ADP

Question 1

Interest Rates:

Fixed versus Floating

Answer 1

Fixed rate loans or bonds: the interest rate remains constant from origination to maturity

Floating rate loans or bonds: the interest rate adjusts periodically (e.g. every 3-mths or 6-mths). Common floating rate indexes (the “Basis”) include:
Prime: Originally, a rate given to creditworthy corporate borrowers for short-term working capital loans. Meaning has changed over the years.
LIBOR: London Inter-bank Offer Rate. Rate offered on short-term euro currency inter-bank loans, maturities range from a week to 12 months
Short term UST rates or yields (e.g. 1-yr CMT)

Question 2

Important Factors when analyzing Floating Rate Debt
e.g.
loan 5 yrs, $10 million, risk spread 2%,
1) libor 3 month =0.5%
2) Libor =2%

Meaning you got to pay me back $10 million at the end of 5 years roll over every 3 month in 5 year.

Answer 2

What is the Basis?
How often does the rate re-set?
What is the Spread?
Are there any Caps or Floors on the rate?
Day convention: Actual/365, Actual/ 360, 30/360?
Answer
1) $10ml * (0.5% + 2%) * 90/360 =62,500
2) $10 ml * (2%+2%) * 90/360 =100,000

Question 3

Fixed Rate Bond Analysis

Answer 3

Debt obligations, or Loans in the form of Securities.

Issued by private and public corporations or government agencies.

Question 4

Measures of Value

Answer 4

Market Value: current price the bond can be purchased for in the market (trader’s offer price).
bid (buy) /offer (sell): 101/102 meaning, you have to pay 102% * 10 ml par =mkt price of 10,200,000

Intrinsic Value: the bond’s perceived value by an investor based on its terms, conditions, credit risk, liquidity, and other fundamental factors.
PV the bond based on your RRR (rf + your risk spread). If I value it 103, then yes, I should buy it.

Question 5

Measures of Return

If I think rf is 2% and spread is 3.5% = 5.5%, should I buy it?

Answer 5

Yield to Maturity (YTM): rate a bond will return if purchased at the current market price and held until maturity assuming no defaults. Also, called expected rate of return.

Investor’s Required Rate of Return (RRR): rate an investor thinks is a reasonable return given the bond’s terms, conditions, risk, liquidity and other fundamental factors.

answers: yes. because I think it worth 5.5%, but yield 6%

Question 6

Buy or Don’t Buy Bond?

Answer 6

Buy when
YTM > RRR
Your Intrinsic Value > Market Value

Don’t Buy when
YTM < RRR
Your Intrinsic Value < Market Value

i up, BV down
i down, BV up

Question 7

Bond’s Value = Present Value (PV) of the bonds cash flows (principal and interest) using an appropriate, risk-adjusted discount rate or Required Rate of Return (RRR). For example, a bond where Par = $1,000, Annual Coupon = $60 (6%), Maturity = 2 years and the your RRR = 4% would be valued as follows:

Answer 7

Set i/y=1 since it is annual coupon
n=2, i =4, pmt=60, fv=1000
Cpt PV= -1037.72

Question 8

Example 1: Bond Pricing
You are interested in purchasing a Ruby Tuesday bond that matures in 5 years and has a $100 par value. The annual coupon rate is 5% and, after analyzing Ruby Tuesday’s credit strength, your required rate of return is 4%. What is the bond’s intrinsic or present value?

Answer 8

Set i/y =1
n=5, i =4, pmt=5%*100=5, FV=100
Cpt PV= -104.45 ,

Intrinsic value =104.45
if B/O is 104/105, should I buy it?
Value

Question 9

Example 2: Bond Yield
Hoyden Co.’s bonds mature in 15 years and pay 8% interest annually. If you purchase the bonds for $1,175, what is your expected rate of return or yield to maturity?
B/O =114.1 / 117.5

Answer 9

Set i/y = 1
n=15, pv= -1175, pmt = 8%*1000=80, PV=1000
Cpt i/y = 6.18% = rf 2% + spread 4.18

if my spread is 4.5%, would I buy?
no, I don’t want to buy because they only give me spread of 4.18, but I want 4.5.
Change i/y to 6.5, then cpt Pv= -1,140.04, less than the price. so I don’t want to buy it.

Question 10

Example 3
Hawaiian Electric Co. issued $300 million of 7% bonds maturing in 2018 (i.e. 3 years from now). The bonds are issued in $1,000 denominations. An investor requires an 8% return on this type of bond. If the bond is selling in the market for $980 will this investor want it? (Assume semiannual payments.)

Answer 10

set i/y=2
n=32=6, pv = -980, pmt=7%1000/2=35, FV=1000
Cpt i/y =7.76
(change i/y =8, cpt pv= -973.79)

No, should not buy it. because MKT spread

Question 11

Two Key Debt Product Risks:

Answer 11

Credit Risk (spread):
What is the probability the bond, loan or other debt product will default? And, in the case of default, what is the severity of loss?
Investors require an additional credit spread (“Spread”) to cover this risk.
Interest Rate Risk (Risk Free):
Changes in interest rates impact the value or price of debt
*When interest rates rise, bond prices fall
*When interest rates fall, bond prices will rise
Interest rate risk is measured by “Duration”
*Longer Duration = Higher level of interest rate risk
(We focus on Credit risk, because you can hedge interest rate. When rf move, the whole market move. it usually course by inflation and monetary policy.)

Question 12

Key to Bond Pricing:Required Rates of Return

Answer 12

Bond’s Value = Present Value (PV) of the bonds cash flows (principal and interest) using an appropriate, risk-adjusted discount rate or Required Rate of Return (RRR).
Bond cash flows are fixed therefore the critical question in bond valuation is:
What is the appropriate RRR?
Risk-free interest rate
+ Spread (Risk Premium)
Investor’s Required Rate of Return
Note: Investors’ risk perception and analysis on the issuer will differ. All the various investors buying and selling the bond will drive the market Spread.

Question 13

Risk-free (rf) rates:

Answer 13

To determine a risk-free rate, use the govt. bond yield with a maturity that matches the bond’s or loan’s maturity you are pricing

Risk-free rates differ by currency/country

Question 14

Credit “Spread”

The Return for holding Risk

Answer 14

Additional return investors require when buying debt products (bonds, loans, etc.)
Compensates investors for undertaking risk
Main risk is default or credit risk
Typically quoted in basis points (100bps = 1%) over risk-free, For example:
UST + 150 bps (fixed bond)
3-mth LIBOR + 225 bps (floating rate bond)

Question 15

Credit “Spread”

Answer 15

Notes:
Spreads are market driven and determined on a case-by-case basis so the indications above are only rough ranges for a given rating.
Market or financial crisis can massively widened out spreads from the normal levels shown above.
“Spreads” move around depending on market conditions and the economic trends

Question 16

Interest Rate Risk

Answer 16

A decrease in interest rates (required rates of return) will cause the value of a bond to increase; an interest rate increase will cause a decrease in value. The change in value caused by changing interest rates is called interest rate risk.
Note: Interest rate changes can result from changes in risk-free rates or the company’s credit spread.

Question 17

Interest Rate Risk and Duration

Answer 17

Interest Rate Risk: how sensitive is a bond’s or loan’s price to changes in interest rates?
Duration is a measure of interest rate risk
Duration equals the average life of a bond’s discounted cash flow payments (both coupon and principal)
Longer Duration means a bond’s price is more sensitive to interest rate changes
Relationships
Longer maturity = longer duration
Higher coupon = shorter duration
Duration management from bond investors perspective
When interest rates are falling, lengthen duration
When interest rates are rising, shorten duration

Question 18

Price Changes on 7.5% coupon bond

key Relationship

Answer 18

If RRR =4%, bond trades at premium
if RRR=10%, bond trades at discount
The longer the maturity (duration), the bigger impact
interest rate changes have on price.

Question 19

Price Sensitivity of a Security

Answer 19

(changing in P/ P) = -D * [changing in i / (1+i)]
A fixed rate asset or liability with longer duration is exposed to greater interest rate risk than a fixed rate asset or liability with shorter duration.
A bond with a duration of 2 will be twice as risky in terms of price volatility from interest rate changes as a bond with a duration of 1.

Question 20

Example for

Price Sensitivity of a Security

Answer 20

(changing in P/ P) = -D * [changing in i / (1+i)]
if duration is 4.2, interest increase from 3% to 4%.
=-4.2 * (0.01/1+0.03) = - 0.0408
means bond goes down by 4.1%
duration is the relationship between changing i + Debt value + fixed rate
duration: i increase, bond goes down by how much?
In sum: when interest goes up 1%, Duration will be about 4.2, and Bond goes down by 4.1%

Question 21

Duration Management

Answer 21

• -The Purpose of Asset-Liability Management (ALM) is to manage a company’s sensitivity to changes in interest rates and limit its losses in Earnings and/or Net Worth
• -Work to achieve a balanced duration match between interest rate sensitive assets and liabilities
• -Financial institutions (banks, insurance companies, securities companies, finance companies) need to be most concerned about interest rate risk.
• -Duration risk depends on perspective
• Bond Investor: Longer duration increases risk
• Bond Issuer (borrower): Longer duration reduces risk

Question 22

Other Bond Topics:

Answer 22

• -Amortizing Bonds: issuer makes principal payments over the life of bond
• -Callable Bonds: issuer may choose to redeem bonds early, usually at a premium above par value.
• -Convertible Bonds: bondholder accepts less interest for the option of converting bonds into stock. Issuer saves interest expense.
• -Dirty or Clean Price?
• Clean price pay accrual interest separately
• Dirty price, no payment of accrual interest

Question 23

Example Callable Bonds
$1,000 par value, 8% coupon bond pays semi-annual interest, has 10 years left till maturity. If it’s selling at $1,050, what is YTM? Assume it’s callable in 5 years at a price of $1,025. What is YTC?

If your RRR on the bond is 7.25%, should you buy it?

Answer 23

Set i/y=2
1) n=20, pmt=10008%=40, PV= -1050, FV =1000
Cpt YTM = 7.28 with no call
2) n=10, pmt=10008%=40, PV= -1050, FV =1025
Cpt YTM = 7.215 with callable in 5 yrs
3) if my RRR is 7.25%, no buy because the probability to get call is high. Why?
Because the bond’s coupon is 8% and the issuer could refinance this bond at around 7.25%, therefore the probability of the call is relatively high. Most investors would not purchase this bond if their RRR was 7.25% because they would assume a call with a YTC of only 7.215%.
if the bond’s coupon rate is lower then RRR, e.g.5-6%, then the probability of the call would be relatively low.