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Pages 3

One attribute of a bond that influences its interest rate is its risk of default, which occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or pay off the face value when the bond matures. A corporation suffering big losses, such as Chrysler Corporation did in the 1970s, might be more likely to suspend interest payments on its bonds.1 The default risk on its bonds would therefore be quite high. By contrast, U.S. Treasury bonds have usually been considered to have no default risk because the federal government can always increase taxes to pay off its obligations. Bonds like these with no default risk are called default-free bonds. (However, during the budget negotiations in Congress in 1995 and 1996, the Republicans threatened to let Treasury bonds default, and this had an impact on the bond market, as one application following this section indicates.) The spread between the interest rates on bonds with default risk and default-free bonds, called the risk premium, indicates how much additional interest people must earn in order to be willing to hold that risky bond. Our supply and demand analysis of the bond market in Chapter 5 can be used to explain why a bond with default risk always has a positive risk premium and why the higher the default risk is, the larger the risk premium will be.

To examine the effect of default risk on interest rates, let us look at the supply and demand diagrams for the default-free (U.S. Treasury) and corporate long-term bond markets in Figure 2. REFER TO SLIDE To make the diagrams somewhat easier to read, let’s assume that initially corporate bonds have the same default risk as U.S. Treasury bonds. In this case, these two bonds have the same attributes (identical risk and maturity); their equilibrium prices and interest rates will initially be equal (P c1…...

...Interest Rate Risk Dr HK Pradhan XLRI Jamshedpur Hull Ch 7 Fabozzi chapters on duration & Convexity, Ch-7, Convexity Stochastic Process notes Session Objectives j Valuation of fixed income securities Risks in fixed income securities Traditional measures of risk – (we know PVBP, duration and convexity, M-Square) M Square) VaR based risk measures Interest rate volatility calculations Portfolio risk & Cash flows mapping issues Var for Interest Rate Derivatives Interest rate risk and Bond portfolio management Profile of Interest Rate Markets, Instruments & Institutions Bond Price P 1 y C1 1 1 y C2 2 1 y Ct C3 3 1 y n Cn price Sum of the present values of each cashflows p P n t 1 1 y t M 1 y n yield price < par (discount bond) price = par (par bond) price > par (premium bond) Concept of Accrued Interest p When you buy a bond between coupon dates, you pay the seller: Clean Price plus the Accrued Interest – pro-rated share of the fi coupon: i d h f h first interest d does not compound b d between coupon payment dates. LD Days Accrued Interest Total T from last Coupon between Coupon Date Dates Days ND (Coupon) Dirty Price Clean price Accrued Interest Accrued Interest Face * C T LD * 2 ND LD Bond Valuation Value of a bond is the present value of future cashflows, so...

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...Bonds are appealing to investors because they provide a generous amount of current income and they can often generate large capital gains. These two sources of income together can lead to attractive and highly competitive investor returns. Bonds make an attractive investment outlet because of their versatility. They can provide a conservative investor with high current income or they can be used aggressively by investors who prefer capital gains. Given the wide and frequent swings in interest rates, investors can find a variety of investment opportunities. In addition to their versatility, certain types of bonds can be used to shelter income from taxes. While municipal bonds are perhaps the best known tax shelters, some Treasury and federal agency bonds also give investors some tax advantages. Bonds are exposed to the following five major types of risk: (1) Interest rate risk: This affects the market as a whole and therefore translates into market risk. When market interest rates rise, bond prices fall, and vice versa. (2) Purchasing power risk: This is the risk caused by inflation. When inflation heats up, bond yields lag behind inflation rates. A bond investor is locked into a fixed-coupon bond even though market yields are rising with inflation. (3) Business/financial risk: This refers to the risk that the issuer will default on interest and/or principal payments. Business risk is related to the quality and integrity of the issuer, whereas financial risk relates to the......

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...of Form Bottom of Form * Bond Markets / Prices * Commentary * Learn More * Overview * Bond Basics * What You Should Know * Buying and Selling Bonds * Types of Bonds * Strategies * Bonds at Your Stage of Life * About Municipal Bonds * About Government/Agency Bonds * About Corporate Bonds * About MBS/ABS * How to Use This Site * Links to Other Sites Learn More * Overview * Bond Basics * What You Should Know * Overview * The Role of Bonds in America * Investor's Checklist * Investor Protection * Asset Allocation * Reading Bond Prices In the Newspaper * Understanding Economic Statistics * Bond and Bond Funds * Risks of Investing in Bonds * Rating Changes and Your Investments * Corporate Bankruptcy & Your Investment * Selecting and Working with a Financial Professional * Rising Rates and Your Investments * Tax Tables * Buying and Selling Bonds * Types of Bonds * Strategies * Bonds at Your Stage of Life * About Municipal Bonds * About Government/Agency Bonds * About Corporate Bonds * About MBS/ABS * How to Use This Site * Links to Other Sites What You Should Know * Print * Email Risks of Investing in Bonds All investments offer a balance between risk and potential return. The risk is the chance that you will......

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...1. Introduction: We know the fact that low interest rate affects stock market price. Low interest rate decreases the cost of capital and increases the confidence of investors. The equity risk premium is the "extra return" that investors collectively demand for investing their money in stocks instead of holding it in a risk less or close to risk less investment. As a consequence, equity risk premium reflects both investor hopes and fears about stocks, rising as the fear factor increases. As a measure the equity risk premium can be an individual stock or the overall stock market provides over a risk-free rate. And the size of the premium will be a standard to compensate with a higher premium in the stock market. Thus, a portfolio manager when the equity risk premium increases in the future， the investors will sell out stock market because the stocks are over priced. So the legislators and pension administrators decide how much to set aside to meet future pension obligations, based upon assessments of equity risk premiums. However the history data of ERP (Equity Risk Premium) from Federal Reserve System shows it keeps low and stable state but increases suddenly since 2006. At the same time the Federal Funds Effective Rate goes down and keeps low state. We know that interest rate is a way to control inflation. Inflation is a factor causes too much money chasing too few goods. “Changes in the federal funds rate affect the behavior of consumers and......

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...importance of nominal bonds in investment portfolios, and in the design and execution of fiscal and monetary policy, financial economists and macroeconomists need to understand the determinants of nominal bond risks. This is particularly challenging because the risk characteristics of nominal bonds are not stable over time. In this paper the authors ask how monetary policy has contributed to these changes in bond risks. They propose a model that integrates the building blocks of a New Keynesian model into an asset pricing framework in which risk and consequently risk premia can vary in response to macroeconomic conditions. The model is calibrated to US data between 1960 and 2011, a period in which macroeconomic conditions, monetary policy, and bond risks have experienced significant changes. Findings show that two elements of monetary policy have been especially important drivers of bond risks during the last half century. First, a strong reaction of monetary policy to inflation shocks increases both the beta of nominal bonds and the volatility of nominal bond returns. Positive inflation shocks depress bond prices, while the increase in the Fed funds rate depresses output and stock prices. Second, an accommodating monetary policy that smooths nominal interest rates over time implies that positive shocks to long-term target inflation cause real interest rates to fall, driving up output and equity prices, and nominal long-term interest rates to increase, decreasing bond prices.......

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...-In order to understand the effect of issuing and refinancing bonds, I want to present you with some important bond basics. -So what’s the goal of a bond? -Companies issue bonds to create debt for its company. -For example, maybe the company needs to finance a project and needs immediate capital. -So the goal is to borrow money for a given period of time, specified in the contract. -So what does the company have to give up? -Must pay interest each period -Must repay the face value of the bond at the end of the period. -Bonds can be sold at a discount, a premium, or par value -If the bond is sold at a premium, the bond costs more than the face value of the bond -Thus the company will increase the interest offered over market rate -If the bond is sold at a discount, the bond costs less than the face value of the bond. -Thus the company will decrease the interest offered over market rate. -And of course, par means it is sold at the face value. -Liability is the whole amount of the bond that the company owes at the time in question. -As we will soon see, because the prevailing market rate for bonds has decreased over recent years, Lyons will have the opportunity to buyback the old bonds and offer new bonds at a lowest interest rate. -I will now pass it to Aditya who will further discuss the specifics of the original bond issue....

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...project rate of return > cost of capital ( value of firm increases • If project rate of return < cost of capital ( value of firm decreases • Goal: minimize cost of capital Assumptions: 1. Business risk (not able to cover operating costs) is unchanged 2. Financial risk (not able to cover financial obligations) is unchanged 3. Cost of capital is measured on an after-tax basis Basic equation: Ways to evaluate the basic equation: 1. Time-series: historic cost of capital 2. Compare with other firms (cross-section) Example 1 (Time-series) Firm A had a cost of long-term debt 2 years ago of 8%. Risk-free cost of long-term debt is 4%. Business risk premium is 2%, and financial risk premium is 2%. What is the cost of long-term capital of the firm when the current risk-free cost of long-term debt is 6%? Example 2 (Cross-section comparison) Firm B is in the same business and with a financial premium of 4%. The cost of capital of firm B is higher than that of firm A by 2 %. Definition: Target capital structure refers to the desired optimal mix of debt and equity financing that most firms attempt to achieve and maintain. B. COST OF LONG-TERM DEBT Definitions • Net proceeds : Funds received from the sale of a security (e.g. bond) – Incur two types of costs: flotation and discount • Flotation costs : issuing and selling a security – Apply to all public offerings of securities (debt, preferred and common......

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...Corporate Finance & Asset Markets M1 – Finance & Economics Track Solutions to Assignment 5: Section 8 - Interest Rates and Bonds Solutions to Part A: Practice Problems 1. When you are paying out money, you prefer not to pay interest on interest. Thus, you would prefer a low compounding frequency, which is monthly. 2. If the term structure is ﬂat and a 2-year bond with a face value of $1,000 and a 3.5% annual coupon (paid semi-annually) is selling at par, this means that the annual discount rate (compounded semi-annually) is 3.5%, since 4 1, 000 = t=1 1, 000 17.50 + . t (1 + 0.0175) (1 + 0.0175)4 But then it is straightforward to value bonds with any coupon rate and maturity: (a) 10-year bond with a 2% coupon: 20 V = t=1 10 1, 000 + t (1 + 0.0175) (1 + 0.0175)20 1− 1 (1 + 0.0175)20 + 1, 000 (1 + 0.0175)20 = 10 0.0175 = 874. (b) 10-year bond with a 6% coupon: 20 V = t=1 1, 000 30 + t (1 + 0.0175) (1 + 0.175)20 1− 1 (1 + 0.0175)20 + 1, 000 (1 + 0.0175)20 = 30 0.0175 = 1, 209. 3. Expressing the present values bond prices B(0, t), we get A : 92.70 B : 102.10 C : 111.25 of the coupon bonds in terms of the pure discount = 103 B1 = 6 B1 + 106 B2 = 12 B1 + 12 B2 + 112 B3 Solving sequentially, the solution is B1 = 0.900, B2 = 0.912, and B3 = 0.799. 1 4. (a) The discount factors B1 and B2 implicit in the bonds prices should satisfy: 82.0 = 100 B2 92.5 = 6 B1 + 106 B2 102.5 = 12 B1 + 112 B2 Solving for B1 and B2...

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... 07/24/2011 5.1 Jackson Corporation's bonds have 12 years remaining to maturity. Interest is paid annually...? Jackson Corporation's bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The bonds have a yield to maturity of 9%. What is the market price of these bonds? Solution:- Rate = 9% Nper =12 PMT = 1000x8%=-80 FV = -1,000 PV = ? Solve for PV PV = $928.39 Market Price of the bond = $928.39 5-2-Wilson Wonders’s bond have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 10%. The bonds sell at a price of $850. What is their yield to maturity? USING A BOND YOELD CALCULATOR Current Price = $850 Par Value = $1000 Coupon Rate = 10% Years t5o Maturity = 12 Years CALCULATION RESULT Current Yield = 11.765 Yield to Maturity = 12.48 5-6. The real risk-free rate is 3%, and inflation is expected to be 3% for the next 2 years. A 2- year Treasury security yields 6.3 % . What is the maturity risk premium for the two year security? K= K* + IP + DRP + LP + MRP KT-2 = 6.3% = 3% +3% + MRP; DRP=LP=0 MRP = 6.3%-6% MRP=0.3% 5-7. Renfro Rentals has issued bonds that have a 10%coupon rate, payable semiannually. The bonds mature in 8 years, have a face value of $1,000, and a yield to maturity of 8.5%. What is the price of the bonds? Answer:- FV =1,000, PMT= 50, N= 16, R=......

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...Option Pricing, Interest Rate Risk in U.S Diana PĂUN & Ramona GOGONCEA (2013). Interest Rate Risk Management and the Use of Derivative Securities. Economia Seria Management. Retrieved from: <http://www.management.ase.ro/reveconomia/2013-2/4.pdf> The study by these two authors aims at demonstrating how derivative financial instruments can be utilized to prudently manage interest rate risk majorly faced by numerous banks and financial institutions as well as enable the efficient application of monitoring and control tools. There are a couple of risk management methods at the disposal of banks including both balance sheet and off the balance sheet such as the gap method of managing interest rate risk for purposes of controlling short-term rates exposure, combined with derivatives such as options to manage the residual interest rate exposures. Interest rate risks emanate from interest rates sensitivity differentials of capital outflows and inflows. Due to the common view or misconception that high interest rates are the best way of fighting inflation, banks’’ engaging in monetary policy. Financial institutions play a major role in influencing interest rates since they engage in releasing capita to the public by buying assets in the primary markets and selling securities in the secondary market so as to fund purchase of assets. Furthermore, any interest-bearing asset for instance a loan or bond may face interest rate risk caused by changes in the value of assets......

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...Why Bonds With Different Maturities Have Different Interest Rates In this paper, I will discuss why bonds with different maturities can have different interest rates. I will do so by explaining the importance of understanding the term structure, as well as the three theories that support the term structure; the expectations theory, the segmented markets theory, and the liquidity premium theory. Term Structure According to Hubbard and O’Brien, the term structure “is the relationship among the interest rates on bonds that are otherwise similar but have different maturities.” Term structure is most commonly analyzed by looking at the Treasury yield curve, which is the relationship of interest rates on Treasury bonds with different maturities on a particular day. Yields generally tend to move in line with maturity, producing an upward sloping yield curve or a “normal yield curve.” Rarely, however, the yields on the long-term treasuries fall below the yields of short-term treasuries. This creates an inverted yield curve. According to a class lecture, six times when the yield curve became inverted, there was an economic recession. Wheelock and Wohar believe that term structure plays an important role in an economy because it “has been found useful for forecasting such variables as output growth, inflation, industrial production, consumption, and recessions.” The Expectations Theory According to Hubbard and O’Brien, the expectations theory “holds that the interest rate on a...

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...BONDS AND SINKING FUNDS Amortization of Bond Premiums and Discounts *APPENDIX: The origin and calculation of bond premiums and discounts were discussed in Section 15.2. We will now look at the premiums and discounts from an accountant’s perspective. The point of view and the schedules developed here provide the basis for the accounting treatment of bond premiums, discounts, and interest payments. Amortization of a Bond’s Premium Bonds are priced at a premium when the coupon rate exceeds the yield to maturity required in the bond market. Suppose that a bond paying a 10% coupon rate is purchased three years before maturity to yield 8% compounded semiannually. The purchase price that provides this yield to maturity is $1052.42. The accounting view is that a period’s earned interest is the amount that gives the required rate of return on the bond investment. The interest payment after the first six months that would, by itself, provide the required rate of return (8% compounded semiannually) on the amount invested is 0.08 ϫ $1052.42 ϭ $42.10 2 The earned interest during the first six months from an accounting point of view is $42.10. The actual first coupon payment of $50 pays $50 Ϫ $42.10 ϭ $7.90 more than is necessary to provide the required rate of return for the first six months.7 The $7.90 is regarded as a refund of a portion of the original premium, leaving a net investment (called the bond’s book value) of $1052.42 Ϫ $7.90 ϭ $1044.52 This......

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...BONDS: TYPES, RISKS, AND BENEFITS When a corporation wants to borrow money from the public on a long-term basis, it does so by selling securities that are called bonds. There are different types of bonds available, each with different risks and rewards. The different factors associated with each type of bond, determines how it fits into your portfolio. A bond is an interest-only loan, where the borrower will pay the interest every period, and then repay the principal amount at the end of the loan. The value of bonds fluctuates. When the interest rate increases, the bond becomes worth less. When interest rates fall, the bond becomes worth more. A bonds value at a particular point in time, known as its yield to maturity, can be calculated by using information such as: the number of periods to maturity, the face value, the coupon or stated interest payment made on a bond, and the market interest rate for bonds with similar features. With this information we can calculate the bonds yield to maturity (YTM) or “Yield” for short. The US government is the biggest borrower in the world. In early 2009, the total debt of the US Government was approaching $11 Trillion Dollars. When the government wants to borrow money for more than one year, it sells Treasury Notes/Bonds to the public. Most US treasury bonds are just ordinary coupon bonds. Some older issues are callable meaning the government can repurchase the bond at specific price prior to maturity. Treasury issues......

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...use this information to make a profit? Explain. Q3) Suppose a bond is sold for $1,000 and pays an annual interest rate of 10% on the par value, which is also $1,000. The bond was issued 20 years ago and will mature in one week. You own some of these bonds. The yield on these bonds suddenly goes way up, to 15%. Calculate your loss. Explain your results? Q4) Suppose a bond has a par value of $1,000 and a market value of $1,100. It is convertible into 40 shares of stock, and the current stock price is $26. a. What is the conversion ratio? b. What is the conversion price? c. What is the conversion value? Q5) Suppose you buy a stock for $100. You receive $4 as a cash dividend at the end of the year. The stock price at the end of the year is $95. a. What is the rate of return on your investment? b. What is the dividend yield as measured at the beginning of the year? At the end of the year? Q6) The net asset value of a mutual fund is $12. The share price is $13. a. Is it an open-end fund or a closed-end fund? Calculate the premium or discount. Q7) Bill buys a $1000 par value 10-year bond for $850. It pays $75 a year in interest. Calculate Bill’s yield to maturity on the bond using a financial calculator or software. Q8) Alex holds a convertible bond with a market value of $1700. If the conversion ratio is 50 and the stock’s price is $39 per share, should he convert the bond or sell the bond? Q9) Classify each of the following types of assets as either......

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... a) Bond – is a long term contract under which the borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond. Treasury bonds – sometimes referred to as government bonds, are issued by the U.S. federal government. These bonds have not default risk. However, these bonds decline when interest rates rise, so they are not free of all risk Corporate bonds – issued by corporate; exposed to default risk – if the issuing company gets into trouble, it may be unable to make the promised interest and principal payments. Different corporate bonds have different levels of default risk, depending on the issuing company’s characteristics and the terms of the specific bond. Default risk often referred to as “credit risk” and the larger the default or credit risk, the higher the interest rate the issuer must pay. Municipal bond – or “munis “ are issued by state and local governments. Like corporate bonds, munis have default risk. Munis offer one major advantage over all the other bonds is exempt from federal taxes and also from state taxes if the holder is a resident of the issuing state. Munis bonds carry interest rates that are considerably lower than those on corporate bonds with the same default risk Foreign bond – are issued by foreign governments or foreign corporations. Foreign corporate bonds are of course exposed to default risk, and so are some foreign government bonds. An additional risk exists if the bonds are......

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