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Opportunity Cost/Time Value of Money

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Presentation on theme: "Opportunity Cost/Time Value of Money"— Presentation transcript:

1 Opportunity Cost/Time Value of Money
Opportunity cost -- value forgone for something else. Example: Suppose a bank would pay 3.5%/year but you decide to keep $10,000 in your mattress. Opportunity cost of keeping in mattress as opposed to the bank is $350/yr. Time value of money -- because of “time preference ffffor consumption” There is a time value of money even if no inflation. Inflation just makes it more pronounced.

2 Future Value Future value (FV) of a dollar amount (PV) is where
r is the amount of interest per period n is the number of compounding periods Compounding period can be any length of time: day, month, quarter, every 6 months, year, etc. Hard part is in getting r and n right.

3 Legend has it that Lenape Indians sold Manhattan Island to the Dutch for $24 in 1626.

4 $24 compounded over 388 years
Example 1 If the Lenape could have invested the $24 at X%, how much would they have today? $24 compounded over 388 years Excel formula for monthly at 6% : =24*( /12)^(12*388)

5 Present value (PV) of a sum expected at a future time is
where r is the discount rate per period n is the number of compounding periods Greater the discount rate, the smaller the present value.

6 Example 2 How much should US Treasury charge for a 10-year $5,000 Savings Bond if designed to earn 4.2% per annum? How much should US Treasury charge for the same bond if designed to earn 2.1% semi-annually?

7 Example 3 What is the maximum you would pay for a financial claim that pays $120,000 four years from now, if you could otherwise place your money in a bank that pays 4.00% compounded monthly?

8 Example 3 What is the maximum you would pay for a financial claim that pays $120,000 four years from now, if you could otherwise place your money in a bank that pays 4.00% compounded monthly? Wouldn’t pay more than what would grow to $120,000 at bank = 120,000 / (( /12)^48) = 102,284.47

9 Annuities When same amount is paid at end of each period, with first payment one period from now, the series is an ordinary annuity whose PV is given by where A = amount of each payment r = appropriate discount rate per period n = total number of periods (n must be integer) Annuity due is when first payment is now.

10 Example 4 Suppose an investor receives $10,000 on this date for the next 8 years, with first payment one year from now. Assume 9% per annum is the appropriate discount rate. What is the PV of this annuity? 10/10

11 2014 Federal Income Tax Rate Schedules
single married, filing jointly

12 Single with Taxable Income = 60,000
What is 2014 FedTax?

13 Example 5 You win $1 million lottery (annuitized, $50,000/yr for 20 years). How much will you bring home if you select lump sum payment? Assume 6% per annum discount rate.

14 What is a Bond? Borrower (issuer) promises to make periodic payments (called coupon payments) to bondholder over a given number of years. At maturity, bondholder receives last coupon payment and principal (face value or par value). Coupon payments are determined by the coupon rate. Coupon rates are specified as a percentage of par.

15 How Bonds Are Expressed
Example: Baa2 Valero Energy 6.625% ’ where Baa rating 6.625% coupon rate (most likely paid in two installments) ’ year of maturity price as a percent of par 7.652% yield-to-maturity Most Treasury and corporate bonds make coupon payments twice per year (semiannually)

16 How to Compute the PB of a Bond.
Compute the PV of each of the bond’s cash flows and sum. Discount rate is ascertained from yields on similar bonds. (discount rate and coupon rate are not to be confused). If price of bond (PB) is below face value, called a discount bond. If above face value, called a premium bond.

17 Bond Pricing Notation C = amount of each coupon payment
r = appropriate discount rate per period n = total number of periods F = principal, face value, par When first coupon payment is one period from now, this is formula

18 Example 6 (Time Line Way)
What is the PB of a $1,000 bond that has just made a coupon payment, has 2 years to maturity, pays interest semiannually, and has a coupon rate of 6%? Assume is rarely traded, but similar bonds yield 7%.

19 Example 6 (Using Annuity Formula)
What is the PB of a $1,000 bond that has just made a coupon payment, has 2 years to maturity, pays interest semiannually, and has a coupon rate of 6%? Assume is rarely traded, but similar bonds yield 7%. What would $150 million in face value of these bonds cost? 10/15

20 Outstanding US MM & Bond Market Debt
(in trillions) Outstanding 2013 Issuance Ave Daily Trading Volume Municipal 3.671 0.335 0.012 US Treasury 11.854 2.140 0.545 Mortgage Related 8.803 1.965 0.228 Corporate 7.451 1.384 0.018 Agency Securities 2.058 0.396 0.010 Asset-Backed 1.280 0.188 0.002 Money Market 2.714 n/a TOTAL 38.832 6.408 - AVERAGE 0.809 Total marketcap of all listed US stocks ≈ trillion 2013 US IPO volume = trillion Ave daily US stock trading volume (all exchanges) ≈ 5 billion shares

21 Example 7 From the table, approximately:
How many times does US Treasury debt turnover per year? What’s ave time to maturity of corporate bonds? What’s ave time to maturity of mortgage related debt?

22 US IPO Volume (so far)

23 Example 8: Zero Coupon Bond
Since there is no C, customary formula is where n is double the number of years. Do semiannual compounding when pricing a zero coupon bond. What is price of a $1,000 zero coupon bond that matures in 15 years if it is to yield 9.4%?

24 Example 9 As of today, what is the value of a $5, % bond (coupon payments made semi-annually) that matures 5 months from now assuming yield to use is 5.8%?

25 Fixed Income Securities
Fixed income securities – pay a return according to a fixed formula. Although payment amounts can vary, formula is known in advance. Fixed income securities generally carry lower returns because of their guaranteed income characteristics. Generally used by people for income purposes rather than for capital appreciation (as in stock market).

26 Example 10: A Distressed Bond
A company trying to emerge from bankruptcy arranges with the holders of its 8.0% bonds (par $1,000) that mature on July 1, 2020 the following: coupon payments will restart on 1/1/16 but at half the coupon rate. will pay full rate starting on 1/1/18 until bond matures. For what value should this bond be listed on a 10/15/14 balance sheet if discount rate to apply is 10%? 10/17

27 Example 11: A U.S. Treasury In 1985 the US Treasury issued a 30-year bond with a coupon rate of 11.25% that matures on 2/15/15. A bank made an error with this bond on its 10/15/12 balance sheet. Using a discount rate of 2.6%, what value should the bank have used for this bond on that balance sheet?

28 Example 12: Accrued Interest
Clean price, Dirty price. Full price also known as “dirty price”. Clean Price = Full Price – Accrued Interest Accrued Interest = days since last coupon payment coupon payment x days in coupon period What is accrued interest on a 5% $1000 bond if 181 days in coupon period and last coupon payment was 136 days ago?

29 Example 13: Saw-Tooth Pattern
When buy a bond, what you pay is full price. But clean price is what is reported in the media. Clean Price + Accrued Interest = Full Price Full price has a saw-tooth pattern. Clean price smoothes this out. Plot saw-tooth pattern of the full price of a 3-year 6% bond (semi-annual payments) yielding 6%. Bond price and yield inversely related 29

30 What is one day’s accrued interest on this purchase?
Example 14: Full Price Suppose an 8% $1,000 bond (next semi-annual coupon payment on Feb 14, 2015) is quoted in the media at As of 10/21/14, how much would 2000 of them cost? What is one day’s accrued interest on this purchase? 30

31 Example 15: Clean Price Assume a 5% bond whose next semiannual coupon payment is on 11/1/14, and that on 10/17/14 someone paid $ for the bond. What clean price corresponds to this sale assuming 184 days in current coupon period?

32 Example 16: 3 In-class Exercises

33 When Full Price = Clean Price
When no interest has accrued Clean Price = Full Price Can happen: At absolute beginning of a coupon period Zero coupon situation Coupon payments have been suspended

34 All trial-and-error “number crunching” calculations
Three Bond Yields Yield-to-maturity. Assumes Issuer makes all payments as promised Coupon payments are reinvested at the rate that the bond yielded when purchased Investor holds bond to maturity Realized yield. An ex post calculation of the bond’s yield while holding it. For instance, holder sells a bond before maturity. Expected yield. An ex ante calculation of a bond’s expected yield based upon anticipated cash flows. All trial-and-error “number crunching” calculations

35 Example 17: Yield-to-Maturity
Yield-to-maturity. The annual rate that causes all cash flows to discount back to the bond’s market price. Solve by trial-and-error. What is the yield-to-maturity on a 12-year, 8% coupon bond (semi-annual payments) whose price is $1,097.37? Find r-value that fits. 25 terms (lot of work). Then double to obtain yield-to-maturity answer.

36 Example 17: (con’t) Easier if we employ annuity formula. Only 2 terms.

37 Example 18: Realized Yield
Realized yield. Rate that causes all cash flows to discount back to the purchase price. What did bond project yield (annual rate) now that it is over? Paid $995 for a new 6% coupon bond (semi-annual payments). Sold after 3 years for $1,068 (minutes after coupon payment). What was realized yield? Principle: If trial r makes RHS too low, decrease r If trial r makes RHS too high, increase r

38 Example 19: Expected Yield Calculation
Expected yield -- the discount rate that causes the sum of the PV’s of all expected cash flows to equal purchase price. Solve by trial-and-error. Let’s do 6-month clock version of prob on p. 148 in book: Purchased a new 8% 10-yr, semiannual coupon payment bond at par. Plan to sell in 2 yrs when bond expected to yield 6% (at which point PB = 1,126) . What is project’s expected yield?

39 Price-Time to Maturity Relationship
When bond’s yield differs from coupon rate, price of bond moves toward par as time to maturity decreases. 20 850.61 18 855.01 16 860.52 14 867.44 12 876.11 10 887.00 8 900.65 6 917.77 4 939.25 2 966.20

40 Convexity of Price-Yield Curve
Bond prices goes up if its yield goes down, and vice versa. “Bowed” shape of curve is known as convexity. 0.05 0.06 0.07 0.08 0.09 0.1 0.11 920.37 0.12 850.61 0.13 789.26 0.14 735.07 0.15 687.03 0.16 644.27

41 Bond Theorems A bond’s price is inversely related to its yield.
The longer the time to maturity, the greater the bond’s volatility (the more sensitive the PV of the bond is to yield rates). The lower the coupon rate, the greater the bond’s volatility.

42 Price-Yield Relationship

43 Risks Faced by Holder of a Bond
Credit or default risk. Interest rate risk. Two components: Reinvestment risk (chance lender will not be able to reinvest coupon payments at yield-to-maturity in effect at time instrument was purchased) Price risk (chance interest rates will change thereby affecting price of the bond) Recall 11.25% Treasury of Example 11. Say bond yielded 11.35% when bought. But now coupon payments can only be reinvested at about 1%. (Was discount bond when issued, now premium bond). a) and b) offset one another. Duration is the number of years from now at which a) and b) exactly counterbalance one another. 10/29 43

44 Duration Duration is given by a time-weighted average of a bond’s cash flows over price of bond. Formula for duration is D is expressed in years.

45 Example 20 Assume 1-yr clock. With 4 years to maturity and annual coupon payments, what are the durations of (4% coupon rate, 5% required yield)? (4% coupon rate, 10% required yield)? (8% coupon rate, 10% required yield)?

46 Duration Properties D is sum of discounted time-weighted cashflows divided by PB (with time measured in years) Higher coupon rates mean shorter duration D of a zero coupon bond is time to maturity. The greater the required yield, the less the duration. Longer maturities generally mean longer durations.

47 Example 21: Bond Price Volatility
In the following, i is yield in percent per year Consider a 20-year, 5% bond (annual payments) yielding 4.5% whose D = If interest rates change causing yield to rise 75 basis points, what happens to price of bond? Correcting for convexity, actual change in price of bond is a little less (next slide).

48 Things for Sure To Know for Exam …
Everything on slides of Modules 2.3, 2.4, 2.5 until this slide How to price a zero coupon corporate or US Treasury bond – semiannually Names of items on both sides of balance sheet of Module 2.3, slide 18 Know the 5 indicated items of a bond quote as in Module 2.5, slide 15 Names of 7 categories of US debt on Module 2.5, slide 20 Monday 2:30 to 4:00pm accessibility. Good to send .

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