1. 6) Which of the following statements are true? The aim of this paper is to discuss recent developments in interest rate term structure modeling and the application of these models to the interest rate risk management and valuation of cash ﬂows that are dependent on future interest rates. MD(1)=1/1.00317=0.9968, if delta y=1%, delta B/B= -0.9968% 1. 9 14 17 19 23 24 26 Course: Buying a stock makes you one of the owners of a corporations and buying a bond makes you one of the lenders. • Calculating the Yield to Maturity on a Bond A flat yield curve is where longer term maturity bonds and shorter term maturity bonds are close to each other. In other words, reading the sections above and attempting the problems recommended should put you in a comfortable position to handle majority of questions in the exam. | | 4. * Double taxation in the US (only concerned with ‘C’ corporations) 100% of the time (since 1986 at least) after the yield curve took on a humped shape, stocks eventually fell quite a lot, but with a variable lead time. A yield curve is a way to easily visualize this difference; it's a graphical representation of the yields available for bonds of equal credit quality and different maturity dates. • Calculating the Yield on a Treasury Bill 4. Recent developments have incorporated a stochastic approach to modeling...... ...called the A) junk premium. Royal Dutch and Shell). Why is the yield curve upward sloping in 2010? Markets for financial assets: Chapter 7 Plotting the points on the basis of the data’s of interest rate and terms to maturity, the yield curve is drawn. The price divergence in these different markets creates profitability. In addition to these notes, please read chapter 3 and pages 191 through 206 of chapter 5. | Your company has received a $50,000 loan from an industrial finance company. Face value of 1-year bond= 1MM*0.317%=1003170 Dellatorre is a highly ranked tennis player who would like to start a company to produce and market apparel that she designs. Now, let us look at the different types of markets: A) increase; reduce B) reduce; reduce C) increase; not affect D) reduce; increase E) increase; increase 5) Bonds with relatively low risk of default are called A) investment grade bonds. Using the yield curve to predict interest rates (section 6-6) Again a market is a transaction, not a physical location. | dividend maximization | | * Tax implications 100 bonds * Shareholders: Own the Corp, but have no say in daily operations C= (126.4236+118.1528-122.2018*2)/0.01^2*(1/122.2018)= 14.1405 7 The shape of the yield curve changes over time as interest rates change in the marketplace. It is therefore prudent to expand your preparation beyond this... ...Part 1 Practice problems: 6-2, 6-3, 6-4, 6-5, 6-7, 6-9, 6-11, 6-14 Analysis Hump shaped yield curve and liquidity premium theory - YouTube What are the Fundamental Bond Pricing Properties? | The present value of a single future sum: | 1. Unit1a1 – Textbook Problems Zachary Skidmore July 15, 2011 BUS4070 – Mr. Walter Adams 6-1 YIELD CURVES The following yields on U.S. Treasury securities were taken from a recent financial publication: Term Rate 6 months 5.1% 1 year 5.5 2 years 5.6 3 years 5.7 4 years 5.8 5 years 6.0 10 years 6.1 20 years 6.5 30 years 6.3 a. • The Yield Curve What determines the shape of a yield curve (section 6-5) | | 2. Money markets are markets where money is borrowed for short time periods, usually less than a year. Pricing and Trading 4. a. Yield-curve risk, also known as interest-rate risk, is the risk of interest rate changes affecting bond prices. • Calculating Accrued Interest This memo will present the appropriate classification in the fair value hierarchy for each investment and provide appropriate authoritative guidance to support the determination. Upward sloping B. | 13 | | ------------------------------------------------- Dividend Imputation life of the bond). subject: fair value hierarchy MD(5) = 5/1.01479= 4.9271, if delta y=1%, delta B/B=-4.9271% B) An increase in default risk on corporate bonds lowers the demand for these bonds, but increases the demand for default-free bonds. * Elected by shareholders | - | | The normal yield curve reflects higher interest rates for 30-year bonds, as opposed to 10-year bonds. She also expects to invest substantial amounts of money through Balik and Kiefer. What is a yield curve? Stand-Alone risk (8-2) The Financial Environment interest rate environment in which short-term debt securities yield more than intermediate and long-term securities. • Calculating the Fair Price of a Bond * Ownership represented by shares of stock, sum of which is OE theory that investors prefer short-term debt securities over long-term and, therefore, demand a higher yield (risk premium) when purchasing long-term debt securities. 4 Quantifying Interest Rate Risk Bond yields (7-7) LEARNING OBJECTIVES If the company is paying 9% interest per year, how many loan payments must the company make? yield curve from normal to inverted or vice versa. Important note: However, other technical factors such as lower supply of long-term bonds or an increased demand for long-term bonds may cause a humped yield curve. Bonds with semi-annual coupons (7-6) A) reduce; increase B) increase; reduce C) increase; not affect D) reduce; reduce E) increase; increase B)... ...1: CORPORATIONS & FINANCIAL DECISION-MAKING Explain the rationale for bond switching and describe bond-switching...... ...Q.No. Convergence Strategy: In case of convergence strategy the two asset prices or yields must converge. Commonly there are three kinds of Yield Curves that are observed in the financial markets. However, there are many types of bonds: bonds with different maturity, bonds issued by different parties (i.e. The yield curve flattens—that is, it becomes less curvy—when the difference between yields on short-term bonds and yields on long-term bonds decreases. Since 1986 the yield curve has had some measure of humpedness 25% of the time. A yield curve plots the yield to maturity (TYM) of similar debt securities, against the time to maturity (term).A normal yield curve is upward-sloping and shows higher yield for longer maturity due to the risks associated with the passage of time. D) risk premium. Answer: Corporate finance provides the skills managers need to: (1) identify and select the corporate strategies and individual projects that add value to their firm; and (2) forecast the funding requirements of their company, and devise strategies for acquiring those...... ...different trading strategies of LTCM Why is a yield curve generally positively sloped? The exchange could be goods for goods, goods for service, or goods and services for money. | The theoretically logical and operationally feasible normative goal for guiding financial decision making is | 1. - Segmented Market Theory of the Yield Curve. The fair value measurement of the Collateralized Debt Obligation investment shall be categorized within Level 3 of the fair value hierarchy. Investors demand higher interest when lending their money for longer periods. 1. There are two common explanations for upward sloping yield curves. If you think about it intuitively, if you are lending your money for a longer period of time, you expect to earn a higher compensation for that. C) default premium. • The Impact of Maturity Market value of portfolio= 1MM-0.2023MM=797700 Whereby, if that date was not a business date the preceding date was selected as shown in the table below. | 15 | | ------------------------------------------------- * Australian company tax rate: τc=30% Relationship between risk and rate of return (8-4) 2. 2. | | 5. Humped yield curve: The intermediate yield is higher than both the short-term and long-term yields. Chapter 7: Bond Valuation Risk in a portfolio context (8-3) | The degree of risk reduction for a portfolio depends only on the number of securities in the portfolio | | net shareholder tax=div1-τc*(τP-τC) * Corporate tax rate is 34% * Ultimate decision-making...... ...Chapter 1 Markets, Institutions, and Interest Rates *In addition please review the Cengage assignments & Team application activities that apply to the above chapters. ...Exam 2 Study Guide The normal yield curve has a positive slope. | | FFC measures the derivative at fair value, presenting the portion of the fair value change by using the fair value hierarchy. According to the theory of asset demand, this leads to an increase in interest rate. b. Explain the way in which the default risk and illiquidity premium affect the price of corporate bonds. 3 Macrofoundations of Interest Rates | wealth maximization | | * Franking (imputation) credit: Dividends paid have a credit attached for tax paid by the corporation What is the market predicting about the future of short-term interest rates if the yield curve is: (a) upward sloping, (b) downward sloping, (c) humped? In other words, we want to look at the risk structure of interest rates. 1. | increases as the number of discount periods increases. 39 Lecturer: Such cash ﬂows include the cash ﬂows on assets such as bonds and mortgage-backed securities as well as those for annuity products, life insurance products with interest-rate-sensitive withdrawals, accrued liabilities for deﬁnedbeneﬁt pension funds, and property and casualty liability cash ﬂows. Bond valuation (7-3) Name: 1. Date: | | 2. Generally, a flat curve is temporary in nature and indicates uncertainty in the market place as to what direction the fed will take. Part 2 So rationally, an investor would expect higher compensation (yield), thus giving rise to a normal positively sloped yield curve. • The Impact of the Coupon Chapter 6: Interest Rates $12220 to: Accounting department of family finance co. 2 Bond Arithmetic A yield curve where interest rates on medium-term maturities are higher than rates on both short-and long-term maturities i • The Real Rate of Return ...Memorandum I Instruments with Fixed Payments Short, intermediate, and long term bonds all yield the same. * Legal entity separate from its owners must be legally formed These ideas were pioneered in the actuarial profession by the British actuary Frank Redington (1952). Value of the portfolio= 1003170/1.00352^(11/12)-217727/1.0204^(59/11)=$802797 C) zero coupon bonds. | | 3. Everybody sells the short-term debt in order to buy the long-term debt. - Liquidity Premium Theory of the Yield Curve. The primary investments of FFC are collateralized debt obligation, mortgage-backed securities, auction-rate securities, equity securities in nonpublic companies, interest rate swaps, and a fuel swap for gasoline. | - | | 3. Fixed-Income Securities: * Board of Directors: a. By the end of this chapter, you should be able to: NEW! ------------------------------------------------- from: Daisy 5. * Dividend imputation in Australia (franking credits) On Feb. 1, the two … ABSTRACT These developments extend the concepts of immunization and matching to a stochastic interest rate environment. date: december 15, 2012 | | 3. government vs. corporate), etc. Markets for physical assets（财产，有利条件）: Defi ne present value and the discount rate, and perform calculations relating to the time value of Summary We thought we were coming out of recession. The rates were picked from the current dates (1st January2012) back to five years a go (1st January 2007). ...Chapter 6 Rate The Risk and Term Structure of Interest In the previous section, we have generalized our discussion of the influence of various factors on the behavior in interest rate by examining only a particular type of bonds: namely, the 1-year zero coupon bond. Here's an example. 1 2 Markets are transactions where individuals or organizations exchange items. Humped or Flat yield curve – no one knows what economy will do . This stands true for securities with longer maturities that have greater risk exposure as opposed to short term securities. CHAPTER OUTLINE Defi ne a real rate of return and a yield curve, and evaluate three theories of interest rate Face value of 5-year bond= 0.2023MM*1.479%=217727 Please note that this is only a study guide and should not be taken as the actual content of your second exam. 1. Since the yield spread between on- and off-the-run bonds is very narrow, it is possible to make significant profits only with large positions. | 1 | 1. Problems 5-18 through 5-23 of chapter 5 are related to this topic. • The Impact of Yield Changes This paper surveys the main concepts and techniques of recent developments in the modeling of the term structure of interest rates that are used in the risk management and valuation of interest-rate-dependent cash ﬂows. Short 5-year bond value=$0.2023 MM Bond value when zero-curve shifts up by 1% =$118.1528 * You only pay the amount required to make your total tax rate your personal * Risk Premiums * Bond ratings * Yield Curves: normal, inverse, humped * Three theories of the yield curve: - The Pure-Expectations Theory of the Yield Curve. As a result, there is a different interest rate for each type of bond. determination. Introduction How are Price and Yield of a Bond Calculated? Yield curves are usually upward sloping asymptotically: the longer the maturity, the higher the yield, with diminishing marginal increases (that is, as one moves to the right, the curve flattens out).. Bond value when zero-curve shifts up by 1% = 5/1.015+5/1.0155^2+5/1.0165^3+5/1.0175^4+5/1.02^5+5/1.0225^6+5/1.025^7+105/1.0255^8= $118.1528 * Sole proprietorship * Partnership * Limited liability company * Corporation | * Sole traders * Partnerships * Trusts * Companies | Let's say that on Jan. 2, a two-year note is at 2%, and a 10-year note is at 3%. • Global Indexes These three kinds of yield curve comprise of a normal shaped yield curve, an inverted yield curve and a flat yield curve. MD = -(118.1528-126.4236)/(2*0.01)*(1/122.2018)= 3.3841 a). An Overview of Corporate Finance and What is the definition of Liquidity preference? 1. 3) Other things being equal, an increase in the default risk of corporate bonds shifts the demand curve for corporate bonds to the _____ and the demand curve for Treasury bonds to the _____. v 1 Answer: A parallel shift in the yield curve neither flattens nor steepens the yield curve. ...Working Draft: No Guarantees August 27, 1998 Home page: http: www.stern.nyu.edu ~dbackus when there was a specifiable future date(usually medium-term fixed maturities) by which convergence of offsetting short and long positions in similar instruments should occur. A yield curve is a way to measure bond investors' feelings about risk, and can have a tremendous impact on … Learn vocabulary, terms, and more with flashcards, games, and other study tools. b. 1. | With perfect negative correlation, the risk on a portfolio can be zero if an appropriate allocation of funds is made | 1 | 802797-797700= $5097 increase How does Bond Market Trading Work? | 19 | | 1. 4. Based on the information retrieved from the Board of Governors of the Federal Reserve System on a 1-month business day, the following information concerning historical dairy interest rates on the U.S treasury was obtained. b). | | 4. (122.2018*(1+0.02/360)-118.1528)*100= $405.58 MINI CASE it involves long and short positions of similar instruments. If a firm...... ...Yield Curve and Bond Valuation * Shareholders compute tax at their own tax rate (τp) based on the corporation’s pre-tax income, then subtract the tax paid at the corporate level What is an inverted yield curve/negative yield curve? Delta B/B= -3.3841*0.01+1/2*14.1405*0.01^2= -0.033 | - | | 1. Corporations Determinants of market interest rates (section 6-3) What does the interest rates shape change from 2001 to 2010 mean? 1MM* -0.9968%= 5-year bond value *-4.9271% Analyze the impact of fi xed-income pricing properties on bond prices. What is the Term Structure of Interest Rates? Inverted "Abnormal" Yield Curve: The following analysis for classification of each instrument will be based on SFAS 157, which provides a hierarchy of the three-level inputs to the valuation techniques that can be used to measure fair value. Once the newly issued on-the-run bonds become off-the run, the yields on the two bonds converge and LTCM makes a profit. This creates a rounded or humped curve. A humped yield curve is only a somewhat rare occurrence. Investors demand higher interest when lending their money for longer periods. | sales maximization | | A) left; left B) left; right C) right; right D) right; left ...The Financial Environment: Yield Curve and Bond Valuation | In cases of zero correlations between the assets, risk can be fully eliminated through diversification | | Yields generally tend to move in line with maturity, producing an upward sloping yield curve or a “normal yield curve.” Rarely, however, the yields on the long-term treasuries fall below the yields of short-term treasuries. 2. Bond value when zero-curve shifts down by 1% = 5/1.005+5/1.0055^2+5/1.0065^3+5/1.0075^4+5/1.01^5+5/1.0125^6+5/1.015^7+105/1.0155^8= $126.4236 ------------------------------------------------- Although the price may not completely converge, but the premium tends to narrow over time. A normal yield curve is one in which longer-termed maturities have higher interest rates. A humped yield curve is where yield increases for a range of maturities and then decreases. Key characteristics of bonds (7-2) 3. | | 2. 2.1 Prices and Yields in the US Treasury Market : : : : : : : : : : : : : : : : : 2.2 Replication and Arbitrage : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.3 Day Counts and Accrued Interest : : : : : : : : : : : : : : : : : : : : : : : : 2.4 Other Conventions : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.5 Implementation Issues : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.6 Common Yield Fallacies : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 2.7 Forward Rates optional : : : : : : : : : : : : : : : : : : : : : : : : : : : : (2) Bonds issued by the same agency but have different term to maturity (i.e. Fixed-Income Securities: 4. What can cause an inverted/negative yield curve? An example would be a strategy consists of buying off-the-run high yield bonds and shorting on-the-run low yield bonds. These are markets where tangible（有形的） assets, things you can touch are exchanged for money. Studies have shown that there have been three factors that affect Treasury returns: (1) change in the level of yield, (2) changes in the slope of the yield curve, and (3) changes in the curvature of the yield curve. 4) An increase in the riskiness of corporate bonds will _____ the yield on corporate bonds and _____ the yield on Treasury securities. 2. * Personal tax rate on dividend income is 15% | 12 | 3 | Humped yield curves are a sign of economic transition, and could indicate slowed economic growth. Humped Yield Curve: Definition. Implications for corporate managers & investors (8-6) Interest rates have long been recognized as important to the risk management of insurance liabilities. 1. I will do so by explaining the importance of understanding the term structure, as well as the three theories that support the term structure; the expectations theory, the segmented markets theory, and the liquidity premium theory. CONTENTS | | | 1. Why is corporate finance important to all managers? 4. C) As their relative riskiness increases, the expected return on corporate bonds decreases relative to the expected return on default-free bonds. There are a number of factors that affect the risk level of a bond. Relative value strategy : It is a spread trade and it involves two assets whose prices or yields tend to converge with time . According to Hubbard and O’Brien, the term structure “is the relationship among the interest rates on bonds that are otherwise similar but have different maturities.” Term structure is most commonly analyzed by looking at the Treasury yield curve, which is the relationship of interest rates on Treasury bonds with different maturities on a particular day. Principles of Finance BS120 Tutorial Week 4: Topic Risk and Term-Structure of Interest Rates Issues Considered * Risk-free Rate. Here the loans are used mainly to manage cash in a corporation. Practice problems: 7-1, 7-2, 7-3, 7-4, 7-5, 7-8, 7-9, 7-16 A yield curve where interest rates on medium-term maturities are higher than rates on both short-and long-term maturities: Term "Normal" Yield Curve: Definition. 4.1 Price and Yield : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.2 More on Duration : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.3 Immunization : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.4 Convexity optional : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 4.5 Fixed Income Funds : : : : : : : : : : : : : : : : :...... ...maturities can have different interest rates. An upward-sloping yield curve: Term. | Question | Options | Answer | If interest rates have been high but are expected to drop. Be sure you know how to calculate any given components with given supporting information. Plot a yield curve based on these data. 2. | 1. These are markets where financial assets sold and bought. The annual payments are $6,202.70. 6. 5. C. inflation is expected to rise in the future. Family Finance Co. (FFC), a publicly traded commercial bank, invests in a variety of securities in order to enhance returns greater than interest paid on bank deposits and other liabilities. money, bond pricing and yield. Long-term bonds yield more than intermediate and short-term bonds. • Calculating the Current Yield on a Bond * Company earning for $1 dividend income: gross dividend=div1-tc Andrew Ang* and Michael Sherris† B. interest rates are expected to fall. Assume that you recently graduated with a degree in finance and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer Inc. One of the firm’s clients is Michelle Dellatorre, a professional tennis player who has just come to the United States from Chile. 1.1 Overview : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : 1.2 The Instruments : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : Traditional approaches to risk management and valuation are based on the concepts of immunization and matching of cash ﬂows. 100 bonds Flat Yield Curve: Flat yield curves exist when shorter and longer-term yield rates are very close to one another. franking credit=gross div-div=div1-τc*τc c). D) The expected return on corporate bonds decreases as default risk increases. This is the most common shape for the curve and, therefore, is referred to as the normal curve. Downward sloping C. Horizontal D. Humped 6-16 Chapter 06 - Working Capital and the Financing Decision 96. This is a simple strategy and not necessarily a risky trade since it is very likely that the yields will converge once the on-the-run bonds become off-the-run. LTCM engaged in primarily in convergence and relative value strategies. Examples of financial assets include stocks （股票，存货）and bonds（债券）. Pricing and Trading Dellatorre is also very bright, and, therefore, she would like to understand, in general terms, what will happen to her money. The "Liquidity preference". Your boss has developed the following set of questions which you must ask and answer to explain the U.S. financial system to Dellatorre. | - | | | | 3. We will look at the behavior of interest rates of two groups of bonds: (1) Bonds with the same features but are issued by different agency. © CSI GLOBAL 7•2 EDUCATION INC. (2011) 7) An increase in the liquidity of corporate bonds will _____ the price of corporate bonds and _____ the yield of Treasury bonds. | | 4. • Clearing and Settlement You When the yield curve is flat, then it generally indicates a slow down in the economy so investors are not being compensated for the risk of taking on longer term bonds. As this happens, prices on long-term debt rise (yields drop) and prices on short term debt plummet (yields rise). | | 2. Instrument 1 —Collateralized Debt Obligation Start studying Finance Chapter 6 terms. 3. | | 5. What are Bond Indexes? | | (What are investors expectations?) Contents Question 1 and 2 Assessing a bond’s risk (7-7) $12220 This often happens when a company has more than one holding company listed in different markets (e.g. | | 5. 3. Essay. Flat (Humped) Yield Curve. However, the yield curve can be inverted and downward-sloping if the economy is expected to slow or a recession is imminent. Practice problems: 8-1, 8-3, 8-4, 8-6, 8-7, 8-11, 8-12, 8-14 • The Relationship Between Bond Prices and Interest Rates In other words, investors need to be compensated with a higher return (in the form of higher interest rate) in order to induce them to hold the assets. | Which of the following statements is true? In this section, we will focus on only 3 of them: default risk, liquidity, and...... ...© CSI GLOBAL EDUCATION INC. (2011) 7•1 The higher the relative risk level, the lower the demand of that asset. The reason for that is that debt issued for a longer term generally carries greater risk because of the greater likelihood of inflation or default in the long run. Corporate Ownership versus Control Bond value = 5/1.01+5/1.0105^2+5/1.0115^3+5/1.0125^4+5/1.015^5+5/1.0175^6+5/1.02^7+105/1.0205^8 = $ 122.2018 | increases as the discount rate increases. Preface 1 Debt Instruments By buying a financial asset you become an owner of a company or a lender to one. Bond yields or interest rates are plotted against X-axis while time horizons are plotted on Y-Axis. According to a class lecture, six times when the yield curve became inverted, there was an economic recession. What are Bond-Switching Strategies? Since this part of the course deals with different types of markets, let us start by defining what these markets are. 8 A yield curve is typically upward sloping; as the time to maturity increases, so does the associated interest rate. Yield Curve. Repo dealer In other words, we want to look at the term structure of interest rates. Possibly because personally I’m a bit deep into bonds, not many would agree with the second part though. What are markets in general? Whenever you exchange something for another you have a market. The time to maturity is smaller. | profit maximization | 2 | 2. | | 4. 3. 9 In other words, it is cheaper to borrow short-term or long-term than it is to borrow intermediate-term. © CSI GLOBAL EDUCATION INC. (2011) 7•3 Find GCSE resources for every subject. E) All of the above are true statements. Four Types of Firms US | Four Types of Firms AUS | The different yields currently available on debt securities of similar credit quality according to their term-to-maturity, typically represented graphically. Market Financial assets are intangible. Because the interest rates do not change in the same amount of percentages, the yield curve is steeper. | | 3. | All of the above | | In order to buy the long-term debt rise ( yields drop ) prices... Curvy—When the difference between yields on long-term debt curves exist when shorter and longer-term yield rates plotted., bonds issued by different parties ( i.e loan from an industrial company! Financial assets: these are markets where financial assets sold and bought 30-year... And the discount rate, and could indicate slowed economic growth % per... Value, presenting the portion of the above | | 3 s risk ( )... 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