...MEASURES OF CREDIT SPREAD: YIELD SPREAD: Yield Spread is the difference between the yield-to-maturity of a risky bond and the yield-to-maturity of an on-the-run treasury benchmark bond with similar but not necessarily identical maturity. YTM is the constant discount rate which, when applied to the bond’s cash flows, re-prices the bond. Assumptions: * An investor who buys a bond can achieve a return equal to the YTM if the bond is held to maturity and if all coupons can be reinvested at the same rate as the YTM. In practice, this is difficult if not impossible to achieve since changes in the credit quality of the issuer may cause yields to change through time. As many investors may re-invest coupons at rates closer to LIBOR, at least temporarily, the realized return will usually be lower than the YTM. * The YTM assumes that the yield curve is flat which is not generally true. In practice, there are different reinvestment rates for different maturities. The YTM assumes that these reinvestment rates are the same for all maturities. Weaknesses: * It shares all of the weaknesses of the YTM measure in terms of constant reinvestment rate and hold to maturity. * It is not a measure of return of a long-defaultable bond, short treasury position. * As a relative value measure, it can only be used with confidence to compare different bonds with the same maturity which may have different coupons. * The benchmark security’s maturity may not match that...
Words: 2238 - Pages: 9
...Assignment Print View http://ezto.mheducation.com/hm_finance.tpx award: 1.00 point A pension fund has an average duration of its liabilities equal to 14 years. The fund is looking at 5-year maturity zero-coupon bonds and 4% yield perpetuities to immunize its interest rate risk. How much of its portfolio should it allocate to the zero-coupon bonds to immunize if there are no other assets funding the plan? → 57.14% 42.86% 35.71% 26.00% Duration of the perpetuity = 1.04/0.04 = 26 years Duration of the zero = 1 years 14 = (wz)(5) + (1 – wz)26; wz = 57.14% Learning Objective: 11-04 Formulate fixed-income immunization strategies for various investment horizons. Multiple Choice Difficulty: 3 Hard award: 1.00 point You own a bond that has a duration of 5 years. Interest rates are currently 6%, but you believe the Fed is about to increase interest rates by 29 basis points. Your predicted price change on this bond is ________. (Select the closest answer.) +1.37% → –1.37% –4.72% +4.72% D* = 5/1.06 = 4.72 ∆P/P = –D*(∆y) = –4.72(0.29%) = –1.37% Learning Objective: 11-02 Compute the duration of bonds; and use duration to measure interest rate sensitivity. Multiple Choice Difficulty: 2 Medium 1 of 13 11/29/2014 1:56 PM Assignment Print View http://ezto.mheducation.com/hm_finance.tpx award: 1.00 point You have purchased a guaranteed investment contract (GIC) from an insurance firm that promises to pay you a 7% compound rate of return per...
Words: 2817 - Pages: 12
...important measure for investors to consider, as bonds with higher durations (given equal credit, inflation and reinvestment risk) may have greater price volatility than bonds with lower durations. It is an important tool in structuring and managing a fixed-income portfolio based on selected investment objectives. Investment theory tells us that the value of a fixed-income investment is the sum of all of its cash flows discounted at an interest rate that reflects the inherent investment risk. In addition, due to the time value of money, it assumes that cash flows returned earlier are worth more than cash flows returned later. In its most basic form, duration measures the weighted average of the present value of the cash flows of a fixed-income investment. All of the components of a bond—price, coupon, maturity, and interest rates—are used in the calculation of its duration. Although a bond’s price is dependent on many variables apart from duration, duration can be used to determine how the bond’s price may react to changes in interest rates. This issue brief will provide the following information: < A basic overview of bond math and the components of a bond that will affect its volatility. < The different types of duration and how they are calculated. < Why duration is an important measure when comparing individual bonds and constructing bond portfolios. < An explanation of the concept of convexity and how it is used in conjunction with the duration measure. January...
Words: 2749 - Pages: 11
... Session Objectives j Valuation of fixed income securities Risks in fixed income securities Traditional measures of risk – (we know PVBP, duration and convexity, M-Square) M Square) VaR based risk measures Interest rate volatility calculations Portfolio risk & Cash flows mapping issues Var for Interest Rate Derivatives Interest rate risk and Bond portfolio management Profile of Interest Rate Markets, Instruments & Institutions Bond Price P 1 y C1 1 1 y C2 2 1 y Ct C3 3 1 y n Cn price Sum of the present values of each cashflows p P n t 1 1 y t M 1 y n yield price < par (discount bond) price = par (par bond) price > par (premium bond) Concept of Accrued Interest p When you buy a bond between coupon dates, you pay the seller: Clean Price plus the Accrued Interest – pro-rated share of the fi coupon: i d h f h first interest d does not compound b d between coupon payment dates. LD Days Accrued Interest Total T from last Coupon between Coupon Date Dates Days ND (Coupon) Dirty Price Clean price Accrued Interest Accrued Interest Face * C T LD * 2 ND LD Bond Valuation Value of a bond is the present value of future cashflows, so the pricing equation of the bond is: tP 1 y n C1 v 1 y Ct C2 1 v 1 y C3 2v M ...
Words: 6633 - Pages: 27
...MEASURING YIELD CHAPTER SUMMARY In Chapter 2 we showed how to determine the price of a bond, and we described the relationship between price and yield. In this chapter we discuss various yield measures and their meaning for evaluating the relative attractiveness of a bond. We begin with an explanation of how to compute the yield on any investment. COMPUTING THE YIELD OR INTERNAL RATE OF RETURN ON ANY INVESTMENT The yield on any investment is the interest rate that will make the present value of the cash flows from the investment equal to the price (or cost) of the investment. Mathematically, the yield on any investment, y, is the interest rate that satisfies the equation. ------------------------------------------------- P = ------------------------------------------------- ------------------------------------------------- where CFt = cash flow in year t, P = price of the investment, N = number of years. The yield calculated from this relationship is also called the internal rate of return. ------------------------------------------------- ------------------------------------------------- Solving for the yield (y) requires a trial-and-error (iterative) procedure. The objective is to find the yield that will make the present value of the cash flows equal to the price. Keep in mind that the yield computed is the yield for the period. That is, if the cash flows are semiannual, the yield is a semiannual yield. If the cash flows are monthly, the yield is a...
Words: 9863 - Pages: 40
...of the following are advantages of owning bonds? I. diversification properties II. higher long-term returns than equity holdings III. current income IV. relatively low risk A. I and II only B. I, III and IV only C. I, II and III only D. I, II, III and IV 2. The bond market is considered bearish when A. market interest rates are low or falling. B. market interest rates are high or rising. C. the risk-free rate of return exceeds the required rate of return. D. more bonds are called than issued over a given period of time. 3. The Franklin Company issued a 6% bond three years ago at par value. The market interest rate on comparable bonds today is 5%. The Franklin Company bond currently pays ____ a year in interest and the bond sells at a _____. A. $60; discount B. $60; premium C. $50; discount D. $50; premium 4. At the time you purchase a bond, you know the exact holding period return you will earn if A. the bond is called at any time prior to maturity. B. you resell the bond in exactly one year from the date of purchase. C. the market rate of interest declines within the next year. D. you hold the bond to maturity. 5. Which one of the following combination of features causes bond prices to be the most volatile? A. low coupon, short maturity B. high coupon, short maturity C. low coupon, long maturity D. high coupon, long maturity 6. Which of the following statements are correct concerning yield-to-maturity (YTM)? I. YTM considers both...
Words: 5197 - Pages: 21
...Theory Covariance: how close two variables move Together The reward-to-volatility = sharpe ratio Serial correlation of daily returns is close to zero => very hard to predict from their past Value-at-Risk (VaR): a measure of downside risk ->Measures the potential loss over a specified horizon such that there is a (low) probability α that the actual loss will be larger No clear guidelines as to the choice of sample length m: small m means that the VaR will be more influenced by recent events; large m is needed for precise estimates - No way to extrapolate the 1-day VaR to a longer n-day horizon (except if nonoverlapping n-period returns are considered to re-calculate the n-day VaR) A risk-averse investor: - Accepts risk-free or speculative prospects with positive risk-premiums - Rejects portfolios that are fair games (or worse) The higher the indifference curve, the higher the utility levelT he steeper the indifference curve, the higher the risk aversion -> higher compensation required for the same level of risk Two major sources of uncertainty for the risky assets in a portfolio: 1. Market risk -? Systematic, non-diversifiable 2. Firm-specific risk -> Non-systematic, diversifiable The minimum-variance frontier, which gives the lowest variance that can be attained for any target level of expected portfolio return The separation property The portfolio choice problem may be separated into two independent tasks -Determination of the optimal...
Words: 2387 - Pages: 10
... if your investments are not showing any gains or your account value is slipping, you’ll have to determine why and decide on your next move. In addition, because investment markets change all the time, you’ll want to be alert to opportunities to improve your portfolio’s performance, perhaps by diversifying into a different sector of the economy or allocating part of your portfolio to international investments. To free up money to make these new purchases, you may want to sell individual investments whose performance has been disappointing while not abandoning the asset allocation you’ve selected as appropriate. To assess how well your investments are doing, you’ll need to consider several different ways of measuring performance. The measures you choose will depend on the exact information you’re looking for and the types of investments you own. For example, if you have a stock that you hope to sell in the short term at a profit, you may be most interested in whether its market price is going up, has started to slide or seems to have reached a plateau. On the other hand, if you’re a buy-and-hold investor more concerned about the stock’s value 15 or 20 years in the future, you’re likely to be more interested in whether it has a pattern of earnings growth and seems to be well positioned for future expansion. In contrast, if you’re a conservative investor or you’re approaching retirement, you may be primarily...
Words: 5272 - Pages: 22
... of Bonds DEBT MARKETS: FM2014 5-‐6. Debt Markets: Structure, Par+cipants, Instruments, Interest Rates and Valua+on of Bonds 1 FM: Objec+ves A?er successfully comple+ng this topic, you will be able to: § Apply basic pricing models to evaluate stocks and bonds § Describe the theoreIcal determinants of the level and term structure of interest rates § Explain the concept of “yield” and its rela+on to “interest rate” § Determine the price of coupon and discount bonds § Compute the dura+on and convexity of a bond § Differen+ate between Macaulay and modified dura+on § Understand the rela+onship between dura+on and convexity and bond price vola+lity FM2014 5-‐6. Debt Markets: Structure, Par+cipants, Instruments, Interest Rates and Valua+on of Bonds 2 FM: Bond. J. Bond. § ...
Words: 4045 - Pages: 17
...CONTENTS BONDS 1 STOCKS 6 OPTIONS 10 FUTURES 16 PORTFOLIO PERFORMANCE EVALUATION 20 INTERNATIONAL INVESTING 26 BONDS Page 480 –CFA Problems Questions #1 1. Leaf Products may issue a 10-year maturity fixed-income security, which might include a sinking fund provision and either refunding or call protection. a) Describe a sinking fund provision. The sinking fund provision allows the firm to repurchase a fraction of the outstanding bonds at either the market price or the sinking fund price (usually set at par), depending on the structure of the provision. The provision may be for a specific number of bonds or a percentage of the bond issue. The bonds selected for repurchase are generally selected at random. b) Explain the impact of a sinking fund provision on: i. The expected average life of the proposed security. We would expect a fraction of the total bond issue to be retired before the stated maturity data under the sinking fund provision. Therefore, the sinking fund provision decreases the expected average life of the proposed security. ii. Total principal and interest payments over the life of the proposed security. The sinking fund provision does not affect the total principal payments that investors would receive. However, investors may receive their principal repayments earlier than expected if the firm invokes the sinking fund provision. The sinking fund provision could decrease the amount of interest payments investors would receive...
Words: 6386 - Pages: 26
...dividends would be steady or will increase at a perpetual rate for years. But we know that due to the ups and downs of the economy it can be pretty tricky to forecast exactly what the dividends would be year from now. #3 Yes I was noticing in order to calculate the DDM there are three main inputs to have and I was missing at least one or tow to be able to calculate it. DPS(1) = Dividends expected to be received in one year Ks= requires rate of return for a specific investment G=growth rate in dividends in years from now at some point I found it tricky to come up with these components to calculate for DDM. As I searched on line there are more than one way to calculate DDM so it was a bit challenging. !!! #4 In bond investing, yield is the tool to measure the return of...
Words: 722 - Pages: 3
...Chapter 4 – Bond Price Volatility Extra Questions 1. Be sure you understand all the relationships shown in Exhibit 4-11 2. The price of a bond can be written as either as the sum of series of discounted CFs (Equation 4.1, page 63) or as the sum of the PV of an annuity and the discounted maturity value (Equation 4.9, page 67). Note that the PV of an annuity formula used in Equation 4.9 is derived from the difference between a perpetuity starting at time zero and a perpetuity starting at time n. The difference is an annuity starting at time 0 and ending at time n. Equation 4.3 is the first derivative of price w.r.t. yield (∂P/∂y) using equation 4.1. The numerator of equation 4.10 is first derivative of the price w.r.t. yield using equation 4.9. Consider either equation 4.3 or the numerator of 4.9. Determine only the sign of following second derivative and mixed partial derivatives: * ∂2P/∂y2 * ∂2P/∂y∂C * ∂2P/∂y∂n (a) Does duration increase or decrease as the initial yield increases?(decrease) (b) Does duration increase or decrease as the coupon increases?(decrease) (c) Does duration increase or decrease as the maturity increases?(increase) 3. (This is questions 2 and 4 from the text.) Consider semi-annual bonds A and B. | Bond A | Bond B | Coupon | 8% | 9% | Yield to maturity | 8% | 8% | Maturity (years) | 2 | 5 | Par | $100.00 | $100.00 | Price | $100.00 | $104.055 | Produce an Excel...
Words: 1140 - Pages: 5
...the government bond market. We will be focusing specifically on Canadian federal government bonds, and conducting our analysis on the exploration of 3 month, 5 year, and 10 year bond statistics. The decision to explore the Canadian federal government bond market is motivated by a keen interest towards the impact that the global financial crisis has had on government bonds that are typically seen as low-risk, safe investments due to their implicit high-liquidity and low default rate. Through our investigation, analysis, and comparison of these bonds, we will arrive at a conclusion that will allow us to see not only the trends that have been prevalent over the past several years, but enable us to make an informed recommendation as to whether or not this market is a sound one to invest in based on our interpretation of trends and future projections. Qualitative Analysis The federal bond market has four key economic factors: interest rates, inflation rates, GDP per capita, and unemployment rates. Interest rates and inflation rates affect the yield-to-maturity of a bond as well as the bond price. GDP per capita and unemployment rates are factors that influence the demand for federal government bonds. Interest Rates The Bank of Canada Overnight Interest Rate affects the rate at which money is borrowed and lent, and as well as the price of a bond. The yield-to-maturity of a bond is directly related to this interest rate. As the interest rate increases, the yield-to-maturity...
Words: 1847 - Pages: 8
...CH. 9: The Capital Asset Pricing Model (Global Edition: CH. 9) 1) In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of risk is: A) unique risk. B) beta. C) standard deviation of returns. D) variance of returns. E) none of the above. Feedback: B – In the context of the Capital Asset Pricing Model (CAPM) the relevant measure of risk is beta. ---------------------------------------------------------------------------------------------------------------------------------------------------2) Which statement is not true regarding the market portfolio? A) It includes all publicly traded financial assets. B) It lies on the efficient frontier. C) All securities in the market portfolio are held in proportion to their market values. D) It is the tangency point between the capital market line and the indifference curve. E) All of the above are true. Feedback: D – The market portfolio includes all publicly traded financial assets, lies on the efficient frontier, and all securities in the market portfolio are held in proportion to their market values. ---------------------------------------------------------------------------------------------------------------------------------------------------3) According to the Capital Asset Pricing Model (CAPM), the expected rate of return on any security is equal to: A) Rf + β [E(RM)]. B) Rf + β [E(RM) – Rf]. C) β [E(RM) – Rf]. D) E(RM) + Rf. E) none of the above. Feedback: B – The expected rate of return on any security...
Words: 5247 - Pages: 21
...i) Can the recent deviation in basis between CDS prices and bond yield spreads be explained by funding liquidity (shadow cost of capital) and asset-specific liquidity (margin requirement) variations? (Word Limit: 750) In order to prove this statement, it is first necessary to understand the relationship of CDS and bond yield spread as well as to distinguish between the two types of liquidity in determining the circumstances in which relative prices will converge. CDS (credit default swaps) are derivative contracts and their payouts are dependent on the creditworthiness of a firm. The purpose of CDS is to allow market participants to reduce the risk of investments which is associated with certain debt-related events. The CDS we will study in this paper is a contract that provides protection against the risk of a credit event by a single company as a response to regular payments by the investor of a bond. While bond yield spread is the difference between the yield to maturity on a corporate bond and the risk-free rate on treasury bills. This yield spread is determined to a large extent by the credit risk of the bond. This can be called the credit risk of the bond. The implication of the relationship between CDS and bond yield spread is that; if the cost of protecting against the risk with a CDS is less than the bond’s yield spread, investors can buy the bonds and the CDS contracts and collect the excess risk premium without taking any risk. Funding liquidity is the...
Words: 779 - Pages: 4
