Tài chính doanh nghiệp - Chapter 8: Bond valuation and risk

Chapter 8Bond Valuation and RiskFinancial Markets and Institutions, 7e, Jeff MaduraCopyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.1Chapter OutlineBond valuation processRelationships between coupon rate, required return, and bond priceExplaining bond price movementsSensitivity of bond prices to interest rate movementsBond investment strategies used by investorsReturn and risk of international bonds2Bond Valuation ProcessBonds:Are debt obligations with long-term maturities issued by government or corporations to obtain long-term fundsAre commonly purchased by financial institutions that wish to invest for long-term periodsThe appropriate bond price reflects the present value of the cash flows generated by the bond (i.e., interest payments and repayment of principal):3Computing the Current Price of A BondA 2-year bond has a par value of $1,000 and a coupon rate of 5 percent. The prevailing annualized yield on other bonds with similar characteristics is 7 percent. What is the appropriate market price of the bond?4Bond Valuation Process (cont’d)Bond valuation with a present value tablePresent value interest factors in Exhibit 8A.3 can be multiplied by coupon payments and the par value to determine the present value of the bondImpact of the discount rate on bond valuationThe appropriate discount rate for valuing any asset is the yield that could be earned on alternative investments with similar risk and maturityInvestors use higher discount rates to discount the future cash flows of riskier securitiesThe value of a high-risk security will be lower than the value of a low-risk security5Computing the Current Price of A Bond Using PVIFsA 2-year bond has a par value of $1,000 and a coupon rate of 5 percent. The prevailing annualized yield on other bonds is 7 percent. What is the appropriate market price of the bond using PVIFs?6Bond Valuation Process (cont’d)Impact of the timing of payments on bond valuationFunds received sooner can be reinvested to earn additional returnsA dollar to be received soon has a higher present value than one to be received laterValuation of bonds with semiannual paymentsFirst, divide the annual coupon by twoSecond, divide the annual discount rate by twoThird, double the number of years7Computing the Current Price of A Bond With Semiannual CouponsA 2-year bond has a par value of $1,000 and a semiannual coupon rate of 5 percent. The prevailing annualized yield on other bonds with similar characteristics is 7 percent. What is the appropriate market price of the bond?8Bond Valuation Process (cont’d)Use the annuity tables for valuationA bond can be valued by separating its payments into two components:PV of bond = PV of coupon payments + PV of principalThe bond’s coupon payments represent an annuity (an even stream of payments over a given period of time)The present value can be computed using PVIFAs9Computing the Current Price of A Bond Using PVIFs and PVIFAsA 30-year bond has a par value of $1,000 and an annual coupon rate of 10 percent. The prevailing annualized yield on other bonds with similar characteristics is 9 percent. What is the appropriate market price of the bond?10Relationship between Coupon Rate, Required Return, and PriceIf the coupon rate of a bond is below the investor’s required rate of return, the present value of the bond should be below par value (discount bond)If the coupon rate equals the required rate of return, the price of the bond should be equal to par valueIf the coupon rate of a bond is above the required rate of return, the price of the bond should be above par value11Relationship between Coupon Rate, Required Return, and Price12Relationship between Coupon Rate, Required Return, and Price (cont’d)Implications for financial institutionsThe impact of interest rate movements depends on how the institution’s asset and liability portfolios are structuredInstitutions with interest rate-sensitive liabilities that invest heavily in bonds are exposed to interest rate riskMany institutions adjust the size of their bond portfolio according to interest rate expectationsWhen rates are expected to rise, bonds can be sold and the proceeds used to purchase short-term securitiesWhen rates are expected to fall, the bond portfolio can be expanded in order to capitalize on the expectations13Explaining Bond Price MovementsThe price of a bond should reflect the present value of future cash flows based on a required rate of return:An increase in either the risk-free rate or the general level of the risk premium results in a decrease in bond prices14Explaining Bond Price Movements (cont’d)Factors that affect the risk-free rateInflationary expectationsEconomic growthMoney supplyBudget deficit15Explaining Bond Price Movements (cont’d)Factors that affect the risk-free rate (cont’d)Impact of inflationary expectationsAn increase in expected inflation will increase the required rate of return on bondsIndicators of inflation are closely monitoredConsumer price indexProducer price indexOil pricesA weak dollar16Explaining Bond Price Movements (cont’d)Factors that affect the risk-free rate (cont’d)Impact of economic growthStrong economic growth places upward pressure on the required rate of returnSignals about future economic conditions affect bond prices immediatelyEmploymentGDPRetail salesIndustrial productionConsumer confidence17Explaining Bond Price Movements (cont’d)Factors that affect the risk-free rate (cont’d)Impact of money supply growthIf there is no simultaneous increase in the demand for loanable funds, an increase in money supply growth should place downward pressure on interest ratesIn high inflation environments, an increased money supply may increase the demand for loanable funds and place upward pressure on interest ratesImpact of budget deficitAn increase in the budget deficit places upward pressure on interest rates18Explaining Bond Price Movements (cont’d)Factors that affect the credit (default) risk premiumThe general level of credit risk on corporate or municipal bonds can change in response to a change in economic growth:Strong economic growth tends to improve a firm’s cash flows and reduce the probability that the firm will default on its debt payments19Explaining Bond Price Movements (cont’d)Summary of factors affecting bond pricesOther factors are also changing, making the precise impact of each factor on bond prices uncertainImpact of bond-specific characteristicsChanges in the issuing firm’s capital structure and factors such as call features can affect individual bond prices20Explaining Bond Price Movements (cont’d)Bond market efficiencyIn an efficient market, bond prices should fully reflect all available informationIn general bond prices should reflect information that is publicly availablePrices may not reflect information about firms that is known only by managers of the firms21Sensitivity of Bond Prices to Interest Rate MovementsIf bonds are not held to maturity, future prices are most sensitive to changes in the risk-free rateA measurement of bond price sensitivity can indicate the degree to which the market value of bond holdings may decline in response to an increase in interest rates22Sensitivity of Bond Prices to Interest Rate Movements (cont’d)Bond price elasticityMeasures the sensitivity of bond prices to changes in the required rate of return:The price sensitivity is greater for declining interest rates than rising interest ratesBond price elasticity is always negative23Sensitivity of Bond Prices to Interest Rate Movements (cont’d)Bond price elasticity (cont’d)Influence of coupon rate on bond price sensitivityThe relationship between bond price elasticity and coupon rates is inverseZero-coupon bonds have the greatest price sensitivityBonds yielding only coupon payments are least sensitiveFinancial institutions may restructure their bond portfolios to contain higher-coupon bonds when they are concerned about a possible increase in interest ratesInfluence of maturity on bond price sensitivityAs interest rates decrease, long-term bond prices increase by a greater degree than short-term bond prices24Computing Bond Price ElasticityA 15-year bond has a yield to maturity of 7 percent and a coupon rate of 10 percent. The current price of this bond is $1,273.24. If the yield to maturity increases to 9 percent, the new price of the bond is $1,080.61. What is this bond’s bond price elasticity?25Sensitivity of Bond Prices to Interest Rate Movements (cont’d)DurationDuration measures the life of a bond on a present value basisThe longer the bond’s duration, the greater its sensitivity to interest rates26Computing the Duration of A BondA bond has two years remaining to maturity, a $1,000 par value, a 9 percent coupon rate, and a 10 percent yield to maturity. What is the duration of this bond?27Sensitivity of Bond Prices to Interest Rate Movements (cont’d)Duration (cont’d)Duration of a portfolioBond portfolio managers commonly immunize their portfolio from the effects of interest rate movementsA bond portfolio’s duration is the weighted average of bond durations, weighted according to relative market value:28Sensitivity of Bond Prices to Interest Rate Movements (cont’d)Duration (cont’d)Modified durationDuration can be used to estimate the percentage change in a bond’s price in response to a 1 percentage point change in bond yields:The estimate of modified duration should be applied such that the bond price moves in the opposite direction from the change in bond yieldsThe percentage change in a bond’s price in response to a change in yield is:29Computing the Modified Duration of A BondA bond has two years remaining to maturity, a $1,000 par value, a 9 percent coupon rate, and a 10 percent yield to maturity. What is the modified duration of this bond? Interpret the modified duration for this bond.A 1 percent increase in bond yields leads to a 1.75 percent decline in the price of the bond.30Computing the Price Change of A Bond in Response to A Change in YieldIn the previous example, assume that bond yields rise by 0.30%. What is an estimate of the percentage drop in the bond’s price?31Sensitivity of Bond Prices to Interest Rate Movements (cont’d)Duration (cont’d)Estimation errors from using modified durationIf investors rely only on modified duration to estimate percentage price changes in bonds, they will tend to overestimate price declines and underestimate price increasesTo accurately estimate the percentage change in price, bond convexity must also be considered32Sensitivity of Bond Prices to Interest Rate Movements (cont’d)Duration (cont’d)Bond convexityModified duration estimates assume a linear relationship between bond prices and yieldsThe actual relationship between bond prices and yields is convexHow the estimation errors from modified duration can varyFor high-coupon, short-maturity bonds, price change estimates based on modified duration will be very close to actual price changesFor low-coupon, long-maturity bonds, price change estimates based on modified duration can give large estimation errors33Bond Investment Strategies Used by InvestorsMatching strategyThe bond portfolio generates periodic income that can match expected periodic expensesInvolves estimating future cash outflows and developing a bond portfolio that can generate sufficient payments to cover those outflowsLaddered strategyFunds are evenly allocated to bonds in each of several different maturity classesAchieves diversified maturities and different sensitivities to interest rate risk34Bond Investment Strategies Used by Investors (cont’d)Barbell strategyFunds are allocated to bonds with a short term to maturity and bonds with a long term to maturityAllocates some funds to achieving relatively high returns and other funds to cover liquidity needsInterest rate strategyFunds are allocated to capitalize on interest rate forecastsRequires frequent adjustment in the bond portfolio to reflect current forecasts35Return and Risk of International BondsThe value of an international bond is influenced by:Changes in the risk-free rate of the currency denominating the bondChanges in the perceived credit risk of the bondExchange rate risk36Return and Risk of International Bonds (cont’d)Influence of foreign interest rate movementsAn increase in the risk-free rate of the foreign currency results in a lower value for bonds denominated in that currencyInfluence of credit riskAn increase in risk causes a higher required rate of return on the bond and lowers the present value of the bondInfluence of exchange rate fluctuationsThe most attractive foreign bonds offer a high coupon rate and are denominated in a currency that strengthens over the investment horizon37Return and Risk of International Bonds (cont’d)International bond diversificationReduction of interest rate riskInternational diversification of bonds reduces the sensitivity of the overall bond portfolio to any single country’s interest rate movementsReduction of credit riskBecause economic cycles differ across countries, there is less chance of a systematic increase in the credit risk of internationally diversified bondsReduction of exchange rate riskFinancial institutions attempt to reduce their exchange rate risk by diversifying among foreign securities denominated in various foreign currencies38