Chapters 6-8 - up to midterm Flashcards
money markets securities
debt securities with a maturity of one year or less
treasury bills
- minimum is $1,000, in multiples of 1000
- don’t offer interest, instead at a discount to par
- maturity is 1 year or less
bond equivalent yield =
((sale price - buy price) / buy price) * 365 / n
discount =
((par - buy price) / par) * 360 / n
commercial paper
- short-term debt issued by creditworthy financial institutions and corporations
- minimum of $100,000 ay a discount to par
- all mature in 270 days or less
certificates of deposits
- Certificates issued by large commercial banks and other depository institutions as a short-term source of funds
- minimum is $100,000
- maturity is 2 weeks - 1 year
- issued at par, pay interest
repurchase agreements
- collateralized loan
- One party sells securities to another with an agreement to repurchase the securities at a specified date and price
federal funds
- Enable depository institutions to lend or borrow short-term funds from each other at or around the federal funds rate
banker’s acceptances
- Indicates that a bank accepts responsibility or a future payment
required rate of return =
= risk free rate + risk premium
market price =
= par / (1 + k)^n
- k = EAR
- n = time to maturity / 365
money market mutual funds
- Extremely common as cash alternative(cash equivalent)
- Important intermediary between both institutional and individual investors and the money markets generally invested in short term/safe investments
Eurodollars
- US dollar denominated deposits at foreign banks of overseas branches of American banks
bonds
- a security that represents a long-term loan of money to a company/government entity
- maturity > 1 year
- interest payments + par at maturity
stock market
- equity shares of publicly owned companies
- $44T market size
- $506B daily volume
- 5,284 securities
bond market
- $53T market size
- $1T daily volume
- 1,197,000 securities
US treasury bonds
Various maturities, minimal risk, interest exempt from state and local income taxes
municipal bonds
- Issued by a state/local government
- Interest on a majority are exempt from federal income tax and usually state/local income taxes if the investor lives in the state of issuance
corporate bonds
- Issued in denominations of $1,000, semiannual interest payments
- Maturity varies but is generally 2-30 years
- Category is generally split between financial and non-financial issuers
secured bond
the issuer has pledged specific assets or future cash flows as collateral
senior bond
has the right to be repaid ahead of subordinate debt holders
general obligation municipal bonds
backed by the revenue generating capacity(taxes) of the municipality
TIPS
- treasury inflation-protected securities
- adjust the principal amount the securities for the inflation rate
what represents the risk free rate?
a US treasury bond of the same maturity
high yield(junk) bonds
rated as “non-investment grade” by the rating agencies representing a higher potential for default
fallen angels
- Investment grade bonds that are downgraded to high yield
rising stars
bonds that are upgraded to investment grade
clean price
dealer prices will exclude accrued interest from the previous coupon date
dirty price
the actual amount that will exchange hands will be quoted + the accrued interest
treasury note maturity
1-10 years
treasury bond maturity
> 10 years
competitive bids
specify a price and a dollar amount of securities to be purchased
non-competitive bids
only specify a dollar amount of securities to be purchased
STRIPS
- separate trading or registered interest and principal of securities
- cash flows are transformed(stripped) by securities forms to create principal/interest only bonds
federal agency bonds
issued by federal agencies who use the proceeds to purchase mortgages in the secondary market
what are the 2 “government sponsored agencies”?
Fannie Mae and Freddie Mac
indenture
legal document specifying the rights and obligations of the issuing forms and the bondholder
trustee
by law, is appointed to ensure the issuer complies with the indenture
firm commitment
the underwriter guarantees the issue that all bonds will be sold at a specified price
best efforts arrangement
the underwriter attempts to sell the bonds at a specified price, with no guarantee
sinking fund provision
requires the firm to pay a price above par value when it calls its bonds
call premium
the difference between the bond’s call price and par value
debt-for-equity-swap
corporations issue bonds and then use the proceeds to repurchase some of their existing stock
CDOs
- collateralized debt obligation
- corporate bonds packaged by commercial banks
how is the value of a bonds determined?
by the present value of its expected future cash flows
yield to maturity
the annualized return on a bond, based on the current purchase price and assuming that you hold the bond to maturity, receive all promised cash flows from the date of purchase, and reinvest annual payments at te same rate
discount rate
the yield that could be earned on an alternative investment with similar risk and maturity
what will cause a bond price to drop?
of the market rate of interest is higher than the coupon payments
par bonds
- bonds selling at par
- If coupon rate equals the required rate, the price of the bond = par value
discount bonds
- bonds selling below par
- If coupon rate is below required rate, the price of the bond is below par
premium bonds
- bonds selling above par
- If coupon rate is above the required rate the price of the bond is abvoe par
factors influencing the risk-free-rate
- inflation
- economic growth
- money supply
- budget deficit
how does inflation impact the risk free rate?
- If inflation is expected to increase, there will be an upward pressure on interest rates and on the RROR
- Anticipated federal reserve policy
- Exchange rate movements
how does economic growth impact the risk free rate?
Strong economic growth tends to generate upward pressure on interest rates
how does the money supply impact the risk free rate?
- Increase in the money supply may result in an increased supply of loanable funds
- The increase money supply should place downward pressure on interest rates
how does the budget deficit impact the risk free rate?
An increase in the budget deficit can put upward pressure on interest rates
systemic factors
- factors the impact all issuers
- e.x. the expectation for economic growth
idiosyncratic factors
- factors specific to a single issuer
- e.x. industry, customer base, or geography
bond price elasticity
The sensitivity of bond prices(Pb) to changes in th required rate of return(k)
Pbe =
% change in Pb / % change in k
- Pb = bond price
- k = RROR
what bond is most sensitive to changes in the required ROR?
- zero-coupon bonds
- because the discount is applied to a lump sum at maturity
what is the relationship between tome to maturity and sensitivity to IR changes?
direct relationship
duration
measurement of the life of the bond on a PV basis
what is the duration on a zero coupon bond?
equal to term to maturity
how do you find the duration of a portfolio of bonds?
the WA of the bond dratins weighted according to their relative MV
modified duration(DUR*)
estimates the impact of a change in the k(current bond yields) on the price of the bond
expected change in price =
(-)modified duration x change in yield
convexity
the slope of the price versus yield relationships
convexity is more pronounced when?
bonds have:
- longer maturities
- low or no coupons
- uncertain cash flows and mortgages
DUR* =
duration / (1 + k)
DV01 =
dollar value of a bond’s price change for a 1 basis point change in rate (Δ)
CV01 =
dollar value of a bond’s price change for a 1 basis point change in credit spread
value at risk =
downside risk for financial instruments based on a statistical level of confidence assuming a “business as usual” environment
stressed value at risk =
downside risk for financial instruments based on statistical level of confidence during a stressed market environment
matching strategy
The investor knows/estimates future cashflows and develops a bond portfolio that can generate sufficient coupon or principal payments to cover those outflow
laddered strategy
Investing an even allocation across maturity types
barbell strategy
Funds are allocated to bonds with a short term to maturity as well as to bonds with a long term to maturity with little allocation elsewhere
interest rate strategy
funds are allocated in a manner that capitalizes on interest rate forecasts
what do government bonds offer?
- low(er) risk, generally don’t worry about credit
- good way to invest with an interest rate strategy
what do municipal bonds offer?
- tax sensitive
- low(ish) risk, slightly more yield
what do agency bonds offer?
- Greate way to invest with interest rate forecasts
- low(ish) risk, slightly more yield
what do corporate bonds offer?
- Return seeking investors
- Investing based on credit and interest rate forecasts
