Seminar 02
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BUSINESS FINANCE/ FINANCIAL MARKETS & INSTITUTIONS [B Sc (Hons) in Management]
SEMINAR 2
S2
SOURCES OF FINANCING : DEBT VS EQUITY Characteristic
Debt
Equity
Cash flow
Coupon + Face Value
Dividends
Variability
Fixed
Variable
Redemption
Yes Face Value
No
Maturity
Fixed Term (@ n years)
Relative riskiness
Low
High
Formula
[PV(Ann) + PV(S)]
[D1/(r-g)]
Infinite (growing perpetuity)
BONDS 1. Valuation of Bonds • Price = PV (Cashflow) = PV (Coupons) + PV (Face Value) 2. Yields • Yield to Maturity/Redemption Yield
•
Rate of Return (coupon + price change)/investment
3. Price vs Face Value • Coupon rate = YTM, sell @ par • Coupon rate > YTM, sell @ premium • Coupon rate < YTM, sell @ discount
BONDS 1. Accrued Interest • When an investor purchases a bond between coupon payments, the investor must compensate the seller of the bond for the coupon interest earned from the time of the last coupon payment to the settlement date of the bond. PRICE
Clean
Dirty
Other Names
Market price Quoted price
Invoice price Full price
Accrued interest
Excluded
Included
BONDS 1. Spot vs Forward • Spot rate (aka zero-coupon rate) : current interest rate for a stipulated period • Forward rate : interest rate payable that commences n months from the spot date for a stipulated period Eg. 1-year spot = 7% 2-year spot = 8% Find the Forward from year 1 to year 2, F1,2
TERM STRUCTURES 1. Yield Curve •
Yields vs Maturity
•
Variations : •
Par yield
•
Spot
•
Annuity
TERM STRUCTURES 1. Theories of Term Structure • Unbiased Expectations Theory Expectations about the future state of the economic world
•
Liquidity Premium Theory Unbiased Expectations Theory + liquidity premium
•
Segmentation Theory Each segment of the yield curve is determined independently by the supply & demand conditions of that segment
2. Risk Structure • Interest Rate/Price Risk • Default Risk
RISK STRUCTURES - Bond Price Sensitivity to Interest Rates Bond price $1 800
Coupon = $100 20 years to maturity $1 000 face value
$1 600
Key Insight: Bond prices and YTMs are inversely related.
$1 400 $1 200 $1 000 $ 800 $ 600
Yield to maturity, YTM 4%
6%
8%
10%
12%
14%
16%
EXAMPLE Let us assume that you are considering the respective merits of three bonds, whose details are :
Coupon Rate Maturity Value Time to Maturity Expected YTM Price
A 10% US$1000 3 years 12% ?
BOND B 8% US$1000 4 years ? US$906.5
C 6% US$1000 5 years 10% ?
a) Calculate : • Current market price of Bond A • YTM of Bond B b) Calculate the current market price of Bond C. Draw the yield curve as far as the data permits and comment on this curve c) Let us assume that we have the above 5 year to maturity US government bond and a similar bond issued by the Singaporean government. What does the difference between their yields tell you? Explain what would happen if these 2 bonds offer different real yields?
SEMINAR 2
S2
SOURCES OF FINANCING : DEBT VS EQUITY Characteristic
Debt
Equity
Cash flow
Coupon + Face Value
Dividends
Variability
Fixed
Variable
Redemption
Yes Face Value
No
Maturity
Fixed Term (@ n years)
Relative riskiness
Low
High
Formula
[PV(Ann) + PV(S)]
[D1/(r-g)]
Infinite (growing perpetuity)
BONDS 1. Valuation of Bonds • Price = PV (Cashflow) = PV (Coupons) + PV (Face Value) 2. Yields • Yield to Maturity/Redemption Yield
•
Rate of Return (coupon + price change)/investment
3. Price vs Face Value • Coupon rate = YTM, sell @ par • Coupon rate > YTM, sell @ premium • Coupon rate < YTM, sell @ discount
BONDS 1. Accrued Interest • When an investor purchases a bond between coupon payments, the investor must compensate the seller of the bond for the coupon interest earned from the time of the last coupon payment to the settlement date of the bond. PRICE
Clean
Dirty
Other Names
Market price Quoted price
Invoice price Full price
Accrued interest
Excluded
Included
BONDS 1. Spot vs Forward • Spot rate (aka zero-coupon rate) : current interest rate for a stipulated period • Forward rate : interest rate payable that commences n months from the spot date for a stipulated period Eg. 1-year spot = 7% 2-year spot = 8% Find the Forward from year 1 to year 2, F1,2
TERM STRUCTURES 1. Yield Curve •
Yields vs Maturity
•
Variations : •
Par yield
•
Spot
•
Annuity
TERM STRUCTURES 1. Theories of Term Structure • Unbiased Expectations Theory Expectations about the future state of the economic world
•
Liquidity Premium Theory Unbiased Expectations Theory + liquidity premium
•
Segmentation Theory Each segment of the yield curve is determined independently by the supply & demand conditions of that segment
2. Risk Structure • Interest Rate/Price Risk • Default Risk
RISK STRUCTURES - Bond Price Sensitivity to Interest Rates Bond price $1 800
Coupon = $100 20 years to maturity $1 000 face value
$1 600
Key Insight: Bond prices and YTMs are inversely related.
$1 400 $1 200 $1 000 $ 800 $ 600
Yield to maturity, YTM 4%
6%
8%
10%
12%
14%
16%
EXAMPLE Let us assume that you are considering the respective merits of three bonds, whose details are :
Coupon Rate Maturity Value Time to Maturity Expected YTM Price
A 10% US$1000 3 years 12% ?
BOND B 8% US$1000 4 years ? US$906.5
C 6% US$1000 5 years 10% ?
a) Calculate : • Current market price of Bond A • YTM of Bond B b) Calculate the current market price of Bond C. Draw the yield curve as far as the data permits and comment on this curve c) Let us assume that we have the above 5 year to maturity US government bond and a similar bond issued by the Singaporean government. What does the difference between their yields tell you? Explain what would happen if these 2 bonds offer different real yields?
