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Finance 100

Prof. Michael R. Roberts

Topic Overview

Introduction to bonds and bond markets Zero coupon bonds

Valuation Yield-to-Maturity & Yield Curve Spot Rates Interest rate sensitivity DVO1 Valuation Arbitrage Bond Prices Over Time Yield Curve Revisited Interest rate sensitivity Duration & Immunization

Coupon bonds

Forward Rates

Copyright Michael R. Roberts

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A bond is a security that obligates the issuer to make interest and principal payments to the holder on specified dates.

Maturity (or term) Face value (or par): Notional amount used to compute interest payments Coupon rate: Determines the amount of each coupon payment, expressed as an APR

Coupon =

Repayment type Issuer Maturity Security Priority in case of default

Repayment Schemes

Bonds with a balloon (or bullet) payment

Pay no coupons prior to maturity.

Coupon bonds

Pay a stated coupon at periodic intervals prior to maturity.

Floating-rate bonds

Pay a variable coupon, reset periodically to a reference rate.

Perpetual bonds

Pay a stated coupon at periodic intervals.

Pay a regular fixed amount each payment period. Principal repaid over time rather than at maturity.

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US Government (Treasuries)

T-bills: 4,13,16-week maturity, zero coupon bonds T-notes: 2,3,5,10 year, semi-annual coupon bonds T-bonds: 20 & 30-year, semi-annual coupon bonds TIPS: 5,10,20-year, semi-annual coupon bond, principal -adjusted Strips: Wide-ranging maturity, zero-coupon bond, IB-structured

Maturities from one month to 40 years, semiannual coupons Exempt from federal taxes (sometimes state and local as well). Generally two types: Revenue bonds vs General Obligation bonds Riskier than government bonds (e.g., Orange County)

Agencies:

E.g. Government National Mortgage Association (Ginnie Mae), Student Loan Marketing Association (Sallie Mae) Most issues are mortgage-backed, pass-through securities. Typically 30-year, monthly paying annuities mirroring underlying securities Prepayment risk.

Corporations

4 types: notes, debentures, mortgage, asset-backed ~30 year maturity, semi-annual coupon set to price at par Additional features/provisions:

Callable: right to retire all bonds on (or after) call date, for call price convertible bonds putable bonds

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Bond Ratings

Moodys Aaa Aa A Baa Ba B Caa Ca C D S&P AAA AA A BBB BB B CCC CC C Quality of Issue Highest quality. Very small risk of default. High quality. Small risk of default. High-Medium quality. Strong attributes, but potentially vulnerable. Medium quality. Currently adequate, but potentially unreliable. Some speculative element. Long-run prospects questionable. Able to pay currently, but at risk of default in the future. Poor quality. Clear danger of default. High speculative quality. May be in default. Lowest rated. Poor prospects of repayment. In default.

Debt Instrument U.S. Gov. Municipal Corporate Consumer Credit Mortgages 2005 307.3 195 53.6 94.5 1417.5 2006 183.7 177.3 213.4 104.4 1397.1 2007 237.5 214.6 314.1 132.3 1053.2

Dollar volume of bonds traded daily is 10 times that of equity markets! Outstanding investment-grade dollar denominated debt is about $8.3 trillion (e.g., treasuries, agencies, corporate and MBSs

Copyright Michael R. Roberts

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Notation Reminder:

Vn= Bn = Market price of the bond in period n F = Face value R= Annual percentage rate m = compounding periods (annual m = 1, semiannual i = Effective periodic interest rate; i=R/m T = Maturity (in years) N = Number of compounding periods; N = T*m r = discount rate

m = 2,)

Two cash flows to buyer of a zero coupon bond (a.k.a. zero): What is the price of a bond?

V0 = B 0 = F

(1 + r )

F or V0 = B0 = N 1 + i) (

Value a 5 year, U.S. Treasury strip with face value of $1,000. The APR is 7.5% with quarterly compounding? Approach 1: Using R (APR) and i (effective periodic rate) ?

Approach 2: Using r (EAR) ?

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Yield to Maturity

The Yield to Maturity (YTM) is the one discount rate that sets the present value of the promised bond payments equal to the current market price of the bond Doesnt this sound vaguely familiar ? Example: Zero-Coupon Bond

V0 = F

(1 + r )

F r= V0

1/ T

1 = YTM = y

0 = V0 F

(1 + IRR )

F IRR = V0

1/ T

1 = YTM = y

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A spot rate is the interest rate on a T-year loan that is to be made today

r1=5% indicates that the current rate for a one-year loan today is 5%. r2=6% indicates that the current rate for a two-year loan today is 6%. Etc. Spot rate = YTM on default-free zero bonds.

The term structure of interest rates is the series of spot rates r1, r2, r3, relating interest rates to investment term The yield curve is just a plot of the term structure: interest rates against investment term (or maturity)

Zero-Coupon Yield Curve: built from zero-coupon bond yields (STRIPS) Coupon Yield Curve: built from coupon bond yields (Treasuries) Corporate Yield Curve: built from corporate bond yields of similar risk (i.e., credit rating)

Term Structure of Risk-Free U.S. Interest Rates, January 2004, 2005, and 2006

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We should discount each cash flow by its appropriate discount rate, governed by the timing of the cash flow Example: What is the present value of $100, 10 years from today ? (Use the term structure from January 2004)

Generally speaking, we must use the appropriate discount rate for each cash flow:

PV = C1 C2 + + 1 + r1 (1 + r2 ) 2 + CN = (1 + rN ) N

n =1

CN (1 + rn ) n

A Cautionary Note

All of our valuation formulas (e.g., perpetuity, annuity) assume a flat term structure.

I.e., there is only one discount rate for cash flows received at any point in time

Recall:

Growing Annuity:

PV = C

Growing Perpetuity:

1 (r g )

PV =

N 1 + g 1 (1 + r )

C (r g )

Copyright Michael R. Roberts 16

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Why do zero-coupon bond prices change?...Interest rates change! F

V0 =

(1 + i )

The price of a zero-coupon bond maturing in one year from today with face value $100 and an APR of 10% is:

V0 = 100

(1 + 0.10 )

= $90.91

Example: Now imagine that immediately after you buy the bond, the interest rate increase to 15%. What is the price of the bond now ?

Consider the following 1, 2 and 10-year zero-coupon bonds, all with

F=$1,000 APR of R=10%, compounded annually.

$1,200 $1,000 $800 $600 $400 $200 $0 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 1-Year 2-Year 10-Year

Note 4 things: 1. Bond prices are inversely related to IR 2. Fix the interest rate: Longer term bonds are less expensive 3. Longer term bonds are more sensitive to IR changes than short term bonds 4. The lower the IR, the more sensitive the price.

Copyright Michael R. Roberts 18

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Whats the natural thing to do? Compute the derivative

V0 = F

(1 + i )

If we change the interest rate by a little (e.g., 0.0001 or 1 basis point) than multiplying this number by the derivative should tell me how much the price will change, all else equal (i.e., DV01 = Dollar Value of 1 Basis Point)

Alternatively, we can just compute the prices at two different interest rates and look at the difference: B0(i) B0 (i+0.0001)

Amortization Bonds

Consider an amortization bond maturing in two years with semiannual payments of $1,000. Assume that the APR is 10% with semiannual compounding How can we value this security?

1. Brute force discounting (i): V0 = + + + = $3545.95 (1 + 0.10 / 2 ) (1 + 0.10 / 2 )2 (1 + 0.10 / 2 )3 (1 + 0.10 / 2 )4 or 1000 1000 1000 1000 EAR (r): V0 = + + + = $3545.95 0.5 1 1.5 2

1000 1000 1000 1000

(1 + 0.1025)

V0 =

(1 + 0.1025)

(1 + 0.1025 )

(1 + 0.1025 )

1000 (1 (1 + 0.10 / 2)4 ) = $3,545.95 0.10 / 2

Copyright Michael R. Roberts 20

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Replication

Can we construct the same cash flows as our amortization bond using other securities?

What if the bond is selling for $3,500 in the market?

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What is the market price of a U.S. Treasury bond that has a coupon rate of 9%, a face value of $1,000 and matures exactly 10 years from today if the interest rate is 10% compounded semiannually? 0 6 12 108 Timeline: Months

Cash Flows 45 45 45

120 1045

What is the market price of a bond that has an annual coupon C, face value F and matures exactly T years from today if the required rate of return is R, with m-periodic compounding?

Coupon payment is: c = C/m Effective periodic interest rate is: i = R/m number of periods N = Tm

V 0 = [ Annuity

] + [Zero ]

1 (1 + i ) N F = c N + ( i 1 + i)

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Bond prices are inversely related to interest rates (or yields). A bond sells at par only if its interest rate equals the coupon rate.

A bond sells at a premium if its coupon rate is above the interest rate. A bond sells at a discount if its coupon rate is below the interest rate.

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Recall: The Yield to Maturity is the one discount rate that sets the present value of the promised bond payments equal to the current market price of the bond Prices are usually given from trade prices

need to infer interest rate that has been used

B=

c 1 1 yield / m (1 + yield / m )N

F + (1 + yield / m )N

This is not the annualized yield, which equals yield* = ( 1 + yield / m)m-1 E.g., IRR function in excel or your calculator since:

B=

c 1 1 yield / m (1 + yield / m )N

F + (1 + yield / m )N

Copyright Michael R. Roberts 28

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Treasury Coupon-Paying Yield Curve

Often referred to as the yield curve Same idea as the zero-coupon yield curve except we use the yields from coupon paying bonds, as opposed to zerocoupon bonds.

Treasury notes and bonds are semi-annual coupon paying bonds

On-the-Run Bonds are the most recently issued bonds

The Duration of a security is the percent sensitivity of the price to a small parallel shift in the level of interest rates.

Duration = DB = 1 dB B dy

A small uniform change dy across maturities might by 1 basis point. Duration gives the proportionate decline in value associated with a rise in yield Negative sign is to cancel negative first derivative

Alternatively, given a duration DB of a security with price B, a uniform change in the level of interest rates brings about a change in value of dB = DB dy B

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The mathematical expression for Duration is:

1 dB 1 1 N n 1 = + N F (1 + y / m) N 1 n cn (1 + y / m ) B dy B m n =1

N n c (1 + y / m ) n N F (1 + y / m) N 1 D = (1 + y / m ) n + B m B n =1 m N PV ( cn ) N PV ( F ) n 1 = (1 + y / m ) + n =1 m B m B Time in Years "Weight" on until nth payment nth payment

Compute the duration of a two-year, semi-annual, 10% coupon, par bond, with face value of $100.

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More on Duration

Duration is a linear operator: D(B1 + B2) = D(B1) + D(B2)

The duration of a portfolio of securities is the value-weighted sum of the individual security durations DVO1 is also a linear operator

Based on slope of price-yield relation at a specific point Based on a bond of fixed maturity but maturity declines over time

Duration of a zero is

D = (1 + y / m )

1

N m

Bank of Philadelphia balance sheet (Figures in $billions, D=duration assuming flat spot rate curve) Assets Liabilities & Shareholders Equity Commercial Paper (D = 0.48) 2-Year Notes (D = 1.77) Shareholder Equity Total Assets (D = 1) 25 Total Liabilities (D = ?) Duration of liabilities = ? The problem:

Increases in interest rates will decrease value of liabilities by more than assets because of duration mismatch.

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What is the change in assets value when interest rates change uniformly? What is the change in liability value when interest rates change uniformly ? We want our assets and liabilities to experience similar value changes when interest rates change, so set these two expressions to be equal and solve for DL (DA=1.0): ?

What fraction of the banks liabilities should be in CP and Notes in order to get a liability duration of 1.25 ?

How much money should the bank hold in CP and Notes in order to get a liability duration of 1.25? How should the bank alter their liabilities to achieve this structure ?

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Forward Rates

A forward rate is a rate agreed upon today, for a loan that is to be made in the future. (Not necessarily equal to the future spot rate!)

f2,1=7% indicates that we could contract today to borrow money at 7% for one year, starting two years from today.

Consider two investment strategies:

1. Invest $100 for three years how much do we have? 2. Invest $100 for two years, and invest the proceeds at the one-year forward rate, two periods hence how much do we have?

When are these two payoffs equal? (i.e. what is the implied forward rate?)

Copyright Michael R. Roberts 37

Forward Rates

Strategy #1: Invest $100 for three years have ? how much do we

Strategy #2: Invest $100 for two years and then reinvest the proceeds for another year at the one year forward rate, two periods hence how much do we have ?

When are these two payoffs equal? (i.e. what is the implied forward rate?) ?

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What if the prevailing forward rate in the market is 7%, as opposed to what calculated in the previous slide? Step 1: Is there a mispricing and, if so, what is mispriced ? Step 2: Is the forward loan cheap or expensive ?

Step 3: Given your answer to Step 2, what is the first step in taking advantage of the mispricing ?

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Forward rates are entirely determined by spot rates (and vice versa) by no arbitrage considerations. General Forward Rate Relation: (1+rn+t)n+t=(1+rn)n(1+fn,t)t Think of this picture for intuition:

(1+r1) (1+r1) (1+f1,1) (1+r3)3 (1+r2)2 (1+f2,1) (1+f1,2)2 (1+f2,1)

Time 0

3

Copyright Michael R. Roberts 41

Summary

Bonds can be valued by discounting their future cash flows Bond prices change inversely with yield Price response of bond to interest rates depends on term to maturity.

Works well for zero-coupon bond, but not for coupon bonds

Measure interest rate sensitivity using duration. The term structure implies terms for future borrowing:

Forward rates Compare with expected future spot rates

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