Quiz 6 Notes - Damien Brooks PDF

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FINA 4310: Quiz 6 Study Guide Bonds: -Bond indenture: contract between issuer and holder; set forth obligations of the issuer -“Fixed income” -2 Cash Flows: (1) Principal and (2) Coupon payments (annuity) -Price vs Face value -Yield decreases  price increases; vice versa -Current interest rate determines yield -Legal default: failure to pay either principal or interest -Security for bonds: (1) Mortgage bonds: secured by mortgage property (2) Collateral trust bonds: secured by stocks, notes, bonds, etc. (3) Debenture bonds: not backed by any security (4) Subordinated debenture bond: rank after debenture, “junior bond” -Three common option provisions: call, put, conversion -Implemented through: (1) Fixed/optional redemption: the option is available at the times specified (2) Extraordinary redemption: available after “an event” occurs -Callable bond: grants issuer the right to retire the bond before the maturity date; “call price” that bondholder must accept; Good for issuer b/c can refinance at a lower rate and bad for bondholder b/c receive less than fair value and must reinvest at lower rates -Call price is generally higher than par but less than full value; call provision is increasingly common -Puttable bond: allow bondholder to sell the bond back to issuer at par value; Good for investors (receive above fair value and can reinvest at higher rates) and Bad for issuer (must cover these redemptions and might have to refinance at now higher rates) -Good when interest rate rises; put provision grants you the right to sell the bond -Poison put: The poison put covenant stipulates that bondholders can redeem their bond before the maturity date and receive full payment in the event there is a takeover of the company.  “scare off” potential acquires due to the potential additional expense of having to pay off the loan -Conversion provision: gives the bondholder the right to exchange he bond for shares of stock (ratio specified in contract); Good for investor (allows exposure of the upside of the underlying stock) and costly to issuer (dilution once converted); but may be good for start-up, cash-strapped firm as debt disappears -Forced conversion: pairing conversion with a call provision; bondholders must convert or risk loosing value; limits the ability to double-dip by holding the bond as long as possible then converting -Bond is typically non-amortizing; interest and coupon payments prevent firms from paying massive dividends -Repayment provisions: (1) Sinking fund: the firm agrees to make early principal payments on a set schedule “pre-planned”, similar to a call provision 1

(2) Serial bonds: the firm issues bonds with staggered maturities, so that the portions of the issue mature sooner than others -Investing risks: (1) Interest rate risk: if rates rise, bond is sold below purchase price (2) Reinvestment risk: market rate which you reinvest (3) Call risk: issuer may “call”/retired bond before maturity date bad for bondholder b/c of having to invest at a lower rate (4) Credit risk (default risk): risk of bankruptcy -Credit Ratings: Investment vs junk bonds; depends on: coverage ratio, leverage, liquidity ratio, profitability, cash-flow to debt Common Yields: -Yield to Maturity: discount rate that makes the price equal to the present value; return if you hold the bond to maturity and reinvest coupons; “bond equivalent yield” ; Best-case scenario -Current Yield: measures cash income as a percentage of price; ignores capital gains; and useful if you need to consider the C/F of the bond investment Premium: YTM < Current Yield (capital loss) Discount: YTM > Current Yield (capital gain) At Par: YTM = Current Yield -Yield to Call: yield that sets the current price equal to the present value until the bond is called; only relevant if the bond is currently trading at a premium; Worst-case scenario -Compresses the capital loss we expect into a shorter time period; lower yield for any callable bond trading at a premium -Realized Compound Yield: convert coupon payments to future value and then find the discount rate so that FV equals current price; allows to account for differing reinvestment rates; set up to be used historically as opposed to forward-looking

Bond Arbitrage and Bootstrapping -Spot yield: the yield to maturity on a zero-coupon bond; can be any length of time to maturity; starts today -Deconstruct any bond and reproduce it as a series of zero coupon bonds: the two investments should be the same price, whether we purchase one coupon-paying bond or multiple zero coupon bonds  If not, arbitrage opportunity -“Swap rates”: fixed rate in exchange for a variable rate; Advantages over treasuries: eliminates sovereign credit risk, represents a baseline commercial bank credit risk, tends to be more maturities available -“Bootstrapping”: fill in the missing values using available data; derive the theoretical term structure of interest rates; When bootstrapping we are subtracting the amount “paid for” the coupons from the amount paid for the overall bond, and then solving for a YTM on the resulting synthetic zero coupon bond

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-Spot rates: rate at which you agree today for an investment starting today; based on other spot rates -Forward rates: rate at which we would agree today for an investment that will take place in the future (not necessarily the rate we expect to happen); built synthetically on today’s spot rates -Expected spot rate: the rate that we believe will be the spot rate in the future Expectations Theory: we expect forward rates to equal expected spot rates -Long-term rates are a function of expected future short-term rates -Upward slope means that the market is expecting higher future short-term rates -Downward slope means that the market is expecting lower future short-term rates  All bond will earn the same returns over the same time period Liquidity Preference: we expect forward rates to be greater than expected rates; -Upward bias over expectations -The observed long-term rate includes a risk premium  Longer-term bonds will earn greater returns over the same time period -“On the run” vs “off the run” -Matrix pricing: using features in common with other bonds to set a price for a bond issue -Nominal Spread: add a risk premium to the yield of an equivalent Treasury security; PROBLEM  ignores differences in cash flow patterns (there aren’t Treasury security available at every possible maturity nor with every possible coupon combination) [similar to CAPM] -Zero Volatility Spread (Z-Spread): the spread the investor would capture over the entire Treasury yield curve if the bond is held to maturity; PROBLEM: hard to calculate by hand; implicitly assumes that rates won’t vary -Option-Adjusted Spread (OAS): the zero volatility spread adjusted for the effects of an embedded option; includes the effect of volatility; calculates the implicit value/cost of the option provision For bond with a call provision: OAS < Z-spread For a bond with a put provision: OAS > Z-spread (put is a “negative” cost for me) For an option-free bond: OAS = Z-spread Measuring Option Cost: -Measure by using binomial interest rate trees; Assume that at each time period, there are two potential interest rates; each rate is a potential risk free rate for that period plus the optionadjusted spread -Dollar Terms vs Yield Terms Dollar terms: -The result is positive for a callable bond “How much less investors will pay” -The result is negative for a puttable bond “How much more investors will pay” Yield terms: -The result is positive for a callable bond “How much more yield investors demand” -The result is negative for a puttable bond “How much less yield investors will accept” 3

Binomial Tree Formulas: -Choose the lower of the calculated price and the call price if the bond is callable -Choose the higher of the calculate price and the put price if the bond is puttable Treasury Bills: “T-Bill” -T-notes have maturities longer than 1 year, up to 10 years -T-bonds have maturities of 10 years or longer -Highly liquid: liquidity is the ability to sell an asset quickly and at a known price -Issued in weekly auctions: competitive vs non-competitive bids -Zero-coupon: sold a discount to maturity value -Most common denomination is $10,000 Bank discount rate vs bond equivalent yield -Bid-Ask price calculated using the “bank discount” method -Bank discount rate < Bond equivalent yield < Effective annual yield Municipal Bond: “Muni” a bond that is issued by a city/state; generally just like corporate bond; but not federally taxed -Equivalent Taxable Yield: the yield a corporate bond must offer for me to be indifferent between it and a tax-free investment -Future Value Interest Factor (FVIF): measure our gross return net of taxes “Gross” includes the principal “If we start with $1, how much do we have at the end?” -Accrual Taxes: most intuitive; a tax that is owed at the end of the year (ex: income); most commonly used in interest and dividend payments; can differ depending on the income source -Deferred Capital Gain Taxes: common tax on investment tax is owed when the asset is sold; “long-term capital gain” “Cost basis”: an accounting term that means our investment in asset (generally not taxeswe only pay taxes on gains above our basis) -Wealth Taxes: tax on the value of an asset (property taxes); base on entire/partial value -Weighted Average Realized Tax Rate (WARTR): deducts the realized taxes each year (note that the weight won’t add up to 100%) -Annual Return After Realized Taxes: return we earn after deducting the taxes we have to pay each year -Effective Capital Gain Tax Rate -Accrual Equivalent Return: “take-home” return after all taxes have been accounted for -Tax Drag: reduction in our return due to tax drag -Accrual Equivalent Tax Rate: tax rate that sets our nominal return equal to our accrual equivalent return -The longer we are to able to defer capital gains, the lower our accrual equivalent tax rate 4...