Chapter 9 FIXED INCOME SECURITIES: VALUATION AND RISKS

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Chapter 9 FIXED INCOME SECURITIES VALUATION AND
RISKS

• Why are bonds viable investment alternatives?
• What are the risks faced by bond investors?
• How bonds are priced?
• What are the basic bond pricing theorems?
• How can interest rate risk be measured?
• How can credit risk be evaluated?
• How are bond risk and required return related?

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Why bonds?

• Income
• Potential for capital gains
• Paper versus real losses
• Diversification
• Tax advantages

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Figure 9.1 Yield on Long-Term Treasury
Bonds vs. the Dividend Yield from the SP500
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Risks associated with investing in bonds

• Credit risk
• Interest rate risk
• Reinvestment risk
• Purchasing power risk
• Call risk
• Liquidity risk
• Foreign exchange risk

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Bond valuation

• Basics of bond pricing
• Identifying the bonds cash flows
• Bond price is present value of its cash flows
• Semiannual coupons
• Accrued interest

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Bond valuation Cont.

• Yield-to-maturity
• Relationship between coupon rate and yield to
  maturity
• Current yield
• Yield to call
• Actual return versus yield to maturity

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Figure 9.2 - Reinvestment Rate and the
Actual Rate of Return for a Bond
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Five bond pricing theorems

• Bond prices move inversely to changes in interest
  rates
• Bonds with longer maturities are more price
  sensitive
• Price sensitivity increases at a decreasing rate
• Bonds with lower coupon rates are more price
  sensitive
• A price increase caused by a decrease in interest
  rates is larger than a price decrease caused by
  an increase in interest rates of the same
  magnitude

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Figure 9.3 Bond Price vs. Yield to Maturity
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Figure 9.4 Price Sensitivity and Maturity
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Figure 9.5 Price Sensitivity and Coupon
Rate
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Figure 9.6 Price Changes for Increase and
Decrease in Yield
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Assessing interest rate risk

• What is duration?
• Finding a bonds duration
• Duration and price sensitivity
• Duration and price changes

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Figure 9.7 Relationship Between Duration
and Maturity
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Figure 9.8 Relationship Between Duration
and Coupon Rate
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Figure 9.9 Relationship Between Duration
and Yield to Maturity
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Credit risk

• Bond ratings
• Description of bond ratings
• Determinants of bond ratings
• Bond ratings and default rates
• Graham Dodd on credit risk and bond selection

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Risk and required return for bonds

• General relationship (equation 9.8) r f (i,
  ?p, ir, rr, dr, cr, lr, fxr)
• Bond yields and maturity
• Bond yields and credit risk

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Figure 9.10 Yield Spread Between T-Bonds
and T-Bills
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Figure 9.11 Quality Yield Spreads in the
U.S. Capital Markets