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61 Cards in this Set
- Front
- Back
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Bond issuer
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The short position in a bond transaction
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Bondholder
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The long position in a bond transaction.
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Principal
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The nominal value of a bond that is repaid to bondholders at maturity date.
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Coupon Payments
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The periodic payment of interest on a bond.
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Coupon Rate
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The dollar amount of coupon payments receives over the course of a year divided by the principal of the bond.
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Maturity Date
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The date upon which a bond issuer repays investors the principal of the bond.
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Term to maturity
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The time remaining until maturity.
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How we describe financial securities
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Using everyday language
Mathematically Using a time line Graphically |
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What is a bond?
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A bond is an agreement between two parties (whether individuals or organizations) obligating each to exchange pre-specified (fixed) amounts of cash at specific times.
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Zero coupon bonds: Everyday language
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One party initially invests a fixed amount with the other party. At some specific future point in time, the other party returns a fixed amount of cash
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Define the party making the initial investment
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the long position
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Define the party receiving the initial investment
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the short position
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Zero coupon bonds: Mathematical
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The long position gives the short position the amount bt at time t. The short position gives the long position BT at time T.
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Coupon bonds: Everyday language
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One party initially invests a fixed amount of cash with the other party. At a number of specific future points in time, the other party returns fixed amounts of cash.
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Coupon Bond: Mathematical
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The long position gives the short position the amount bt at time t. The short position gives the long position BT1 at time T1, BT2 at time T2, and BT3 at time T3, etc..
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two ways to describe a financial security
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Rights and obligations statement (legal perspective)
Cash flow description (finance perspective |
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2 Bond assumptions
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Assuming there is no risk of default, and assuming we know the expected series of coupons and principals the bondholder will receive,
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capitalization of income method of valuation
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The true value of a financial asset is equal to the present (discounted) value of future cash flows generated by the asset
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compounding
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The number of times that an investment is assumed to be reinvested during a given year
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NAR
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Nominal Annual Rate - Stated annual rate that cannot be understood unless we know how often it is compounded
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NRP
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The periodic rate that once again can only be understood if you know how frequently it is compounded.
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EAR
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The Annual Rate assuming one-time per year compunding
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NAR by period
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NAR1=NAR4=NAR8=NARx
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APR
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Credit cards - Periodic rate * # periods per year. APR=NARm
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What is the term structure of interest rates
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no “single” interest rate
interest rate differs, depending on the length of the investment period term structure” is describe to rates with different times to maturity |
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Define yield curve
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term structure of interest rates represented graphically
Generally, the longer the investment, the higher interest rate |
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yield curve
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cannot always slope upwards, as risk-free profit could be earned
yield curve is occasionally inversed This is a “liquidity trap” for someone borrowing short term and investing long term |
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Arbitrage
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Risk free and requires no investment
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4 term structure theories
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The liquidity preference theory
The unbiased expectations theory The market segmentation theory The preferred habitat theory |
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Liquidity preference theory
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When you make an investment for a fixed period of time, you sacrifice liquidity
longer investment period, greater the sacrifice longer the investment the higher the return you receive |
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Unbiased expectations theory
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interest rates reflect future expectations
upward sloping yield curve then market expects rates to rise downward sloping curve then market expects rates to decline |
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Market segmentation theory 1
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Assumes bondholders and issuers restricted by law to purchase bonds of specific maturities, or “segments
interest rates determined through supply and demand supply and demand specific to the segment determine the segment rate - independent of other segments. |
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Market segmentation theory 2
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Suggests that investors will not leave their “segment”,regardless
upward sloping curve = supply and demand for shorter-term bonds intersect at a lower rate than longer-term bonds Little evidence |
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Preferred habitat theory
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Similar to the market segmentation theory
bondholders and issuers are willing to leave their segments Hence, the supply and demand in each segment is affected by the other segments |
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pv method
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simple and logical
no assumptions many steps |
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pva method
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Few steps
makes 4 assumptions |
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pva assumptions
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All future cash flows identical
rate identical all maturities amount time btw cash flow identical, incl time btw initiation and the first cash flow |
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To get bond value
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discount the cash flows associated with the bond to the present,
using the rates (whether EAR or nominal rate per period), that are associated with the points in time the cash flows takes place. |
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Why pricing a bond is not necessary
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The source of the value of a bond is of theoretical interest.
In reality, the actual price is often available – determined by the market. Hence, “how to value a bond” is not as practical an issue as one might expect. |
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What is “yield to maturity”?
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One discount rate that equates the future cash flows from the bond to the current price.
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Calculate YTM
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Typically, trial and error is used to determine the YTM.
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What is the YTM of a zero-coupon bond?
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The spot interest rate for the period of time associated with the cash flow.
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semantics of interest rates
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Is the rate a spot rate or yield to maturity?
If a spot rate, with what period of time is it associated? If a YTM, with which bond is it associated? Is the rate a nominal rate per period, nominal annual rate, or EAR? If a nominal rate per period or nominal annual rate, how many times is it compounded per year? |
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Sensitivity of bond prices to change in interest rates
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interest rates increase
denominator larger entire value smaller |
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coupon effect
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the lower the coupon,
the larger the bond price change, for a given change in interest rates |
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maturity effect
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the longer the time to maturity, the greater the bond price change for a given change in interest rates
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Duration
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Due to the coupon and maturity effects, it is difficult to compare the sensitivity of different bonds.
A single measure of price sensitivity to yield is desirable |
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Duration: definition
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The present value weighted (Implication: the sooner the cash flow is expected, the greater weight it has) average time until reception of the cash flows that the bondholder expects to receive
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Duration: zero coupon bond
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duration = time to maturity
This is obvious, as the weight given to the single cash flow, at maturity, is 100%. |
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Common Share Analysis rights and obligations
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A common share is a
legal representation of ownership in a corporation |
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Common Share Analysis cash flow
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The long position gives the shareholder the amount St at time t. The firm may choose to give the investor Dt1 , Dt2 , etc… at times t1, t2, etc…. Upon sale of the share, at some unspecified future time T, the shareholder receives ST
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Investing in a Common Share: Graphical Description
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can't draw the variable graph before the fact
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risk-return tradeoff
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investors willing to invest in riskier stocks are compensated with higher expected returns
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Dollar Return
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Dividend + Change in Market Value
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percentage return 1
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dollar return divided by beginning market value
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percentage return 2
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dividend plus change in market value all divided by original market value
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percentage return 3
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dividend yield plus capital gains yield
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If returns are normally distributed
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There is approximately 68% probability of returns between plus or minus one standard deviation
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Consider a situation where the average return is 13.3%.
You are informed that the standard deviation is 20.1% |
There is approximately 68% probability of returns between –6.8% and 33.4%
There is approximately 95% probability of returns between –26.9% and 53.5% There is a approximately 98% probability of returns between –47% and 73.6% |
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Correlation: interpretation
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Correlation ranges from –1 through 1.
A correlation of 1 is “perfect positive correlation. |
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Historical risk - return
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The difference between the return on T-bills and stocks is the risk premium for investing in stocks.
An old saying on Wall Street is “You can either sleep well or eat well |
