Fixed Income securities

Type of fixed income securities:-

A fixed income security is a financial claim with a promised cash flows of fixed amounts and fixed dates. This does not mean that they are risk free. Types of fixed income securities:-

1. Treasuries- Government bonds issued by various governments to conduct their fiscal policy. Fannie Mae and Freddie Mac, these agencies support the function of the housing market and important players in fixed income markets.

2. Municipal Bonds- They are exempt from federal tax in the US and for local investors they are exempt from local state taxes.

3. Corporate Bonds- issued by firms and used to finance business activities

4. Mortgage Backed and Asset Backed securities- Created using financial engineering process called securitization based on underlying pool of other primitive assets such as mortgages, car loans, student loans and so forth.

There are three important characteristics that define a bond - Time to maturity, the principal payment which is the payment the bond is promising at maturity date and coupon.

Law of One Price- If two assets have the same pay off they must have the same market price.

Law Of One Price- Price of coupon bonds is equal to the price of replicating portfolio of discount bonds.

Price of various fixed income securities provide information that we need to value other cash flows. Other risk free cash flows\

Spot Interest Rates - Varies with maturity. For maturity t it the rate of return that the fixed income investor is going to get by investing today and collecting the payoff t periods from now, t years from now. Its indexed by term t. When we talk about spot interest rates we talk about the entire term structure of interest rates. For each maturity there is a corresponding interest rate. This collection of interest rates corresponding to different maturities is called yield curve.

To take advantage of the arbitrage opportunity we either sell the overpriced bond or buy the under-priced bond.