SAA: Bond pricing and valuation Flashcards
Callable bonds*
–Can be repurchased before the maturity date
Convertible bonds**denotes corporate bonds
–Can be exchanged for shares of the firm’s common stock
Putable bonds*
–Gives the holder an option to retire or extend the bond
•Floating-rate bonds
Floating-rate bonds
–Have adjustable coupon rate that increases with the reference rate
–Rate can be tied to T-bill rate, LIBOR, EURIBOR, etc.
–Some governments also issue these bonds
•Preferred stock
–Shares with characteristics of both equity and fixed income
–Dividends are paid in perpetuity but the non-payment of dividends does not mean bankruptcy
–Preferred dividends are paid before common
–No tax break
•Foreign issuers
–Foreign bonds (foreign currency denom.) vs. Eurobonds (local currency denom. sold abroad)
Innovation in the bond market
•Inverse floaters
–Similar to floating rate bonds but here coupon falls when reference rate rises
•Asset-backed bonds
–E.g. mortgage backed securities
•Catastrophe bonds
–Payout tied to a disaster, a way to transfer catastrophe risk
–Higher coupon but no payment in case a catastrophe occurs
Bond Pricing
Summe: C /(1+r)^t + Par value /(1+r)^t
Bond prices and yields
•Yields are equivalent to required rates of return
•Prices and yields have an inverse relationship
–The bond price curve is convex
•The longer the maturity, the more sensitive the bond’s price to changes in market interest rates
–Spot rate
Yield curve under certainty
–Spot rate
•The rate that prevails today for a given maturity
–Short rate
•The rate for a given maturity (e.g. one year) at different points in time
–A spot rate is the geometric average of its component short rates
Short Rates and Yield Curve Slope
When next year’s short rate, r2 , is greater than this year’s short rate, r1, the yield curve slopes up
•May indicate rates are expected to rise
The forward interest rate
The forward interest rate is a forecast of a
future short rate
