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Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.
Chapter Outline
Bond valuation process Relationships between coupon rate, required return, and bond price Explaining bond price movements Sensitivity of bond prices to interest rate movements Bond investment strategies used by investors Return and risk of international bonds
Bonds:
Are debt obligations with long-term maturities issued by government or corporations to obtain long-term funds Are commonly purchased by financial institutions that wish to invest for long-term periods
The appropriate bond price reflects the present value of the cash flows generated by the bond (i.e., interest payments and repayment of principal):
Present value interest factors in Exhibit 8A.3 can be multiplied by coupon payments and the par value to determine the present value of the bond The appropriate discount rate for valuing any asset is the yield that could be earned on alternative investments with similar risk and maturity Investors use higher discount rates to discount the future cash flows of riskier securities The value of a high-risk security will be lower than the value of a low-risk security
Funds received sooner can be reinvested to earn additional returns A dollar to be received soon has a higher present value than one to be received later First, divide the annual coupon by two Second, divide the annual discount rate by two Third, double the number of years
The
bonds coupon payments represent an annuity (an even stream of payments over a given period of time)
If the coupon rate of a bond is below the investors required rate of return, the present value of the bond should be below par value (discount bond) If the coupon rate equals the required rate of return, the price of the bond should be equal to par value If the coupon rate of a bond is above the required rate of return, the price of the bond should be above par value
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Present Value
0.12
0.15
The impact of interest rate movements depends on how the institutions asset and liability portfolios are structured
Institutions with interest rate-sensitive liabilities that invest heavily in bonds are exposed to interest rate risk Many institutions adjust the size of their bond portfolio according to interest rate expectations When rates are expected to rise, bonds can be sold and the proceeds used to purchase short-term securities When rates are expected to fall, the bond portfolio can be expanded in order to capitalize on the expectations
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The price of a bond should reflect the present value of future cash flows based on a required rate of return:
Pb f ( k ) f ( Rf , RP ) An increase in either the risk-free rate or the general level of the risk premium results in a decrease in bond prices
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of inflationary expectations
An increase in expected inflation will increase the required rate of return on bonds Indicators of inflation are closely monitored
Consumer price index Producer price index Oil prices A weak dollar
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general level of credit risk on corporate or municipal bonds can change in response to a change in economic growth:
RP f ( ECON )
Strong economic growth tends to improve a firms cash flows and reduce the probability that the firm will default on its debt payments
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Other factors are also changing, making the precise impact of each factor on bond prices uncertain Impact of bond-specific characteristics
Changes in the issuing firms capital structure and factors such as call features can affect individual bond prices
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an efficient market, bond prices should fully reflect all available information In general bond prices should reflect information that is publicly available
Prices may not reflect information about firms that is known only by managers of the firms
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pe
The
price sensitivity is greater for declining interest rates than rising interest rates Bond price elasticity is always negative
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The relationship between bond price elasticity and coupon rates is inverse Zero-coupon bonds have the greatest price sensitivity Bonds yielding only coupon payments are least sensitive Financial institutions may restructure their bond portfolios to contain higher-coupon bonds when they are concerned about a possible increase in interest rates
As interest rates decrease, long-term bond prices increase by a greater degree than short-term bond prices
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Duration
Duration
measures the life of a bond on a present value basis The longer the bonds duration, the greater its sensitivity to interest rates
Ct ( t ) t ( 1 k ) 1 DUR t n Ct t ( 1 k ) t 1
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$90 $1,090(2) (1.10)1 (1.10)2 $90 $1,090 (1.10)1 (1.10)2 1.92 years
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Duration (contd)
Duration
of a portfolio
Bond portfolio managers commonly immunize their portfolio from the effects of interest rate movements A bond portfolios duration is the weighted average of bond durations, weighted according to relative market value:
DUR p
w DUR
j j 1
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Duration (contd)
Modified duration
Duration can be used to estimate the percentage change in a bonds price in response to a 1 percentage point change in bond yields:
DUR DUR* (1 k )
The estimate of modified duration should be applied such that the bond price moves in the opposite direction from the change in bond yields The percentage change in a bonds price in response to a change in yield is:
%P -DUR * y
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A 1 percent increase in bond yields leads to a 1.75 percent decline in the price of the bond.
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Duration (contd)
Estimation
If investors rely only on modified duration to estimate percentage price changes in bonds, they will tend to overestimate price declines and underestimate price increases To accurately estimate the percentage change in price, bond convexity must also be considered
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Duration (contd)
Bond convexity
Modified duration estimates assume a linear relationship between bond prices and yields The actual relationship between bond prices and yields is convex For high-coupon, short-maturity bonds, price change estimates based on modified duration will be very close to actual price changes For low-coupon, long-maturity bonds, price change estimates based on modified duration can give large estimation errors
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Matching strategy
The
bond portfolio generates periodic income that can match expected periodic expenses Involves estimating future cash outflows and developing a bond portfolio that can generate sufficient payments to cover those outflows
Laddered strategy
Funds
are evenly allocated to bonds in each of several different maturity classes Achieves diversified maturities and different sensitivities to interest rate risk
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Barbell strategy
Funds
are allocated to bonds with a short term to maturity and bonds with a long term to maturity
Allocates some funds to achieving relatively high returns and other funds to cover liquidity needs
are allocated to capitalize on interest rate forecasts Requires frequent adjustment in the bond portfolio to reflect current forecasts
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in the risk-free rate of the currency denominating the bond Changes in the perceived credit risk of the bond Exchange rate risk
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An increase in the risk-free rate of the foreign currency results in a lower value for bonds denominated in that currency An increase in risk causes a higher required rate of return on the bond and lowers the present value of the bond The most attractive foreign bonds offer a high coupon rate and are denominated in a currency that strengthens over the investment horizon
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International diversification of bonds reduces the sensitivity of the overall bond portfolio to any single countrys interest rate movements Because economic cycles differ across countries, there is less chance of a systematic increase in the credit risk of internationally diversified bonds
Financial institutions attempt to reduce their exchange rate risk by diversifying among foreign securities denominated in various foreign currencies
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