1. Finance 300 Financial Markets Lecture 11 Fall, 2001© Professor J. Petry http://www.cba.uiuc.edu/broker/fin300/fin300pp.htm

2. 2 Investment Challenge Trading begins today. One change regarding recording of transactions: students must turn in the trading sheets with the time and date of trade at the next class meeting after the trade. These transactions must then match the monthly report records. Records of transactions will not be accepted after the next class period, and the trade must be done when markets are open, so that we know the trade could have been made. At the end of each month, you must print off the list of quotes which include all your holdings (if done in abbreviated version, you can get up to ~20 quotes per page), to make sure that your reconciliation with the market is accurate.

3. 3 Debt Markets & Interest Rates Yield The rate of return on an investment under specific assumptions. Nominal Yield –The coupon rate. A bond with a 10% coupon, has a 10% nominal yield. Current or Income Yield –The current income divided by its price. A 5% coupon bond, which trades at 941/2 has a Current Yield of 5.29%. Promised Yield to Maturity –The fully compounded rate of return on a bond bought at the current market price and held to maturity. This is the IRR on the bond, and uses the net present value calculations we developed last class.

4. 4 Debt Markets & Interest Rates Yield (cont’d) Promised Yield to Maturity (cont’d) –Requires three assumptions for the promised yield to maturity to be realized. 1) Investor must hold to maturity; 2) Investor must reinvest coupons at the same yield as when the coupon was issued; 3) no defaults or payment delays. –Interest on interest is a large percentage of the earnings of a coupon bond. For instance a 20 year, $1,000 bond, w/ 8% coupon »Earns 0% of return from interest on interest at 0%, and returns 4.84% total realized compound yield. »Earns 47% of return from interest on interest ($1,416) at 6%, and returns 7.07% ($3016) total realized compound yield. »Earns 58% of return from interest on interest ($2,201) at 8%, and returns 8.0% ($3,801) total realized compound yield. »Earns 67% of return from interest on interest ($3,232) at 10%, and returns 9.01% ($4,832) total realized compound yield. –Yield illusion is the mistaken belief that the investor will receive the promised yield to maturity even if assumptions do not hold.

5. 5 Debt Markets & Interest Rates Yield (cont’d) Calculating Yield to Maturity –To approximately calculate this IRR, use the following formula: Example: –A $1,000 5% bond with 20 years to maturity selling at $1,200:

6. 6 Debt Markets & Interest Rates Yield (cont’d) Calculate the same example as above, but with Price = 900

7. 7 Debt Markets & Interest Rates Yield (cont’d) Realized Yield –The holding period yield for a bond which is sold prior to maturity. You calculate this the same way as a YTM, but with holding period rather than number of years to maturity, and with the estimated sale price of the bond instead of its par value.

8. 8 Debt Markets & Interest Rates Things to Do: IV-9 –A $100, 12% bond maturing March 1, 2014 is purchased April 12, 2001 at $147.99. It is sold October 13, 2010 for $118.85. What is the Yield to Maturity on the date of purchase? What is the Yield to Maturity on the date of sale? What is the Realized or Holding Period Yield?

9. 9 Debt Markets & Interest Rates Effective Annual Rate Calculations Most bonds pay out half the annual rate semi-annually. The effective annual rate is the rate of interest which provides an identical future value under annual compounding. Example: A $1,000 bond with 10% coupon or nominal rate, pays out $100 per year; $50 every six months. The effective annual rate = 10.25%. (1+.10/2) 2 =1.1025=1+10.25%.

10. 10 Debt Markets & Interest Rates Things To Do: IV-10 –You purchase a 10% coupon bond. What is the effective annual rate of interest if the bond pays coupons quarterly? What if the bond pays monthly? What if the bond pays continuously?

11. 11 Bond Pricing The Term Structure of Interest Rates 1.Term to maturity. Life of the bond contract 2.Coupon Rate. Interest rate specified by the bond contract 3.Call provisions. Contractual provisions whereby the bond can be paid off early. 4.Liquidity. Ability to buy or sell quickly without affecting price. 5.Risk of default. Risk that the issuer will not pay coupon and/or principal when it is due. 6.Tax Status. How income and capital gain are treated under the tax law. These six factors combine to determine the Yield Structure.

12. 12 Bond Pricing The Term Structure of Interest Rates (cont’d) –These six factors combine to determine the Yield Structure. (All facets and characteristics of existing yields.) –The “Term Structure of Interest Rates” looks at the Yield Structure across time periods—yield to maturity and “Term to Maturity” for like bonds. The only difference between the bonds is the maturity. –The “Yield Curve” is the graphic representation of the “Term Structure”.