Transcript Slide 1

Management 183
Financial Markets
Investments 1
(bonds)
Financial Instruments
• Money Market
– Certificates of Deposit
– U.S. Treasury Bills
– Money Market Funds
• Bond Market
– U.S Treasury Notes and
Bonds
– U.K. Gilts and Consols
– Municipal Bonds
– Corporate Bonds
• Equity Market
– Common Stock
– Preferred Stock
• Derivative Market
– Options
– Futures
• Other
– Swaps
– Pass-throughs
Fixed Income Securities & Rates
• Fixed
–
–
–
–
–
–
CDs – bank time-deposits
Paper – unsecured, trade-able company debt
Acceptances – bank promises
Eurodollars - $ denominated foreign bonds
Repos, Reverse Repos – of treasury debt
Treasuries – bills, notes, bonds
• Rates
–
–
–
–
Prime
Fed Funds
LIBOR
TED Spread : the 3-month Treasury less LIBOR
TED Spread
Denominated in basis points (bps). Historically 10 to 50 bps –
average 30 bps
A rising TED spread indicates shrinking liquidity –an indicator
of perceived credit risk:
T-bills are considered risk-free
LIBOR reflects the credit risk of lending banks.
Widening TED spread is a sign that lenders believe default risk
on interbank (counterparty) loans is increasing.]
2007
average
September 2008
10/10/2008
150 – 200 bps
> 300 bps
465 bps
a
Pick the Federal Reserve Bank
Chairmen
c
b
Click Glenn Hubbard
for the parody
d
e
What’s the problem with the Fed balance sheet?
Not it’s size. But the quality of the assets.
The largest piece of the pie is pass-thru-securities (pass
thrus from sub-prime mortgages) CDO’s.
No one knows the real value of this balance sheet.
Did the Fed break the law? (Federal Reserve Act of 1913)
by taking less than Federal government backed
securities?
Inflation? Or Deflation?
The problem is losing dollar strength.
Most people get this wrong.
The effects are similar:
Prices go up – but the cause is subtly different.
The weakening dollar due to the extreme moves by
the Fed undermine Americans buying power.
Bonds
• Debt Security – corporate or government borrowing
• Also called a Fixed Income security
• Covenants or Indenture define the contract (this can be
complex)
• 2 types of Payments:
interest
principal
• Interest payments are the Coupon
• Principal payment is the Face
Bond Basics
• Fixed Income Securities: A security such as a
bond that pays a specified cash flow over a
specific period.
Fixed Income Securities vs. Common Stock
Fixed Claim
High Priority on cash flows
Tax Deductible
Fixed Maturity
No Management Control
Bonds
Residual Claim
Lowest Priority on cash flows
Not Tax Deductible
Infinite life
Management Control
Hybrids (Combinations
of debt and equity)
Common Stock
Bond Analysis
• Characteristics –
– Types: mortgage/asset-backed, callable or puttable?,
convertible?, senior or subordinated, floating rate, zero
coupon or stripped
– Denomination (Par value) Face
– Coupon, Dates of Coupon Payments
– Sinking Funds?
– Rating
• Pricing – present value of future cash flows
• Yields:
– Coupon yield
– YTM
– RCYTM
• Sensitivity to Time, i.e. maturity
• Sensitivity to changes in interest rates
Treasury Bills, Notes, & Bonds
•
•
•
•
•
•
•
Bills – 90 days to 6 months
Notes – 1 year up to 10 years
Bonds – to 30 years
Face (denomination) of $1,000; quotes in $100’s
Coupon (rate) paid semi-annually
Prices quoted in points (of face) + 1/32
No default / credit risk
US Treasury Bonds Rates Comparared
Maturity
1984
1991
4/9/2014
3 Month
0.02
6 Month
0.04
2 Year
0.40
3 Year
0.87
5 Year
1.69
10 Year
2.71
30 Year
3.56
4/15/2015
http://www.treasury.gov/resource-center/data-chart-center/interestrates/Pages/TextView.aspx?data=yield
Corporate Bonds April 9, 2014
Maturity
4/9/2014
2yr AA
0.50
2yr A
0.70
5yr AAA
1.80
5yr AA
2.05
5yr A
2.18
10yr AAA
3.10
10yr AA
3.33
10yr A
3.59
20yr AAA
3.99
20yr AA
4.32
20yr A
4.64
106.85-0.12 (-0.11%)
Apr 9, 2014
•52 Wk. High111.10
•52 Wk. Low103.14
BOND News
Why the market may be underpricing fear
Bond investors take note: This could be trouble
Pressure rises on Gross as investors pull $3.1 billion from
Pimco's flagship fund
Bond Pricing
As with all Financial Assets
The price is a Present Value of the expected cash flows
discounted at the appropriate (relative to risk) discount
(interest) rate.
Coupon Payments
• Relative to other types of securities, bonds produce cash
flows that an analyst can predict with a high degree of
precision.
–
–
–
–
Fixed rate
Variable rate
Zero coupons
Consols – consolidated annuities - perpetuities
introduced in 1751.
Rates, Returns
Total Return (TR)
Holding Period Return (HPR)
Compound Average Growth Rate (CAGR)
Risk-adjusted Discount Rate (RADR)
Annual Percentage Rate (APR)
Annual Percentage Yield (APY)
Example
We invest $100. 1 year later we have $130
and, a year later, we have $150. Calculate the
following:
Total Return
1.5x
HPR
50%
Annualized HPR
22.47%
CAGR
22.47%
APR
22.24%
APY
25.19%
Bond Pricing
• DCF Technique
Face
T
C
t
PB  

T
t
(1 r )
t 1 (1 r )
T
PB =
Ct =
T =
r =
Price of the bond
interest or coupon payments
number of periods to maturity
discount rate
Bond Pricing
an 8% 10 year bond at 6%.
Ct = 80 (A), F = 1000,
T = 10 periods, r = 6% (A)
10
PB =
S
t=1
80 + 1000
1
(1+.06) t
(1+.06) 10
PB = $1,147.20
Bond Pricing
an 8% 10 semi-annual year bond at 6%.
Ct = 40 (SA), F = 1000,
T = 20 periods, r = 3% (SA)
20
PB =
S
t=1
40 + 1000
1
(1+.03) t
(1+.03) 20
PB = $1,148.77
Three Bonds in a 10 percent world …
Insert Figure 4-6 here.
Bond Pricing
• Zero Coupon Bonds
currentbond price PV(principal) 
par value
1  r  n
• Consols – Zero Face Bonds

cash flow at timet
current bond price  
t


1

r
t 1
cash flow at timet

r
Bond Yields
• Yield to Maturity: The discount rate that makes
the present value of a bond’s payments equal to
its price.
– Internal rate of return from holding bond till
maturity.
– Example
3 year bond with interest payment of $100,
principal of $1,000 and current price of $900
– Assume coupon proceeds are reinvested at the
YTM.
Bond Yields
• Prices and Yields (required rates of return) have
an inverse relationship
– When yields get very high the value of the bond
will be very low
– When yields approach zero, the value of the
bond approaches the sum of the cash flows
Price
Yield
Bond Risks
• Price Risks
– Default risk
– Interest rate risk
• Convenience Risks
– Call risk
– Reinvestment rate risk
– Marketability risk
Default Risk
• The income stream from bonds is not riskless
unless the investor can be sure the issuer will not
default on the obligation.
• Rating companies
–
–
–
–
–
Moody’s Investor Service
Standard & Poor’s
Duff and Phelps
Fitch
Kroll
Default Risk
• Rating Categories
– Investment Grade Bonds
– Speculative Grade Bonds
S&P
Moody’s
Very High Quality
AAA, AA
Aa
High Quality
A, BBB
Speculative
BB, B
Very Poor
CCC, CC, C, D
Aaa,
A, Baa
Ba, B
Caa, Ca, C, D
Bond Yields
• Current or Annual Yield: Annual coupon divided by bond
price.
– Different from YTM
• Accrued Interest
– Interest is earned for each day that a bond is held, although
interest payments are generally made twice a year only.
– A bond buyer must pay the accrued interest to the seller of the
bond.
• dirty price = bond price + accrued interest
• clean price = bond price
– By convention, accrued interest is calculated using a 360-day
year.
Bond Pricing: Accrued Interest
• Example
– Consider a bond that is paying a six percent
annual coupon rate in semiannual payments with
a yield to maturity of 10 percent and two years
and ten months until its maturity.
• What is the quoted price or clean price?
• What is the dirty price?
Bond Pricing: Accrued Interest
• What is the quoted price or clean price?
Step One: Calculate the present value of a bond that has 2.5
years until it matures and pays semiannual interest coupons.
5
30
1,000

 913.39
t
5
1  0.10/ 2
t 1 1  0.10 / 2
p0  
Step Two: The $30 coupon is added to $913.39.
The sum is $943.19.
Step Three: The value $943.19 is discounted back 4 months
to the purchase date.
943.39
p0 
 913.16
4/ 6
1  0.10 / 2
Bond Pricing: Accrued Interest
• What is the dirty price?
Calculate the accrued interest for two months.
There are 180 days between semiannual coupon
payments and 30 days in a month. Therefore
60/180 is the fraction of the coupon payment
earned by the seller. In other words the accrued
interest is $10 and the dirty price is $923.16.
Forward Rates
term years r at year
(1  2 r 0) 2  (1  1r 0)1 (1  1r1)1
(1  2 r 0) 2 / (1  1r 0)1  (1  1r1)1
One-year rate one year from now
(1  3r 0)3  (1  2r 0) 2 (1  1r 2)1
(1  3r 0)3 / (1  2r 0) 2  (1  1r 2)1
One-year rate two years from now