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Transcript of Economics 173A Financial Markets Bonds. Capital Markets To help to finance Companies Circa 2010-11...
Economics 173AFinancial Markets
Bonds
Capital Markets
• To help to finance CompaniesCirca 2010-11
1. Annual Working Capital increases = $ 150 Billion2. Annual Capital Expenditures = $ 900 Billion
= $ 1,050 Billion
• Source of funds:1. Annual Earnings = ($ 800 Billion)
GAP $ 250 Billion2. New Debt Issued = ($ 300 Billion)
Repurchases of Equity = $ 50 Billion
Assets & Investing
The Assets• Fixed Income Bonds Real Estate
• Equity Shares Units
• Derivatives Options Futures
The Process• Asset Allocation
Equity/Fixed• 40/60• 80/20• 120/20 ?
• Security Selection • Security Analysis
Risk Return Trade-off
Return
Risk
Risk and expected Return
Intermediation and Innovation
• Banks– Commercial Banks– Investment Banks
• Funds– Mutual– Hedge– Pension– Private Equity (“PIPES”)– Foreign Exchange– Commodity
• Securitization– GNMA– CMOs, CDOs
• Bundling (Un)– STRIPS
• Engineering– Custom-tailored
Risk/Return– Synthetics – derivative
hedges – mimic something
Financial Instruments
• Money Market– Certificates of Deposit– U.S. Treasury Bills– Money Market Funds
• Bond Market– U.S Treasury Notes and
Bonds– U.K. Gilts and Consols– Municipal Bonds– Corporate Bonds
• Equity Market– Common Stock– Preferred Stock
• Derivative Market– Options– Futures
• Other– Swaps– Pass-throughs
Fixed Income Securities & Rates
• Fixed– CDs – bank time-deposits– Paper – unsecured, trade-able company debt– Acceptances – bank promises– Eurodollars - $ denominated foreign bonds– Repos, Reverse Repos – of treasury debt– Treasuries – bills, notes, bonds
• Rates– Prime– Fed Funds– LIBOR– TED Spread : the 3-month Treasury less LIBOR
Bonds
• Debt Security – corporate or government borrowing• Also called a Fixed Income security• Covenants or Indenture define the contract (this can be
complex)• 2 types of Payments:
interestprincipal
• Interest payments are the Coupon• Principal payment is the Face
Bond Basics
• Fixed Income Securities:Fixed Income Securities: A security such as a bond that pays a specified cash flow over a specific period.
Fixed ClaimHigh Priority on cash flowsTax DeductibleFixed MaturityNo Management Control
Residual ClaimLowest Priority on cash flowsNot Tax DeductibleInfinite life Management Control
Bonds Common StockHybrids (Combinationsof debt and equity)
Fixed Income Securities vs. Common StockFixed Income Securities vs. Common Stock
• Characteristics –– Types: mortgage/asset-backed, callable or puttable?,
convertible?, senior or subordinated, floating rate, zero coupon or stripped
– Denomination (Par value) Face– Coupon, Dates of Coupon Payments– Rating
• Pricing – present value of future cash flows• Yields:
– Coupon yield– YTM– RCYTM
• Sensitivity to Time, i.e. maturity• Sensitivity to changes in interest rates
Bond Analysis
Treasury Bills, Notes, & Bonds
• Bills – 90 days to 6 months • Notes – 1 year up to 10 years• Bonds – to 30 years• Face (denomination) of $1,000; quotes in $100’s• Coupon (rate) paid semi-annually• Prices quoted in points (of face) + 1/32
• No default / credit risk
US Treasury Bonds Rates April 9, 2014
Maturity Yield Yesterday Last Week Last Month
3 Month 0.02 0.02 0.01 0.04
6 Month 0.04 0.03 0.04 0.06
2 Year 0.40 0.39 0.45 0.36
3 Year 0.87 0.85 0.92 0.77
5 Year 1.69 1.66 1.79 1.62
10 Year 2.71 2.68 2.80 2.77
30 Year 3.56 3.54 3.65 3.72
Corporate Bonds April 9, 2014
Maturity Yield Yesterday Last Week Last Month
2yr AA 0.50 0.49 0.55 0.51
2yr A 0.70 0.69 0.75 0.72
5yr AAA 1.80 1.76 1.98 1.84
5yr AA 2.05 2.01 2.14 2.04
5yr A 2.18 2.15 2.31 2.20
10yr AAA 3.10 3.06 3.21 3.35
10yr AA 3.33 3.30 3.44 3.51
10yr A 3.59 3.56 3.70 3.74
20yr AAA 3.99 3.97 4.06 4.05
20yr AA 4.32 4.30 4.38 4.42
20yr A 4.64 4.63 4.71 4.70
Bond Pricing
As with all Financial Assets
The price is a Present Value of the expected cash flows discounted at the appropriate (relative to risk) discount (interest) rate.
Coupon Payments
• Relative to other types of securities, bonds produce cash flows that an analyst can predict with a high degree of precision.
– Fixed rate– Variable rate– Zero coupons– Consols – consolidated annuities - perpetuities
introduced in 1751.
Rates
Risk-adjusted Discount Rate (RADR)
Annual Percentage Rate (APR)
Annual Percentage Yield (APY)
Bond Pricing
• DCF Technique
PB = Price of the bond
Ct = interest or coupon payments
T = number of periods to maturity
r = discount rate
1 (1 )(1 )
T
TtTt
t
BFaceCP
rr
Bond Pricing
CCtt = 40 (SA), F = 1000, = 40 (SA), F = 1000,
T = 20 periods, r = 3% (SA)T = 20 periods, r = 3% (SA)
PB = $1,148.77
tt=1=1++
2020
== PPBB4040
(1+.03)) t 1000 1(1+.03) 20
Insert Figure 4-6 here.
Three Bonds in a 10 percent world …
Bond Pricing
• Zero Coupon Bonds
• Consols – Zero Face Bonds
nr 1
par value al)PV(princip price bondcurrent
r
t
r
t
tt
at time flowcash
1
at time flowcash price bondcurrent
1
Bond Yields
• Yield to Maturity:Yield to Maturity: The discount rate that makes the present value of a bond’s payments equal to its price.– Internal rate of return from holding bond till
maturity.– Example
3 year bond with interest payment of $100, principal of $1,000 and current price of $900
– Assume coupon proceeds are reinvested at the YTM.
Bond Pricing
• Example (annual coupon paid SA) in a 6 percent world.Solving for Price: 10-yr, 8% Coupon Bond, Face = $1,000
CCtt = 40 (SA), P = 1000, = 40 (SA), P = 1000,
T = 20 periods, r = 3% (SA)T = 20 periods, r = 3% (SA)
PB = $1,148.77
tt=1=1++
2020
== PP BB4040
(1+.03)) t 1000 1(1+.03) 20
Approximate Yield to Maturity
• Approximating YTMUsing the earlier example
Avg. Income = 80 + (1000-1149)/10 = 65.10
Avg. Price = (1000 + 1149)/2 = 1074.50
Approx. YTM = 65.10/1074.50 = 0.0606
Actual YTM = 6.00%
• Prices and Yields (required rates of return) have an inverse relationship
– When yields get very high the value of the bond will be very low
– When yields approach zero, the value of the bond approaches the sum of the cash flows
Bond Yields
Price
Yield
Bond Risks
• Price Risks– Default risk– Interest rate risk
• Convenience Risks– Call risk– Reinvestment rate risk– Marketability risk
Default Risk
• The income stream from bonds is not riskless unless the investor can be sure the issuer will not default on the obligation.
• Rating companies – Moody’s Investor Service– Standard & Poor’s– Duff and Phelps– Fitch– Kroll
Default Risk
• Rating Categories– Investment Grade Bonds– Speculative Grade Bonds
S&PMoody’sVery High Quality AAA, AA Aaa, AaHigh Quality A, BBB A, BaaSpeculative BB, B Ba, BVery Poor CCC, CC, C, D Caa, Ca, C, D
2 1 12 0 1 0 1 1
2 1 12 0 1 0 1 1
(1 ) (1 ) (1 )
(1 ) / (1 ) (1 )
r r r
r r r
Forward Rates term years r at year
3 2 13 0 2 0 1 2
3 2 13 0 2 0 1 2
(1 ) (1 ) (1 )
(1 ) / (1 ) (1 )
r r r
r r r
One-year rate one year from now
One-year rate two years from now