Yield to Maturity (YTM)

Measure of total return anticipated on a bond if it is held

until its maturity date and all interest payments are made
in full and reinvested at the same rat
Average return an investor can expect to earn if they
purchase a bond at its current market price and hold it
until maturity.

Other Yield Measures

Bond Equivalent Yiel
simplified

Effective Annual Yiel Holding Period Return

Current Yield

Callable VS Straight Bond

Yield to Call

6.64% 6.82%
Realised Compound Return (VS YTM
YTM assumes a;l coupons are re-invested to earn bond’s
yield to maturity
Refers to the investment rate at which the coupon can be
re-invested

Altman’s Z-Score (Likelihood of Bankruptcy —

Credit Strength Test)

Protective Covenant
Sinking Fund
Subordination of Future Deb
Dividend Restriction
Collateral
Corporate Bond Yield Terms

Yield Spread = Default Premium + Risk Premium

Chapter 18
Spot Rates
Zero Coupon Bonds

Pre-Midterm bid: sell

T-year spot rate is

ask: buy an “average” of one-year future spot rates

APR to EAR (when continiously compounded)

 indirect way would be LOR

Contango: If F(f,t) > S(t)

rf + y >0

rf always positive

Commodities always has storage costs which are very high so y is

usually positive

(It would be more attractive go buy a futures contract for oil and avoid
cost of storage than to buy the oil in the spot market and store it)

Backwardation: If F(f,t) < S(t)

rf + y <0

Financial assets --> No storage costs; Need to pay dividend or coupon (if
you get lots of dividend coupons, possible that it will turn negative)

(these cash flows reduce to effective yield of the asset)

GOLD

Health Insurance as an Option

Type of option? Put Option

Underlying Asset? Our Health

Current Asset Price? Current Health

Time to Maturity? When the contract ends (in HK, one year)

Strike Price? When state of health is bad, and its time to go see the doctor/
make use of insurancce

Put premium? Insurance Premium

Levered Equity

Stocks are actually call when exercise price is the amount of debt outstanding;
Value of stock is the value of the call option

GASOLINE

Shares are issued by firms which has debt. Thus, if value of the firm is less than
amount of debt outstanding --> company maybe insolvenet and unable to pay
off its debts

because of law that debt holders are first priority, shareholders get nothing ;

only when the firm is solvent, then they make money (Call option)

call
put

FINANCIALS Risky Debt

If company is solvent, bond holders get what id promoised

If company is bankrupt, bond holders take hold of company; if company is worth

nothing, they get 0

stocks have upside but limited downside bonds have limited upside but big downside
(uses YTM) (Put option)

Thus... stokcholders tend to take risky projects and bondholders tend to take less
risky projects

(uses future
spot rates) EXAMPLE

Term Structure Model

Expectation Hypothesis (Expected Future Spot = Current
Forward

Liquidity Preference (Expected Future Spot < Current

Forward) (Require premium for long-term borrowings since
investors prefer a premium)

you just need three of these four pairs to build all

financial assets (past present and future)

Binomial Options
Pricing Model

Chapter 19

Black Scholes Model

Valuation of Futures Markets Today, t=0

Valuation of Futures Markets at time T

Optimal Wd for Risky
Portfolio

B represents systematic risk

ε represents unsystematic risk

a>0 --> underpriced (y ’s return too
curly = expected excess return
hgih)

straight = expected return a<0 --> overpriced (y ’s return too low)

SI Model