I'm trying to wrap my head around bonds.
There are many types of bonds, but to put it simply, it can either be floating rate or fixed rate, and it can also have collateral to account for the credit risk (like ABS bonds).
Now, it seems to me that ALL we need to understand everything there is to understand about bonds, is two things:
- The discount curve: the cash flows of the bonds will be discounted using this discount curve, so that we can get the present value.
- The fixing curve: this is only needed if the bond is floating rate. It is used to actually calculate the above cash flows (approximately, ie using expected future rates, since we dont know whats actually realized)...and then we discount as before.
My confusion is this: how do you actually determine these curves? How do I know what discount and fixing curve to use? Are they specified in the literal contract? Or do you pick them randomly yourself? And how does the choice depend on whether the bond is fixing or float, and how do we adjust for higher credit risk, and what happens if the bond also has collateral (like mortgage-backed securities) and what happens as that collateral is diminished as time goes by (e.g. if you have a mortgage backed security, what happens if as time goes by, some mortgage payers default and so the collateral becomes worth less?)
I think the fixing curve must be specified in the contract so if thats the case, all my questions for that are answered: but what about the discount curve?