AGB 310 Lec 2 Debt

AGB 310 Lec 2 Debt - 6-1 Interest Rates, Bonds, and Bond...

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6 - 1 Interest Rates, Bonds, and Bond Valuation Key features of bonds Bond valuation Measuring yield 6 - 2 What are Financial Assets? A financial asset is a contract that entitles the owner to some type of payoff. Debt Equity Derivatives Remember the accounting identity: Assets = Liabilities + Equity (A = L + E)
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6 - 3 What do we call the price, or cost, of debt capital? The interest rate What do we call the price, or cost, of equity capital? Required Dividend Capital return yield gain = + . 6 - 4 Real versus Nominal Rates r* = Real risk-free rate. T-bond rate if no inflation; 1% to 4%. = Any nominal rate. = Rate on Treasury securities. r r RF
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6 - 5 What is the nominal risk-free rate? r RF = (1+r*)(1+IP)-1 = r*+ IP + (r*xIP) r*+ IP. (Because r*xIP is small) r RF = Rate on Treasury securities. 6 - 6 r = r* + IP + DRP + LP + MRP Here: r = Required rate of return on a debt security. r* = Real risk-free rate. IP = Inflation premium. DRP = Default risk premium. LP = Liquidity premium. MRP = Maturity risk premium.
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6 - 7 The Maturity Risk Premium Long-term bonds: High interest rate risk, low reinvestment rate risk. Short-term bonds: Low interest rate risk, high reinvestment rate risk. Nothing is riskless! Yields on longer term bonds usually are greater than on shorter term bonds, so the MRP is more affected by interest rate risk than by reinvestment rate risk. 6 - 8 Premiums Added to r* for Different Types of Debt ST Treasury : only IP for ST inflation LT Treasury : IP for LT inflation, MRP ST corporate : ST IP, DRP, LP LT corporate : IP, DRP, MRP, LP
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6 - 9 What is reinvestment rate risk? The risk that CFs will have to be reinvested in the future at lower rates, reducing income. Illustration: Suppose you just won $500,000 playing the lottery. You’ll invest the money and live off the interest. You buy a 1-year bond with a YTM of 10%. 6 - 10 What is reinvestment rate risk? Year 1 income = $50,000. At year- end get back $500,000 to reinvest. If rates fall to 3%, income will drop from $50,000 to $15,000. Had you bought 30-year bonds, income would have remained constant.
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6 - 11 What is the “term structure of interest rates”? What is a “yield curve”? Term structure : the relationship between interest rates (or yields) and maturities. A graph of the term structure is called the yield curve . 6 - 12 How can you construct a hypothetical Treasury yield curve? Estimate the inflation premium (IP) for each future year. This is the estimated average inflation over that time period. Step 2: Estimate the maturity risk premium (MRP) for each future year.
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6 - 13 IP 1 = 5%/1.0 = 5.00%. IP 10 = [5 + 6 + 8(8)]/10 = 7.5%. IP 20 = [5 + 6 + 8(18)]/20 = 7.75%. Must earn these IPs to break even versus inflation; that is, these IPs would permit you to earn r* (before taxes). 6 - 14 Step 1: Find the average expected inflation rate over years 1 to n: n Σ INFL t t = 1 n IP n = .
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This note was uploaded on 10/18/2009 for the course AGB 7510 taught by Professor Slezak during the Fall '09 term at Cal Poly.

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AGB 310 Lec 2 Debt - 6-1 Interest Rates, Bonds, and Bond...

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