STUDY SESSION 16 ANALYSIS OF FIXED INCOME

STUDY SESSION 16

ANALYSIS OF FIXED INCOME
INVESTMENTS:
Analysis and Valuation


This study session illustrates the primary tools for valuation and analysis of fixed
income securities and markets. It begins with a study of basic valuation theory
and techniques for bonds and concludes with a more in-depth explanation of the
primary tools for fixed income investment valuation, specifically, interest rate and
yield valuation and interest rate risk measurement and analysis.

LEARNING OUTCOMES

Reading 67: Introduction to the Valuation of Debt Securities

The candidate should be able to:
a. explain the steps in the bond valuation process;
b. identify the types of bonds for which estimating the expected cash flows is difficult,
and explain the problems encountered when estimating the cash flows for
these bonds;
c. compute the value of a bond and the change in value that is attributable to a
change in the discount rate;
d. explain how the price of a bond changes as the bond approaches its maturity
date, and compute the change in value that is attributable to the passage
of time;
e. compute the value of a zero-coupon bond;
f. explain the arbitrage-free valuation approach and the market process that forces
the price of a bond toward its arbitrage-free value, and explain how a dealer can
generate an arbitrage profit if a bond is mispriced.


Reading 68: Yield Measures, Spot Rates, and Forward Rates

The candidate should be able to:
a. explain the sources of return from investing in a bond;
b. compute and interpret the traditional yield measures for fixed-rate bonds, and
explain their limitations and assumptions;
c. explain the importance of reinvestment income in generating the yield computed
at the time of purchase, calculate the amount of income required to generate
that yield, and discuss the factors that affect reinvestment risk;
d. compute and interpret the bond equivalent yield of an annual-pay bond and the
annual-pay yield of a semiannual-pay bond;
e. describe the methodology for computing the theoretical Treasury spot rate curve,
and compute the value of a bond using spot rates;
f. differentiate between the nominal spread, the zero-volatility spread, and the
option-adjusted spread;
g. describe how the option-adjusted spread accounts for the option cost in a bond
with an embedded option;
h. explain a forward rate, and compute spot rates from forward rates, forward rates
from spot rates, and the value of a bond using forward rates.

Reading 69: Introduction to the Measurement of Interest Rate Risk

The candidate should be able to:
a. distinguish between the full valuation approach (the scenario analysis approach)
and the duration/convexity approach for measuring interest rate risk, and explain
the advantage of using the full valuation approach;
b. demonstrate the price volatility characteristics for option-free, callable,
prepayable, and putable bonds when interest rates change;
c. describe positive convexity, negative convexity, and their relation to bond price
and yield;
d. compute and interpret the effective duration of a bond, given information about
how the bond’s price will increase and decrease for given changes in interest
rates, and compute the approximate percentage price change for a bond, given
the bond’s effective duration and a specified change in yield;
e. distinguish among the alternative definitions of duration, and explain why effective
duration is the most appropriate measure of interest rate risk for bonds with
embedded options;
f. compute the duration of a portfolio, given the duration of the bonds comprising
the portfolio, and explain the limitations of portfolio duration;
g. describe the convexity measure of a bond, and estimate a bond’s percentage
price change, given the bond’s duration and convexity and a specified change in
interest rates;
h. differentiate between modified convexity and effective convexity;
i. compute the price value of a basis point (PVBP), and explain its relationship to
duration.