Rating agencies provides information about default

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Unformatted text preview: rsity, Fall 2013 37 Rating and cost of debt finance for rating classes (2003) Rating Default spread Market interest AAA AA A+ A ABBB BB+ BB B+ B BCCC CC C D 0.35% 0.50% 0.70% 0.85% 1.00% 1.50% 2.00% 2.50% 3.25% 4.00% 6.00% 8.00% 10.00% 12.00% 20.00% 4.35% 4.50% 4.70% 4.85% 5.00% 5.50% 6.00% 6.50% 7.25% 8.00% 10.00% 12.00% 14.00% 16.00% 24.00% Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 38 Terminology Market interest=risk free rate + default spread Remark - The lower the rating, the higher the interest rate, the lower the price of the bond. - For a given payment scheme, a firm with a low rating receive less money when issuing bonds. The cost of capital is high. Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 39 Example (Bond Finance) Firm that issues the following AAA rated bonds can obtain 131.45. 10 110 r 0.04 : PV 131.45 t 6 t 1 (1 r ) (1 r6 ) 1 5 Firm that issues C rated bonds (junk bonds) can obtain 66.74 10 110 r 0.2 : PV 66.74 t 6 t 1 (1 r ) (1 r6 ) 1 5 Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 40 I.1.C. Bond arbitrage Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 41 Remark This section provides some illustrative examples of bond stripping and bond arbitrage. The next section develops the theory and some general principles for doing arbitrage trading. Corporate Finance, Tri Vi Dang, Columbia University, Fall 2013 42 Bond Stripping t=1 t=2 Bond A 10 10+100 Bond B 20 20+100 Question How can you generate a...
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