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FINC4101 Investment Analysis

FINC4101 Investment Analysis. Instructor: Dr . Leng Ling Topic: Bond Pricing and Yields. Learning objectives. Compute the price of a zero-coupon bond. Compute the price of a fixed coupon bond. Describe the price-yield relationship of bonds.

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FINC4101 Investment Analysis

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  1. FINC4101 Investment Analysis Instructor: Dr. Leng Ling Topic: Bond Pricing and Yields

  2. Learning objectives • Compute the price of a zero-coupon bond. • Compute the price of a fixed coupon bond. • Describe the price-yield relationship of bonds. • Distinguish between a bond’s flat price and its invoice price. • Compute different measures of bond returns. • Calculate how bond prices will change over time for a given interest rate projection. • Recognize default/ credit risk as a source of risk for bonds. • Identify the determinants of bond safety and rating. • Understand how default risk can affect yield to maturity.

  3. Portfolio Theory Foreign Exchange Asset Pricing FI4000 Equity Derivatives Fixed Income Market Efficiency Concept Map

  4. Types of fixed-income securities Fixed-income security / bond: • A security that obligates the issuer to make specified payments to the holder over a period of time. • We focus on the pricing of two types of fixed-income securities: • Fixed-coupon bond (FCB) • Zero-coupon bond (ZCB)

  5. Fixed-coupon bond (FCB) 1 • Firm pays a fixed amount of interest (‘coupon payment’) to the investor every period until bond matures. • At maturity, firm pays face value of the bond to investor. • Face value also called par value. Unless otherwise stated, always assume face value to be $1000. • Period: can be year, half-year (6 months), quarter (3 months). • Coupon rate: annual coupon payment as a fraction of face value.

  6. How to ‘read’ a fixed-coupon bond: Example • A firm issues an 8% 30-year bond with annual coupon payments. Par value is $1,000. What does the above tell us? • 8%: the coupon rate. • Multiply coupon rate by par value to get annual coupon payment. Coupon= 8% x 1,000 = $80. • Maturity = 30 years. • Coupon of $80 is paid annually, i.e., period=annual. • At maturity (end of 30 years), firm will pay $1000 to investor. • What happens if coupon is paid semi-annually? Quarterly?

  7. Fixed-coupon bond (FCB) 2 • FCB gives you a stream of fixed payments plus a single payment (face value) at maturity. • This cash flow stream is just an annuity plus a single cash flow at maturity. • Therefore, we calculate the price of a FCB by finding the PV of the annuity and the single payment, using an appropriate interest rate. • We use the financial calculator to compute the price of the FCB.

  8. Fixed-coupon bond (FCB) 3 Reminder: • The “interest rate” used to find the PV of a bond is also known as: • Yield-to-maturity (“YTM” or “yield” for short) • Discount rate • Required rate of return • Cost of debt

  9. Fixed-coupon bond (FCB) 4 Price of the FCB, PFCB Fixed periodic coupon Number of periods to maturity Face value Yield to maturity (in decimals)

  10. Find FCB price • Consider an 8%, 30-year coupon bond that pays coupons semi-annually. Compute the bond’s price if the yield to maturity is a) 6%, b) 8%, c) 10%. • If YTM = 6%, verify that bond price = $1,276.76 • If YTM = 8%, verify that bond price = $1000. • If YTM = 10%, verify that bond price = $810.71

  11. Inverse relationship between price & interest rate • Notice that as YTM (interest rate) increases, bond price decreases. Conversely, as YTM decreases, bond price increases. • This is the inverse relationship between bond price and yield to maturity (interest rate). • This is a crucial general rule in bond pricing based on time value of money.

  12. Figure 9.3 The Inverse Relationship Between Bond Prices and Yields

  13. US Treasury Note and Bond Quotes, Figure10.1

  14. Invoice price, Flat price, Accrued interest when you buy or sell a bond between coupon payment dates, the invoice price must incorporate accrued interest. Invoice price = Flat price + Accrued interest (actual price paid by buyer) (price quoted in the financial press) • For a semi-annual payment bond, accrued interest between two coupon payment dates =

  15. example • Suppose the coupon rate is 8%, face value is $1000 and coupon is paid semiannually. 30 days have passed since the last coupon payment. The quoted price is 990. What is the invoice price? 990+(1000*8%/2)*(30/182) =990+6.59 =996.59

  16. Exercise • Suppose the coupon rate is 10%, face value is $1000 and coupon is paid semiannually. 125 days have passed since the last coupon payment. The asked quote is 100:11. What is the invoice price that the investor has to pay?

  17. Corporate Bonds Figure 10.2

  18. Find YTM, Coupon rate 1)A $1,000 par value bond sells for $863.05. It matures in 20 years, has a 10 percent coupon rate, and pays interest semi-annually. What is the bond’s yield to maturity on a per annum basis (to 2 decimal places)? Verify that YTM = 11.80% 2) ABC Inc. just issued a twenty-year semi-annual coupon bond at a price of $787.39. The face value of the bond is $1,000, and the YTM is 9%. What is the annual coupon rate (in percent, to 2 decimal places)? Verify that annual coupon rate = 6.69% What happens if bond pays coupon annually? Quarterly?

  19. Zero-coupon bond (ZCB) 1 • Zero coupon rate, no coupon paid during bond’s life. • Bond holder receives one payment at maturity, the face value (usually $1000). • Price of a ZCB, PZCB F = face value of the bond N = number of periods to maturity Yield to maturity (in decimals)

  20. Zero-coupon bond (ZCB) 2 • As long as interest rates are positive, the price of a ZCB must be less than its face value. • Why? With positive interest rates, the present value of the face value (i.e., the price) has to be less than the face value.

  21. These problems are just basic TVM problems where you receive a single cash flow in the future. ZCB Problems 1) Find the price of a ZCB with 20 years to maturity, par value of $1000 and a yield to maturity of 15% p.a. Assume annual compounding. N=20, I/Y=15, FV=1000, PMT=0. Price = $61.10 2) XYZ Corp.’s ZCB has a market price of $ 354. The bond has 16 years to maturity and its face value is $1000. What is the yield to maturity for the ZCB. Assume annual compounding. PV=-354, FV=1000, N=16, PMT=0. YTM = 6.71% p.a. What if semi-annual compounding?

  22. U.S. Treasury Bills (T-bills) page 24 • Short-term, issued at a discount from par value, return the par value at maturity. • The cash flow pattern looks like a ZCB. • The discount from the par value is annualized based on a 360-day year.

  23. Figure 2.2

  24. Measures of return • We measure the rate of return from investing in a bond in several ways: • Yield to maturity (YTM) • Current yield (CY) • Yield to call (YTC) • Realized compound yield (RCY) • Holding period return (HPR)

  25. Yield to maturity • The discount rate that makes the present value of a bond’s payments (coupons & par value) equal to its price. • Interpretation: it is the compound rate of return that will be earned over a bond’s life if • It is bought now and held until maturity • All coupons are reinvested at the same YTM.

  26. Annualizing YTM (1) • If coupons are paid semi-annually, then the YTM we get from the financial calculator is a six-month YTM. • We can convert this six-month YTM to an annual YTM using • Simple interest => bond equivalent yield to maturity (or bond equivalent yield for short) OR • Compound interest => effective annual yield to maturity (or effective annual yield for short)

  27. Annualizing YTM (2) • In general, if a coupon bond pays coupons m times a year, then: Bond equivalent yield = periodic YTM x m Effective annual yield = (1 + periodic YTM)m – 1 Note: periodic YTM is the value of I/Y you get from the financial calculator. Stated in decimals

  28. Annualizing YTM (3) • A 20-year maturity bond with par value $1000 makes semi-annual coupon payments at a coupon rate of 8%. Find the bond equivalent and effective annual yield to maturity of the bond if the bond price is $950. • Verify that • Bond equivalent yield = 8.53% • Effective annual yield = 8.71%

  29. Annualizing YTM (4) • Treasury bonds paying an 8% coupon rate with semi-annual payments currently sell at par value. What coupon rate would they have to pay in order to sell at par if they paid their coupons annually ?

  30. Practice 6 (1) Chapter10: 4,5,6,12,13,15,16,20,27

  31. Homework 6 • You are a US. Treasury bond dealer who trades a 4.75%, 3year, semi-annual coupon bond. Your required YTM is 0.92826126%. How should you quote your Asked price in percentage of par value as shown in Figure 10.1? • Suppose today is Oct 23, 2013. A bond with a 10% coupon paid semiannually every Feb 15 and Aug15 is listed as selling at an ask price of 102:11. if you buy the bond from a dealer today, what price will you pay for it? the coupon period has 182 days.

  32. Bond price, coupon rate & YTM (1) • A $1,000 par value bond has coupon rate of 5% and the coupon is paid semi-annually. The bond matures in 20 years and has a yield to maturity of 10%. Compute the current price of this bond. FV=1000, PMT =25, I/Y=5, N=40. CPT, then PV. PV = -571.02. Thus, price = $571.02 < par value

  33. Bond price, coupon rate & YTM (2) Go back to the bond in the last problem. • Suppose annual coupon rate = 10%. • Verify that price = $1000 = par value • Suppose annual coupon rate = 12% • Verify that price = $1,171.59 > par value. It turns out that the following property is true.

  34. Bond price, coupon rate & YTM (3)

  35. Apply what we learnt • A 10-year annual coupon bond was issued four years ago at par. Since then the bond’s yield to maturity decreased from 9% to 7%. Which of the following statements is true about the current market price of the bond? • The bond is selling at a discount • The bond is selling at par • The bond is selling at a premium • The bond is selling at book value • Insufficient information

  36. Try one more • One year ago Pell Inc. sold 20-year, $1,000 par value, annual coupon bonds at a price of $931.54 per bond. At that time the market rate (i.e., yield to maturity) was 9 percent. Today the market rate is 9.5 percent; therefore the bonds are currently selling: • at a discount. • at a premium. • at par. • above the market price. • not enough information.

  37. Current yield (1) • Annual coupon payment divided by bond price. • Measures return from coupon payments. • Shortcomings: • Ignores capital gains or losses from bond sale. • Ignores income from reinvestment of coupon payments.

  38. Current yield (2) • Consider a 6%, 15-year, semi-annual payment bond with a par value of $1000. • Compute the current yield if the yield to maturity is: (a) 7%, (b) 6%, (c) 5% Verify that • Price = $908.0398, current yield = 6.61% • Price = $1000, current yield = 6% • Price = $1104.6515, current yield = 5.43%

  39. Current yield (3) Observe that…

  40. In general, we have the following relationship between coupon rate, current yield, & YTM

  41. Quick review • A bond has a current yield of 9% and a yield to maturity of 10%. Is the bond selling above or below par value? • Is the coupon rate of the bond more or less than 9%.

  42. Yield to call (1) • Applicable only to callable bonds. • What’s a callable bond? • Bond that may be repurchased by the issuer at a specified price (“call price”) before the maturity date. • Call period: The period of time during which the issuer can repurchase the bond. • Time until call: The period of time before the issuer can start repurchasing the bond. • Motive: if interest rates fall, issuer can repurchase the bonds and issue new bonds at lower coupon rate. This lowers interest payments.

  43. Yield to call (2) • Yield to call is calculated just like the yield to maturity, except: • Time until call replaces time to maturity • Call price replaces par value Fixed periodic coupon Time until call Yield to call

  44. Yield to call (3) • A 20-year maturity bond with par value $1000 makes semi-annual coupon payments at a coupon rate of 8%. The bond is currently selling for $1,150 and is callable in 10 years at a call price of $1,100. • Compute the bond equivalent yield to call and the effective annual yield to call. • What is N? What is FV? • Verify that • Bond equivalent yield to call = 6.64% • Effective annual yield to call = 6.75%

  45. Realized compound yield (1) • Compound rate of return based on coupon payments, reinvestment income and sale price during the holding period. • Realized compound yield depends on: • Reinvestment rate: interest rate at which coupon payments are reinvested. • Holding period • YTM at the end of holding period

  46. Realized Compound Yield (2) • Realized compound yield, y • Purchase price = what you paid for the bond • Final proceeds = future value of coupon payments and reinvestment income + sale price • n = length of holding period (could be in years, half-years, quarters etc). Length of holding period

  47. Realized Compound Yield (3) • Suppose you buy a 30-year, 7.5%, annual payment coupon bond for $980 and plan to hold it for 20 years. Your forecast is that the bond’s YTM will be 8% when it is sold and that the reinvestment rate on the coupons will be 6%. Compute the annual realized compound yield.

  48. Realized Compound Yield (4) • Five years ago, XYZ Inc issued a 5% semi-annual payment coupon bond with a maturity of ten years. You buy the bond now at a price of $683.94 and plan to hold it for three years. You forecast that you can invest the coupon payments at a stated annual rate of 6.25% and that at the end of three years, the yield will be 7.75%. • What is the bond equivalent realized compound yield? (i.e., annualize using simple interest) • What is the effective annual realized compound yield? (i.e., annualize using compound interest)

  49. Yield to Maturity vs. Realized Compound Yield (1) • Consider a 7% annual payment bond with two years to maturity. The YTM is 8% right now. Compute the realized compound yield if the reinvestment rate is (a) 7%, (b) 8%, (c) 9%. • Verify that the realized compound yield is: • 7.97% < YTM • 8% = YTM • 8.03% > YTM

  50. Yield to Maturity vs. Realized Compound Yield (2) • In general, if you hold a bond to maturity, then: • RCY < YTM if reinvestment rate < YTM • RCY = YTM if reinvestment rate = YTM • RCY > YTM if reinvestment rate > YTM

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