FNCE30001 Investments (Fixed Income)

Transcription

1 FNCE30001 Investments (Fixed Incme) Week 8- Fixed Incme Valuatin What is a fixed Incme Security Fur characteristics f a fixed incme security (nte, bill, bnd, debenture) are: 1. the issuer (debtr, brrwer) prmises t repay the investr (lender, bndhlder) 2. the amunt brrwed (principal r price) 3. plus, interest (cupn payments) 4. at a specific pint r pints in time. A typical cupn bnd bligates the issuer t make semi-annual payments When the bnd matures, the issuer repays the debt by paying the bnd's par value (r equivalently, its face value) The cupn rate f the bnd determines the interest payment: the annual payment equals the cupn rate times the bnd's par value. The cupn rate, maturity date and par value f the bnd are part f the bnd indenture, which is the cntract between the issuer and the bndhlder. Zer-cupn bnds make zer payments; investrs simply receive par value at maturity date Cmparing US and Australian Terminlgy Wh s Invlved? Issuers: Cmmnwealth gvernment state gvernments financial intermediaries crpratins. semi-gvernment bnds are issued by the assciated state gvernment. Investrs: Financial intermediaries investment funds superannuatin funds crpratins individuals- bth Australian and internatinal. Others: Credit Rating Agencies: S&P Mdy s Fitch.

2 Regulatrs: ASIC APRA ATO RBA Industry bdies: AFMA ABA Bnd Types Fixed Cupn Bnds The fixed-cupn bnd is the classic bnd type. A fixed-cupn bnd makes tw kinds f payments: Par value (face value): The payment the bnd hlder receives when the bnd matures. Interest (cupn payment): Additinal pre-specified payments made befre (and n) the maturity date at pre-specified intervals (e.g. yearly, half-yearly, quarterly). Usually expressed as a simple annual % rate. These are called cupn payments because, in precmputer days, mst bnds had cupns that investrs wuld clip ff and present t the issuer f the bnd t claim the interest payment. Nte n Australian Treasury Bnds: All Australian Treasury bnds issued after August 2010 pay twice a year, n the 21st f the mnth. Bnds issued earlier pay interest n the 15th f the mnth. Fr this subject Hwever, ALWAYS assume 21st

3 Capital Indexed Bnds A capital indexed bnd is the same as a fixed-cupn bnd except that the: par value and cupn payments are stated in real (ie after-inflatin) terms That is, a CPI adjustment is made at each cupn date s that the investr earns the stated real interest rate Flating Rate Bnds (Ntes) Like the fixed-cupn bnd, a flating rate bnd pays regular cupns and the par value at maturity, but: the cupn rate is nt fixed. Typically, each cupn payment is linked t a shrt-term interest rate current at the beginning f the cupn perid. Therefre: If interest rates rise during the life f the bnd, the cupn payments als rise. But if interest rates fall during the life f the bnd then the cupn payments als fall. Cnvertible Bnds Like a straight (ie fixed-cupn) bnd plus, the investr has an ptin t cnvert t shares at maturity. Fr example, a cnvertible nte may have a par value f $100 and at maturity the investr can chse t get: The $100 in cash r 20 shares in the brrwer. Clearly, the investr chses the $100 if the share price n the maturity date is less than $5 per share. A cnvertible bnd must be wrth mre than an therwise equivalent straight bnd. This may shw up as a lwer cupn interest rate. Callable Bnds Like a straight (ie a fixed-cupn) bnd plus, the brrwer has an ptin t repay the bnds early. This ptin may nt apply until (eg) the last 2 years f the bnd s life. The brrwer may chse t repay early if interest rates have fallen since the mney was brrwed. A callable bnd must be wrth less than an therwise equivalent straight bnd. This may shw up as a higher cupn interest rate

4 Dmestic and Internatinal Bnds Dmestic eg a US cmpany issues a USD bnd in the US. Internatinal Freign bnd eg an Australian cmpany issues a USD bnd in the US (knwn as a Yankee bnd ) Eurbnd eg a cmpany issues a USD bnd in the UK. These bnds may be cupn-paying, cnvertible, callable etc. Zer-cupn bnds / Pure Discunt Securities Only ne cash flw (the par value), which ccurs n the maturity date. Examples: Many shrt-term debt securities such as: Treasury Ntes (Australia) Treasury Bills (US) Cmmercial Bills (Australia). In principle, there culd als be lng-term zer-cupn bnds but in practice there are few. But nte: the zer-cupn bnd is a very imprtant building blck fr thery and practice. Pricing Zer-cupn bnds In determining the price f a zer-cupn bnd (a zer fr shrt), the market takes int accunt: 1. the features f the bnd: a. Time t maturity ( ) b. The default risk f the brrwer ( ) 2. Tax ( ) 3. Liquidity in the secndary market (+) 4. Expected inflatin ( ) Ntatin

5 1.a) Time t Maturity/ TVM $1 t be received in the future has a lwer value than $1 t be received tday. There are many ways t represent the time value f mney: Prices f zer-cupn bnds Zer-cupn rates Yields-t-maturity Frward rates Discunt factrs 1.b) Default Risk N Default Risk Cnsider a default-free zer that pays $Par n a date that is T years frm nw (time 0). Its price is: P 0 = Par (1+z 0T ) T Where z 0T is the interest rate that applies per year frm time 0 t time T z 0T is called the T year zer cupn rate Nte: that zer rates are n a cmpund interest basis, regardless f their term quted per annum. If we knw P 0 we can calculate z 0T : z 0T = ( Par 1 T ) P 0 1 Cmparative Statistics: The price (P0) is related t: The par value (Par): psitively Tday s zer-cupn rate (z0t): negatively The term t maturity (T): negatively; when the term t maturity (T) is larger, the bnd price is mre sensitive t changes in the interest rate: Nte that fr zers, P 0 is always less than Par. This is nt necessarily true f cupn-paying bnds. Default Risk present When there is default risk we need t distinguish between the prmised interest rate and the expected interest rate. Cnsider a T-year zer with a face value f Par. The prbability f default is b. If default ccurs, the prbability f recvering sme f the amunt wed is r. The prprtin recvered is and will be received at time T.

6 Prmised zer rate (pa) z 0T = ( Par 1 T ) P 0 Expected zer rate (pa) P 0 = 1 Expected Cash Flw (1+z 0T ) T = (1 b)par+brπpar (1+z 0T ) T b=0 then expected (z 0T) = prmised (z 0T ) Cmparative Statistics: The expected rate pa (z 0T) is related t: 1 T } P 0 = z 0T = { Par[1 b(1 rπ)] The prbability f default (b): negatively The prbability f recvery (r): psitively The prprtin expected t be recvered ( π): psitively 1 Pricing Mney Market Securities In Australia, these securities are priced using simple interest and 365 days E.g. 4% pa ver 90 days = 90 x 0.04 = = z 365 0T Frmula: P 0 = Par 1+s 365 n n is the number f days until maturity s is the simple annual interest rate (yield). Therefre: s = ( Par 1) 365 P 0 n US Mney Market Securities US mney market dealers trade in terms f bank discunt rates, which are defined this way: P 0 = Par (1 q n 360 ) q means the quted rate Nte there are tw differences here: The price is expressed as a subtractin frm (nt a prprtin f) the par value. It uses a 360-day year instead f a 365-day year.