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Fixed Income Securities: Tools for Today's Markets, 3rd Edition by Bruce Tuckman, Angel Serrat

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Part One

The Relative Pricing of Securities with Fixed Cash Flows

Consumers and businesses are willing to pay more than $1 in the future in exchange for $1 today. A newly independent adult borrows money to buy a car today, agreeing to repay the loan price plus interest over time; a family takes a mortgage to purchase a new home today, assuming the obligation to make principal and interest payments for years; and a business, which believes it can transform $1 of investment into $1.10 or $1.20, chooses to take on debt and pay the prevailing market rate of interest. At the same time, this willingness of potential borrowers to pay interest attracts lenders and investors to make consumer loans, mortgage loans, and business loans. This fundamental fact of financial markets, that receiving $1 today is better than receiving $1 in the future, or, equivalently, that borrowers pay lenders for the use of their funds, is known as the time value of money.

Borrowers and lenders meet in fixed income markets to trade funds across time. They do so in very many forms: from one-month U.S. Treasury bills that are almost certain to return principal and interest to the long-term debt of companies that have already filed for bankruptcy; from assets with a simple dependence on rates, like Eurodollar futures, to callable bonds and swaptions; from assets whose value depends only on rates, like interest rate swaps, to mortgage-backed securities or inflation-protected securities; and from fully taxable private-sector ...

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