Money market
Bond market
Equity Securities
Indices
Derivative markets
In the Market
Reinvestme
nt Risk
Prevailing
Interest Rate
In the Market
Bond Price
Bond Price
This bond was issued near par value of 100 in
the middle of January 2007. price quoted here
is for the year 2009 (January to December).
Fluctuation in bond price may be due to:
(a) An increase in interest rate in the market.
(b) An increase in unanticipated inflation rate.
(c) A fall in risk premium that causes investors
to prefer riskier securities than treasury
securities.
Credit Risk
Treasury securities do not carry
credit risk. However there are
corporate bonds that carry significant
amount of credit risk: that the issuer
may be unable to service all or some
of the promised obligations due to
financial distress, reorganization,
workouts, or bankruptcy.
Liquidity Risk
Some debt securities may trade in
illiquid markets (few dealers, wide bidoffer spreads, low depth, and so on).
Emerging market debt and some high
yield debt fall into this category.
Liquidity refers to the ease with which
a reasonable size of a security can be
transacted in the market within a short
notice, without adverse price reaction.
Liquidity Risk
The seller or the buyer will face following:
1. High Transaction costs such as fees and
commissions,
2. Bid-offer spreads
3. Market impact costs, which refer to the
possibility that following the placement
of a buy (Sell) order the market makers
may increase (Decrease) the prices at
which they are willing to trade.
Contractual Risk
Debt securities may be callable by the issuer at the issuers
option.
Holders of mortgage loans have the right to prepay their old
mortgages if they can refinance them at a cheaper rate.
This implies that prepayment should increase when
mortgage rates in market drop.
The lender will want to charge a higher interest rate to
account for the fact that he or she is giving the borrower a
valuable option to call away the loans when interest rate fall
in the market.
This is call risk in the mortgages.
Hence mortgages must trade at a yield higher than similar
non callable treasury debt securities.
Inflation Risk
Inflation risk is the risk that money obtained in the future will be
worth less than when it is invested, which is almost always the
case.
The real risk is how much this risk will be. On the other hand, it is
possible, in some cases, to take advantage of deflation that occurs
when interest rates rise.
A good example is when interest rates are rising, newly issued
fixed-income securities start to pay more, while prices of things that
generally require borrowing, such as real estate, start declining.
Thus, for instance, one could buy 4 week T-bills as a way to save for
a house or for a down payment. As the T-bills expire, they can be
re-invested at progressively higher rates (while rates are rising).
In the meantime, real estate prices are falling because it is
becoming more expensive to borrow the money to pay for it. So the
money earned on the T-bills becomes even more valuable than the
interest rate itself suggests when used to purchase real estate.
Event Risk
Some debt securities may be sensitive to events
such as hostile reorganizations or leveraged buyouts
(LBOs). Such events can lead to a significant price
loss.
In October 1988 RJR Nabisco was taken over through
an LBO. The resulting company took on heavy debt
to finance the takeover. As a result Moodys rating for
RJR Nabiscos debt from A1 to B3.
The prices of RJR Nabisco dropped about 15%, and
yield spread went from about 100 BPS above
treasury to 350 BPS above treasury.
In corporate debt market this risk is called event risk.
Tax Risk
If debt securities were originally
issued with certain tax exemption
features and subsequently there
developed an uncertainty regarding
their tax status, it could to lead to a
price loss.
Bond Pricing
Bond Characteristics
Face or par value
Coupon rate
Zero coupon bond
Compounding and payments
Accrued Interest
Indenture
Accrued Interest
Bond Pricing
The price of any financial instrument
is equal to the present value of the
expected cash flows from financial
instrument.
Determining the price require:
1. An estimate of the expected cash
flows.
2. An estimate of the appropriate
required yield.
Bond Pricing
The required yield refers to the yield for
financial instruments with comparable risk, or
alternative (or substitute) investments.
The first step in determining the price of a bond
is to determine its cash flows.
The cash flows of a bond that the issuer can not
retire prior to its stated maturity date. (a non
callable bond) consist of:
1. Periodic coupon payments to the maturity date.
2. The Par (or maturity) value at maturity.
Bond Pricing
T
ParValue
C
PB
T
t
(1 r )
t 1 (1 r )
PB = Price of the bond
Ct = interest or coupon payments
T = number of periods to maturity
y = semi-annual discount rate or the semi-annual
yield to maturity
Bond Pricing
You may recall that PV of an annuity was:
PV = c/y [ 1 1/(1+y)N ]
Where 1/y [ 1 1/(1+y)N ] is called an
annuity factor.
And also PV of Terminal Value is:
Par Value * 1/(1+r)N
Where 1/(1+r)N is called PV factor.
So Price = Coupon* Annuity factor (r,
T) + Par Value* PV factor (r, T)
Complications
The framework for pricing a bond
discussed here assumes that:
1. The next coupon is exactly six
month away.
2. The cash flows are known.
3. The appropriate required yield can
be determined.
4. One rate is used to discount all the
cash flows.
Discount
Price = Par
Par
Premium
Computing Yield
P = t=1N CFt/ (1+y)t
Where:
CFt = Cash flow in year t
P = Price of the investment
N= Number of years
Measuring Yields
Current Yield
Yield to Maturity
Yield to Call
Yield to Put
Yield to Worst
(6.09%)
Current Yield
Limitations?
Yield to Maturity
In practice, an investor considering the
purchase of a bond is not quoted a promised
rate of return.
Instead the investor must use Bond Price,
Maturity Date, Coupon Payments, to infer the
return offered by the bond over its life.
YTM is often interpreted as a measure of true
average rate of return that will be earned if it is
bought now and held until maturity.
Bond price used in the function should be the
reported flat price, without accrued interest.
Yield to Maturity
Interest rate that makes the present
value of the bonds payments equal
to its price
Solve the bond formula for r
T
ParValue
C
PB
T
t
(1 r )
t 1 (1 r )
Yield to Maturity
15 year 7%- Semiannual pay bond
with par value of $1000 selling at
$769.42.
Coupon = 7% of $1000 = $70 annual
Cash flow 1. $35 semiannual
payments for 30 periods.
Cash flow 2. $1000 principal amount
to be received 30 periods from now.
Relationship
Par
Discount
Premium
Yield to Call
What if the bond is callable, and may be
retired prior to the maturity? (YTM is not
Relevant).
The price at which a bond may be called
back is referred to as the call price.
For some issues, the call price is the same
regardless of when the issue is called.
For other callable issues, there is a call
schedule that specifies a call price for each
call date.
Yield to Put
When bondholders can force the issuer to buy
the issue at a specified price. As with callable
issue, putable issue can have a put schedule.
The schedule specifies when the issue can be
put and the price, called the put price.
The YTP (yield to put) is the interest rate that
makes the present value of cash flows to the
assumed put date plus the put price on that
date equal to the bond price.
PV of Cash Flows to put date + PV of Put Price =
Bond Price
Yield to Worst..
A Practice in the industry is for an
investor to calculate the yield to
maturity, yield to every possible call
date, and the yield to every possible
put date.
The minimum of all of these is called
Yield to Worst.
Implication of Negative
YTM..
An implication is that someone who doesnt plan
to hold until maturity can still make a profit on a
bond with a negative YTM. For example, someone
who buys a Swiss government bond with a YTM of
negative 0.1% today will have the opportunity of
selling at a profit if the YTM subsequently falls to
negative 0.2%. The current ridiculous valuations
of some government bonds could therefore be
partly explained by the belief that valuations will
become even more ridiculous in the future, thus
enabling todays buyers to exit at a profit.
Example..
floating rate yield.xlsx
A six year floating-rate security
selling for 99.3098 pays a rate based
on some reference rate plus 80 BPS.
the coupon rate is reset every six
months. Assume that current value
of the reference rate is 10%.
Cash flow = 10.8/2*100 = 5.4