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Transcript of The Capital Markets: Bonds Prof. Ian Giddy New York University New York University/ING Barings.
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The Capital Markets:Bonds
Prof. Ian GiddyNew York University
New York University/ING Barings
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Copyright ©1998 Ian H. Giddy Bonds 2
The Bond Markets
Treasuries Corporates International Bonds Market Risk Credit risk
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Copyright ©1998 Ian H. Giddy Bonds 3
Fixed-Income Benchmarks
02/13/97 - 11:06 PM ET
Money rates
Treasury securities
Thu. 6-mos. ago Yr. ago3-mo. T-bill discount 4.98% -0.02 5.05% 4.77%6-mo. T-bill discount 4.99% -0.05 5.12% 4.71%10-yr. note 6.31% -0.10 6.60% 5.70%30-yr. bond 6.62% -0.08 6.80% 6.16%
Savings rates, latest 7-day averages
Thu. 6-mos. ago Yr. agoMoney mut. funds 4.81% 4.79% 4.84%Tax-free money funds 2.83% 2.96% 2.82%Bank money market 2.60% 2.64% 2.74%6-mo. CDs 4.76% 4.73% 4.59%1-yr. CDs 5.05% 5.07% 4.69%5-yr. CDs 5.57% 5.67% 5.02%
Mortgage rates
Thu. 6-mos. ago Yr. ago30-yr. fixed (FHLMC) 7.65% 7.88% 6.94%15-yr. fixed (FHLMC) 7.14% 7.39% 6.44%Adj. rate (FHLMC) 5.52% 5.81% 5.19%1-yr. Treas. ARM index(*) 5.53% 5.60% 4.85%11th dist. ARM index 4.842% 4.809% 5.059%Fannie Mae 30 year commitments 30 days, 7.77 60 days, 7.84
Other rates
Thu. 6-mos. ago Yr. agoPrime lending 8.25% 8.25% 8.25%Fed. discount 5.00% 5.00% 5.00%Federal funds 5.06% 5.63% 5.38%
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Copyright ©1998 Ian H. Giddy Bonds 4
Money Market Instruments
Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Repurchase Agreements (RPs) and Reverse
RPs Federal Funds
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Copyright ©1998 Ian H. Giddy Bonds 5
The Eurocurrency Market and its Linkages
US Domestic German
Market EUR0CURRENCY MARKET Domestic Market
Euro-Deutsche Mark
Eurodollar Market
Market Foreign
Exchange
Market Japanese
Euro-Yen Domestic
Market Market
Euro-Commercial Euro-Floating Rate Straight
Paper Market Note Market Eurobond Market
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Copyright ©1998 Ian H. Giddy Bonds 6
Instruments and Markets
BondsBonds
GovernmentsGovernments CorporatesCorporates
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Copyright ©1998 Ian H. Giddy Bonds 7
Instruments and Markets
GovernmentsGovernments
TreasuriesTreasuries Agencies, Mortgage-backed
Securities
Agencies, Mortgage-backed
Securities
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Copyright ©1998 Ian H. Giddy Bonds 8
Benchmark Bonds
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Copyright ©1998 Ian H. Giddy Bonds 9
The Yield
Yield to maturity combines coupons and capital gains - all cash flows.
The yield to maturity on any bond, is the rate that will make the present value of the cash flows from the investment equal to the price of the investment.
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Copyright ©1998 Ian H. Giddy Bonds 10
Prices and Yields in the Wall Street Journal
Rate Mat.Mo/yr
Bid Asked Chg AskYld
5 1/85...7 7/88 1/2...7 1/86 1/4
May 94nJun 94n
Feb 95-00Feb 00n
Feb 23Aug 23
100:01100:04
101:14107:11
95:0685:21
100:03100:06
101:16107:13
95:0885:23
...+1
+1+7
+16+14
2.443.35
5.716.92
7.537.46
Monday, May 16, 1994
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Copyright ©1998 Ian H. Giddy Bonds 11
Yield To Maturity (YTM)
YTM is the rate of return investors earn if they buy a bond at a specific price and hold it until maturity
YTM is also the discount rate that causes the bond’s current price to just equal the present value of its interest payments and par value.
Find y such that LHS=RHS:
PC
yCy
My n0 1 21 1 1
( ) ( )
...( )
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Copyright ©1998 Ian H. Giddy Bonds 12
The Yield Curve
Maturity(years)
Yield toMaturity
12345678910
5.426.026.426.696.826.927.077.167.247.23
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Copyright ©1998 Ian H. Giddy Bonds 13
Yield Curves
Yields
Maturity
Upward Upward SlopingSloping
Downward Downward SlopingSloping
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Theories of Term Structure
Expectations Liquidity Preference
Upward bias over expectations Market Segmentation
Preferred Habitat
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Copyright ©1998 Ian H. Giddy Bonds 15
Yield Has Problems
Reinvestment assumption: YTM assumes we reinvest at the same yield.
Coupon effect: different bonds with the same maturity, all fairly priced, have different yields.
Callable bonds have no defined maturity.
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Copyright ©1998 Ian H. Giddy Bonds 16
Yield of a Zero
Zero-coupon bonds simply pay the principal at maturity, no interest, so find k such that:
Example: 10-year US Treasury zero with face value $1,000 priced at $399.85: k=9.60%
BM
k n0 1
( )
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Copyright ©1998 Ian H. Giddy Bonds 17
Better Bond Pricing
The method used previously discounts all the bond's cash flows at a single rate, the yield to maturity.
But as the yield curve shows, different yields apply to different maturities. The best way to look at the yield for a particular maturity is to find out the yield on a zero-coupon bond for that maturity.
Then we can find the PV of each cash flow (coupons & principal) by discounting each cash flow at the corresponding zero-coupon rate. (Or, equivalently, by multiplying by the corresponding discount factor.)
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Copyright ©1998 Ian H. Giddy Bonds 18
Better Bond Pricing
So we need to find out the z's: the zero-coupon bond yields. There are two ways of doing this.
B o n d V a l u e = 1C
( 1 + 1z 1) + 2C
( 1 + 2z 2) + 3C
( 1 + 3z 3) + + nM
( 1 + nz n)
Let us call the zero-coupon rate for each maturity zt. Then the value of a bond should be the sum of the PVs of each of the cash flows.
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Copyright ©1998 Ian H. Giddy Bonds 19
The Zero Approach
Use zero-coupon rates to value each cash flow - then add them!
Where can we get the z’s? One place is from the Treasury strip market.
BCz
Cz
Mzn
n0
1
1
2
21 1 1
( ) ( )...
( )
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Copyright ©1998 Ian H. Giddy Bonds 20
Treasury Strips in the Wall Street Journal
Mat. Type Bid Asked Chg AskYld
Aug 94Nov 94
...May 20May 20
...Aug 23Aug 23
cici
cibp
cibp
98:3197:21
13:2213:25
11:3112:07
98:3197:22
13:2513:29
12:0212:10
+1+1
+4+4
+4+4
4.424:83
7.777.74
7.367.29
Monday, May 16, 1994
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Copyright ©1998 Ian H. Giddy Bonds 21
Bond Lego
To value this bond, break it up into its component cash flows - e.g. 1st coupon of (5 3/4)/2 in Feb 1996, and so on...
Then use zero’s to see what each is worth, and add the total.
In general, breaking up a security into its component parts is an excellent path to valuation.
R ate6
M aturity, M o/YrD ec 97
B id Asked99:29 99:31
Ask Y ld.6.01
A Treasury Noteas quoted in the W all Street Journal M onday, July 24, 1995
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Copyright ©1998 Ian H. Giddy Bonds 22
Identifying Undervalued Securities
BondsBonds
Spot
Rates
Spot
Rates“Correct”
pricing
“Correct”
pricingCompare
with actual
Compare
with actual
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Copyright ©1998 Ian H. Giddy Bonds 23
Instruments and Markets
BondsBonds
GovernmentsGovernments CorporatesCorporates
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Copyright ©1998 Ian H. Giddy Bonds 24
Corporate Bonds: Spread over Benchmark
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Copyright ©1998 Ian H. Giddy Bonds 25
Corporate Bonds
Legal Aspects Of Corporate BondsA Bond Indenture is a contract between the
borrowing corporation and the bondholders, stating the conditions under which a bond has been issued
Common features of bond indentures include: Sinking-Fund Requirements Security Interest
A Trustee is a third party paid to protect the bondholders' interest
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Copyright ©1998 Ian H. Giddy Bonds 26
Provisions of Bonds
Secured or unsecured Call provision Convertible provision Put provision (putable bonds) Floating rate bonds Sinking funds
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Copyright ©1998 Ian H. Giddy Bonds 27
Default Risk and Ratings
Rating companiesMoody’s Investor ServiceStandard & Poor’sDuff and PhelpsFitch
Rating CategoriesInvestment gradeSpeculative grade
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Copyright ©1998 Ian H. Giddy Bonds 28
Bond Credit Ratings
Moody’sStandard &Poor’s Interpretation
AaaAa
AAAAA
High-quality debt instruments
ABaa
ABBB
Strong to adequate ability topay principal and interest
BaBCaaCaC
BBBCCCCCC
Ability to pay interest andprincipal speculative
D In default
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Copyright ©1998 Ian H. Giddy Bonds 29
Factors Used by Rating Companies
Coverage ratios Leverage ratios Liquidity ratios Profitability ratios Cash flow to debt
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Copyright ©1998 Ian H. Giddy Bonds 30
Protection Against Default
Sinking funds Subordination of future debt Dividend restrictions Collateral
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Copyright ©1998 Ian H. Giddy Bonds 31
AT&T’s Cost of Debt
After the divestiture of AT&T analysts lowered the corporation's bond rating due to the uncertainty of the outcome of the massive breakup. While AT&T eventually regained its former top rating, for the interim period AT&T bond prices fell... and its cost of debt was higher as a result of investors increasing their required rates of return on AT&T bonds.
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Copyright ©1998 Ian H. Giddy Bonds 32
Instruments and Markets
Corporate BondsCorporate Bonds
DomesticDomestic InternationalInternational
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Copyright ©1998 Ian H. Giddy Bonds 33
International Capital Markets The Eurobond Market is the market for bonds issued
outside the country of the currency The Foreign Bond Market is one in which a foreign
corporation or government issues bonds in a domestic market in the local currency
An International Equity Market has emerged that allows corporations to sell large blocks of shares simultaneously to investors in several different countries
Major Securities Markets
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Copyright ©1998 Ian H. Giddy Bonds 34
International Bond Markets are Linked
Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps
BONDMARKETSWITHINCOUNTRYOFCURRENCY
BONDMARKETSOUTSIDECOUNTRYOFCURRENCY
CurrencySwaps
Long-datedForwardExchange
Domestic US
- Gov't- Corporate
ForeignBonds
"Yankee"
DomesticJapanese
- Gov't- Corporate
ForeignBonds
"Samurai"
EurodollarBond Market
EuroyenBond Market
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Copyright ©1998 Ian H. Giddy Bonds 35
Foreign Bonds
A foreign bond is a bond issued in a host country's financial market, in the host country's currency, by a foreign borrower
The three largest foreign bond markets are Japan, Switzerland, and the U.S., representing issuance of about $40 billion in bonds annually
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Copyright ©1998 Ian H. Giddy Bonds 36
Private Placements and Rule 144A
The private placement exemption from registration and disclosure is extended to Eurobonds as long as the U.S. investors meet the following requirements:They are large and sophisticatedThere are only a few investorsThey have access to information and analysis similar
to that which would ordinarily be contained in a registered offering prospectus
They are capable of sustaining the risk of losses, andThey intend to purchase the bonds for their own
investment portfolios, and not for resale.
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Copyright ©1998 Ian H. Giddy Bonds 37
Characteristics of Eurobonds
Issued outside country of currency Not subject to domestic registration or disclosure
requirements In most cases take form of private placements Placed through syndicates in many countries who sell
principally to nonresidents Bonds are structured so as to be free of withholding
tax Bearer form
But... Eurobonds usually influenced de facto by government
and banks of country of currency
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Copyright ©1998 Ian H. Giddy Bonds 38
Key Dates in the Issuance of a Eurobond
Issuance need oropportunity identified
Announcement ofEurobond issue
Offering day:Eurobond issued
Closing day:Eurobonds delivered,
Issuer gets money
Issuerdiscussesdeal withleadmanager
Syndicateformed,bonds"presold"prior tofinal terms
Finalterms,bonds soldby sellinggroup toinvestors
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Key Players in the Issuance of a Eurobond
MANAGERSUNDER-
WRITERS
SELLING
GROUP
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A Day in the Life...
NEW INTER NA TIONAL BO ND ISSUES
Bo rrowerBo rrower Amou nt m .Amou nt m . Cou pon %Cou pon % Pr icePr ice Mat ur ityMat ur ity FeesFees Boo k ru nn erBoo k ru nn er
Celworks Trust 1990-1¶ (b) US$250 9 1/4 99.80 1998 1 7/8-1 5/8 Credit Suisse
Marui Corp* US$500 (4 3/ 8) 100 1995 2 1/4-1 1/2 Nomura
Holderbank (a) US$150 9 3/4 101 1994 1 3/8-1 CSFB
Battle Mountaingold US$100 7 1/2 100 2006 2 1/2-1 1/2 Merrill Lynch
SN CF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF
Viennische Stadtsbank (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BN L
Eurofima (a ) P ta10bn 12 5/8 101 1/8 1996 1 5/8-1 Deutsche Bank
Ir ish Bldg Soc . (a ) ¥15bn 7.4 101 5/8 1995 1 5/8-1 1/8 IBJ
Bank of Montreal (c ) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon Credit
¶Final te rms. *With equity warrants. Private placement. Convertible. (a) Non-callable. (b) Callable at par af ter 5 years. I f call notexercised, bond pays 50bp over Libor in last year . (c) Redemption linked to Nikkei stock index .
NEW INTER NA TIONAL BO ND ISSUES
Bo rrowerBo rrower Amou nt m .Amou nt m . Cou pon %Cou pon % Pr icePr ice Mat ur ityMat ur ity FeesFees Boo k ru nn erBoo k ru nn er
Celworks Trust 1990-1¶ (b) US$250 9 1/4 99.80 1998 1 7/8-1 5/8 Credit Suisse
Marui Corp* US$500 (4 3/ 8) 100 1995 2 1/4-1 1/2 Nomura
Holderbank (a) US$150 9 3/4 101 1994 1 3/8-1 CSFB
Battle Mountaingold US$100 7 1/2 100 2006 2 1/2-1 1/2 Merrill Lynch
SN CF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF
Viennische Stadtsbank (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BN L
Eurofima (a ) P ta10bn 12 5/8 101 1/8 1996 1 5/8-1 Deutsche Bank
Ir ish Bldg Soc . (a ) ¥15bn 7.4 101 5/8 1995 1 5/8-1 1/8 IBJ
Bank of Montreal (c ) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon Credit
¶Final te rms. *With equity warrants. Private placement. Convertible. (a) Non-callable. (b) Callable at par af ter 5 years. I f call notexercised, bond pays 50bp over Libor in last year . (c) Redemption linked to Nikkei stock index .
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The Bond Markets:Risk
Prof. Ian GiddyNew York University
New York University/ING Barings
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Copyright ©1998 Ian H. Giddy Bonds 42
Risk and ReturnA positive relationship exists between risk and nominal
or expected return The actual return earned on a security will affect the
subsequent actions of investors Investors must be compensated for accepting greater
risk with the expectation of greater return
Return
Risk
Interest Ratesand Required Returns
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Copyright ©1998 Ian H. Giddy Bonds 43
FEMSA, the Mexican brewing company, recently borrowed 5-year US$ funds at 16% from American International Insurance Co.
On the same day, Heineken was able to issue a 3-year Eurobond at 8%.
Meanwhile, US government securities were paying the following interest rates: 1-year bills: 5% 3-year notes: 5.5% 30-year bonds: 6.5%
To what do you attribute these differences?
Why do Interest Rates Differ?
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Copyright ©1998 Ian H. Giddy Bonds 44
Risk
Bond RiskBond Risk
Market RiskMarket Risk Credit RiskCredit Risk
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Copyright ©1998 Ian H. Giddy Bonds 45
A $1 Investment in Different Types of Portfolios: 1926-1996
0.1
1
10
100
1000
10000
1925 1935 1945 1955 1965 1975 1985 1995
Index ($)
$4,495.99
$33.73
$13.54$8.85
$1,370.95
Small Company Stocks
Large Company Stocks
Long-Term Government Bonds
Treasury BillsInflation Year-End
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Average Annual Returns and Risk Premiums: 1926-1996
Investment Average Return Risk Premium
Large company stocks 12.7% 8.9%
Small company stocks 17.7 13.9
Long-term corporate bonds 6.0 2.2
Long-term government bonds 5.4 1.6
U.S. Treasury bills 3.8 0.0
Source: © Stocks, Bonds, Bills and Inflation 1997 Yearbook™, Ibbotson Associates, Inc. Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved
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Price Risk of Treasuries
Treasuries differ: Liquidity - traders quote wider bid-ask
spreads for illiquid bonds Duration - sensitivity of price to a change in
interest rates - is based on the bond’s coupon levels and maturity date (low duration means less risky)
Convexity - measures how duration changes with a change in rates (high convexity is desirable)
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The Price-Yield Relationship
Bond prices and interest rates have an inverse relationship:
PRICE
YIELD(RATE)9%
100
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The Price-Yield Relationship
But plotting price vs yield shows that the relationship is non-linear:
100
9%
Price of a 9% bond
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Maturity
In general, the longer the maturity, the more sensitive is a bond’s price to interest-rate changes, other things being equal:
PriceRequiredyield
9%,5 year
9%,25 year
8%9%10%
104.0554100.000096.1391
110.7510100.000090.8720
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The Coupon Effect...
But three bonds with the same maturity can have very different sensitivities, depending on their coupon levels:
PriceRequiredyield
9%,5 year
6%,5 year
0%,5 year
8%9%10%
104.05100.0096.13
91.8888.1384.56
67.5664.3961.39
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Duration as a Measure of Price Sensitivity
Duration measures the % price change for a given change in yield:
PRICE
YIELD9%
100
The steeper the line, the more the price falls for a given rise in yield
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Uses of Duration
Summary measure of length or effective maturity for a portfolio
Immunization of interest rate risk (passive management)Net worth immunizationTarget date immunization
Measure of price sensitivity for changes in interest rate
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Managing Fixed Income Securities: Basic Strategies
Active strategyTrade on interest rate predictionsTrade on market inefficiencies
Passive strategyControl riskBalance risk and return
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Active Bond Management: Swapping Strategies
Substitution swap Intermarket swap Rate anticipation swap Pure yield pickup Tax swap
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Frequency Distribution of Returns on Common Stocks, 1926-1996
0
2
4
6
8
10
12
14
16
18
-55 -45 -35 -25 -15 -5 5 15 25 35 45 55
2
16
1
8
11
6
10
13
1 3
Number of Years
Return (%)
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Returns, Standard Deviations, and Frequency Distributions: 1926-1996
Source: © Stocks, Bonds, Bills, and Inflation 1997 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
– 90% + 90%0%
Average Standard Series Annual Return Deviation Distribution
Large Company Stocks 12.7% 20.3%
Small Company Stocks 17.7 34.1
Long-Term Corporate Bonds 6.0 8.7
Long-Term Government Bonds 5.4 9.2
U.S. Treasury Bills 3.8 3.3
Inflation 3.2 4.5
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The Normal Distribution
Probability
Return onlarge companystocks
68%
95%
> 99%
– 3 – 48.2%
– 2 – 27.9%
– 1 – 7.6%
012.7%
+ 1 33.0%
+ 2 53.3%
+ 3 73.6%
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Risk and Return of Stocks, Bonds and a Diversified Portfolio
Rate of Return
State Prob. Equity Bond Portfolio
Recession 1/3 -7% +17% +5%
Normal 1/3 +12% +7% +9.5%Boom 1/3 +28% -3% +12.5%
Expected Return 11% 7.0% 9.0%Variance 204.7% 66.7% 9.5%Standard Deviation 14.3% 8.2% 3.1%
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The Correlation Between Stock and Bond Returns Covariance
= 0.3333(-7-11)(17-7) + 0.3333(12-11)(7-7) +0.3333(28-11)(-3-7)
= -116.67
Correlation
= -116.66 / 14.3(8.2) = -0.99
p R E R R E Rss
n
s e e s b b1
, ,( ) ( )
cov ,e b
e b
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Portfolio Return and Standard DeviationGiven:
WS = 0.5 RS = 12% S = 25%
WB = 0.5 RB = 9% B = 12%
and S,B = 0.2
Rp = 0.5(12)+0.5(9) = 10.5%
P = [(0.5)2(25) 2+(0.5) 2(12) 2+2(0.5)(0.5)(25)(12)(0.2)]1/2
= (156.25+36+30)1/2
= (222.25) 1/2
= 14.91%
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Portfolio Risk/Return Two Securities: Correlation Effects
Relationship depends on correlation coefficient
-1.0 < < +1.0 The smaller the correlation, the greater
the risk reduction potential If= +1.0, no risk reduction is possible
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Case Study: A Portfolio
Weight E(R) Std DevGPU 0 0.1267 0.1715Teledyne 0.25 0.1396 0.2893Kodak 0.25 0.1402 0.3082Thai Fund 0 0.2075 0.3278Merck 0 0.1781 0.341ATT 0.5 0.1126 0.1606TOTAL 1
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Portfolio Return Computation
ASSET RETURN WEIGHT PRODUCT1 GPU 12.67% 0.00% 0.00002 Teledyne 13.96% 25.00% 0.03493 Kodak 14.02% 25.00% 0.03514 Thai Fund 20.75% 0.00% 0.00005 Merck 17.81% 0.00% 0.00006 ATT 11.26% 50.00% 0.0563
TOTAL 100%Portfolio return 12.63%
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Portfolio Risk Computation
CORRELATION MATRIXPRODUCT STD DEV GPU TeledyneKodakThai FundMerck ATT
GPU 0.1715 1Teledyne 0.2893 0.44 1Kodak 0.3082 0.17 0.65 1Thai Fund 0.3278 0.22 0.44 0.24 1Merck 0.341 0.35 0.15 0.13 0.03 1ATT 0.1606 0.68 0.4 0.43 0.23 0.6327 1
Portfolio Variance 3.48%Portfolio Std Deviation 18.66%
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To Find the Risk-Return Possibilities, Vary the Proportions
A
E(r)
B
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The Minimum-Variance Frontier of Risky Assets
“Efficient frontier”
Individual assets
Global minimum-variance portfolio
E(r)
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Risk
Bond RiskBond Risk
Market RiskMarket Risk Credit RiskCredit Risk
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Bond Credit Ratings
Moody’sStandard &Poor’s Interpretation
AaaAa
AAAAA
High-quality debt instruments
ABaa
ABBB
Strong to adequate ability topay principal and interest
BaBCaaCaC
BBBCCCCCC
Ability to pay interest andprincipal speculative
D In default
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Credit Risk versus Market Risk
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CreditMetrics Methodology
Establishes the exposure profile of each obligor in a portfolio.
Computes the volatility in value of each instrument caused by possible upgrades, downgrades, and defaults.
Taking into account correlations between each of these events, it combines the volatility of the individual instruments to give an aggregate portfolio volatility.
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Copyright ©1998 Ian H. Giddy Bonds 72
CreditMetrics Roadmap
Compute exposure profile of
each asset
Compute exposure profile of
each asset
Compute the volatility of value caused by
upgrades/downgrades and defaults
Compute the volatility of value caused by
upgrades/downgrades and defaults
Compute correlations
Compute correlations
Portfolio value-at-risk due to creditPortfolio value-at-risk due to credit
Exposures Value-at-risk due to credit Correlations
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Volatilities from “Transition Matrix”
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Construction of Volatility Across Credit Horizons
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Defaults and Recovery Rates
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A Picture of a BBB Bond’s Value Distribution
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Calculating Mean and Standard Deviation
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CreditMetrics
www.jpmorgan.com
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The Bond Markets
Treasuries Corporates International Bonds Market Risk Credit risk
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www.giddy.org
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www.giddy.org
Ian Giddy
NYU Stern School of Business
Tel 212-998-0332; Fax 212-995-4233
http://www.giddy.org