Finance Topic 6 Flashcards
bonds
means by which companies and gov raise/borrow money
form of debt finance
bond holders
lenders & investors
principal amount
amount borrowed
nominal value/par value
since recorded on bond agreement document
face value of bond
coupons
in return for lending = inv in bond receive regular interest payment of a fixed size
size of regular coupon
defined by annual % rate applied to nominal amount of bond
fixed income securities
since coupon lvl doesnt vary
bonds are often called ….
irredeemable/perpeutal bond
unless above = investors are repaid principal amount (some amount calculated by reference to principal amount) at end of agreed lending period (maturity/redemption)
value of bond
price of any fixed income security = depends on size & timing of coupon payments and time remaining to maturity
value of bond = sum of present values of remaining coupons and principal repayment
(discounting at investors required rate of return)
relationship between coupon rate & required return
and current value and redemption amount
higher coupon rate = higher price/value of bond
(coupon rate & bond price = +ve associated)
higher req return = lower price/value of bond
(req return and bond price = -ve associated = inverse/non linear relationship)
bond price and required return diagram,
2 key impactors on interest rate sensitivity of value
= price risk
1. term to maturity (longer = greater % change in bond price following change in interest rate/req return)
2. size of coupon (bonds paying lower show higher % change in bond price following change in interest rate/req return) -> lower coupon = greater sensitivity to bond changes
price changes
required return changes
price risk = sensitivity of value to changes in discount rate
coupon factors
lower coupon implies = higher interest rate sensitivity (price risk)
longer maturity = implies higher interest rate sensitivity
naive bond investing strategy
-investor believes interest rates will rise
- invest in lesser interest rate sensitive bonds (shorter maturity & higher coupon payment)
-investor believes interest rates will fall
- invest in greater interest rate sensitive bonds (longer maturity and lower coupon payment)
bond yields
yields - often quoted for bonds
key measure = gross redemption yield (yield to maturity or total return)
GRY
gross redemption yield
represents return an investor would make if held bond to maturity
IRR of cash flows associated with bond from investor/lender perspective
conditions to hold for GRY
- bond is actually to be held to maturity
(any sale prior = give proceeds subject to mkt conditions at Time of sale) - GRY assumes all coupon amounts received can be reinvested at gRY rate (may not be the case, re-investment risk)
- regular coupon payments
re-investment risk
having cash flows coming out of bond dont know the market conditions
shares returns arithmetic return equation
rise in value = contributes to equity investors return
rule of the return
returns can never be less than -1
cant do anything worse than lose all your money which would be -1
descriptive statistics
- returns
- deviations (historic return - expected return)
- deviations squared = variance
- product of deviations
- co-variance
- correlation
correlation formulae
co variance of A & B divided by
std deviation of A x std deviation of B
uncertainty and risk
actual future returns = uncertain = measures of risk quantify this
(different approaches) = no universal def of risk
-common approach = calculate amount of variation in possible returns around their mean value
-majority = adopt std dev of returns as measure of risk
-wider possible variation in share returns = lower chance actual return will be close to mean (expected) return higher std = higher risk
-std deviation of returns = measure of total risk for asset
beta = systematic risk
portfolio theory
following parameters estimated
1. expected return of asset
2. risk for each asset (Std dev of return)
3. covariance of returns between each pair of assets
total risk vs systematic risk
risk free inv
positive return & no risk
sovereign debt (gov bonds) of developed countries, strong economies = held nearly risk free, position open to criticism
expected return on portfolio
total risk
risk inherent in individual stock/security specific to particular company
systematic risk
risk inherent in overall mkt or particular segment of market
diversification
Markowitz space
rho: +1 = perf positive correlation (form straight line)
as rho decreases more shedding of risk bows to the left
perf negative correlation = perfect smoothing
risk averse investor
doesnt seek to avoid all risk (health appreciation for level of risk vs return)
- demand higher expected return to compensate for higher risk
equivalent risk = chose highest expected return
equivalent expected return = chose lowest risk
risk hating investor
seek to avoid all possible risk
no care for return
choose alternative with lowest risk (zero risk) mo matter what expected returns are available
price risk (interest rate risk)
potential for value of bond to fluctuate due to changes in interest rate
existing bond with fixed coupon rate = less attractive to inv compared to newly issued bonds with higher coupon rate rising interest rate env
-relevant for bonds with longer maturities, lower coupon rates, higher durations = more sensitive to interest rate changes
affects value of bond in secondary market
reinvestment risk
potential uncertainty or risk associated with reinvesting periodic coupon payments /principal repayments from bond
