Financial Markets Exam 2

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How do you calculate BEY?

[(Face value - purchase price)/Purchase price] * 365/days to maturity.

There is an inverse relationship between the value of a share of stock and

a change in interest rates

Treasury notes and bonds

issued by the u.s. treasury to finance the national debt and other government expenditures

Bond indenture

legal contract that specifies the rights and obligations of the issuers and the holders

Bond Markets

markets in which bonds are issued and traded (T-notes and bonds, municipal bonds, and corporate bonds).

2-year notes are auctioned

monthly

Accrued interest

must be paid by the buyer of a bond to the seller of a bond if the bond is purchased between interest payment dates

Present Value of a Bond Using a TVM Function: What is the value of a $1,000 par value bond with a coupon rate of 8% that has 15 years to maturity if similar maturity bonds with similar risk are offering a 10% return (Yield to Maturity) if payments are paid semiannually.

n = 15 X 2 = 30, r = 10 / 2 = 5, PV = ?, PMT = 80 / 2 = 40, FV = 1000, PV = 846.28. The similar maturity bond return %'s go in the r, and the PMT is based on the payment that would be made with the coupon rate.

T-notes have original maturities from

over 1 to 10 years

T-bonds have original maturities from

over 10 years

3, 5, and 10 year notes are auctioned

quarterly

Return on a stock with constant dividend growth

r sub s = D sub 1/P sub0 + g

Return on a stock with zero dividend growth

r subs = D/P sub0

Converting muni interest rates to tax equivalent rates of return

second formula under chapter 6, isuba is after-tax rate of return on a taxable corporate bond, isubb is before-tax rate of return on a taxable bond, t is marginal total income tax rate of bond holder.

Municipal bonds

securities issued by state and local governments. Any state or local government that has taxing authority may issue a muni. The purpose is to fund imbalances between expenditures and receipts, and to finance long term capital outlays. Municipal bonds are attractive to wealthy household investors because interest is exempt from federal and most local income taxes.

30 year bonds are auctioned

semi-annually

Revenue bonds

sold to finance specific revenue generating projects.

Competitive bidders

submit bid yields, highest bid accepted is called the stop out yield.

The full or dirty price of a bond is the

sum of the clean price (V subb) and the accrued interest

The price of a bond without accounting for accrued interest is called

the clean price

The price of a bond with accrued interest is called

the full price or dirty price.

Duration and coupon interest

the higher the coupon payment, the lower the bond's duration.

All noncompetitive bidders and competitive bidders who bid less than the stop out receive

their full allotment. Bidders at the stop out yield may receive pro-rata share of their allotment. T-note or bond coupon rate is rounded down from stop yield to the nearest 1/8th if needed.

T-bonds and notes trade in

very active secondary markets. Prices are quoted as percentages of face value, may be in 32nds or quoted in decimals.

T-bonds and notes are issued in minimum denominations of

$100

A dealer is quoting a $10,000 face 180-day T-bill quoted at 2.75 bid, 2.65 ask. You could buy this bill at ______________ or sell it at _______________.

$9,867.50; $9,862.50. We find this by taking our ask and multiplying it by 180/360, which gives us 1.8%. We then take our bid and do the same, which gives us 1.375%. Then in order to calculate the buying price, we take the face (10,000) and subtract out the face multiplied by the ask percentage. 10000-(10000*1.8%), and do the same thing with the bid percentage to find the amount we could sell for.

Characteristics of Treasury Notes and Bonds

1. Default risk free - backed by the full faith and credit of the U.s Government. 2. Low returns - low interest rates (yield to maturity) reflect low default risk 3. Interest rate risk - because of their long maturity, T-notes and bonds experience wider price fluctuations than money market securities when interest rates change 4. Liquidity risk - older issued T-bonds and T-notes trade less frequently than newly issued T-bonds and T-notes

Municipal Bond Primary Markets

1. Firm commitment underwriting: a public offering of Munis made through an investment bank, where the investment bank guarantees a price for the newly issued bonds by buying the entire issue and then reselling it to the public 2. Best efforts offering: a public offering in which the investment bank does not guarantee a firm price 3. Private placement: bonds are sold on a semi-private basis to accredited investors.

Discount Bond

A bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate. If INT < r, then V subb < Par.

In the T-Bill auction process, what is the non-competitive bidder guaranteed?

A given quantity

In the T-Bill auction process, what is the competitive bidder guaranteed?

A maximum price

You buy a 6% coupon $1,000 par T-bond 59 days after the last coupon payment. Settlement occurs in two days. You become the owner 61 days after the last coupon payment (59+2), and there are 121 days remaining until the next coupon payment. The bond's clean price quote is 120.59375. What is the full or dirty price (sometimes called the invoice price)? The clean price is 120.59375% of $1,000 or $1,205.9375. Thus, the dirty price is $1,205.9375 + $10.05 = $1,215.9875.

Accrued interest example

Treasury bills and commercial paper rates are quoted as discount yields

First formula under chapter five, p sub f is the face value of the security, P sub 0 is the discount price of the security, and n is the number of days until maturity.

General Obligation (GO) Bonds

Backed by the full faith and credit of the issuing municipality. Many GO bonds are insured by a third party to improve the credit rating and liquidity.

Fair Present Value Calculation (used for required rate of return)

First on formula sheet.

Corporate bonds

Long term obligations issued by corporations.

What is a short term unsecured promissory note issued by a company?

Commercial paper

Present Value of a Stock assuming zero growth in dividends (P sub t)

D / r sub s, D is the constant dividend paid at end of every year. P sub t is the stock's price at the end of year t. r sub s is the interest rate used to discount future cash flows. Fourth formula on sheet.

Present Value Assuming Constant Dividend Growth

D sub t+1/(r sub s - g), g is the constant dividend growth rate.

Accrued Interest on T-bonds and notes calculation

First formula under chapter 6

Current Market Price of a Security

Determined using the expected rate of return or E(r) as the discount rate. Second formula on sheet.

Actual purchase price (Pbar)

Equated to the present value of the realized cash flows (RCF sub t) using realized rate of return (rbar) as a discount rate. Third formula on sheet.

Negotiable CDs and fed funds are money market securities that pay interest only at maturity. These use single-payment yields (i subsp)

Fourth formula under chapter 5. To convert a single payment yield to a bond equivalent yield, use the fifth formula under chapter 5. To convert a single payment yield to an EAR, use the sixth formula.

Premium Bond

Has a coupon rate (INT) greater than the required rate of return (r) and the fair present value of the bond (V subb) is greater than the face or par value (Par). If INT > r; then V subb > par

Expected Rate of Return (E(r))

Rates participants would earn by buying securities at current market prices (P)

Required Rate of Return (r)

Rates used by individual market participants to calculate fair present values (PV)

Money Market securities exhibit which of the following: 1. Large denomination 2. Maturity greater than one year 3. Low default risk 4. Contractually determined cash flows

Large denomination, low default risk, and contractually determined cash flows

Change in Value of a Bond Given Duration

Last formula on formula sheet

Given the nature of money markets, why is it necessary that they have a maturity of one year or less and low default risk?

Money market securities need to have a maturity of one year or less and low default risk because they are intended to be safe investments, coinciding with a small chance that principle will be lost. If you need money within a short period of time, but don't want the risk associated with more volatile investments, money markets are great because they short term and very reliable. The short maturity allows money markets to resist changes in interest rates, and the low default risk promises that payoff is relatively guaranteed and timely.

Municipal Bond Secondary Markets

Munis trade infrequently due to a lack of information on bond issuers. Secondary market is made up primarily of bond dealers.

Bearer vs registered bonds

New bearer bonds are illegal in the U.S.

Bigalow Giant Corporation pays a fixed annual dividend on its $100 face value Preferred Stock of 6%. Preferred Stock of similar companies offer a 7% rate of return. What is the fair value of BG's preferred stock?

P sub t = 6/.07 = 85.71

Bigalow Giant company just paid a dividend on it's common stock of $2.30 per share. Dividends are expected to grow at a rate of 5% per year for the foreseeable future. If investors have determined that the required rate of return on BG's stock is 11%, what is the fair value of BG's stock? FAIR VALUE

P sub0 (because they want to know what the stock's fair value is now) = D sub0 * (1+g)/ (r subs - g) = 2.3*(1.05)/(.11-.05) = 2.42/.06 = 40.33.

The Present Value of a Bond Notation

Par - the par value of the bond, usually $1000 INT - The annual interest (or coupon) payment T - The number of years until the bond matures r - the annual interest rate (often called yield to maturity YTM)

Coupon Rate

Periodic cash flow a bond issuer contractually promises to pay a bond holder

Realized Rate of Return (rbar)

Rate actually earned on investments.

Bond equivalent yields (i sub be)

Second formula under chapter 5

How do you find out how much you will collect from a 180 day CD?

Take the annual rate quote, and multiply it by 180/360. Then take this new percentage and multiply it by the face value, and then add that outcome to the face value.

The primary market of T-notes and bonds is similar to that of T-bills

The U.S. treasury sells T-notes and bonds through competitive and noncompetitive single-bid auctions.

Par Bond

When the bond's coupon rate equals the market yield; Bonds are typically issued near par value. if INT = r, then V subb = par.

Duration and yield to maturity

The higher the yield to maturity, the lower the bond's duration.

National Debt

The sum of historical annual federal deficits.

Duration

The weighted average time to maturity (measured in years) on a financial security. Measures the sensitivity (or elasticity) of a fixed-income security's price to small interest changes. Captures the coupon and maturity effects on volatility.

Relationship between bond values and interest rates

There is an inverse relationship between changes in interest rates and bond values. Take a $1000 par value bond that has a coupon rate of 10%, paid semiannually, and 12 years to maturity if similar bonds are offering a 10% return (YTM)? As interest rates go up, bond values go down

Effective Annual Returns (EAR)

Third formula under chapter 5

Inflation indexed bonds (TIPS)

Treasury Inflation Protection Securities. The principal value of TIPS is adjusted by the percentage change in the Consumer Price Index (CPI) every six months

As a corporate treasurer who is unsure how soon funds will be needed, which type of money market investment might you prefer? Explain the trade-offs. Would your answer differ if you had a definite time period during which you would not need the money? Explain.

Treasury bills would be good for this situation mainly because they are highly liquid and backed by the government, which would allow for quick and relatively certain access. The main trade off is that T-bills don't offer very high rates of interest. If there was a definite time period in which the money was not needed I would select something with a higher interest rate like commercial paper.

STRIPS (Separate Trading of Registered Interest and Principal Securities)

a.k.a Treasury zero bonds or treasury zero-coupon bonds. Financial institutions and government securities brokers and dealers create STRIPS from T-notes and bonds. These have periodic interest payments separated from each other and from the principal payment. STRIPS are used to immunize against interest rate risk.

Duration and maturity

duration increases with maturity but at a decreasing rate

Federal deficit

equal to the annual expenditures (G) less taxes received (T).

There is a positive relationship between the value of a share of stock and

growth in earnings


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