FI: Valuation Flashcards
3 steps to valuation =
1) estimate cash flows over the bond’s life
2) determine the appropriate discount rate based on the risk of the receipt of the cash flows (for a risky bond we’ll add a risk premium to the yield on a risk free bond to get the overall yield/discount rate)
3) calculate the present value using the discount rate
Cash flow unknowns that make valuation difficult =
1) principal repayment stream is not known with certainty (embedded options, prepayment options, accelerated sinking fund provisions)
2) coupon repayment stream is not known with certainty ie floating rate coupons
3) bond is convertible or exchangeable into another security
Valuing a bond with a single yield/discount rate =
+ semiannual payment
we treat this just like an annuity - FV is par, discount rate is whole numbers (ie 8% is ‘8’),
IF WE RECEIVE PAYMENT SEMIANNUALLY…
we simply have 2x number of payments, half the payment amount and half the ‘i’ (discount rate) –> the present value will be greater due to compounding than for a bond that pays annually.
Calculating for a zero =
it is customary to value zero coupons at semiannual discount rates - this is why we have the number of semiannual periods and the semiannual discount rate.
on the calculator: PMT = 0, N = years to maturity x 2, i = discount rate/2, FV = par
Premium, par and discount bonds =
change in price from changes in interest rates and time to maturity
As interest rates increase, bond’s price goes down, and vice versa.
As a bond moves closer to maturity, it will price closer to par.
Price-yield curve =
shows the inverse yield/price relationship.
Arbitrage free valuation approach =
we discount each cash flow based on the spot rate of the maturity of each cash flow.
the sum of these present values should equal the market price.
If it does not we can make an arbitrage profit by
a) buying the bond and selling each cash flow if the sum of the PV cash flows is more than the market price
b) buying the zero’s corresponding to the individual cash flows and packaging them as a bond if the bond’s market price is more than the PV of the individual cash flows
THIS IS POSSIBLE GIVEN STRIPS, AND SHOULD PUSH BOND PRICES TO THEIR ARBITRAGE FREE VALUES.
