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Increase in bond issues will lead to drop in bond prices and increase yield
Required return on debt(not bonds)= Real Risk Free + Inflation premium + Default risk premium +
liquidity premium + maturity risk premium (interest rate fluctuation)
- Real Rf=same
- IP=depends
- DRP=depends
- LP=depends(unlikely to change)
- MRP=Increases
Term structure of ir show relationship between yield and maturity (not time)
- Risk
- Production opportunities
- Expected inflation
- Time preferences for consumption
TVM
When using NPV in multiple changes in conditions, imagine drawing out the money and putting it in
again in the bank STANDARDISE USE “-“ for withdrawal and “+” deposit into a interest bearing
account
When the question has funny cash flow, break it down to EAR of FV of each year and analyse each
year’s cash flow
The difference in arears and advance, is the interest rate. Since default is arears, if transaction is in
advance, PV and FV will multiple by interest, PMT divide (arears ordinary annuity, advance is
annuity due)
1) Every payment has an interest rate occurrence thus when we need to calculate a annually
compounded, monthly paid scheme, we need to find the YTM and divide by 12 then you know
the effective interest rate. YTM can be divided and not rooted because there is no
compounding involved monthly but only annually
2) When there is annual compounding with monthly payment. Find the compoundable monthly
rate. i.e. the norminal interest rate for monthly, the interest rate should be able to be
compounded to the EAR of the annual compounding rate. Use that norminal interest rate as
periodical interest rate.
3) Nominal ratepayment EARcompounding
Bonds
Callable bonds company call @ par value (if interest drops, price rise, company call to refinance at
cheaper price)
Sinking fund the issuer of the bond has to recall a percentage of bonds annually, be it recalling it at
face value or buying it at market value (it kinda protect the bondholders?)
Nominal interest ratenot effective, compounding follows coupon issue period unless otherwise
states
High coupon high reinvestment risk, low interest rate risk, the other way for low coupon
Shorter duration is like high coupon high reinvestment risk, low interest rate risk
Call provision call premium to compensate the reinvestment risk that investors suffer
However, Low credit rating DRP will increase much more than the inflation rate decreases
nature of default risk premium is very different from inflation premium
High credit rating DRP don’t drop that much in fact when bear sterns’ hedge funds start to
implode, 10 yr bond yield drop from 5- 3.5%
Portfolio
Required rate of return ri = rRF + (rM – rRF) bi stock risk premium
SML is different from regression of Rm and Ri because Regression of the curve to find the beta of
the stock. SML is the universal line for the market at the moment
Total risk(stand alone risk) is standard deviation
2 methods weighted average beta(only if it is at equilibrium) or return to find the expected return
of the portfolio
Equity
Stock price is expected to grow at dividend growth rate (cause of Gordon growth model and Cost of
Equity=Dividend yield+ capital yield)
To calculate if the stock is undervalue or overvalue (check the intrinsic value through Gordon growth
value)
When calculating the stock’s expected return RMB use capital gains(assume go back to next year’s
intrinsic value) + dividend gains
Strong market efficiency no abnormal returns some times security has different value from
intinsic
TERMS
Nominal interest rate Not effective, it’s the one that can be divisible to periodic