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Finance 100
Prof. Michael R. Roberts
Topic Overview
Introduction to bonds and bond markets Zero coupon bonds
Valuation Yield-to-Maturity & Yield Curve Spot Rates Interest rate sensitivity DVO1 Valuation Arbitrage Bond Prices Over Time Yield Curve Revisited Interest rate sensitivity Duration & Immunization
Coupon bonds
Forward Rates
Copyright Michael R. Roberts
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Coupon =
Repayment Schemes
Bonds with a balloon (or bullet) payment
Coupon bonds
Pay a stated coupon at periodic intervals prior to maturity.
Floating-rate bonds
Pay a variable coupon, reset periodically to a reference rate.
Perpetual bonds
Pay a stated coupon at periodic intervals.
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T-bills: 4,13,16-week maturity, zero coupon bonds T-notes: 2,3,5,10 year, semi-annual coupon bonds T-bonds: 20 & 30-year, semi-annual coupon bonds TIPS: 5,10,20-year, semi-annual coupon bond, principal -adjusted Strips: Wide-ranging maturity, zero-coupon bond, IB-structured
Corporations
4 types: notes, debentures, mortgage, asset-backed ~30 year maturity, semi-annual coupon set to price at par Additional features/provisions:
Callable: right to retire all bonds on (or after) call date, for call price convertible bonds putable bonds
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Bond Ratings
Moodys Aaa Aa A Baa Ba B Caa Ca C D S&P AAA AA A BBB BB B CCC CC C Quality of Issue Highest quality. Very small risk of default. High quality. Small risk of default. High-Medium quality. Strong attributes, but potentially vulnerable. Medium quality. Currently adequate, but potentially unreliable. Some speculative element. Long-run prospects questionable. Able to pay currently, but at risk of default in the future. Poor quality. Clear danger of default. High speculative quality. May be in default. Lowest rated. Poor prospects of repayment. In default.
Dollar volume of bonds traded daily is 10 times that of equity markets! Outstanding investment-grade dollar denominated debt is about $8.3 trillion (e.g., treasuries, agencies, corporate and MBSs
Copyright Michael R. Roberts
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m = 2,)
Two cash flows to buyer of a zero coupon bond (a.k.a. zero): What is the price of a bond?
V0 = B 0 = F
(1 + r )
F or V0 = B0 = N 1 + i) (
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Yield to Maturity
The Yield to Maturity (YTM) is the one discount rate that sets the present value of the promised bond payments equal to the current market price of the bond Doesnt this sound vaguely familiar ? Example: Zero-Coupon Bond
V0 = F
(1 + r )
F r= V0
1/ T
1 = YTM = y
(1 + IRR )
F IRR = V0
1/ T
1 = YTM = y
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The term structure of interest rates is the series of spot rates r1, r2, r3, relating interest rates to investment term The yield curve is just a plot of the term structure: interest rates against investment term (or maturity)
Zero-Coupon Yield Curve: built from zero-coupon bond yields (STRIPS) Coupon Yield Curve: built from coupon bond yields (Treasuries) Corporate Yield Curve: built from corporate bond yields of similar risk (i.e., credit rating)
Term Structure of Risk-Free U.S. Interest Rates, January 2004, 2005, and 2006
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Generally speaking, we must use the appropriate discount rate for each cash flow:
PV = C1 C2 + + 1 + r1 (1 + r2 ) 2 + CN = (1 + rN ) N
n =1
CN (1 + rn ) n
A Cautionary Note
All of our valuation formulas (e.g., perpetuity, annuity) assume a flat term structure.
I.e., there is only one discount rate for cash flows received at any point in time
Recall:
Growing Annuity:
PV = C
Growing Perpetuity:
1 (r g )
PV =
N 1 + g 1 (1 + r )
C (r g )
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(1 + i )
The price of a zero-coupon bond maturing in one year from today with face value $100 and an APR of 10% is:
V0 = 100
(1 + 0.10 )
= $90.91
Example: Now imagine that immediately after you buy the bond, the interest rate increase to 15%. What is the price of the bond now ?
Note 4 things: 1. Bond prices are inversely related to IR 2. Fix the interest rate: Longer term bonds are less expensive 3. Longer term bonds are more sensitive to IR changes than short term bonds 4. The lower the IR, the more sensitive the price.
Copyright Michael R. Roberts 18
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(1 + i )
Alternatively, we can just compute the prices at two different interest rates and look at the difference: B0(i) B0 (i+0.0001)
(1 + 0.1025)
V0 =
(1 + 0.1025)
(1 + 0.1025 )
(1 + 0.1025 )
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Replication
Can we construct the same cash flows as our amortization bond using other securities?
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120 1045
] + [Zero ]
1 (1 + i ) N F = c N + ( i 1 + i)
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A bond sells at a premium if its coupon rate is above the interest rate. A bond sells at a discount if its coupon rate is below the interest rate.
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B=
c 1 1 yield / m (1 + yield / m )N
F + (1 + yield / m )N
This is not the annualized yield, which equals yield* = ( 1 + yield / m)m-1 E.g., IRR function in excel or your calculator since:
B=
c 1 1 yield / m (1 + yield / m )N
F + (1 + yield / m )N
Copyright Michael R. Roberts 28
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A small uniform change dy across maturities might by 1 basis point. Duration gives the proportionate decline in value associated with a rise in yield Negative sign is to cancel negative first derivative
Alternatively, given a duration DB of a security with price B, a uniform change in the level of interest rates brings about a change in value of dB = DB dy B
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More on Duration
Duration is a linear operator: D(B1 + B2) = D(B1) + D(B2)
The duration of a portfolio of securities is the value-weighted sum of the individual security durations DVO1 is also a linear operator
Duration of a zero is
D = (1 + y / m )
1
N m
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How much money should the bank hold in CP and Notes in order to get a liability duration of 1.25? How should the bank alter their liabilities to achieve this structure ?
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Forward Rates
A forward rate is a rate agreed upon today, for a loan that is to be made in the future. (Not necessarily equal to the future spot rate!)
f2,1=7% indicates that we could contract today to borrow money at 7% for one year, starting two years from today.
When are these two payoffs equal? (i.e. what is the implied forward rate?)
Copyright Michael R. Roberts 37
Forward Rates
Strategy #1: Invest $100 for three years have ? how much do we
Strategy #2: Invest $100 for two years and then reinvest the proceeds for another year at the one year forward rate, two periods hence how much do we have ?
When are these two payoffs equal? (i.e. what is the implied forward rate?) ?
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Step 3: Given your answer to Step 2, what is the first step in taking advantage of the mispricing ?
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Time 0
3
Copyright Michael R. Roberts 41
Summary
Bonds can be valued by discounting their future cash flows Bond prices change inversely with yield Price response of bond to interest rates depends on term to maturity.
Works well for zero-coupon bond, but not for coupon bonds
Measure interest rate sensitivity using duration. The term structure implies terms for future borrowing:
Forward rates Compare with expected future spot rates
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