Financial Markets CH 8
Institutional use of mortgage markets
1. Commercial banks, savings institutions, life insurance companies account for 43% of the market. Other participants are Government National Mortgage Association (GNMA) and Federal National Mortgage Association (FNMA) 2. Mortgage companies do not hold large mortgage portfolios; less interest rate risk
Residential Mortgage Characteristics
1.Federally insured vs conventional mortgages. The guarantors are: Federal housing administration (FHA) Veterans Administration (VA) 2. Fixed vs adjustable rate mortgages (interest rate risk implications) 3. Mortgage maturities (interest rate risk implications); balloon-payment mortgage (refinancing risk)
How Interest Rates Affect Bond Prices. Explain the impact of a decline in interest rates on: a. An investor's required rate of return. b. The present value of existing bonds. c. The prices of existing bonds.
A: ANSWER: An investor's required rate of return should decrease. B: ANSWER: The present value of existing bonds should increase. C: ANSWER: The prices of existing bonds should increase.
14. Sensitivity of Bond Values. a. How would the present value (and therefore the market value) of a bond be affected if the coupon payments are smaller and other factors remain constant? b. How would the present value (and therefore the market value) of a bond be affected if the required rate of return is smaller and other factors remain constant?
A: ANSWER: The bond would have a lower present value, since the future cash flows would be smaller. B: ANSWER: The bond would have a higher present value, since the cash flows would be discounted at a lower discount rate.
Impact of the Fed. Assume that the bond market participants suddenly expect the Fed to substantially increase the money supply. a. Assuming no threat of inflation, how would bond prices be affected by this expectation? b. Assuming that inflation may result, how would bond prices be affected? c. Given your answers to (a) and (b), explain why expectations of the Fed's increase in the money supply may sometimes cause bond market participants to disagree about how bond prices will be affected.
A: ANSWER: Without the threat of inflation, an increase in the money supply could reduce interest rates and bond prices would increase. Thus, bond portfolio managers would purchase more bonds now, causing immediate upward pressure on bond prices. B: ANSWER: If inflation increases, interest rates will likely increase, and prices of existing bonds will decline. Therefore, bond portfolio managers would sell bonds now, causing immediate downward pressure on bond prices. C: ANSWER: Some bond market participants may expect that the Fed's actions will cause higher inflation (and therefore higher interest rates), and therefore expect bond prices to decline. Other bond market participants may expect that the Fed's actions will not cause higher inflation, and therefore expect bond prices to increase.
Interpret the following comments made by Wall Street analysts and portfolio managers. a."Given the recent uncertainty about future interest rates, investors are fleeing from zero-coupon bonds." b."Catrell Insurance Company invests heavily in bonds, and its stock price increased substantially today in response to the Fed's signal that it plans to reduce interest rates." c."Bond markets declined when the Treasury flooded the market with its new bond offering."
A: Zero-coupon bonds are most sensitive to interest rate movements; investors who were concerned about an increase in interest rates sold their holdings of zero-coupon bonds. B: Some of Catrell's assets are long-term bonds, which increase in value when interest rates decrease. The stock valuation is influenced by the increase in the market value of its assets. C: If the Treasury issues new bonds, the supply of bonds may exceed the demand, causing a decline in the price of bonds. That is, the yields to be offered on any new bonds must be raised to attract buyers.
Bond Valuation. Assume the following information for an existing bond that provides annual coupon payments: Par value = $1,000 Coupon rate = 11% Maturity = 4 years Required rate of return by investors = 11% b. If the required rate of return by investors were 14 percent instead of 11 percent, what would be the present value of the bond? c. If the required rate of return by investors were 9 percent, what would be the present value of the bond? ANSWER: PV of Bond = PV of Coupon Payments + PV of Principal = $110(PVIFAi = 9%,n = 4) + $1,000(PVIFi = 9%,n = 4) = $110(3.2397) + $1,000(.7084) = $356 + $708 = $1,064
ANSWER: A) PV of Bond = PV of Coupon Payments + PV of Principal = $110(PVIFAi = 11%,n = 4) + $1,000(PVIFi = 11%,n = 4) = $110(3.1024) + $1,000(.6587) = $341 + $659 = $1,000 B) ANSWER: PV of Bond = PV of Coupon Payments + PV of Principal = $110(PVIFAi = 14%,n = 4) + $1,000(PVIFi = 14%,n = 4) = $110(2.9137) + $1,000(.5921) = $321 + $592 = $913 C) ANSWER: PV of Bond = PV of Coupon Payments + PV of Principal = $110(PVIFAi = 9%,n = 4) + $1,000(PVIFi = 9%,n = 4) = $110(3.2397) + $1,000(.7084) = $356 + $708 = $1,064
Predicting Bond Portfolio Value. (Use the chapter appendix to answer this problem). Ash Investment Company manages a broad portfolio with this composition: Zero-coupon bonds 8% Treasury bonds 11% corporate bonds Par Value 200,000,000 300,000,000 400,000,000 Present Market Value 63,720,000 290,000,000 380,000,000 733,720,000 Years remaining to maturity 12 8 10 Ash expects that in four years, investors in the market will require an 8 percent return on the zero-coupon bonds, a 7 percent return on the Treasury bonds, and a 9 percent return on corporate bonds. Estimate the market value of the bond portfolio four years from now.
ANSWER: PV of Zero-Coupon Bonds in 4 Years = $200,000,000(PVIFi = 8%,n = 8) = $200,000,000(.5403) = $108,060,000 PV of Treasury Bonds in 4 Years = $24,000,000(PVIFAi = 7%,n = 4) + $300,000,000(PVIFi = 7%,n = 4) = $24,000,000(3.3872) + $300,000,000(.7629) = $81,292,800 + $228,870,000 = $310,162,800 PV of Corporate Bonds in 4 Years = $44,000,000(PVIFAi = 9%,n = 6) + $400,000,000(PVIFi = 9%,n = 6) = $44,000,000(4.4859) + $400,000,000(.5963) = $197,379,600 + $238,520,000 = $435,899,600 PV of Portfolio in 4 Years = $108,060,000 + $310,162,800 + $435,899,600 = $854,122,400
Bond Valuation. You are interested in buying a $1,000 par value bond with 10 years to maturity and an 8 percent coupon rate that is paid semiannually. How much should you be willing to pay for the bond if the investor's required rate of return is 10 percent?
ANSWER: PV = C(PVIFA k = 5%, n = 20) + FV(PVIFk = 5%, n = 20) PV = 40(12.4622) + 1,000(0.3769) PV = $875.39
Comparison of Bonds to Mortgages. Since fixed-rate mortgages and bonds have similar payment flows, how is a financial institution with a large portfolio of fixed-rate mortgages affected by rising interest rates? Explain.
ANSWER: A financial institution with a large portfolio of fixed-rate mortgages is adversely affected by rising interest rates, because the market value of its mortgage portfolio is reduced.
Implications of a Shift in the Yield Curve. Assume that there is a sudden shift in the yield curve, such that the new yield curve is higher and more steeply sloped today than it was yesterday. If a firm issues new bonds today, would its bonds sell for higher or lower prices than if it had issued the bonds yesterday? Explain.
ANSWER: A higher and steeper yield curve implies that long-term bond yields have increased. The firm would have to sell the bonds for lower prices to entice investors with a high yield today.
Bond Convexity. Describe how bond convexity affects the theoretical linear price-yield relationship of bonds. What are the implications of bond convexity for estimating changes in bond prices?
ANSWER: Bond convexity illustrates that the price-yield relationship is not linear, but convex. This is particularly pronounced for bonds with low coupons and long maturities. From a bond pricing perspective, bond convexity leads to estimation errors in the price change of a bond, although the effect is negligible for small yield changes. Specifically, using modified duration to estimate the percentage price change of a bond yields to an underestimation of bond price increases when yields drop and an overestimation of bond price decreases when yields increase.
Bond Price Elasticity. Explain the concept of bond price elasticity. Would bond price elasticity suggest a higher price sensitivity for zero-coupon bonds or high-coupon bonds that are offering the same yield to maturity? Why? What does this suggest about the market value volatility of mutual funds containing zero-coupon Treasury bonds versus high-coupon Treasury bonds?
ANSWER: Bond price elasticity measures the percentage change in a bond's price in response to a percentage change in interest rates. The percentage change in the price (as measured by present value) of the zero-coupon bonds would be more sensitive to interest rate movements than the high-coupon bonds. Thus, a mutual fund containing zero-coupon bonds would likely have a more volatile market value over time.
Bond Duration. A bond has a duration of 5 years and a yield to maturity of 9 percent. If the yield to maturity changes to 10 percent, what should be the percentage price change of the bond?
ANSWER: First compute the modified duration of the bond: DUR * DUR/(1 + k) =5.0/1.09=4.59 Next, compute the percentage price change of the bond if the yield increases to 10 percent: %change price = - DUR * change in coupon rate =-4.59 * 0.01 =-4.59% Consequently, the bond should decrease in price by 4.59%.
Impact of Economic Conditions. Assume that breaking news causes bond portfolio managers to suddenly expect much higher economic growth. How might bond prices be affected by this expectation? Explain. Now assume that breaking news causes bond portfolio managers to suddenly anticipate a recession. How might bond prices be affected? Explain.
ANSWER: Higher economic growth places upward pressure on interest rates and downward pressure on bond prices. As bond portfolio managers sell their bonds based on this expectation, there is immediate downward pressure on bond prices. A recession tends to imply a reduced demand for loanable funds and therefore lower interest rates and higher prices of existing bonds. As bond portfolio managers purchase bonds to capitalize on this expectation, there is immediate upward pressure on bond prices.
Relevance of Bond Price Movements. Why is the relationship between interest rates and bond prices important to financial institutions?
ANSWER: Most financial institutions maintain a portfolio of bonds or mortgages that provide fixed payments over time. Because the market values of these securities are very sensitive to interest rate movements, financial institutions must understand the relationship between interest rates and security prices.
Impact of Oil Prices. Assume that oil-producing countries have agreed to reduce their oil production by 30 percent. How would bond prices be affected by this announcement? Explain.
ANSWER: Reduced oil production implies higher oil prices, higher interest rates, and lower bond prices. Thus bond portfolio managers would sell bonds immediately causing immediate downward pressure on the bond prices.
Inflation Effects. Assume that inflation is expected to decline in the near future. How could this affect future bond prices? Would you recommend that financial institutions increase or decrease their concentration in long-term bonds based on this expectation? Explain.
ANSWER: Since lower inflation normally causes a decline in interest rates (other things being equal), financial institutions would benefit if they increase their concentration of long-term bonds before this occurs.
Systemic Risk. Explain why there are concerns about systemic risk in the bond and other debt markets. Also explain how the Financial Reform Act of 2010 was intended to reduce systemic risk.
ANSWER: Systemic risk refers to the potential collapse of the entire market or financial system. Many financial institutions rely heavily on debt to fund their operations, and they are interconnected by financing each other's debt positions. If some of these financial institutions cannot repay their debt, they may create cash flow problems for those other financial institutions from which they borrowed funds. In addition, if they took positions in derivative securities to offer insurance to another party in case of debt default, they may suffer major losses. The Financial Reform Act of 2010 resulted in the creation of the Financial Stability Oversight Council, consisting of heads of agencies that oversee key participants in the debt markets. This council is responsible for identifying risks in the U.S. financial system, and making regulatory recommendations that could reduce these risks.
Economic Effects on Bond Prices. An analyst recently suggested that there will be a major economic expansion that will favorably affect the prices of high-rated fixed-rate bonds, because the credit risk of bonds will decline as corporations improve their performance. Assuming that the economic expansion occurs, do you agree with the conclusion of the analyst? Explain.
ANSWER: The decline in the credit risk will result in slightly lower bond premiums, which would favorably affect the price if other things are held constant. However, the major economic expansion will likely result in higher interest rates, which could cause a major decline in bond prices. The interest rate effect on the bond prices will likely overwhelm the risk premium effect.
Link between Market Uncertainty and Bond Yields When stock market volatility is high, corporate bond yields tend to increase. What market forces cause the increase in corporate bond yields under these conditions?
ANSWER: The high stock market volatility partially reflects high uncertainty of investors about corporate performance in the future, so corporate risk premiums on bonds may rise.
Exposure to Bond Price Movements. How would a financial institution with a large bond portfolio be affected by falling interest rates? Would it be affected more than a financial institution with a greater concentration of bonds (and fewer short-term securities)? Explain.
ANSWER: The market value of the financial institution's bond portfolio will increase. A financial institution that has a greater concentration of bonds would be even more favorably affected because the market value of its portfolio would be more sensitive to interest rates.
Bond Price Sensitivity. Is the price of a long-term bond or the price of a short-term security more sensitive to a change in interest rates? Why?
ANSWER: The price of a long-term bond is more sensitive to a change in interest rates than the price of a short-term security. The long-term bond provides fixed payments for a longer period of time. Consequently, it will provide these fixed payments, whether interest rates decline or rise. The benefit of fixed payments during a period of falling interest rates is more pronounced for longer maturities. The same is true for the disadvantage of fixed payments during a period of rising rates.
Required Return on Bonds. Why does the required rate of return for a particular bond change over time?
ANSWER: The required rate of return on a bond changes because of a change in interest rates, or a change in the risk of the bond.
Impact of the Credit Crisis on Risk Premiums. Explain how the prices of bonds were affected by a change in the risk-free rate during the credit crisis. Explain how bond prices were affected by a change in the credit risk premium during the credit crisis.
ANSWER: The risk-free rate declined, which placed upward pressure on bond prices. However, the credit risk premium increased, which placed downward pressure on bond prices.
Coupon Rates. If a bond's coupon rate is above the investor's required rate of return on the bond, would the bond's price be above or below its par value? Explain.
ANSWER: When a bond's coupon rate is above the investor's required rate of return, the price of the bond would be above its par value because the coupons provide more than the return required.
Creative mortgage financing Second mortgage
Lower maturity and higher rate
Activities to mortgage markets Income
Origination fees, interest earnings, servicing fees
Activities to mortgage markets Activities
Origination, maintenance, servicing
Creative mortgage financing Graduated payment mortgage (GPM)
Payment increase then level off
Creative mortgage financing Growing equity mortgage
Payment never level off
Creative mortgage financing Shared application mortgage
lower rates; lender share in price appreciation
Activities to mortgage markets Secularization
pooling and repacking of loans into securities; allows for sale of smaller mortgages; attractive to large institutional investors; reduce exposure to risk.