Summary

Valuation of fixed income securities is basically an exercise in finding the discounted present value of their cash flows. This process involves solving finite and infinite (in the case of annuities) geometric series. Understanding this methodology provides a powerful tool in determining value not only for bonds but for virtually any kind of installment loan including mortgages. That methodology leads us immediately to amortization, which, in turn, is linked to the relationship between price and interest and the time horizon. For bonds, these concepts help us motivate the notion of duration and convexity, which help us understand interest rate risk in the pricing model. We then develop ways to immunize, or hedge, interest rate risk—hedging is a topic we return to many times in succeeding chapters. Applications are extended to cover a diversity of topics, including cash matching of pension assets and liabilities for hedging purposes, the impact of risky coupons (not all bonds are riskless Treasuries), general cash flow analysis (pension logic) and finally, a first look at a portfolio strategy that invests in bonds.