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Fixed Income Securities Professionals

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Fixed Income Securities Professionals Fixed Income Securities Professionals AMIR II Achievement of Market-Friendly Initiatives and Results March 2006 This document was produced for review by the United States Agency for International Development. It was prepared by Chemonics International Inc. JORDAN AMIR II Achievement of Market-Friendly Initiatives and Results Contract No. 278-C-00-02-00210-00 The author’s views expressed in this publication do not necessarily reflect the views of the United States Agency for International Development or the United States Government. Contract No.: 278-C-00-02-00210-00 Contractor Name: Chemonics International, Inc. USAID Cognizant Technical Office: Office of Economic Opportunities, USAID/Jordan Date of Report: March 15, 2006 Document Title: Fixed Income Securities Professionals Final Report Author’s Name: Dr. Ronald Copley, Copley Investment Management (CIM) Activity Title and Number: Achievement of Market-Friendly Initiatives and Results Program (AMIR Program) F/Securities Pricing Workshop, FMD Component, Work Plan No. 650 Fixed Income Securities Professionals Final Report March 15, 2006 The opinions expressed herein are those of the author(s) and do not necessarily reflect the opinions of the United States Agency for International Development or the United States Government or Chemonics International or any firms in the AMIR Program consortium or the management of the AMIR Program. Fixed Income Securities Professionals . Data Page Name of Component : Financial Markets Development (FMD) Authors : National Association of Securities Dealers (NASD) Practice Area : Financial Sector Services Service Offering : Bank and Other Financial Institution Strengthening List of Key Words Contained in Report : • T-bills, Notes, and Bonds • Interest rate risk • Credit/Default risk • Maturity and liquidity risk • Inflation risk • Risk rating agencies • Current yield • Yield to maturity • Yield to call • Duration • Convexity • Bond “priced-to-yield” • Yield curve • Total return • Discount bond • Premium bond • Price convergence • Term structure of interest rates • Risk-free rate • Risk premium • Forward rates • Spread analysis • Diversification __________________________________________________________________________________ AMIR Program 1 Fixed Income Securities Professionals . Abstract The purpose of this workshop was to explain how government bonds are priced in the primary market at the time of issuance and re-priced in the secondary market when the bond begins trading after the initial offering. The workshop focused on the investor side of the market as opposed to the issuer side. The development of an efficient government bond market requires that investors possess a basic knowledge of how to price a new bond issue that, in turn, requires investors understand the concept of opportunity cost. If an investor can invest in a competing security of comparable risk, then that investor can efficiently price a new bond issue. The key for investors, then, is to have a fundamental understanding of risk and the return associated with any given level of risk. Because risk is a dynamic concept, investors also need to understand how risk affects the price of the bond after issuance when the bond is trading in the secondary market and how that risk can change through time. Since interest rates as determined in the open market reflect risk, much time was spent on explaining interest rates, how they are determined, and the relationship between interest rates and maturity as reflected in the yield curve. The above concepts were presented in detail using basic terminology that a person with a general business background could understand. When technical terminology was necessary, I took extra time to explain the term using practical examples to show how the term is used in the investment community. The workshop encouraged participant discussion and divergent opinions on any topic. After I began speaking and listening to comments coming from the audience, I quickly learned that the participants did not need an explanation of introductory concepts such as the definition of a bond and how it is used. As a consequence, I was comfortable focusing my attention on the analysis of how bonds work in a competitive market environment. __________________________________________________________________________________ AMIR Program 2 Fixed Income Securities Professionals . Table of Contents Executive Summary…………………………………………………………….. 4 Appendix I: Fixed Income Securities Professionals Agenda ……………...………………… 5 Appendix II: Fixed Income Securities Professionals Presentation ………………………….. 8 Appendix III: Fixed Income Securities Professionals Background Reading ……………… 38 __________________________________________________________________________________ AMIR Program 3 Fixed Income Securities Professionals . Executive Summary My responsibility in the workshop was to present a technical analysis of how to price a newly issued bond and re-price it in the secondary market. After discussing the risks of both investing in newly issued bonds (primary market) and seasoned bonds (secondary market), I focused on how to measure the expected return ( ex ante ) and the actual return ( ex post ) and why these two measures may differ. A problem with this type of discussion is that bond terminology is difficult and I made this difficulty well known to all the participants. Even experienced bond people use the same terms to mean different things under different circumstances. I cautioned participants on this seemingly incomprehensible practice. Certainly, an essential part of any bond workshop is the yield curve: what it is, how it is derived, and how it is used in the market. Consequently, I explained that the yield curve reflects investor expectations about the future course of interest rates that, in turn, drives current bond prices. Inherent to the discussion of interest rates is an analysis of the risks associated with any given bond both at the time of issuance as well as afterwards when the bond is trading in the secondary market. While risk analysis is crucial in determining a bond’s fair price, the investor will never really know the true price of a bond until an actual transaction occurs in the open market. As a consequence, I instructed participants not to lose sight of the fact that bonds trade infrequently relative to stocks so trying to determine the fair market value of a bond ex ante involves a measure of guesswork. This is especially true in the Jordanian market that is still in the developmental stage. A final part of my presentation involved duration. I explained duration as the management of future asset values relative to future liability values. Matching the duration of a bond to that of a future liability is a conservative investment approach. Likewise, mismatching the duration of an asset to that of a future liability is an aggressive approach with greater risk. In order to better understanding this important relationship, I presented a table showing the impact of matching and mismatching on the investor’s return over various holding periods. For example, funding my 9 year- old child’s freshman year of college (9 years into the future) with a 1-year duration bond would involve reinvesting the proceeds from the maturing bond eight times prior to the time my child enters college. Because future interest rates are unknown, this investment approach is much more risky that an approach of funding the future liability with a 9-year duration bond that involves no reinvestment risk. __________________________________________________________________________________ AMIR Program 4 Fixed Income Securities Professionals . Appendix I: Fixed Income Securities Professionals Agenda Workshop for Fixed Income Securities Professionals at the Central Bank of Jordan March 7-8, 2006 DAY ONE: Tuesday, March 7, 2006 08:30 Registration 09:00-09:10 Welcoming Remarks and Introduction Speaker: Mr. Gregory Ambrosio, Residence Advisor, U.S. Treasury 09:10-10:10 Overview of the Types and Features of Fixed Income Securities - T-bills (money market securities) - Notes and Bonds (government and corporate) Speaker: Dr. Ronald Copley, AMIR Program Consultant 10:10-10:30 Group Photo and Coffee Break 10:30-11:00 Practical Application Which products do bank treasurers' use when and how? Speaker: Mr. Robert McDonough, FSVC Volunteer 11:00-12:00 Risks Associated with Investing in Fixed Income Instruments - Interest rate risk - Credit/Default risk - Maturity and liquidity risks - Inflation risk Speaker: Dr. Ronald Copley, AMIR Program Consultant 12:00-1:00 Lunch 01:00-03:00 Practical Application How does a bank treasurer measure and incorporate fixed income instrument risk in managing a bank’s portfolio? Speaker: Mr. Robert McDonough, FSVC Volunteer 03:00-03:30 Coffee Break __________________________________________________________________________________ AMIR Program 5 Fixed Income Securities Professionals . 03:30-04:00 A Review of Time Value of Money - Future value - Present value - Yield concepts (Internal rate of return) Speaker: Dr. Ronald Copley, AMIR Program Consultant 04:00-05:00 Bond Pricing - Pricing methods and principles - Conventional yield measures - Total return analysis Speaker: Dr. Ronald Copley, AMIR Program Consultant DAY TWO: Wednesday, March 8, 2006 09:00-10:00 Bond Price Volatility - Price-yield relationships - Measure of bond price volatility Speaker: Dr. Ronald Copley, AMIR Program Consultant 10:00-10:30 Coffee Break 10:30-11:15 Practical Application Managing Fixed Income securities
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