Economics 173A. Comprehensive (excluding MPT) Slide Deck. To help to finance Companies Annual Working Capital increases = $ 150 Billion Annual Capital Expenditures “CAPEX” = $ 900 Billion = $ 1,050 Billion Source of funds: Annual Earnings = ($ 800 Billion)
Comprehensive (excluding MPT) Slide Deck
Annual Working Capital increases = $ 150 Billion
Annual Capital Expenditures “CAPEX” = $ 900 Billion
= $ 1,050 Billion
Source of funds:
Annual Earnings = ($ 800 Billion)
GAP $ 250 Billion
2. Annual Debt issued ($ 300 Billion)
( $ 50 Billion)
Equity -this represents repurchases of EquityCapital Markets
Risk and expected Return
CDs – bank time-deposits
Paper – unsecured, trade-able company debt
Acceptances – bank promises
Eurodollars - $ denominated foreign bonds
Repos, Reverse Repos – of treasury debt
Treasuries – bills, notes, bonds
TED Spread : the 3-month Treasury less LIBORFixed Securities & Rates
Originally calculated as the difference between interest rates on 3-month T-bills and 3-month Eurodollar contracts w/ identical expiration.
Acronym is derived from the “T” for “Treasuries" and the ticker symbol for Eurodollars, which is “ED”.Today, the TED spread is calculated as the difference between interest rates on 3-month T-bills and 3-month LIBOR (London Interbank Offered Rate).
Denominated in basis points (bps).
Historically 10 to 50 bps – average 30 bps
A rising TED spread indicates shrinking liquidity –an indicator of perceived credit risk:
T-bills are considered risk-free
LIBOR reflects the credit risk of lending banks.
Widening TED spread is a sign that lenders believe default risk on interbank (counterparty) loans is increasing.]
2007 Average 150 – 200 bps
September 2008 > 300 bps; and on October 8th 465 bps
Fixed Income Securities vs. Common Stock
High Priority on cash flows
Lowest Priority on cash flows
Not Tax Deductible
No Management Control
of debt and equity)
Amount of Issue, Date of Issue, Maturity
Denomination (Par value) Face
Annual Coupon, Dates of Coupon Payments
Features that may change over time:
Market priceBond Basics
As with all Financial Assets
The price is a Present Value of the expected cash flows discounted at the appropriate (relative to risk) discount (interest) rate.
The effective, or true, annual rate of return. The APY is the rate actually earned or paid in one year, taking into account the affect of compounding. The
APY is calculated by taking 1+r
… the periodic rate and raising it to the number of periods in a year.
For example, a 1% per month rate has an APY of 12.68% (1.01^12).
PB = Price of the bond
Ct = interest or coupon payments
T = number of periods to maturity
r = semi-annual discount rate or the semi-annual yield to maturity
Insert Figure 4-6 here.
Using the earlier example
Avg. Income = 80 + (1000-1149)/10 = 65.10
Avg. Price = (1000 + 1149)/2 = 1074.50
Approx. YTM = 65.10/1074.50 = 0.0606
Actual YTM = 6.00%
Step One: Calculate the present value of a bond that has 2.5 years until it matures and pays semiannual interest coupons.
Step Two: The $30 coupon is added to $913.39. The sum is $943.19.
Step Three: The value $943.19 is discounted back 4 months to the purchase date.
Calculate the accrued interest for two months. There are 180 days between semiannual coupon payments and 30 days in a month. Therefore 60/180 is the fraction of the coupon payment earned by the seller. In other words the accrued interest is $10 and the dirty price is $923.16.
Very High Quality AAA, AA Aaa, Aa
High Quality A, BBB A, Baa
Speculative BB, B Ba, B
Very Poor CCC, CC, C, D Caa, Ca, C, D
term yearsrat year
One-year rate one year from now
One-year rate two years from now
Measured in units of time; always less-than-equal to the bond’s maturity because the value of more distant cash flows is more sensitive to the interest rate.
“Duration" generally means Macaulay duration.Bond Duration
The time-weighted average present value term to payment of the cash flows on a bond.Macaulay Duration
The higher the coupon rate of a bond, the shorter the duration.
Duration is always less than or equal to the overall life (to maturity) of the bond.
A zero coupon bond will have duration equal to the maturity.Macaulay Duration
The dollar variation in a bond\'s price for small variations in the yield.
For small interest rate changes, duration is the approximate percentage change in the value of the bond for a 1% increase in market interest rates.Dollar Duration
What will happen to the price of a 30 year 8% bond priced to yield 9% (i.e. $897.27) with D* of 11.37 - if interest rates increase to 9.1%?
Duration versus Convexity
Both price changes, called capital gains, and dividend income:
Growth Stocks: stocks that experience high rates of growth in operations and earnings
Speculative Stocks: stocks that offer potential for substantial price appreciation, usually due to some special situation such as a new product.
Defensive Stocks: stocks that tend to hold their value, and even do well, when the economy starts to falter