Bond valuation (7-3) interest rate environment in which short-term debt securities yield more than intermediate and long-term securities. Pricing and Trading Investors demand higher interest when lending their money for longer periods. I will do so by explaining the importance of understanding the term structure, as well as the three theories that support the term structure; the expectations theory, the segmented markets theory, and the liquidity premium theory. If interest rates have been high but are expected to drop. 1.1 Overview : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 1.2 The Instruments : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : C) As their relative riskiness increases, the expected return on corporate bonds decreases relative to the expected return on default-free bonds. Delta B/B= -3.3841*0.01+1/2*14.1405*0.01^2= -0.033 Please note that this is only a study guide and should not be taken as the actual content of your second exam. ------------------------------------------------- Analyze the impact of fi xed-income pricing properties on bond prices. CHAPTER OUTLINE Using the yield curve to predict interest rates (section 6-6) Although the price may not completely converge, but the premium tends to narrow over time. How are Price and Yield of a Bond Calculated? Since 1986 the yield curve has had some measure of humpedness 25% of the time. Humped yield curves are a sign of economic transition, and could indicate slowed economic growth. © CSI GLOBAL 7•2 EDUCATION INC. (2011) * Ownership represented by shares of stock, sum of which is OE 3. These ideas were pioneered in the actuarial profession by the British actuary Frank Redington (1952). 6. | |  2. The "Liquidity preference". 2 Bond Arithmetic Unit1a1 – Textbook Problems Zachary Skidmore July 15, 2011 BUS4070 – Mr. Walter Adams 6-1 YIELD CURVES The following yields on U.S. Treasury securities were taken from a recent financial publication: Term Rate 6 months 5.1% 1 year 5.5 2 years 5.6 3 years 5.7 4 years 5.8 5 years 6.0 10 years 6.1 20 years 6.5 30 years 6.3 a. A yield curve is a way to measure bond investors' feelings about risk, and can have a tremendous impact on … Implications for corporate managers & investors (8-6) • Clearing and Settlement NEW! |  is generally larger than the future sum. ...Exam 2 Study Guide | |  4. LEARNING OBJECTIVES Market value of portfolio= 1MM-0.2023MM=797700 7 What is the definition of Liquidity preference?  1. (122.2018*(1+0.02/360)-118.1528)*100= $405.58 Short, intermediate, and long term bonds all yield the same. What are Bond Indexes? Yield curves are usually upward sloping asymptotically: the longer the maturity, the higher the yield, with diminishing marginal increases (that is, as one moves to the right, the curve flattens out).. Everybody sells the short-term debt in order to buy the long-term debt. 4. Andrew Ang* and Michael Sherris† $12220 |  Question |  Options |  Answer | Studies have shown that there have been three factors that affect Treasury returns: (1) change in the level of yield, (2) changes in the slope of the yield curve, and (3) changes in the curvature of the yield curve. Here the loans are used mainly to manage cash in a corporation. 1. CONTENTS A yield curve is typically upward sloping; as the time to maturity increases, so does the associated interest rate. In other words, investors need to be compensated with a higher return (in the form of higher interest rate) in order to induce them to hold the assets. 3. 100% of the time (since 1986 at least) after the yield curve took on a humped shape, stocks eventually fell quite a lot, but with a variable lead time. |  1. MD = -(118.1528-126.4236)/(2*0.01)*(1/122.2018)= 3.3841 * Sole proprietorship * Partnership * Limited liability company * Corporation | * Sole traders * Partnerships * Trusts * Companies | The time to maturity is smaller. 1. Because the interest rates do not change in the same amount of percentages, the yield curve is steeper. |  All of the above | | Markets, Institutions, and Interest Rates 2. B) capitalized risk. C) zero coupon bonds. government vs. corporate), etc. FFC measures the derivative at fair value, presenting the portion of the fair value change by using the fair value hierarchy. Explain the rationale for bond switching and describe bond-switching...... ...Q.No. 3) Other things being equal, an increase in the default risk of corporate bonds shifts the demand curve for corporate bonds to the _____ and the demand curve for Treasury bonds to the _____. ------------------------------------------------- Markets for financial assets: |  Your company has received a $50,000 loan from an industrial finance company. A normal yield curve is one in which longer-termed maturities have higher interest rates. 8 Course: | |  3. Problems 5-18 through 5-23 of chapter 5 are related to this topic. Let's say that on Jan. 2, a two-year note is at 2%, and a 10-year note is at 3%. The annual payments are $6,202.70. • Calculating the Fair Price of a Bond Bond yields or interest rates are plotted against X-axis while time horizons are plotted on Y-Axis. Answer: Plotting the points on the basis of the data’s of interest rate and terms to maturity, the yield curve is drawn. • The Relationship Between Bond Prices and Interest Rates * Franking (imputation) credit: Dividends paid have a credit attached for tax paid by the corporation Examples of financial assets include stocks （股票，存货）and bonds（债券）. ...Memorandum Risk structure of interest rate As we have discussed in the previous section, the (relative) risk level of an asset affects its demands according to the theory of asset demand. |  depends upon the number of discount periods. On Feb. 1, the two … (2) Bonds issued by the same agency but have different term to maturity (i.e. *In addition please review the Cengage assignments & Team application activities that apply to the above chapters. from: Daisy If a firm...... ...Yield Curve and Bond Valuation This stands true for securities with longer maturities that have greater risk exposure as opposed to short term securities. C) default premium. i Practice problems: 7-1, 7-2, 7-3, 7-4, 7-5, 7-8, 7-9, 7-16 Buying a stock makes you one of the owners of a corporations and buying a bond makes you one of the lenders. So rationally, an investor would expect higher compensation (yield), thus giving rise to a normal positively sloped yield curve. Four Types of Firms US | Four Types of Firms AUS | |  The theoretically logical and operationally feasible normative goal for guiding financial decision making is |  1. • Duration as a Measure of Bond Price Volatility Dellatorre is also very bright, and, therefore, she would like to understand, in general terms, what will happen to her money.  1. | | |  - | | 100 bonds These are markets where financial assets sold and bought. 1. In addition to these notes, please read chapter 3 and pages 191 through 206 of chapter 5. |  dividend maximization | | A parallel shift in the yield curve neither flattens nor steepens the yield curve. 3. The price divergence in these different markets creates profitability. We thought we were coming out of recession. |  - | | As this happens, prices on long-term debt rise (yields drop) and prices on short term debt plummet (yields rise). Generally, a flat curve is temporary in nature and indicates uncertainty in the market place as to what direction the fed will take. |  In cases of zero correlations between the assets, risk can be fully eliminated through diversification | | Now, let us look at the different types of markets: * Board of Directors: A) A corporate bond's return becomes more uncertain as default risk increases. | |  4. Dellatorre is a highly ranked tennis player who would like to start a company to produce and market apparel that she designs. Whereby, if that date was not a business date the preceding date was selected as shown in the table below. Since the yield spread between on- and off-the-run bonds is very narrow, it is possible to make significant profits only with large positions. She also expects to invest substantial amounts of money through Balik and Kiefer. What are Bond-Switching Strategies? This paper surveys the main concepts and techniques of recent developments in the modeling of the term structure of interest rates that are used in the risk management and valuation of interest-rate-dependent cash flows. What is the Term Structure of Interest Rates? Recent developments have incorporated a stochastic approach to modeling...... ...called the A) junk premium. 100 bonds You Face value of 5-year bond= 0.2023MM*1.479%=217727 3. Based on the information retrieved from the Board of Governors of the Federal Reserve System on a 1-month business day, the following information concerning historical dairy interest rates on the U.S treasury was obtained. Traditional approaches to risk management and valuation are based on the concepts of immunization and matching of cash flows. B) An increase in default risk on corporate bonds lowers the demand for these bonds, but increases the demand for default-free bonds. | | Flat (Humped) Yield Curve. * Company earning for $1 dividend income: gross dividend=div1-tc A) reduce; increase B) increase; reduce C) increase; not affect D) reduce; reduce E) increase; increase B)... ...1: CORPORATIONS & FINANCIAL DECISION-MAKING Yield Curve and Bond Valuation The higher the relative risk level, the lower the demand of that asset. theory that investors prefer short-term debt securities over long-term and, therefore, demand a higher yield (risk premium) when purchasing long-term debt securities. The fair value measurement of the Collateralized Debt Obligation investment shall be categorized within Level 3 of the fair value hierarchy. * Tax implications In other words, it is cheaper to borrow short-term or long-term than it is to borrow intermediate-term. * Legal entity separate from its owners must be legally formed According to a class lecture, six times when the yield curve became inverted, there was an economic recession. |  1. Fixed-Income Securities: D) The expected return on corporate bonds decreases as default risk increases. |  Which of the following statements is true? The normal yield curve reflects higher interest rates for 30-year bonds, as opposed to 10-year bonds. Short 5-year bond value=$0.2023 MM 2.1 Prices and Yields in the US Treasury Market : : : : : : : : : : : : : : : : : 2.2 Replication and Arbitrage : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.3 Day Counts and Accrued Interest : : : : : : : : : : : : : : : : : : : : : : : : 2.4 Other Conventions : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.5 Implementation Issues : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.6 Common Yield Fallacies : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.7 Forward Rates optional : : : : : : : : : : : : : : : : : : : : : : : : : : : : C. inflation is expected to rise in the future. |  1 | In other words, we want to look at the term structure of interest rates. Dividend Imputation Important note: This creates an inverted yield curve. |  - | | Such cash flows include the cash flows on assets such as bonds and mortgage-backed securities as well as those for annuity products, life insurance products with interest-rate-sensitive withdrawals, accrued liabilities for definedbenefit pension funds, and property and casualty liability cash flows. Pricing and Trading However, the yield curve can be inverted and downward-sloping if the economy is expected to slow or a recession is imminent. * Personal tax rate on dividend income is 15% Bonds with semi-annual coupons (7-6) $12220 This often happens when a company has more than one holding company listed in different markets (e.g. In this section, we will focus on only 3 of them: default risk, liquidity, and...... ...© CSI GLOBAL EDUCATION INC. (2011) 7•1 Why is the yield curve upward sloping in 2010? Chapter 6: Interest Rates Principles of Finance BS120 Tutorial Week 4: Topic Risk and Term-Structure of Interest Rates Issues Considered * Risk-free Rate. Upward sloping B. Royal Dutch and Shell). Value of the portfolio= 1003170/1.00352^(11/12)-217727/1.0204^(59/11)=$802797 1. An inverted yield curve would suggest that A. interest rates are expected to rise. |  12 |  3 | |  The degree of risk reduction for a portfolio depends only on the number of securities in the portfolio | | • Calculating Accrued Interest • The Real Rate of Return In other words, reading the sections above and attempting the problems recommended should put you in a comfortable position to handle majority of questions in the exam. Bond yields (7-7) Corporations ------------------------------------------------- © CSI GLOBAL EDUCATION INC. (2011) 7•3 to: Accounting department of family finance co. ...The Financial Environment: A yield curve where interest rates on medium-term maturities are higher than rates on both short-and long-term maturities: Term "Normal" Yield Curve: Definition. Term Structure | |  3. • Calculating the Yield on a Treasury Bill b. I Instruments with Fixed Payments • The Impact of Maturity Market 4) An increase in the riskiness of corporate bonds will _____ the yield on corporate bonds and _____ the yield on Treasury securities. Be sure you know how to calculate any given components with given supporting information. The Financial Environment  1. Inverted "Abnormal" Yield Curve: According to Hubbard and O’Brien, the term structure “is the relationship among the interest rates on bonds that are otherwise similar but have different maturities.” Term structure is most commonly analyzed by looking at the Treasury yield curve, which is the relationship of interest rates on Treasury bonds with different maturities on a particular day. 6) Which of the following statements are true? Humped or Flat yield curve – no one knows what economy will do . A humped yield curve is where yield increases for a range of maturities and then decreases. We will look at the behavior of interest rates of two groups of bonds: (1) Bonds with the same features but are issued by different agency. E) All of the above are true statements. Introduction | |  5. * Double taxation in the US (only concerned with ‘C’ corporations) Practice problems: 8-1, 8-3, 8-4, 8-6, 8-7, 8-11, 8-12, 8-14 yield curve from normal to inverted or vice versa. Key characteristics of bonds (7-2) 4.1 Price and Yield : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.2 More on Duration : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.3 Immunization : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.4 Convexity optional : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.5 Fixed Income Funds : : : : : : : : : : : : : : : : :...... ...maturities can have different interest rates. Fixed-Income Securities: If the company is paying 9% interest per year, how many loan payments must the company make? it involves long and short positions of similar instruments. These three kinds of yield curve comprise of a normal shaped yield curve, an inverted yield curve and a flat yield curve. Yields generally tend to move in line with maturity, producing an upward sloping yield curve or a “normal yield curve.” Rarely, however, the yields on the long-term treasuries fall below the yields of short-term treasuries. INTRODUCTION c). The different yields currently available on debt securities of similar credit quality according to their term-to-maturity, typically represented graphically. However, there are many types of bonds: bonds with different maturity, bonds issued by different parties (i.e. determination. | |  5. life of the bond). | |  4. Humped yield curve: The intermediate yield is higher than both the short-term and long-term yields. |  The present value of a single future sum: |  1. | |  5. franking credit=gross div-div=div1-τc*τc Family Finance Co. (FFC), a publicly traded commercial bank, invests in a variety of securities in order to enhance returns greater than interest paid on bank deposits and other liabilities. A yield curve is a way to easily visualize this difference; it's a graphical representation of the yields available for bonds of equal credit quality and different maturity dates. The reason for that is that debt issued for a longer term generally carries greater risk because of the greater likelihood of inflation or default in the long run. |  increases as the number of discount periods increases. Whenever you exchange something for another you have a market. Financial assets are intangible. 4. a. 802797-797700= $5097 increase 1. These developments extend the concepts of immunization and matching to a stochastic interest rate environment. v 1 Determinants of market interest rates (section 6-3) * Australian company tax rate: τc=30% ...Working Draft: No Guarantees August 27, 1998 Home page: http: www.stern.nyu.edu ~dbackus a). Possibly because personally I’m a bit deep into bonds, not many would agree with the second part though. Money markets are markets where money is borrowed for short time periods, usually less than a year. ...Chapter 6 Rate The Risk and Term Structure of Interest In the previous section, we have generalized our discussion of the influence of various factors on the behavior in interest rate by examining only a particular type of bonds: namely, the 1-year zero coupon bond. Investors demand higher interest when lending their money for longer periods. Assume that you recently graduated with a degree in finance and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle Dellatorre, a professional tennis player who has just come to the United States from Chile. Chapter 8: Risk & rates of Return Learn vocabulary, terms, and more with flashcards, games, and other study tools. • Global Indexes Essay. By buying a financial asset you become an owner of a company or a lender to one. Bond value when zero-curve shifts up by 1% =$118.1528 Instrument 1 —Collateralized Debt Obligation The normal yield curve has a positive slope. The shape of the yield curve changes over time as interest rates change in the marketplace. The yield curve flattens—that is, it becomes less curvy—when the difference between yields on short-term bonds and yields on long-term bonds decreases. | |  4. Chapter 7: Bond Valuation MD(1)=1/1.00317=0.9968, if delta y=1%, delta B/B= -0.9968% • Calculating the Current Yield on a Bond Corporate Ownership versus Control Why is corporate finance important to all managers? Here's an example. Flat Yield Curve: Flat yield curves exist when shorter and longer-term yield rates are very close to one another. • Canadian Bond Market Indexes Stand-Alone risk (8-2) LTCM engaged in primarily in convergence and relative value strategies. Bond value when zero-curve shifts down by 1% = 5/1.005+5/1.0055^2+5/1.0065^3+5/1.0075^4+5/1.01^5+5/1.0125^6+5/1.015^7+105/1.0155^8= $126.4236 When the yield curve is flat, then it generally indicates a slow down in the economy so investors are not being compensated for the risk of taking on longer term bonds. (What are investors expectations?) b). Relationship between risk and rate of return (8-4) Bond value when zero-curve shifts up by 1% = 5/1.015+5/1.0155^2+5/1.0165^3+5/1.0175^4+5/1.02^5+5/1.0225^6+5/1.025^7+105/1.0255^8= $118.1528 when there was a specifiable future date(usually medium-term fixed maturities) by which convergence of offsetting short and long positions in similar instruments should occur. 3. |  With perfect negative correlation, the risk on a portfolio can be zero if an appropriate allocation of funds is made |  1 | * Ultimate decision-making...... ...Chapter 1 Narrow, it becomes less curvy—when the difference between yields on short-term bonds yields... 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