Ch1 Background Issues Types of financial assets 1 Debt pay specified CF over specific period least closely tied to financial condition of issuer Money market ST highly marketable low risk T bills CDs Bonds Preferred stock hybrid 2 Common Stock equity ownership stake in corporation tied directly to success of firm real assets riskier than debt pay div 3 Derivative securities provide payoffs that depend on value of other assets ex options future contracts Investment Process 1 Asset Allocation choice among broad asset classes deciding proportions 2 Security selection choice of which securities to hold within class Ch 3 Securities Market How securities are traded 1 Brokered markets 3rd party assistance in location buyer seller 2 Dealer markets 3rd party act as intermediat buyer seller purchase assets sell later for profit bid ask spread 3 Auction markets brokers dealers trade in 1 location continuous training ex NYSE Bid price price dealer is willing to pay offers to buy Ask price price dealer willing to sell offers to sell investors must pay the ask price Bid ask spread diff between dealers bid asked price profit Types of orders 1 Market order execute immed best price ex bid p 90 ask p 90 05 to buy pay 90 05 to sell receive 90 2 Limit order an order specifying price or better which investor is willing to buy sell limit order book top line inside quotes 3 Stop order becomes market sell buy order when trigger price is encountered Buying on Margin Margin own cash inputed total amt Equity Position Value Borrowing Add Cash Intial Margin Requir IMR 50 for stocks Maintence Margin Requir MMR xchanges min 25 Margin MV Amt borrowed MV when MV P or lower w less equity more vulnerable to MC Margin call MMR shares P borrowed shares P Pay back principal interest Short Sales allows investors to profit from decline in security s price sell higher price buy back lower price must replace shares pay lender any div paid during sale Profit decline in price x shares Long position buy first less and sell later more Ch 10 Bond prices and yields Coupon pmts semiannual pmts of interest Coupon rate determines interest pmt rate par value Zero coupon pays 0 coupons sells disc pays par maturity PMT 0 Accrued interest if bond purchased between coupon pmts buyer must pay stated price accrued interest annual coupon pmt x Days since last coupon pmt Days separating coupon pmts 2 Bond Pricing PV of future CFs r discount rate PV 100 1 rT T Perpetuity PV price r constant CF of same amt Annuity PV price x 1 1 T specified amt time r 1 r Calc N yrs semi x2 I requr yield semi 2 PV PMT coupon rate x par semi 2 FV par Bond Price between coupon dates flat price accrued interest flat price assumes bond purchased on coupon payment date Bond Yields Yield to Maturity rate of return YTM discount rate that equates the PV of the bonds CF s to the bond s price I Current Yield annual coupon pmt bond price Inverse Relationship between Prices and Yield When yield 0 value of bond approaches sum of CFs If YTM coupon rate then bond sells at par If YTM coupon rate then bond sells at a discount If YTM coupon rate then bond sells at a premium Default Risk Main rating cos Moody s Investor Service Standard Poor s Fitch Main rating categories investment garde AAA AA A BBB speculative grade BB B CCC CC C D junk bonds Call provisions allow issuer to repurchase bond specified price before maturity date Convertible provisions give bondholders option to exhcnage bond for C S Puttable bonds holder may choose to exchange for par value at some date or to extend for a given years Floating rate bonds make interest pmts that are tied to some measure of current mkt rates Catasophe bonds disaster causes bond issuers required pmts to be reduced eliminated Yield Curve YTM relative to yrs to maturity Expectation Theory long term rates fuction of future short term interest rates upward slope market is expected higher future ST rates downward slope market expected lower future ST rates Forward Rates 1 yn n 1 yn 1 n 1 1 fn Liquidity Preference Theory upward bias over expectations the observed long term rate includes a risk premium expect 1 year spot rate in 5 years to be lower than then 1 yr spot rate today Ch 11 Managing Bond Portfolios Interest Rate Sensitivity Inverse relationship between bond price interest rates Curve is convex YTM smaller p vs p when YTM Prices of LT bonds more sensitive to YTM than ST bonds sensitivity decreases as bond matures Inverse relationship w bond s coupon rate prices of low coupon bonds are more sensitive to interest rates than prices of high coupon Sensitivity of bonds price to YTM is inversely related to YTM at which bond currently is selling Any security that gives investors more money back sooner will have lower price volatitly when interest rates Duration term for effective maturity of a bond years Zero coupon bonds duration years to maturity Duration increases w maturity Higher coupon lower duration Duration is shorter than all maturity except zero coupon Duration is shorter higher YTM Duration of perpetuity 1 YTM YTM How to calculate make table 1 Find payment coupon rate x par 2 use payment as FV I YTM N yrs so far solve for PV 3 Do for all years remember pmt on last year 1000 pmt 4 Find weights for each discounted payment EXAMPLE 9 coupon 8 YTM 4 yrs bond price 1033 12 Time Payment Discount PMT Weight Time Weight 1 2 3 4 TOTAL 8 06 0806 83 33 77 16 7 47 1494 71 45 6 92 2076 801 18 77 55 3 1020 1033 12 100 DURATION 90 90 90 1090 Modified Duration measures int rate sensitivity to bond D p p D x difference in YTMs 1 old YTM solve for p 1 basis points 01 0001 Passive Bond Management Immunization strategy to ensure investor earns promised ytm Target date attempt to earn promised yield over investment horizon accomplished by matching duration of bond to the investment horizon Net worth equity of industry can be immunized by matching duration of assets to duration of liabilites Problems may be suboptimal strategy doesn t work well for complex portfolios w option components nor for large interest rate changes Requires rebalancing of portfolio transaction costs Convexity Duration approximation change in value of bond p p D x y convexity x y 2 Active Bond Management Swapping Strategies exchanging 1 bond for another w very similar characteristics but more attractively priced Intermarket spread swap exploiting deviations in spreads between 2 market segments Rate anticipation swap choosing a duration different than your investment