2.3 Debt Valuation

Question 1

Flat yield formula

Answer 1

Gross annual coupon/market price x 100%

Question 2

Drawbacks of flat yield

Answer 2

• Time value of money overlooked
• Ignores redemption flows
• Not applicable to floating rate

Question 3

Other names for flat yield

Answer 3

Interest yield
Running Yield
Simple Yield

Question 4

Gross Redemption Yield (GRY) aka Yield to Maturity (YTM) formula

Answer 4

GRY = FY% + (Gross Profit/Loss at redemption)divided by number of years/market price
x 100%

Careful with +/- with profit and loss!!!!

Question 5

What is the Net Redemption Yield (NRY)

Answer 5

Considers impact of tax on YTM by applying income tax to coupon

Question 6

What happens if bond price is higher than the nominal value

Answer 6

Coupon > Flat yield> Gross redemption Yield

Question 7

What happens if bond price is lower than nominal value

Answer 7

Coupon< Flat Yield< Gross Redemption Yield

Question 8

What is meant by modified duration

Answer 8

Measure of volatility - approximate % change in a bond’s price for a 1% change in interest rates

Higher modified duration = more volatile

Interest rates rise—> Bond prices fall and yields rise

Question 9

If a government bond is priced at $95.84, and its modified duration is 1.02, what is the effect on the price after an increase in interest rates by one percentage point?

Answer 9

If interest rates rise by one percentage point, the bond’s price will fall by 1.02 / 100 x $95.84 = $0.98.
If interest rates rise by one half of a percentage point, the bond’s price will fall by 1.02 / 100 x $95.84
x 0.5 = $0.49

Question 10

Features of more volatile bonds

Answer 10

• Lower coupon bond more volatile to a change in interest rates than higher coupon bond
• Longer dated bond more responsive than shorter dated bond

Question 11

What are convertible bonds

Answer 11

Convertible bonds give the holder of the bond the right, but not the obligation, to convert the bond into a predetermined number of ordinary shares of the issuer.

They trade at a premium due to downside protection and potential gains if share price rises

Question 12

Conversion ratio formula

Answer 12

Nominal value / conversion price of shares

The number of shares that each £100 of nominal value of bonds can convert into

Question 13

Conversion Premium Calculation

Answer 13

Price of bond - share value of conversion choice
_______________________________________

Share value of conversion choice

x100

Question 14

What is accrued interest and give formula

Answer 14

The interest that has been earned, but not paid

Accrued interest = Coupon payment x

Number of days between payments
______________________________________
Number of days in payment period

Question 15

Difference between dirty vs clean price

Answer 15

Dirty price = clean price + accrued interest.

Question 16

Cum coupon period vs Ex coupon period

Answer 16

In cum coupon period, seller sells bond at higher price to reflect the coupon payment they would have been entitled to as they have held it for a few months since last coupon payment.

In ex coupon period, seller discounts price as buyer missing out on a few days of interest- here dirty price<clean price as accrued interest subtracted.

Question 17

What is the ex-coupon period for a UK gilt

Answer 17

7 business days

Question 18

Explain ACT/360 day count convention

Answer 18

ACT/360 (days per month, days per year) – each month is treated normally and the year is
assumed to be 360 days, eg, the period from 1 February 2024 to 1 April 2024 is considered to be 59
days divided by 360 (even in instances like this one, when the year is actually a leap year). ACT/360
counts are used for US Treasury bills and money market instruments

Question 19

What is the purpose of spreads and examples

Answer 19

A spread is simply the difference
between two yields, usually expressed in basis points, with each basis point representing 1/100
of 1%. For example, if the yield on Bond A is 5.5%, and the yield on Bond B is 5%, the spread is 5.5 – 5 = 0.5%, or 50 basis points.

Spreads are used to compare instruments to one another or to a benchmark- represents risk of holding compared to comparison

1. Government securities
2. Published reference rates
3. Swap rates

Question 20

What are swap rates

Answer 20

There is a very active market in exchanging floating rates for fixed rates in the so-called
swaps market. The rates available on swaps are also used as benchmarks against which to judge yields.

Question 21

What are published reference rates

Answer 21

LIBOR, SONIA in UK, SOFR in US

Question 22

Describe and explain a normal yield curve

Answer 22

Shape is upward-sloping to the right (GRY on y axis and maturity on x axis)

Shape captures how investors prefer more liquidity, so willing to accept lower yield on more liquid short-dated government bonds. Longer dated bonds have higher yields as more risk

Question 23

Describe and explain an inverted yield curve

Answer 23

Downward sloping to the right. In this scenario, the yield on short term bonds is more than long term ones and occurs when interest rates expected to fall.

The consequence of this is that, when
investing in longer-term instruments that will be outstanding when the interest rates fall, the investor is willing to accept a lower yield. For shorter-term instruments that will not be outstanding when the interest rate falls, the investor is demanding a higher yield

Question 24

Implications of negative yields

Answer 24

Negative interest rates on bank deposits would give savers an incentive to switch out
of deposits into holding cash. This would see the savings move out of the banking system. If banks were
to try to keep hold of the deposits by not charging the negative rates, then profitability will suffer. This
could have an adverse impact on the stability of the financial system

Where investors are paying to lend money. Occurring in some government bond markets, where uncertainty of economic climate creates desire to put money somewhere safe, even if you have to pay for it.

Question 25

Present value of bond formula

Answer 25

Value of bond = £coupon/(1+r)^n +

(£coupon+ £red value)/(1+r)^n