adms 4504 - lecture 1, part 1
TRANSCRIPT
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Week 1 (Part I)
Features of DebtSecurities
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Plan of the lecture
Some basic features of a bond
Coupon rate structures
Floating rate securities
Accrued interest
Options embedded in a bond Borrow funds to purchase bonds (repo)
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Basic features of a bond
Bonds can have anypar value The market practice is to quote the price of a
bond as a percentageof its par value
Example: Suppose a bond has a par value of$1,000
If the bond sells at $1,000, the bond price isquoted as 100, i.e., 100% of par value
If the bond price is $950, the bond is said to beselling at 95,i.e., 95% of par value
And if the bond price is $1,050, the bond is tradingat 105, i.e., 105% of par value
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Basic features of a bond
A bond is said to be trading at adiscountif it sells belowits par value, e.g., at 95
A bond is trading at parif it sells atits parvalue, i.e., at 100
A bond is said to be trading at a premiumif it sells aboveits par value, e.g., at 105
A bond sells above or below its par valuedepending on the levels of interest rates
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Basic features of a bond
In the United States, when computing thedollar price of a bond, we first compute theprice per US$1 of par value, which is thenmultiplied by the bond par valueto get thedollar priceof the bond
Quoted price Price per US$1 of par value Par value Dollar price
(1) (2) (3) (4) = (2) (3)86 1/4 0.86250 $50,000 $43,125
110 3/8 1.10375 $200,000 $220,750
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Coupon rate structures
Couponis the annualinterestpayment made to abondholder
Coupon rate(also known as nominal rate) is anannualrate
The coupon rate is specified for a bond, along with itsmaturity date Example: 5s of 12/16/2015 means the coupon rate is 5%
In both Canada and the U.S., bonds typically pay coupons in
two equal semiannualinstallments
125$500,2$%5
500,2$%,5
coupon
valueparratecoupon:Example
valueparratecouponCoupon
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Coupon rate structures
Step up notes (continued) Multiple step up note: where there are
multiple (i.e., more than one) increases in thecoupon rate
Example: A three year bond has the followingcoupon schedule
5% from 1/1/2012 to 12/31/2012
5.25% from 1/1/2013 to 12/31/2013
5.60% from 1/1/2014 to 12/31/2014
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Coupon rate structures
Deferred coupon bonds
Bonds whose interest payments are deferredfor several years, i.e., nointerest paymentduring the deferred period
At the end of the deferred period, the issuerpays higher periodic interests (than that
would otherwise have been paid) to thebondholder as a compensation
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Floating rate securities
The quoted marginis the additionalamount paid above the reference rate
Example: The coupon formula is
A basis pointis 0.01% or 0.0001 So 100 basis points = 1%, 120 basis points = 1.2%
etc.
Suppose the U.S. Treasury bill rate is 4%, thenthe coupon rate = 4% + 1.2% = 5.2%
Coupon rate = U.S. Treasury bill rate + 120 basispoints
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Floating rate securities
The quoted margin could be a negativevalue
Example: The coupon formula is
Suppose the U.S. AAA rate is 5%, then the
coupon rate = 5% - 0.6% = 4.4%
Coupon rate = U.S. AAA rate -60 basispoints
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Floating rate securities
Capsand floors A capis the maximumcoupon rate paid on a
floater
Example: The coupon formula is
and the cap is 10%
Suppose the reference rate is 8.5%, then thecoupon rate is 10%, not10.5% (= 8.5% + 2%)
Coupon rate = reference rate + 200 basis points
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Floating rate securities
Caps and floors (continued) A flooris the minimumcoupon rate paid on a
floater
Example: The coupon formula is
and the floor is 3%
Suppose the reference rate is 3.25%, then thecoupon rate is 3%, not2.75% (= 3.25% - 0.5%)
Coupon rate = reference rate -50 basis points
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In-class exercise 1 Fill in the table below. The coupon
formula is: reference rate + 60 basis pointswith a capof 5.50%
Reference rate Coupon rate
First reset date 4.50% ?
Second reset date 5.00% ?
Third reset date 4.85% ?
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In-class exercise 2 Fill in the table below. The coupon
formula is: reference rate + 25 basis pointswith a floorof 2.75%
Reference rate Coupon rateFirst reset date 3.00% ?Second reset date 2.80% ?
Third reset date 2.25% ?
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Floating rate securities
Inverse floater(or reverse floater) Floating rate securities where the coupon rate
moves in the oppositedirection from thereference rate
The coupon formula is:
where Kand Lare fixed values
Example: Suppose Kis 25%, Lis 2.5, the reference
rate is 8%, then the coupon rate is 25% - 2.5 8% =5%
A cap and/or floor can be imposed on an inversefloater
Coupon rate = KL (reference rate)
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Accrued interest
Accrued interestis the interest earned by thebond seller between the last coupon paymentdateand the bond settlement date
Lastcouponpayment
date
(A)
Settlement date(B)
Nextcoupon
paymentdate
(C)
Accrued interest earnedby the seller
Interest earned by the buyer
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Embedded options
Options beneficial to issuers include: The right to call(i.e., repurchase) a bond at a
specified call price Call risk
Theright to prepayprincipal above thescheduled principal payment on, e.g., mortgagebacked securities Prepayment risk
And the capon a floater
Bondholders do notlike these options. Sowhat would happen to the bond price?
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Embedded options
Options beneficialto lendersinclude: The right to put(i.e., sell back) a bond at a
specified put price
The right to convertor exchangea bond for anumber of common shares
Convertible bonds
And the flooron a floater
Embedded options can significantly impactthe bond prices, as we will see in laterchapters
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Borrow funds to
purchase bonds
The investor(A)
Sellssecurities
Receives
cash
Buys back thesame securities
Pays (a higher)
repurchase priceincluding reporate
Time 0 Time 1
Repurchase agreement(repo)
The
Buyer(B)
The
Buyer(B)
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Repo
Repo is a collateralizedloanbetween theinvestor (A) and the buyer (B): A effectivelyuses securities as collateralto borrowfunds from B to finance her purchase of
some other assets Overnight repo: the term of the loan is one
day
Term repo: the term of the loan is more thanone day
The interest rate on the loan is called therepo rate
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Repo
General collateral repo rate
Special repo rate
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Repo
Repo (from the investor (A)s perspective):agrees to sell the securities and buy themback, i.e., borrow funds
Reverse repo (from the buyer (B)sperspective): agrees to buy the securitiesfirst and sell them back later, i.e., make aloan
Repo is primarily for institutional investorsto meet their short term financing needs
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Repo
Example: How much does a mutual fundneed to pay back an investment bank on a
14 day $94.8 million 3% repo loan?
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million9106.94$)360
14%31(million8.94$