Lec XIII

Debt Markets
Note: Coupon bonds may have a redemption value (or maturity value) dierent from the face value. We will not deal with those cases here.
http://www.mysmu.edu/faculty/yktse/FMA/S FMA 6.pdf
http://www.mysmu.edu/faculty/yktse/FMA/S FMA 7.pdf
Notation is tedious but very insightful.
Sridhar Telidevara GITAM School of International Business GITAM University Global Financial Markets408 and 406 (7)Lecture-XII
Overview
The most active government bond market is the US government debt. UK government bonds are called GILTS
How bonds are quoted and valued using discount cash ow techniques Two measures of yield:
current or running yield and Yield to maturity
Some Simple Measures of Yield
Current yield is the annual dollar amount of coupon payment(s) divided by the quoted (clean) price of the bond. It is the annual coupon rate of interest divided by the price of the bond per unit face value. The current yield does not adequately reect the potential gain of the bond investment. The nominal yield is the annual amount of coupon payment(s) divided by the face value, or simply the coupon rate of interest per annum. Like the current yield, the nominal yield is not a good measure of the potential return of the bond. In practice, however, the yield rate or the term structure are not observable, while the transaction price of the bond can be observed from the market.
Yield to Maturity
Given the transaction price, we can solve for the rate of interest that equates the discounted future cash ows (coupon payments and redemption value) to the transaction price. This rate of interest is called the yield to maturity (or the yield to redemption), which is the return on the bond investment if the investor holds the bond until it matures, assuming all the entitled payments are realized. The yield to maturity is indeed the internal rate of return of the bond investment. In the case of a n-year semiannual coupon bond, we solve iY from the equation (the coupon rate C is per half-year, FV is the face value of the bond.)
2n
P=C
j=1
1 (1 +
iY j 2 )
FV (1 +
iY 2n 2 )
(1)
Risks
default risk, interest rate risk ination risk liquidity risk, call risk, reinvestment risk, event risk market risk
The risk that we consider here is interest-rate risk
Interest Rate Risk
Price of a bond and the yield-to-maturity on a bond are inversely related. An increase in the interest rate (meaning an increase in the yield) on a bond implies a fall in the price of a bond and the borrowing costs for the borrower would increase. For an issuer of bond, he will be getting less money from the issue for a given set of cash outows. As interest rates rise an already existing bond holder experiences decrease in capital gains (or may even suer capital losses) that could have obtained by selling the bond before maturity. An important question here is which debt instruments experience higher interest rate risk? Is it short term bonds or long term bonds?
Interest Rate Risk
Price of a bond and the yield-to-maturity on a bond are inversely related. As can be seen from the illustration, the price of a long-term bond falls by more than the price of a short term bond for the same percentage change in the interest rate. This is because, for the same percentage change in the interest rate, the end terms of a long term bond in (1) are discounted more heavily compared to the end terms in a short term bond. However, this assumes that the yield curve shifts out parallelly to the original yield curve.
Yield Curve: Shapes
Various shapes are Upward yield curve Flat yield curve Inverted Yield Curve http://xedincome.delity.com//FIHistoricalYield
Duration
Macaulay duration and modied duration Duration and interest-rate sensitivity Convexity
Macaulay Duration and Modied Duration
Suppose an investor purchases a n-year semiannual coupon bond for P 0 at time 0 and holds it until maturity. As the amounts of the payments she receives are dierent at dierent times, one way to summarize the horizon is to consider the weighted average of the time of the cash ows. We use the present values of the cash ows (not their nominal values) to compute the weights. Consider an investment that generates cash ows of amount Ct at time t = 1, . . . , n, measured in payment periods. Suppose the rate of interest is i per payment period and the initial investment is P.
Callable Bonds
Callable bonds are bonds that can be redeemed by the issuer prior to the bonds maturity date. Investors whose bonds are called are paid a specied call price, which was xed at the issue date of the bond. The call price may be the bonds face value, or it may be a price somewhat higher. The dierence between the call price and the face value is called the call premium. If a bond is called between coupon dates, the issuer must pay the investor accrued interest in addition to the call price. Investors of callable bonds often require a higher yield to compensate for the call risk as compared to non-callable bonds.
Callable Bonds
Some callable bonds oer a call protection period. The issuer is not allowed to call the bond before the ending date of the protection period. The rst call date is the date after which the bond is fully callable. Theoretically, there is an optimal call date for the issuer to maximize the call benet. However, in addition to the call benet, there are many other factors (such as transaction costs, possible negative impact on the companys reputation and competition, etc.) aecting the decision of the issuer to make a call. Therefore, it is dicult to predict when the issuer will call.
Callable Bonds
If a callable bond is traded at a discount and the call price is xed at the bonds redemption value, the optimal call date for the issuer is at maturity. On the other hand, if a callable bond is traded at a premium and the call price is xed at the bonds redemption value, the optimal call date for the issuer is the rst call date. In general, when the call price is not a constant but varies in a prexed relation with the possible call dates, it is not easy to determine the issuers optimal call date.

Lec XIII

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Debt Markets

http://www.mysmu.edu/faculty/yktse/FMA/S FMA 6.pdf

http://www.mysmu.edu/faculty/yktse/FMA/S FMA 7.pdf

Notation is tedious but very insightful.

Some Simple Measures of Yield

The risk that we consider here is interest-rate risk

Interest Rate Risk

Interest Rate Risk

Yield Curve: Shapes

Macaulay Duration and Modied Duration

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