Fixed income

From Traderpedia

Definition:
A market, to include the money market, which covers the array of instruments and securities which involve interest rates.


The term "fixed income" comes from the fact that these instruments often have pre-set (fixed) pay-outs. For example, a standard bond has a stream of set periodic (coupon) payments and then pays back the par value at maturity. The value of such a security is based on the current market interest rate in an inverse relationship (price rises as rates fall an vice versa).

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[edit] Types of Fixed Income Securities

Money Market Instruments Intermediate to Long-term Instruments Other, Specialized Types of Debt Instruments

[edit] Fixed Income Security Pricing

Fixed income prices are based on the principle of discounted cash flow. Each payment a given security pays (coupons or other interest payments, plus the final par value) is discounted back at the market interest rate. They are then added together to come up with a current value or price.


[edit] Example 1: T-Bill, CD, Eurodollar, Zero Coupon Bonds, Etc.

These instruments have no interest payments, paying only the par value at maturity. They are considered discounted securities for this reason.

The forumla for such calculations is: P/(1+i)^t where:

P = Par value i = annualized interest rate t = whole or fractional years to maturity

Assuming a 100 par value and 1 year to maturity, and a 10% current market interest rate, the value of such as security would be:

100 / (1+.10)^1 or 90.91


[edit] Example 2: Coupon and other intermediate interest payment securities

We will use the same formula as above, just on multiple cashflows.

Assuming a 100 par value, 1 year note with semiannual 3% coupon payments, and a 10% market rate:

Coupon 1: 3/(1+.10)^.5 = 2.86

Coupon 2: 3/(1+.10)^1 = 2.73

Principle: 100/(1+10)^1=90.91

Total: 96.50


[edit] Influences on Fixed Income Securities Prices

Fixed Income security prices are inversely related to price. When interest rates rise, prices fall. As interest rates fall, prices rise.

Strong economic growth tends to lead to higher rates as investors seek better returns and concerns about inflation creep in, while slower growth will tend to put downward pressure on interest rates. As such, any development which has implications for economic growth will impact interest rates, and thereby fixed income prices.

Economic growth rates aside, there are some things which influence interest rates in a more directly as they influence things like the supply of debt (fixed income securities) and the requirements for investment returns. Among those factors are:

  • Inflation (measured by Consumer & Producer Prices, GDP Deflator)
  • Central Bank Policy
  • Government Fiscal Spending
  • Current Account Balance

[edit] Ways to Trade the Fixed Income Market

The most basic way one can trade the fixed income market is by taking an outright position in one of the instruments listed above. To do so is to take a straight forward position based on the direction of interest rates, at least so far as the price of the security is concerned.

Another approach to trading fixed income is via the yield curve. This is essentially a type of spread trade whereby one takes opposing long and short positions with the expectation that the yield curve will either flatten or steepen.

[edit] Fixed Income Indices

The most well known and used fixed income index (or rather set of indices) is the J.P. Morgan Government Bond Index.

[edit] T2W links