Introduction to the Valuation of Debt Securities Flashcards
Valuation
the process of determining the fair value of a financial asset
fundamental principle of financial asset valuation
its value is equal to the present value of its expected cash flows.
valuing a financial asset steps
- the expected cash flows must be estimated,
- appropriate interest rates must be determined to discount the cash flows,
- the present value of the expected cash flows is calculated
Estimating cash flows
- involves projecting the cash that is expected to be received in the future from an investment
- can be difficult if the security has options such as callables, putables, or convertibles (risk of default)
- the analysis must consider how future changes in interest rates and embedded option may affect cash flows
cash flows of a fixed income security
are the collection of each period’s cash flow, which may be the interest income or payment of principal
Future interest rate movements
the key factor in determining if the option will be exercised, and if they fall enough, the issuer/borrower may have an incentive to refinance.
appropriate interest rate to discount cash flows
- the yield available in the market on a default-free cash flow, which is the yield on a U.S. Treasury security
- investors require a yield premium to reflect the added risks (non-government securities)
- valued using an interest rate specific to its maturity, rather than a single interest rate
final step in the valuation process
to value cash flows by discounting expected cash flows using the appropriate interest rate.
The present value of a cash flow
- depends on the timing of the cash flow and the interest rate (discount rate) used to calculate it.
- value of a financial asset = add up the present values of all expected cash flows
- PV = expected cash flow in period t/(1 + discount rate)^n
- decreases as time elapses, making it important to use a suitable discount rate.
- affected by the chosen discount rate, with higher rates leading to lower present values.
A security’s value
- determined by the present value of expected cash flows,
- and inversely related to the discount rate;
- a higher discount rate yields a lower security value, and vice versa
option-free bond
- The shape of the curve showing the inverse relationship between security value and discount rate is CONVEX;
- it has implications for price volatility when interest rates change
relationship between coupon rate, required market yield and price
relative to par value
- when coupon rate > yield, price > par value (premium);
- when coupon rate < yield, price < par value (discount);
- when coupon rate = yield, price = par value
Change in a Bond’s Value as it Moves Toward Maturity
- its price will move to its par value
- selling at a premium, its price declines as it moves towards
maturity. - initially below the par value increases in price as it moves towards maturity.
- changes due to both the change in the discount rate and cash flows as it moves towards maturity
Decline of bond value due to an increase in discount rate
decomposed into two parts:
1. attributable to moving towards maturity and
2. increase in discount rate
Valuation Using Multiple Discount Rates
The proper way to value the cash flows of a bond is to use a different discount rate that is unique to the time period in which a cash flow will be received