Describe WHICH LIABILITIES ARE FIXED-INCOME INSTRUMENTS?.
Fixed-income instruments are essentially loans made by an investor to a borrower. These instruments are called "fixed-income" because the borrower is required to make fixed payment on a specified schedule.
For example, when a company issues a bond, it is borrowing money from the investor who purchases the bond. In return, the company promises to pay the investor a fixed amount of interest at regular intervals (usually every six months or annually) and to return the principal amount of the loan at a specified future date, known as the maturity date.
Similarly, when a government issues a Treasury bond, it is borrowing money from the investor and promises to make fixed interest payments and return the principal at maturity.
In both cases, the interest payments and return of principal are obligations or liabilities of the issuer, whether it's a company or a government. So, these obligations or liabilities are fixed-income instruments from the perspective of the investor, who is effectively acting as a lender.
Describe Contingency Provisions in bonds and relationship with embedded options.
Contingency provisions in bonds are essentially conditions or scenarios that can change the cash flow of a bond. They are called "contingent" because they depend on certain events or conditions occurring.
One of the most common types of contingency provisions are embedded options. These are rights given to either the bond issuer (the company or government that is borrowing money) or the bondholder (the investor who is lending money) that can change the cash flow of the bond.
For example, a call option is a type of embedded option that benefits the issuer. It allows the issuer to "call" or buy back the bond before its maturity date, usually when interest rates have fallen. This is beneficial to the issuer because they can pay off their debt early and possibly reissue new bonds at a lower interest rate, reducing their cost of borrowing.
On the other hand, a put option is a type of embedded option that benefits the bondholder. It allows the bondholder to "put" or sell the bond back to the issuer before its maturity date, usually when interest rates have risen. This is beneficial to the bondholder because they can get their money back early and possibly reinvest in new bonds that offer a higher interest rate.
To illustrate, let's say a company issues a bond with a call option. If interest rates fall, the company can exercise the call option, pay off the bond early, and then issue new bonds at the lower interest rate. This would save the company money in interest payments. On the other hand, if a bondholder has a bond with a put option and interest rates rise, they can exercise the put option, get their money back, and then invest in new bonds that offer a higher interest rate. This would earn the bondholder more money in interest payments.
In summary, contingency provisions like embedded options can significantly impact the cash flow and value of a bond, depending on changes in interest rates and the actions of the issuer and bondholder.
Describe bond Yield Measures, with example
Bond yield measures are used to calculate the return an investor would get if they were to buy a bond. There are several types of yield measures, including simple yield, street convention yield, and yield-to-worst.
1. Simple Yield: This is a basic calculation that involves adding up the bond's coupon payments (the interest payments made to the bondholder) and the straight-line amortized share of the gain or loss (the difference between the purchase price and the face value of the bond, divided by the number of years to maturity), and then dividing this sum by the flat price (the price of the bond without considering accrued interest).
For example, if you buy a bond with a face value of $1000, a coupon rate of 5%, and a price of $950, the simple yield would be (50 + (1000-950)/10) / 950 = 5.79%.
2. Street Convention Yield: This yield measure assumes that all cash flows (coupon payments and the repayment of the principal) are paid on their scheduled dates, without taking into account weekends and bank holidays. This simplifies the calculation but may not accurately reflect the actual timing of cash flows.
3. Yield-to-Worst: This is the lowest yield that an investor can expect from a bond, considering all possible call dates (dates when the issuer can choose to repay the bond early) and the bond's maturity date. The yield-to-worst is calculated by comparing the yields-to-call and the yield-to-maturity, and choosing the lowest one. This gives the investor a conservative estimate of the bond's return.
For example, if a bond has a yield-to-first call of 2%, a yield-to-second call of 3%, a yield-to-third call of 4%, and a yield-to-maturity of 5%, the yield-to-worst would be 2%.
These yield measures can help investors compare different bonds and make informed investment decisions
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