十五 Asset Valuation Debt Investments Analysis and Valuation

十五 Asset Valuation Debt Investments Analysis and Valuation

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十十 Asset Valuation: Debt Investments: Analysis and Valuation 1.A: Introduction to the Valuation of Fixed Income Securities a: Describe the fundamental principles of bond valuation. Bond investors are basically entitled to two distinct types of cash flows: 1) the periodic receipt of coupon income over the life of the bond, and 2) the recovery of principal (par value) at the end of the bond's life. Thus, in valuing a bond, you're dealing with an annuity of coupon payments, plus a large single cash flow, as represented by the recovery of principal at maturity, or when the bond is retired. These cash flows, along with the required rate of return on the investment, are then used in a present value based bond model to find the dollar price of a bond. b: Explain the three steps in the valuation process. The value of any financial asset can be determined as the sum of the asset’s discounted cash flows. There are three steps: Estimate the cash flows. Determine the appropriate discount rate. Calculate the sum of present values of the estimated cash flows. c: Explain what is meant by a bond's cash flow. This LOS is very straightforward. A bond's cash flow is the coupon or principal value. For an option-free bond (meaning that the bond is not callable, putable, convertible, etc.), the expected cash flow structure is shown on the time line below. Where m = maturity, par, or face value (usually $1,000, 1,000, et cetera), CPN = (maturity value * stated coupon rate)/# coupons per year, and N= # of years to maturity * # coupons per year. So, for an arbitrary discount rate i, the bond’s value is: Bond value= CPN 1 + CPN 2 + . .. + CPN n*m + M (l + i/m) 1 (1 + i/m) 2 (l + i/m) n*m Where: i = interest rate per annum (yield to maturity or YTM), m = number of coupons per year, and n = number of years to maturity. d: Discuss the diffulties of estimating the expected cash flows for some types of bonds and
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identify the bonds for which estimating the expected cash flows is difficult. Normally, estimating the cash flow stream of a high-quality option-free bond is relatively straight forward, as the amount and timing of the coupons and principal payments are known with a high degree of certainty. Remove that certainty, and difficulties will arise in estimating the cash flow stream of a bond. Aside from normal credit risks, the following three conditions could lead to difficulties in forecasting the future cash flow stream of even high-quality issues: The presence of embedded options, such as call features and sinking fund provisions - in which case, the length of the cash flow stream (life of the bond) cannot be determined with certainty. The use of a variable, rather than a fixed, coupon rate - in which case, the future annual or semi-annual coupon payments cannot be determined with certainty. The presence of a conversion or exchange privilege, so you're dealing with a
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This note was uploaded on 12/06/2011 for the course SMO Chartered taught by Professor Peterpellat during the Fall '08 term at University of Alberta.

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十五 Asset Valuation Debt Investments Analysis and Valuation

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