If you want to borrow money, you can go to a financial institution such as a bank. If you satisfy the bank that you have the ability to repay the loan, plus interest, it will lend you the money. This creates a fixed-income security, which is a contract specifying the timing and amounts of cash flows over time. The "timing" is how often you make payments, and the "amount" is the dollar amount you pay each time.

For this fixed-income security, you are the "seller" and the bank is the "buyer." That is, you sell a legal obligation to repay the loan plus interest, and in return, you receive the amount of the loan. The interest rate is what the bank charges you for use of the money. It compensates the bank for not being able to lend the money to anyone else for the term of your loan.

There are many types of fixed-income securities. When an economic unit, such as the U.S. Treasury, borrows cash from the general investing public, it also creates a fixed-income security. The public is now the buyer that lends money to the Treasury. This fixed-income security specifies the timing and amounts of cash payments by the U.S. Treasury (the seller) to the owner of the fixed-income security.

Fixed-income securities are traded in primary and secondary markets. The primary market is the market in which the security is first issued. For example, the U.S. Treasury initially auctions Treasury bills. Once issued in the primary market, securities are re-traded in the secondary market.

These markets determine a price for each fixed-income security. Since a fixed-income security specifies a series of future payments (or cash flows), the price of the security is the value today of future cash flows.

To understand the basic principle of valuation, ask yourself if you would pay $1,000 today in return for $1,000 in five years. You are likely to respond no, indicating that you clearly do not place the same value on $1,000 in five years as you place on $1,000 today. Similarly you are likely to place even less value on $1,000 in ten years than you place on $1,000 today. This means that money at different times has a different value. The principle behind this concept is called the time value of money.

(C) Copyright 1999, OS Financial Trading System