Chapter 3: Cashflow models Flashcards
cashflows
cashflows are a payment from one person to another
cashflows timeline
- time line with arrows for each cashflow
- Direction of arrows (up or down) indicate direction of payment, (in or out)
- Size indicates magnitude (or just use a number)
- Flip the arrows to swap the POV
Example where the size of cashflows are uncertain
Under a mortgage agreement (not fixed rate), the holder will know the size of the monthly repayment initially. However, if interest rates change, the amounts repayable will change also and borrowers will probably not know the size of the new repayment until they are told from who they borrowed
Example where the timings of cashflows are uncertain
A holding of premium bonds. (holders of a premium bond have their investment enterred into a prize draw each month. every bond has a small probability of winning a prize, which might be anything from £25 to £1 million. This process is repeated until the bond is sold by the investor)
Zero-coupon bonds cashflows
A loan that pays no interest. The amount paid at the end is (sometimes substantially) greater than the amount originally borrowed.
1 cashflow at the beginning and 1 at the end in the opposite direction.
Timing and payments know in advance.
A zero-coupon bond costs 10,000 and pays out 20,000 after 10 years. Estimate the interest rate
10,000(1+i)^10=20,000
(1+i)^10=2
i=(2^-10)-1
=7.18% pa
fixed-interest security cashflows
From POV of purchaser of the security (investor/lender)
There is a large negative cashflow at time zero.
Then small positive cashflows (coupons) at regular intervals (normally every 6 months) and a large positive cashflows (redemption payment) at the end of the term.
Both timings and amounts are fixed and known at the outset. The only uncertainty is the risk of defualt (on the coupons or the redemption payment)
How are gilt prices affected by interest rates?
If interest rates are low, the price will be higher as people will be willing to pay more for the guaranteed coupon payments
index-linked securities cashflows
coupon and redemption repayment linked to an index (usually an inflation one).
Timing is certain, amount uncertain.
Real value of investor returns is maintained
Disadvantage is that the initial interest is normally much lower than a corresponding fix-interest stock.
cash on deposit cashflows
Similar to cash in a bank account.
Likely to earn a variable interest rate, which may change often and at very short notice.
out at beginning, in at intervals, in when disinvested
equity cashflows
Out when bought, then in when sold. Unknown payments of dividends at unknown times and of unknown amounts.
interest-only loan cashflows
Big in at beginning, then out at end, and the interest goes out at regular intervals until then (including the final lumjp sum payment)
interest could be variable in which case the bank could change the rate under certain circumstances.
If the loan can be repaid early, the the timing of the final cashflow is uncertain
repayment loan cashflows
monthly payments include an element of repaying capital as well as interest.
if the interest rate is fixed, the amounts of cashflows are certain
property cashflows
Large negative cashflow at purchase, then a positive at sale.
Out at cost of moving in, renovating, maintenance, comission to estate agents
in for rent
timing and amounts uncertain
annuity certain cashflows
A stream of regular payments in exchange for a single lump sum at the start.
Amount and timing known with certainty
