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-2021 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. In the face of this a flight-to-quality in financial markets keeps yields on US Treasury securities at historically low levels. As we enter the fall of 2021 financial markets are focused on the question of what the US Federal Reserve will do along 2 dimensions. First, the federal funds rate. The Fed wants to return to normal conditions, but confronts an economy with weak wage growth and low inflation. In addition to the novel corona virus outbreak that has severely hurt the global economy. Second, the Fed greatly expanded its balance sheet during the financial crisis. On April 26, 2017 the Federal Reserve owned $2.4 trillion in US Treasury securities and $1.7 trillion in mortgage-backed securities. By comparison, on December 31, 2004, the Fed owned $0.7 trillion in US Treasury securities and no mortgage-backed securities. 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:

In spite of uncertainties surrounding the corona virus pandemic, we are planning to operate fully in-person this semester. We meet each Monday morning from 8:00 - 10:45 am in McClelland Hall, Room 120. All of your grade will depend on class participation and problem set quality.

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.

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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 Sunil. 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!

No Quizzes or Exams?

These problem sets are more involved and must be completed--and turned in--in Excel. This is better in some ways in that it is more similar to what we do in the work place. The problem sets require time to organize, think and execute. It is best to start as soon as possible after our Monday morning class. It is important to review all of the concepts I introduce, and work through the examples that we did in class. Once you are confident with the material, you should tackle the problems. Starting early allows you to take your time and be careful. The objective is to learn.

I expect you to behave professionally in each class. You should use this class to serve as practice for professional comportment, demeanor, and behavior.

Accessibility and Accommodations: