Fixed Income
What you must know
Bond features and indenture provisions, including embedded options (callable, putable, convertible); pricing as the present value of cash flows discounted at the market yield; yield measures (current yield, yield to maturity, yield to call); the term structure and spot, forward and par rates; duration (Macaulay, modified, money duration, PVBP) and convexity; credit risk (ratings, spreads, recovery, seniority); and securitisation.
Traps
(1) Price and yield move inversely; a premium bond (coupon above yield) pulls toward par as maturity nears. (2) A zero-coupon bond's Macaulay duration equals its maturity. (3) Modified duration = Macaulay duration / (1 + y/k) where k is coupons per year. (4) For a callable bond, yield to worst may be yield to call, and its price is lower than an otherwise identical straight bond. (5) Approximate price change = -modified duration x change in yield + one-half x convexity x (change in yield) squared.
Worked example
A bond has modified duration of 4.4 and convexity of 60. If its yield rises 50 basis points, the approximate price change is -(4.4)(0.005) + 0.5(60)(0.005)^2 = -0.0220 + 0.00075 = -2.125%, i.e. a fall of about 2.13%. Duration alone would predict -2.20%, so convexity improves the estimate.