An interest rate is a price, or rent, for the most popular of all traded commodities—money. The one-year interest rate, for example, is just the price that must be paid for borrowing money for one year. Markets for money are well developed, and the corresponding basic market price—interest—is monitored by everyone who has a serious concern about the financial activity.
The overall market associated with interest rates is more complex than the simple bank accounts discussed before. There are varieties of bills, notes, bonds, annuities, futures contracts, and mortgages are part of the well-developed markets for money. These market items are not real goods in the sense have intrinsic value—such as potatoes or gold—but instead are traded only as pieces of paper, or as entries in a computer database. These items, in general, are referred to as financial instruments. Their values are derived from the promises they represent. If there is a well-developed market for an instrument, so that it can be traded freely and easily, then that instrument is termed a security. There are many financial instruments and securities that are directly related to interest rates and, therefore, provide access to income—at a price defined by the appropriate interest rate or rates.
Fixed income securities are financial instruments that are traded in well-developed markets and promise a fixed income to the holder over a span of time. They are Important to an investor because they define the market for money, and most investors participate in this market.
The classification of a security as being a fixed-income security is actually a bit vague. The only uncertainties about the promised stream were associated with weather the issuer of the security might default (by, say, going bankrupt), in which case the income would be discontinued or delayed.
There are many different kinds of fixed income securities, and we cannot provide a comprehensive survey of them here. However, we shall mention some of the principal types of fixed-income securities in order to indicate the general scope of such securities.
The most familiar fixed-income instrument is an interest-bearing bank deposit. These are offered by commercial banks, savings and loan institutions, and credit unions. The simplest demand deposit pays a rate of interest that varies with market conditions. Over an extended period of time, such a deposit is not strictly of fixed-income type. The interest rate is guaranteed in a time deposit account, where the deposit must be maintained for a given length of time (such as 6 months), or else a penalty for early withdrawal is assessed.
Money market instruments
The term money market refers to the market for short-term (1 year or less) loans by corporations and financial intermediaries like a bank. It is a well-organized market which is designed for large amounts of money, but it is not of great importance to long-term investors because of its short-term and specialized nature.
This is a legal agreement by which a bank, building society, etc lends money at interest in exchange for taking the title of the debtor’s property, with the conveyance of title becomes void upon the payment of the debt. The standard mortgage is structured so that equal monthly payments are made throughout its term. Most standard mortgages allow for early repayment of the balance. Hence from the mortgage holder’s viewpoint, the income stream generated is not completely fixed, since it may be terminated with an appropriate lump-sum payment at the discretion of the homeowner.
There are many variations on the standard mortgage. There may be modest-sized periodic payments for several years followed by a final balloon payment that completes the contract. Adjustable-rate mortgages adjust the effective interest rate periodically according to an interest rate index, and hence these mortgages do not really generate fixed income in the strict sense.
Mortgages are not usually thought of as securities since they are written as contracts between two parties, a homeowner, and a bank.
An annuity is a contract that pays the holder money periodically, according to predetermined schedule or formula, over a period of time. Pensions are the best examples of annuities. Sometimes annuities are structured to provide a fixed payment every year for as long as the annuitant is alive, in which case the price of the annuity is based on the age of the annuitant when the annuity is purchased and on the number of years until payments are initiated.
Annuities are not really securities since they are not traded. However, these are considered to be investment opportunities that are available at standardized rates. Hence from an investor’s viewpoint, they serve the same role as other fixed-income instruments.
As a step toward the development of the formula, we consider an interesting and conceptually useful fixed income instrument termed as perpetual annuity or perpetuity which pays a fixed amount periodically forever.