Presentation on theme: "Factors Affecting bond Yields and the Term structure of interest Rates"— Presentation transcript:
1 Factors Affecting bond Yields and the Term structure of interest Rates Base interest rate., benchmark interest rate or the minimum interest rate investors demand in the US treasury market. This yield is refereed to “on the run” yield.Risk premiumMarket sectors (types of issuers)Default riskImbedded optionsTaxability of the interestLiquidity and term to maturity of the issue
2 Yield Curves Why we should not use the yield curve to price a bond? The yield curve is a snap shot of yields for various maturities, cetris paribus, however other things does not remain the same. Just look at the treasury market.Treasury spot definition and derivationForward rateCoupon stripping an arbitrage example:Forward rate as a hedgeable rate
7 Determinants of the Shape of the Term structure Expectation theory: the forward rates is the market best unbiased expectation of future interest rates.For example, expectation of falling short term future rate would affect the responsiveness of the various market participants, thus creating an inverted yield curve.Suppose that subsequent economic news leads market participants to expect interest rate to fall in the near future assuming initial flat term structure.Speculators expecting fall in interest rate would anticipate a rise in price of long term bonds and would want to buy long term bonds, bidding their price higher and their yield down.
8 Expectation Theory1: Borrower wishing to borrow now , may be induced to wait and postpone their borrowing at a later date when it will be less expensive.2: Those market participant interested in the long end of the market would want to buy long term bond now for expectation of capital gain in near future as rates start to fall.3: All these responses would tend to derive the price of long term bond higher and their yield lower
9 4: The actions of borrower, speculators and investors tend to derive short term rates higher and long term rates lower. Expectation theory fails to recognize that bonds of different maturities are not perfect substitute. The future interest rate is unknown and price is unpredictable over differing horizon resulting in unknown future return.5: There are price risk and reinvestment rate risk, which expectation theory ignores.
10 Liquidity theoryForward rate should embody a premium for risk ( liquidity) premium for long term bond which has greater price volatility as compared to short term bond.Preferred habitat Theory:The term structure reflect future interest rate as well as risk premium which is not expected to uniformly rise over maturity horizonMarket segmentation Theory: supply and demand in each sector will determine the shape of the yield curve.
11 Quotes on treasury Bills Quotes on Bank Discount Basis: bids and offer quotes are different for T/bills and treasury securities. The yield on bank discount basis is as follows:Y=D/F * 360/t, where D is discount, F is face value and t is the time to expiration.CD equivalent yield=360Y/360-t.YDealers profit in treasury market:Bid/ask spread, appreciation(Dep) on long and short position and cost of carry ( the difference Between the interest earned in the long position and interest paid on the short position.
13 PRISMPRISM, core credit risk management model used in the banking system.Perspective,Repayment,Intention,Safeguard,Management
14 The PRISM looks at the big picture of what the borrower is all about, including history and prospect Management, is like contours of decision tree: solution in one sector leads to solutions further along…Intention, what is the purpose of the loan? The purpose serves the basis for repayment.Repayment, focuses on external and internal sources of fund. Conversion of short term assets in the balance sheet provides the means for repayment of short term debts, while long term debts are serviced from internally generated cash flow.Safeguard, internal safeguard originates from the soundness of financial statements, while collateral and guarantees provide external safeguards..Perspective, provides the deal’s risk and reward and operating and financial strategies to create value for the shareholders, while enabling the borrower to repay the loans.
15 PRISM: ManagementBusiness operationManagementBank relationshipFinancial reportingNumber of years the firm has been in businessThe firm reputation and performance record,The firm ability and willingness to pay,business longevity
16 Company information:Changes in capital structure, any predecessor company,Present capitalization, any insolvencyDescription of products: markets, principal customers, subsidiaries, and line of business.Technological innovation and recent product change.Customers growth, ecological problems, availability of supplies.List of principal suppliers, any delinquenciesMarket segmentation by customer types, geography, distribution channel, pricing policy, and degree of integration.Strategic goals and company’s track record for meeting and or missing goals.Number and types of customers broken down in percentage of the sale/profit.Government contractsCapital equipments requirements and commitments
17 Industry information Industry composition and any recent changes # of firms in the industryProducts and services compared to industryBorrower’s market share and trendRecent merger and acquisitionsRecent foreign entrantsRate of business failure in the industryIndustry’s average bond ratingDegree of operating leverage/financial leverageAdverse conditions reported by analyst for the industryIf publicly traded, which exchange the borrower’s stock tradedThe effect of government regulation on the industry
18 Management Information Banks need to know to whom they are granting creditRatio of management salaries to net revenueThe reputation of management in mitigating various problemsManagement basic philosophyList of directors, their longevity# of people employed and extent of their activitiesMission statementAdequacy of information system, control, and risk management.
19 Financial reporting Secure tax return for the last five years Secure audited financial statementsSecure un-audited quarterly statementAsk client to submit projected financial and operating statementsCheck bank records for the client.
20 Accounting watch listObsolete inventories, or contingent liabilities, hiding operating cost to increase earnings per share (Worldcom)Product liabilityUnfunded pension liabilitiesExpenses being paid by stockholders through bargain pricingStockholders-managers drawing excessive compensationAdoption of less conservative accounting policiesSales subject to guarantee and warrantyCheck out that subsidiaries have different accounting
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