Topic. Various risks associated with investing in the bond market Pricing Bond, pricing floating rate and inverse floating rate securities Computing the yield on portfolio of bonds Various yield measures Sources of income from bond or bond portfolio
where y* is the yield to maturity in defaultable debt.
Using risk neutral pricing
P = 100/(1+y*)= [100/(1+y)](1-π) + [100/(1+y)](π)
Where y is the yield to maturity for default free debt and π is the probability of default.
π = 1/(1- f) [1- (1+y)/(1+y*)]
Y* ≈ y + π (1-f)
(Y* - y) = π’ (1-f) + RP
π/(1-f) = [1- (1+y/2)^20/(1+y*/2)^20]
π/(1-.45)= [1- (1+.055/2)^20/(1+.0625/2)^20]
π = 7.27 percent
π = 3.4 % historical default probability for an A rated credit over 10 years (Moody’s 1920-2002)
(y* - y) = π (1-f)
= .02 ( 1-.40)
= 120 bps
Fair price = L + 1.2%
WAC=.0715 WAM= 5
WAC of 2-tranches= .07
Coupon of Floating rate note= L +2%
Assume 6-month LIBOR is 3.5 percent.
Coupon of Inverse floater= .27- 4(L)