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Homework 5

Vikas Kumar Singh

International Bond Pricing Homework


The purpose of this assignment is to develop your knowledge of asset pricing
models in an international context. In particular you will to investigate if the law
and finance factors are important in pricing of individual securities. In addition,
you will get hands-on exposure to corporate bond pricing models and re-enforce
your knowledge of spreadsheet (or regression package) modeling.
The Miller Investment Trust is the manager of a large, privately held stock and
bond portfolio. The board of directors has recently had decided that in order to
diversify, it should contemplate the purchase of some international bonds.
Currently, all the corporate bonds it holds are from U.S. based firms. In particular,
the fund is contemplating corporate bonds issued by non-U.S. companies and
therefore needs to develop a model that will help identify the factors that are
important to pricing foreign corporate bonds. They have given this assignment to
the bond portfolio manager (your mentor), who has in-turn given it to you. You will
present your findings to the board, so your boss has asked you to answer the
following questions to get you ready.
Specifically, your boss asked you to address the following questions:
1. Are the factors the firm currently uses to price U.S. corporate bonds
useful in explaining non-U.S. corporate bonds?
In order to answer this question, you should the run firms current U.S.
bond pricing model on a sample of foreign corporate issues provided.
As per the current method of pricing the bonds, the regression analysis is as
follow:
SUMMARY
OUTPUT
Regression Statistics
Multiple R
0.898846073
R Square
0.807924262
Adjusted R
Square
0.798592648
Standard
Error
0.663662434
Observations
260
ANOVA
df
Regression
Residual
Total

12
247
259

SS
457.604
108.791
566.394

MS
38.134
0.440

F
86.579

Significanc
eF
0.000

Homework 5

Vikas Kumar Singh

Coefficients
1.4727

Standar
d Error
0.6169

t Stat
2.3871

Pvalue
0.0177

Lower 95%
0.2576

Upper
95%
2.6878

rating1

0.1187

0.3575

0.3322

0.7400

-0.5853

0.8228

rating2
rating3
rating4
rating5

0.3613
0.6082
2.3314
3.7291

0.2519
0.2500
0.2761
0.2946

1.4341
2.4331
8.4431
12.6570

0.1528
0.0157
0.0000
0.0000

-0.1349
0.1159
1.7875
3.1488

lnnetpro

-0.2360

0.0775

-3.0450

0.0026

-0.3887

0.8574
1.1005
2.8752
4.3093
0.0834

lnyfmat
default

-0.0837
0.8514

0.0860
0.3600

-0.9735
2.3652

0.3312
0.0188

-0.2532
0.1424

0.0857
1.5603

utildum
calldum
sinkdum
subdum

-0.0822
0.3274
0.7465
0.5382

0.1187
0.1110
0.3132
0.2299

-0.6929
2.9503
2.3837
2.3411

0.4890
0.0035
0.0179
0.0200

-0.3160
0.1088
0.1297
0.0854

0.1515
0.5461
1.3633
0.9910

Intercept

Lower
95.0%
0.2576
0.5853
0.1349
0.1159
1.7875
3.1488
0.3887
0.2532
0.1424
0.3160
0.1088
0.1297
0.0854

It can be seen from the adjusted r-squared value which is 0.799, that this model explains
79.9% the movement of prices of all the non-US bonds. And it can be seen from above
model that most of the parameters except rating1, rating2, innetprp, infymat and utildum
have t-statistics over 2 hence all those parameters are statistically significant and hence
there is 95% probability that the parameters with a t-statistics over 2 are having the yield
spread within 2 standard deviations.
2. Are the signs of the each of the coefficients what you expected from the
U.S. market? (go through each one individually)
There are few parameters which are not statistically significant and most of the
parameters are significant such as
Intercept
Coefficient:- 1.4727 and t-stat:- 2.3871
This is positive and it should be positive since the other markets will take this as
base and hence will increase the yield because of the other constraint or
parameters.
Rating 1
Coefficient:- 0.1187 and t-stat:- 0.3322
The yield spread is dependent on the the yield of US treasury bond so higher the
bond rating the lower would the yield spread be and since this rating is for other
markets, it would have a positive sign and higher the rating coefficient, the higher
the yield spread will be. And the low t-stat indicates that this rating may not be as
accurate in pricing the bonds.

Upper
95.0%
2.6878
0.8228
0.8574
1.1005
2.8752
4.3093
0.0834
0.0857
1.5603
0.1515
0.5461
1.3633
0.9910

Homework 5

Vikas Kumar Singh

Rating 2
Coefficient:- 0.3613 and t-stat:- 1.4341
As explained in rating 1, the same goes for rating 2 and the t-stat is not
significant enough for this rating as well.
Rating 3
Coefficient:- 0.6082 and t-stat:- 2.4331
As explained in rating 1, the same goes for rating 3 and the t-stat is significant
enough for this rating as it is more than 2 and hence it has 95% probability that it
will be in 2 standard error.
Rating 4
Coefficient:- 2.3314 and t-stat:- 8.4431
As explained in rating 1, the same goes for rating 4 and the t-stat is significant
enough for this rating as it is more than 2 and hence it has 95% probability that it
will be in 2 standard error.
Rating 5
Coefficient:- 3.7291 and t-stat:- 12.6570
As explained in rating 1, the same goes for rating 4 and the t-stat is significant
enough for this rating as it is more than 2 and hence it has 95% probability that it
will be in 2 standard error.
Bond Maturity (lnyfmat)
Coefficient:- -0.0837 and t-stat:- -0.9735
The more the bond maturity period the lesser the price of the bond has to be. So
this rating would act as negative parameter and hence it has negative coefficient
and the t-stat for this parameter is not statistically significant.
Issue Size (lnnetpro)
Coefficient:- -0.2360 and t-stat:- -3.0450
The more the size of the bond will be the debt offering will be more stabe and
hence the yield of the bond would be lower. So the coefficient for this has to be
negative and hence it is as shown in the regression analysis.
Market Conditions (default)
Coefficient:- 0.8514 and t-stat:- 0.3600
The price of the bond hugely depends on the market conditions so the better the
market, the more priced the bond will and hence the coefficient of this bond has
to positive and close to 1.
Covenant provisions (calldum,subdum,sinkdum)
Calldum- Coefficient:- 0.3274 and t-stat:- 2.9503
Subdum- Coefficient:- 0.5382 and t-stat:- 2.3411

Homework 5

Vikas Kumar Singh

Sinkdum- Coefficient:- 0.7465 and t-stat:- 2.3837


The more liquid the bond is and it has more flexibility the bond price would be
more and hence the coefficient of this parameter would be positive.
Industry (utildum)
Coefficient:- -0.0822 and t-stat:- -0.6929
This indicator denotes if the firm is a utility, otherwise an industrial firm. And
Utilities would be expected to be relatively stable in comparison to other
industries.

3. Are there additional factors that the market uses to price foreign
corporate bonds? Specifically, he wants to know if the volatility of the
exchange rate and the firms location are important. To answer this, add to
the U.S. model the variables for Volatility, Rule of Law and Creditor rights.
What do you find, what does it mean?
With the addition of the three new factors in the decision pricing model, the analysis is as
follows:
SUMMARY
OUTPUT
Regression Statistics
Multiple R
0.903139801
R Square
0.815661501
Adjusted R
Square
0.804329216
Standard
Error
0.654142803
Observations
260
ANOVA
df

MS
30.7991
0.4279

F
71.9768

Significanc
eF
0.0000

15
244
259

SS
461.9861
104.4083
566.3944

Coefficients
2.32250

Standard
Error
0.69514

t Stat
3.34107

P-value
0.00097

Lower 95%
0.95327

Upper
95%
3.69174

rating1

0.01168

0.35502

0.03289

0.97379

-0.68761

0.71097

rating2
rating3
rating4

0.33036
0.60781
2.20333

0.25127
0.24729
0.27622

1.31476
2.45792
7.97666

0.18983
0.01467
0.00000

-0.16458
0.12072
1.65925

0.82530
1.09489
2.74742

Regression
Residual
Total

Intercept

Lower
95.0%
0.95327
0.68761
0.16458
0.12072
1.65925

Upper
95.0%
3.69174
0.71097
0.82530
1.09489
2.74742

Homework 5

Vikas Kumar Singh

rating5

3.63522

0.29558

12.29844

0.00000

3.05300

4.21744

lnnetpro

-0.25003

0.07811

-3.20115

0.00155

-0.40388

-0.09618

lnyfmat
default

-0.07005
0.75064

0.08540
0.35836

-0.82022
2.09466

0.41289
0.03723

-0.23826
0.04477

0.09817
1.45651

utildum
calldum
sinkdum
subdum

-0.08789
0.42537
0.72376
0.54695

0.12284
0.11468
0.30953
0.22932

-0.71549
3.70925
2.33823
2.38510

0.47499
0.00026
0.02018
0.01784

-0.32985
0.19949
0.11406
0.09525

0.15407
0.65126
1.33346
0.99865

fxvoliti

40.65339

22.82200

1.78133

0.07610

-4.29987

85.60666

credrgts

-0.08861

0.04636

-1.91113

0.05716

-0.17993

0.00272

ruleofla

-0.08086

0.03055

-2.64682

0.00865

-0.14104

-0.02069

3.05300
0.40388
0.23826
0.04477
0.32985
0.19949
0.11406
0.09525
4.29987
0.17993
0.14104

It can be seen from the adjusted r-squared value which is 0.804, that this model explains
80.4% the movement of prices of all the non-US bonds. And it can be seen from above
model that most of the parameters except rating1, rating2, innetprp, infymat and utildum
have t-statistics over 2 hence all those parameters are statistically significant and hence
there is 95% probability that the parameters with a t-statistics over 2 are having the yield
spread within 2 standard deviations.
Rule of Law (ruleofla)
Coefficient:- -0.08086 and t-stat :- -2.64682
The index of the law and order tradition of the country. It is scaled from 0 to 10, with
higher scores for counties with more tradition for law and order. So more better the laws
would be the more rating a country has so this factor should be negatively correlated with
a negative coefficient.
Creditor Rights (credrgts)
Coefficient:- -0.08861 and t-stat :- -1.91113
This is an index aggregating different creditor rights a particular country provides. This
should be negatively correlated as the higher the chances of default higher would be the
yield spread.
FX Volatility (fxvoliti)
Coefficient:- 40.65339 and t-stat :- 1.78133
The greater the volatility, the greater would be the yield spread of a given bond. But this
factor is statistically not significant since the t-stat value is less than 2.

4.21744
-0.09618
0.09817
1.45651
0.15407
0.65126
1.33346
0.99865
85.60666
0.00272
-0.02069

Homework 5

Vikas Kumar Singh

Miller Investment Trust U.S. Bond Pricing Model


Yield Spread = constant + B1(Rating1) + + B5(Rating5) + B6(Bond Maturity) +
B7(Issue Size) + B8(Market Conditions) +B9(Call Indicator) +B10(Sinking Fund
Indicator) +B11(Subordinated Indicator) + B12(Industry Indicator)
where
Yield Spread = Difference between the Yield-to-Maturity for the bond minus the
yield of a Treasury bond with similar maturity (variable name in dataset: ysprd)
Bond Ratings: The company uses 6 ratings classifications that correspond to
Moodys rating of the bond issue. Rating 0 denotes if the bond was rated Aaa,
Rating 1denotes if the bond was rated Aa1, Aa2, or Aa3, Rating 2 denotes if the
bond was rated A1,A2,A3, and so on. Note: Rating 0 is not included in the
dataset to overcome the dummy variable trap. Therefore, the estimated beta
coefficient is going to be marginal affect of the rating over Aaa. For example if
you find the B1 is .1, that means the Bonds with Aa1 ratings rating have a.1%
greater interest rate then AAA bonds.
Bond Maturity: The natural logarithm of the issues maturity in years (variable
name in dataset: lnyfmat)
Issue Size: The natural Logarithm of the dollar size of the net proceeds of the
bond issue in USD millions (variable name in dataset: lnnetpro)
Market Conditions: The difference between the Moodys Aaa seasoned
corporate bond yield index and the composite Treasury yield on the offer date.
This measure is the average risk premium for corporate bonds.(variable name in
dataset: default)
Convent Provisions: Indicators to denote the if the bond is Callable, has a
Sinking fund provision, or is Subordinated. (variable name in dataset:
calldum,subdum,sinkdum)
Industry: Indicator to denote if the firm is a utility, otherwise an industrial firm.
(variable name in dataset: utildum)
Proposed Additional Factors

Homework 5

Vikas Kumar Singh

Rule of Law: The index of the law and order tradition of the country. It is scaled
from 0 to 10, with higher scores for counties with more tradition for law and order.
From LLSV (1998) (variable name in dataset: ruleofla)
Creditor Rights: is an index aggregating different creditor rights a particular
country provides. The index ranges from 0 to 4, with 4 representing the highest
protection. One point is added if there is no automatic stay on assets, secured
creditors get paid first, there are restrictions on reorganizations, and if
management does not stay in reorganizations. From LLSV (1998).(variable name
in dataset: credrgts)
FX Volatility: The 30-day historical volatility of the U.S. to home country currency
exchange rate(variable name in dataset: fxvol)

The Data
The spreadsheet, [bond case data], contains data on 260 corporate bonds issued
by foreign firms in the U.S. over the period 1987-1998.