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Unit 7 (Chapter 10) Bond Prices and Yields

Unit 7 (Chapter 10) Bond Prices and Yields. MBA 536 Spring 2012. Characteristics Of All Debt Instruments. Interest (coupons) and maturity value ($1000 for corporate bonds). Indenture Agreement, Loan contract between lender and borrower.

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Unit 7 (Chapter 10) Bond Prices and Yields

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  1. Unit 7 (Chapter 10)Bond Prices and Yields MBA 536 Spring 2012

  2. Characteristics Of All Debt Instruments • Interest (coupons) and maturity value ($1000 for corporate bonds). • Indenture Agreement, • Loan contract between lender and borrower. • Appoints the trustee; a fiduciary responsible for guarding the lenders' interests. • Terms and conditions, legal remedies. • Sources of risk • Default = probability of not getting all of the promised interest and principal. • Price fluctuations = changes in prices as interest rates change over time. • Loss of purchasing power = effects on inflation on coupon income. • Reinvestment rate risk

  3. Principal Categories of Bonds • Corporate • Mortgage (collateralized) • Debentures (uncollateralized) • Convertibles • Commercial Paper, Notes, Bonds • US Treasury • Bills, Notes, Bonds • Interest exempt from state taxation • Municipals • Revenue, Development, Tax Anticipation • Interest exempt from Federal taxes

  4. Bond Values And Bond Yields • Valuation Model Vb = Coupon * PVIFA + Face Value * PVIF • Coupon Yield • Current yield = coupon ÷ price (PV) • Yield to maturity (YTM) • Yield to First Call (YTC)

  5. Five Bond Pricing Theorems • Bond prices moveinversely to changes in interest rates • The longer the maturity of a bond, the more price sensitive the bond • The price sensitivity of bonds to changes in interest rates increases as maturity increases, but at a decreasing rate • Bonds with lower coupons are more price sensitive • Yield decreases have a greater impact on bond prices than similar yield increases

  6. start here 3/20 FINANCIAL CALCULATORS & BOND PRICES • The value of a bond (VB) is a combination of a present value of an annuity (the present value of the coupons to be received) and the present value of the face value of the bond. • VB = $Coupon * PVIFA + $Face * PVIF

  7. General Observations on Bonds • When bonds sell at prices greater than their maturity or Face values, the are said to be selling at a premium. • When bonds sell at prices less than their maturity or Face values, the are said to be selling at a discount. • When bonds sell at prices equal to their maturity or Face values, the are said to be selling at a par.

  8. TERM STRUCTURE OF INTEREST RATES • Factors Influencing Interest rates. • Federal Reserve Monetary Policy. • Investor expectations about economy. • Inflation expectations. • Business Decisions.

  9. Unit 7: Chapter 11Managing Bond Portfolios MBA 536 Spring 2012

  10. Student Learning Objectives • Sources of Risk • Managing risk: Duration • Passive bond portfolio management • Active bond management strategies

  11. SOURCES OF RISKS FOR BONDS • Interest Rate Risk • Bond prices move inversely with interest rates, rates risk • The value of the bond declines • Opportunity cost • All bonds expose investors to interest rate risk, but some have more than others

  12. SOURCES OF RISKS FOR BONDS • Reinvestment Risk • Most bonds pay coupon interest • Must reinvest these coupons • If interest rates decline, the actual return will be less than the promised return • Interest rate risk and reinvestment risk tend to offset one another • Immunization techniques attempt to strike a balance between the two

  13. SOURCES OF RISKS FOR BONDS • Purchasing Power Risk • Impact on cash flows of inflation • Must earn at least the rate of inflation to stay “even” • What if actual inflation exceeds the expected inflation? • Rising inflation means higher interest rates

  14. DURATION • Duration measures the relative price sensitivity of bonds to interest rate changes. • Duration is a function of a bond’s coupon rate, time to maturity and yield to maturity; duration: • Duration increases as the coupon rate decreases • Duration increases as the time to maturity increases • Duration decreases as yield to maturity increases • The longer the duration of a bond, the more sensitive its price to a given change in interest rates. • Adjustments to duration of a portfolio based on expectations of interest rate trends. • Swapping high-coupon short-maturity onds for low-coupon long-maturity bonds.

  15. Actively Managed Bond Portfolios • Actively managed bond portfolios require the investor to estimate: • interest rate trends (rising, falling) • interest rate volatility • yield spreads • foreign exchange rates (for transactions denominated in a foreign currency)

  16. Actively Managed Bond Portfolios • Actively managed bond portfolios require the investor to estimate: • interest rate trends (rising, falling) • interest rate volatility • yield spreads • foreign exchange rates (for transactions denominated in a foreign currency)

  17. Actively Managed Bond Portfolios • Interest Rate Expectations Strategies • As interest rate rise, bond prices fall • short maturity bonds (or bills) are preferred. • As interest rate fall, bond prices rise • long maturity bonds preferred.

  18. Actively Managed Bond Portfolios • Riding the Yield Curve • Strategy based on interest rate expectations • Upward-sloping yield curve not expected to change in shape nor slope. • Yields will fall as bonds “ride the yield curve” downward, increasing the return. • Return = coupon yield plus capital gain • Change in bond prices induce positive returns. • Magnitude of gains a function of convexity. • Changes in shape and slope over time provides profit opportunities if correctly anticipated. Changes in slope: curve gets flatter or steeper (convexity).

  19. Actively Managed Bond Portfolios • Yield Spread Strategies • Risk premiums vary between quality levels of bonds over time • Change the composition of a bond portfolio based on expected changes in yield spreads • Foreign Exchange Strategies • Based on expected changes in foreign interest and/or exchange rates • If no change is expected, may switch to foreign bonds for higher yields • Strategies are complex since interest rates are major determinant of foreign exchange rates

  20. Actively Managed Bond Portfolios • Bond Swaps • Technique for managing bond portfolio by selling some bonds and buying others • Possible benefits achieved: • tax treatment • yields • maturity structure • trading profits

  21. Passively Managed Bond Portfolios • Passive Strategies Seek To Control The Risk Of A Bond Portfolio: • Indexing strategies to replicate the performance of broad market indexes. • Immunization strategies to reduce the risks from fluctuations in interest rates.

  22. Passively Managed Bond Portfolios • Indexing Bond Portfolios • Recognize the difficulty of an actively managed portfolio consistently outperforming the overall market • Indexing reduces transaction costs and management expenses • Indexing does not guarantee funds availability at specific times • Tracking error is a way of assessing how well an index fund replicates the benchmark

  23. Passively Managed Bond Portfolios • Immunization Strategies • Seek to reduce interest rate risk and reinvestment risk • Selection of strategy based on the risk requiring protection • Horizon date immunization [HD = Du] • Cash flow matching [HDt = Dut] • Net worth immunization [Du A = Du L]

  24. Break Time

  25. CHAPTER 19 GLOBALIZATION & INTERNATIONAL INVESTING

  26. GLOBAL MARKETS • Developed Countries • OECD (34) • Market Cap – GDP per capita • Emerging Markets • BRIC • FTSE: advanced, secondary • TIMBI (Turkey, India, Mexico, Brazil, Indonesia)

  27. RISK FACTORS IN INTERNATIONAL INVESTING • Exchange Rate Risk • Differential rates of return local currency vs. translation into USD. • Solving the Interest Rate Parity problem (or Covered Interest Arbitrage) • Inability to form perfect hedges.

  28. RISK FACTORS IN INTERNATIONAL INVESTING • Country Risk • Political Risk: stability of government, local ethnic conflicts, legal structures • Financial Risk: convertibility of currency, ability to repatriate profits, exchange controls • Economic Risk: GDP per capita levels, domestic inflation rates, current account balance • Emerging markets riskier than developed markets.

  29. RISK FACTORS IN INTERNATIONAL INVESTING • COVERED INTEREST ARBITRAGE • How can we take advantage of differences in interest rates to earn risk free returns? • Examine the relationship between spot rates, forward rates, and nominal rates between 2 countries • Again, the formulas will assume that the exchange rates are quoted in terms of foreign currency per U.S. dollar • The U.S. risk-free rate is assumed to be the T-bill rate

  30. COVERED INTEREST ARBITRAGEEXAMPLE • Consider the following information • S0 = .8 Euro / $ RUS = 4% • F1 = .7 Euro / $ RE = 2% • What is the arbitrage opportunity? • Borrow $100 at 4% • Buy $100 (.8 Euro/$) = 80 Euro and invest at 2% for 1 year • In 1 year, receive 80(1.02) = 81.6 Euro and convert back to dollars • 81.6 Euro / (.7 Euro / $) = $116.57 and repay loan • Profit = 116.57 – 100(1.04) = $12.57 risk free

  31. RISK FACTORS IN INTERNATIONAL INVESTING • INTEREST RATE PARITY • Based on the previous example, there must be a forward rate that would prevent the arbitrage opportunity. • Interest rate parity defines what that forward rate should be • Short-Run Exposure • Risk from day-to-day fluctuations in exchange rates and the fact that companies have contracts to buy and sell goods in the short-run at fixed prices • Managing risk • Enter into a forward agreement to guarantee the exchange rate • Use foreign currency options to lock in exchange rates if they move against you, but benefit from rates if they move in your favor

  32. EVALUATING OPPORTUNITIES TO INVEST/DIVERSIFY • Level of infrastructure development • Investment Opportunity Set: Natural resources, consumer goods, capital goods/services • Emerging markets offer higher returns and more risk.

  33. INTERNATIONAL INVESTMENT PERFORMANCE • Active investors more likely to do well than passive investors • Additional competencies required: e.g., Currency exchange, key source of risk. • Importance of Benchmarks • How do we know when we are doing well? • Identify best opportunities by country.

  34. INTERNATIONAL INVESTMENT PERFORMANCE • Key Consideration Factors • Currency: convertibility and exchange rate stability • Country: political stability, transparent legal structure • Investment Selection: company performance versus relevant index.

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