Lecture_14_

Lecture_14_ - FixedIncomeSecurities (contd)...

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Fixed-Income Securities (cont’d) Professor Ruslan Goyenko
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Locking in future interest rates  con’d One can use bonds to lock in future interest rates Example: Suppose a 3 year zero-coupon bond A  is selling for $900, and a 7  year zero-coupon bond  B is selling for $600 (face values are $1,000). How  could you lock in a borrowing rate between years 3  and 7 for $10,000 borrowed at time 3? What would that borrowing rate be? How much would  you owe at t = 7?
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Callable Bonds and Their  Investment Characteristics v The presence of a call option results in two disadvantages to the bondholder: i. callable bonds expose bondholders to reinvestment risk ii. price appreciation potential for a callable bond in a declining interest-rate environment is limited v If the investor receives sufficient potential compensation in the form of a higher potential yield, an investor would be willing to accept call risk.
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Callable Bonds and Their Investment  Characteristics  (continued) v Price-Yield Relationship for a Callable Bond o The price–yield relationship for an option-free bond is convex. o The reason for the shape of the price–yield relationship for the callable bond is as follows. When the prevailing market yield for comparable bonds is higher than the coupon interest, it is unlikely that the issuer will call the bond. o If a callable bond is unlikely to be called, it will have the same convex price–yield relationship as a noncallable bond when yields are greater than y*.
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 Price-Yield Relationship for a Noncallable and  Callable Bond Price Yield y * b Noncallable Bond a’ - a a’ a Callable Bond a - b
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Callable Bonds and Their  Investment Characteristics  (continued) v Price-Yield Relationship for a Callable Bond o As yields in the market decline, the likelihood that yields will decline further so that the issuer will benefit from calling the bond increases. o The exact yield level at which investors begin to view the issue likely to be called may not be known, but we do know that there is some level, say y *. o At yield levels below y *, the price-yield relationship for the callable bond departs from the price-yield relationship for the noncallable bond. o For a range of yields below y *, there is price compression–that is, there is limited price appreciation as yields decline. o The portion of the callable bond price-yield relationship below y * is said to be negatively convex.
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 Decomposition of a Price of a Callable Bond Price Yield y ** b Noncallable Bond a’ - a a’ a Callable Bond a - b y * PNC B PC B Note: At y** yield level: PNCB = noncallable bond price PCB = callable bond price PNCB - PCB = call option price
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Fall 2010 Investment Management,  8 The Shape of the Yield Curve 1. The Expectations Hypothesis   Ø http://stockcharts.com/charts/yieldcurve.html Ø The  expectations  hypothesis  of  the  term  structure  of  interest  rates  states  that  forward 
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Lecture_14_ - FixedIncomeSecurities (contd)...

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