supply and demand
conditions in secured funding markets.
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3.1 Term Structure of Interest Rates
➢ Pure (Unbiased) Expectations Theory
⚫ Description:
✓ The forward rate is an unbiased predictor of the future spot
rate.
◆For example, buying a bond with a maturity of five years and
holding it for three years has the same expected return as
buying a three-year bond or buying a series of three one-year
bonds.
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✓ The predictions of the unbiased expectations theory are consistent

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with the assumption of risk neutrality.

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◆This assumption is in conflict with the large body of evidence

that shows that investors are risk averse.
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Term Structure of Interest Rates
➢ The implications for the shape of the yield curve under the
expectations theory are:
⚫ For a upward sloping yield curve, it implies that the short-term rate
are expected to rise.
⚫ For a downward sloping yield curve, it implies that the short-term rate
are expected to decline.
⚫ A flat yield curve implies that the market expects short-term rates to
remain constant
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➢ Local Expectation Theory
⚫ A theory that is similar but more rigorous than the unbiased
expectations theory is the local expectations theory. This theory
instead contends that the expected return for every bond over short
time periods is the risk-free rate.
✓ Although the theory requires that risk premiums be nonexistent for
very short holding periods, no such restrictions are placed on
longer-term investments.
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➢ Liquidity preference theory
⚫ Description:
✓ Liquidity preference theory asserts that liquidity premium exist to
compensate investors for the added interest rate risk they face when
lending long term and that these premiums increase with maturity.
✓ The theory suggests that this liquidity premium is positively related
to maturity. Thus, given an expectation of unchanging short-term spot
rates, liquidity preference theory predicts an upward-sloping yield curve.
✓ The forward rate provides an estimate of the expected spot rate that
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is biased upward by the amount of the liquidity premium.

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◆ f= E(s)+liquidity premium
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⚫ A positive-sloping yield curve may indicate that:

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✓ The market expects future interest rates to rise; or

✓ that rates are expected to remain constant, but the addition of the
liquidity premium results in positive slope.
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➢ Segmented Market Theory
⚫ The shape of the yield curve is determined by the preferences of

borrowers and lenders, which drive supply and demand for funds of a
particular maturity.
⚫ Yield is determined independently from the yields that prevail in other

maturity segments.
⚫ The theory is consistent with a world there are asset/liability

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management constraints, either regulatory or self-imposed. It assumes

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market participants are either unwilling or unable to invest in anything

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other than securities of their preferred maturity.
✓ For example, because the liabilities of pension plans are long term,
they typically invest in long-term securities.
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➢ Preferred habitat theory
⚫ The preferred habitat theory is similar to segmented market theory in
proposing that many borrowers and lenders have strong preferences for
particular maturities but it does not assert that yields at different
maturities are determined independently of each other.
✓ If the expected additional returns to be gained become large
enough, institutions will be willing to deviate from their preferred
maturities or habitats.
✓ For example, if the excess returns expected from buying short-term
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securities become large enough, life insurance companies might

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part of their portfolios in shorter-term investments.

✓ Agents and institutions will accept additional risk in return for
additional expected returns.
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➢ Subtle difference between preferred habitat theory and liquidity
theory
⚫ The premium is a positive or negative risk premium related to supply
and demand for funds at various maturities, nor necessarily a liquidity
premium
⚫ This risk premium is not necessarily related to maturity
➢ Subtle difference between preferred habitat theory and segment
market theory
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⚫ Limited to matched maturity

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⚫ May deviate from preferred maturity

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Example
1. In 2010, the Committee of European Securities Regulators created
guidelines that restricted weighted life (WAL) to 120 days for short-term
money market funds. The purpose of this restriction was to limit the ability
of money market funds to invest in long-term, floating-rate securities. This
action is most consistent with a belief in:
A. The preferred habitat theory.
B. The segment markets theory.
C. The local expectations theory.
➢ Correct answer: A
2. The term structure theory that asserts that investors cannot be induced to
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hold debt securities whose maturities do not match their investment

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horizon is best described as the:

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A. Preferred habitat theory.

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B. Segmented markets theory.

C. Unbiased expectations theory.
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4.1 Yield Curve Factor Models
➢ Factors affecting the shape of the yield curve
⚫ The level movement refers to an upward or downward shift in the

yield curve.
⚫ The steepness movement refers to a non-parallel shift in the yield

curve when either short-term rates change more than long-term
rates or long-term rates change more than short-term rates.
⚫ The curvature movement is a reference to movement in three segments

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of the yield curve: the short-term and long-term segments rise while
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the middle-term segment falls or vice versa.

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Factors Affecting the Shape of the Yield Curve
➢ Three factors explain historical treasury security returns.
⚫ The level movement factor explains most of the total changes in swap
and bond market yields. This factor may be interpreted as a reflection of
parallel yield curve moves in which rates move in the same direction and
by a similar order of magnitude.
⚫ The steepness factor addresses the shape of the curve, with short-term
yields typically moving more than long-term yields. These changes take
place over time and therefore explain less of the total variance in rates
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than the level factor.

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⚫ Curvature, tends to have a negative impact on intermediate yields and

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a positive impact on short- and long-term yields. This variable

explaining the “twist” in the yield curve has the smallest impact of the
three.
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Example
1. The most important factor in explaining changes in the yield curve has
been found to be:
A. Level
B. Curvature
C. Steepness
➢ Correct Answer: A
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Example
2. A movement of the yield curve in which the short rate decreases by
150 bps and the long rate decreases by 50 bps would best be
described as a:
A. flattening of the yield curve resulting from changes in level and

steepness.
B. steepening of the yield curve resulting from changes in level and

steepness.
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C. steepening of the yield curve resulting from changes in steepness

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and curvature.
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➢ Correct Answer: B
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Example
3. A movement of the yield curve in which the short- and long-maturity
sectors increase by 100 bps and 75 bps, respectively, but the
intermediate-maturity sector increases by 10 bps, is best described as
involving a change in:
A. Level only
B. Curvature only
C. Level and curvature

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➢ Correct Answer: C
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4.2 Managing Yield Curve Risks
➢ Yield curve risk (Shaping risk): risk to portfolio value arising from
unanticipated changes in the yield curve, can be managed on the basis of
several measures of sensitivity to yield curve movements
➢ Managing yield curve risk
⚫ Effective duration: measures the sensitivity of a bond's price to a small

parallel shift in a benchmark yield curve
✓ Address risk associated with parallel yield curve changes

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⚫ key rate duration: measures a bond's sensitivity to a small change in a

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benchmark yield curve at a specific maturity segment

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✓ allows identification and management of "shaping risk"—that is,

sensitivity to changes in the shape of the benchmark yield curve
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Key Rate Duration
➢ Key rate duration
⚫ Duration is an adequate measure of bond price risk only for small

paralleled shifts in the yield curve.
⚫ A key rate duration is a measure of a bond’s sensitivity to a change in

the benchmark yield curve at a specific maturity segment. (for non-
parallel shifts)
✓ 𝐷𝑃 = σ 𝑊𝑖 𝐷𝑖
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✓ 𝐾𝑅𝐷𝑖 = 𝐷𝑖 × 𝑊𝑖
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✓ 𝐷𝑃 = σ 𝐾𝑅𝐷𝑖
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Example
Bond Key Rate
Weight D1 D2 D3 D4
(zero coupon) Duration
2 year 10 2 0.2
10 year 20 10 2.0
20 year 40 20 8.0
25 year 30 25 7.5
Portfolio 100 17.7
Example: non-parallel shift

Bond Key Rate Changes
Weight D1 D2 D3 D4 Shifts
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(zero coupon) Duration in value

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2 year 10 2 0.2 +1% -0.2%

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10 year 20 10 2.0 +1.5% -3.0%

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20 year 40 20 8.0 +0.8% -6.4%

25 year 30 25 7.5 -1% 7.5%
Portfolio 100 17.7 -2.1%
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Managing Yield Curve Risks
➢ Decompose the risk into sensitivity to the following three categories of yield
curve movement:
⚫ Level( xL ): A parallel increase or decrease of interest rate
⚫ Steepness( xs ): Long-term interest rates increase while short-term rates

decrease
⚫ Curvature( xc ): Increasing curvature means short- and long-term

interest rates while intermediate rates do not change
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P
 − DL xL − DS xS − DC xC
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Example
➢ Suppose for a given portfolio that key rate changes are considered to
be changes in the yield on 1-year, 5-year, and 10-year securities.
Estimated key rate durations are D1 = 0.50, D2 = 0.70, and D3 = 0.90.
What is the percentage change in the value of the portfolio if a parallel
shift in the yield curve results in all yields declining by 50 bps?
A. ‒1.05%.
B. +1.05%.
C. +2.10%.
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⚫ A decline in interest rates would lead to an increase in bond

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portfolio value: ‒0.50(‒0.005) ‒ 0.70(‒0.005) ‒ 0.90(‒0.005) =

0.0105 = 1.05%.
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Example
➢ Winter asks Madison to analyze the interest rate risk portfolio positions
in a 5-year and a 20-year bond. Winter requests that the analysis be
based on level, slope, and curvature as term structure factors. Madison
presents her analysis in Exhibit.
Tree-Factor Model of Term Structure

Time to Maturity (years)
Factor 5 20
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Level -0.4352% -0.5128%

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Steepness -0.0515% -0.3015%

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Curvature 0.3963% 0.5227%

Note: Entries indicate how yields would change for a one standard
deviation increase in a factor.
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Example
➢ Winter asks Madison to perform two analyses:
⚫ Analysis 1: Calculate the expected change in yield on the 20-year
bond resulting from a two standard deviation increase in the
steepness factor.
⚫ Analysis 2: Calculate the expected change in yield on the five-year
bond resulting from a one standard deviation decrease in the level
factor and a one standard deviation decrease in the curvature
factor.
➢ Based on Exhibit, the results of Analysis 1 should show the yield on the
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20-year bond decreasing by:

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A. 0.3015%.
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B. 0.6030%.
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C. 0.8946%.
⚫ Change in 20-year bond yield = –0.3015% × 2 = –0.6030%.
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Example
➢ Based on Exhibit, the results of Analysis 2 should show the yield on the
five-year bond:
A. decreasing by 0.8315%.
B. decreasing by 0.0389%.
C. increasing by 0.0389%.
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⚫ Because the factors in Exhibit 1 have been standardized to have

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unit standard deviations, a one standard deviation decrease in both

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the level factor and the curvature factor will lead to the yield on the
five-year bond increasing by 0.0389%, calculated as follows:
⚫ Change in five-year bond yield = 0.4352% – 0.3963% = 0.0389%.
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4.3 Maturity Structure of Yield Curve Volatilities
➢ In modern fixed-income management, quantifying interest rate volatilities is
important for at least two reasons.
⚫ First, most fixed-income instruments and derivatives have embedded

options. Option values, and hence the values of the fixed-income
instrument, crucially depend on the level of interest rate volatilities.
⚫ Second, fixed-income interest rate risk management is clearly an

important part of any management process, and such risk management
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includes controlling the impact of interest rate volatilities on the

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instrument’s price volatility.

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Maturity Structure of Yield Curve Volatilities
➢ Term structure of interest rate volatilities: a representation of the yield
volatility of a zero-coupon bond for every maturity of security.
➢ Interest rate volatility is not the same for all interest rates along the yield
curve. The volatility term structure typically shows that short-term rates are
more volatile than long-term rates.
⚫ Short-term volatility is most strongly linked to uncertainty regarding

monetary policy;
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⚫ Long-term volatility is most strongly linked to uncertainty

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regarding the real economy and inflation.

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Maturity Structure of Yield Curve Volatilities
➢ On the basis of the typical assumption of a lognormal model, the
uncertainty of an interest rate is measured by the annualized standard
deviation of the proportional change in a bond yield over a specified time
interval.
⚫ For example, if the time interval is a one-month period, then the
specified time interval equals 1/12 years.
➢ The square root rule of interest volatility
1
 month =  annual   annual =  month  12
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12
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⚫ Example: If we observe the monthly interest rate volatility is 2%, then

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the annual interest rate volatility can be calculated as
 annual =  month  12 = 2%  12 = 6.93%

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5. Developing Interest Rate Views Using
Macroeconomic Variables
➢ Bond risk premium refers to the expected excess return of a default-free
long-term bond less that of an equivalent short-term bond or the one-
period risk-free rate.
⚫ This premium is also referred to as the term (or duration) premium.
⚫ It is usually measured using government bonds to capture uncertainty

of default-free rates, whereas credit, liquidity, and other risks may
increase the overall risk premium for a specific bond.
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5.1 Developing Interest Rate Views
➢ (1) Several macroeconomic factors influence bond pricing and required
returns such as inflation, economic growth, and monetary policy,
among others.
➢ Research shows that short- and intermediate-term bond yields are

driven mostly by inflation, whereas other factors such as monetary policy
are key drivers of long-term yields.
⚫ Inflation explains about two-thirds of short- and intermediate-term

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attributable to economic growth and factors including monetary policy.

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⚫ In contrast, monetary policy explains nearly two-thirds of long-term

yield variation, and the remaining third is largely attributable to
inflation.
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Developing Interest Rate Views
➢ Monetary policy impacts the bond risk premium
⚫ During economic expansions, monetary authorities raise benchmark

rates to help control inflation. This action is often consistent with
bearish flattening, or short-term bond yields rising more than long-
term bond yields, resulting in a flatter yield curve.
⚫ During economic recessions or anticipated recessions, the monetary

authority cuts benchmark rates to help stimulate economic activity.
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➢ In recent years, central banks have increasingly used their balance sheets
for large-sale asset purchases.
⚫ For example, the Federal Reserve has bought large quantities of US

Treasury bonds and mortgage-backed securities.
⚫ The intended purpose is to stimulate economic activity by increasing the

money supply through benchmark bond purchases and driving down
the bond risk premium, encouraging capital allocation to incrementally
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⚫ Asset purchases impact the term structure by raising demand in a range

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of maturity segments.
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➢ Other factors that influence bond prices, yields, and the bond risk premium
include fiscal policy, the maturity structure of debt, and investor
demand.
➢ (2) Fiscal Policy: benchmark government bonds are the means by which
nations fund their cumulative (current and past) budget deficits.
⚫ Greater deficits require more borrowing, which influences both bond
supply and required yield.
⚫ Thus, fiscal supply-side effects affect bond prices and yields by
increasing (decreasing) yields when budget deficits rise (fall).
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➢ (3) Maturity structure: longer government debt maturity structures predict

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greater excess bond returns.

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⚫ This is effectively a segmented market factor, where in the greater

supply of bonds of long-term maturity increases the yield in that market
segment.
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➢ (4) Investor demand:
⚫ Domestic investor demand is a key driver of bond prices, especially among
pension funds and insurance companies that use long-dated government
bonds to match expected future liabilities. Greater domestic investor
demand increases prices and reduces the bond risk premium.
⚫ Non-domestic flows significantly influence bond prices because inflows
(outflows) bid up (down) bond prices, lowering (raising) the bond risk
premium.
⚫ During highly uncertain market periods, investors flock to government
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✓ This term refers to investors’ selling off higher-risk asset classes such as
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stocks and commodities in favor of default-risk-free government bonds.

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✓ A flight to quality is often associated with bullish flattening, in which

the yield curve flattens as long-term rates fall by more than short-
term rates.
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➢ Fixed-income trades based on interest rate forecasts can take a variety of
forms, often using bond futures contracts to avoid significant portfolio
turnover.
⚫ Investors expecting interest rates to fall will generally extend portfolio

duration relative to a benchmark to take advantage of bond price
increases from falling rates.
⚫ Investors expecting higher rates will shorten portfolio duration to

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➢ To capitalize on a steeper curve under which long-term rates rise relative
to short-term rates, traders will short long-term bonds and purchase
short-term bonds.
➢ A trader forecasts curve flattening, whereby short-term rates rise relative
to long-term rates, she may capitalize on this trend by purchasing long-
term bonds and selling short-term bonds short.
➢ In both the expected steepening and flattening trades, the position may be
designed as duration neutral in order to insulate from changes in the level
of the term structure.
➢ Fixed-income investors with long-only investment mandates may alternate
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between portfolios concentrated in a single maturity, known as a bullet

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portfolio, and those with similar duration that combine short and long
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maturities, known as a barbell portfolio.

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⚫ For example, an investor may seek to capitalize on an expected bullish

flattening of the yield curve by shifting from a bullet to a barbell
position.
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➢ Morgan Salaz is a fixed income analyst responsible for advising fixed
income clients about bond trading opportunities. In the current
recessionary environment, the level of government bond yields is low and
the term structure is nearly flat. Salaz’s firm forecasts that after a brief
recession, economic growth will return quickly during the coming 12
months.
➢ 1. Which of the following changes to the yield curve is consistent with
Salaz’s expectation of increasing economic growth over the coming year?
A. Decrease in the level
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B. Decrease in the term spread of long-term rates over short-term rates

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C. Increase in the term spread of long-term rates over short-term rates

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➢ Answer: C is correct. Economic growth forecasts impact long-term rates.

The view that economic growth will return to robust levels is consistent
with a shift to a positively sloped term structure.
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➢ 2. Salaz also expects the Federal Reserve to decrease asset purchases of
long-term bonds as the economic recovery continues. Which of the
following scenarios is consistent with this view? The reduced asset
purchases will likely:
A. amplify the effect of increased economic activity on the term
spread.
B. dampen the effect of increased economic activity on the term
spread.
C. have no effect on the term spread.
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➢ Answer: A. Reduced asset purchases constitute a negative shift in

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demand for longer-term bonds, which raises their yields. The reduced
asset purchases of long-maturity bonds would add to the effect of
greater economic activity, both of which will increase the term spread.
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Learning
Module
2
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The Arbitrage-Free Valuation Framework

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1. Arbitrage opportunity
Framework 2. Introduction of arbitrage free valuation
3. Interest rate trees and arbitrage-free

valuation
• Binomial interest rate tree
• Option-free bond valuation
• Pathwise valuation
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4. Monte Carlo Method

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1. Arbitrage Opportunity
➢ Arbitrage-free valuation: an approach to security valuation that
determines security values that are consistent with the absence of arbitrage
opportunities.
⚫ Arbitrage opportunities are opportunities for trades that earn riskless
profits without any net investment of money.
✓ Arbitrage opportunities arise as a result of violations of the law of
one price.
◆The law of one price states that two goods that are perfect
substitutes must sell for the same current price in the absence
of transaction costs.
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⚫ Well functioning market complies with principle of no arbitrage.

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➢ There are two types of arbitrage opportunities

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⚫ Value additivity. the value of the whole must equal the sum of the
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values of the parts.

⚫ Dominance. A financial asset with a risk-free payoff in the future must
have a positive price today.
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Example
Asset Price Today Payoff in One Year
A 0.952381 1
B 95 105
➢ Value additivity
⚫ Asset A is a simple risk-free zero-coupon bond that pays off one
dollar and is priced today at 0.952381 (1/1.05).
⚫ Asset B is a portfolio of 105 units of Asset A that pays off 105 one
year from today and is priced today at 95. The portfolio does not
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equal the sum of the parts.

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⚫ An astute investor would sell 105 units of Asset A for 105 ×

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0.952381 = 100 while simultaneously buying one portfolio Asset

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B for 95. This position generates a certain 5 today (100-95) and

generates net 0 one year from today because cash inflow for
Asset B matches the amount for the 105 units of Asset A sold.
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Example
Asset Price Today Payoff in One Year
C 100 105
D 200 220
➢ Dominance
⚫ Consider two assets, C and D, that are risk-free zero-coupon bonds.
⚫ It appears that Asset D is cheap relative to Asset C.
⚫ If both assets are risk-free, they should have the same discount rate.
To make money, sell two units of Asset C at a price of 200 and
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use the proceeds to purchase one unit of Asset D for 200. The
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construction of the portfolio involves no net cash outlay today.

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Although it requires zero dollars to construct today, the portfolio

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generates 10 one year from today. Asset D will generate a 220

cash inflow whereas the two units of Asset C sold will produce a
cash outflow of 210.
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Arbitrage Opportunity
➢ Any fixed-income security should be thought of as a package or portfolio of
zero-coupon bonds using the arbitrage-free approach.
⚫ Stripping: The market mechanism for US Treasuries that enables this

approach is the dealer's ability to separate the bond's individual cash
flows and trade them as zero-coupon securities.
⚫ Reconstitution: dealers can recombine the appropriate individual zero-

coupon securities and reproduce the underlying coupon Treasury
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⚫ The arbitrage-free valuation approach does not allow a market

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participant to realize an arbitrage profit through stripping and

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reconstitution
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2. Arbitrage-Free Valuation
➢ A fundamental principle of valuation is that the value of any financial
asset is equal to the present value of its expected future cash flows.
⚫ This principle holds for any financial asset from zero-coupon bonds to
interest rate swaps. Thus, the valuation of a financial asset involves the
following three steps:
✓ Step 1 Estimate the future cash flows.
✓ Step 2 Determine the appropriate discount rate or discount rates

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that should be used to discount the cash flows.

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✓ Step 3 Calculate the present value of the expected future cash flows
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found in Step 1 by applying the appropriate discount rate or rates

determined in Step 2.
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Arbitrage-Free Valuation
➢ For option-free bonds, performing valuation discounting with spot rates
produces an arbitrage-free valuation.
➢ For bonds that have embedded options, we need a different approach.
⚫ The challenge one faces when developing a framework for valuing

bonds with embedded options is that their expected future cash
flows are interest rate dependent. Changes in future interest rates
impact the likelihood the option will be exercised and in so doing
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⚫ In order to develop a framework that values both bonds without and

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with embedded options, we must allow interest rates to take on

different potential values in the future based on some assumed level of
volatility.
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3.1 Binomial Interest Rate Tree
➢ Binomial interest rate tree construction
⚫ The set of possible interest rate paths that are used to value bonds with
binomial model over multiple periods
✓ Assumes that interest rates have an equal probability of taking one

of two possible values in the next period.
✓ The interest rate tree is also referred as lognormal tree because it is

constructed using the lognormal random walk.
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✓ The assumed level of interest rate volatility.

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✓ The current benchmark yield curve.

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Binomial Interest Rate Tree
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➢ Determine interest rate in interest rate trees
i1, H = i1, L e 2  i2, HL = i2, LL e  i2, HH = i2, LL e 
⚫ σ = assumed volatility of the one-year rate,
⚫ e ≈ 2.7183 (i.e., the base of natural log)
⚫ i1,L = the lower one-year forward rate one year from now at Time 1,
⚫ i1,H = the higher one-year forward rate one year from now at Time 1.
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➢ Construction of a binomial interest rate tree
⚫ Interest rate tree is generated using specialized computer software in
practice.
✓ We fit the interest rate tree to the current yield curve by choosing
interest rates so that the model produces the benchmark bond values.
We should ensure that the model is arbitrage free.
✓ The distance of adjacent forward rates are 2σ.
◆Compute one forward rate by another forward rate given for the
period in the tree.
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◆If the interest rate volatility increases, the forward rates shown in
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the binomial interest rate tree will spread out.

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◆If the interest rate volatility decreases, the forward rates shown
in the binomial interest rate tree will converge to the implied one-
year forward rate.
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Example
Maturity Par Rate Spot Rate

1 2% 2%
2 3% 3.015%
3 4% 4.055%
➢ Interest volatility is 15% for all years.
Time 0 Time 1 Time 2

:
2.0% A C
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B D
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E
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➢ Calculate interest rates: A, B, C, D, and E.
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Example
➢ Correct Answer:
➢ Time 1
⚫ 1.030152 = (1.02)(1+f1,1) implies f1,1 = 4.040%.
⚫ A=fl,lu = (4.040%)(e0.15)= 4.694%
⚫ B=fl,ld = (4.040%)(e-0.15) = 3.477%
➢ Time 2
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⚫ D = f2,1= (1.040553/1.030152)- 1= 6.167% as the middle value

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⚫ C = (6.167%)(e0.15X2) = 8.325% as the upper value

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⚫ E = (6.167%)(e-0.15X2) = 4.569% as the lower value
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3.2 Arbitrage-Free Valuation with Binomial Tree
➢ Option free; 2 years; annual coupon rate of 6%
100
6
?
7.20%
? (Today)
100
4.50%
6
?
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5.30%
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(Year 1)
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100
金
6
（Year 2）
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Arbitrage-Free Valuation with Binomial Tree
➢ Solution:
100
6.0
98.88
6.0
104.88
? 7.20% 100
4.50% 6.0
100.66
6.0
106.66
5.30%
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100
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6.0
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1 
金
1
V1,U =   (100 + 6) +  (100 + 6)  / (1 + 7.20%) = $98.88
2 2 
1 1 
V1,L =   (100 + 6) +  (100 + 6)  / (1 + 5.30%) = $100.66
2 2 
1 1 
V0 =   (98.88 + 6) +  (100.66 + 6)  / (1 + 4.50%) = $101.22
2 2  94／248
3.3 Pathwise Valuation
➢ Pathwise valuation: For a binomial interest rate tree with n period, there
will be 2n paths. The Cash flow can be discounted by choosing a specific
path.
➢ Example: pathwise valuation
⚫ Use the pathwise valuation approach to determine the value of a three-
year, 3% annual-pay treasury bond. The interest rate tree is shown as the
following.
⚫ One-period forward rate in year
:
0 1 2
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2.00% 5.00% 8.50%

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3.50% 6.00%
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4.50%
⚫ Compute the value of the $1000 par option-free bond.

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Arbitrage-Free Valuation
➢ Solution:
Path Year1 Year 2 Year 3 Value
1 SUU 2.00% 5.00% 8.50% $943.80
2 SUL 2.00% 5.00% 6.00% $964.70
3 SLU 2.00% 3.50% 6.00% $978.26
4 SLL 2.00% 3.50% 4.50% $991.47
Average $969.56
➢ The value of the bond in Path 1 is computed as:
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30 30 1030
value1 = + + = $943.80
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(1.02) (1.02)(1.05) (1.02)(1.05)(1.085)

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4. Monte Carlo Method
➢ The Monte Carlo method: involves randomly selecting paths in an effort to
approximate the results of a complete pathwise valuation. This method is often
used when a security’s cash flow are path dependent.
➢ The implications for valuation models
⚫ Cash flows for MBS are dependent on the path that interest rates follow
and can not be properly valued with the binomial model or any other
model that employs the backward induction methodology.
➢ Steps in the valuation of an MBS using the Monte Carlo simulation model:
⚫ Step 1: Simulate interest rate paths (e.g. 1,000 different paths) using
assumptions concerning volatility and probability distribution.
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⚫ Step 2: Generate spot rates from the simulated future one-month interest
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rates;
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⚫ Step 3: Determine the cash flow along each interest rate path;
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⚫ Step 4: Calculate the present value for each path.

⚫ Step 5: Calculate the theoretical value of the MBS as the average of the
present values along each path.
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Monte Carlo Method
➢ Using the procedure just described, the model will produce benchmark
bond values equal to the market prices only by chance. A constant is added
to all interest rates on all paths such that the average present value for each
benchmark bond equals its market value. The constant added to all short
interest rates is called a drift term. The model is said to be drift adjusted.
➢ Increasing the number of paths increases the accuracy of the estimate in a

statistical sense. It does not mean the model is closer to the true
:
fundamental value of the security.

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➢ Yield curve modelers often include in the Monte Carlo estimation is mean
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reversion. We implement mean reversion by implementing upper and

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lower bounds on the random process generating future interest rates.
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➢ Term structure models：provide quantitatively precise descriptions of how
interest rates evolve.
⚫ Equilibrium Term Structure Models：Models that seek to describe the

dynamics of the term structure using fundamental economic variables
that are assumed to affect interest rates
✓ Restrictions are imposed that allow for the derivation of equilibrium

prices for bonds and interest rate options.
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✓ Require the specification of a drift term and the assumption of a

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functional form for interest rate volatility

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✓ The best-known equilibrium models are the Cox—Ingersoll—Ross

model and the Vasicek model
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Term Structure Models
⚫ Arbitrage-free model
✓ the analysis begins with the observed market prices of a reference

set of financial instruments and the underlying assumption is that
the reference set is correctly priced.
✓ The computational process that determines the term structure is

such that the valuation process generates the market prices of the
reference set of financial instruments.
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✓ These models are called “arbitrage-free” because the prices they

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generate match market prices.

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✓ The best-known arbitrage models are the Ho-Lee Model and

Kalotay–Williams–Fabozzi (KWF) model
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Term Structure Models
➢ Multiple factor models
⚫ The Gauss+ model is a multi-factor interest rate model used extensively

in valuation and hedging. The Gauss+ model incorporates short-,
medium- and long-term rates.
✓ The long-term factor is mean reverting and reflects trends in

macroeconomic variables.
✓ The medium-term rate also reverts to the long-run rate.

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✓ The short-term rate does not exhibit a random component, which

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is consistent with the central bank controlling the short end of the
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rate curve.
✓ This results in a hump-shaped volatility curve across tenors, with

medium-term rates being the most volatile.
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5.1 Equilibrium Term Structure Models
➢ Characteristics of Equilibrium Term Structure Models
⚫ They are one factor or multifactor models.
✓ One-factor models assume that a single observable factor drives all

yield curve movements.
✓ Both the Vasicek and CIR models assume a single factor, the short-
term interest rate, r.
⚫ They make assumptions about the behavior of factors

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⚫ They are, in general, more sparing with respect to the number of

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parameters that must be estimated compared with arbitrage free term

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structure models.
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5.1.1 Cox-Ingersoll-Ross Model
➢ Cox-Ingersoll-Ross Model
⚫ The CIR model assumes that every individual has to make consumption and
investment decisions with their limited capital.
✓ The individual must determine his or her optimal trade-off assuming
that he or she can borrow and lend in the capital market.
✓ Ultimately, interest rates will reach a market equilibrium rate at which no
one needs to borrow or lend.
⚫ The CIR model assumes that the economy has a constant long-run interest
rate that the short-term interest rate converges to over time.
✓ Mean reversion is an essential characteristic of the interest rate that
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sets it apart from many other financial data series. Unlike stock prices,
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for example, interest rates cannot rise indefinitely because at very high
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levels, they would hamper economic activity, which would ultimately

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result in a decrease in interest rates. Similarly, with rare historical

exceptions, nominal interest rates are non-negative. As a result, short-
term interest rates tend to move in a bounded range and show a
tendency to revert to a long-run value.
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Cox-Ingersoll-Ross Model
drt = k ( − rt )dt +  rt dz
⚫ dr = change in the short-term interest rate

k = speed of mean reversion parameter (k high means fast mean
reversion)
θ = long-run value of the short-term interest rate
rt = level of rates at time t
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t = time
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dt = a small increase in time (time step)

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σ = volatility
dz = a small random walk movement
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Cox-Ingersoll-Ross Model
drt = k ( − rt )dt +  rt dz
⚫ The model has two parts:
✓ A deterministic part (sometimes called a “drift term”), the expression
in dt;
✓ A stochastic (i.e., random) part, the expression in dz, which models
risk.
⚫ The deterministic part, k(θ - r)dt, ensures mean reversion of the interest
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rate toward a long-run value θ, with the speed of adjustment governed by

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the strictly positive parameter k.

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⚫ The random component varies as rates change. In other words, the short-
rate volatility is a function of the short rate. Importantly, at low rates, rt, the
term becomes small, which prevents rates from turning negative..
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5.1.2 Vasicek Model
➢ Vasicek Model
drt = k ( − rt )dt + dz
⚫ The Vasicek model has the same drift term as the CIR model and thus
tends toward mean reversion in the short rate.
⚫ The stochastic or volatility term follows a random normal distribution
for which the mean is zero and the standard deviation is 1.
:
⚫ Compare to CIR model:

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✓ Unlike the CIR model, interest rates are calculated assuming

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constant volatility over the period of analysis.

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⚫ A key characteristic of the Vasicek model worth noting is that it is

theoretically possible for the interest rate to become negative.
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5.2 Arbitrage-Free Models
➢ Arbitrage-free models
⚫ In arbitrage-free models, the analysis begins with the current term structure,
extrapolated from the market prices of a reference set of financial
instruments.
⚫ A maintained assumption is that the reference bonds are priced correctly.
⚫ Unlike general equilibrium models, which have only a few parameters and
can thus match only a few term structure points, arbitrage-free models
allow the parameters to vary deterministically with time, creating a
greater number of parameters and thus more points of match.
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✓ As a result, the market yield curve can be modeled with the accuracy
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needed for such applications as valuing derivatives and bonds with

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embedded options.
⚫ Advantage over equilibrium model: the ability to calibrate arbitrage-free
models to match current market prices.
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5.2.1 The Ho-Lee Model
➢ The Ho-Lee Model
drt = t dt + dzt
⚫ The drift term, θt, is time dependent. This time dependency means
there is a value for θt at each time step, which is critical for the model to
produce prices that match market prices.
⚫ The Ho–Lee model, similar to the Vasicek model, has constant volatility,
and interest rates may become negative because of the symmetry of the
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normal distribution and the model’s use of constant volatility.

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5.2.2 The Kalotay–Williams–Fabozzi model
➢ Kalotay–Williams–Fabozzi (KWF) model
d ln(rt ) = t dt + dzt
⚫ KWF model is analogous to the Ho–Lee model in that it assumes

constant drift, no mean reversion, and constant volatility.
⚫ However, the stochastic differential equation describes the dynamics of
the log of the short rate, and as a result, the log of the short rate is
distributed normally, meaning the short rate itself is distributed
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lognormally.
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✓ The main implication of modeling the log of the short rate is that it
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will prevent negative rates.

✓ It becomes evident that there are pricing implications where interest
rate option values are influenced by the tails of the rate distributions.
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➢ The key differences between these term structure models.
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Example
1. Which term structure model can be calibrated to closely fit an
observed yield curve?
A. The Ho-Lee Model
B. The Vasicek Model
C. The Cox-Ingersoll-Ross Model
2. The CIR model:

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A. assumes interest rates are not mean reverting.

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B. has a drift term that differs from that of the Vasicek model.
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C. assumes interest rate volatility increases with increases in the level

of interest rates.
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Learning
Module
3
:
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Valuation and Analysis of Bonds with Embedded Options

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1. Fixed-income securities with embedded
Framework options
2. Valuation of callable and putable bonds
• Valuation of callable or putable bond
• Valuation of an embedded option
• Effect of interest rate volatility
• OAS calculation and explanation
• Interest rate risk
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3. Valuation of a capped or floored

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floating-rate bond
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4. Convertible bonds
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1. Bonds with Embedded Options
➢ Simple Options
⚫ Callable bonds give the issuer the option to call back the bond; the
investor is short the call option.
✓ European-style option: the option can only be exercised on a single
day immediately after the lockout period
✓ American-style option: the option can be exercised at any time after
the lockout period
✓ Bermudan-style option: the option can be exercised at fixed dates
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after the lockout period

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Bonds with Embedded Options
➢ Simple Options
⚫ A putable bond gives the investor the right to exercise the option is at
the discretion of the bondholder. The put provision allows the
bondholders to put back the bonds to the issuer prior to maturity,
usually at par.
✓ Extendible bond: At maturity, the holder of an extendible bond
has the right to keep the bond for a number of years after maturity,
possibly with a different coupon.
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◆Putable and extendible bonds are equivalent, except for their

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underlying option-free bonds. Consider a three-year 3.30%

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bond putable in Year 2. Its value should be exactly the same as

that of a two-year 3.30% bond extendible by one year.
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Bonds with Embedded Options
➢ Complex Options
⚫ Convertible bond allows bondholders to convert their bonds into the

issuer’s common stock.
⚫ Bonds with estate puts: colloquially know as “death-put” bonds, bonds

with an estate put or survivor’s option can be redeemed at par by the
heirs of a deceased bondholder. The value of the estate put depends
on the bondholder’s life expectancy. The shorter the life expectancy,
:
the greater the value of the estate put.

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⚫ Sinking fund bond requires the issuer to set aside funds over time to
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retire the bond issue, thus reducing credit risk.
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2.1 Valuation and Analysis: Callable and Putable
➢ Example: Strike price is 100; Annual coupon rate is 6%
⚫ Callable? (100.90)
⚫ Putable? (101.75)
100
6.0
98.88
6.0
7.20%
? 100
4.50% 6.0
100.66
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6.0
5.30%
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100
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6.0
金
1 1 
Vcallable =   (98.88 + 6) +  (100 + 6)  / (1 + 4.50%) = 100.90
2 2 
1 1 
V putable =   (100 + 6) +  (100.66 + 6)  / (1 + 4.50%) = 101.75
2 2 117／248 
2.2 Valuation of an Embedded Option
Vcall = Vnoncallable − Vcallable  Vcallable = Vnoncallable − Vcall
Vput = Vputable − Vnonputable  Vputable = Vnonputable + Vput
➢ Example: 2 years; annual coupon rate of 6% 100
6.0
98.88
6.0
7.20%
? 100
4.50% 6.0
100.66
6.0
:
5.30%
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➢ Pure bond: 100

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1 1  6.0
V0 =   (98.88 + 6) +  (100.66 + 6)  / (1 + 4.50%) = $101.22
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2 2 
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➢ Callable bond:
1 1 
Vcallable =   (98.88 + 6) +  (100 + 6)  / (1 + 4.50%) = 100.90
2 2 
➢ Call option:
Vcall = V pure − Vcallable = 101.22 − 100.90 = 0.32 V put = V putable − V pure = 101.75 − 101.22 = 0.53
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2.3 Effect of Interest Rate Volatility
➢ The procedure to value a bond with an embedded option in the presence of
interest rate volatility
⚫ Generate a tree of interest rates based on the given yield curve and
interest rate volatility assumptions.
⚫ At each node of the tree, determine whether the embedded options will
be exercised.
⚫ Apply the backward induction valuation methodology to calculate the
bond's present value. This methodology involves starting at maturity
and working back from right to left to find the bond's present value.
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➢ The rate in the up state (Ru) is given by

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Ru = Rd  e2 t
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⚫ where Rd is the rate in the down state, a is the interest rate volatility
(10% here), and t is the time in years between "time slices" (a year, so
here t = 1).
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Effect of Interest Rate Volatility
➢ Effect of volatility on the arbitrage-free value of an option
➢ Interest rate volatility effect on the value of a callable or putable bond:
⚫ The values of call and put options increase when interest rate volatility
increases
✓ The value of a callable bond decreases
✓ The value of a putable bond increases
⚫ The value of a straight bond is unaffected by changes in the volatility of
interest rate
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volatility change → option value change → bond price / value change

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2.4 Option-Adjusted Spread
Description Character
CF1 CF2 Assume the interest rate
Z-spread Pmarket = + + ... volatility is zero
(1 + R1 + Z )1 (1 + R2 + Z ) 2
The constant spread added
Pmarket =
CF1'
+
CF2''
+ ...
to all one-period rates in
(1 + R1 + OAS )1 (1 + R2 + OAS ) 2 the tree such that the
OAS
calculated value equals the
Option cost =Z-spread – OAS market price of the risky
bond
:
➢ Benchmark interest rates:

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⚫ US treasury securities
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⚫ A specific sector of the bond market with a certain credit rating higher
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than the issue valued

⚫ A specific issuer
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2.4.1 Calculate OAS
➢ Calculate OAS
⚫ Suppose that the market price of a three-year 4.25% annual coupon bond
callable in one year and two years from now at 10% interest rate volatility is
101.00. To determine the OAS, the constant spread added uniformly to all the
one-period forward rates that justifies the given market price of 101.00 is 28.55
bps; this number is the OAS
C=4.25 V3=104.25
R2,HH=5.5258%
+28.55bps
C=4.25 V2,HH=98.524
R1,H=3.8695% V3=104.25
C=4.25
+28.55bps
:
V0=101.000 R2,HL=4.5242%
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V1,H=99.126 +28.5bps
R0=2.5%
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+28.55bps V2,HL=99.466
C=4.25
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V3=104.25
R1,L=3.1681% C=4.25
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+28.55bps R2,LL=3.7041%
V1,L=100.512 +28.55bps
Called at 100 V2,LL=100.25 V3=104.25
Called at 100
Year 0 Year 1 Year 2 Year 3
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2.4.2 OAS Application — Relative valuation
➢ OAS is often used as a measure of value relative to the benchmark.
⚫ An OAS lower than that for a bond with similar characteristics and
credit quality indicates that the bond is likely overpriced (rich) and
should be avoided.
⚫ A larger OAS than that of a bond with similar characteristics and credit
quality means that the bond is likely under- priced (cheap).
⚫ If the OAS is close to that of a bond with similar characteristics and

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credit quality, the bond looks fairly priced.

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123／248
Example
➢ An analyst makes the following spread estimates relative to U.S. Treasuries
for a callable corporate bonds:
⚫ G-spread relative to the Treasury yield curve is 240 basis points
⚫ Z-spread relative to the Treasury yield curve is 225 basis points
⚫ OAS relative to the Treasury yield curve is 190 basis points
➢ The analyst also determine that the Z-spread over Treasuries on
comparable option-free bonds in the market is 210 basis points. Determine
whether the bond is overvalued, undervalued, or properly valued
➢ Answer:
:
⚫ The required OAS in this case is the Z-spread on comparable option-

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free bonds (because Z-spread is equal to OAS for option-free bonds),

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which is 210 basis points. This bond is overvalued, because its OAS of
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190 basis points is less than the required OAS. It is not appropriate to
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compare the bond’s Z-spread or G-spread to the required spread

because the embedded option cost is not reflected in those spread
measures.
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2.4.3 Effect of Interest Rate Volatility on OAS
➢ The dispersion of interest rates on the tree is volatility dependent, and so is
the OAS.
➢ The following Exhibit shows the effect of volatility on the OAS for a callable
bond. As interest rate volatility increase, the OAS for the callable bond
decreases.
Effect of Interest Rate Volatility on the OAS for a Callable Bond

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125／248
2.5.1 Effect of Changes in the Interest Rates
➢ Effect of changes in the Level of interest rates
⚫ Interest rate declines: the price of a callable bond rise less than the
equivalent straight bond.
⚫ Interest rate increase: the price of a putable bond fall less than the
equivalent straight bond.
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Effect of Changes in the Yield Curve
➢ Effect of changes in the Shape of the yield curve
⚫ Call option
✓ Interest rate decline, the value of an embedded call option increases
✓ Value of a call option will be lower for an upward sloping yield curve
◆A higher interest rate scenario limits the probability of the call
option being in the money.
◆As an upward-sloping yield curve becomes flatter, the call
option value increases.
⚫ Put option
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✓ Interest rate increases, the value of a put option increases

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✓ Put option value will be lower as an upward-sloping yield curve

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flattens
◆When yield curve is upward sloping, the probability of the put
option going in the money is higher
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2.5.2 Effective Duration and Effective Convexity
➢ Effective duration and effective convexity
⚫ Modified duration and modified convexity, can be used only for option-
free bonds because these measures assume that a bond’s expected cash
flows do not change when the yield changes.
⚫ The values of embedded options are typically contingent on interest

rates. Thus, for bonds with embedded options, the only appropriate
duration and convexity measures are effective duration and effective
:
convexity.
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( PV− ) − ( PV+ ) ( PV− ) + ( PV+ ) − 2  ( PV0 )

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ED = EC =
2  ( curve )  ( PV0 )
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(  )  ( PV0 )
2
curve
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Effective Duration
➢ Using the binomial model to compute effective duration and convexity.
➢ The procedure for calculating the value of PV+ is as follows:
⚫ Step 1 Given a price (PV0), calculate the implied OAS to the benchmark
yield curve at an appropriate interest rate volatility.
⚫ Step 2 Shift the benchmark yield curve down, generate a new interest
rate tree, and then revalue the bond using the OAS calculated in Step 1.
This value is PV–.
⚫ Step 3 Shift the benchmark yield curve up by the same magnitude as in
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Step 2, generate a new interest rate tree, and then revalue the bond
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using the OAS calculated in Step 1. This value is PV+.

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⚫ Step 4 Calculate the bond’s effective duration using the equation:
ED =
( PV− ) − ( PV+ )
2  ( curve )  ( PV0 )
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Effective Duration
➢ Comparison of effective durations among callable, putable and straight
bonds
⚫ Effective duration (zero-coupon) ≈ maturity of the bond
⚫ Effective duration of fixed-rate bond < maturity of the bond
⚫ Effective duration of floater ≈ time (years) to next reset
⚫ Effective duration (callable) ≤ effective duration (straight)
✓ When interest rates fall, call option gives the issuer the right to retire
the bond at the call price. The call option reduces the effective
duration of the callable bond relative to that of the straight bond.
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⚫ Effective duration (putable) ≤ effective duration (straight)

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✓ When interest rates rise, the investor can put the bond and reinvest
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the proceeds of the retired bond at a higher yield. Thus, the put
option reduces the effective duration of the putable bond relative to
that of the straight bond.
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Effective Convexity
➢ Comparison among effective convexities of callable, putable and
straight bonds
⚫ Straight bonds have positive effective convexity
✓ The increase in the value of an option-free bond is higher when
rates fall than the decrease in value when rates increase by an equal
amount
⚫ Callable bonds are unlikely to be called and will exhibit positive
convexity when rates are high
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✓ The effective convexity turns negative when the underlying call

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option is near the money

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✓ The upside potential of the bond’s price is limited due to the

call(while the downside is not protected)
⚫ Putable bonds exhibit positive convexity throughout
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Effective Duration
➢ Effective durations: normally calculated by averaging the changes resulting
from shifting the benchmark yield curve up and down by the same amount.
⚫ This calculation works well for option-free bonds
⚫ In the presence of embedded options, the results can be misleading.
✓ The problem is that when the embedded option is in the money,
the price of the bond has limited upside potential if the bond is
callable or limited downside potential if the bond is putable.
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✓ The price sensitivity of bonds with embedded options is not

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symmetrical to positive and negative changes in interest rates of

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the same magnitude.
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2.5.3 One-Side Durations
➢ One-side durations - that is, the effective durations when interest rates go
up or down – are better at capturing the interest rate sensitivity of a callable
or putable bond than the (two-side) effective duration, particularly when the
embedded option is near the money.
⚫ The fact that the one-side up-duration is higher than the one-side
down-duration confirms that the callable bond is more sensitive to
interest rate rises than to interest rate declines.
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✓ Callable bond: one-side up-duration > one-side down-duration

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⚫ The putable bond is more sensitive to interest rate declines than to

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interest rate rises.

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✓ Putable bond: one-side down-duration > one-side up-duration
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2.5.4 Key Rate Duration
➢ Key rate duration: shifting any par rate has an effect on the value of the
bond
⚫ Option-free bond
✓ Trading at par, the bond’s maturity matched rate is the only rate
that affects the bond’s value. Its maturity key rate duration is the
same as its effective duration, and all other key rate durations are
zero.
✓ Not trading at par, shift the maturity-matched par rate has the
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greatest effect.
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⚫ Key rate durations can sometimes be negative for maturity points that
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are shorter than the maturity of the bond being analyzed if the bond is
a zero-coupon bond or has a very low coupon.
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Key Rate Duration
Key Rate Duration of 10-Year Option-Free Bonds

Valued at a 4% Flat Yield Curve
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Key Rate Duration
➢ Key rate duration
⚫ Callable bonds
✓ with low coupon rate are unlikely to be called, hence, the rate that
has the highest effect on the value of the callable bond is the
maturity-matched rate.
✓ As the bond’s coupon increase, however, so does the likelihood of
the bond being called. The rate that has the highest effect on the
callable bond’ value is the time-to-exercise rate.
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⚫ Putable bonds
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✓ with high coupon rates are unlikely to be put, their prices are most
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sensitive to their maturity-matched rates

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✓ A low-coupon bond is more likely to be put, its price is most

sensitive to the time-to-exercise rate.
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Key Rate Duration
Key Rate Duration of 30-Year Bonds Callable in 10 Years

Valued at 4% Flat Yield Curve with 15% Interest Rate Volatility
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Key Rate Duration
Key Rate Duration of 30-Year Bonds Putable in 10 Years

Valued at 4% Flat Yield Curve with 15% Interest Rate Volatility
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3. Valuation of Floater with Cap or Floor
➢ Options in floating-rate bonds (floaters) are exercised automatically
depending on the course of interest rates—that is, if the coupon rate rises
or falls below the threshold, the cap or floor automatically applies.
⚫ The capped floater protects the issuer against rising interest rates and
is thus an issuer option.
Value of capped floater= Value of straight bond – Value of embedded cap
⚫ The floor floater protects the investor against declining interest rates
:
and is thus an investor option.

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Value of floored floater= Value of straight bond + Value of embedded floor

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➢ Similar to callable and putable bonds, capped and floored floaters can be
valued by using the arbitrage-free framework.
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Example
➢ A two-year floating rate note pays LIBOR set in arrears. Par value is
$100. The following is the two-year binomial LIBOR tree:
One-period forward rate

Year 0 Year 1
4.50% 7.20%
5.30%
➢ Compute:
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1. The value of the floater, assuming that it is an option-free bond

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2. The value of the floater, assuming that it is capped with a cap rate
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of 6.50%. Also compute the value of the embedded cap

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3. The value of the floater, assuming that it is floored with a floor rate
of 5.20%. Also compute the value of the embedded floor.
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Example
➢ Correct Answer :
1. An option-free bond with a coupon rate equal to the required rate
of return will be worth par value. Hence the straight value of the
floater is $100.
2. The value of the capped floater is $99.69 as shown below:
$99.35 $100
$4.50 $7.20
$99.69 7.20% $6.50
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4.50%
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$100
$100
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$4.50
$5.30
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5.30%
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Year 0 Year 1 Year 2
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Example
⚫ Note that when the option is not in the money, the floater is valued
at par
⚫ The upper node in the year 2 shows the exercise of the cap (the
coupon is capped at $6.50 instead of $7.20)
V1,U = $99.35 = ($100 + $6.50) / (1 + 0.072)

V1, L = $100
⚫ The year 0 value is the average of the year 1 values (including their
:
adjusted coupons) discounted for one period. The year 1 coupon

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don’t require any adjustment as the coupon rate is below the cap
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rate.
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$99.69 =
(99.35 + 4.50) + (100 + 4.50) / 2
1.045
⚫ The value of the embedded cap=$100-$99.69=$0.31

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Example
➢ The value of floored floater:
$100
$4.50 $100
$5.20 $7.20
$100.67 7.20%
4.50%
$100
$4.50 $100
$5.20 $5.30
5.30%
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Year 0 Year 1 Year 2

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⚫ Year 0 value is the average of year 1 values (including their adjusted

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coupons)
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(100 + 5.2 ) + (100 + 5.2)  / 2

$100.67 =
1.045
⚫ The value of the embedded floor=$100.67-$100=$0.67
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4.1 Valuation and Analysis: Convertible Bond
➢ A convertible bond includes an embedded call option. The option is slightly
different from the embedded option in a callable bond.
⚫ The convertible bondholder owns the call option, the issuer owns the call
option in a callable bond.
⚫ The holder has the right to buy shares with a bond that changes in value,
not with cash at a fixed exercise price.
➢ Conversion ratio is the number of shares of common stock that a bondholder
receives from converting the bond into shares.
➢ Conversion price is the bond issue price divided by the conversion ratio. (some
investors refer to it as the stated conversion price.)
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➢ Market conversion price is the market price of bond divided by the conversion
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ratio
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➢ Conversion value = market price of stock × conversion ratio

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➢ Straight value can be estimated by using the market value of a non-convertible

bond of the issuer with the same characteristics as the convertible bond but
without the conversion option.
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Valuation and Analysis: Convertible Bond
➢ The minimum value of a convertible bond sets a floor value for the convertible
bond at the greater of the conversion value or the straight value
 straight value = the price of straight bond 
min value = max  
 conversion value = stock Pm  conversion ratio 
➢ The market conversion premium per share
= market conversion price – market price
➢ Market conversion premium ratio
= market conversion premium per share/market price of common stock
 market price of convertible bond 

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➢ Premium over straight value =   −1

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 straight value 
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⚫ Many investors use the straight value as a measure of the downside risk of a
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convertible bond
⚫ The greater the premium over straight value, the less attractive the
convertible bond.
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➢ Corporate actions—such as stock splits, bonus share issuances, and
rights or warrants issuances—affect a company’s share price and may
reduce the benefit of conversion for the convertible bondholders. Thus, the
terms of issuance of the convertible bond contain detailed information
defining how the conversion price and conversion ratio are adjusted
should such a corporate action occur during the life of the bond.
⚫ For example: ABC, Inc., $1 billion, 0.25% Convertible Bonds
✓ Conversion price: $57.14 per share
✓ Conversion Rate: Each bond of par value of $1,000 is convertible to
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17.5 shares of common stock.

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⚫ Suppose that ABC performs a 2:1 stock split to its common shareholders.
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✓ The conversion price would be adjusted to $28.57 (i.e., $57.14/2) per

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share
✓ The conversion rate adjusted to 35 (i.e., 17.5 × 2) shares per $1,000
of nominal value.
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➢ As long as the convertible bond is still outstanding and has not been
converted, the bondholders receive interest payments.
➢ If the issuer declares and pays dividends, common shareholders receive
dividend payments. The terms of issuance may offer no compensation to
convertible bondholders for dividends paid out during the life of the bond
at one extreme, or they may offer full protection by adjusting the
conversion price downward for any dividend payments at the other
extreme.
⚫ Typically, a threshold dividend is defined in the terms of issuance.
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✓ Annual dividend payments below the threshold dividend have no

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effect on the conversion price. (<)

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✓ In contrast, the conversion price is adjusted downward for annual

dividend payments above the threshold dividend to offer
compensation to convertible bondholders. (>)
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➢ Should the issuer be acquired by or merged with another company during the life of
the bond, bondholders might no longer be willing to continue lending to the new
entity. Change-of-control events are defined in the prospectus or offering circular,
and if such an event occurs, convertible bondholders usually have the choice between:
⚫ a put option that can be exercised during a specified period following the
change-of- control event and that provides full redemption of the nominal value
of the bond;
✓ Hard put: the issuer must redeem the convertible bond for cash.
✓ Soft put: the investor has the right to exercise the put but the issuer chooses
how the payment will be made. The issuer may redeem the convertible bond
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for cash, common stock, subordinated notes, or a combination of the

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three.
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⚫ an adjusted conversion price that is lower than the initial conversion price.
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This downward adjustment gives the convertible bondholders the opportunity to

convert their bonds into shares earlier and at more advantageous terms—thus
allowing them to participate in the announced merger or acquisition as common
shareholders.
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➢ It is more frequent for convertible bonds to include a call option that gives the
issuer the right to call the bond during a specified period and at specified
times.
➢ The issuer may believe that its share price will increase significantly in the
future because of its performance or because of events that will take place in the
economy or in its sector. In this case, the issuer may try to maximize the benefit
to its existing shareholders relative to convertible bondholders and call the
bond.
➢ To offer convertible bondholders protection against early repayment, convertible
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bonds usually have a protection period. Subsequently, they can be called but
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at a premium, which decreases as the maturity of the bond approaches.

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➢ If a convertible bond is callable, the issuer has an incentive to call the bond
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when the underlying share price increases above the conversion price in order to
avoid paying further coupons. Such an event is called forced conversion
because it forces bondholders to convert their bonds into shares.
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4.2 Valuation of Convertible Bond
➢ Valuation of convertible bond
Noncallable/nonputable convertible = Straight value of bond
bond value + Value of the call option on the stock
➢ Most convertible bonds are callable, giving the issuer the right to call the
issue prior to maturity.
= Straight value of bond
Callable convertible bond value + Value of the call option on the stock
- Value of the call option on the bond
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= Straight value of bond

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Callable and putable convertible + Value of the call option on the stock
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bond value
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- Value of the call option on the bond

+ Value of the put option on the bond
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4.3 Effects of Embedded Option
➢ Effects of embedded option in convertible bond
⚫ Stock price volatility ↓=>Value of the call option on the stock ↓

=>convertible bond value ↓
⚫ Stock price volatility ↑=>Value of the call option on the stock ↑

=>convertible bond value ↑
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4.4 Analysis of Convertible Bond
➢ Comparisons between convertible bonds and stocks
⚫ Stock price↓=>the returns on convertible bonds exceed those of the

stock
✓ Reason: The convertible bond’s price has a floor =its straight bond
value.
⚫ Stock price↑=>the bond will underperform
✓ Reason: conversion premium.

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⚫ Stock price remains stable=>the returns on convertible bonds exceed

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those of the stock

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✓ Reason: The coupon payments received from the bond, assuming no

change in interest rates or the yield or credit risk of the issuer.
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Analysis of Convertible Bond
➢ Comparison between underlying stock and risk-return characteristics of the
convertible bond
⚫ Fixed-income equivalent: When underlying share price < the conversion
price, the convertible bond is described “busted convertible” and exhibits
mostly bond risk-return characteristics.
✓ The call option is out of money, the share price movements do not
significantly affect the price of the call option or the convertible bond.
⚫ Common stock equity: When the underlying share price > the
conversion price, a convertible bond exhibits mostly stock risk-return
characteristics.
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✓ The call option is in the money, the price of the call option and thus the
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price of the convertible bond is significantly affected by share price

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movements but mostly unaffected by factors driving the value of an

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otherwise identical option-free bond.

⚫ In between the bond and the stock extremes, the convertible bond trades
like a hybrid instrument.
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Example
➢ Nick Andrews, a fixed-income investment analyst, has been asked by
his supervisor to prepare an analysis of the convertible bond issued by
Heavy Element Inc., a chemical industry company, for presentation to
the investment committee. Andrews has gathered the following data
from the convertible bond’s prospectus and market information:
⚫ Issuer: Heavy Element Inc.
⚫ Issue Date: 15 September 2010
⚫ Maturity Date: 15 September 2015
⚫ Interest: 3.75% payable annually
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⚫ Issue Size: $100,000,000

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⚫ Issue Price: $1,000 at par

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⚫ Conversion Ratio: 23.26

⚫ Convertible Bond Price on 16 September 2012: $1,230
⚫ Share Price on 16 September 2012: $52
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Example
1. The conversion price is closest to:
A. $19.
B. $43.
C. $53.
2. The conversion value on 16 September 2012 is closest to:
A. $24.
B. $230.
C. $1,209.
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3. The market conversion premium per share on 16 September 2012 is closest

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to:
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A. $0.88.
B. $2.24.
C. $9.00.
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Example
4. The risk—return characteristics of the convertible bond on 16
September 2012 most likely resemble that of:
A. a busted convertible.
B. Heavy Element's common stock.
C. a bond of Heavy Element that is identical to the convertible bond
but without the conversion option.
5. As a result of favorable economic conditions, credit spreads for the
chemical industry narrow, resulting in lower interest rates for the debt
:
of companies such as Heavy Element. All else being equal, the price of
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Heavy Element's convertible bond will most likely:

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A. decrease significantly.
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B. not change significantly.

C. increase significantly.
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Example
6. Suppose that on 16 September 2012, the convertible bond is available
in the secondary market at a price of $1,050. An arbitrageur can make a
risk-free profit by:
A. buying the underlying common stock and shorting the

convertible bond.
B. buying the convertible bond, exercising the conversion option,

and selling the shares resulting from the conversion.
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C. shorting the convertible bond and buying a call option on the

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underlying common stock exercisable at the conversion price on

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the conversion date.
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Example
7. A few months have passed. Because of chemical spills in lake water at
the site of a competing facility, the government has introduced very
costly environmental legislation. As a result, share prices of almost all
publicly traded chemical companies, including Heavy Element, have
decreased sharply. Heavy Element's share price is now $28. Now, the
risk–return characteristics of the convertible bond most likely resemble
that of:
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A. a bond.
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B. a hybrid instrument.
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C. Heavy Element's common stock.
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Learning
Module
4
:
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Credit Analysis Models

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1. Modeling credit risk and the credit
valuation adjustment
Framework 2. Valuing risky bonds in an arbitrage-free
framework
3. Credit scores and credit ratings
4. Structural model and reduced-form
credit models
5. Credit spread analysis
:
• Interpreting changes in credit

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spreads
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• The term structure of credit spreads

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6. Credit analysis for securitized debt
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1. Modeling Credit Risk
➢ Credit risk is the risk associated with losses stemming from the failure of a
borrower to make timely and fully payments of interest or principal. Credit risk
depends on:
⚫ Expected exposure is the projected amount of money the investor could
lose if an event of default occurs, before factoring in possible recovery.
⚫ Probability of default (POD) is the probability that the bond issuer will not
meet its contractual obligations on schedule.
⚫ Recovery rate is percentage of the loss recovered from a bond in default.
⚫ Loss given default (LGD) is the amount of loss if a default occurs.
✓ Loss given default (%) =100% - Recovery rate
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✓ Loss given default ($) = Expected exposure – Recovery ($)

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⚫ Expected loss = Probability of default × Loss severity given default

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⚫ Credit valuation adjustment (CVA) is the value of the credit risk in present
value term. ( the sum of PV of expected loss)
⚫ Fair value of corporate bond = VND – CVA
✓ VND: the value for the corporate bond assuming no default
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Probability of Default
➢ Probability of default
⚫ Actual probability of default
✓ The actual default probability for the corporate bond can observed
from historical data.
⚫ Risk-neutral probability of default
✓ In practice，we use the risk neutral probability of default, which is
the probability of default implied in the current market price.
⚫ Usually, risk-neutral default probability is higher than actual
default probability.
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⚫ The reason for the difference between actual (or historical) and
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risk-neutral default probabilities.

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✓ Actual default probabilities do not include the default risk premium

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associated with uncertainty over the timing of possible default loss.

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✓ The observed spread over the yield on a risk-free bond in practice

also includes liquidity and tax considerations in addition to credit
risk.
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2.1 Credit Analysis of Zero-Coupon Corporate Bond
➢ Considering a 5-year, zero-coupon corporate bond, to determine its
fair value given the credit risk, the rate of return, and the spread over a
maturity-matching government bond.
➢ Assume:
⚫ A flat government bond yield curve at 3.00%.
⚫ Given POD on date 1 is 1.25%. We assume conditional probabilities
of default, meaning that each year-by-year POD assumes no prior
default. This initial POD, which is called the hazard rate in statistics,
is used to calculate the remaining PODs.
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⚫ Default occurs only at year-end – on dates 1, 2, 3, 4, and 5 – and

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that default will not occur on date 0.

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⚫ The exposure on date 5 is 100.

⚫ The recovery rate is 40%.
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Credit Analysis of Zero-Coupon Corporate Bond
A 5-Year, Zero-Coupon Corporate Bond
Date Exposure Recovery LGD POD POS EL DF PVEL
（1）（2）（3）（4）（5）（6）（7）（8）（9）

0
1 88.8487 35.5395 53.3092 1.2500% 98.7500% 0.6664 0.970874 0.6470
2 91.5142 36.6057 54.9085 1.2344% 97.5156% 0.6778 0.942596 0.6389

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3 94.2596 37.7038 56.5558 1.2189% 96.2967% 0.6894 0.915142 0.6309

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4 97.0874 38.8350 58.2524 1.2037% 95.0930% 0.7012 0.888487 0.6230

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5 100.000 40.0000 60.0000 1.1887% 93.9043% 0.7132 0.862609 0.6152
6.0957% CVA = 3.1549
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➢ Exposure on date T (2):
⚫ Date 1: 100/(1.03)4 = 88.8487
⚫ Date 2: 100/(1.03)3 = 91.5142
⚫ Date 3: 100/(1.03)2 = 94.2596
⚫ Date 4: 100/(1.03)1 = 97.0874
⚫ Date 5: 100
➢ The recovery rate is 40%, recovery on date T (3):
⚫ Date 1: 88.8487 X 0.4 = 35.5395
⚫ Date 2: 91.5142 X 0.4 = 36.6057
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⚫ Date 3: 94.2596 X 0.4 = 37.7038

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⚫ Date 4: 97.0874 X 0.4 = 38.8350

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⚫ Date 5: 100.0000 X 0.4 = 40.0000

➢ LGD = exposure – recovery (4)
⚫ For example, date 4: LGD = 97.0874 – 38.8350 = 58.2524
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➢ Risk-neutral probability of default (POD) and probability of survival (POS) on
date T (5&6):
⚫ Date 1:
✓ POD = 1.25%
✓ POS = 1-1.25% = 98.75%
⚫ Date 2:
✓ POD = 98.75% X 1.25% = 1.2344%
✓ POS = 98.75% - 1.2344% = 97.5156%
⚫ Date 3:
✓ POD = 97.5156% X 1.25% = 1.2189%
✓ POS = 97.5156% - 1.2189% = 96.2967%
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⚫ Date 4:
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✓ POD = 96.2967% X 1.25% = 1.2037%

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✓ POS = 96.2967% - 1.2037% = 95.0930%

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⚫ Date 5:
✓ POD = 95.0930% X 1.25% = 1.1887%
✓ POS = 95.0930% - 1.1887% = 93.9043%
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➢ Expected loss = LGD X POD (7)
⚫ For example, date 3: Expected loss = 56.5558 X 1.2189% = 0.6894
➢ Risk-free discount factors based on the flat government bond yield
curve at 3.00%, DFT=1/1.03T (8)
⚫ For example, date 5: DF = 1/1.035=0.862609
➢ Present value (PV) of the expected loss for each year = EL X DF (9)
⚫ For example, date 5: PVEL = 0.7132 X 0.862609 = 0.6152
➢ Credit valuation adjustment (CVA) is the sum of PVEL is 3.1549
➢ Fair value = VND – CVA = 86.2609 – 3.1539 = 83.1060
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⚫ VND = 100/1.035 = 86.2609

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➢ Given a price of 83.1060, we can calculate its yield to maturity:

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100
⚫ = 83.1060, YTM = 3.77%
(1+𝑌𝑇𝑀)5
➢ The yield on the 5-year, zero-coupon government bond is 3.00%. Therefore,
the credit spread is 77 basis points: 3.77% – 3.00% = 0.77%.
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➢ Projected annual rates of return
➢ If the issuer defaults on date 1:
35.5395
⚫ = 83.1060,
1+𝐼𝑅𝑅
⚫ IRR = -57.24%
0 36.6057
⚫ + = 83.1060,
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1
1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 2
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⚫ IRR = -33.63%
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0 0 0 0 40.0000
⚫ 1 + 2 + 3 + 4 + = 83.1060,
1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 5
⚫ IRR = −13.61%
➢ If there is no default, which is most likely because the probability of

survival to date 5 is 93.9043%, the realized rate of return is 3.77%.
⚫ This reminds us that a yield to maturity on a risky bond is a measure of

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return to the investor, assuming no default.

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2.2 Analysis of Coupon-Paying Corporate Bond
➢ A fixed-income trader at a hedge fund observes a 3-year, 5% annual
payment corporate bond trading at 104 per 100 of par value. The
research team at the hedge fund determines that the risk-neutral
probability of default used to calculate the conditional POD for each
date for the bond is 1.50% given a recovery rate of 40%. The
government bond yield curve is flat at 2.50%.
➢ Based on these assumptions, does the trader deem the corporate bond
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to be overvalued or undervalued? By how much? If the trader buys the

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bond at 104, what are the projected annual rates o f return?

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Analysis of Coupon-Paying Corporate Bond
➢ Solution:
A 3-Year, Coupon-paying Corporate Bond, with flat benchmark curve
Date Exposure Recovery LGD POD POS EL DF PVEL
（1）（2）（3）（4）（5）（6）（7）（8）（9）

0
1 109.8186 43.9274 65.8911 1.5000% 98.5000% 0.9884 0.975610 0.9643

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2 107.4390 42.9756 64.4634 1.4775% 97.0225% 0.9524 0.951814 0.9066

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3 105.0000 42.0000 63.0000 1.4553% 95.5672% 0.9169 0.928599 0.8514
4.4328% CVA = 2.7222
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➢ The exposures are the values for the bond plus the coupon payment
for each date assuming a yield to maturity of 2.50%. (2)
⚫ For example, the exposure is 109,8186 for date 1 when two years to
maturity remain.
5 105
⚫ 5+ 1 + 2 = 109.8186
1.025 1.025
➢ Recovery = Exposure X 40% (3)
⚫ For example, date 1: Recovery = 109.8186 X 40% = 43.9274
➢ LGD = Exposure – Recovery (4)
:
育
⚫ For example, date 1: LGD = 109.8186 – 43.9274 = 65.8911

教
➢ Expected loss = LGD X POD (7)

程
金
⚫ For example, date 1: Expected loss = 65.8911 X 1.5% = 0.9884

➢ DFT=1/1.025T (8)
⚫ For example, date 1: DF1 = 1/(1.025)1 = 0.975610
172／248
➢ Present value (PV) of the expected loss for each year = EL X DF (9)
⚫ For example, date 1: PVEL = 0.9884 X 0.975610 = 0.9643
➢ Credit valuation adjustment (CVA) is the sum of PVEL is 2.7222.
➢ If this 3-year, 5% bond were default-free, its price would be 107.1401 (VND).
5 5 105
⚫ 1 + 2 + 3 = 107.1401
1.025 1.025 1.025

:
育
➢ Therefore, The fixed-income trader at the hedge fund would deem this
教
corporate bond to be undervalued by 0.4178 per 100 of par value if it is

程
金
trading at a price of 104.
173／248
➢ The projected annual rates of return:
⚫ If the issuer defaults on date 1:
43.9274
✓ = 104, IRR = -57.76%
1+𝐼𝑅𝑅
5 42.9756
✓ 1 + = 104, IRR = -33.27%
1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 2

:
育
教
5 5 42.0000
✓ + + = 104, IRR = -22.23%
程
1 2
1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 3
金
⚫ If there is no default, the rate of return is:
5 5 105
✓ 1 + 2 + 3 = 104, IRR = 3.57%
1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 1+𝐼𝑅𝑅
174／248
2.3 Arbitrage-Free Valuation for Risky Bonds
➢ The first step is to build the binomial interest rate tree under the assumption
of no arbitrage.
➢ The second step is confirming that the binomial interest rate tree has been
correctly calibrated.
➢ The third step is to assess the fair value for the risky bond. This is done in
three steps:
⚫ First, determine the value for the corporate bond assuming no default
:
育
(VND).
教
⚫ Second, calculate the credit valuation adjustment (CVA).

程
金
⚫ Third, the fair value of the risky bond is the VND minus the CVA.
175／248
Arbitrage-Free Valuation for Risky Bonds
➢ The Exhibit displays the data on annual payment benchmark government
bonds. This is the par curve because each bond is priced at par value. The
coupon rates are equal to the yields to maturity. The 1-year government
bond has a negative yield to reflect the conditions seen in some financial
markets. However, on a par curve whereby all the bonds are priced at 100, it
is shown as having a negative coupon rate.
Exhibit 1. Par Curve for Annual Payment Benchmark Government Bonds, Spot Rates,
Discount Factors, and Forward Rates
Maturity Coupon rate Price Discount factor Spot rate Forward rate
:
育
1 -0.25% 100 1.002506 -0.2500%

教
程
2 0.75% 100 0.985093 0.7538% 1.7677%

金
3 1.5% 100 0.955848 1.5166% 3.0596%

4 2.25% 100 0.913225 2.2953% 4.6674%
5 2.75% 100 0.870016 2.8240% 4.9664%
176／248
➢ 1-year Binomial Interest Rate Tree for 10% Volatility
7.2918%
(0.0625)
6.2197%
(0.1250)
3.7026% 5.9700%
(0.2500) (0.2500)
1.9442%
(0.5000) 5.0922%
(0.3750)
-0.2500% 3.0315% 4.8878%
(1.0000) (0.5000) (0.3750)
:
1.5918% 4.1692%
育
(0.5000) (0.3750)
教
2.4820% 4.0018%
程
(0.2500) (0.2500)
3.4134%
金
(0.1250)
3.2764%
(0.0625)
Date 0 Date 1 Date 2 Date 3 Date 4
177／248
➢ Consider a 5-year, 3.50% annual payment corporate bond. A fixed-
income analyst assigns an annual default probability of 1.25% (the
hazard rate) and a recovery rate of 40% to this bond and assumes 10%
volatility in benchmark interest rates. To determine the fair value for the
bond under these assumptions.
➢ This is done in three steps:
⚫ First, determine the value for the corporate bond assuming no

:
育
default (VND).
教
⚫ Second, calculate the credit valuation adjustment (CVA).

程
金
⚫ Third, the fair value of the risky bond is the VND minus the
CVA.
178／248
➢ Value of a 3.5% Annual Payment Corporate Bond Assuming No Default
96.4659
7.2918% 103.50
94.6788
3.50
6.2197%
95.6703 97.6692
3.50 103.50
3.7026% 5.9700%
98.4920 96.7465
1.9442% 3.50 3.50
5.0922%
103.5450 98.6769
98.1435
-0.2500% 3.50 3.50 4.8878% 103.50
3.0315%
101.0803 98.4909
:
1.5918% 3.50 3.50

育
4.1692%
99.5175
教
100.2352 103.50
4.0018%
程
2.4820% 3.50
金
99.9551 3.50
3.4134%
100.2165
3.2764% 103.50
Date 0 Date 1 Date 2 Date 3 Date 4 Date 5

179／248
➢ Step 1: determine VND
⚫ The binomial interest rate tree for benchmark rates can be used to
calculate the VND for the bond. The VND is 103.5450 per 100 of par
value.
⚫ This could also have been obtained more directly using the benchmark
discount factors:
✓ (3.50 × 1.002506) + (3.50 × 0.985093) + (3.50 × 0.955848) + (3.50 ×

:
育
0.913225) + (103.50 × 0.870016) = 103.5450

教
程
金
180／248
➢ Step 2: determine CVA
Exhibit 2. Credit Valuation Adjustment (CVA) for the 3.50% Annual

Payment Corporate Bond
Expected Discount CVA per
Date LGD POD
Exposure Factor Year
0
1 103.2862 61.9717 1.2500% 1.002506 0.7766
2 101.5481 60.9289 1.2344% 0.985093 0.7409

:
育
教
3 101.0433 60.6260 1.2189% 0.955848 0.7064

程
4 102.0931 61.2559 1.2037% 0.913225 0.6734

金
5 103.5000 62.1000 1.1887% 0.870016 0.6422

6.0957% CVA = 3.5394
181／248
➢ The expected exposure for date 4 is 102.0931.
⚫ Calculated using the bond values at each node, the probability of

attaining the node, and the coupon payment.
⚫ Expected exposure = [(0.0625 × 96.4659) + (0.25 × 97.6692) + (0.375 ×

98.6769) + (0.25 × 99.5175) + (0.0625 × 100.2165)] + 3.50 = 102.0931
➢ The LGD for date 4 is 61.2559.
⚫ Assumed recovery rate is 40% of the exposure.

:
育
⚫ LGD = 102.0931 × (1 – 0.40) = 61.2559

教
程
➢ The POD at date 4 is 1.2037% assuming no prior default.

金
⚫ This is based on the probability of survival into the fourth year.
⚫ POD = 1.25% × (100% – 1.25%)3 = 1.2037%
182／248
➢ The expected loss at date 4 is 0.737337.
⚫ Expected loss = LGD × POD = 61.2559 × 1.2037% = 0.737337
➢ The PV of expected loss at date 4 is 0.6734.
⚫ PVEL = EL × DF = 0.737337 × 0.913225 = 0.6734
➢ Credit valuation adjustment (CVA) is the sum of PVEL is 3.5394
➢ Step 3: determine fair value
⚫ Fair value = VND – CVA = 103.5450 – 3.5394 = 100.0056

:
育
教
程
金
183／248
➢ The yield to maturity (YTM) for the corporate bond given a fair value of
100.0056 is 3.4988%.
3.5 3.5 3.5 3.5 103.5

⚫ + + + + = 100.0056
(1+𝑌𝑇𝑀) (1+𝑌𝑇𝑀)2 (1+𝑌𝑇𝑀)3 (1+𝑌𝑇𝑀)4 (1+𝑌𝑇𝑀)5
⚫ YTM = 3.4988%
➢ The credit spread over the benchmark bond is 0.7488%, given the 5-year
par yield for the government bond is 2.75%.
:
⚫ Credit spread = 3.4988% - 2.75% = 0.7488%

育
教
➢ We can say that the credit risk on this corporate bond is captured by a CVA
程
of 3.5394 per 100 in par value as of date 0 or as an annual spread of 74.88

金
basis points per year for five years.
184／248
➢ For this example we use a no-arbitrage binomial interest rate tree for
20% volatility to value the 5-year, 3.50% annual payment corporate
bond using the same credit risk parameters as in the previous
calculations. 93.7706
103.50
10.3757%
93.3858
3.50
8.0804%
93.1558 96.7697
3.50 103.50
4.3999% 6.9550%
97.226 96.1232 3.50
2.1180% 3.50 5.4164%
103.5450 98.4158 98.8897
-0.2500% 3.50 3.50 103.50
:
2.9493% 4.6621%
育
102.3458 99.5136
3.50 3.50
教
1.4197% 3.6307%
100.3635
程
102.1817 103.50
1.9770% 3.50 3.1251%
金
101.8902 3.50
2.4338% 101.3764
103.50
2.0948%
185／248
➢ Determine CVA
Exhibit 3. CVA Calculation for the 3.50% Corporate Bond Assuming 20%
Volatility
Date LGD POD
0
1 103.2862 61.9717 1.2500% 1.002506 0.7766
2 101.5423 60.9289 1.2344% 0.985093 0.7408

:
育
3 101.0233 60.6260 1.2189% 0.955848 0.7062

教
程
4 102.0636 61.2559 1.2037% 0.913225 0.6732

金
5 103.5000 62.1000 1.1887% 0.870016 0.6422

6.0957% CVA = 3.5390
186／248
➢ The fair value of the bond is now slightly higher at 100.0060 (= 103.5450 –
3.5390) compared to the value for 10% volatility of 100.0056 (= 103.5450 –
3.5394).
➢ The reason for the small volatility impact on the fair value is the asymmetry in
the forward rates produced by the log-normality assumption in the interest
rate model. In building the tree, rates are spread out around the implied
forward rate for each date, the more so the greater the given level of volatility.
⚫ For example, the middle rate is 4.6621% on date 4. With 20% volatility, the
date-4 rate at the top of the tree is higher by 5.7136% (=10.3757% -
4.6621%), while the rate at the bottom of the tree is lower by 2.5673%
(=4.6621% - 2.0948%).
:
育
⚫ The net effect is to reduce the expected exposure to default loss. The top of
教
the tree shows less potential loss because the current value of the bond is
程
lower, which more than offsets the greater exposure to loss at the bottom of
金
the tree.
➢ Conclusion: the fair value of the bond will increase with a higher interest
rate volatility.
187／248
2.4 Arbitrage-Free Valuation for Risky Floater
➢ Consider a 5-year “floater” that pays annually the 1-year benchmark
rate plus 0.50% (quoted margin) , using the binomial interest rate
tree for 10% interest rate volatility. Notice that the interest payment is
set at the beginning of the period and paid at the end of the period.
➢ Assume that for the first three years the annual default probability (the
hazard rate) is 0.50% and the recovery rate 20%. The credit risk of the
issuer then worsens: For the final two years the probability of
:
育
default goes up to 0.75% and the recovery rate goes down to 10%.
教
This is an example in which the assumed annual hazard rate changes

程
金
over the life time of the bond .
➢ Determine the fair value for the bond under these assumption.
188／248
Arbitrage-Free Valuation for Risky Floater
➢ Determine VND
100.4660
7.2918% 107.7918
100.9122
6.7197
6.2197%
101.3689 100.4718
4.2026 106.4700
3.7026% 5.9700%
101.8442 100.9271
2.4442 5.5922
1.9442% 5.0922%
102.3633 100.4767
0.2500 101.3911 105.3878
-0.2500% 3.5315 4.8878%
3.0315%
101.8707 100.9396 4.6692
:
1.5918% 2.0918
育
4.1692%
101.4098 100.4808
教
2.9820 104.5018
2.4820% 4.0018%
程
3.9134
金
100.9500
3.4134% 100.4841
3.2764% 103.7764

189／248
➢ The VND of 102.3633 is obtained via backward induction (i.e., beginning at
maturity and working backwards in time).
➢ These are the calculations for the bond values for date 4:
⚫ 107.7918/1.072918 = 100.4660
⚫ 106.4700/1.059700 = 100.4718
⚫ 105.3878/1.048878 = 100.4767
⚫ 104.5018/1.040018 = 100.4808
⚫ 103.7764/1.032764 = 100.4841
:
➢ These are the calculations for date 3:

育
教
⚫ {[(0.5 × 100.4660) + (0.5 × 100.4718)] + 6.7197}/1.062197=100.9122

程
⚫ {[(0.5 × 100.4718) + (0.5 × 100.4767)] + 5.5922}/1.050922=100.9271

金
⚫ {[(0.5 × 100.4767) + (0.5 × 100.4808)] + 4.6692}/1.041692=100.9396

⚫ {[(0.5 × 100.4808) + (0.5 × 100.4841)] + 3.9134}/1.034134=100.9500
190／248
⚫ {[(0.5× 100.9122) + (0.5 × 100.9271)] +4.2026}/1.037026=101.3689
⚫ {[(0.5× 100.9271) + (0.5 × 100.9396)] +3.5315}/1.030315=101.3911
⚫ {[(0.5× 100.9396) + (0.5 × 100.9500)] +2.9820}/1.024820=101.4098
⚫ {[(0.5× 101.3689) + (0.5 × 101.3911)] +2.4442}/1.019442=101.8442
⚫ {[(0.5× 101.3911) + (0.5 × 101.4098)] +2.0918}/1.015918=101.8707

:
育
教
程
⚫ {[(0.5× 101.8442) + (0.5 × 101.8707)] +0.2500}/0.997500=102.3633

金
191／248
➢ Determine CVA
CVA Calculation for the Value of a Floating-Rate Note Paying the

Benchmark Rate Plus 0.50%
Date LGD POD
0
1 102.1074 81.6859 0.5000% 1.002506 0.4095
2 103.6583 82.9266 0.4975% 0.985093 0.4064

:
育
3 104.4947 83.5957 0.4950% 0.955848 0.3955

教
4 105.6535 95.0881 0.7388% 0.913225 0.6416

程
金
5 105.4864 94.9377 0.7333% 0.870016 0.6057
2.9646% CVA = 2.4586
192／248
➢ The calculation for the expected exposure recognizes that the bond values
for each date follow the probabilities of attaining those rates, whereas
possible interest payments use the probabilities for the prior date. For
example, the expected exposure to default loss for date 4 is 105.6535:
⚫ ሾ 0.0625×100.4660 + 0.25×100.4718 + 0.375×100.4767 +

0.25×100.4808 + 0.0625×100.4841 ሿ + ሾ 0.125×6.7197 +
0.375×5.5922 + 0.375×4.6692 + 0.125×3.9134 ሿ = 105.6535
:
➢ Expected LGD = expected exposure × (1- recovery rate)

育
教
⚫ Date 2: LGD = 103.6583 × (1-20%) = 82.9266

程
金
⚫ Date 4: LGD = 105.6535 × (1-10%) = 95.0881
193／248
➢ Probability of default (POD) and probability of survival (POS)
⚫ For date 1. the POD is 0.50%, POS = 1- 0.50% = 99.5%
⚫ For date 2, the POD = 0.50% x (100% - 0.50%) = 0.4975%.
⚫ For date 3, the POD = 0.50% x (100% - 0.50%)2 = 0.4950%.
⚫ The POS into the fourth year is 98.5075%: (100% - 0.50%)3 = 98.5075%.
Therefore, the POD for date 4 increases to 0.7388%: 0.75% x 98.5075%
= 0.7388%.
:
育
⚫ The POS into the fifth year is 97.7687% (= 98.5075% - 0.7388%). The
教
程
POD for date 5 is 0.7333% (= 0.75% x 97.7687%).

金
➢ Given these assumptions about credit risk, the CVA for the floater is 2.4586.
➢ Fair value = VND – CVA =102.3633 – 2.4586 = 99.9047
194／248
➢ The discount margin for a floating-rate note is a yield measure commonly
used on floating-rate notes in the same manner that the credit spread
issued with fixed-rate bonds.
➢ Given these assumptions about credit risk, the CVA for the floater is 2.4586.
The fair value is 99.9047, the VND of 102.3633 minus the CVA. Because the
security is priced below par value, its discount margin (DM) must be
higher than the quoted margin of 0.50%.
➢ The arbitrage-free framework can be used to determine the DM for this
:
育
floater by trial-and-error search. We add a trial DM to benchmark rates

教
that are used to get the bond values at each node in the tree.
程
金
⚫ After trial-and-error search, a DM of 0.52046% gives the same date-0

value for the floating-rate note of 99.9047 as is obtained with the VND
and CVA models.
195／248
3. Credit Scores and Credit Ratings
➢ Credit scoring and credit ratings, two traditional approaches to credit risk
analysis, apply to different types of borrowers.
⚫ Credit scores are used primarily in the retail lending market for small
businesses and individuals.
⚫ Credit ratings are used in the wholesale market for bonds issued by
corporations and government entities as well as for asset-backed
securities (ABS).
:
育
⚫ Credit rating and credit scoring are ordinal measures, a higher rating
教
implies lower credit risk, but the difference between difference in scores
程
金
or ratings is not proportional to the difference in risk.
✓ Not cardinal measure, e.g. A scores 600, B scores 300, A’s credit
quality is higher than B, but not twice than B.
196／248
3.1 Credit Scores
➢ The FICO score, which is the federally registered trademark of the Fair Isaac
Corporation, is used in the United States by about 90% of lenders to retail
customers.
➢ Five primary factors are included in the proprietary algorithm used to get
the score:
⚫ 35% for the payment history
⚫ 30% for the debt burden
⚫ 15% for the length of credit history
⚫ 10% for the types of credit used
:
育
⚫ 10% for recent searches for credit

教
程
➢ Fair Isaac Corporation, on its website, notes items that are not included in
金
the FICO credit score: race, color, national origin, sex, marital status, age,
salary, occupation, employment history, home address, and child/family
support obligation.
197／248
3.2 Credit Ratings
➢ Credit ratings are widely used in corporate and sovereign bond markets.
➢ The three major global credit rating agencies are Moody's Investors
Service, Standard & Poor's, and Fitch Ratings. Each provides quality
ratings for issuers as well as specific issues.
⚫ Notching is an adjustment to the issuer rating to reflect the priority of
claim for specific debt issues of that issuer and to reflect any
subordination.
✓ The issuer rating is typically for senior unsecured debt.
:
育
✓ The rating on subordinated debt is then adjusted, or “notched”, by

教
lowering it one or two levels.

程
⚫ In addition to the “letter grade”, the rating agencies provide an outlook

金
(positive, stable, or negative) for the issuer as well as when the issuer is
under “watch”.
198／248
Credit Transition Matrix
➢ The rating agencies report transition matrixes based on their historical experience. It
shows the probabilities of a particular rating transitioning to another over the course
of the following year and representative credit spreads for a 10-year corporate bond.
Representative One-Year Corporate Transition Matrix (entries are%)
From/To AAA AA A BBB BB B CCC,CC,C D
AAA 90.00 9.00 0.60 0.15 0.10 0.10 0.05 0.00
AA 1.50 88.00 9.50 0.75 0.15 0.05 0.03 0.02
A 0.05 2.50 87.50 8.40 0.75 0.60 0.12 0.08

:
BBB 0.02 0.30 4.80 85.50 6.95 1.75 0.45 0.23

育
教
BB 0.01 0.06 0.30 7.75 79.50 8.75 2.38 1.25

程
B 0.00 0.05 0.15 1.40 9.15 76.60 8.45 4.20

金
CCC,CC,C 0.00 0.01 0.12 0.87 1.65 18.50 49.25 29.60

Credit
0.60% 0.90% 1.10% 1.50% 3.40% 6.50% 9.50%
Spread
199／248
Impact of Credit Migration on Expected Return
➢ The credit transition matrix and the credit spreads allow a fixed-income
analyst to estimate a 1-year rate of return given the possibility of credit
rating migration but still no default.
➢ Assume that an A-rated 10-year corporate bond will have a modified
duration of 7.2 at the end of the year given stable yields and spreads.
➢ For each possible transition, the analyst can calculate the expected
percentage price change as the product of the modified duration and
the change in the spread:
From A to AAA –7.2 × (0.60% – 1.10%) = +3.60%
:
育
From A to AA –7.2 × (0.90% – 1.10%) = +1.44%

教
程
From A to BBB –7.2 × (1.50% – 1.10%) = –2.88%

金
From A to BB –7.2 × (3.40% – 1.10%) = –16.56%

From A to B –7.2 × (6.50% – 1.10%) = –38.88%
From A to CCC,CC,C –7.2 × (9.50% – 1.10%) = –60.48%
200／248
➢ The probabilities of migration now can be used to calculate the
expected percentage change in the bond value over the year.
⚫ The expected percentage change in bond credit transition by its
respective transition probability and summing the products: value
for an A-rated corporate bond is found by multiplying each
expected percentage price change for a possible credit transition
by its respective transition probability and summing the products:
⚫ (0.0005 × 3.60%) + (0.0250 × 1.44%) + (0.8750 × 0%) +
(0.0840 × –2.88%) + (0.0075 × –16.56%) + (0.0060 × –38.88%)
:
+ (0.0012 × –60.48%) = –0.6342%

育
教
⚫ In this calculation, we neglect the small probability of migration to

程
the default state. That would need to be taken into consideration if

金
the bond was not investment-grade.

➢ Therefore, the expected return on the bond over the next year is
its YTM – 0.6342%, assuming no default.
201／248
➢ Credit spread migration typically reduces the expected return for two
reasons.
⚫ First, the probabilities for change are not symmetrically distributed

around the current rating. They are skewed toward a downgrade rather
than an upgrade.
⚫ Second, the increase in the credit spread is much larger for

downgrades than the decrease in the spread for upgrades.
:
育
教
程
金
202／248
4.1 Structural Model
➢ Structural model depends on the structure o f the company’s balance
sheet- its assets, liabilities, and equity. It also can be called a company-
value model because the key variable is the asset value of the company.
⚫ In Exhibit the asset value has
been volatile prior to now, time
0, but has remained above the
horizontal line that represents
the default barrier. If the asset
value falls below the barrier, the
company defaults on the debt.
:
育
⚫ The probability of default is

教
endogenous to this structural

程
model. This default probability

金
increases with the variance of

the future asset value, with
greater time to T and with
greater financial leverage.
203／248
Structural Model
➢ In structural model, the key insights were that a company defaults on its debt if
the value of its assets falls below the amount of its liabilities and that the
probability of that event has the features of an option. Credit risk is linked to
option pricing theory.
➢ Option analogy: consider a company with asset financed by equity and zero-
coupon debt.
⚫ the shareholders have call option on the asset with a strike price equal to
the face value of debt (K).
✓ If at maturity, assets value > face value of debt, exercise the call option
✓ If at maturity, assets value < face value of debt, option expire worthless
:
✓ At maturity:
育
value of stock = Max(0, AT -K)

教
value of debt = Min(AT ,K)

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⚫ Owning risky debt with a face value of K is analogous to owning a risk-free

bond with the same face value (K) and writing a European put option on the
assets with a strike price of K.
⚫ Value of risky debt = value of risk-free debt – value of a put option
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4.2 Reduced-Form Model
➢ Reduced-form models avoid a fundamental problem with the structural models
which assumes that the assets of the company are actively traded. However, the
assets of the company typically do not trade. Reduced-form models get around
this problem by not treating default as an endogenous (internal) variable.
Instead, the default is an exogenous (external) variable that occurs
randomly.
➢ Unlike structural models that aim to explain why default occurs (i.e., when the
asset value falls below the amount o f liabilities), reduced-form models aim to
explain statistically when. This is known as the default time and can be
modeled using a Poisson stochastic process.
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⚫ The key parameter in this process is the default intensity, which is the
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probability of default over the next time increment. Reduced-form credit

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risk models are thus also called intensity-based and stochastic default
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rate models.
⚫ Default intensity can be estimated using regression models. These
regression models employ several independent variables including
company specific variables as well as macro-economic variables.
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4.3 Credit Analysis Models
➢ Assumption of the structural models:
⚫ The company’s assets trade in frictionless markets that are arbitrage free.
⚫ The debt liabilities are zero-coupon bonds that mature at time T.
⚫ The probability of default is endogenous (internal) to this structural model
➢ Advantages of structural models:
⚫ It provides insight into the nature of credit risk. The company defaults
when the value of its assets dips below the default barrier.
⚫ It provides an option analogy for understanding a company’s default
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probability and recovery rate.

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➢ Disadvantages of structural models:

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⚫ Assumptions of simple balance sheet and traded assets are not realistic.
⚫ It can be difficult in practice because of limitations in available data.
⚫ The credit risk measures do not explicitly consider the business cycle.
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➢ Assumptions of the reduced-form models:
⚫ Reduced-form models treating default as an exogenous (external) variable
that occurs randomly.
➢ Advantages of reduced-form models:
⚫ The inputs are observable variables, including historical data.
⚫ The default intensity is estimated using regression analysis on company-
specific variables (e.g., leverage ratio, net income-to-assets ratio, and cash-
to-assets ratio) and macroeconomic variables (e.g., unemployment rate, GDP
growth rate, measures of stock market volatility). This flexibility allows the
model to directly reflect the business cycle in the credit risk measure.
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➢ Disadvantages of reduced-form models:

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⚫ Unlike structural models, do not explain the economic reasons for

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default.
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⚫ Reduced-form models assume that default comes as a “surprise” and can

occur at any time. In reality, default is rarely a surprise because the issuer
usually has been downgraded several times before the final event.
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➢ Structural model
⚫ Structural models require information best known to the managers

of the company (and perhaps their commercial bankers and the credit
rating agencies).
⚫ Therefore, they can be used for internal risk management, for banks’
internal credit risk measures, and for publicly available credit ratings.
➢ Reduced form model

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⚫ Reduced-form models only require information generally available in

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financial markets, which suggests that they should be used to value

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risky debt securities and credit derivatives.
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5. Interpreting Changes in Credit Spreads
➢ Components of a corporate bond yield
⚫ Benchmark bond yields, in general, capture the macroeconomic
factors affecting all debt securities.
⚫ The spread over the benchmark bond yield captures the
microeconomic factors that pertain to the corporate issuer and the
specific issue itself.
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5.1 Evaluating Changes in Credit Risk Parameters
➢ Probability of default
⚫ POD (+) => PVEL (+) => CVA (+) => Fair value (-) => YTM (+) =>
Credit Spread (+)
⚫ Probability of default is positively correlated with credit spread.
➢ Recovery rate
⚫ RR (+) => PVEL (-) => CVA (-) => Fair value (+) => YTM (-) =>
Credit Spread (-)
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⚫ Recovery rate is negatively correlated with credit spread.

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Evaluating Changes in Credit Risk Parameters
➢ Edward Kapili is a summer intern working on a fixed-income trading desk
at a major money-center bank. His supervisor asks him to value a 3-year,
3% annual payment corporate bond using a binomial interest rate tree
model for 20% volatility and the current par curve for benchmark
government bond par curve. (This is the binomial tree in Exhibit 1). The
assumed annual probability of default (the hazard rate) is 1.50%, and the
recovery rate is 40%.
➢ The supervisor asks Mr. Kapili if the credit spread over the yield on the 3-
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year benchmark bond, which is 1.50% in Exhibit 1, is likely to go up more if

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the default probability doubles to 3.00% or if the recovery rate halves

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to 20%.
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➢ Mr. Kapilis intuition is that doubling the probability of default has the
larger impact on the credit spread. Is his intuition correct?
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➢ Mr. Kapili first determines the fair value of the 3-year, 3% annual payment
bond given the assumptions for the original credit risk parameters.
➢ Determine VND = 104.4152
98.6591
103
4.3999%
100.2313
3
2.1180%
104.4152
100.0492
-0.2500% 3 103
2.9493%
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102.0770
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3
1.4197%
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101.0032
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103
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1.9770%
Date 0 Date 1 Date 2 Date 3
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➢ Determine CVA

Date LGD POD
0
1 104.1541 62.4925 1.5000% 1.002506 0.9397
2 102.9402 61.7641 1.4775% 0.985093 0.8990
3 103.0000 61.8000 1.4553% 0.955848 0.8597
4.4328% CVA = 2.6984
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➢ The yield to maturity is 2.40%:

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3 3 103
⚫ 1 + 2 + 3 = 101.7168, YTM = 2.40%
1+𝑌𝑇𝑀 1+𝑌𝑇𝑀 1+𝑌𝑇𝑀
➢ Credit spread = 2.40% -1.50% = 0.90%
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➢ Calculate the fair values under the new credit risk parameters.
3.00% Default Probability, 40% Recovery Rate
Date LGD POD
0
1 104.1541 62.4925 3.0000% 1.002506 1.8795
2 102.9402 61.7641 2.9100% 0.985093 1.7705
3 103.0000 61.8000 2.8227% 0.955848 1.6674
8.7327% CVA = 5.3174
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➢ Fair value = VND – CVA =104.4152 – 5.3174 = 99.0978 (-)

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➢ The yield to maturity increases to 3.32% (+)

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3 3 103
⚫ 1 + 2 + 3 = 99.0978, YTM = 3.32%
➢ Credit spread = 3.32% -1.50% = 1.82% (+)
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➢ Calculate the fair values under the new credit risk parameters.
1.50% Default Probability, 20% Recovery Rate
Date LGD POD
0
1 104.1541 83.3233 1.5000% 1.002506 1.2530
2 102.9402 82.3522 1.4775% 0.985093 1.1986
3 103.0000 82.4000 1.4553% 0.955848 1.1463
4.4328% CVA = 3.5978
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➢ Fair value = VND – CVA =104.4152 – 3.5978 = 100.8173 (-)

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➢ The yield to maturity increases to 2.71% (+)

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3 3 103
⚫ 1 + 2 + 3 = 100.8173, YTM = 2.71%
➢ Credit spread = 2.71% -1.50% = 1.21% (+)
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5.2 The Term Structure of Credit Spreads
➢ A credit curve shows the spread over a benchmark security for an issuer for
outstanding fixed-income securities with shorter to longer maturities.
➢ Key drivers of the term structure of credit spreads
⚫ Credit quality is a key factor.
✓ The credit term structure for the most highly rated securities
tends to be either flat or slightly upward sloping.
✓ Securities with lower credit quality, however, face greater
sensitivity to the credit cycle. The greater likelihood of default
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associated with high-yield securities generally results in a steeper

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credit spread curve (sometimes face a downward-sloping credit

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term structure), both in cases where a weaker economy suggests

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credit spread widening and when an inverted credit spread curve

suggests tighter spreads for longer maturities.
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The Term Structure of Credit Spreads
⚫ Financial conditions are another critical factor affecting the credit spread
term structure.
✓ A stronger economic climate is generally associated with higher
benchmark yields but lower credit spreads for issuers whose default
probability declines during periods of economic growth.
⚫ Market supply and demand dynamics are another critical factor
influencing the credit curve term structure.
✓ Given that new and most recently issued securities tend to represent the
largest proportion of trading volume and are responsible for much of
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the volatility in credit spreads, the credit curve will be most heavily
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influenced by the most frequently traded securities.

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✓ Infrequently traded bonds trading with wider bid-offer spreads can

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also impact the shape of the term structure, so it is important to

gauge the size and frequency of trades in bonds across the maturity
spectrum to ensure consistency.
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⚫ From a microeconomic perspective, company-value model results are
another key driver of the credit spread term structure.
✓ These models take stock market valuation, equity volatility, and
balance sheet information into account to derive the implied default
probability for a company.
✓ Holding other factors constant, any microeconomic factor that
increases the implied default probability, such as greater equity
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volatility, will tend to drive a steeper credit spread curve, while the
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reverse is true with a decline in equity volatility.

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⚫ When a bond is very likely to default, it often trades close to its recovery
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value at various maturities; moreover, the credit spread curve is less

informative about the relationship between credit risk and maturity.
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➢ Two further considerations are important when analyzing the term
structure of credit spreads.
⚫ The first concerns the appropriate risk-free or benchmark rates used
to determine spreads.
✓ The duration and maturity of the most liquid or on-the-run
government bonds rarely match that of corporate bonds trading in
the secondary market, so it is often necessary to interpolate
between yields of the two government securities with the closest
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duration.
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✓ As the interpolation may impact the analysis for less-liquid

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maturities, the benchmark swap curve based on interbank rates is

often substituted for the government benchmark because of greater
swap market liquidity for off-the-run maturities.
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➢ Two further considerations are important when analyzing the term
structure of credit spreads.
⚫ The second consideration concerns the all-in spread over the
benchmark itself. Term structure analysis should include only bonds
with similar credit characteristics, which are typically senior
unsecured general obligations of the issuer.
✓ Any bonds of the issuer with embedded options, first or second lien
provisions, or other unique provisions should be excluded from the
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analysis.
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✓ It is also important to note that such securities typically include

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cross-default provisions so that all securities across the maturity

spectrum of a single issuer will be subject to recovery in the event of
bankruptcy.
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6. Credit Analysis for Securitized Debt
➢ For securitized debt, the characteristics of the asset portfolio themselves
suggest the best approach for a credit analyst to take when deciding among
investments. Important considerations include the relative concentration
of assets and their similarity or heterogeneity as it concerns credit risk.
⚫ The granularity of the portfolio refers to the actual number of
obligations that comprise the overall structured finance instrument.
✓ A highly granular portfolio may have hundreds of underlying
creditors, suggesting it is appropriate to draw conclusions about
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creditworthiness based on portfolio summary statistics rather

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than investigating each borrower.

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✓ Alternatively, an asset pool with fewer more-discrete or non-

granular investments would warrant analysis of each individual
obligation.
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Credit Analysis for Securitized Debt
⚫ The concept of homogeneity refers to the degree to which underlying
debt characteristics within a structured finance instrument are similar
across individual obligations.
✓ On the one hand, an investor or credit analyst might draw general

conclusions about the nature of homogeneous credit card or auto
loan obligations given that an individual obligation faces strict
eligibility criteria to be included in a specific asset pool.
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✓ On the other hand, heterogeneous leveraged loan, project finance,

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or real estate transactions require scrutiny on a loan-by-loan basis

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given their different characteristics.

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➢ A second critical aspect of the credit exposure associated with ABS
relates to the origination and servicing of assets over the life of the
transaction.
⚫ Investors are exposed to the ability of the servicer to effectively manage
and service the portfolio over the life of the transaction.
➢ Finally, the structure of a collateralized or secured debt transaction is a
critical factor in analyzing this type of investment.
⚫ A key question related to the issuer is its relationship to the originator,
namely the degree to which the bankruptcy of the obligor is related to
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that of the originator. The bankruptcy remoteness is typically

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determined by whether the transfer of the assets from the originator to

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the SPE may be deemed a true sale, which otherwise allows for the
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ability to separate risk between the originator and SPE at a later date.
⚫ Second, additional credit enhancements are a key structural element to
be evaluated in the context of credit risk.
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➢ A covered bond is a senior debt obligation of a financial institution that
gives recourse to the originator/issuer as well as a predetermined
underlying collateral pool.
⚫ The dual recourse to both the issuing financial institution as well as the
underlying asset pool has been a hallmark of covered bonds.
⚫ Although the dual recourse principle is of central importance in

evaluating the credit risk of a covered bond, the underlying collateral
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plays a role as well. These asset pools vary across jurisdictions but are
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generally comprised of residential mortgages or public sector assets.

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Learning
Module
5
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Credit Default Swaps

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1. Credit default swaps (CDS)
Framework
fundamentals
• CDS fundamentals
• Structure and features of credit
default swaps
• Common types of credit events
2. Types of credit default swaps
3. Pricing and valuation of CDS
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• CDS pricing conventions

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• Valuation after inception of CDS

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4. Applications of CDS
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1. Credit Default Swaps (CDS) Fundamentals
➢ Credit default swaps (CDS) is essentially an insurance contract for the
reference, the reference obligation is the fixed income security on which the
swap is written-usually a bond but potentially also a loan.
⚫ The issuer of the reference obligation is called the reference entity.
⚫ Protection buyer receives a payment from the protection seller if default

occurs on the reference entity.
⚫ The protection buyer pays the seller a premium that is either paid
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upfront or over a period of time. The default swap premium is also

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referred to as the CDS spread.

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⚫ Standardization in the market has led to a fixed coupon on CDS.
⚫ The difference between the standardized coupon rate and the credit
spread is paid upfront by one of the parties to the contract.
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Credit Default Swaps (CDS) Fundamentals
➢ The CDS market is large, global, and well organized. The unofficial industry
governing body is the International Swaps and Derivatives Association
(ISDA), which publishes industry-supported conventions that facilitate the
functioning of the market. Parties to CDS contracts generally agree that their
contracts will conform to ISDA specifications. These terms are specified in a
document called the ISDA Master Agreement, which the parties to a CDS
sign.
➢ Each CDS contract specifies a notional amount, or "notional" for short,
which is the amount of protection being purchased.
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➢ The credit protection buyer is short and the credit protection seller is
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long.
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⚫ Credit quality is based on the underlying debt obligation, and when it

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improves, the credit protection seller benefits.

⚫ When credit quality deteriorates, the credit protection buyer benefits.
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Structure and Features of CDS
➢ When there is a credit event, the swap will settle in cash or physical delivery.
⚫ Physical settlement on CDS after a Credit Event.
Swap reference obligation (bond or loan) Swap

seller par value buyer
⚫ Cash settlement on CDS after a Credit Event.
Swap par value－market value Swap

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seller buyer
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➢ In cash settlement:
⚫ Payout amount =payout ratio × notional principal
⚫ Payout ratio = 1- recovery rate (%)
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Common Types of Credit Events
➢ Common types of credit events
⚫ Bankruptcy: is a declaration provided for by a country’s laws that typically
involves the establishment of a legal procedure that forces creditors to defer
their claims.
⚫ Failure to pay: occurs when a borrower does not make a scheduled
payment of principal or interest on any outstanding obligations after a grace
period, without a formal bankruptcy filing.
⚫ Restructuring: refers to a number of possible events, including reduction or
deferral of principal or interest, change in seniority or priority of an
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obligation, or change in the currency in which principal or interest is

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scheduled to be paid.
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✓ In the United States, restructuring is not considered a credit event

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because bankruptcy is typically the preferred route for US companies.

✓ Outside the United States, restructuring is more commonly used and is
considered a credit event.
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2. Types of CDS
➢ (1) A CDS on one specific borrower is called a single-name CDS.
⚫ The borrower is called the reference entity, and the contract specifies a
reference obligation, a particular debt instrument issued by the
borrower that is the designated instrument being covered.
⚫ The designated instrument is usually a senior unsecured obligation,
which is often referred to as a senior CDS, but the reference obligation is
not the only instrument covered by the CDS. Any debt obligation issued
by the borrower that is pari passu (ranked equivalently in priority of
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claims) or higher relative to the reference obligation is covered.

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⚫ The payoff of the CDS is determined by the cheapest-to-deliver

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obligation, which is the debt instrument that can be purchased and

delivered at the lowest cost but has the same seniority as the reference
obligation.
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Example
➢ Assume that a company with several debt issues trading in the market
files for bankruptcy. What is the cheapest-to-deliver obligation for a
senior CDS contract?
A. A subordinated unsecured bond trading at 20% of par
B. A five-year senior unsecured bond trading at 50% of par
C. A two-year senior unsecured bond trading at 45% of par
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➢ Correct Answer: C.
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⚫ The CTD, or lowest-priced, instrument is the two-year senior

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unsecured bond trading at 45% of par. Although the bond in A

trades at a lower dollar price, it is subordinated and, therefore,
does not qualify for coverage under the senior CDS.
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Types of CDS
➢ (2) Index CDS (CDX) involves a combination of borrowers. This type of
instrument allows participants to take positions on the credit risk of a
combination of companies, in much the same way that investors can trade
index or exchange-traded funds that are combinations of the equities of
companies.
⚫ Correlation of returns is a strong determinant of a portfolio's behavior.
For index CDS, this concept takes the form of a factor called credit
correlation, and it is a key determinant of the value of an index CDS.
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✓ The more correlated the defaults, the more costly it is to

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purchase protection for a combination of the companies.

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✓ In contrast, for a diverse combination of companies whose defaults

have low correlations, it will be much less expensive to purchase
protection.
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Types of CDS
➢ Index CDS
⚫ A company called Markit has been instrumental in producing CDS
indexes.
✓ Markit updates the components of each index every six months by
creating new series while retaining the old series.
✓ The latest-created series is called the on-the-run series, whereas the
older series are called off-the-run series.
✓ When an investor moves from one series to a new one, the move is
called a roll.
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⚫ The buyer of a CDX is long credit exposure and the seller of a CDX is
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short credit exposure.

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➢ (3) A third type of CDS is the tranche CDS, which covers a combination of
borrowers but only up to pre-specified levels of losses—much in the same
manner that asset-backed securities are divided into tranches, each covering
particular levels of losses.
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Example
➢ SGS recently buys €400 million of protection on the on-the-run CDX
high yield index that includes a Maxx bond; the index contains 100
entities. Maxx bond defaults and trades at 30% of par after defaults.
⚫ What will be the payoff on the CDS?
⚫ What will be the notional principal of the CDS after defaults?
➢ Correct Answer:
⚫ The notional principal attributable to Maxx bond is $400

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million/100 = $4.0 million. SGS should receive payment of

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$4.0million – (0.3) (4.0) = $2.8 million.

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⚫ Post the default event, the remainder of the CDX continues with a
notional principal of $396 million.
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Example
➢ Assume that an investor sells $500 million of protection using the CDX IG index,
which has 125 reference entities. Concerned about the creditworthiness of a few
of the components, the investor hedges a portion of the credit risk in each. For
Company A, he purchases $3 million of single-name CDS protection, and
Company A subsequently defaults.
1. What is the investor’s net notional exposure to Company A?

➢ Solution to 1:
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⚫ The investor is long $4 million notional credit exposure ($500 million/125)

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through the index CDS and is short $3 million notional credit exposure
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through the single-name CDS. His net notional credit exposure is $1 million.
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2. What proportion of his exposure to Company A has he hedged?
➢ Solution to 2:
⚫ He has hedged 75% of his exposure ($3 million out of $4 million).

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3.1 Basic Pricing Concepts
➢ CDS price is the CDS spread or upfront payment for a particular coupon
rate under the contract.
➢ Factors that influence the pricing of CDS ( i.e. CDS spread):
⚫ Probability of default: The probability that a bond issuer will not meet
its contractual obligations on schedule.
⚫ Loss given default: the amount that will be lost if a default occurs.
⚫ The CDS spread is higher for a higher probability of default and for
a higher loss given default. (positively related)
➢ For a simple version, considering a one-period CDS swap with no
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upfront payment:
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⚫ CDS spread ≈ (1 – RR) × POD (probability-weighted amount of loss)

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⚫ For example: if the probability of default is 2% and the recovery rate is

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60%, the estimated CDS spread for the period would be 80 bps for the
period. Assuming a $100 notional contract value and a period of a year,
the CDS contract fair value would be (the present value of) $0.80.
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CDS Pricing Conventions
➢ Premium leg: The series of payments the credit protection buyer promises
to make to the credit protection seller.
➢ Protection leg: The contingent payment that the credit protection seller
may have to make to the credit protection buyer.
➢ Upfront premium on a CDS
⚫ Upfront payment = Present value of protection leg - Present value of

premium leg
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⚫ Upfront premium ≈ (Credit spread - Fixed coupon) × Duration

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➢ CDS price can be quoted as:

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⚫ Price of CDS in currency per 100 par ≈ 100-upfront premium (%)
⚫ Upfront premium (%) = 100 – Price of CDS in currency per 100 par
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Example
➢ Assume a high-yield company’s 10-year credit spread is 600 bps, and
the duration of the CDS is eight years. What is the approximate upfront
premium required to buy 10-year CDS protection? Assume high-yield
companies have 5% coupons on their CDS.
➢ Correct Answer:
⚫ To buy 10-year CDS protection, an investor would have to pay a

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500 bps coupon plus the present value of the difference between
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that coupon and the current market spread (600 bps).

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⚫ In this case, the upfront premium would be approximately
100 bps × 8 (duration), or 8% of the notional.
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Example
➢ Imagine an investor sold five-year protection on an investment-grade
company and had to pay a 2% upfront premium to the buyer of
protection. Assume the duration of the CDS to be four years. What are
the company’s credit spreads and the price of the CDS per 100 par?
➢ Correct Answer:
⚫ The value of the upfront premium is: (-2%)/4 = -50bps. The sign of
the upfront premium is negative because the seller is paying the
premium rather than receiving it.
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⚫ The credit spread is: 100bps + (- 50bps) = 50bps. As a reminder,

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because the company’s credit spread is less than the fixed coupon,
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the protection seller must pay the upfront premium to the

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protection buyer.
⚫ The price in currency would be 100 minus the upfront premium,
but the latter is negative, so the price is 100 - (-2) = 102.
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3.2 Valuation after Inception of CDS
➢ Market participants constantly assess the current credit quality of the reference
entity to determine its current value and credit spread.
➢ A approximation of the change in value of the CDS for a given change in spread
is as follows:
⚫ Profit for the buyer of protection ≈ Change in spread in bps × Duration ×
Notional
⚫ % change in CDS price = Change in spread in bps × Duration
✓ The protection buyer is short credit risk and hence benefit when credit
spreads widen.
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➢ As with any financial instrument, changes in the price of a CDS gives rise to
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opportunities to unwind the position, and either capture a gain or realize a loss.
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This process is called monetizing a gain or loss.

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➢ Termination of CDS prior to expiration or default: enter into an offsetting

transaction
⚫ i.e a protection seller can buy protection with the same terms as the original
CDS and maturity equal to the remaining maturity to remove his exposure.
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4. Applications of CDS
➢ 1) Naked CDS: a party with no exposure to the reference entity might
also purchase credit protection.
⚫ In buying a naked CDS, the investor is taking a position that the entity's
credit quality will deteriorate, whereas the seller of a naked CDS is taking
the position that the entity's credit quality will improve.
➢ 2) A party can take a long position in one CDS and a short position in
another, called a long/short trade. One CDS would be on one reference
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entity, and the other would be on a different entity.

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⚫ This transaction is a bet that the credit position of one entity will
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improve relative to that of another.
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Applications of CDS
➢ 3) Another type of long/short trade, called a curve trade, involves buying a
CDS of one maturity and selling a CDS on the same reference entity with a
different maturity.
⚫ We will assume the more common situation of an upward-sloping credit
curve, meaning that long-term CDS rates are higher than short-term rates.
⚫ An investor who believe that long-term credit risk will increase relative to
short-term credit risk (credit curve steepening) can go short (buy) a long-
term CDS and long (sell) a short-term CDS.
⚫ In the short run, a curve-steepening trade is bullish. It implies that the
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short-term outlook for the reference entity is better than the long-term
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outlook.
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⚫ In the short run, a curve-flattening trade is bearish. It implies that the

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short-run outlook for the reference entity looks worse than the long-run
outlook and reflects the expectation of near-term problems for the reference
entity.
243／248
Applications of CDS
➢ 4) In principle, the amount of yield attributable to credit risk on the bond
should be the same as the credit spread on a CDS. A difference in the
credit spreads in bond markets and CDS markets is the foundation of a
strategy known as a basis trade.
➢ An investor wants to be long the credit risk of a given company. The
company's bond currently yields 6% and matures in five years. A
comparable five-year CDS contract has a credit spread of 3.25%. The
investor can borrow in the market at a 2.5% interest rate.
➢ Identify a basis trade that would exploit the current situation.
:
➢ Solution:
育
教
➢ The bond and CDS markets imply different credit spreads. Credit risk is
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cheap in the CDS market (3.25%) relative to the bond market (6%-
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2.5%=3.5%). The investor should buy protection in the CDS market at

3.25% and go long the bond, thereby earning 3.5% for assuming the
credit risk. The trade will capture a profit closest to 0.25%=3.5%-3.25%.
244／248
Applications of CDS
➢ 5) CDS indexes also create an opportunity for a type of arbitrage trade.
⚫ If the cost of the index is not equivalent to the aggregate cost of the
index components, an investor might go long the cheaper instrument
and short the more expensive instrument.
➢ 6) Another type of trade using CDS can occur within the instruments issued
by a single entity.
⚫ Credit risk is an element of virtually every unsecured debt instrument or

:
育
the capital leases issued by a company. Each of these instruments is

教
priced to reflect the appropriate credit risk.

程
金
⚫ Investors can use the CDS market to first determine whether any of
these instruments is incorrectly priced relative to the CDS and then buy
the cheaper one and sell the more expensive one.
245／248
Example
➢ An investor believes that a company will undergo a leveraged buyout (LBO)
transaction, whereby it will issue large amounts of debt and use the
proceeds to repurchase all of the publicly traded equity, leaving the
company owned by management and a few insiders.
1. Why might the CDS spread change?
2. What equity-versus-credit trade might an investor execute in
anticipation of such a corporate action?
➢ Solution to 1:
⚫ Taking on the additional debt will almost surely increase the probability
:
of default, thereby increasing the CDS spread.

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教
➢ Solution to 2:
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⚫ The investor might consider buying the stock and buying credit
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protection. Both legs will profit if the LBO occurs because the stock
price will rise as the company repurchases all outstanding equity and
the CDS price will rise as its spread widens to reflect the increased
probability of default.
246／248
It’s not an end but just the beginning.
If you have people you love, allow them to be free beings. Give and don't
expect. Advise, but don't order. Ask, but never demand. It might sound simple,
but it is a lesson that may take a lifetime to truly practice. It is the secret to true
Love. To truly practice it, you must sincerely feel no expectations from those
who you love, and yet an unconditional caring.
如果你有爱的人，允许他们自由随意的存在。给予而不指望；建议而不命令；请
:
求而不要求；可能听起来简单，但这需要一辈子去实践。这就是真爱的秘诀。真
育
教
正去实践它，你必须对那些你爱的人没有期望，并给予无条件的关爱。
程
金
247／248
问题反馈
➢ 如果您认为金程课程讲义/题库/视频或其他资料中存在错误，欢迎您告诉我
们，所有提交的内容我们会在最快时间内核查并给与答复。
➢ 如何告诉我们？
⚫ 将您发现的问题通过电子邮件告知我们，具体的内容包含：
✓ 您的姓名或网校账号
✓ 所在班级（eg.2305CFA二级ReX智能班）
✓ 问题所在科目（若未知科目，请提供章节、知识点）和页码
:
育
✓ 您对问题的详细描述和您的见解
教
程
⚫ 请发送电子邮件至：academic.support@gfedu.net
金
➢ 非常感谢您对金程教育的支持，您的每一次反馈都是我们成长的动力。后续
我们也将开通其他问题反馈渠道（如微信等）。
248／248

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Fixed Income

Financial Statement Analysis 10-15

Corporate Issuers 5-10

Alternative Investments 5-10

Portfolio Management 10-15

Ethical and Professional Standards 10-15

• LM1 The Term Structure and

• LM3 Valuation and Analysis

• LM4 Credit Analysis Models

• LM5 Credit Default Swaps

The Term Structure and Interest Rates Dynamics

3. Traditional theories of the term structure

4. Yield curve factor models

5. Developing Interest Rate Views Using

different maturities, which can also be interpreted as the yield to

from today with tenor of B-A years

coupon bond maturing at time B

from today, f(2,1).

⚫ Based on your answers to 1 and 3, describe the relationship

(1 + r (2) = 1 + r (1)1 + f (1,1) , (1 + 0.1) 2 = (1 + 0.09) 1 + f (1,1)

1 + r (3) = 1 + r (2) 1 + f (2,1) , (1 + 0.11)3 = (1 + 0.10) 2 1 + f (2,1) 

⚫ f(1,2) is calculated as follows

1 + r (3) = 1 + r (1)1 + f (1, 2) , (1+0.11)3 = (1 + 0.09)1 1 + f (1, 2) 

⚫ This relationship is a reflection of the basic mathematical truth that

marginal changes between future time periods.

➢ One-year rate that can be locked in today by buying an eight-year zero-

that can be locked in by extending maturity by one year.

⚫ In developed markets, yield curves are most commonly upward

✓ Because nominal yields incorporate a premium for expected

reflecting a market expectation of increasing or at least level future

inflation (associated with relatively strong economic growth).

upward-sloping to a downward-sloping yield curve, or vice versa.

⚫ A humped yield curve, which is relatively rare, occurs when

intermediate-term interest rates are higher than short- and long-term

⚫ Values forward contracts based on arbitrage-free pricing

➢ Forward contract price that delivers a T-year-maturity zero-coupon bond

DF𝐵 = 𝐷𝐹𝐴 × 𝐹𝐴,𝐵−𝐴

⚫ Q1: Calculate the three-year discount factor DF(3).

⚫ Q2: Calculate the forward price of a two-year bond to be issued in

predicted by the prevailing forward rate, the forward contract value is

expected to increase. The trader would buy the forward contract.

➢ 1. Assume a flat yield curve 8% and that a trader holds a three-year

will earn an 8% return.

return is 9.81%, which is greater than 8%:

⚫ When a yield curve is upward sloping, the forward curve is always

⚫ A bond investor with an investment horizon of five years could

⚫ However, assuming no change in the yield curve over the investment

2. The “riding the yield curve” strategy is executed by buying bonds

whose maturities are:

A. Equal to the investor’s investment horizon.

B. Longer than the investor’s investment horizon.

Maturity Spot Rate

A. Bond Z will be held to maturity.

B. The three-year forward curve is above the spot curve.

Three year zero coupon rate

0.0691 0.0691 1 + 0.0691

(1.05) (1.06) 1 + r (3)

Four year zero coupon rate

0.0781 0.0781 0.0781 1 + 0.0781

✓ most bonds outstanding have coupon payments and many have