WEEK 5 - Bonds Flashcards
What is a Bond?
Debt instrument, issued by a borrower for a fixed period of time, paying interest known as a coupon which is fixed at issue date and is paid periodically until it is redeemed at maturity, at which time the principal amount is repaid
How can we classify bonds
- In terms of the nature of the bond
- Can classify based on place of issue
- Can classify by issuer
What are the variety of forms bonds come in?
- Straight, plain vanilla or bullet bonds
- Zero coupon bonds
- Floating-rate or variable-rate bonds
- Index-linked bonds
- Convertible bonds
What are the differing classifications of Bonds based on place of issue?
-Domestic Bonds
-Foreign Bonds
-Eurobonds
(Issued in a currency outside that country)
e.g. Bond issued in US in GBP
What are the differing issuers of Bonds?
Central governments and -government agencies
- State and local governments
- Companies
- Supranational institutions (eg. World Bank)
What are the 3 big credit rating agencies?
- Moodies
- Standard and Poor (S&P)
- Fitch
How does the credit rating agency scale work?
AA= Minimal Risk
All the way down to D which indicated a company/country defaulted
What the Current Types of Gilts?
Conventional gilts, for example: 1 1/2% Treasury Gilt 2047
Index-linked Gilts:
Coupon and Redemption increases with inflation
Gilt Strips:
breaking it down into its individual cash flows can be traded separately as zero coupon bonds
E.G. a three-year gilt will have seven individual cash flows: six (semi-annual) coupon payments and a principal repayment.
How do you calculate Perpetual Bonds?
PV = C/R
Where:
- PV: Present Value of bond
- C: The coupon rate x Nominal (par) value of the bond
- R: Discount Rate
How do you calculate the Conventional Bond?
PV =
PV(P) = C(1/R-1/R(1+R)t) + V/(1+R)t
Where V is the par value
Where t is to the power of
What are the historic type of Gilts?
- Undated gilts
- Double-dated conventional gilts
- Floating rate gilts
How do you calculate the interest yield?
Coupon/ Market Price
What are the issues to calculating the Interest Yield?
Doesn’t take into consideration:
- Time value of money
- No way to see capital gain/loss
What is the Redemption Yield? (Also known as Yield to Maturity)
The discount rate such that the present value of all the cash inflows from the bond (interest plus principal) is equal to the bond’s current market price
How do you calculate the redemption yield?
YTM = (C+ F-P/N)/(F+P)/2
Where:
- C = Coupon Rate
- F = Face Value
- P = Current Price
- N = Number of Years
CHECK NOTES FOR CLEARER PRESENTATION OF CALCULATION
How do you calculate spot rates?
Finding R1:
P= C+V/ 1 +R1
Simply just rearrange
Finding R2:
P= C/1+R1 + C+V/ (1+R2)2
Simply just rearrange
Finding R3:
P = C/1+R1 + C/(1+R2)2 + C+V/ (1+R3)3
Simply rearrange
ETC.
EXAMPLE OF CALCULATING SPOT RATE
SEE IN NOTES
EXAMPLE OF VALUING BONDS
SEE IN NOTES
What is a Zero Coupon Bond?
- Have only one payment on maturity
- Pure Discount Bond
How do you calculate zero coupon bonds?
P0 = 100/ (1 + Rt) t
- Where Rt = tth period spot rate
But can also use:
P0 = 100/ (1+ R) t
- Where r = Yield to maturity
Therefore, Spot Rate equals yield to maturity for zero coupon bonds
How do we calculate Forward Rates?
Focusing on £100 in 2 years:
Step 1: Find Present Value of £100 one year from now (PV):
- Use Discount Rate f 1,2 where 1,2 indicates that this is a rate from year one to year two. We refer to it as a forward rate:
PV = £100/ (1+ F 1,2)
Step 2: Find present value of PV0 of PV1:
PV0 = PV1/ (1+R1)
F 1,2 = 100 / PV0 (1+R1)
What is the Interest Rate Hypothesis?
Made up of:
- Interest Rate Hypothesis:
That the forward rate is simply the forecast of future spot rates
- Liquidity Premium
Lenders prefer to lend short time and borrowers prefer to borrow over a long time - Inflation Premium
Inflation risk is the greatest concern to investors
Inflation can only be accurately forecasted only in short term. In order to lend for longer, investors require investment premium
-Market Segmentation
Demand and Supply of bonds of differing maturities will vary.
