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Interest Rate Risk
Risk associated with fluctuations of bond prices in response to the general movement of the interest rates and to changes in investor perceptions of government monetary policy and economic data.
Issue Date The issue date is the first day a fixed income security begins accruing interest. Most issues have issue dates that occur on a six month anniversary date of maturity. But some bonds are issued on odd dates. These odd-first coupon bonds pay a different coupon amount during their first Market Risk Market risk is synonymous to the classic price/yield behavior of bonds. As yields fall, bond prices rise; as yields rise, bond prices fall. In some contexts, this phenomenon may be called "interest rate risk" or "price risk". Maturity The maturity of a security is the date the issuer makes the final payment to the security holder. After maturity, no further obligations or rights exist between the two parties. Typically, at maturity the issuer pays the redemption value to the holder, along with the final coupon payment Option Adjusted Spread (OAS) The spread over the Treasury spot curve which equates the present value of a bond's cashflows to its market price, incorporating the fact that the bond's cashflows may change under different interest rate environments. For corporate bonds with embedded options, the OAS is derived using a "finite difference grid" to examine the impact of option features on cashflows across interest rates and through time. For mortgage-backed securities (pass-throughs, CMOs and ARMs), OAS is derived using a Monte Carlo simulation which generates cashflows along various interest rate paths, using the appropriate prepayment model. The spread over the initial Treasury spot curve which equates the average present value of the cashflows across these various paths to the market price of the security is the OAS. Option Adjusted Yield (OAY) For corporate bonds, this is calculated by adding/(subtracting) the value of a call option/(put option) to the bond's market price to obtain the price of an otherwise equivalent but option-free bond. The yield which equates this new higher/(lower) price to the bond's cashflows to maturity is the Option Adjusted Yield. For mortgage-backed securities (pass-throughs and CMOs), this is calculated by first generating the cashflows produced by the vector of single monthly mortality rates (SMMs) based on today's forward curve. These cashflows, which may be thought of as the cashflows which exclude the time value of the prepayment option, are discounted by today's spot curve plus the bonds OAS to derive a theoretical option-adjusted price. The single IRR which equates the SMM cashflows to this theoretical price is the Option Adjusted Yield.
The copyright of the article BOND BASICS - III in Fixed Income & Bonds is owned by Naeem Akhtar. Permission to republish BOND BASICS - III in print or online must be granted by the author in writing.
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