Institutional and Intellectual Context of the course:

This class serves as an introduction to debt securities as well as the behavior of interest rates.

Management of debt and obtaining capital and working capital at the lowest cost is an important part of corporate finance. CFOs and corporate treasurers work with commercial and investment bankers to structure their liabilities. To such managers a basic knowledge of the Fixed Income environment is critical.

On Wall Street, Fixed Income securites run the gamut from the staid, traditional US Treasury securities to complex Collaterized Debt Obligations. A big part of this course is an introduction to the institutional context of fixed income. As an example, Mortgage Backed Securities provide an early example of financial engineering. Why do such securities exist? What is the role of the US Government (via Ginnie Mae), and Government Sponsored Enterprises, such as Fannie Mae and Freddie Mac?

Traditionally, Fixed Income has been the most quantitative area within finance. The (ironic) reason for this is that the securities tend to simpler than equity securities. The simplicity of the securities' cash flows suggests that there should exist tools to evaluate the value and riskiness of fixed income securities.

Perhaps the most important situation in the financial markets over the past fifty years has been the credit crisis which started in the summer of 2007. The catalyst for this credit event is the fall in house prices in both the United States and the United Kingdom. Placed in a backdrop of extraordinarily liberal credit standards for home buyers means that credit risks are high and potentially lurking in unexpected places. Investment Banks, Commercial Banks, and Hedge Funds with exposure to mortgage credit are especially vulnerable. The surprise unwinding of Bear Stearns in March, 2008 (terminating in the purchase of Bear Stearns by J.P. Morgan-Chase on May 30, 2008), facilitated by federal regulators, is but one example of the consequences. A consequence of this is that matters relating to the world of fixed income have moved from the back office to the headlines.

The most surprising event in Wall Street history was the bankruptcy of Lehman Brothers in September, 2008. This clarified the severity of the on-going financial crisis, but it muddied the waters in terms of governmental involvement and the concept of too big to fail. My slides on the evolution of the 2007--20?? financial crisis.

In mid-2023 the effects of this financial crisis are still reverberating through the world economy. The popularity of populist and isolationist economic policies can be laid at the feet of the fragility in the global economy that the financial crisis highlighted. This has led to fragility of the British Pound, and has brought the stability of European banks into question. Both monetary and fiscal policy reacted aggressively to the Global Covid Pandemic in March 2020. In March 2020 the Fed injected over \$1 trillion into capital markets. Here's their balance sheet. This move was prompted by a lack of dealer capital owing to heightened regulatory costs of repo, introduced following the global financial crisis. One reason dealer capital was needed was a large unwinding of US Treasury basis trades by hedge funds. We will explore these trades in depth this semester. Over the past 12 months the economy has experienced high inflation (i.e., deterioration in the value of the dollar -- in terms of real goods and services). The Fed has responded to this by increasing its target for the overnight interest rate at which banks borrow and lend cash reserves. In August 2023, this target is 5.5%. The yield curve is downward-sloping: the current yields on US Treasury bills, notes are bonds are: 1-year , 5.31%; 2-year, 4.84%; 5-year, 4.23%; 10-year, 4.11%; 30 year, 4.25%. This suggests that investors think that the Fed has largely been successful at curtailing inflation, and will probably start cutting its target Federal Funds Rate within a year. Otherwise, why would you be willing to lend for 2 years at 47 basis points lower than you get for lending at 1 year. Longer term rates are still very low by historical standards. In March 2020 the Fed injected over \$1 trillion into capital markets. Here's their balance sheet. This move was prompted by a lack of dealer capital owing to heightened regulatory costs of repo, introduced following the global financial crisis. One reason dealer capital was needed was a large unwinding of US Treasury basis trades by hedge funds. We will explore these trades in depth this semester.

Conduct of Course and Grading:

We meet each Monday morning from 8:00 - 10:45 am in McClelland Hall, Room 120.

Grading Rubric:

• At the beginning of the semester, I give each student 60 points,
• I will deduct points as follows:
  • Missing a class without a valid excuse provided in advance: -10 points
  • If Jaffe or I see a cell phone in your possession in class: -2 points
  • Coming to class late: Every portion of 5-minute intervals: -2 points (to max -10)
  • If Jaffe or I see non-professional material (non class-related) on laptop: -4 points
  • Talking with a neighbor -- outside of group work times: -3 points
• You will earn points by correctly responding to in-class questions, and performing in-class exercises. We have a class spinning wheel to rendomly call on students.
  • Points awarded will depend on the type of question and the quality, comprehensiveness, and thoughtfulness of your answer.
  • In-class exercises-- in which you are requested to build a spreadsheet in front of the class-- are worth more than in-seat responses. The former may carry as many as 10 possible points and the latter up to 2.
  • Asking an insightful question that reveals a depth of understanding: 1 point (to a maximum of 6 points).
  • Bringing in an article from the business press that relates to class material -- provided you provide the context and some analysis: 1 or 2 points (to a maximum of 10 points).
• Note that points will only be deducted for unprofessional behavior. And points can only be earned by demonstrating mastery and understanding of the material.

Learning Outcomes:

Institutional Knowledge:

• Treasury sealed-bid auctions,
• The when-issued market for US Treasuries.

• In financing long positions in Fixed Income securities.
• In securities lending and shorting financial securities.

Analytical Tools:

• Extract spot and forward rates from financial press, e.g., Bloomberg.
• Know how to build a yield curve and interpret its implications for the macroeconomy.
• Develop an understanding of the law of one price (LOOP) and the absence of arbitrage.
• Apply the LOOP / absence of arbitrage in the US Treasury Market.
• Know how to measure interest rate risk using both Duration and DV01 of both individual securities and levered positions.
• Understand the role of convexity in the valuation of fixed income securities.
• Build a duration-neutral position to buy or sell convexity, and understand the butterfly spread in the yield curve.
• Vasicek model of the term structure -- one and two-factor models.
• Factor duration in affine term structure model (Vasicek).
• Monte Carlo in VBA to simulate dynamic hedging.

- - - - - -

How to Succeed in My Class

1. Pay attention and ask questions in class. Learning the material starts with my presentation and our working through examples in class. If you do not do this you start the week behind where you have to be.
2. Start working on the problem set / old quizzes as soon as possible after the class. You may think that waiting until just before class or the problem set's due date will be more efficient, since otherwise you will have to retain the knowledge. Nothing could be more wrong. I do not want you to memorize very much -- I want you to think, and apply constructs appropriately.
3. Once you start working on a problem set, if something is unclear (even if you get the right answer), send an e-mail to me or Jaffe. This feedback loop highlights the importance of the above 2 points, about time management.
4. If you think you are no good in math, you are wrong. Please read this article. Quantitative and analytical material takes patience and quiet time. Once again, time management! If you are confident in your math and analytical skills, it is because you are patient and not afraid of quiet, solitary study.
5. And related to time management and thinking: as the New York Times reminds us: Get enough sleep!

I expect you to behave professionally in each class. You should use this class to serve as practice for professional comportment, demeanor, and behavior. Part of my thinking is that this is a professional school. You do not graduate from here and go to work in the ``real world.'' This activity--learning, and communicating what you have learned--is a basic activity for finance and business professionals. A wise student knows that building a professional portfolio started yesterday.

Accessibility and Accommodations:

McClelland Hall Emergency Response Plan. (Including Evacuation Routes).

Map of the first floor of McClelland Hall for Evacuation Purposes.