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Analysis
ANURAG MISHRA
Regression
Dependent variable
B1 = slope
= ∆y/ ∆x
b0 (y intercept)
Observation: y
Zero
Independent variable (x)
The function will make a prediction for each observed data point.
The observation is denoted by y and the prediction is denoted by y. ^
Simple Linear Regression
Prediction error: ε
Observation: y
Prediction: y^
Zero
y=y+ε ^
Dependent variable
The Sum of Squares Regression (SSR) is the sum of the squared differences
between the prediction for each observation and the population mean.
Regression Formulas
Mathematically,
SSR = ∑ ( y – y ) ^(measure
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of explained variation)
SSE = ∑ ( y – y ) ^
(measure of unexplained variation)
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SST = SSR + SSE = ∑ ( y – y ) (measure of total variation in y)
The Coefficient of Determination
The proportion of total variation (SST) that is explained by the regression (SSR) is
known as the Coefficient of Determination, and is often referred to as R .
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R = =
2 SSR SSR SST
SSR + SSE
The value of R can range between 0 and 1, and the higher its value the more
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accurate the regression model is. It is often referred to as a percentage.
Standard Error of Regression
Standard Error is calculated by taking the square root of the average prediction
error.
SSE
Standard Error =
√ n-k
y=A+β*x+ε
β is the per unit change in the dependent variable for each unit change in the
independent variable. Mathematically:
∆y
β=
∆x
Multiple Linear Regression
More than one independent variable can be used to explain variance in the
dependent variable, as long as they are not linearly related.
y = A + β X + β1 X1 + … + β k Xk + ε
2 2
Example table of
Correlations
Y X1 X2
Y 1.000
X1 0.802 1.000
X2 0.848 0.578 1.000
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.982655 Y = B0 + B1 X1 + B2X2 + B3X3 - - - +/- Error
R Square 0.96561 Total = Estimated/Predicted +/- Error
Adjusted R Square 0.959879
Standard Error 26.01378
Observations 15
ANOVA
df SS MS F Significance F
Regression 2 228014.6 114007.3 168.4712 1.65E-09
Residual 12 8120.603 676.7169
Total 14 236135.2
Coefficients
Standard Error t Stat P-value Lower 95%Upper 95%
Intercept 562.151 21.0931 26.65094 4.78E-12 516.1931 608.1089
Temperature -5.436581 0.336216 -16.1699 1.64E-09 -6.169133 -4.704029
Insulation -20.01232 2.342505 -8.543127 1.91E-06 -25.1162 -14.90844
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Rating
Category Moody’s S&P
------------------------------------------
High Grade Aaa AAA
Aa AA
-------------------------------------------
Investment A A
Grade Baa BBB
-------------------------------------------
Speculative Ba BB
B B
-------------------------------------------
Default Caa CCC
Ca CC
C C
D
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Interest Rate Risk
Example: Two bond issues of ABC Co.
N1=1 yr N2= 10 yrs r = 5%
Bond Value
Market Rate of First Issue: Second Issue:
Interest N = 1 yr N = 10 yrs
5% 100.00 100.00
6% 99.06 92.64
7% 98.13 85.95
8% 97.22 79.87
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Bond Value and Coupon Rates
Example:Two issues of ABC Co. n=20 yrs, r1=10%, r2=6%
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Value of a Bond in Time
Example: Market rate stays at 10%, values of
two bonds with coupon rates of 8% and 12%
as the term to maturity approaches:
Maturity Bond 1 Bond 2
R=8% R=12%
5 92.42 107.58
4 93.66 106.34
3 95.03 104.97
2 96.53 103.47
1 98.18 101.82
0 100.00 100.00
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Term Structure of Interest Rates
Relationship between yield and time to
maturity.
Yield Curve
Maturity
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Possible Explanations of the Term Structure
1. Expectations Hypothesis
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Duration
Volatility in bond price is directly proportional
to term to maturity but inversely proportional
to coupon payments. Duration of a bond is a
measure that incorporates both factors that
affect volatility.
n
(t )Ct
D V
t 1 (1 i )
t
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Duration Example
n=5 yrs, r=8%, i=10%
(1) (2) (3) (4) (5) (6)
Year PMT PVIF (2)x(3) (4)/V (1)x(5)
1 8 0.9091 7.27 0.0787 0.0787
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Hedging Interest Rate Risk
$12 $12 $12 $12 $12 $12 $112
|___|____|____|____|____|...…..|___ |
0 1 2 3 4 5 9 10
Duration of Liabilities:
7217.38 ->7794.77
(1000.00)
6794.77 ->7338.35
(2000.00)
5338.35->5765.42
(2500.00)
3265.42->3526.66
(2000.00)
1526.66->1650
(1650)
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Modified Duration
D
MD = -----------
(1 + i)
Example:
If the yield decreases from 10% to 8%
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Convexity
Price-Yield Relationship
Yield
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Convexity (Cont’d )
Higher convexity means that when interest
rates go up, bond value declines slowly; but
when rates decline, increase in bond price is
large
* Low coupon
* Long term to maturity
* Low yield
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Convexity (Cont’d )
d 2V
Convexity 2 V
di
d 2V 1 n
Ct
2
(t 2
t)
di 2
(1 i) t 1 (1 i) t
Convexity = [1/(1.10)2][2247.41][1/92.42]
= 20.10
Appox. Change in V = -MD x i + K x (i)2
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Alternative Measures of
Yield
Current Yield = rM / V
Yield-to-maturity
◦ Bond is held until maturity
◦ All coupon and principal repayments are made on time
◦ Bond is not called before maturity
◦ Coupon payments are reinvested at yield-to-maturity
Yield-to-call
Holding period yield
Vt+1 - Vt + rM
HPY = --------------------
Vt
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Approximate yield-to-maturity
M V
rM
i n
V M
2
Example V= $877.11 n=3 yrs r=8% M=$1000
1000 877.11
80
i 10 0.0983
877.11 1000
2
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Bond Investment Strategies
I. Passive Strategies
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II. Active Strategies
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- Riding the yield curve
Investing in bonds assuming that the
yield curve will not shift
i
A
B
Maturity
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Strategies based on lack of market efficiency (cont’d)
Possible shortcomings of bond swaps:
◦ time to execute the swap
◦ taxes
◦ transaction costs
◦ risk level of bonds
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