Bond Market Overview and Bond Pricing. Overview of Bond Market 2. Basics of Bond Pricing 3. Complications 4. Pricing Floater and Inverse Floater 5. Pricing Quotes and Accrued Interest
What is A Bond? Bond: a debt instrument requiring the issuer (debtor) to repay to lender/investor the amount borrowed plus interest over a specified period of time Plain vanilla bonds Advanced debt contract mortgage pass-through securities 2
Most Generic Classification Government bonds low/no risk, low yield, low expected returns -- return is high when yield goes down Risky bonds non-government bonds, including corporate bonds, municipal bonds, mortgage securities (subprime market securities) 3
Sectors of US Bond Market Treasury Sector have you heard of saving bonds? Agency Sector Municipal Sector Corporate Sector Asset-Backed Security Sector Mortgage Sector See: www.investinginbonds.com 4
More Info of Bonds Federal Reserve Flow of Funds report: http://www.federalreserve.gov/releases/z/ TRACE: http://www.finra.org/industry/compliance/mark ettransparency/trace/ Mergent FISD: http://www.kellogg.northwestern.edu/rc/fisd.htm 5
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. Different Characteristics Stocks vs. Bonds 2. Different Markets Stocks: traded on exchanges and OTC markets: NYSE, AMEX, NASDAQ Bonds: traded on OTC markets 3. Similarity: Buy stocks and bonds through online traders. 7
Returns of Aggregate Stocks, Gov Bonds, Corporate Bonds 0.4 0.3 0.2 Returns 0. 0 985-0. 990 995 2000 2005-0.2-0.3 Year ret_stock ret_gov ret_credit 8
Overview of Bond Features Term to maturity Coupon rate Fixed rate bonds Floating rate bonds Reference rate quoted margin Principal/Face Value Interest rate/yield to maturity Price 9
Example of a fixed payment bond 0 years, face value $000, coupon rate 8%, semi-annually paid, interest rate 9%. What is the bond price? There are many variations in bond designs: () deferred-coupon (2) amortizing securities: securities with a schedule of periodical principle repayments. (3) options could be embedded (page 6) 0
FV versus PV Future Value: P n = P 0 (r) n Present Value: P 0 = P n /(r) n Future value for a regular annuity Present value for a regular annuity
Examples. Cash flow (): you receive $00 in year, $200 in year 2, $300 in year 3. Interest rate is 9%. What is the value of the cash flow? 2. Cash flow: you need to pay $00 in year, $200 in year 2, and $300 in year 3. Interest rate is 9%. How much you need invest today to pay for this loan? 3. Coupon Bond: 2 years, face value $000, coupon rate $8, semi-annually paid, interest rate 9%. What is the bond price? Using your financial calculator 2
Zero-coupon bonds Price of zero-coupon bond: P 0 = M/(r) n Example 3
Complications If the next payment is due in fewer than 6 months Cash flows may not be known What is the appropriate required yield and whether one discount rate can be applied to all cash flows 4
5 Next Due Payment < 6 months = = n t n t r r M r r C P ) ( ) ( ) ( ) ( ν ν month period days in six - and next coupon days between settlement = ν In fact, this is a 3-step approach to calculate bond price. () In the first step, we compute bond price if I buy the bond in the next payment date (i.e., I won t get any payment for it): = = ) ( ) ( n t n t r M r C P (2) Add in the payment I receive in the next payment date, then = = = = n t n t n t n t r M r C r M r C C P ) ( ) ( ) ( ) ( (3) Discount the above price back to the date I purchase the bond. The idea is to suppose I buy the bond right before the next payment day, thus I can have the next payment, then discount the value back to time 0.
Price Quoted and Accrued Interest Price quoted: 00: meaning 00% of its par value/face value Accrued interest: when an investor purchases a bond between coupon payments, the investor must compensate the seller of the bond for the coupon interest earned from the time of the last coupon payment to the settlement date of the bond. for a treasury bond, accrued interest is based on the actual number of days the bond is held by the seller. Full price/dirty price = price accrued interest Clean price 6
Example A bond face value $000, YTM=5%, coupon rate=6% semiannually paid, maturity=5 years. The bond was issued on 7//2003, and bought on //2005. What is price of the bond. v=? n=? 7
Procedures of computing price Step Step 2 Step 3 8
Example (cont d) What is the accrued interest of the bond? What is the dirty price of the bond? 9
Floater and Inverse Floater See Exhibit 2-4. Inverse s price = collateral s price floater price Collateral is the fixed-rate security from which the inverse floater is created Floor: the minimum interest rate on the inverse floater Cap: the maximum interest rate on the floater The sum of interests paid on floater and inverse floater must always equal interests on the collateral. 20
Risk Associated with Bonds. Interest-rate risk 2. Reinvestment risk 3. Call risk 4. Credit risk 5. Inflation risk 6. Exchange-rate risk 7. Liquidity risk institutional investor must trade frequently in some extent 8. Risk risk 2