Bond Valuation - Systematic

8/10/2019 Bond Valuation - Systematic

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Bonds Fixed Income Securities

Fixed income securities, promises to pay a stream of

semiannual or annual payments for a given number of years

& then repay the loan amount at the maturity date.

What is a Bond?

In its broadest sense, a bond is any debt instrumentthat promises a fxed income stream to the holder

Key Characteristics of Bonds

Par Value

Coupon payment

Coupon interest rate

Floating Rate Bond Original issue discount / premium bonds

Maturity Date


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7 -

Key Features of a Bond!" Par #alue$ Face amount% paid at maturity"

&" Coupon interest rate$ 'tated interest rate" Multiply by par #alue toget dollars o( interest"

)enerally (i*ed"

" Maturity$ +ears until bond must be repaid" Declines"

," ssue date$ Date .en bond .as issued"

0" De(ault ris1$ Ris1 tat issuer .ill not ma1e interest or principal

payments"

STRATEGIC ROLE OF BONS

Portfolio management can be viewed as a two level process.

Macro Decision

Micro Decision


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Strategic Role of Bonds

Macro Decision :he proportion o the portolio to hold inthe available asset classes. Example: Stock and bonds

Micro Decision : Micro decision o which individualsecurities to hold that will comprise the respectivecomponents.

onds tend to represent an important investment alternative

in the portolio asset allocation decision.

!he total risk o a portolio may be thou"ht o as the individualrisk o each investment # its correlation or tendency to moverelative to each other.

!he combination between stocks # bonds in a portolio can

help to reduce the portolio$s risk.

!hus, bond not only possess lower risk than stocks, they alsocan be useul when combined with stocks in a portolio


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Markets for Debt Securities

%e can classiy bond market into two se"ments&omestic

'overnment

(orporate

International

!ypes o Speciali)ed onds

Mort"a"e backed bonds *ero coupon bond

+loatin" ate bond


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CHAPT! " # Bond aluation andnterest !ates

" & '

Coupon Rate Relationship to Yield-to-Maturity

!he relationship between the coupon rate and thebond$s yield0to0maturity -1!M/ determines i thebond will sell at a premium, at a discount or at par

I !hen ond Sells at a:

(oupon 2 1!M(oupon 2 1!M Market 2 +aceMarket 2 +ace &iscount&iscount

(oupon 3 1!M(oupon 3 1!M Market 3 +aceMarket 3 +ace 4ar4ar

(oupon 5 1!M(oupon 5 1!M Market 5 +aceMarket 5 +ace 4remium4remium -'/-'/


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CHAPT! " # Bondaluation and nterest

" &

Factors Affecting Bond PricesInverse Relationship Between Yields and Prices

1ield to maturity -investor$s reuired return/ ond prices "o down when the 1!M "oes up ond prices "o up when the 1!M "oes down

Other Factors Affecting Bond PricesTerm to Maturity and Size of Coupon

Term to maturity5

long bonds a#e greater price #olatility tan sort bonds

Size of coupon5

lo. coupon bonds a#e greater price #olatility tan ig coupon

bonds


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Basic Structure of Bonds6 typical bond has the ollowin" characteristics: 6 (i*ed (ace or par #alue paid to te older o( te bond at maturity

6 (i*ed coupon .ic speci(ies te interest payable o#er te li(e o(te bond coupons are usually paid eiter annually or semi-annually

6 (i*ed maturity date

8ote$

4e coupon rate te maturity date par #alue are all set 9(i*ed: at

te time te bond .as originally sold to te mar1et

4e coupon rate .ill re(lect te re;uired rates o( interest at te time

o( bond issue 6(ter issue interest rates and re;uired rates o( return .ill cange"

Because e#eryting is (i*ed e*cept te re;uired rate o( return and

te bond price as rates cange so too .ill bond prices to and its price alls =>,

calculate the duration.

I a bond has a duration o = and the yield increases rom >to , calculate the approx. > chan"e in the bond price.

6 bond has a duration o .C. I the yield decreases rom to .;> , calculate the approx. > chan"e in bond price.

I a bond$s yield decreases by .9> and its price increase by9.=>, calculate its duration.

6 bond is currently tradin" at s.9,DL.=, has a yield o.D, and has a duration o ,calculate the new price o the bond.


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Ris1 6ssociated .it Bond n#estments nterest Rate ris1 Call ris1

Rein#estment ris1 =i;uidity ris1 >*cange rate ris1

>#ent ris1

nterest !ate !isk

t is te e((ect o( canges in te pre#ailing mar1et rate o( interest onbond #alues"

4is is also 1no.n as Duration/Mar1et Ris1/'ystematic ris16rise in interest rates .ill depress te mar1et prices o( outstandingbonds .ere as a (all in interest rates .ill pus te mar1et pricesup"


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Call Ris1

t is te ris1 o( calling bac1 te bond by te issuer o(

tat security due to increase in interest rates"

Rein#estment Ris1

t arises .en mar1et rates (all te cas (lo.s 9botinterest ? principal: must be rein#ested at lo.er rates"

=i;uidity Ris1

4e ris1 o( selling a (i*ed income security at a priceless tan (air mar1et #alue because o( lac1 li;uidity

(or a particular issue"


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>*cange Rate Ris1

4is ris1 arises (rom te uncertainty about te#alue o( (oreign currency cas (lo.s to an

in#estor in terms o( is ome country currency"

>#ent Ris1

t encompasses te ris1s outside te ris1s o(

(inancial mar1ets suc as ris1 posed bynatural disasters and corporate ta1eo#ers"

Bond Valuation - Systematic

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