Asset Pricing

ECONM2035

Fixed Income Securities

 Bond Characteristics

Face or par value

Coupon rate
Zero coupon bond
Compounding and payments
Accrued Interest
Indenture
 Different Issuers of Bonds
U.S. Treasury
Notes and Bonds
Corporations
Municipalities
International Governments and Corporations
Innovative Bonds
Floaters and Inverse Floaters
Asset-Backed
Catastrophe
 Provisions of Bonds

Secured or unsecured
Call provision
Convertible provision
Put provision (putable bonds)
Floating rate bonds
Preferred Stock
 Bond Pricing

PB
T
C
ParValue
t 1 (1 r ) (1 r )
t T

PB = Price of the bond

Ct = interest or coupon payments
T = number of periods to maturity
y = semi-annual discount rate or the semi-annual yield
to maturity
Figure 14.3 The Inverse Relationship
Between Bond Prices and Yields
 Yield to Maturity

Interest rate that makes the present value

of the bonds payments equal to its price
Solve the bond formula for r

PB
T
C
ParValue
t 1 (1 r ) (1 r )
t T
Figure 14.4 Bond Prices: Callable and Straight Debt
Figure 14.6 Prices over Time of 30-Year
Maturity, 6.5% Coupon Bonds
 Default Risk and Ratings
Rating companies
Moodys Investor Service
Standard & Poors
Fitch
Rating Categories
Investment grade
Speculative grade/Junk Bonds
Figure 14.8 Definitions of Each Bond
Rating Class
 Factors Used by Rating Companies

Coverage ratios
Leverage ratios
Liquidity ratios
Profitability ratios
Cash flow to debt
Table 14.3 Financial Ratios and Default
Risk by Rating Class, Long-Term Debt
 Protection Against Default

Sinking funds
Subordination of future debt
Dividend restrictions
Collateral
 Credit Risk and Collateralized Debt
Obligations (CDOs)
Major mechanism to reallocate credit risk in
the fixed-income markets
Structured Investment Vehicle (SIV) often
used to create the CDO
Mortgage-backed CDOs were an
investment disaster in 2007
Figure 14.12 Collateralized Debt
Obligations
Figure 15.1 Treasury Yield Curves
 Bond Pricing

Yields on different maturity bonds are not all

equal
Need to consider each bond cash flow as a
stand-alone zero-coupon bond when
valuing coupon bonds
 Yield Curve Under Certainty

An upward sloping yield curve is evidence

that short-term rates are going to be higher
next year
(1 y2 ) 2 (1 r1 ) x(1 r2 )
1
1 y2 (1 r1 ) x(1 r2 ) 2

When next years short rate is greater than

this years short rate, the average of the two
rates is higher than todays rate
Forward Rates from Observed Rates

(1 yn ) n
(1 f n ) n 1
(1 yn 1 )

fn = one-year forward rate for period n

yn = yield for a security with a maturity of n

(1 yn ) n (1 yn1 ) n1 (1 f n )
 Interest Rate Uncertainty
What can we say when future interest rates
are not known today
Suppose that todays rate is 5% and the
expected short rate for the following year is
E(r2) = 6% then:
(1 y2 )2 (1 r1 ) x[1 E (r2 )] 1.05 x1.06
The rate of return on the 2-year bond is risky
for if next years interest rate turns out to be
above expectations, the price will lower and
vice versa
 Interest Rate Uncertainty Continued

Investors require a risk premium to hold a

longer-term bond
This liquidity premium compensates short-
term investors for the uncertainty about future
prices
 Theories of Term Structure
Expectations
Liquidity Preference
Upward bias over expectations
 Expectations Theory

Observed long-term rate is a function of

todays short-term rate and expected future
short-term rates
Long-term and short-term securities are
perfect substitutes
Forward rates that are calculated from the
yield on long-term securities are market
consensus expected future short-term rates
 Liquidity Premium Theory

Long-term bonds are more risky

Investors will demand a premium for the
risk associated with long-term bonds
The yield curve has an upward bias built
into the long-term rates because of the risk
premium
Forward rates contain a liquidity premium
and are not equal to expected future short-
term rates
Forward Rates as Forward Contracts

In general, forward rates will not equal the

eventually realized short rate
Still an important consideration when trying to
make decisions :
Locking in loan rates
 Bond Pricing Relationships

Inverse relationship between price and yield

An increase in a bonds yield to maturity
results in a smaller price decline than the
gain associated with a decrease in yield
Long-term bonds tend to be more price
sensitive than short-term bonds
Figure 16.1 Change in Bond Price as a
Function of Change in Yield to Maturity
 Duration
A measure of the effective maturity of a
bond
The weighted average of the times until
each payment is received, with the
weights proportional to the present value
of the payment
Duration is shorter than maturity for all
bonds except zero coupon bonds
Duration is equal to maturity for zero
coupon bonds
 Duration: Calculation

wt CF t (1 y )
t
Price
T
D t wt
t 1

CFt Cash Flow for period t

 Duration/Price Relationship

Price change is proportional to duration and not

to maturity
P (1 y )
Dx
P 1 y
D* = modified duration

P
D * y
P
 Convexity

The relationship between bond prices and

yields is not linear
Duration rule is a good approximation for only
small changes in bond yields
 Figure 16.3 Bond Price Convexity: 30-
Year Maturity, 8% Coupon; Initial Yield to
Maturity = 8%
 Correction for Convexity

1 n
CFt
Convexity
P (1 y ) 2
(1 y )t (t t )
t 1
2

Correction for Convexity:

P
D y 1 [Convexity (y ) 2 ]
P 2
Figure 16.10 Immunization
Cash Flow Matching and Dedication

Automatically immunize the portfolio from

interest rate movement
Cash flow and obligation exactly offset each
other
i.e. Zero-coupon bond
Not widely used because of constraints
associated with bond choices
Sometimes it simply is not possible to do