Slides 2 Bonds Student1

8/24/2016Fall 2016, BF 4211, Dr. Zhi Li1BondasInvestmentFall2016,BF4211,Dr.ZhiLi1MasteroftheUniverseFall2016,BF4211,Dr.ZhiLi2BondmarketismarchlargerthanstockmarketUSbondmarketismorethan2xthesizeoftheUSstockmarketWhoissuesbondsinU.S?Bondtraders–“MastersoftheUniverse”8/24/2016Fall 2016, BF 4211, Dr. Zhi Li2BondsDefinitionofaBond:Securitythatobligatestheissuertomakespecificpaymentstothebondholder.VerypopularformoffinancingforU.S.companiesFaceValue(ParValueorPrincipalValue):Paymentatthematurityofthebond.Usually$1,000intheU.S.Coupon:Interestpaymentmadetobondholders.UsuallypaideverysixmonthsintheU.S.Itcanbeexpressedinpercentageofthefacevalue(CouponRate).Maturity:DateoflastpaymentExample:T-Bond3%2021Fall2016,BF4211,Dr.ZhiLi3LevelCouponBondMainFeature:(Semi)–AnnualPayments06MonthsYear1…YearTPaymentsCoupon(C)Coupon(C)Coupon(C)+FaceValue(F)Fall2016,BF4211,Dr.ZhiLi4YearperCPof#ValueFaceRateCouponCoupon8/24/2016Fall 2016, BF 4211, Dr. Zhi Li3BondPricing•ThepriceofabondisthePresentValueofallcashflowsgeneratedbythebond(i.e.couponsandfacevalue)discountedattherequiredrateofreturn.Bondscanbevaluedlike“packageoftwoinvestments”:PresentvalueofinterestpaymentsPresentvalueofprincipalThecouponrateISNOTthediscountrateusedinthePresentValuecalculations.Thecouponratemerelytellsuswhatcashflowthebondwillproduce.ttrFrcouponrcouponrcouponPV)1()1(....)1()1(21Fall2016,BF4211,Dr.ZhiLi5DeterminantsofRequiredReturnInterestRateBondcharacteristics:TimetomaturityLongertermbondsshouldhavehigherrequiredrateofreturnRiskofdefaultRiskismeasuredbybondratingsFall2016,BF4211,Dr.ZhiLi68/24/2016Fall 2016, BF 4211, Dr. Zhi Li4RiskandBondRatingMoody’sinvestorsServiceorStandard&Poor’scouldbehiredbyfirmsthatneedtheirdebtratedDebtRatingdependson:LikelihoodofDefaultProtectionaffordedbytheloancontractincaseofdefaultFall2016,BF4211,Dr.ZhiLi7DefaultRiskStandardMoody's&Poor'sSafetyAaaAAAThestrongestrating;abilitytorepayinterestandprincipalisverystrong.AaAAVerystronglikelihoodthatinterestandprincipalwillberepaidAAStrongabilitytorepay,butsomevulnerabilitytochangesincircumstancesBaaBBBAdequatecapacitytorepay;morevulnerabilitytochangesineconomiccircumstancesBaBBConsiderableuncertaintyaboutabilitytorepay.BBLikelihoodofinterestandprincipalpaymentsoversustainedperiodsisquestionable.CaaCCCBondsintheCaa/CCCandCa/CCclassesmayalreadybeCaCCindefaultorindangerofimminentdefaultCCC-ratedbondsofferlittleprospectforinterestorprincipalonthedebtevertoberepaid.Fall2016,BF4211,Dr.ZhiLi88/24/2016Fall 2016, BF 4211, Dr. Zhi Li5DefaultbyOriginalRating12345678910AAAYearly0.00%0.00%0.00%0.00%0.04%0.00%0.00%0.00%0.00%0.00%Cumulative0.00%0.00%0.00%0.00%0.04%0.04%0.04%0.04%0.04%0.04%AAYearly0.00%0.00%0.36%0.20%0.00%0.00%0.00%0.00%0.03%0.03%Cumulative0.00%0.00%0.36%0.56%0.56%0.56%0.56%0.56%0.59%0.62%AYearly0.00%0.00%0.03%0.08%0.04%0.08%0.05%0.09%0.07%0.00%Cumulative0.00%0.00%0.03%0.11%0.15%0.23%0.28%0.37%0.44%0.44%BBBYearly0.07%0.25%0.27%0.53%0.32%0.32%0.35%0.06%0.06%0.24%Cumulative0.07%0.32%0.59%1.12%1.44%1.76%2.11%2.17%2.23%2.47%BBYearly0.71%0.81%2.65%1.41%2.35%0.80%1.71%0.30%1.45%3.03%Cumulative0.71%1.52%4.17%5.58%7.93%8.73%10.44%10.74%12.19%15.22%BYearly1.58%3.92%4.88%5.78%4.62%3.65%2.38%1.77%1.54%0.92%Cumulative1.58%5.50%10.38%16.16%20.78%24.43%26.81%28.58%30.12%31.04%CCCYearly1.63%13.60%15.16%8.27%3.05%8.96%4.02%3.36%0.00%3.56%Cumulative1.63%15.23%30.39%38.66%41.71%50.67%54.69%58.05%58.05%61.61%YearAfterIssuanceFall2016,BF4211,Dr.ZhiLi9BondRatingandMarketRequiredRateofReturn(Yield)GotoFRED(https://research.stlouisfed.org/fred2/),type“bond”insearchbox,thenchoosethebondratingyouareinterestedin(e.g.Moody'sSeasonedAaaCorporateBondYield)Fall2016,BF4211,Dr.ZhiLi108/24/2016Fall 2016, BF 4211, Dr. Zhi Li6ValuingaTreasuryBond:LevelCouponBondValueatreasurybondwiththefollowingcharacteristics:Facevalue:$1000Couponrate(C):13%,semi-annualpaymentTimetomaturity:4yearsDiscountrate:10%(annual)Whatisthepriceofthebond?Fall2016,BF4211,Dr.ZhiLi11FinancialCalculatorSolutionHP‐12CEmulator:https://epxx.co/ctb/hp12c.phpN=4years×2=8PMT=(13%×$1000)÷2=$65IorI/Y=10%/2=5%FV=1000PV=?12Fall2016,BF4211,Dr.ZhiLi8/24/2016Fall 2016, BF 4211, Dr. Zhi Li7ValuingaCorporateBond-DupontTwoyearsago,DuPontissueda30yearmaturitybondswithacouponrateof7.95%.Interestispaidsemi-annuallyThesebondscurrentlyhave28yearsremainingtomaturityandareratedAA.Thebondshaveaparvalueof$1000TherequiredrateofreturnfornewlyissuedAAbondswithmaturitiesgreaterthan10yearsis8%WhatisthevalueofDuPontbondtoday?Fall2016,BF4211,Dr.ZhiLi13Dupontexample(continued)Semiannualcouponpayment=Semiannualdiscountrate=Numberofsemiannualperiods=PV=Financialcalculator:PMT=N=FV=i(orI/Y)=PV=???Fall2016,BF4211,Dr.ZhiLi148/24/2016Fall 2016, BF 4211, Dr. Zhi Li8PureDiscount(ZeroCoupon)BondMainFeature:CouponRateisequaltozeroWhatwillazero-couponbondsellat?Payments00FaceValue:FNoPaymentuntilMaturity!0Year1Year2…YearTFall2016,BF4211,Dr.ZhiLi15PureDiscount(ZeroCoupon)BondZeroCoupon-Maturity20years.AnnualdiscountRate:10%.Forsimplicity,assumeannualdiscounting.0Year1Year2…Year20Payments001,000200%)101(000,1)1(TrFPVFall2016,BF4211,Dr.ZhiLi168/24/2016Fall 2016, BF 4211, Dr. Zhi Li9PureDiscountBonds:Pricevs.Maturity020040060080010001357911131517192123252729MaturityPureDiscountBondPriceFaceValue:1000–DiscountRate:10%Year5:620.9Year10:385.5Year20:148.6Fall2016,BF4211,Dr.ZhiLi17Yield-to-MaturityInactualmarketsituations,weknowthefollowingvariables:CouponRate/FaceValueMaturityPRICETheYield-to-Maturityisthatdiscountratethatmakesthepresentvalueofthecashflowsofthebondequaltotheprice,asfollows:InterpretationfortheYTM:thecurrentdiscountrate(requiredrateofreturn)thatisimpliedbythemarketpricesystem.TT1=tt0)YTM+1(F+)YTM+1(C=icePrｅFall2016,BF4211,Dr.ZhiLi188/24/2016Fall 2016, BF 4211, Dr. Zhi Li10Yield-to-Maturity-ExampleData:Price:890.65TimetoMaturity:10yearsCouponRate(annual):10%FindthatdiscountratethatmakesthePVofthepaymentofthebondequalto890.65Financialcalculator:PMT=100;N=10;PV=-890.65;FV=1000I(orI/Y)=???101010)1(1000)1(11100)1(100,1...)1(100)1(10065.890YTMYTMYTMYTMYTMYTMFall2016,BF4211,Dr.ZhiLi19Fall2016,BF4211,Dr.ZhiLiPricesandDiscountratesWhenthediscountrateis:a)equaltothecouponrate,thebondsellsat___?b)Belowthecouponrate,thebondsellsat___?c)Abovethecouponrate,thebondsellsat___?Whatwillazero-couponbondsellat?208/24/2016Fall 2016, BF 4211, Dr. Zhi Li11PriceGoesDown,WhenYieldGoesUp800100011001200130000.010.020.030.040.050.060.070.080.090.1Yield-to-maturityBondPriceCouponrateWhentheYTM<coupon,thebondtradesatapremium.WhentheYTM=coupon,thebondtradesatpar.WhentheYTM>coupon,thebondtradesatadiscount.21Alevelcouponbond:Couponrate6%Fall2016,BF4211,Dr.ZhiLiFall2016,BF4211,Dr.ZhiLiTheeffectofchangesininterestratesonbondpricesConsidertwoidentical8%couponbondsexceptthatonematuresin4years,theothermaturesin10yearsCalculatethechangeinthepriceofeachbondifinterestratesfallfrom8%to6%,from8%to10%Thelongerabondhastomature,thelargertheimpactofinterestratechanges228/24/2016Fall 2016, BF 4211, Dr. Zhi Li12PracticeQuestion-DeferredCouponBondThedeferredcouponbondisjustlikeanordinarycouponbond,exceptthatpaymentsaredeferredforanumberofyearsYear012345…23Payments000CCC+FZeroCouponPaymentfor3yearsNormalCouponPaymentfor20yearsFall2016,BF4211,Dr.ZhiLi23PracticeQuestion-DeferredCouponBond(Cont’d)AnnualCoupon:8%,paymentdeferredfor3years,23yearsmaturity.DiscountRate:10%.Forsimplicity,assumeannualcouponpayments.Year012345…23Payments00080801,080Fall2016,BF4211,Dr.ZhiLi24Whatisthepriceofthecoupontoday?