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Fixed-Income Investment and Risk Management: A Theoretical Interview Guide for Finance Professionals (2.0)

Congratulations! You've landed an interview I understand, and now it's time to prepare for it!

One of the most important guides at your disposal is this interview guide. think of it as your roadmap to success, guiding you through the twists and turns of the interview process. Here's how to decode and utilize this essential document effectively.


Fixed-Income Investment and Risk Management: A Quantitative Interview Guide for Finance Professionals

  • Start by carefully reading through this interview guide from start to end. Pay attention to any instructions, formatting, or specific questions provided.


  • Spend time on each topic, take notes, strive for understanding, and, most importantly, attempt to model these complex problems using either Excel or Python.


  • While this interview guide provides a detailed framework, be prepared to adapt and think on your feet. Interviewers may ask unexpected or follow-up questions to test deeper into certain areas.


After the interview, reflect on your performance and seek feedback from trusted sources, such as mentors, career advisors, or interview coaches. Again, take notes of areas of improvement and incorporate them into your preparation for future interviews.


 

Fundamentals of Fixed-Income Market and Traded Securities

 

Explain the different types of bonds available in the fixed-income market.

In the bond market, there are several types of bonds available, each serving different purposes and catering to diverse investor needs. some of the key types are:


  • Zero-Coupon Bonds: Zero-coupon bonds do not pay regular interest to the bondholders but are available at a discount to face value, with the investor receiving the principal amount (face value) at the time of maturity. However, bondholders have to pay taxes on the accrued interest value.

  • Fixed-Rate Bonds: Fixed-rate corporate bonds, also known as vanilla bonds, pay the bondholders a predetermined amount as interest. The coupon rate is fixed at the time of issuance of such bonds and does not change throughout the tenure of the bonds.

  • Floating Rate Bonds: Floating-rate bonds have fluctuating interest rates and provide different interest payments to the bondholders every time. The coupon rate is based on the prevailing interest rates in the market and the ability of the company to provide a certain interest to the bondholders.

  • Convertible Bonds: Convertible bonds are hybrid bonds that have the option to be converted to stocks based on the underlying asset of the bond. Once the bonds are converted to regular shares, the bondholders become shareholders and the issuer is not liable to pay interest in the future.

  • Municipal Bonds: Municipal bonds are debt securities issued by local governments and municipal corporations. The funds raised through municipal bonds are used to finance various public works projects, such as building schools, highways, bridges, and other municipal infrastructure.

  • Investment Grade Bonds: Investment-grade bonds are those corporate bonds that have a credit rating higher than BBB- and go up to the highest possible rating of AAA. Investment-grade bonds are issued by financially strong companies and have a negligible possibility of default on payments.

  • Junk Corporate Bonds: Junk corporate bonds are a type of bond that carries a higher risk of default. The bonds issued by financially struggling companies are termed junk bonds and generally have higher yields as it is only through a high yield that junk bonds can offset any risk of default.

  • Covered Bonds: Covered bonds are fixed-income instruments that are secured by assets (mostly home and car loans on the books of financial institutions). Covered bonds are generally issued by financial institutions like banks and NBFCs.

  • Sovereign Gold Bonds (SGBs): SGBs are government securities denominated in grams of gold. These are substitutes for holding physical gold. Investors have to pay the issue price in cash and the bonds are redeemed in cash on maturity. The Bond is issued by the Reserve Bank of India on behalf of the Government of India.

  • Green Bonds: Green bonds are debt instruments that raise capital to finance environmental or climate-related projects. These bonds are designed to promote the transition to a low-carbon and climate-resilient economy.


Each type of bond has its unique features and risk-return profile, allowing investors to diversify their portfolios and achieve their financial objectives effectively.


What are Treasury bill rates? And how are their daily rates determined, including the significance of the Bank Discount Rate and the Coupon Equivalent Yield?

Treasury Bills are short-term debt securities issued by the United States government


Daily Treasury Bill Rates represent the daily secondary market quotations on recently auctioned Treasury Bills across various maturity tranches. These maturity tranches typically include 4-week, 8-week, 13-week, 17-week, 26-week, and 52-week periods. These rates are obtained daily at around 3:30 PM from the secondary market by the Federal Reserve Bank. The rates reflect the prevailing market conditions and investor sentiment towards Treasury Bills.


Daily Treasury Bill Rates

  • Bank Discount Rate: One of the primary rates provided is the Bank Discount Rate. This rate reflects how much a Treasury Bill is quoted in the secondary market. It considers factors such as the bill's par value, the amount of discount, and assumes a 360-day year.

  • Coupon Equivalent Yield: Another significant metric provided is the Coupon Equivalent, also known as the Bond Equivalent or Investment Yield. This metric calculates the yield of the Treasury Bill based on factors like the purchase price, discount, and assumes a 365- or 366-day year. The Coupon Equivalent is particularly useful for comparing the yield of a Treasury Bill (which typically doesn't pay periodic interest) to the yield of a nominal coupon security that pays semiannual interest and has a similar maturity date.


What are some common valuation methods used in the financial industry specifically for fixed-income bonds, and explain how they are applied to determine the value of these assets?


  • Discounted Cash Flow (DCF) Method: this method estimates the present value of future cash flows generated by the fixed-income bond, including coupon payments and the return of principal at maturity. By discounting these cash flows back to their present value using an appropriate discount rate, we can determine the intrinsic value of the bond.

  • Yield Measures: Yield measures such as yield to maturity (YTM) and yield to call (YTC) are widely used for bond valuation. YTM represents the total return an investor can expect if they hold the bond until maturity, considering both coupon payments and any capital gains or losses. YTC is relevant for callable bonds, where the issuer can redeem the bond before maturity.

  • Relative Valuation: this approach involves comparing the yield of the bond to other similar securities in the market. We can assess the yield spread between the bond and other bonds with similar characteristics such as maturity, credit quality, and coupon rate. this helps in determining whether the bond is overvalued or undervalued relative to its peers.

  • Duration and Convexity: Duration measures the sensitivity of a bond's price to changes in interest rates. It provides an estimate of the bond's price sensitivity to interest rate movements. Convexity measures the curvature of the bond price-yield relationship, providing additional insights into the bond's risk profile.

  • Credit Spreads: for bonds with credit risk, such as corporate bonds or high-yield bonds, we often use credit spreads to assess their valuation. Credit spreads measure the difference in yield between the bond and a risk-free benchmark, reflecting the bond's credit risk premium.


What is a Discounting Cashflow (DCF) Model?

the Discounted Cash Flow (DCF) model is a financial valuation method used to estimate the value of an investment based on its expected future cash flows. It operates on the principle that the present value of a future cash flow is worth less than the same amount received today due to the time value of money.


Also, explains how it works:


  • future cash flows associated with the investment are projected. these cash flows could include interest payments over a certain period, typically spanning several tenors and the principal amount due at maturity.

  • a discount rate, often referred to as the required rate of return or discount rate, is determined. this rate represents the minimum rate of return that investors expect to receive from the investment to compensate for the risk associated with it. the discount rate is usually based on factors such as the investment's risk profile, prevailing interest rates, and market conditions.

  • each projected future cash flow is then discounted back to its present value using the discount rate. this is done by dividing each future cash flow by (1 + discount rate)^n, where 'n' represents the number of periods into the future the cash flow occurs. this process accounts for the time value of money, reflecting the idea that a dollar received in the future is worth less than a dollar received today.

  • after discounting all future cash flows, the present values are summed to arrive at the total present value of the investment. this total represents the estimated intrinsic value of the investment based on its expected future cash flows and the investor's required rate of return.

  • finally, the calculated present value is compared to the current market price of the investment. If the present value is higher than the market price, the investment may be considered undervalued and potentially attractive for purchase. Conversely, if the present value is lower than the market price, the investment may be considered overvalued.


How is the discount factor used to calculate the present value of future cash flows?

the discount factor is a numerical value used in finance to calculate the present value of future cash flows. It represents the present value of $1 to be received or paid in the future, discounted at a specific rate. In other words, it's the factor by which future cash flows are multiplied to find their present value.


the discount factor formula is: Discount Factor (1Y) = 1/(1+r)^n

In this formula:

  • "r" is the discount rate (also known as the required rate of return).

  • "n" is the number of periods into the future, when the cash flow occurs.


for example, let's say you have a discount rate of 5% and want to find the present value of receiving $100 one year from now. Using the discount factor formula:


Discount Factor = 1/(1+0.05)^1 = 1/1.05 ≈ 0.9524

So, the present value of receiving $100 one year from now is approximately 0.9524 * 100 = $95.24.


the discount factor decreases as the discount rate or the number of periods increases, reflecting the principle that the value of money decreases over time due to factors such as inflation and the opportunity cost of investing money elsewhere.


discount factors are commonly used in various financial calculations, including discounted cash flow (DCF) analysis, and bond pricing, to determine the present value of future cash flows and make investment decisions.


What is Bond Equivalent Yield (BEY)? And how does it help investors compare the yields of short-term and long-term securities?

Bond Equivalent Yield (BEY) is a method used to compare the yield of a short-term security like a Treasury bill, which is typically quoted on a discount basis, with the yield of a longer-term security like a treasury bond, which pays periodic interest.


Also, explain how it works!

Bond Equivalent Yield is calculated by taking the discount yield on a Treasury bill and converting it into an annual yield. Since Treasury bills are typically quoted on a discount basis and do not pay periodic interest, the BEY is calculated using the following formula:


BEY = (Discount/Price​) * 365/n

In this formula:

  • D is the discount amount, or the difference between the face value of the security and its purchase price.

  • P is the purchase price of the security.

  • n is the number of days to maturity.


Also, explain how you convert the bond equivalent yield to an annualized yield!

the first part of the formula, "Discount/Price"​, calculates the discount yield on the Treasury bill. this represents the yield earned from purchasing the bill at a discount and holding it until maturity.

the second part, "365/n"​, adjusts the yield to an annual basis by assuming a 365-day year.


by converting the discount or bond equivalent yield into an annualized yield, allows investors to evaluate the relative attractiveness of different fixed-income securities, especially when comparing short-term treasury securities such as Treasury bills with long-term maturity securities. It provides a standardized measure that facilitates comparison and decision-making for investors.


What does Effective Annualized Yield (EAY) measure in finance, and how is it calculated?

Effective Annualized Yield (EAY) is a measure that represents the annual rate of return earned on an investment over a given period, taking into account the effect of compounding. It is especially useful for comparing investments with different compounding periods or for investments where interest is reinvested periodically.


EAY = (1 + (Interest Rate / Couponding Periods)^Compouding Periods) - 1


the "interest rate" refers to the stated annual interest rate, and the "compounding periods" represent how frequently the interest is compounded within a year (such as daily, monthly, or quarterly)


BEY is used to convert the discount yield of short-term securities like Treasury bills into an annualized yield for comparison purposes, while EAY represents the annualized rate of return on investment, accounting for the effect of compounding


What are Treasury Bills? And how are they priced?

Treasury Bills, often referred to as T-bills, are short-term debt securities issued by the United States government. they are considered one of the safest investments available, as they are backed by the full faith and credibility of the US Government.


T-Bills typically have maturities ranging from 4 weeks to 52 weeks, sold at auctions conducted by the US Department of the Treasury. Investors can purchase T-bills at a discount to the face value (also known as par value). When a T-Bill matures, the investor receives the full face value of the bill.


When T-Bills are sold at a discount, the purchase price is lower than the face value. The difference between the face value and the discounted price represents the income earned by the investor. The formula used to calculate the purchase price of a T-Bill at a given discount rate is:


Price = Face Value (1 - Discount Rate * (Time/360))

In this formula:

  • Price: Represents the purchase price of the T-Bill.

  • Face Value: Refers to the nominal value of the T-Bill.

  • Discount Rate: Indicates the rate at which the T-Bill is sold at a discount.

  • Time: Denotes the number of days to maturity.


Treasury bills are short-term, low-risk investments offered by the U.S. government. When purchased at a discount, the investor earns interest upon maturity.


What is the Internal Rate of Return (IRR)?

Explain the steps involved to price a 5-Year 7% coupon-paying interest rate bond having a face value of $100.

first, explain the financial instrument a bit...

  • This is an interest-rate bond that consists of five coupon payments of $7 each and one principal repayment of $100 at maturity.


now, explain the process:

  • The first step is to identify the prevailing spot rates in the market, which can be used to calculate the present value of each cash flow based on the current rates. This is done by discounting each cash flow by the appropriate spot rate for the corresponding time period. for instance, the cash flow due in the first year will be discounted using the corresponding spot rate for that year, i.e., spot rate 1, and the cash flow due in the second year will be discounted using the spot rate for the second year, i.e., spot rate 2, and so on for each year up to year five.

  • Using the spot rates, the present value of each cash flow can be calculated by discounting them to their present value. the formula to calculate the present value of the cash flows using the spot rates involves dividing the cash flows by a factor of (1 + spot rate) raised to the power of the corresponding year of the cash flow.

  • Once the cash flows are discounted to their present value, the next step is to sum them up to arrive at the total present value of the bond, which would be the price of the bond.

  • The IRR is the rate at which the present value of the bond equals its market price. This can be calculated using the IRR function in Excel or by using trial and error to find the rate that makes the present value of the bond equal to its market price.


What is accrued interest? and how it affects the purchase and sale of interest-rate bonds.

Accrued interest is the interest that has accumulated on a bond since the last interest payment up to the point of sale.


When a bond is issued, it typically pays interest to its holder periodically (usually semiannually). This means that interest on the bond accumulates between these payment dates. If the bond is bought or sold between interest payment dates, the buyer owes the seller the interest that has accumulated (or "accrued") from the last payment date to the transaction date.


Accrued Interest in Discounting Cash Flow (DCF) Table

for example, If an investor buys a bond two months after its last coupon payment, he will need to pay the seller not only the price of the bond but also the two months of interest that has accrued since the last payment. In this way, the seller is compensated for holding the bond during that time, and the investor as the buyer will receive the full six months' interest on the next coupon payment date, even though he held the bond for only four of those months.


note that accrued interest is calculated based on the day count convention of the bond, which could be Actual/360, 30/360, or some other standard depending on the market and type of bond. this is used to determine the exact amount of interest accrued on a given day.


What's the main difference between pricing and valuation in finance?

What factors influence the price of a treasury bond, and how is it different from determining the intrinsic value of the same?


  • Pricing refers to the market-determined value of an asset at a specific point in time. It is influenced by supply and demand dynamics, investor sentiment, economic conditions, and other market factors. Pricing reflects what buyers and sellers are willing to pay for an asset in the open market and can be determined using a pricing model.


  • Valuation is the process of determining the intrinsic or fundamental value of a treasury bond based on its characteristics, expected cashflows, risk factors, and other fundamental factors. Valuation attempts to estimate what an asset is worth irrespective of current market prices. It involves various methodologies such as discounted cash flow, comparable company, or asset-based valuation.


What is the difference between the clean price and the dirty price of a treasury bond?

the difference between the clean price and the dirty price of a treasury bond lies in the inclusion of accrued interest in the dirty price.


  • Clean Price: the clean price of a treasury bond represents the bond's price excluding any accrued interest. It is the price at which the bond is traded on the market without considering any interest that has accumulated since the last coupon payment.

  • Dirty Price: the dirty price, also known as the full price or the invoice price, includes the accrued interest in addition to the clean price. It reflects the total amount a buyer must pay to acquire the bond, including the accrued interest since the last coupon payment.


the clean price only accounts for the principal value of the bond, while the dirty price incorporates both the principal and the accrued interest.


What are the c-strips and p-strips of a treasury note or a bond?

In a treasury bond, C-strips and P-strips refer to separate components of its cash flows:


  • Coupon Strips (C-Strips): these represent the individual coupon payments of a treasury note or bond. Each coupon payment is separated or "stripped" from the principal payment and sold as an individual security. Investors can purchase these coupon strips to receive specific future coupon payments without owning the underlying note or bond.

  • Principal Strips (P-Strips): these represent the principal repayment of the bond at maturity. similar to C-strips, P-strips are created by separating the principal payment from the coupon payments and selling it as a separate security. Investors can purchase P-strips to receive the principal amount at maturity without owning the entire note or bond.


both C-strips and P-strips allow investors to customize their exposure to the cash flows of a treasury note or treasury bond based on their investment preferences and risk management strategies.


How do accurate pricing and valuation of fixed-income securities help in managing risks within fixed-income investment portfolios?

Accurate pricing and valuation of fixed-income securities play a critical role in providing insights into the risk exposure of fixed-income portfolios and are essential for effective risk management.


  • Risk Assessment: the accurate valuation of fixed-income securities allows portfolio managers to assess the risk profile of their portfolios effectively. By knowing the current market value of each asset, managers can evaluate the extent to which various types of risks, such as market risk, credit risk, liquidity risk, and operational risk, are present in the portfolio.

  • Portfolio Diversification: valuation helps in determining the composition of the portfolio and identifying concentrations in specific types of security, maturity, sectors, or geographical regions. This information is crucial for diversifying the fixed-income portfolio adequately to mitigate concentration risk and spread exposure across different assets with varying risk-return profiles.

  • Stress Testing: pricing and valuation data are used in stress testing scenarios to assess the potential impact of adverse market movements or economic events on portfolio value. By simulating various stress scenarios, portfolio managers can evaluate the resilience of the portfolio and identify vulnerabilities that may arise under extreme conditions.

  • Asset Liability Management (ALM): In the case of institutional investors such as pension funds and insurance companies, accurate valuation is essential for managing asset-liability mismatches effectively. By valuing both assets and liabilities accurately, institutions can match cash flows and ensure that they have sufficient funds to meet their obligations as they fall due.

  • Risk-adjusted Performance Measurement: valuation data are used in calculating risk-adjusted performance measures such as the Sharpe ratio, the Treynor ratio, and the Information ratio. These metrics enable investors to assess the return generated by a portfolio relative to the amount of risk taken. Accurate valuation is essential for calculating these ratios correctly.

  • Regulatory Compliance: regulatory authorities often require financial institutions to conduct periodic risk assessments and report on their risk exposure. Accurate pricing and valuation data are crucial for complying with these regulatory requirements and demonstrating that the institution has appropriate risk management practices in place.

  • Counterparty Risk Management: In the case of fixed-income derivatives and other financial instruments with counterparty exposure, accurate valuation is essential for assessing and managing counterparty risk effectively. Pricing data are used to calculate the mark-to-market value of interest rate derivative contracts and determine the potential exposure to counterparties in the event of default.


How do changes in interest rates affect bond prices?

And what would happen to the value of existing bonds if interest rates were to increase by 1%?

Changes in interest rates have a direct impact on bond prices.


  • When interest rates rise, newly issued bonds offer higher yields, making previously issued bonds with lower interest rates less attractive in comparison. As a result, the prices of existing bonds decrease to adjust for the increased yield required by investors to match the higher rates available in the market.

  • When interest rates fall, newly issued bonds provide lower yields, making existing bonds with higher interest rates more desirable. this increased demand for existing bonds drives up their prices.


If interest rates were to increase by 1%, the value of existing bonds would generally decrease. This decrease in value would vary depending on factors such as the bond's maturity, coupon rate, and the time remaining until maturity. Generally, bonds with longer maturities and lower coupon rates experience more significant price declines when interest rates rise compared to bonds with shorter maturities and higher coupon rates. This phenomenon is known as interest rate risk, and it underscores the inverse relationship between bond prices and interest rates.

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