Securities Analyst Program 2016 – 2017 Academic Year

Plan for the Year Investment Styles / Famous Investors Fall Winter Investment Styles / Famous Investors What Makes a Good Investment? & Valuation Macroeconomic Analysis Fixed Income Other Asset Classes (Commodities, Derivatives) Industry Specific Analysis How To Leverage Resources Key Moments in the History of Finance

Cover Our Bases: Time Value of Money 1 Cover Our Bases: Time Value of Money 2 Yield Curve 3 How to Calculate a Bond Price? 4 Credit Spread & Duration 5 How to Invest in the Fixed Income Market?

Time Value of Money The Basics 1 Do you prefer $1,000 today or $1,000 in 1 year? Assume the interest rate is 10% Is the answer impacted by the moment you need the money? Assume you are given $1,000 now. How much is it worth in 1-year terms? This is called compounding Assume you are given $1,210 in 2-year. How much is it worth in 1-year terms? In today’s dollars? This is called discounting 2 3 4

Time Value of Money Compounding –> You get to Future Value Assume the interest rate is 12%, what is $100 received at t=0 worth at t=2? $100 x (1+0.12) x (1+0.12) = $144 Assume the interest rate is 10%, you receive $100 at t=0 and you receive $10 at t=1. How much is it worth at t=2? $100 x (1+0.10)^2 + $10 x (1+0.10)^1 = $121 + $11 = $132 Assume the interest rate is 10%, what is $100 received at t=0 worth at t=7 $100 x (1+0.1)^7 = $194.87 Rule of Thumb = 72 -> doubling time

Time Value of Money Discounting -> You Get To Present Value Assume the interest rate is 10%, what is $121 received at t=2 worth at t=0? $121 / (1+0.12)^2 = $100 Assume the interest rate is 10%, what is $110 received at t=1 and $121 received at t=2 worth at t=0? $110 / (1+0.10) + $121 x (1+0.10)^2 = $100 + $100 = $200 Assume the interest rate is 10%, what is $10 receive every year at perpetuity worth? $10 / 0.10 = $100 Intuition behind it, you could invest $100 @ 10% for perpetuity and receive $10 per year

Cover Our Bases: Time Value of Money 1 Cover Our Bases: Time Value of Money 2 Yield Curve 3 How to Calculate a Bond Price? 4 Credit Spread & Duration 5 How to Invest in the Fixed Income Market?

The Yield Curve? There are different risk free rates for different maturities Normal (Upward) Yield Curve Flat Yield Curve Inverted (Downward) Yield Curve Negative Interest Rates?

The Yield Curve Movements The Yield Curve Moves Over Time Types of Movement

Low Interest Rate Environment Current Yield Curve United-States Canada

Low Interest Rate Environment Evolution of Interest Rates Over Time

Low Interest Rate Environment Worldwide Yield Curve

Cover Our Bases: Time Value of Money 1 Cover Our Bases: Time Value of Money 2 Yield Curve 3 How to Calculate a Bond Price? 4 Credit Spread & Duration 5 How to Invest in the Fixed Income Market?

Fixed Income Fixed Income From the Perspective of the Investor Fixed Income Securities Fixed-income securities provide investors a return in the form of fixed periodic payments and eventual return of principal at maturity. Let’s assume that the required interest rate is 10% and you invest $100 at t=0.

Bond Price – Key Terms Interest Rates Tell Me How Much I should Pay for A Bond Yield curve is flat at 10%. You are buying a 3-year 10% coupon-bond. How much will I pay for that bond? 1 day after I buy the bond, the curve steepens. R1 = 9.5%. R2 = 10.0%. R3 = 10.5%. How much can I sell the bond for? If a new investor comes in and buys the stock, how much does he make if he holds it to maturity?

Cover Our Bases: Time Value of Money 1 Cover Our Bases: Time Value of Money 2 Yield Curve 3 How to Calculate a Bond Price? 4 Credit Spread & Duration 5 How to Invest in the Fixed Income Market?

Credit Rating The Different Credit Ratings Metrics To Look AT Credit rating agencies: Moody’s S&P Fitch EBITA / Average Assets EBITA / Interest Expense EBITA Margin (FFO + Interest Expense) / Interest Expense FFO / Debt Debt / EBITDA Debt / Book Capitalization Operating Margin CAPEX / Depreciation Expense Revenue Volatility

Credit Spread The Different Credit Spreads A credit spread is the difference in yield between a government bond and a debt security with the same maturity

Credit Spread The Different Credit Spreads The credit spread evolves over time. It increases when default risk (or perception of default risk) rises

Time 1 2 … n Cash Flow C1 C2 F + Cn Duration Sensitivity of a Given Bond Price to Changes in Interest Rates Interest rates go up -> bond prices go down Interest rates go down -> bond prices go up How do we measure the sensitivity? Let’s assume the bond has the following cash flows: Then duration is calculated as follow: Time 1 2 … n Cash Flow C1 C2 F + Cn

Duration Example MD = D/(1+YTM) = 1.93/1.08 = 1.78 A 2-year 8% coupon bond with face value of $100 has 8% YTM. Using the modified duration approximation, by how much will the bond price decrease if its YTM rises to 8.3%? P = $100. Method 1 MD = D/(1+YTM) = 1.93/1.08 = 1.78 -0.0053 (Pinitial) =-0.0053(100) = -0.53 New Price = 99.47 Method 2 Credits: Vadim Di Pietro

Cover Our Bases: Time Value of Money 1 Cover Our Bases: Time Value of Money 2 Yield Curve 3 How to Calculate a Bond Price? 4 Credit Spread & Duration 5 How to Invest in the Fixed Income Market?

How to Invest in the Fixed Income Market? Buying A Bond – Breaking Down Returns 1 Carry Net cash income of holding a position Position revenue: accrued coupons Position expense: financing costs (neglected since DCM is an unlevered long-only fund) Easy to calculate Number of actual fractional year between the purchase settlement date and the sale settlement date multiplied by the annual coupon amount Carry does not depend on market forces 2 Roll P&L from bond price as maturity approaches, all other things being equal As maturity approaches, future value of cash flows get re-evaluated at new time-appropriate discount rates Example: you see 10Y at 5% and 9Y at 4% on the curve 1 year roll of 100bps: in a year, the 10Y bond will be valued at 4%, assuming constant curve shape One year return: 100 1.04 9 / 100 1.05 10 −1= 14.4% Roll is where we can take a view Creditors target the yield on which the bond will roll onto, given an investment horizon Example: you’re bullish on an issuer and have an investment horizon of 1-year, which debt do you buy? 1Y yielding at 4% 2Y yielding at 4%; you think it will be 2% in one year later

How to Invest in the Fixed Income Market? Buying A Bond – Corporate or Government Bonds 1 Corporate Bonds Holdings range in credit quality and industry Look for spread compression or hold to maturity Spread compression Look for companies whose cash flow streams will be more stable than the market realizes, which warrants a lower credit spread Can apply to both Investment Grade and High Yield credit Hold to maturity Look for bonds with attractive YTM to hold till maturity and for which you think the risk of default is lower 2 Government Bonds Buying risk-free government bond or more risky foreign bonds Holdings range in credit quality and duration

Other Ways to Invest in the Fixed Income Market Bonds are Not Necessarily Meant to Be Boring View Strategy Interest rates will go up Long-term interest rates will go up more than short-term interest rates Expecting the yield curve to become more convex Protecting portfolio against inflation Protecting against rise in interest rates Betting on recovery rate during a bankruptcy Shorting a bond Curve steepener / widener Butterfly trade Treasury inflation protected securities Floating rate bond Buying discounted bonds of bankrupted companies 1 2 3 4 5 6