Essential Topic: Fixed-interest securities

Similar documents
Manual for SOA Exam FM/CAS Exam 2.

Chapter 10 - Term Structure of Interest Rates

Chapter 3 Mathematics of Finance

Practice Test Questions. Exam FM: Financial Mathematics Society of Actuaries. Created By: Digital Actuarial Resources

CONTENTS CHAPTER 1 INTEREST RATE MEASUREMENT 1

FINA 1082 Financial Management

BBK3413 Investment Analysis

Time value of money-concepts and Calculations Prof. Bikash Mohanty Department of Chemical Engineering Indian Institute of Technology, Roorkee

Stat 274 Theory of Interest. Chapter 6: Bonds. Brian Hartman Brigham Young University

INSTITUTE AND FACULTY OF ACTUARIES EXAMINATION

Computational Mathematics/Information Technology

Chapter 5. Learning Objectives. Principals Applied in this Chapter. Time Value of Money. Principle 1: Money Has a Time Value.

Chapter 5. Time Value of Money

Chapter 6. Learning Objectives. Principals Applies in this Chapter. Time Value of Money

Errata and Updates for the 12 th Edition of the ASM Manual for Exam FM/2 (Last updated 5/4/2018) sorted by page

Chapter 2: BASICS OF FIXED INCOME SECURITIES

1) Cash Flow Pattern Diagram for Future Value and Present Value of Irregular Cash Flows

Course FM/2 Practice Exam 2 Solutions

Mathematics of Financial Derivatives

Mathematics of Financial Derivatives. Zero-coupon rates and bond pricing. Lecture 9. Zero-coupons. Notes. Notes

INSTITUTE OF ACTUARIES OF INDIA

Global Financial Management

Introduction to Bonds. Part One describes fixed-income market analysis and the basic. techniques and assumptions are required.

This Extension explains how to manage the risk of a bond portfolio using the concept of duration.

CHAPTER 8 INTEREST RATES AND BOND VALUATION

1 Cash-flows, discounting, interest rates and yields

CHAPTER 4. The Time Value of Money. Chapter Synopsis

Bond Analysis & Valuation Solutions

Homework #1 Suggested Solutions

Essential Topic: The Theory of Interest

Investment Science. Part I: Deterministic Cash Flow Streams. Dr. Xiaosong DING

Essential Topic: Forwards and futures

Math 147 Section 6.4. Application Example

FINANCIAL DECISION RULES FOR PROJECT EVALUATION SPREADSHEETS

Describe the importance of capital investments and the capital budgeting process

Cash Flow. Future Value (FV) Present Value (PV) r (Discount rate) The value of cash flows at a given future date

Manual for SOA Exam FM/CAS Exam 2.

Advanced Financial Management Bachelors of Business (Specialized in Finance) Study Notes & Tutorial Questions Chapter 3: Cost of Capital

Definition 2. When interest gains in direct proportion to the time in years of the investment

FINA 1082 Financial Management

Public Disclosure Authorized. Public Disclosure Authorized. Public Disclosure Authorized. cover_test.indd 1-2 4/24/09 11:55:22

INSTITUTE AND FACULTY OF ACTUARIES. Curriculum 2019 SPECIMEN SOLUTIONS

Module 1 caa-global.org

MTH302-Business Mathematics and Statistics. Solved Subjective Questions Midterm Examination. From Past Examination also Including New

Measuring Interest Rates

Chapter 11: Duration, Convexity and Immunization. Section 11.5: Analysis of Portfolios. Multiple Securities

SOLUTIONS. Solution. The liabilities are deterministic and their value in one year will be $ = $3.542 billion dollars.

Math 34: Section 7.2 (Bonds)

FINANCE FOR EVERYONE SPREADSHEETS

Stock valuation. A reading prepared by Pamela Peterson-Drake, Florida Atlantic University

Finance 402: Problem Set 5 Solutions

6. Pricing deterministic payoffs

ACCTG101 Revision MODULES 10 & 11 LITTLE NOTABLES EXCLUSIVE - VICKY TANG

Appendix A Financial Calculations

Chapter 03 - Basic Annuities

MIDTERM EXAMINATION Spring 2009 ACC501- Business Finance (Session - 1)

You will also see that the same calculations can enable you to calculate mortgage payments.

SOCIETY OF ACTUARIES FINANCIAL MATHEMATICS EXAM FM SAMPLE QUESTIONS

Mortgages & Equivalent Interest

BOND ANALYTICS. Aditya Vyas IDFC Ltd.

Queens College, CUNY, Department of Computer Science Computational Finance CSCI 365 / 765 Spring 2018 Instructor: Dr. Sateesh Mane. September 16, 2018

Solutions to Questions - Chapter 3 Mortgage Loan Foundations: The Time Value of Money

Chapter 5: How to Value Bonds and Stocks

Introduction to Financial Mathematics

DUKE UNIVERSITY The Fuqua School of Business. Financial Management Spring 1989 TERM STRUCTURE OF INTEREST RATES*

Interest Rates: Inflation and Loans

Time value of money-concepts and Calculations Prof. Bikash Mohanty Department of Chemical Engineering Indian Institute of Technology, Roorkee

Actuarial Society of India

Fin 5633: Investment Theory and Problems: Chapter#15 Solutions

C H A P T E R 6 ACCOUNTING AND THE TIME VALUE OF MONEY. Intermediate Accounting Presented By; Ratna Candra Sari

Math116Chap10MathOfMoneyPart2Done.notebook March 01, 2012

Fairfield Public Schools

Midterm Review Package Tutor: Chanwoo Yim

M339W/389W Financial Mathematics for Actuarial Applications University of Texas at Austin Sample In-Term Exam I Instructor: Milica Čudina

12. Cost of Capital. Outline

APPENDIX 3 TIME VALUE OF MONEY. Time Lines and Notation

Cha h pt p er 2 Fac a t c o t rs r : s : H o H w w T i T me e a n a d I nte t r e e r s e t s A f f e f c e t c t M oney

The Many Flavors of Yield

Commercestudyguide.com Capital Budgeting. Definition of Capital Budgeting. Nature of Capital Budgeting. The process of Capital Budgeting

Monetary Economics Valuation: Cash Flows over Time. Gerald P. Dwyer Fall 2015

Our Own Problem & Solution Set-Up to Accompany Topic 6. Consider the five $200,000, 30-year amortization period mortgage loans described below.

FINANCIAL MATHEMATICS WITH ADVANCED TOPICS MTHE7013A

MBAX Credit Default Swaps (CDS)

3.1 Simple Interest. Definition: I = Prt I = interest earned P = principal ( amount invested) r = interest rate (as a decimal) t = time

CS 413 Software Project Management LECTURE 8 COST MANAGEMENT FOR SOFTWARE PROJECT - II CASH FLOW ANALYSIS TECHNIQUES

Investment Decision Criteria. Principles Applied in This Chapter. Disney s Capital Budgeting Decision

Lecture #1. Introduction Debt & Fixed Income. BONDS LOANS (Corporate) Chapter 1

University of Colorado at Boulder Leeds School of Business MBAX-6270 MBAX Introduction to Derivatives Part II Options Valuation

MGT201 Current Online Solved 100 Quizzes By

2/22/2016. Compound Interest, Annuities, Perpetuities and Geometric Series. Windows User

M339W/M389W Financial Mathematics for Actuarial Applications University of Texas at Austin In-Term Exam I Instructor: Milica Čudina

Hello I'm Professor Brian Bueche, welcome back. This is the final video in our trilogy on time value of money. Now maybe this trilogy hasn't been as

Methods of Financial Appraisal

Bond Prices and Yields

The Time Value. The importance of money flows from it being a link between the present and the future. John Maynard Keynes

************************

ACCOUNTING FOR BONDS

Paper P7 Financial Accounting and Tax Principles. Examiner s Brief Guide to the Paper 20

Final Examination. ACTU 363- Actuarial Mathematics Lab (1) (10/ H, Time 3H) (5 pages)

Time Value of Money. Lakehead University. Outline of the Lecture. Fall Future Value and Compounding. Present Value and Discounting

Transcription:

Essential Topic: Fixed-interest securities Chapters 7 and 8 Mathematics of Finance: A Deterministic Approach by S. J. Garrett

CONTENTS PAGE MATERIAL Fixed-interest securities Equation of value Makeham s formula Capital growth/loss Capital gains tax Optional redemption dates SUMMARY

FIXED-INTEREST SECURITIES We consider securities that pay fixed monetary amounts at known times. The cash flows arising from investment in a 100 nominal of a security are determined by the security parameters purchase price, P (outflow) annual coupon, D, paid pthly (inflow) redemption payment, R (inflow) We assume that the investor is subject to income tax at rate t 1. We begin by neglecting capital gains tax.

EQUATION OF VALUE In the simplest case, the equation of value for an n-year fixed-interest security is P = D(1 t 1 )a (p) n + Rν n If the price is known, the EoV can be solved to give the yield, i. If the desired yield is known, the EoV can be evaluated to determine the maximum price, P.

EXAMPLE Consider a 10-year fixed-interest security that pays coupons of 5% per annum at 6-monthly intervals and is redeemed at par. a.) Calculate the maximum price than an investor should pay to achieve a net yield of 6% per annum. b.) Calculate the net yield if the investor actually purchases the security for 75%. You should assume that the investor pays income tax at a rate of 20% per annum and no capital gains tax.

EXAMPLE Answer The EoV for 100 nominal is written as P = 5 (1 0.20) a (2) 10 + 100ν10 a.) We evaluate this at i = 6% to determine that P = 85.71%. b.) Setting P = 75, the EoV is solved (by trial and error or Excel s Goalseek) to give i = 7.8%.

MAKEHAM S FORMULA Consider a general nominal amount, N, of the security and define C = RN to be the redemption cash flow. The annual coupon payment is of amount DN and we define g = D/R to be the annual coupon expressed as a percentage of the redemption payment. If A = PN, the EoV can be written as A =NRν n + (1 t 1 )DNa (p) n =Cν n + (1 t 1 )gc 1 νn i (p) A =K + g(1 t 1) i (p) (C K) where K = Cν n is the PV of the redemption payment. This is Makeham s formula for pricing fixed-interest securities.

EXAMPLE Consider a 10-year fixed-interest security that pays coupons of 5% per annum at 6-monthly intervals and is redeemed at par. If an investor pays income tax at a rate of 20% per annum, use Makeham s formula to determine the maximum price that he should pay for the security to achieve a net yield of at least 6% per annum. Answer We have p = 2, n = 10, t 1 = 0.20, g = 0.05/1 and, for 100 nominal, C = 100. A = 100ν 10 + 0.05 (1 0.20) ( i (2) 100 100ν 10) = 85.71 This price is identical to that found earlier.

CAPITAL GROWTH/LOSS Makeham s formula is simply an alternative form of the EoV, it contains no new information. However, its use can simplify problems. In particular, K is considered as the PV of redemption payments irrespective of how complicated they may be distributed. Furthermore, we immediately see a simple test for a capital gain/loss at redemption: if g(1 t1 ) = i (p), A = C and there is no capital gain or loss, if g(1 t1 ) > i (p), A > C and there is a capital loss, if g(1 t 1 ) < i (p), A < C and there is a capital gain. In some sense, i (p) is the internalized return and g(1 t 1 ) the externalized return prior to redemption. The size of the externalized return relative to the target yield determines whether there is a further return required from a capital gain at redemption.

CAPITAL GROWTH/LOSS In the previous example we had i (2) = 5.9126% and g(1 t 1 ) = 4% and so g(1 t 1 ) < i (p). This implies that a capital gain at redemption is needed to achieve the required 6% per annum from the investment. Indeed we had A = 85.71 and C = 100, i.e. a capital gain. If the net yield demanded were instead i = 3%, then i (2) = 2.9778% < g(1 t 1 ) = 4%. We would then expect a capital loss at redemption to offset the large externalized return from the coupon payments. In fact, Makeham s formula gives A = 108.78 and C = 100. Which would indeed give a capital loss at redemption.

CAPITAL GAINS TAX We now consider investors that are liable to capital gains tax at rate t 2. Capital gains tax will be due when A < C, i.e. the redemption cash flow is greater than the price paid. In this case, the investor is liable to pay an amount t 2 (C A) at time t = n. Makeham s formula for the EoV is then modified to A = K + g(1 t 1) i (p) C A (C K) t 2 C K Which is rearranged to give an expression for A A = (1 t 2)K + (1 t 1 )(g/i (p) )(C K) 1 t 2 K/C

CAPITAL GAINS TAX We now have a situation where the expression for determining the price to pay for the security is dependent on whether a capital gain will occur. However, whether a capital gain occurs depends on the price paid. Fortunately, this circular argument is broken by the comparison of i (p) to g(1 t 1 ), as discussed above. We therefore have the following generalized form of Makeham s formula for an investor liable to income tax at rate t 1 and capital gains tax at rate t 2 A = { g(1 t K + 1 ) (C K) i (p) if i (p) g(1 t 1 ) (1 t 2 )K+(1 t 1 )(g/i (p) )(C K) 1 t 2 K/C if i (p) > g(1 t 1 )

EXAMPLE Consider a 5-year fixed-interest security that pays coupons of 3% per annum at 3-monthly intervals and is redeemed at 105%. If an investor pays income tax at a rate of 40% per annum and capital gains tax at 25%, determine the maximum price to pay so that the net yield is at least 4% per annum. Answer We have p = 4, n = 5, t 1 = 0.40, t 2 = 0.25, g = 0.03/1.05 and, for 100 nominal, C = 105. If i = 4%, i (4) = 3.9414% > g(1 t 1 ) and there is a capital gain. The appropriate pricing formula is then A = (1 0.25)105ν5 + (1 0.4)(g/i (p) ) ( 105 105ν 5) 1 0.25ν 5 = 91.70

OPTIONAL REDEMPTION DATES The redemption date of a security can be at the option of the borrower (i.e. issuer). In this case, the value of n is not known in advance and the investor s decision to invest is made more complicated. The investor should take a prudent approach and assume that redemption will occur at the time that gives the lowest yield. If there is a capital gain, i (p) > g(1 t 1 ), the lowest yield will be achieved with redemption at the latest possible date. If there is a capital loss, i (p) < g(1 t 1 ), the lowest yield will be achieved with redemption at the earliest possible date. If there is no capital change, i (p) = g(1 t 1 ), the yield will be independent of the redemption date. These considerations are irrespective of if the investor pays capital gains tax.

EXAMPLE If an investor requires a net yield of 8% per annum, calculate the maximum price he should pay for a fixed-interest security that pays coupons of 10% per annum at 6-monthly intervals and is redeemed at 103%. You are given that the issuer can redeem the security at any coupon date between n = 5 and n = 10 and the investor pays no tax. Answer We have p = 2, t 1 = 0, g = 0.10/1.03 = 9.7087% and, for 100 nominal, C = 103. If i = 0.08%, i (2) = 7.8461% < g(1 t 1 ) and there is a capital loss. It is then prudent to assume that the security is redeemed at t = 5. The price is then A = 90ν 5 + (g/i (p) ) ( 103 103ν 5) = 110.81 Note that if the issuer actually redeems the security at t > 5, the investor will earn a yield greater than 8% per annum.

SUMMARY Fixed-interest securities can be valued from first principles using annuity notation and compound interest tables. Makeham s formula is a standardized expression for the EoV of a fixed-interest security. Makeham s formula can simplify the study of complicated security issues, but essentially contains no new information. The form of Makeham s formula enables one to show that if g(1 t1 ) = i (p), A = C and there is no capital gain or loss, if g(1 t1 ) > i (p), A > C and there is a capital loss, if g(1 t1 ) < i (p), A < C and there is a capital gain. These expressions are also useful in pricing securities with redemption dates at the option of the issuer. An investor s income tax and capital gains tax rates can be incorporated into Makeham s formulation and net yields obtained.