Fixed Income - 1 WhatWeWillCover Bond Basics Valuation The...

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Fixed Income Securities Professor David McLean Alberta School of Business 1
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What We Will Cover Bond Basics Valuation The Term Structure of Interest Rates Estimating Forward Rates Corporate Bonds and Default Risk Interest-Rate Risk Duration, Convexity 2
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The Basics   3
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Bond Basics Bond Security that obligates issuer to make payments to holder over time Face Value, Par Value Payment to bondholder at maturity of bond Coupon Rate Bond’s annual interest payment per dollar of par value Zero-Coupon Bond Pays no coupons, sells at discount, 4
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Bond Basics Issuers: § Governments § Corporations § Commercial Banks § States § Municipalities § SPVs § Foreign Institutions Intermediaries: § Primary Dealers § Other Dealers § Investment Banks § Credit-rating Agencies § Credit Enhancers § Liquidity Enhancers Investors: § Governments § Pension Funds § Insurance Companies § Commercial Banks § Mutual Funds § Hedge Funds § Foreign Institutions § Individuals Fixed-Income Market Participants 5
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Bond Basics: Example Bond Information: Par value = $1,000 Coupon rate = 8% Maturity = 30 years The investor is entitled to $40 Semi-annual coupons until maturity $1,000 at the maturity 6
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7 Bond Basics: Accrued Interest Investors pay a different price than that quoted; accrued interest is the difference Example: 40 days since the last semi-annual coupon Rate is 8%, price is $990 Accrued interest = $1,000 * 40/365 * .08 = $8.76 Sale Price = $990 + $8.76 = $998.76
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Canada Bonds Canada Bonds Issued in $1,000 increments Make semi-annual payments Prices are quoted as a percentage of par value A bid of $118.80 is a bid price of $1188.00 OTC market, not very liquid 8
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More Bond Terminology Yield to Maturity Discount rate that makes present value of bond’s payments equal to price. Current Yield Annual coupon divided by bond price Premium Bonds Bonds selling above par value Discount Bonds Bonds selling below par value 9
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Valuation and Yield to  Maturity   10
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Bond Cash Flows Bond Cash Flows Coupons Principal at Maturity Cash flow for a 3-year bond with principal of $1,000 and annual coupon payment of 5% 11
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Bond Valuation 12
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Computing YTM in EXCEL Semiannual coupons Annual coupons Settlement date 1/1/2000 1/2/2000 Maturity date 1/1/2030 1/2/2030 Annual coupon rate 0.08 0.08 Bond price (flat) 127.676 127.676 Redemption value (% of face value) 100 100 Coupon payments per year 2 1 Yield to maturity (decimal) 0.0600 0.0599 The formula entered here is =YIELD(B3,B4,B5,B6,B7,B8) 13
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YTM vs. Yield to Call Some corporate bonds are callable Yield to Call Calculated like yield to maturity Time until call replaces time until maturity Call price replaces par value Premium bonds more likely to be called than discount bonds Why?
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