...Chapter 6 Rate The Risk and Term Structure of Interest In the previous section, we have generalized our discussion of the influence of various factors on the behavior in interest rate by examining only a particular type of bonds: namely, the 1-year zero coupon bond. However, there are many types of bonds: bonds with different maturity, bonds issued by different parties (i.e. government vs. corporate), etc. As a result, there is a different interest rate for each type of bond. We will look at the behavior of interest rates of two groups of bonds: (1) Bonds with the same features but are issued by different agency. In other words, we want to look at the risk structure of interest rates. (2) Bonds issued by the same agency but have different term to maturity (i.e. life of the bond). In other words, we want to look at the term structure of interest rates. 1. Risk structure of interest rate As we have discussed in the previous section, the (relative) risk level of an asset affects its demands according to the theory of asset demand. The higher the relative risk level, the lower the demand of that asset. According to the theory of asset demand, this leads to an increase in interest rate. In other words, investors need to be compensated with a higher return (in the form of higher interest rate) in order to induce them to hold the assets. There are a number of factors that affect the risk level of a bond. In this section, we will focus on only 3 of them: default risk, liquidity, and tax...
Words: 3232 - Pages: 13
...© CSI GLOBAL EDUCATION INC. (2011) 7•1 Chapter 7 Fixed-Income Securities: Pricing and Trading © CSI GLOBAL 7•2 EDUCATION INC. (2011) 7 Fixed-Income Securities: Pricing and Trading CHAPTER OUTLINE How are Price and Yield of a Bond Calculated? • Calculating the Fair Price of a Bond • Calculating the Yield on a Treasury Bill • Calculating the Current Yield on a Bond • Calculating the Yield to Maturity on a Bond What is the Term Structure of Interest Rates? • The Real Rate of Return • The Yield Curve What are the Fundamental Bond Pricing Properties? • The Relationship Between Bond Prices and Interest Rates • The Impact of Maturity • The Impact of the Coupon • The Impact of Yield Changes • Duration as a Measure of Bond Price Volatility What are Bond-Switching Strategies? How does Bond Market Trading Work? • Clearing and Settlement • Calculating Accrued Interest © CSI GLOBAL EDUCATION INC. (2011) 7•3 What are Bond Indexes? • Canadian Bond Market Indexes • Global Indexes Summary LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Defi ne present value and the discount rate, and perform calculations relating to the time value of money, bond pricing and yield. 2. Defi ne a real rate of return and a yield curve, and evaluate three theories of interest rate determination. 3. Analyze the impact of fi xed-income pricing properties on bond prices. 4. Explain the rationale for bond switching and describe bond-switching strategies. ...
Words: 11227 - Pages: 45
...Q.No. | Question | Options | Answer | 1. | The theoretically logical and operationally feasible normative goal for guiding financial decision making is | 1. | profit maximization | 2 | | | 2. | wealth maximization | | | | 3. | dividend maximization | | | | 4. | sales maximization | | | | 5. | - | | 1. | Your company has received a $50,000 loan from an industrial finance company. The annual payments are $6,202.70. If the company is paying 9% interest per year, how many loan payments must the company make? | 1. | 12 | 3 | | | 2. | 19 | | | | 3. | 15 | | | | 4. | 13 | | | | 5. | - | | 1. | Which of the following statements is true? | 1. | With perfect negative correlation, the risk on a portfolio can be zero if an appropriate allocation of funds is made | 1 | | | 2. | In cases of zero correlations between the assets, risk can be fully eliminated through diversification | | | | 3. | The degree of risk reduction for a portfolio depends only on the number of securities in the portfolio | | | | 4. | All of the above | | | | 5. | - | | 1. | The present value of a single future sum: | 1. | depends upon the number of discount periods. | 1 | | | 2. | increases as the discount rate increases. | | | | 3. | is generally larger than the future sum. | | | | 4. | increases as the number of discount periods increases. | | | | 5. | - | | 1. | The...
Words: 10936 - Pages: 44
...INTEREST RATE RISK MANAGEMENT: DEVELOPMENTS IN INTEREST RATE TERM STRUCTURE MODELING FOR RISK MANAGEMENT AND VALUATION OF INTEREST-RATE-DEPENDENT CASH FLOWS Andrew Ang* and Michael Sherris† ABSTRACT This paper surveys the main concepts and techniques of recent developments in the modeling of the term structure of interest rates that are used in the risk management and valuation of interest-rate-dependent cash flows. These developments extend the concepts of immunization and matching to a stochastic interest rate environment. Such cash flows include the cash flows on assets such as bonds and mortgage-backed securities as well as those for annuity products, life insurance products with interest-rate-sensitive withdrawals, accrued liabilities for definedbenefit pension funds, and property and casualty liability cash flows. 1. INTRODUCTION The aim of this paper is to discuss recent developments in interest rate term structure modeling and the application of these models to the interest rate risk management and valuation of cash flows that are dependent on future interest rates. Traditional approaches to risk management and valuation are based on the concepts of immunization and matching of cash flows. These ideas were pioneered in the actuarial profession by the British actuary Frank Redington (1952). Interest rates have long been recognized as important to the risk management of insurance liabilities. Recent developments have incorporated a stochastic approach to modeling interest...
Words: 18994 - Pages: 76
...called the A) junk premium. B) capitalized risk. C) default premium. D) risk premium. 3) Other things being equal, an increase in the default risk of corporate bonds shifts the demand curve for corporate bonds to the _____ and the demand curve for Treasury bonds to the _____. A) left; left B) left; right C) right; right D) right; left 4) An increase in the riskiness of corporate bonds will _____ the yield on corporate bonds and _____ the yield on Treasury securities. A) increase; reduce B) reduce; reduce C) increase; not affect D) reduce; increase E) increase; increase 5) Bonds with relatively low risk of default are called A) investment grade bonds. C) zero coupon bonds. 6) Which of the following statements are true? A) A corporate bond's return becomes more uncertain as default risk increases. B) An increase in default risk on corporate bonds lowers the demand for these bonds, but increases the demand for default-free bonds. C) As their relative riskiness increases, the expected return on corporate bonds decreases relative to the expected return on default-free bonds. D) The expected return on corporate bonds decreases as default risk increases. E) All of the above are true statements. 7) An increase in the liquidity of corporate bonds will _____ the price of corporate bonds and _____ the yield of Treasury bonds. A) reduce; increase B) increase; reduce C) increase; not affect D) reduce; reduce E) increase; increase B)...
Words: 1256 - Pages: 6
...1: CORPORATIONS & FINANCIAL DECISION-MAKING Four Types of Firms US | Four Types of Firms AUS | * Sole proprietorship * Partnership * Limited liability company * Corporation | * Sole traders * Partnerships * Trusts * Companies | Corporations * Legal entity separate from its owners must be legally formed * Ownership represented by shares of stock, sum of which is OE * Tax implications * Double taxation in the US (only concerned with ‘C’ corporations) * Corporate tax rate is 34% * Personal tax rate on dividend income is 15% * Dividend imputation in Australia (franking credits) * You only pay the amount required to make your total tax rate your personal Dividend Imputation * Australian company tax rate: τc=30% * Company earning for $1 dividend income: gross dividend=div1-tc * For $1 dividends, company must earn $1.4286 @ 30% company tax rate * Franking (imputation) credit: Dividends paid have a credit attached for tax paid by the corporation franking credit=gross div-div=div1-τc*τc * Shareholders compute tax at their own tax rate (τp) based on the corporation’s pre-tax income, then subtract the tax paid at the corporate level net shareholder tax=div1-τc*(τP-τC) Corporate Ownership versus Control * Shareholders: Own the Corp, but have no say in daily operations * Board of Directors: * Elected by shareholders * Ultimate decision-making authority ...
Words: 6606 - Pages: 27
...Chapter 1 ------------------------------------------------- An Overview of Corporate Finance and ------------------------------------------------- The Financial Environment MINI CASE ------------------------------------------------- Assume that you recently graduated with a degree in finance and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle Dellatorre, a professional tennis player who has just come to the United States from Chile. Dellatorre is a highly ranked tennis player who would like to start a company to produce and market apparel that she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. Dellatorre is also very bright, and, therefore, she would like to understand, in general terms, what will happen to her money. Your boss has developed the following set of questions which you must ask and answer to explain the U.S. financial system to Dellatorre. ------------------------------------------------- a. Why is corporate finance important to all managers? Answer: Corporate finance provides the skills managers need to: (1) identify and select the corporate strategies and individual projects that add value to their firm; and (2) forecast the funding requirements of their company, and devise strategies for acquiring those funds. ------------------------------------------------- ...
Words: 3523 - Pages: 15
...different trading strategies of LTCM Answer: LTCM engaged in primarily in convergence and relative value strategies. Relative value strategy : It is a spread trade and it involves two assets whose prices or yields tend to converge with time . it involves long and short positions of similar instruments. This often happens when a company has more than one holding company listed in different markets (e.g. Royal Dutch and Shell). The price divergence in these different markets creates profitability. Although the price may not completely converge, but the premium tends to narrow over time. Convergence Strategy: In case of convergence strategy the two asset prices or yields must converge. when there was a specifiable future date(usually medium-term fixed maturities) by which convergence of offsetting short and long positions in similar instruments should occur. An example would be a strategy consists of buying off-the-run high yield bonds and shorting on-the-run low yield bonds. Once the newly issued on-the-run bonds become off-the run, the yields on the two bonds converge and LTCM makes a profit. This is a simple strategy and not necessarily a risky trade since it is very likely that the yields will converge once the on-the-run bonds become off-the-run. Since the yield spread between on- and off-the-run bonds is very narrow, it is possible to make significant profits only with large positions. It also involved in directional trades, which were un-hedged positions like long...
Words: 2745 - Pages: 11
...Working Draft: No Guarantees August 27, 1998 Home page: http: www.stern.nyu.edu ~dbackus Contents Preface 1 Debt Instruments 1.1 Overview : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 1.2 The Instruments : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : v 1 1 2 I Instruments with Fixed Payments 2 Bond Arithmetic 2.1 Prices and Yields in the US Treasury Market : : : : : : : : : : : : : : : : : 2.2 Replication and Arbitrage : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.3 Day Counts and Accrued Interest : : : : : : : : : : : : : : : : : : : : : : : : 2.4 Other Conventions : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.5 Implementation Issues : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.6 Common Yield Fallacies : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.7 Forward Rates optional : : : : : : : : : : : : : : : : : : : : : : : : : : : : 8 9 9 14 17 19 23 24 26 3 Macrofoundations of Interest Rates 39 CONTENTS i 4 Quantifying Interest Rate Risk 4.1 Price and Yield : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.2 More on Duration : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.3 Immunization : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.4 Convexity optional : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.5 Fixed Income Funds : : : : : : : : : : : : : : : : : :...
Words: 61190 - Pages: 245
...maturities can have different interest rates. I will do so by explaining the importance of understanding the term structure, as well as the three theories that support the term structure; the expectations theory, the segmented markets theory, and the liquidity premium theory. Term Structure According to Hubbard and O’Brien, the term structure “is the relationship among the interest rates on bonds that are otherwise similar but have different maturities.” Term structure is most commonly analyzed by looking at the Treasury yield curve, which is the relationship of interest rates on Treasury bonds with different maturities on a particular day. Yields generally tend to move in line with maturity, producing an upward sloping yield curve or a “normal yield curve.” Rarely, however, the yields on the long-term treasuries fall below the yields of short-term treasuries. This creates an inverted yield curve. According to a class lecture, six times when the yield curve became inverted, there was an economic recession. Wheelock and Wohar believe that term structure plays an important role in an economy because it “has been found useful for forecasting such variables as output growth, inflation, industrial production, consumption, and recessions.” The Expectations Theory According to Hubbard and O’Brien, the expectations theory “holds that the interest rate on a long-term bond is an average of the interest rates investors expect on short-term bonds over the lifetime of the bond.” As an...
Words: 891 - Pages: 4
...Exam 2 Study Guide Chapter 6: Interest Rates 1. Using the yield curve to predict interest rates (section 6-6) 2. Determinants of market interest rates (section 6-3) Be sure you know how to calculate any given components with given supporting information. 3. What determines the shape of a yield curve (section 6-5) Practice problems: 6-2, 6-3, 6-4, 6-5, 6-7, 6-9, 6-11, 6-14 Chapter 7: Bond Valuation 1. Key characteristics of bonds (7-2) 2. Bond valuation (7-3) 3. Bonds with semi-annual coupons (7-6) 4. Assessing a bond’s risk (7-7) 5. Bond yields (7-7) Practice problems: 7-1, 7-2, 7-3, 7-4, 7-5, 7-8, 7-9, 7-16 Chapter 8: Risk & rates of Return 1. Stand-Alone risk (8-2) 2. Risk in a portfolio context (8-3) 3. Relationship between risk and rate of return (8-4) 4. Implications for corporate managers & investors (8-6) Practice problems: 8-1, 8-3, 8-4, 8-6, 8-7, 8-11, 8-12, 8-14 *In addition please review the Cengage assignments & Team application activities that apply to the above chapters. Important note: Please note that this is only a study guide and should not be taken as the actual content of your second exam. In other words, reading the sections above and attempting the problems recommended should put you in a comfortable position to handle majority of questions in the exam. It is therefore prudent to expand your preparation beyond this...
Words: 265 - Pages: 2
...Part 1 1. Bond value = 5/1.01+5/1.0105^2+5/1.0115^3+5/1.0125^4+5/1.015^5+5/1.0175^6+5/1.02^7+105/1.0205^8 = $ 122.2018 2. Bond value when zero-curve shifts up by 1% = 5/1.015+5/1.0155^2+5/1.0165^3+5/1.0175^4+5/1.02^5+5/1.0225^6+5/1.025^7+105/1.0255^8= $118.1528 Bond value when zero-curve shifts down by 1% = 5/1.005+5/1.0055^2+5/1.0065^3+5/1.0075^4+5/1.01^5+5/1.0125^6+5/1.015^7+105/1.0155^8= $126.4236 MD = -(118.1528-126.4236)/(2*0.01)*(1/122.2018)= 3.3841 C= (126.4236+118.1528-122.2018*2)/0.01^2*(1/122.2018)= 14.1405 Delta B/B= -3.3841*0.01+1/2*14.1405*0.01^2= -0.033 3. $12220 $12220 a). You Repo dealer Market 100 bonds 100 bonds b). Bond value when zero-curve shifts up by 1% =$118.1528 c). (122.2018*(1+0.02/360)-118.1528)*100= $405.58 Part 2 1. MD(1)=1/1.00317=0.9968, if delta y=1%, delta B/B= -0.9968% MD(5) = 5/1.01479= 4.9271, if delta y=1%, delta B/B=-4.9271% 1MM* -0.9968%= 5-year bond value *-4.9271% Short 5-year bond value=$0.2023 MM Market value of portfolio= 1MM-0.2023MM=797700 2. Face value of 1-year bond= 1MM*0.317%=1003170 Face value of 5-year bond= 0.2023MM*1.479%=217727 Value of the portfolio= 1003170/1.00352^(11/12)-217727/1.0204^(59/11)=$802797 802797-797700= $5097 increase Because the interest rates do not change in the same amount of percentages, the yield curve is steeper. The time to maturity is smaller. 3. 1003170/1.00317^(11/12)-217727/1.00979^(59/11)=792720 797700 -792720= $4980 decrease Part 3 ...
Words: 483 - Pages: 2
...Memorandum to: Accounting department of family finance co. from: Daisy subject: fair value hierarchy date: december 15, 2012 Introduction Family Finance Co. (FFC), a publicly traded commercial bank, invests in a variety of securities in order to enhance returns greater than interest paid on bank deposits and other liabilities. The primary investments of FFC are collateralized debt obligation, mortgage-backed securities, auction-rate securities, equity securities in nonpublic companies, interest rate swaps, and a fuel swap for gasoline. FFC measures the derivative at fair value, presenting the portion of the fair value change by using the fair value hierarchy. This memo will present the appropriate classification in the fair value hierarchy for each investment and provide appropriate authoritative guidance to support the determination. Analysis The following analysis for classification of each instrument will be based on SFAS 157, which provides a hierarchy of the three-level inputs to the valuation techniques that can be used to measure fair value. Instrument 1 —Collateralized Debt Obligation The fair value measurement of the Collateralized Debt Obligation investment shall be categorized within Level 3 of the fair value hierarchy. According to ASC 820-10-35-52, “Level 3 inputs are unobservable inputs for the asset or liability” and ASC 820-10-35-53, “unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability...
Words: 1268 - Pages: 6
...The Financial Environment: Markets, Institutions, and Interest Rates In addition to these notes, please read chapter 3 and pages 191 through 206 of chapter 5. Problems 5-18 through 5-23 of chapter 5 are related to this topic. Since this part of the course deals with different types of markets, let us start by defining what these markets are. What are markets in general? Markets are transactions where individuals or organizations exchange items. The exchange could be goods for goods, goods for service, or goods and services for money. Whenever you exchange something for another you have a market. Again a market is a transaction, not a physical location. Now, let us look at the different types of markets: Markets for physical assets（财产，有利条件）: These are markets where tangible（有形的） assets, things you can touch are exchanged for money. Markets for financial assets: These are markets where financial assets sold and bought. Financial assets are intangible. Examples of financial assets include stocks （股票，存货）and bonds（债券）. By buying a financial asset you become an owner of a company or a lender to one. Buying a stock makes you one of the owners of a corporations and buying a bond makes you one of the lenders. Money versus capital markets: Money markets are markets where money is borrowed for short time periods, usually less than a year. Here the loans are used mainly to manage cash in a corporation. If a firm has...
Words: 1716 - Pages: 7
...Yield Curve and Bond Valuation Name: Lecturer: Course: Date: Yield Curve and Bond Valuation Question 1 and 2 Based on the information retrieved from the Board of Governors of the Federal Reserve System on a 1-month business day, the following information concerning historical dairy interest rates on the U.S treasury was obtained. The rates were picked from the current dates (1st January2012) back to five years a go (1st January 2007). Whereby, if that date was not a business date the preceding date was selected as shown in the table below. |Business Date chosen Five Years Ago |1st January 2007 | |1-month Nominal T-bill Rate on that date |5.02% | |3--month Nominal T-bill Rate on that date |4.79% | |6-month Nominal T-bill Rate on that date |5.11% | |1-year Nominal T-note Rate on that Date |5% | |5-year Nominal T-note Rate on that Date |4.68% | |10-year Nominal T-note Rate on that Date ...
Words: 966 - Pages: 4
