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Long – purchase b/c price low
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Short – borrow and then sell b/c price high
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Prepayable bonds – pay off principal. Callable = pay the call price =
principal + $ (some fee). L.s lose int income at bad times (b refinance)
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Putable bond – L.s redeem bond early. B lose funding at bad
times.
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TIME VALUE OF MONEY
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Discounting (Compounding int):
PV = FV / (1 + r)^n
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r is the int rate corresponding to the CF frequency
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Annual Percentage Rate =
APR = (1 + r/n)^n
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Bond – an instrument that gives you a series of CFs
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Annuity – series of equal payments
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=
(C / r) [1 – (1 / (1 + r)^n)]
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Bond Pricing – 2 components: All coupons (annuity formula) & principal
pmt (discount using the 6mo int rate)
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i.e. 2yr bond, Face =1000, 6% p.a. s.a., discount rate=8% p.a. s.a
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Coupons: (30 / 0.04) [1 – (1 / (1 + 0.04)^4)] = 108.90
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Principal = 1000 / (1 + 0.04)^4 = 854.80
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Bond price = 108.90 + 854.80 = 963.70
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Perpetuity – an annuity that goes on forever
= C / r
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TREASURY SECURITIES
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Tsecurities – what the US govt sells to the capital mkts to borrow M.
Most actively traded. Avg trading vol 10x higher than that of all equities
listed on the NYSE. Exempt from state/ local taxes in all but interest.
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Tbills – mature in < 1 yr, no coupons. The equivalent to yields –
“discount rate”
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P = FV*[1 –((# days until maturity / 360)*discount rate)]
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Suggests an int rate = FV / P
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APR = (FV / P) * (365 / # days until maturity)
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Bond equivalent yield
: convert APR to s.a. compounding to compare
P = (1 + APR)^(183 / # days until maturity)
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Tnotes – mature in </= 10 years, s.a. coupons
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Tbonds – mature in </= 30 years, s.a. coupons
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TIPS (Tresury Inflation Protected Securities) – like bonds/ notes in all
regards except that the FV adjusted every year to catch up w/ inflation
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Alt to buying tnote = lending to a “very good” bank. But not exactly b/c
banks not as trustworthy, have to borrow at higher rate than govt.
Therefore, using banks rate to discount CFs from the govt will
underestimate bond prices
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BOND PRICES and INT RATES (YIELDS) move in OPP directions
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When yield = coupon rate, P = par value, bond = trading at par
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When yield > coupon rate, P < par value, bond = trading at discount
to par, bond relatively less attractive (than bank)
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When yield < coupon rate, P > par value, bond = trading at premium
to par, bond relatively more attractive (than bank)
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Discount rate = yield to maturity
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YTM isn’t the return on your bond. The return on a bond is a func of
today’s bond P and future bond P and how you can reinvest your coupons.
YTM
 gives you today’s bond P
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Fed – where banks put their cash reserves. Must set aside at least 10% of
their demand deposits.
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Feds fund rate – the overnight rate that banks charge each other. Banks
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 Fall '11
 Staff
 Finance

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