MScFE xxx [Course Name] - Module X: Collaborative Review Task

Video Transcripts
Module 4
MScFE 560
Financial Markets

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Revised: 09/09/2019
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MScFE 560 Financial Markets – Video Transcripts Module 1

Table of Contents

Unit 1: Introduction to Bond Markets ............................................ 3

Unit 2: Fixed Income Risks .............................................................. 5
Unit 3: Bond Valuation I ................................................................... 7
Unit 4: Bond Valuation II .................................................................. 9

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MScFE 560 Financial Markets – Video Transcript (Lecture 1) Module 4: Unit 1

Unit 1: Introduction to Bond Markets

In this module, we will study bond markets. Bond and equity markets together constitute capital
markets, which were briefly discussed in Module 1 of this course. If you have studied accounting,
you might remember the well-known equation stating that Assets equal Equity plus Debt. As an
example, to start a business, the founder or founders need to contribute the initial capital to start
the business themselves, or they need to borrow it (or choose some combination of contributing
and borrowing). From there, further money can be contributed (if, for example, the founders
reinvest profits that they make) or borrowed. The well-known accounting equation reflects this
fact: simply put an organization is funded by some combination of owner contribution (known as
equity) and debt.

In the previous module, we discussed how businesses can obtain short-term funding from the
money market. We are now discussing the long-term, more fundamental funding of the business. If
we ignore short-term, money market borrowing — which changes from month and month,
depending on many changing factors — we are left with the long-term debt, and the equity. In this
module, we examine this long-term debt, while the equity aspect is studied in Module 5. The
markets in which these two types of funding are traded are known as the bond and equity markets
respectively. Together these two types of markets constitute the capital market.

A bond was defined in Module 3 as a long-term debt instrument – that is, a longer-term version of
a bill or note. Just as in the money market, an entity borrows money by issuing a bond. This is a
simply a promise to pay an amount at a future date (although later we’ll consider bonds that pay
several amounts at several times). As with money-market instruments, the amount to be paid is
called the par value (although the terms face value, nominal value or principal are also used for
bonds), and the future payment date is called the maturity. In exchange for the right to receive the
par amount in the future, a bond investor pays some price — determined by supply and demand in
the bond market — to the issuer. Thus, the investor lends money to the issuing entity.

An entity must be funded in some way, and so a choice must be made between issuing debt and
issuing equity (both to establish the entity initially, and to raise further funds later on in its life). It
is well-known to accountants that choosing debt over equity is riskier for the entity — the first set
of notes in this module explains why. The lender invests their money in exchange for the promise

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MScFE 560 Financial Markets – Video Transcript (Lecture 1) Module 4: Unit 1

of a future payment (the risk that the promise might not be fulfilled — that the issuer might default
— is dealt with later). This future payment is known in advance, which is why the bond markets are
also known as the fixed-income markets. The fact that the future payments are fixed makes the
investment risk-free in a certain sense — the amount received is not going to vary in an
unfavorable way, whereas other investments can turn out to have much less value than expected.
Holding a bond is not risk-free in all senses though. An important risk is the fact that, although the
future payment is fixed, the bond value at an earlier time — that is to say, the price determined by
the bond market — can change.

For money market instruments, this concern is minor, because the fixed payment of the par value
will occur in the near future. Suppose you hold a bond that matures in 15 years, however, and
suppose the price drops suddenly. The fixed nature of the future payment is not necessarily
comforting, because there is a very long time to wait until it will occur. This risk — that the market
price of a bond can drop — is known as market risk. This can also be called interest-rate risk,
because — as we’ve seen in the previous module and will see again here — interest rates are linked
to prices, as a change to interest rates causes a change to bond prices as a direct consequence.

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MScFE 560 Financial Markets – Video Transcript (Lecture 2) Module 4: Unit 2

Unit 2: Fixed Income Risks

Having described the market risk inherent in a bond investment, we now consider the other risks
that are present. A very important one is the risk of default — or the credit risk — which was
overlooked in the previous set of notes.

We have seen that a bond is a method for money to be lent from one party (the bond investor or
holder) to another (the bond issuer). The nature of issuer is greatly relevant to their ability to
repay the loan — that is, to fulfil the promise to pay the par value at the maturity date. As was
discussed in the previous module, a large government has a much greater chance of meeting their
debt obligations than a new business does. So, default risk depends greatly on the borrowing, or
the issuing, entity. Note also that default risk is asymmetric: it applies only to the lender, who is
the only party that can face a loss in the event of default. A default — that is, a failure to fulfil an
obligation at the maturity date — does not necessarily imply that the investor receives nothing; it
just implies that they don’t receive the full par value amount. Any amount that the investor does
receive is known as a recovery amount.

Recall from the previous module that the forces of supply and demand will cause the possibility of
default to be factored into bond prices — investors will pay less for a bond if there is a greater
chance of default, all other things being equal. So, the prices of credit-risky bonds are influenced
by at least two types of factors: the bond-market forces that determine the prices of all bonds
including government bonds, and the forces of supply and demand that determine what additional
discount is needed to compensate investors for the possibility of default. The term discount is
used in many ways in finance — note its use here, and ensure you don’t confuse it with a discount
rate, a discount factor, or the discounting of cash flows from a later to an earlier date.

This introduces an interesting dynamic to bond prices. When a bond is issued, the market will
determine a price based on the market’s collective desire to hold fixed-income assets (i.e., on
market interest rates, which reflect this desire) and on their collective view of how likely a default
is (as well as how much recovery will be possible in that event). Recall from Module 1 that the
initial issuance of the bond is known as a primary market trade, whereas subsequent trading of the
bonds — which does not affect or concern the issuing entity — takes place in the secondary
market. The bond price will continue to evolve as it is traded secondarily, as the forces of supply
and demand evolve.

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MScFE 560 Financial Markets – Video Transcript (Lecture 2) Module 4: Unit 2

For example, a new regulation or tax code might induce investors to increase their bond holdings,
which would force the bond prices upward. This would be the first type of factor. For an example
of the second type, suppose that a bond issuer releases new financial statements that reveal it is in
financial distress. The prices of its bonds trading on the secondary market are likely to drop, as a
future default now appears more likely.

In general, financial markets tend to incorporate new information into prices virtually immediately
— put differently, financial markets tend to be efficient. This efficiency means that a default
doesn’t need to take place for there to be price effect — it just needs to be perceived as possible.
For instance, the market might expect that financial statements will reveal bad financial news for
the borrowing entity, in which case the bond prices would have already dropped when this
expectation was formed. If the statements turn out to be better than expected, the prices will
bounce back up to some extent, as the market continues to update its outlook. In conclusion, the
mere possibility of default and the perceived likelihood of the default cause a non-trivial effect on
bond prices (or, equivalently, on the interest rates offered by bonds).

In the next set of notes, we will elaborate on some of these points and develop a comprehensive
list of the risks involved in bond investing.

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MScFE 560 Financial Markets – Video Transcript (Lecture 3) Module 4: Unit 3

Unit 3: Bond Valuation I

Previously, we discussed the various qualitative concerns that affect a bond issuer and a bond
investor. We now address how the prices that result from these concerns can be handled
quantitatively.

We first need to summarize the valuation concepts introduced in Module 3. An interest rate is the
return that a lender will earn on the amount they invested, or in other words money borrowed
from them, assuming the promised repayments are met. If there is a large difference between a
bond’s purchase price and its par value, there is a large amount of interest that the holder will earn
from buying the bond and holding it until maturity. If a bond’s price is low relative to its par value,
its interest rate (or yield, which is the bond-market term for an interest rate) is high, and vice
versa. An interest rate or yield expresses the rate at which the loan value increases over its life,
and a rate is a scale-free way of expressing an increase per unit of time.

The specific, mathematical way in which the interest rate expresses this rate of increase (or rate of
return on investment) can vary; the various ways are known as different interest-rate
conventions or compounding conventions. In the following set of notes, we will list the different
interest rate conventions that were defined in Module 3 and are needed in this module as well.
Understanding these interest-rate conventions allows you to move from a bond price to an
interest rate, or from an interest rate to a bond price. When valuing a bond in this way, the value is
not produced from thin air, but is based on an interest rate that must be taken as an input.

Module 3 concludes with two factors that complicate the valuation of debt instruments. The first
is that interest rates are not necessarily the same for loans of differing terms (and therefore for
bonds of differing times until maturity). The phenomenon is known as the term structure of
interest rates. So, while interest rates adjust for loan size and term, loans of differing terms do not
typically have interest rates that coincide exactly.

The second factor is that default risk affects an interest rate. Because default risk causes bond
prices to decrease, and because bond prices and interest rates have an inverse relationship,
greater default risk is reflected by a higher interest rate. This stands to reason: lenders demand a
larger interest to compensate them for the possibility that the borrower defaults, and the lender
does not end up earning the promised interest. The difference between a yield on a defaultable

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MScFE 560 Financial Markets – Video Transcript (Lecture 3) Module 4: Unit 3

bond (i.e. its interest rate) and the risk-free interest rate is known as the spread (or credit spread).
This is an extremely important use of risk-free, or virtually risk-free, government bonds as
benchmarks. Of course, when comparing defaultable-bond and government-bond yields to
determine spreads, one should compare bonds of equal maturity; otherwise the term structure of
interest rates makes the comparison unfair.

The following set of notes formalizes and elaborates on these ideas, and also considers coupon-
bearing bonds (or just coupon bonds): bonds that make regular payments, called coupons,
throughout their life, in addition to the payment of the par value at the end of its life. The simpler
bonds we have been considering, with one payment at one date, can be called zero-coupon bonds.

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MScFE 560 Financial Markets – Video Transcript (Lecture 4) Module 4: Unit 4

Unit 4: Bond Valuation II

We will now consider some more advanced bond-valuation concepts. The first is a bond’s yield to
maturity.

To price a coupon-bearing bond, one requires several interest rates, as each of the bonds’ cash
flows must be discounted with an interest rate appropriate for its term. Once its price is
established, consider the single interest rate that discounts the cash flows to attain the bond’s
price. In other words, forget about the term structure of interest rates, and then calculate the
interest rate implied by the price. This rate is called the yield-to-maturity. The reason one would
use only one interest rate in this way is that it gives the return earned over the whole investment.
The individual interest rates give the return associated with the individual cash flows, assuming
you hold the bond until they are paid and assuming the issuer does not default. The overall return
is also relevant, and is made up by the various individual returns. This idea can be used to compare
the investments offered by two different bonds, which can be difficult if the bonds have different
maturities and coupons.

The next concept is that of a yield curve. We know that interest rates differ according to the term
they are based on (that is to say, we know interest rates have a term structure), so we can consider
various interest rates for various different terms. Suppose we observed government bond prices
for bonds with remaining terms of one, two, three years, and so on up to 20 years, and suppose we
drew a graph of the rates implied by these prices (in other words, suppose, after calculating the
rates, we plotted them as a function of their underlying terms). This graph is known as the yield
curve — it gives the yields (in the form of a plotted curve or graph) of zero-coupon bonds of the
various possible maturities. This summarizes all the interest rate information available for a
particular bond issuer. A different issuer, if they had a different default risk, would have a different
yield curve. The difference between an entity’s yield curve and a risk-free one is the entity’s
spread. The next set of notes elaborate on this, and on why it is such a powerful idea.

Finally, we need to unpack the concept that bonds with longer terms are riskier. The primary
reason for this is that there is more potential variation in a bond price if the maturity is further
away (that is, longer-term bonds exhibit more market risk). We consider this idea from a
mathematical perspective in the next set of notes, but one can see the intuition with a simple
comparison. A one-year bond price, for instance, is determined by how the bond markets discount

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MScFE 560 Financial Markets – Video Transcript (Lecture 4) Module 4: Unit 4

the par value payment in a year’s time. In pricing a two-year bond, the market discounts the par
value over a two-year period, which includes the one-year period of discounting involved in the
first bond. There is uncertainty in how the market discounts over the one-year period — although
we might observe the price now, it may change in the future. But the uncertainty in the
discounting and pricing of the two-year bond is greater, as it includes the uncertain discounting
over one year in addition to the uncertain discounting over the second year.

Because of the greater market risk in longer-term bonds, yield curves tend to be upward sloping —
investors tend to get additional compensation (in the form of a higher yield) for bearing the
additional market risk. The term of a zero-coupon bond is simply the time until its maturity, but
the cash flows of a coupon bond (or a more complicated portfolio of bonds) are spread over time,
and so one cannot directly compare the terms of two bond portfolios. The notes define the
concept of duration, which gives the average of the terms associated with the cash flows of a bond
portfolio. If the duration of portfolio A is greater than portfolio B’s duration, then portfolio A, on
average, has cash flows that are further away. Because longer terms induce greater market risk,
portfolio A is riskier than portfolio B.

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