16_FixIncome - Introduction to the Valuation of Debt...

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Introduction to the Valuation of Debt Securities: - Three Step Process o Estimate the Cash flows o Determine the appropriate rates o Calculate the PV - Accrued Interest assuming semiannual payments is calculated as follows: o AI=(Annual Coupon x Days in AI Period)/ (2 x Days in coupon period) - Yield on discount basis = (1-p)x(360/Nsm) - Arbitrage-Free Valuation Approach: Value of the treasury bonds based on Treasury spot rates must be equal to the value of the “parts” (i.e., the sum of the present values of all the expected cash flows). o Reconstitution is the opposite process of stripping a coupon bond Yield Measures, Spot Rates and Forward Rates - Sources of return o Coupon Interest Payment o Capital Gain o Income from reinvestment of interim cash flows - Traditional Yield Measures: o Current Yield: Annual Dollar Coupon Interest/Price. Current yield will be greater than coupon rate, when the bond sells at a discount. o Yield to Maturity Limitations to YTM is that it not only considers the coupon income but any capital gain or loss that the investor will realize by holding the bond to maturity. It does consider reinvestment income. However, it assumes that the coupon payments can be reinvested at an interest rate equal to the YTM. It also assumes that the bond will be held to maturity. o Discount: Coupon Rate < Current Yield < Yield to Maturity o Premium: Coupon Rate > Current Yield > Yield to Maturity o Doubling the semi-annual yield is the bond equivalent yield o Factors affecting reinvestment risk: For a given YTM and a given non-zero coupon rate, the longer the maturity, the more the bond’s total dollar return depends on reinvestment income to realize the YTM at the time of purchase. For a coupon paying bond, for a given maturity and a given YTM, the higher the coupon rate, the more dependent the bond’s total dollar return will be on the reinvestment of the coupon payments in order to produce yield to maturity at the time of purchase. o Yield to Call: Yield to call assumes that the issuer will call a bond on some assumed call date and the call price is the price specified in the call schedule. Yield to refunding is used when the bonds are currently callable but have some restrictions on the sources of funds used to buy back the debt when a call is exercised.
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o Yield to Put: The interest rate that will make the present value of the cash
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This note was uploaded on 02/25/2012 for the course MGMT 3303 taught by Professor Staff during the Fall '10 term at Texas State.

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16_FixIncome - Introduction to the Valuation of Debt...

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