Finance Theory: Fixed-Income Securities

This mini course from the MIT Open Courseware Library, explains concepts related to fixed income securities. As part of a larger course on Financial Theory, this series of lectures introduces fixed-income securities along with an industry overview and examples. 

Frameworks for valuations are covered as well as spot and forward rates in the context of yield curves and interest rate forecasts. Other topics in this course include the law of one price in working with multiple coupon bonds, methods to measure interest-rate risks of a bond, and securitization.  Trading frequency and the framework for valuation are presented by use of an example involving a coupon bond.

This course was originally taught in Fall 2008 and references several financial events that occurred at the time. 

Andrew Lo. 15.401 Finance Theory I, Fall 2008. (Massachusetts Institute of Technology: MIT OpenCourseWare), http://ocw.mit.edu (Accessed 15 Jul, 2015). License: Creative Commons BY-NC-SA

Learning Objectives:

• Define fixed income securities and its various categories
• Calculate valuations of discount bonds and coupon bonds
• Identify the relationship between discount and coupon bonds, and use that as a basis for valuation
• Define yield curves and their relationship to interest rates and pricing
• Calculate interest rates based on pattern in the yield curve
• Measure interest-rate risk
• Define and identify when fixed-income arbitrage occurs
• Define corporate bonds and calculate default risk
• Identify why securitization of loans occur and how this lead to the sub-prime crisis

1. Overview and Objectives - 4 minutes

   1. Overview
   2. What do you already know?

2. Defining Fixed Income Securities - 14 minutes

   1. What is a Fixed Income Security and Industry Overview
   2. Fixed Income Market Participants

3. Valuation of Coupon Bonds - 22 minutes

   1. Framework for Valuing Fixed Income Securities
   2. Components of Valuation
   3. Pricing Discount Bonds
   4. Discount Bond Prices as an Indicator of Future Interest Rates
   5. Determining Interest Rates of Discount Bonds
   6. Spot Rates of Interest
   7. Defining r

   8. Example: Defining r

4. Yield Curves - 21 minutes

   1. Term Structure of Interest Rates or the Yield Curve
   2. Yield Curves and Forward Rate Forecasts
   3. Example: Calculating Forward Transactions and Forward Interest Rates
   4. Example: Calculating Forward Interest Rates continued
   5. Example 2: Calculating Forward Interest Rates

5. Valuation of Coupon Bonds - 9 minutes

   1. What is a Coupon Bond? 
   2. Pricing Coupon Bonds and Bond Yields

6. Yield Curves and Interest Rates - 4 minutes

   1. What Yield Curves Tell Us About Interest Rates
   2. Changes in Yield Curves and Market Expectations

7. Models of the Term Structure - 4 minutes

   1. Different Models of the Term Structure
   2. Expectations Hypothesis 
   3. Do These Models Work? 

8. Another Valuation Method for Coupon Bonds - 4 minutes

   1. Another Valuation Method for Coupon Bonds

9. Arbitrage - 8 minutes 

   1. Law of One Price
   2. Arbitrage
   3. Deeper Dive into the Law of One Price
   4. Arbitrage and Short Selling

10. Multiple Coupon Bond and Fixed-Income Arbitrage - 10 minutes

    1. Multiple Coupon Bonds and Fixed-Income Arbitrage

11. Measuring Risk - 18 minutes

    1. Overview of Measuring Risk
    2. Macauley Duration as a Measure of Bond Riskiness
    3. Why Macauley Duration Matters
    4. Example: Measuring Interest Rate Risk
    5. Macauley Duration for Intra-year Coupons
    6. Convexity as a Secondary Measure of Risk
    7. Volatility of Interest Rates and Bond Pricing

12. Corporate Bonds - 12 minutes

    1. Non-Government Bonds and Credit Ratings
    2. Levels of Risk
    3. Example: Moody's Baa Bond Minus US 10-Year Treasury Yield
    4. Decomposition of Corporate Bond Yields

13. The Subprime Crisis - 25 minutes

    1. Disintermediation and Desecuritization
    2. Combining Risky Bonds into One Portfolio
    3. New Prices of Bonds When Combined into One Portfolio
    4. Why Bonds are Combined
    5. Assuming Perfectly Correlated Defaults

14. Wrap-up - 2 minutes

    1. What do you know now?