BU111 Lecture Notes - Lecture 9: Risk Premium

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BU111–Lecture9–EconomicFactors
ConceptofYield
Percentagereturnonanyinvestment
Helpsustocompareinvestments
Higherriskyouexpectahigherreturnforinvestment
Forabond:
Interest=couponratexfacevalue
Capitalgain=facevalue–purchaseprice
● InBU111,alwaysuseafacevalueof$1,000forbonds
ApproximateYieldtoMaturity
● Assumesyouwillholdthebonduntilmaturity
● Needtocalculate“whatyoumade”onanannualbasis
Example:ApproximateYieldtoMaturity
Youbuy6%bondfor$850with10yearstomaturity.
Step1:couponrate=6% purchaseprice=$850 facevalue=$1000
Timetomaturity=10years
Step2:calculatecomponents
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AYM=((0.06x1000)+[(1000–850)/10])/850=8.8%
Sincefacevaluewasgreaterthanpurchasepricewegethigherpercentagethanwhat
thecouponrate.
Whydobondpricesfluctuate?
● Couponrate,facevalue,timetomaturity,facevalueCannotchange
● PricepaidCanchange
● Ifinterestratesineconomygoesup,theexpectedyieldwillgoupaswell
● Ifriskpremiumandinterestrateineconomyarethetwofactorsthatwillresultinchange
inyield
● Yieldshouldbesameforallbondsofequalrisk
● Interestratesandriskpremiumchangepurchasepriceofbond
BondPricing
Threescenariostoconsider:
1) Youpaylessthanfacevalueforthebond–pricedatadiscount
2) Youpaymore
3) Youpayface
Scenario1:payatadiscount
Happenswhencouponrateislessthanexpectedyield
Exampleyouarebuyinga2008bondwitha3%couponandtoday’sexpectedbond
yieldsare5%
oYouknowyieldandinterest–youcancontrolcapitalgainandpricepaid
Withayieldexpectationthatisgreaterthanthecouponrate,youwouldneedacapital
gaintoattaintheyield,whichmeansyoupaylessthanfacevalueforthebond
Scenario2:Payatapremium
Expected yield rate is below coupon rate, you would be willing to pay more than face
valueforthebond–youwouldtakeacapitalloss
Scenario3:Payatpar
Expectedyieldrateissameascouponrate
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