Fixed Income TVM, Bonds Flashcards
- You invest 100K in risk venture, expected to have income of 30K at the end of 1st year, loss of 42500 at the end of 2nd year, and income of 49900 at the end of 3rd year when you expect to sell income for 120,000.
What is the Net Present Value at a nominal annual interest rate of 12%
- Answer CF, CF0=-100K, C01=30K, F01=1; C02=-42.5K, F02=1; C03= 169900,
- Clit NPV, I=12, CPT NPV=13836,
- Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project. NPV is the result of calculations used to find today’s value of a future stream of payments.
- any project or investment with a negative NPV should be avoided
- To find the internal rate of return, that is the discount rate that make NPV=0
- In the above case, since IRR is 11.4, greater than 5%, which is good to accept
If NPV of investment using your required rate of return is 0 or Greater than 0 positive number is Acceptable
- If the internal rate of return is greater than the required rate of return, then investment is acceptable.
T bill is money market instrument, issued by government; Sold at discount, and mature at face value. Low risk, free of default risk, as guaranteed by government
- New Treasury bills are issued every two 2 weeks, with terms of 31 days to 364 days
- Investment dealers purchase the T-bills from government, then sell them through secondary market, they are highly liquid
- T-bills subject to inflation risk and interest risk
- buy at discount and mature at face value—if held to maturity, difference btw face value and purchase amount is Interest Income, not a capital gain.
- The investor can only realize a capital gain or capital loss if sell the T bill before maturity and interest rates have changed since first purchase the Tbill
- due to availability, liquidity and risk free nature, the yield of 91 day T-bills are commonly used as the reference point for all short term negotiable instrument
- T bill trade in secondary market, fair market value is dependent upon the prevailing Interest rates. The FMV changes inversely with interest rates. IR increases, FMV decrease, IR decrease, FV increases
T bill returns are quoted as Yield to maturity expressed on annualized basis.
US denominated T bills can be used to hedge against the risk of depreciation of Canadian dollar
- Yield = ((par value - price)/Price) * (360/term)
US T-bill calcuations use 360 Day year not 365 as Canadai T-bill
The quoted yield is lower on US denominated Tbill, coze 360
- Yield = ((par value - price)/Price) * (360/term)
Canadian T-bill yield is
Yield = ((par value - price)/Price) * (365/term)
Equity-Linked GIC guarantee the Full return of Principal + the opportunity to earn Variable return based on stock index
if IR is low, you want to guarantee the principal, you can use Equity Linked GIC
The return on GIC is interest income still
- Unbiased expectation theory – positively sloped yield curve is the result of investor expectations that interest rates will rise in the future.
a. Liquidity preference theory- that investor require that a long term bond must have a higher return than a short term bond because investors perceive a long term bond to be riskerd to holder
A sinking fund is a fund that is set aside by the company to ensure that the full debt can be retired by maturity
a. However, the investor then faces the uncertainty of when her bond will be called, and this make investment planning more difficult
The lower is the credit rating, the higher is the risk of default, and the higher is the yield on the bond
- The adjusted cost base of a strip bond is the original price of the bond, plus the commission fees and accrued interest that has been reported for tax purposes/
- Strip bond or Zero Coupon Bond that purchased at a discount and mature at Face value
a They not make interest payments
b. When strip is first issued, it is priced at the present value of the face amount, based on the interest rates that prevailed at the time the strip was issues
c. If hold the strip till maturity, this rate of return is guaranted, it’s solely interest income
d. Although the investor does not receive the face value till maturity, he must accrue the interest income annually for tax purposes.
e. However, if an investor holds a strip to maturity, the difference between the purchase price and the cost plus commissions is interet income.
Strip bonds, you bought 2 years ago 50,000, paid 35650. the strip provideds an effective annual return of 7% and will amture on Jan 3 years from now. On Jan 1 of this year, you sold the strip of 44490
- the value at the time the the first bond year was 35650 *1.07=38145
b. Your earned interest for the second bond year 38145*1.07=40815.7. earned 40815-38145=2670
c. At the time of Sale, the adjusted cost base ACB of the bond is 40815.69 is
d. Capital gain is 44490-ACB 40815=3675
What is Seinor Debt?
- Mortgage bond is secured by fixed assets of issuing companies. A FIRST MORTGAGE bond is the most senior debt of a company, raking ahead of all other bond
o If bankrupt, all first mortgage bonds must be repaid from the proceeds of the sale of company’s assets before the repayment any unsecuried liabilities
- In Income Bond that pay interests if the company earns money…income bond rank lower than mortgage bonds
- Debenture is debt that is secured only by the general credit of the company.
o If company issues several debentures, must rank them according to claims on the assets of company
o Subordinated debentures ranking junior to other debentures.
o A debenture ranks lower than all forms of bond - Convertible bond – exchangeable for commons shares
- Junk bond – bond with low credit rating issued by a corporation with questionable credit worthiess
- You bought new 5 year 6.25%, $10,000 real return bond last year. Last year the inflation rate 1.5%, this year inflation expected to be 2.5%. The adjustment for inflation is made on the annual anniversary of the bond’s issue date.
a. The face value of bond on Jan 1 of this year is 10,000*(1+1.5%)
- There are variety of Mutual funds to meet the needs of investors with different investment objectives and strategies
a. Bond and fixed income funds provide good income generation, while maintaining safety of principal and income at relatively low risk
b. Equity and real estate funds tend to carry higher levels of risk, with main objective of long term capital growth
Passive Bond Strategies –suits conservative investor
a. Ladder approach
b. Barbell approach
c. Immunization
d. Purchase strip bonds
- Active bond strategies
a. Matching strategy
Strategy of matching the term to maturity of the selected bond for future income
b. Bond swapping
Switching form one bond to another to take advantage of chaning yield curves
ii. Coz interest rates can be volatile in the short run and pursue a bond swapping strategy is prepared to make frequent trades in bond portfolio
c. A reinvestment risk – a risk that arised form decrease in interest rates when payment of interest and principal need to be reinvested
