Chapter 10 (exam 2)

Chapter 10 (exam 2) - Chapter 10 Chapter 10 Bond Prices and...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Chapter 10 Chapter 10 Bond Prices and Yields Bond Characteristics Bond Characteristics Face or par value Coupon rate → Zero coupon bond Zero coupon bond Compounding and payments Indenture Bond Provisions Bond Provisions Secured or unsecured Call provision Convertible provision Put provision Floating rate bonds Innovations in the Bond Market Innovations in the Bond Market Reverse floaters Catastrophe bonds Treasury inflation protected securities (TIPS) Bond Valuation Principle Bond Valuation Principle Intrinsic value → Is an estimated value Is an → PV of expected cash flows (CFs) PV of expected cash flows (CFs) Required to compute intrinsic value » Expected CFs » Timing of expected CFs » Discount rate (rate required by investors) Bond Pricing Bond Pricing T P B= ∑ t= 1 PB = C t T + Par Value T T (1+ r ) (1+ r ) price of the bond Ct = interest or coupon payments T = number of periods to maturity r = semi­annual discount rate or semi­annual yield to maturity Bond Valuation Examples Bond Valuation Examples Bonds have $1000 face value and pay semi­annual interest. Coupon Yield to Years to Rate Maturity Maturity Value Bond Prices Bond Prices Bond prices move inversely to interest rates Bond prices are directly related to time to maturity Interest Rates Interest Rates Rates and basis points » 100 basis points are equal to one percentage point Short­term riskless rate » Provides foundation for other rates » Approximated by rate on Treasury Bills » Other rates differ because of → Maturity differentials Maturity differentials → Security risk premiums Security risk premiums Interest Rates Interest Rates Maturity differentials » Term structure of interest rates − Accounts for the relationship between time and Accounts for the relationship between yield for bonds the same in every other respect Risk premium » Yield spread or yield differential » Associated with issuer’s particular situation Yields on Long­Term Bonds Yields on Long­Term Bonds Yield Spreads on 10­year Bonds Yield Spreads on 10­year Bonds Bond Ratings Bond Ratings Rating companies − Moody’s Investor Service Moody’s − Standard and Poor’s Standard − Fitch Fitch Rating categories − Investment grade Investment − Speculative grade Speculative Definitions of Each Bond Rating Class Definitions of Each Bond Rating Class Factors Used by Rating Companies Factors Used by Rating Companies Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt Protection Against Default Protection Against Default Sinking funds Subordination of future debt Dividend restrictions Collateral Credit Default Swaps Credit Default Swaps Credit default swap (CDS): insurance policy on the default risk of a bond or loan Seller collects an annual premium (and sometimes an upfront fee) from swap buyer If bond issuer or borrower defaults, seller pays drop in value from par Credit Default Swaps Credit Default Swaps Credit Default Swaps Credit Default Swaps New regulations on CDS ◊ CDS contracts will be traded on exchanges with collateral requirements to limit risk. ◊ Exchange trading will increase transparency Measuring Bond Yields Measuring Bond Yields Current yield » Ratio of coupon interest to current market price Yield to maturity » Compound rate of return » Equates PV of expected future CFs to initialinvestment Yield to call » Assumes bond is called at end of deferred call period Yield to Maturity Yield to Maturity T P B= ∑ t= 1 C t T + Par Value T T (1+ y ) (1+ y ) Yield to Maturity Yield to Maturity Investors earn the YTM if the bond is held to maturity and all coupons are reinvested at YTM YTM Example Problem YTM Example Problem Suppose you invest in a bond that has a $1000 par value and pays 10% coupon rate (paid annually). If you paid face value for the bond and the bond has a maturity of five years, what is your yield to maturity? What is your yield if you paid $900? What is your yield if you paid $1200? Yield to Call Yield to Call Yield to a specified call date and call price Substitute number of periods until first call date for T and call price for par value C Coupon t Call Price P=∑ + t (1 + YTC) C t =1 (1 + YTC) YTC Example Problem YTC Example Problem Suppose you invest in a bond that pays a 6% coupon rate (paid semiannually) and has a 30­year maturity. The bond is currently selling for $1200 and is callable in 10 years at a call price of $1150. What is the yield to call? Reinvestment Risk Reinvestment Risk Reinvestment rate risk means that coupons may be reinvested at various rates Interest on interest is the income earned on the reinvestment of intermediate cash flows Interest on interest significantly affects the total dollar return from a bond A zero coupon bond eliminates reinvestment rate risk Realized Compound Yield Realized Compound Yield Rate of return actually earned on a bond given the reinvestment of the coupons at varying rates Can only be calculated after investment period is over RCY Example Problem RCY Example Problem Assume we paid $900 for a 10% bond (semiannual coupons), with a 20­year maturity. If we were able to reinvest our payments at 12%, what was our realized compound yield? Bond Quotes Bond Quotes Example: IBM 9s26 par value = $1000 coupon = 9% of par value per year = $90 per year ($45 every 6 months (due to s)) maturity = in 2026 so 15 years Issued by IBM Treasury Quotes Treasury Quotes 8 Nov 27 125:05 125:11 ­46 5.86 ­ What is the coupon rate on the bond? ­ ­ ­ ­ When does the bond mature? What is the bid price? What is the ask price? How much did the price change from the previous day? ­ What is the yield based on the ask price? ...
View Full Document

This note was uploaded on 12/10/2011 for the course FIN 401 taught by Professor Staff during the Spring '08 term at Miami University.

Ask a homework question - tutors are online