Fins2624 Notes
BOND PRICING CHAPTER 1
Floating Rate bonds * Floating rate bonds make interest payments that are tied to a measure of current market rates Example: Rate may be adjusted annually to the current T bill rate plus 2% * Major risk involved for floaters is due to the changes in the firm’s financial strength * Yield spread is fixed over life of security however if the firm’s strength deteriorates then investors would demand a greater yield premium * This makes the price of bonds to fall * Floaters do not adjust to changes in financial condition of the firm
* For bonds, the price an investor would be willing to pay for a claim to the interest and principal repayments depends on the value of dollars received in the future compared to dollars in hand today
Bond Value=Present Value of coupons+Present value of par value * At higher interest rates, the present value of payments to be received by the bond holder is lower Bond prices fall as market interest rates rise * Convexity in bond graphs demonstrates that progressive increases in interest rate results in progressive smaller reductions in the bond price Curve is flatter when reaching higher interest rates * Corporate bonds are issued at par value Underwriters must choose coupon rates which matches the market yields * Bondholders may buy or sell bonds in secondary markets In this market, bond prices fluctuate inversely with market interest rates * The maturity of the bond will generally affect the sensitivity of bond prices to market yields * Longer the maturity of bond Greater the sensitivity of price to fluctuations * For example, when you buy a bond at par with an 8% coupon rate and market rates subsequently rise then you suffer a loss There are better alternatives but you’re locked into the 8% * This is called capital loss on the bond Fall in market price * The longer the bond is tied up the greater the loss The
Floating Rate bonds * Floating rate bonds make interest payments that are tied to a measure of current market rates Example: Rate may be adjusted annually to the current T bill rate plus 2% * Major risk involved for floaters is due to the changes in the firm’s financial strength * Yield spread is fixed over life of security however if the firm’s strength deteriorates then investors would demand a greater yield premium * This makes the price of bonds to fall * Floaters do not adjust to changes in financial condition of the firm
* For bonds, the price an investor would be willing to pay for a claim to the interest and principal repayments depends on the value of dollars received in the future compared to dollars in hand today
Bond Value=Present Value of coupons+Present value of par value * At higher interest rates, the present value of payments to be received by the bond holder is lower Bond prices fall as market interest rates rise * Convexity in bond graphs demonstrates that progressive increases in interest rate results in progressive smaller reductions in the bond price Curve is flatter when reaching higher interest rates * Corporate bonds are issued at par value Underwriters must choose coupon rates which matches the market yields * Bondholders may buy or sell bonds in secondary markets In this market, bond prices fluctuate inversely with market interest rates * The maturity of the bond will generally affect the sensitivity of bond prices to market yields * Longer the maturity of bond Greater the sensitivity of price to fluctuations * For example, when you buy a bond at par with an 8% coupon rate and market rates subsequently rise then you suffer a loss There are better alternatives but you’re locked into the 8% * This is called capital loss on the bond Fall in market price * The longer the bond is tied up the greater the loss The