UGBA133 Lecture 5

UGBA133 Lecture 5 - BONDS CONTD CHAPTER 15 TERM STRUCTURE...

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BONDS, CONT’D: CHAPTER 15, TERM STRUCTURE OF INTEREST RATES AND CHAPTER 16, BOND PORTFOLIO MANAGEMENT, INTRODUCTION. 1. TERM STRUCTURE OF INTEREST RATES : THE PREVAILING INTEREST RATE FOR A SET OF BONDS HOLDING QUALITY (RISK LEVEL) CONSTANT, OVER A SPAN OF TIME. THE ONE YOU ARE MOST FAMILIAR WITH IS THE SET OF INTEREST RATES FOR UNITED STATES GOVERNMENT DEBT, RANGING FROM THE VERY SHORT TERM (13 WEEKS) TO THE VERY LONG TERM, 30 YEARS. DO NOT MIX QUALITY WITH TIME…CRITICAL NOTE. 2. TERM STRUCTURE WITH CERTAINTY (A FANTASY, LIKE ONE OF THOSE STORIES YOU HEAR ABOUT WHEN YOU ARE A CHILD…) THE TERM STRUCTURE WITH CERTAINTY ASSUMES THE INTEREST RATE TERM STRUCTURE IS FLAT AND NEVER CHANGES…UNLIKELY… IN YOUR INTRODUCTORY CORPORATE FINANCE COURSE YOU PRICED BONDS USING THE SAME DISCOUNT RATE OVER THE ENTIRE LIFE OF THE BOND…IN HERE WE WILL INTRODUCE SHIFTING ONE PERIOD INTEREST RATES TO DISCOUNT FUTURE CASH INFLOWS (INTEREST PAYMENTS AND SALE PRICE OF THE BOND). ALSO, WE WILL USE DIFFERENT ONE PERIOD INTEREST RATES TO COMPOUND INTO THE FUTURE THE MONEY RECEIVED DURING THE TIME SPAN IN WHICH WE OWN THIS PARTICULAR BOND. WHAT GET’S RE- INVESTED? INTEREST PAYMENTS…SHIFTING INTEREST RATES MAY HAVE A HUGE IMPACT ON PLANNED FUTURE RECEIPTS. 3. YIELD TO MATURITY : DISCUSSED IN HERE LAST WEEK, THIS IS THE INTERNAL RATE OF RETURN EXPECTED OVER THE REMAINING LIFE OF A BOND, GIVEN THE: CURRENT PRICE $ MAGNITUDE OF SEMI-ANNUAL INTEREST RATES 1
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AS PREVIOUSLY MENTIONED, THE ASSUMPTION OF AN IRR IS THE AS- SUMPTION THAT THE CASH FLOWS RECEIVED WILL BE REINVESTED AT THAT INTEREST RATE, THE INTERNAL RATE OF RETURN. BUT IF THE TERM STRUCTURE OF INTEREST RATES IS NOT FLAT, I.E. IDENTICAL AT EVERY POINT IN TIME OVER THE LIFE OF THE BOND, THIS ASSUMPTION WILL BE VIOLATED AT EVERY TIME POINT IN THE SPAN OF INTEREST RATES! 4. TERM STRUCTURE OF INTEREST RATES WITH UNCERTAINTY …AN ADULT STORY…WHERE SOME BIG KIDS PLAY WITH LOTS OF MONEY… LET’S BEGIN WITH A SIMPLE EXAMPLE, UPDATED TO REFLECT THE HIS- TORICALLY LOW PREVAILING INTEREST RATES IN EFFECT NOW. YOU CAN BUY A ONE YEAR TREASURY BILL NOW FOR ABOUT ONE PER- CENT OR YOU CAN BUY A TWO YEAR TREASURY BILL PRICED TO YIELD 1.5% INTEREST ANNUALLY FOR THE TWO YEARS UNTIL IT MATURES. BOTH OF THESE ARE ZERO COUPON INSTRUMENTS—DISCOUNTED DEBT. A ONE YEAR BILL WOULD BE PRICED AS ($1,000 / 1.01) = $990.099 THE TWO YEAR BILL IS PRICED AS (($1,000 / (1.015) 2 ) = $970.662 IN ABOVE WE HAVE CONFLICTING ASSUMPTIONS… THE TERM STRUC - TURE IS NOT 1.5% EITHER THIS YEAR OR IN THE SECOND YEAR . IT IS THE IRR OF TWO DIFFERENT INTEREST RATES. THEY ARE? WE KNOW THE ONE YEAR INTEREST RATE, IT IS 1%. ..THIS IS CALLED A ONE YEAR SPOT RATE. WE KNOW THE TWO YEAR SPOT RATE, IT IS 1.5% ANNUALLY, BUT THAT IS
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This note was uploaded on 12/06/2011 for the course UGBA 133 taught by Professor Distad during the Summer '08 term at Berkeley.

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UGBA133 Lecture 5 - BONDS CONTD CHAPTER 15 TERM STRUCTURE...

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