Chapter 10 & 11 - Analysis of Debt Securities Flashcards
What are the only 2 variables required to calculate the value of a strip bond?
The price (when calculating yield) or yield (when calculating price), days to maturity. The FV is always 100.
What type of return is the yield to maturity of a bond? Why is this only sometimes can accurate return?
Internal rate of return. Given that it’s the PV of a series of cash flows, it’s only a true return if the bond is held to maturity and all cash flows are received and reinvested at a rate equal to the YTM.
How do you calculate the yield of callable and putable bonds?
Must not only calculate the YTM, but the yield to call or yield to put. If there are multiple potential dates, you would normally calculate the yield to each date. The lowest yield (yield to worst) is taken as the assumed yield.
What is the yield to worst?
For callable or putable bonds, it’s the lowest yield to call or yield to put. This is the value that is used as the assumed yield of the bond.
Which function on the financial calculator do you use to calculate a bond’s yield?
IRR
How do you calculate the yield of a bond portfolio?
The yield is NOT the weighted average of the yields of the individual bonds in the portfolio. Instead, it is the “cash flow yield” which is the IRR of all expected cash flows.
What happens if a bond is purchased between coupon payment dates?
The buyer must compensate the seller for interest accrued since the last coupon payment date that has not yet been paid (accrued interest).
What are the 4 different “day count methods” for calculating accrued interest and which applies for which type of bond?
- Actual/365 - Government of Canada & Prov Bonds
- Actual/Actual - US Treasury, Cdn Corp
- Actual/360 - Eurobonds
- 30/60 - US agency, US municipal, US corp
What is the actual/365 day count method and what does it apply to?
Govt of Canada + Prov bonds.
Accrued interest = coupon rate x DSLC (days since last coupon) / 365
What is the actual/actual day count method and what does it apply to?
Cdn corp bonds and US treasury notes.
Accrued interest = (coupon rate / 2) x days since last coupon / DCP (# of days since last coupon to the next)
Example: 73 days since last coupon, 183 days total between last coupon + next coupon
How does the actual/360 day count method work and what bonds does it apply to?
Applies to eurobonds. The year is assumed to have 360 days.
Does the 30/360 day count method work and what bonds does it apply to?
A year is assumed to be 360 days and each month is 30 days. When calculating the number of days accrued, no month can count for more than 30 days. Applies to US agency bonds, US municipal bonds, and US corp bonds.
Are money market yields calculated in the same way as strip coupon yields?
No. T-bills, bankers’ acceptance and commercial paper in Canada is quoted as the “bond equivalent yield” (BEY).
BEY = (100 - price) / price x 365/n
where n = # of days to maturity
In US, the “bank discount rate” BDR method is used.
BDR = (100 - price) / 100 x 360/n
How does calculating the price of a money market security differ if it’s Canadian or US?
For Canadian, you use the BEY. US is the BDR. For Canadian, the calculation is 100 / [1 + (BEY x n/365)]
For US, it’s 100 - (100 x BDR x n/360)
BEY and BDR are the quoted yields.
What is the term structure of interest rates?
The relationship between interest rates and time to maturity, represented by a yield curve.
What are the 3 terms that describe the yield curve?
Normal
Flat
Inverted
What are the 3 TYPES of shifts that can occur in the yield curve?
- Parallel shifts up and down
- Twists (flattening or steepening)
- Humps (positive or negative)
When do parallel shifts in the yield curve occur?
When yields at all maturities move up or down by nearly the same amount.
When do twists in the yield curve occur?
Twists cause the curve to steepen or flatten. They occur when either yields at one end of the curve move up or down by more than yields at the other end, or yields at the other end move in the opposite direction.
When do humps in the yield curve occur?
These occur when the yield at a certain maturity moves up or down independently, or in greater amounts, than yields at all other maturities. These can be positive humps or negative humps.
Which type of shift in the yield curve is rare?
Humps. Most shifts are parallel or twists.
What tends to happen to a normal yield curve when it shifts upward?
It also becomes flatter as short-term yields rise more quickly than longer-term yields.
What are the Government of Canada’s 7 benchmark securities?
3-month T-Bill
6-month T-Bill
1-Year T-Bill
2,5,10,30 year bonds
What happens to old benchmark bonds when new benchmark securities are issued by the Government of Canada?
Old benchmark bonds are said to be “off-the-run” bonds while new ones eventually become the “on-the-run” issue for that benchmark maturity.
How does the growth phase of the economic cycle impact interest rates?
Demand for goods and services increases, resulting in increased demand for credit. This pushes interest rates higher as the supply of credit cannot meet the increase in demand.
How does the boom phase of the economic cycle impact interest rates?
Rising pace of growth leads to increased employment. Labour becomes scarce, so wages rise. Demand for input materials also rises. Rising prices, combined with continued demand for credit, push interest rates higher.
How does the contraction phase of the economic cycle impact interest rates?
Too much inventory is combined with high costs and tight credit conditions. This results in reduced profitability and therefore reduced incentive to invest and expand further. Production slows and the economy slows. Reduced demand for credit pushes interest rates lower.
How does the trough phase of the economic cycle impact interest rates?
Demand is low, profits decline further, unemployment rises , and the need for investment is reduced. Inflation declines and the demand for credit remains low, resulting in further declines in interest rates.
Why do debt market participants watch GDP?
GDP growth rates are barometers of the economic cycle. Growth in GDP is the key measure of an economy’s increase in output over time. These numbers can give an idea as to where Canada is at in the economic cycle.
What is the trade balance and why is it an important factor to watch for debt market participants?
The difference between exports and imports. It can be interpreted in many ways. For example, a trade deficit (more imports than exports) has a negative effect on GDP due to the need to draw in capital to finance foreign liabilities, it also signals strong consumer demand.
What are the 3 primary measures of inflation in Canada?
- Consumer Price Index
- In the US, Producer Price Index (prices for a broad range of goods and commodities). In Canada, Industrial Product Price Index and Raw Materials Price Index would be comparable.
- GDP price deflator covers all goods and services purchased/produced in an economy.
What is the Index of Leading Economic Indicators?
Composite index that consists of an average of economic variables, attempts to anticipate future economic activity. However, most components are released first, so it’s a lagging indicator to the leading indicators.
What are the 2 primary tools the BoC uses to implement monetary policy?
Interest rate policy
Open market operations
How does the BoC’s official interest rate work?
It is enforced indirectly since the central bank is a lender of last resort. To ensure trading in the overnight market stays within a certain range, the BoC’s target for the overnight rate is at the centre of an operating band that is 50 basis points wide.
What are open market operations?
The purchase or sale of T-bills and government bonds.
What is quantitative easing?
Released by the Fed in response to the global financial crisis. The concept is to increase the reserves in the commercial banking system, which will minimize liquidity problems in the short-term. In a QE transaction, the Fed purchases collateral (such as US treasury bonds) from commercial banks and credits their respective Fed reserve accounts. This results in greater liquidity, with a mid-term impact of increasing lending activities and spurring economic growth.
What is Modern Monetary Theory?
Reemerged in 2016 as a viable concept. According to MMT, a country should not worry about running a fiscal deficit in pursuit of a domestic economy with full employment and little spare capacity. Each country has a unique monopoly on printing its own currency, making it impossible to default on sovereign debt outstanding.
What are the 2 important conditions associated with modern monetary theory?
- A country must not depend on debt financing denominated in foreign currencies.
- Once full employment is reached and all capacity has been used up, any additional money printing/govt spending can increase the risk of creating an inflationary environment. Inflation can be eliminated by raising taxes.
How does modern monetary theory posit that a domestic economy run at full employment?
Governments will typically used federally funded, locally administered job programs to provide employment opportunities to the unemployed. These programs will be more in use during times of contraction/trough.
