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FIN 303 Midterm: Test 3 Prep

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FIN 303
Binay Adhikari

FIN 403 Exam 3 Prep CHAPTER 18 Possible Test Question • Bond A o 20 year maturity, semiannual compounding, 6% annual coupon, YTM on similar bond is 10%, face value = $1,000, price? o N  2(20) = 40 i  10%/2 = 5% PV  ? PMT  $60/2 = $30 FV  $1,000 ▪ A: $656.82 • Bond B o Same bonds except Price  $1120, YTM? o N  40 i  ? PV  -$1,120 PMT  $30 FV  $1,000 ▪ A: 2.5203% (2) = 5.04% • Bond C o Same bond except suppose it can be called in 5 years for $1060 and the price is $1,120, calculate YTC (Yield to Call)? o N  10, i  ?, PV  $1,120, PMT  $30, FV  $1,060 ▪ A: i = 2.193627 (2) because semi annual = 4.3872% o Realized (Horizon) Yield PTQ • For Bond A: o If you can reinvest your coupon at 14% (annualized) calculate realized yield? ▪ Answer: ▪ • Find future value ($6,989.05) • Realized yield if not holding until maturity and reinvestment rate changes PTQ o Q: Face Value = $1,000, Coupon = 8% (also today’s YTM), semi-annual payments, 10 years to maturity. ▪ You are only planning on holding the bond for 7 years. When you sell the bond you anticipate a YTM of 4% at that date. You can reinvest your first two years of coupon payments at 8% until year 7, then 6% for the following 2 years of coupon payments, 5% for the next 2 years and 4% for the last year’s coupon payments. FIND REALIZED YIELD? o A: o o o o o o Terms • Pure Yield Curve o Curve for zero coupon or stripped treasuries • On-The Run Yield Curve o Curve for recently issued coupon bonds that are still near par value • Spot Rate for a Zero Coupon Bond o Today’s rate (annual basis) for a zero coupon bond until maturity Bond Pricing Using STRIPS • Separate Trading of Registered Interest and Principal of Securities • • Using this information price a $1,000 face value, 5 years to maturity, 8% coupon bond • • Bootstrapping • Done to construct a theoretical spot rate curve PTQ • Q: Suppose you have the following “on the run” treasury securities and T-Bills • o Goal is to determine zero coupon bond yields o • Yield on STRIPS will differ from “theoretical” spot constructed using “on the run” bonds o Liquidity differences (STRIPS are less liquid) o Tax issues Forward Rates • If a 2 year rate is 10% and a 1 year rate is 9%, what is a 1 year rate in 1 year? • • o T = Time to Maturity o F = Forward Rate ▪ The rate that is used to determine if you are indifferent between longer and shorter term investments Use algebra to find what is effectively your required rate of return. If you can invest for 3 years at 9% and 1 at 6%, what is the return you would require for • reinvestment in years 2 and 3 to make you indifferent between the two? • • o Short term investor (1 year horizon) ▪ Buy 1 year bond 7% ▪ Buy 2 year bond sell in 1 year o Bond Pricing (All Else Constant) 1. Bond Prices and yields are inversely related 2. An increase in a bond’s YTM results in a smaller price change than a decrease of equal magnitude 3. Longer term bond prices are more sensitive to interest rate changes 4. Sensitivity of a bond price to changes in yields increases at a decreasing rate as the maturity increases 5. Interest rate risk is inversely related to a bond’s coupon rate 6. The sensitivity of a bond’s price to an change in YTM is inversely related to the YTM at which it is currently selling Duration • Weighted average time of payment • Also called Macaulay’s Duration notated as  (D) • • Calculate D for a 5 year bond with YTM = 10%; coupon = 10%, Face Value = $1,000 • What is the D if YTM = 12%? Smaller D as a result of increase in YTM o • o Duration is linear while bond prices are NOT linear ▪ o Modified Duration: ▪ For Semi-Annual Bond (See Handout) • @ 12% Price = $926.40 o If YTM increases to 13%? ▪ Use financial calculator (not duration formula)  actual bond price = $892.17 • ▪ Now use duration formula: • Duration Rules (All Else Held Constant) 1. Duration of a zero coupon bond = it’s time to maturity Zero coupon, no cash 2. A bond’s duration is shorter when its coupon is greater flows, your duration is 3. A bond’s duration generally increases with its time to maturity 4. The duration of a coupon bond is greater when the YTM is lower longer. 5. Duration provides a better estimate for small yield changes CHAPTER 19 Fixed Income Portfolios • Generally result in a lower return and lower volatility relative to equity Bond Portfolio Strategies • Passive Management  bond indexing/buy hold strategies • Active Management • Core Plus • Matched Funding • Contingent Procedure Passive Management Strategies • Buy and Hold o Select a portfolio of bonds, based on investor objectives and constraints Duration does not change, this means you are altering your portfolio’s duration to keep consistent with your strategy around changing bond prices. • Indexing o Construct a portfolio of bonds, based on a bond index and limit tracking error Active Management Strategies • Attempt to outperform the market on a risk adjusted basis • Interest Rate Anticipation o Attempt to get capital gains if rates decrease, but preserve capital if rates increase o If you anticipate a increase in rates then duration decreases o If you anticipate a decrease in rates then duration increases ▪ If a manager is expecting an increase in rates, then… o • Valuation Analysis o Attempt to find mispriced bonds, estimate intrinsic value relative to market price • Credit Analysis o Determine expected change in default risk ▪ Expected to upgrade – (BBB to A)  BUY ▪ Expected to downgrade – (A to BBB)  SELL o In order to “predict” credit bureau decisions investors analyze: ▪ Profitability ▪ Stability of profitability ▪ Interest coverage ▪ Liquidity ▪ Market capitalization ▪ Firm size (assets) • Yield Spread Analysis o Assumes normal relationships exist between bonds in alternative sectors ▪ Ex. High vs Low Grade or Individual vs Utility PTQ • Q: If high grade bond is yielding 4% and low grade bond is yielding 7%, then the spread is 3%. If the normal spread is 5%, what should an investor do? o A: Relative to each other… You are trying to trade ahead ▪ The high grade bond yield should decrease of the ▪ The low grade bond yield should increase ▪ Therefore you would BUY the high grade bond, and SELL the low grade bond movement. So simultaneously you are selling • Substitution Swap prior to the o Relies on interest rate expectations yield increasing o Assumes short term imbalance in yield spreads (i.e., bond price o Current Bond  30 year, 12% coupon, 12% YTM Equal Risk decreasing) o Candidate (mispriced) Bond  30 year, 12% coupon, 12.2% YTM and buying in ▪ Assume a yield imbalance will be corrected by 12.2% declining to 12% advance of the ▪ Assume semi-annual payments and that correction occurs by year 1 yield decreasing (i.e., Could the correction ever bond price move in the rising). That way after the opposite
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