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Session 7

1) The document discusses how to value different types of contractual claims such as fixed-rate bonds and floating rate bonds. Fixed-rate bonds can be valued by discounting the fixed coupon payments and face value at the risk-free rate. 2) Default risk is also discussed, and how it affects bond valuations. To account for default risk, the discount rate used is increased by a default spread proportionate to the credit rating of the bond issuer. 3) Other factors like bond maturity and coupon rate that impact the sensitivity of bond prices to interest rate changes are examined through pricing propositions. Longer maturity and lower coupon bonds are more sensitive to interest rate movements.

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15 views

Session 7

1) The document discusses how to value different types of contractual claims such as fixed-rate bonds and floating rate bonds. Fixed-rate bonds can be valued by discounting the fixed coupon payments and face value at the risk-free rate. 2) Default risk is also discussed, and how it affects bond valuations. To account for default risk, the discount rate used is increased by a default spread proportionate to the credit rating of the bond issuer. 3) Other factors like bond maturity and coupon rate that impact the sensitivity of bond prices to interest rate changes are examined through pricing propositions. Longer maturity and lower coupon bonds are more sensitive to interest rate movements.

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spamxacc7
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
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SESSION 7: VALUING A

CONTRACTUAL CLAIM (BONDS)


The nature of contractual claims

¨ A contractual claim cash flow is set at the time a


contract or transaction is initiated, with the promisor
committing to deliver that cash flow at the specified
time.
¨ The cash flow that is contracted can be a constant
cash flow or it can be tied to an observable and
specific index or value.
¤ An example of the first would be a conventional fixed rate
coupon bond
¤ An example of the second would be a floating rate bond.

2
The Effect of Default

¨ Even though a claim is contractually set, there is the


possibility that the promisor may default.
¨ If the promisor has no default risk, the claim is said
to be a risk free claim.
¤ The only entities that can conceivable by default free are
governments that control the printing of currency.
¤ Not all governments are default free.

¨ If there is default risk, you have to adjust for the


likelihood of default, when valuing the claim.

3
A fixed rate, risk free bond

¨ To value a fixed rate, risk free bond (issued by a government


that is default free), you will discount the coupons (which are
annuity) and the face value of the bond at the risk free rate.
¨ Thus, if you view the US government as default free, the
value of 3% coupon rate, US treasury bond with ten years to
maturity, if the US$ risk free rate today for a 10-year bond is
2% can be written as follows:
Price of the Bond = 30* PV(A,10,2%) + 1000/1.0210 =$1089.83
¨ This bond is trading at above par (with the face value of
$1000 defined as par) because the market interest rate is
lower than the coupon rate.

4
The Yield to Maturity and Yield on a Bond

¨ If you have the price for a bond, you can solve for the interest
rate that would make the present value of the coupons and
face value equal to the price of the bond. That IRR is called
the yield to maturity on the bond. Thus, if you had been told
that the price of the 10-year, 3% coupon bond was $1043.76,
you could have solved for the interest rate.
1043.76= 30* PV(A,10,r) + 1000/(1+r)10 YTM = 2.50%
¨ The yield on the bond is a related but less involved concept,
estimated by dividing the coupon by the price of the bond. In
the case of this bond, the yield for the bond is:
Bond Yield = Coupon/Price of Bond = 30/1043.76 = 2.87%

5
Bond Convexity

¨ Let’s go back to the 3% coupon, 10-year bond that we


valued at $1043.76.
Price of the Bond = 30* PV(A,10,2.5%) + 1000/1.02510 =$1043.76
¨ If the market interest rate rises from 2.5% to 3.5%.
Price of the Bond = 30* PV(A,10,3.5%) + 1000/1.03510 =$958.41
Percentage change in price = -8.18%
¨ If the market interest rate falls from 2.5% to 1.5%.
Price of the Bond = 30* PV(A,10,1.5%) + 1000/1.01510 =$1138.33
Percentage change in price = +9.06%
¨ This asymmetric response to interest rate changes is
called convexity.

6
Bond Pricing Proposition 1

¨ The longer the maturity of a bond, the more


sensitive it is to changes in interest rates.
Bond Maturity and Price Change in Percent (for a 1% up and a 1% down
movement)

30%
% Change in 3%, 10 year bond priced at a 2.5% rate

25%

20%

15%

10%

5%

0%
1 5 10 30
-5%

-10%

-15%

-20%
Bond Maturity

Rate up to 3.5% Rate down to 1.5%

7
Bond Pricing Proposition 2

¨ The lower the coupon rate on the bond, the more


sensitive it is to changes in interest rates.
Bond Coupon and Price Change in Percent (for a 1% up and a 1% down movement)
15%
% Change in 3%, 10 year bond priced at a 2.5% rate

10%

5%

0%
0% 1% 2% 3% 4% 5%

-5%

-10%

-15%
Bond Coupon Rate

Rate up to 3.5% Rate down to 1.5%


8
Default Risk

¨ When a fixed rate bond (or loan) is issued by an


entity with default risk, there is a likelihood that you
will not get your promised coupon or principal
payments.
¨ The risk that you will not be paid your contractually
due payments is called default or credit risk.
¨ To compensate for this risk, you (as the lender) have
to charge a higher interest rate on the bond, with
the addition being called the default spread:
¤ Default-risk adjusted rate = Risk free rate + Default Spread
9
Default Risk and Default Spreads

Default Spreads for 10-year Corporate Bonds: 2015 thru 2017


25.00%

20.00%

15.00%
Axis Title

10.00%

5.00%

0.00%
Baa2/BB
Aaa/AAA Aa2/AA A1/A+ A2/A A3/A- Ba1/BB+ Ba2/BB B1/B+ B2/B B3/B- Caa/CCC Ca2/CC C2/C D2/D
B
Spread: 2017 0.60% 0.80% 1.00% 1.10% 1.25% 1.60% 2.50% 3.00% 3.75% 4.50% 5.50% 6.50% 8.00% 10.50% 14.00%
Spread: 2016 0.75% 1.00% 1.10% 1.25% 1.75% 2.25% 3.25% 4.25% 5.50% 6.50% 7.50% 9.00% 12.00% 16.00% 20.00%
Spread: 2015 0.40% 0.70% 0.90% 1.00% 1.20% 1.75% 2.75% 3.25% 4.00% 5.00% 6.00% 7.00% 8.00% 10.00% 12.00%

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Pricing a bond with default risk

¨ To price a bond with default risk, we discount the


promised cash flows (coupons and face value) and
discount back at a rate that includes the default
spread.
¨ Thus, the value of a BBB-rated 3% coupon rate, 10-
year corporate bond in January 2017, when the risk
free rate was 2.5% and the default spread on the
bond was 1.75% would have been:
Price of Bond = 30* PV(A,10,4.25%) + 1000/1.042510 =$899.87

11
Changing Default Risk

¨ If the price of a bond is lower for a firm with more


default risk, it should come as no surprise that the
prices for corporate bonds issued by firms that slip
into distress will drop, even if overall market interest
rates don’t change.
¨ Bonds with ratings below BBB are considered below
investment grade and bonds in the lower ratings
classes are classified as “high yield” bonds.

12
Pricing Floating Rate Bonds

¨ A floating rate bond where the interest rate is reset


to the market interest rate each period should trade
at par.
¨ In general, even if the interest rate reset is not
perfect, floating rate bonds should trade much
closer to par than otherwise similar fixed rate bonds.

13

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