DEBT SECURITIES

MARKET
LEARNING OBJECTIVES
• Identify different types of bonds; and
• Select the bond or debt security investments that will yield higher value.
FINANCIAL MARKETS
• enables suppliers and demanders of funds to make transactions.
• can be money market or capital market.
• can be a debt or equity/stock market.
DEBT SECURITY VS DEBT INSTRUMENT
• Security is a fungible, negotiable instrument that holds some type of monetary value
(negotiable and tradable).
• Instrument is a document that proves a debtor-creditor relationship.
FINANCIAL INSTRUMENTS
• are documents for the exchange and represents a specified value or the main vehicle used
for transactions in the financial market.
• there are two parties involved in the financial instruments:
• issuer – the party that issues the financial instrument and agrees to make future cash
payments to the investor.
• investor - the party that receives and owns the financial instrument and bears the right
to receive payments to be made by the issuer.
FINANCIAL INSTRUMENTS
Financial instruments have two main economic purposes:
• Allows transfer of fund from entities with excess funds (investors) to entities who needs
funds (issuer) for business purposes.
• Permits transfer of fund that allows sharing of inherent risk associated with the cash flows
coming from tangible asset investment between the issuer and investor.
FINANCIAL INSTRUMENTS
• Debt Instrument – enables the issuing party to raise funds by promising to repay a lender in
accordance with the terms of the contract (principal plus interest).
• Equity Instrument – enables the issuing party to raise funds by promising to pay an amount
to the investor in the future based on the future earnings of the company (change in value
plus dividends).
DEBT INSTRUMENTS
• is a legally enforceable evidence of a financial debt and the timely repayment of the
principal and interest.
• Importance: makes repayment of debt legally enforceable and increases the transferability
of the obligation.
• it can be:
• short-term – due within one year.
• long-term – due in more than one year (usually in installment basis).
TYPES OF DEBT INSTRUMENTS
• Notes
• Bonds
• Debentures
• Certificates
• Mortgages
• Leases
DEBT SECURITIES
• are instruments representing a creditor relationship with an entity.
• can be bought or sold between two parties and have the following characteristics:
• maturity value;
• periodic interest payments (at fixed or variable interest rate); and
• maturity date.
• also includes collateralized securities.
• also known as fixed-income securities.
• the interest rate of debt securities is largely determined by repayment ability of the
borrower.
• the traded debt securities is higher than equity securities.
• have an implicit level of safety.
TYPES OF DEBT SECURITIES
• Money Market Debt Securities – with maturities of less than one year (example: treasury
bills and certificate of deposits).
• Capital Market Debt Securities – with maturities of longer than one year (example: notes,
bonds, mortgage).
BOND MARKET
• A bond is a fixed-income instrument that represents a loan made by an investor to a
borrower (typically corporate or governmental).
• The bond market primarily includes government-issued securities and corporate debt
securities.
TYPES OF BOND
• Corporate Bond – issued by companies to raise funds to support operations or business
expansion.
• Government/Agency Bond – issued by national government or agencies to raise funds to
support government projects/activities.
• Municipal Bond – issued by local governments to raise funds to support their projects.
• Mortgage-Backed Bond - secured by a mortgage on one or more assets, typically backed
by real estate holdings and real property.
• Asset-Backed Bond – secured by pool of assets such as loans, leases, credit card debt,
royalties and receivables.
• Collateralized Bond – structured financial product that pools together cash generating
assets and repackages the assets into discrete that can be sold to investors.
CHARACTERISTICS OF BONDS
• Coupon Rate – the fixed return that an investor earns periodically until the bonds mature
(interest rate).
• Maturity Date – all bonds have maturity date (whether short-term or long-term).
• Current/Market Price – the investor may purchase the bonds at par, below par or above par
depending on the level of interest rate.
TYPES OF INTEREST RATES
• Stated rate or nominal rate - is the interest rate indicated in the face of the bonds. It is the
basis of the interest received/receivable or paid/payable.
• Effective interest rate or market rate or yield rate - is the rate that exactly discounts
estimated future cash payments or receipts through the expected life of the financial asset
or financial liability to the gross carrying amount of a financial asset or to the amortized cost
of a financial liability. It is the basis of the interest earned/incurred during a period.
BOND CERTIFICATES
• The value of the bonds can be based on market quotation or the discounted value. Any
quotation for the debt security is expressed as a percentage of its face value.
• If the quotation or purchase price is not available, the bond price or market price is
determined by discounting the maturity value of the bond and each remaining interest
payments at the market rate of interest for similar debt on that date.
• When computing the present value, the interest rates are considered:
• Stated rate = Effective rate → Bonds sell at face value
• Stated rate > Effective rate → Bonds sell at a premium
• Stated rate < Effective rate → Bonds sell at a discount
BOND VALUATION
• It is a technique in determining the theoretical fair value of a particular bond.
• It includes calculating the present value of the bond's future interest payments, and the
bond's value upon maturity (face value/par value):
VALUATION OF NON-TREASURY BOND
• A risk premium is added to the base interest rate (treasury rate).
• The risk premium (credit spread) is assumed to be the same regardless of when a cash flow
is to be received.
APPROCHES IN VALUATION
Traditional Approach
• Discount every cash flow of a bond by the same interest rate (or discount rate).
• The cash flows are viewed as default free/risk-free.
• Use the same discount rate to calculate the present value of securities and use the same
discount rate for the cash flow for each period.

Arbitrage Free Valuation Approach

• View the bond coupon rate as a package of zero-coupon bonds (treasury spot rate).
• It values a bond as a package pf cash flow, with each cash flow viewed as zero-coupon
bond and each cash flow discounted at its own unique discount rate.
VALUATION OF BONDS WITH EMBEDDED OPTIONS
Lattice Model
• used to value derivatives by employing a binomial tree to compute the various paths the
price of an underlying asset might take over the derivative's life.
• used to value callable bonds and puttable bonds.

The Monte Carlo Simulation Model

• used to predict the probability of a variety of outcomes when the potential for random
variables is present.
• helps to explain the impact of risk and uncertainty in prediction and forecasting models.
• used to value mortgage-backed securities and certain types of asset-backed securities.
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