Topic 2

Interest Rates and Debt Securities. Bonds

Valuation.
Topic 2
 Interest rates. The structure of interest rates
 Types of bonds. Pure discount bonds. Coupon bonds
 Impact of the discount rate and timing of payments on bond
valuation
 Term structure of interest rates
 Bond prices and yields. Current yield and yield to maturity.
 Relationships between coupon rate, required return, and bond
price
 Factors that impact bond value and yield.
Debt markets and interest rates
 The interest rate is
the percent charged, or paid, for the use of
money, as a percent of the total amount loaned
(borrowed).
 Interest rate is closely related to the concept
of time value of money.
 Capital markets and money markets

Capital markets Money markets

Long-term securities Short-term securities

 Key money market interest rates

Federal Funds rate – 2%

Federal reserve target (discount rate) – 2%
Prime rate – 5%
1-year Treasury bills – 2,7%

ECB refinancing rate – 0%

Key interest rate of the Central bank – 7,5%

Money market rates
 Federal funds – reserves traded among commercial banks in
amounts of $1 mln or more
 Discount rate (in Russia - key interest rate, in USA –
federal reserve rate) – the charge on loans to depository
institutions by the Federal Reserve banks (Central bank).
 Treasury bill (T-Bill) - is a short-term debt obligation
backed by the U.S. government with a maturity of less than
one year.
 Prime rate - is the interest rate that commercial banks charge
their most credit-worthy customers.
 Key interest rate in Russia
 13.09.2013—02.03.2014 — 5,5 %
 03.03.2014—27.04.2014 — 7,0 %
 28.04.2014—27.07.2014 — 7,5 %
 28.07.2014—04.11.2014 — 8,0 %
 05.11.2014—11.12.2014 — 9,5 %
Highest rate
 12.12.2014—15.12.2014 — 10,5 %
 16.12.2014—01.02.2015 — 17,0 %
 02.02.2015—15.03.2015 — 15,0 %
 16.03.2015—04.05.2015 — 14,0 %
 05.05.2015—15.06.2015 — 12,5 %
 16.06.2015—02.08.2015 — 11,5 %
 03.08.2015 — 13.06.2016 - 11,0 %
 14.06.2016 - 18.09.2016 – 10,5%
 19.09.2016 – 26.03.2017 – 10,0%
 18.09.2017 – 30.10.2017 – 8,5%
 ……………………………………………..
 From 14.09.2018 – 7.5%
International money market rates
The basic borrowing interest rate in the
international currency markets - London
Interbank Offered Rate (LIBOR) – the rate
of interest at which banks offer to lend money
to one another in the wholesale international
money markets.
More information at:
https://www.global-rates.com
 Determinants of interest rates
 Real risk-free interest rate
 Inflation rate
 Credit risk of the borrower (default risk)
 Maturity
 Liquidity.
Real and nominal interest rates
Nominal interest rate Real interest rate

• Expected (required) • Expected (required) rate

actual rate of return on of return on investments,
investments adjusted for inflation
• Actual contract rate, • Reflects real purchasing
announced (reported) for power of investment
use in practice return, not just a nominal
• Is not a true estimate of increase of cash flows
the investment return • It is a true estimate of the
(due to inflation affect) investment return
 Determinants of interest rates
Real risk-free rate
+
Inflation rate

= Nominal risk-free interest rate

Nominal risk-free rate

rrf  r  IP
Here:
rrf = Nominal risk-free rate
r* = Real risk-free rate
IP = Inflation premium
Nominal risk-free rate
 Rate of return on short-term government debt
securities, traded at the money market
 It is assumed, that short-term government debt
does not have any credit risk, liquidity risk,
maturity risk
 This rate should be the lowest interest rate at
the debt market and is used as a benchmark
for other interest rates.
Government bonds rates (Sept, 2018). wsj.com
Russian government bonds rates (Sept, 2018)
https://www.investing.com/rates-bonds/world-government-bonds
Russian government bonds rates (Sept, 2017)
US government bonds rates (Sept, 2018)
https://www.investing.com/rates-bonds/world-
government-bonds
US government bonds rates (Sept, 2017)
 Determinants of interest rates
Real risk-free rate
+ Inflation rate
= Nominal risk-free interest rate
+
Credit (default) risk
 Bond Ratings % defaulting within:
S&P and Fitch Moody’s 1 yr. 5 yrs.
Investment grade bonds:
AAA Aaa 0.00 0.00
AA Aa 0.03 0.17
A A 0.09 0.74
BBB Baa 0.23 2.54
Speculative
bonds (junk,
high-yield):
BB Ba 1.17 6.91
B B 2.14 9.28
20

CCC Caa 24.47 35.23

Bond ratings
 Russian sovereign bond ratings

https://ru.tradingeconomics.com/russia/rating
Credit ratings: Russian oil giant “Rosneft”
High-yield bonds rates over the past
five years
 Determinants of interest rates
Real risk-free rate
+ Inflation rate
= Nominal risk-free interest rate
+ Credit (default) risk premium
+ Maturity risk premium
+ Liquidity risk premium
= Nominal interest rate
 Determinants of interest rates

r = r* + IP + DRP + LP + MRP.
Here:
r = Required rate of return on a debt security.
r* = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.
LP = Liquidity premium.
MRP = Maturity risk premium.
26
Bond Spreads, the DRP, and the LP
 A “bond spread” is often calculated as the
difference between a corporate bond’s yield
and a Treasury security’s yield of the same
maturity. Therefore:
 Spread = DRP + LP.
 Bonds of large, strong companies often have
very small LPs. Bond’s of small companies
often have LPs as high as 2%.
 What is included in the bond spread of the
corporate and treasury bond of the same
maturity

r = r* + IP + DRP + LP + MRP.
Here:
r = Required rate of return on a debt security.
r* = Real risk-free rate.
IP = Inflation premium.
DRP = Default risk premium.
LP = Liquidity premium.
MRP = Maturity risk premium.
28
US composite corporate bonds
rates
US composite municipal bonds
rates
https://finance.yahoo.com/bonds/composite_bond_rates
Exercise
If 10-year T-bonds have a yield of 6.2%, 10-year
corporate bonds yield 8.5%, the maturity risk premium
on all 10-year bonds is 1.3%, and corporate bonds have
a 0.4% liquidity premium versus a zero liquidity
premium for T-bonds, what is the default risk premium
on the corporate bond?

1.9%
Exercise: solution
If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds
yield 8.5%, the maturity risk premium on all 10-year bonds is
1.3%, and corporate bonds have a 0.4% liquidity premium versus
a zero liquidity premium for T-bonds, what is the default risk
premium on the corporate bond?
1. Difference in yields of corporate and treasury bonds:
8.5% - 6.2% = 2.3%

2. This difference is DP (default premium) + LP (liquidity premium) = 2.3%

3. LP = 0.4%, therefore DP is:

DP = 2.3% - 0.4% = 1.9%

Bonds
Bond (corporate) is a debt security, usually a
long-term contract, under which the issuer
(borrower) agrees to pay interest and principal
to the holders of the bond under the terms
specified in the contract.
 Determinants of Intrinsic Value: The Cost of Debt

Net operating Required investments

−
profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 ... + FCF∞

Value = + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Firm’s debt/equity mix

Cost of debt
Market risk aversion Cost of equity Firm’s business risk
35
Debt features
 Not an ownership interest, represents
creditors rights

 Creditors do not have voting rights

 Interest is considered a cost of doing

business and is tax-deductible

 Creditors have legal recourse if interest

or principal payments are missed

 Excess debt can lead to financial

distress and bankruptcy
Types of bonds by issuer
Type of issuer

Government, government
agencies

States (regions,
provinces), municipalities

Corporations

Financial
institutions
Capital markets andmoneymarkets: corporatebonds

Capital markets

Long-termsecurities
Types of bonds by yield

Type of yield

Zero-coupon
(discount) debt
Instruments

Interest-bearing
income
instruments
Types of bonds by the level of risk
By level of
risk

Risk-free instruments
(treasury bills)

Low-risky securities (treasury

notes and bonds,
investment grade corporate
bonds)

High-risky securities (junk

bonds)
Types of financial instruments:
corporate bonds
By level of risk

Low-risky securities
(investment grade
corporate bonds)

High-risky
securities (junk
bonds)
Valuation: financial and real assets
Present • Stock value, bond value
• Present value of investments in real
value assets

• Coupon payments on bonds

Income stream • Dividends
(cash flows) • Capital gains
• Cash flows from investment projects

Return on • Equity returns and bond yields

• Required rate of return on investment
investments projects

Valuation
model Discounted cash flows
Valuation of financial assets
 Present value of future cash flows is the fundamental
(intrinsic) value of the asset.
 Future cash flows are discounted to the present at the
discount rate that depends on the risk of the asset.
 Investment returns, measuring financial results of an
investment, are not known with certainty. The greater the
chance of a return being far below the expected return,
the greater the risk.
 There is a reward for bearing risk of uncertainty of future
cash flows – risk premium for investments in particular
assets.
Key features of a bond
 Par value: Face amount (principal), paid at maturity
(assume $1,000).
 Coupon interest rate: Stated interest rate. Multiply
by par value to get dollars of interest.
 Maturity: Years until bond must be repaid.
 Issue date: Date when bond was issued.
 Default risk: Risk that issuer will not make interest
or principal payments.
Bond valuation
 The value of the bond is based on:
•The discount rate (required rate of interest - the yield that could
be earned on alternative investments with similar risk and
maturity)
•Coupon rate
•Timing of payments
•Maturity of the bond
•Par value repaid at the maturity
What is a cash flow from the bond? How to measure
a fundamental bond value?

 Cash flow includes equal regular interest

(coupon) payments and a par value at the
maturity.
 Future cash flows should be discounted to the
present (to the moment of valuation).
 The value of the bond is the present value of
cash flows the bond is expected to produce.
Bond valuation

N
C M
V  
t 1 1  r 
t
1  r  N

V  bond fundamental value (present value of its

remaining cash flows)
C  coupon payment provided at each period
r  required rate of return per period used to discount
bond cash flows (yield on similar investments)
t  period of coupon payment
N  number of periods to maturity
M  par value
Valuing bonds with fixed coupon payments
 Example. Consider a bond that has 20 years
remaining until maturity. Par value is $1000. Annual
coupon rate is 14%, with annual payments period.
Assume that the prevailing annualized yield on other
bonds with similar characteristics is 14%. What is
the bond’s fair value?
N
C M
V  
t 1 1  r 
t
1  r  N

20
140 1000
V    1000
t 1 (1  0.14) (1  0.14)
t 20
 Valuing bonds with fixed coupon payments
Example. Consider a bond that has 20 years remaining
until maturity. Par value is $1000. Annual coupon rate
is 14%, with annual payments period. Assume that the
prevailing annualized yield on other bonds with similar
characteristics is 14%. What is the bond’s fair value?
20
140 1000
V    1000
t 1 (1  0.14) (1  0.14)
t 20

Why the value of the bond equals to the par

value?
Because coupon rate equals to discount rate
Example. Par value is $1000. Annual coupon rate is 14%,
with annual payments period. Assume that the prevailing
annualized yield on other bonds with similar
characteristics is 14%. What is the bond’s fair value?
20
140 1000
V    1000
t 1 (1  0.14) (1  0.14)
t 20

Assume we make a valuation of the same bond 5 years

from now. Required rate of return did not change. Find
the present value of all future payments, including par
value, that will be paid to the investor 15 years from
now. 15
140 1000
V    $1000
t 1 (1  0.14) t
(1  0.14)
15
Valuing bonds with fixed coupon
payments
 How the bond value will change year by year
till maturity?
 It will remain at the par value as long as the
going interest rate remains equal to the
coupon rate.
Valuing bonds with fixed coupon
payments
 Example. Given the first example, how the value of
the bond will change 5 years from now if the required
rate of return change to 16%?
 Coupon rate is lower than the market return, so its
value should …
decline
15
140 1000
V    $1000
t 1 (1  0.14) (1  0.14)
Initial value t 15

15
140 1000
V    140  5,5755  1000  0,1079  $888,47
t 1 (1  0.16) t
(1  0.16) 15
Valuing bonds with fixed coupon payments

 How the bond value will change year by year

till maturity in this case?
 It will move up to approach the par value at
maturity

15
140 1000
V    140  5,5755  1000  0,1079  $888,47
t 1 (1  0.16) (1  0.16)
t 15
Valuing bonds with fixed coupon payments

 Example. How the value of the bond will

change 5 years from now if the required rate
of return change to 12%?
 Coupon rate is higher than the market return,
so its value should …
increase 15
140 1000
Initial value V    $1000
t 1 (1  0.14) (1  0.14)
t 15

15
140 1000
V    140  6,811  1000  0,183  $1136,54
t 1 (1  0.12) (1  0.12)
t 15
Valuing bonds with fixed coupon payments

 How the bond value will change year by year

till maturity in this case?
 It will move down to approach the par value
at maturity.

15
140 1000
V    140  6,811  1000  0,183  $1136,54
t 1 (1  0.12) (1  0.12)
t 15
Example. Bond value ($) vs. years
remaining to maturity

Coupon = 16%
1123

1,000 r = 14% Coupon = 14% M

877 Coupon = 12%

15 0
Premium and discount
Bonds mature at a par value, which is
almost always $1,000.
A premium bond is any bond that is
currently trading at a price above par.
A discount bond is a bond trading at a price
lower than par.
Examples: http://www.hl.co.uk/shares/corporate-bonds-
gilts/bond-prices/gbp-bonds
http://markets.on.nytimes.com/research/markets/bonds/bonds.asp
Examples:
http://markets.on.nytimes.com/research/markets/bonds/bonds.asp
Valuation of bonds with semiannual
payments
 If the bond has semiannual payments, the
present value can be calculated as following:

2N
C/2 M
V  
t 1 1  r / 2  1  r / 2
t 2N

C/2 – semiannual coupon payment

r/2 – periodic discount rate used to discount the bond cash
flows
2N – denominator exponent to reflect the doubling of periods
Valuation of bonds with semiannual
payments
 Consider a bond of 10 years before the maturity,
14% coupon rate paid semiannually, 12% required
return, $1000 par value. Present value is calculated
as following:
2N
C/2 M
V  
t 1 1  r / 2  1  r / 2
t 2N

20
70 1000
V    70  11,47  1000  0,312  $1114,9
t 1 (1  0.06) (1  0.06)
t 20
Norilsk Nickel bonds
Maturity Date 06.02.2026
Country Russia
Currency Ruble
Callable Yes
Amount outstanding 15 mln
Issue Date 19.02.2016
Par Value 1000
Issue Size 15 mln
Coupon 11,6
Coupon type Fixed
Coupon Frequency Semi-Annually
Exercise
ABC Corporation has issued bonds that bear 12%
annual coupon rate paid semiannually. The bonds
mature in 2 years, have a face value of $1000 and a
required rate of return of 8%. What is the value of these
bonds? Will investor buy this bond if the market price is
$1090? How the price of this bond will change over
time until maturity (the trend)?
2N
C/2 M
V  
t 1 1  r / 2  1  r / 2
t 2N
Exercise: solution
 ABC Corporation has issued bonds that bear 12% annual
coupon rate paid semiannually. The bonds mature in 2 years,
have a face value of $1000 and a required rate of return of
8%. What is the value of these bonds? Will investor buy this
bond if the market price is $1090? How the price of this bond
will change over time until maturity (the trend)?
 Value = $ 1072,6
 We probably do not buy for 1090, because fair value is
lower.
 The bond price will decrease over time to reach a face
value at maturity.
Exercise: solution
 ABC Corporation has issued bonds that bear 12%
annual coupon rate paid semiannually. The bonds
mature in 2 years, have a face value of $1000 and a
required rate of return of 8%. What is the value of
these bonds? Will investor buy this bond if the market
price is $1090? How the price of this bond will change
over time until maturity (the trend)?

4
60 1000
V    60  3,63  1000  0,855  $1072,6
t 1 (1  0.04) (1  0.04)
t 4
 Using Spreadsheets
 PRICE(Settlement,Maturity,Rate,Yld,Redemptio
n,Frequency,Basis)
 YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
 Settlement and maturity need to be actual dates
 The redemption and Pr need to be given as % of par
value
 See Excel file:
Topic 2-bonds valuation_price and yield
Example: Coca-Cola bonds
Exercise. Coca-Cola bonds
 A bond has 7 years remaining until maturity.
Par value is $1000. Annual coupon rate is
2,875%, with semi-annual payments period.
Assume that the prevailing annualized yield
on other bonds with similar characteristics is
equal to the corporate bonds index. What is
the bond’s fair value?
S&P corporate bond index (Sept 2018)
S&P corporate bond index (Sept 2017)
Exercise. Coca-Cola bonds
 A bond has 7 years remaining until maturity.
Par value is $1000. Annual coupon rate is
2,875%, with semi-annual payments period.
Assume that the prevailing annualized yield
on other bonds with similar characteristics is
equal to the corporate bonds index. What is
the bond’s fair value?

V = (see Excel file)

Interest Rate Risk
 Change in price due to changes in interest
rates
 Interest rates up, bond value down
 Long-term bonds have more interest rate risk
than short-term bonds
 More-distant cash flows are more adversely
affected by an increase in interest rates
 Lower coupon rate bonds have more interest
rate risk than higher coupon rate bonds.
The relationship between bond value and
interest rates
Zero-coupon bonds
 Make no periodic interest payments (coupon rate
= 0%, called zeroes, or discount bonds)
 The entire yield to maturity comes from the
difference between the purchase price and the par
value
 Cannot sell for more than par value.
 Valuation of zero-coupon bonds

M
V 
1  r  n

V  value of a bond
М  par value
n  number of periods to maturity
r – required rate of return
Example. Zero-coupon bond with a par value
of $1000, maturity of 5 years is traded for
$588,12. Is it reasonable to invest in this bond,
if investor considers the alternative investment
with 12% annual return?

1000
V  567.4
(1  0.12) 5
Yield to maturity
Example. Suppose we are offered a 10-year,
11% annual coupon, $1000 face value bond at
a price of $1200. What rate of interest would
you earn on your investment if you bought
the bond and held it to maturity?
This rate is yield to maturity.
N
C M
V  
t 1 1  YTM  1  YTM 
t N
Yield to maturity
 Yield to maturity is the calculated return on
investment that investors will get if they hold
the bond to maturity. It takes into account the
present value of all future cash flows, as well
as any premium or discount to par that the
investor pays.
Yield to maturity
Example. Suppose we are offered a 10-year,
11% annual coupon, $1000 face value bond at
a price of $1200. What rate of interest would
you earn on your investment if you bought
the bond and held it to maturity?

N
C M
V  
t 1 1  YTM 
t
1  YTM  N
Yield to maturity
Example. Suppose we are offered a 10-year,
11% annual coupon, $1000 face value bond at
a price of $1200. What rate of interest would
you earn on your investment if you bought
the bond and held it to maturity?
10
110 1000
1200   
t 1 1  YTM  1  YTM 
t 10

YTM = 8,02% Yield-2

 Current yield
 Current yield is the rate of return an investor will
get, taking into account the current value of the
bond and a coupon payment to be paid
 It is calculated by dividing the coupon by the
price.
 The current yield is not a good indicator of your
return on investment.
 Yield to maturity takes into account the value of
the discount or premium paid for the bond, and
as such it offers a much better indication of the
value of the bond.
Current yield
 Example. Suppose we are offered a 10-
year, 11% annual coupon, $1000 face
value bond at a price of $1200. What is
the current yield?

Current yield =
0,11*1000/1200=9,17%
Call provisions
 Some bonds can be called (redeemed) by the
issuer on specified dates throughout the life of
the bond.
 Issuer can refund (repurchase the issue) if
interest rates decline. That helps the issuer to
manage its debt, but hurts the investor.
 Therefore, coupon rates on callable bonds are
higher. Many bonds assume a call premium.
Usually they have a deferred call provision.
General Electric bonds specification
Yield to call
Example. Suppose we are offered a 10-year, 11%
annual coupon, $1000 face value bond at a price of
$1200. What rate of interest would you earn on your
investment if you bought the bond and held it to
maturity?
The previous example:
10
110 1000
1200   
t 1 1  YTM  1  YTM 
YTM = 8,02% t 10
Yield to call
Example. Suppose we are offered a 10-year, 11%
annual coupon, $1000 face value bond at a price of
$1200. What rate of interest would you earn on your
investment if you bought the bond and held it to
maturity?
The previous example:
10
110 1000
YTM = 8,02% 1200 

t 1 1  YTM 
t

1  YTM 10

The bonds may be called 5 years from now at 109%

of face value (call price $1090). What is the yield to
call?
Yield to call
Example. Suppose we are offered a 10-year, 11%
annual coupon, $1000 face value bond at a price of
$1200. What rate of interest would you earn on your
investment if you bought the bond and held it to
maturity?
The bonds may be called in 5 years at 109% of
face value (call price $1090). What is the yield to
call?
5
110 1090 Yield-3
1200   
t 1 1  YTM  1  YTM 
t 5

7,59%
 Using Spreadsheets
 PRICE(Settlement,Maturity,Rate,Yld,Redemptio
n,Frequency,Basis)
 YIELD(Settlement,Maturity,Rate,Pr,Redemption,
Frequency,Basis)
 Settlement and maturity need to be actual dates
 The redemption and Pr need to be given as % of par
value
 See Excel file:
Topic 2-bonds valuation_price and yield
Graphical Relationship Between Price
and YTM
1500
1400
1300
1200
1100
Price

1000
900
800
700
600
0% 2% 4% 6% 8% 10% 12% 14%
YTM
Bond Prices: Relationship Between
Coupon and Yield

N
C M
V  
t 1 1  YTM 
t
1  YTM  N

If YTM = coupon rate, then

par value = bond price
 N
C M
V  
t 1 1  YTM t
1  YTM  N

 If YTM > coupon rate, then

Bond price < par value
 Price below par = “discount” bond
 If YTM < coupon rate, then
Bond price > par value
 Price above par = “premium” bond
Term Structure of Interest Rates
 Term structure is the relationship between time to
maturity and yields, all else equal
 Yield curve – graphical representation of the term
structure and describes YTM (yield to maturity)
for different maturities of debt instruments. It
reflects risk and expectations regarding future
interest rates.
Upward-Sloping Yield Curve

Normal – upward-sloping; long-term yields are

higher than short-term yields
Downward-Sloping Yield Curve

Inverted – downward-sloping; long-term yields are

lower than short-term yields
 http://www.bloomberg.com/markets/rates/inde
x.html
 stockcharts.com/charts/yieldcurve.html

Long-term rates should be higher because of

expectations of higher interest rates including
expected inflation and risk.
Inverted yield curve could be a signal of recession.
What type of yield curve is today for Russian government
bonds?
(Sept, 2018)
What type of yield curve we observed for Russian
government bonds last year?
(Sept, 2017)
Negative-yielding bonds: Why buy
them? Why sell them?
 Henkel and Sanofi broke new ground this
week in selling negative-yielding bonds in
Europe
 This week two public companies took free
euros offered to them by investors, when they
became the first to sell bonds with a negative
yield-to-maturity.
 Ft.com: SEPTEMBER 7, 2016
Negative-yielding bonds: Why buy
them? Why sell them?
• Henkel, a German maker of Persil laundry detergent, sold
€500m of two-year bonds with a yield of minus 0.05 per cent
while Sanofi, a French pharmaceuticals manufacturer, sold
€1bn of three-and-a-half year debt with a yield of minus 0.05
per cent (issued in 2016)
• The £4.5bn of UK government bonds maturing in 2056 was
priced at a yield of -1.361 per cent (issued in July, 2017)
• For negative yielding bonds, the market price is greater than
the remaining coupon and principal payments. If an investor
holds the bond until it matures, they will lose money.
 Negative interest rates: ECB policy
 The European Central Bank cut its deposit rate below zero for the first time in
2014. The ECB has cut interest rates across the eurozone to zero as it unveiled
an unprecedented package of growth-boosting measures against the backdrop
of a fragile global economy.
 The Frankfurt-based institution hopes its latest barrage of measures will get
money into the financial system by discouraging banks from holding on to
deposits. The expectation is that financial institutions will instead lend out
money as cheaply as possible to businesses and households.
 The ECB reduced the eurozone’s main interest rate from 0.05% to zero, also
cut its two other interest rates, expanded its quantitative easing (QE)
programme and announced new ultra-cheap, four-year loans to banks, allowing
them to borrow from the ECB at negative interest rates.
 As expected by markets, the ECB cut its deposit rate by 10 basis points, further
into negative territory to -0.4%. The latest cut in the deposit rate means the
ECB will be charging banks more to hold their money overnight, with the aim
of encouraging them to lend it to businesses. The marginal lending rate, paid
by banks to borrow from the ECB overnight, was cut from 0.3% to to 0.25%.
ECB refinancing rate = 0%
 Negative interest rates: ECB policy
 Some analysts welcomed the announcement of ultra-cheap loans
to banks, hoping they could mitigate the impact of ultra-low
interest rates, which create difficulties for commercial banks by
making it harder for them to lend profitably.
 This is the amount commercial banks are paid (or rather, they now
pay) on money they leave overnight at the central bank. In March
2016, the ECB cut the deposit rate even lower, to minus 0.4 per
cent.
 The ECB expanded its QE programme to €80bn a month, up from
€60bn. Under QE, the central bank pumps money into the
eurozone by buying bonds off financial institutions in the
expectation that they will reinvest the proceeds elsewhere in the
European economy. The QE programme will now include buying
bonds issued by companies and not just by financial institutions.
 Negative-yielding bonds: Why buy them?

 The cost of leaving their cash on deposit with a bank has led
companies and investors to seek out other safe assets. Bonds
with negative yields become attractive, so long as these yields
are less punitive than those for keeping cash in the bank.
 Additionally, some investors may speculate that yields can fall
even further, which will push up the prices of corporate bonds.
So investors in the Henkel and Sanofi bonds may be able to sell
them on at an even higher price later.
Factors that impact bond values and yields
• Market interest rates
Economy • Market liquidity
• Inflation rate

• Supply of bond issues

Market • Investors expectations

• Credit rating
• Company’s reputation
Specific (issuer) • Industry, size of the company
• Maturity
Mortgage securitization and global
financial crisis
 Required reading:
BE, Chapter 1, pp. 15-18, 36-45.
Securitization: issues to discuss
 What was the role of S&L associations in
creating mortgage markets?
 What is a mortgage securitization?
 What types of market participants were
involved in the process of securitization in
2000-s?
The globalization of mortgage
securitization and financial crisis
 What was the win-win-win situation in the
mortgage market until the mortgage crisis?
 What were the roots of the mortgage crisis?
What is a subprime mortgage?
 How the process of securitization changed the
total amount of risk embedded in the
mortgages?
 What triggered the crisis? Why the sub-prime
meltdown caused an economic crisis?