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Ch03 - Chapter 3 Fixed Income Securities Road Map Part A...

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Chapter 3 Fixed Income Securities Road Map Part A Introduction to finance. Part B Valuation of assets given discount rates. Fixed-Income securities. Stocks. Forward and futures. Options Part C Determination of discount rates. Part D Introduction to corporate finance. Main Issues Fixed-Income Markets Term Structure of Interest Rates Interest Rate Risk Hedging Interest Rate Risk Inflation Risk Credit Risk
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3-2 Fixed Income Securities Chapter 3 Contents 1 Motivating Examples . . . . . . . . . . . . . . . . . . . . . . 3-3 2 Fixed-Income Markets . . . . . . . . . . . . . . . . . . . . . 3-5 3 Term Structure of Interest Rates . . . . . . . . . . . . . . . . 3-9 3.1 Spot Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . 3-10 3.2 Discount Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-11 3.3 Coupon Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-12 3.4 Forward Interest Rates . . . . . . . . . . . . . . . . . . . . . . . 3-15 4 Market Conventions . . . . . . . . . . . . . . . . . . . . . . 3-19 4.1 Yield-to-Maturity (YTM) . . . . . . . . . . . . . . . . . . . . . . 3-19 4.2 Pitfalls of YTM . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-23 5 Measuring Interest Rates . . . . . . . . . . . . . . . . . . . . 3-25 6 Interest Rate Risk and Its Measures . . . . . . . . . . . . . . 3-30 6.1 Duration and Modified Duration . . . . . . . . . . . . . . . . . . 3-32 6.2 Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-36 7 Hedging Interest Rate Risk . . . . . . . . . . . . . . . . . . . 3-39 8 Inflation Risk . . . . . . . . . . . . . . . . . . . . . . . . . . 3-41 9 Default Risk . . . . . . . . . . . . . . . . . . . . . . . . . . 3-42 9.1 Default Premium and Risk Premium . . . . . . . . . . . . . . . . 3-43 9.2 Factors in Determining Default Premium . . . . . . . . . . . . . . 3-45 9.3 Factors in Determining Risk Premium . . . . . . . . . . . . . . . . 3-47 10 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 3-49 15.407 Lecture Notes Fall 2003 c Jiang Wang
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Chapter 3 Fixed Income Securities 3-3 1 Motivating Examples Example 1. In the tobacco settlement, required payments by the tobacco companies (in billion dollars): Year 00 01 02-03 04-07 08 on Payment 4.5 5.0 6.5 8.0 9.0 The payments total $216.5 billion by Year 2025. Companies involved have the following capitalization: Name Market Capitalization Brooke Group 0.33 Philip Morris 130.16 RJR 9.46 British American Tobacco 27.03 Lowes 11.02 Total 178.00 How can these companies make the payments? Assuming payments are certain, how do we value them? c Jiang Wang Fall 2003 15.407 Lecture Notes
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3-4 Fixed Income Securities Chapter 3 Example 2. Personal business – Pension benifits. Heard Off the Street: For pension benefits, it’s a matter of interest – as in rates Ben Boselovic (Monday, April 07, 2003 (This article has been edited for class use.) Workers worried about whether their employers will be able to pay them the pension benefits they’ve promised are painfully aware of what the debilitated stock market has done to the asset side of the pension equation. But a lot less ink has been spilled on the liability side of the problem, where major changes in the works could make a serious problem a lot less serious with the stroke of a pen. A pension plan’s liabilities are based on assumptions about how long someone will work for a company, how much his pay will increase over the course of his career, at what age he will retire and how long he will live after retiring. Once pen- sion plan sponsors make a stab at esti- mating their liability, he has to figure out how much money to set aside to cover their expected obligations. That num- ber is based on something called the dis- count rate, basically a conservative esti- mate of what a company’s pension fund assets will earn over a long period of time to cover its long-term retirement obliga- tions.
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