Chapter 12 supplement a
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Chapter 12 Supplement A. Fixed-Income Securities. Basic Concepts of Lending Securities (1 of 2). Fixed-income securities Specified payment dates and amounts Lending securities

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Chapter 12 Supplement A

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Chapter 12 supplement a

Chapter 12Supplement A

  • Fixed-Income Securities


Basic concepts of lending securities 1 of 2

Basic Concepts of Lending Securities (1 of 2)

  • Fixed-income securities

    • Specified payment dates and amounts

  • Lending securities

    • An investor in bonds lends funds to issuer in exchange for a promise of a stream of periodic interest payments and a repayment of principal at maturity


Basic concepts of lending securities 2 of 2

Basic Concepts of Lending Securities (2 of 2)

  • Coupon payments

    • Interest payments paid to bondholder on semiannual basis

    • Based on percentage of par value of bond

  • Maturity

    • Period of time through which issuer has control over bond proceeds

    • Period of time required to pay coupon payments


Valuation of fixed income securities

Valuation of Fixed-Income Securities

  • Value of a bond is equal to the present value of expected future cash flows

  • Cash flows are discounted at appropriate discount rate (determined in same manner as an annuity)


Measures of return

Measures of Return

  • Current yield (CY)

    • Indication of income or cash flow an investor will receive on basis of coupon payment and current price

  • Yield to maturity (YTM)

    • Compounded rate of return on bond purchased at current market price and held to maturity

  • Yield to call (YTC)

    • Expected return on bond from purchase date to first call date


Corporate returns vs municipal returns

Corporate Returns Vs. Municipal Returns

  • Taxable equivalent yield

    • Method used to compare yield on municipal bonds with yield on taxable bonds


Types of fixed income securities 1 of 3

Treasury bills

Zero-coupon bonds

Commercial paper

Certificates of deposit

Banker’s acceptances

Repurchase agreements

Eurodollars

Promissory notes

Treasury notes and bonds

Treasury Inflation-Protected Securities (TIPS)

Treasury STRIPS

Types of Fixed-Income Securities (1 of 3)


Types of fixed income securities 2 of 3

Types of Fixed-Income Securities (2 of 3)

  • US savings bonds

    • Series EE

    • Series HH

    • Series I

  • Municipal bonds

    • General obligation

      • Backed by full faith and credit

    • Revenue

      • Finance specific revenue-producing projects


Types of fixed income securities 3 of 3

Types of Fixed-Income Securities (3 of 3)

  • Corporate bonds

    • Call provision

    • Unsecured or secured

  • Convertible bonds

    • Acquire stock by exchanging bonds under specific formula

  • Asset-backed securities

    • Mortgage-backed securities (MBSs)

      • Prepayment risk

    • Collateralized mortgage obligations (CMOs)


Risks of fixed income securities

Systematic

Interest rate risk

Reinvestment risk

Purchasing power risk

Unsystematic

Default risk

Call risk

Risks of Fixed-Income Securities


Volatility of fixed income securities

Volatility of Fixed-Income Securities

  • Two key factors influencing volatility

    • Coupon rate: Volatility in price for a bond is inversely related to the bond’s coupon payment when interest rates change

    • Maturity: Bonds with longer terms are subject to more volatility with changing interest rates than bonds with shorter terms


Term structure of interest rates

Term Structure of Interest Rates

  • Yield curves

    • Normal (upward sloping)

    • Flat

    • Downward sloping

  • Yield curve theories

    • Pure expectations theory

    • Liquidity preference theory

    • Preferred habitat theory

    • Market segmentation theory


Duration and immunization

Duration and Immunization

  • Duration: Provides a time-weighted measure of a security’s cash flows in terms of payback

    • Factors impacting duration

      • Coupon rate

      • Maturity

      • Yield to maturity

  • Immunization: Concept of minimizing the impact of changes in interest rates on the value of investments


Uses for duration

Uses for Duration

  • Measuring a bond’s volatility

  • Estimating the change in the price of a bond based on changes in interest rates

  • Immunizing a bond or bond portfolio against interest rate risk


Traditional methods of immunizing bond portfolios

Traditional Methods of Immunizing Bond Portfolios

  • Ladder strategy

    • Portfolio of bonds with staggered maturities

  • Barbell strategy

    • One-half of portfolio is invested in short-term bonds, the other-half in long-term bonds

  • Bullet strategy

    • Purchasing a series of bonds with similar maturities, focused around a single point in time


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