BUS307 Topic 11 - Topic 11 VALUING RISKY DEBT II – CALLABLE BONDS BUS307 Commercial Banking DRAWBACKS OF TRADITIONAL YIELD SPREAD ANALYSIS Consider

BUS307 Topic 11 - Topic 11 VALUING RISKY DEBT II –...

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Topic 11 VALUING RISKY DEBT II – CALLABLE BONDS BUS307 Commercial Banking
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DRAWBACKS OF TRADITIONAL YIELD SPREAD ANALYSIS Consider two 8.8% coupon 25-year bonds paying interest semi- annually: The yield spread is the difference between 10.24% and 9.15%, that is 1.09% or 109 basis points (BP). However, the traditional yield spread ignores the Term structure of interest rates Existence of embedded options – callable/putable bonds ISSUE PRICE ($) YIELD TO MATURITY (%) Treasury 96.6133 9.15 Corporate 87.0798 10.24
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STATIC SPREAD: ANALTERNATIVE TO YIELD SPREAD DEMONSTRATION EXAMPLE: FABOZZI 16-2 Is the static spread for a three-year 9% coupon corporate bond selling at $105.58 given the theoretical Treasury spot rate below, 50, 100, or 200 basis points? PERIOD SPOT RATE (%) (NOTE RATE QUOTED P.A.) 1 4.0 2 4.2 3 4.9 4 5.4 5 5.7 6 6.0
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STATIC SPREAD: AN ALTERNATIVE TO YIELD SPREAD The static spread is a measure of the spread an investor would realize over the entire Treasury spot rate curve if the bond is HELD to MATURITY. The difference between the static spread and the traditional yield curve increases with increasing maturity the steeper the yield curve coupon rate amortised (equal) cash flows compared to bullet payments
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CALLABLE BONDS AND THEIR INVESTMENT CHARACTERISTICS
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