Identification of Risk Factors. Market Risk and Credit risk Market risk is defined as the risk of fluctuations in portfolio values due to volatility in.

Slides:



Advertisements
Similar presentations
Bond Valuation Chapter 8.
Advertisements

BOND VALUATION Dr. Rana Singh Associate Professor
Bennie D Waller, Longwood University Personal Finance Bennie Waller Longwood University 201 High Street Farmville, VA.
CHAPTER 4 BOND PRICES, BOND YIELDS, AND INTEREST RATE RISK.
BOND VALUATION AND RISK 1. ■ Bonds are debt obligations with long-term maturities that are commonly issued by governments or corporations to obtain long-term.
Valuation and Characteristics of Bonds.
Fi8000 Valuation of Financial Assets Fall Semester 2009 Dr. Isabel Tkatch Assistant Professor of Finance.
1 Bond Valuation Global Financial Management Campbell R. Harvey Fuqua School of Business Duke University
Bond Yields Fixed Income Securities. Outline Sources of Return for a Bond Investor Measures of Return/Yield Nominal Yield Current Yield Yield to Maturity.
Interest Rate Risk. Money Market Interest Rates in HK & US.
CHAPTER 4 Background on Traded Instruments. Introduction Market risk: –the possibility of losses resulting from unfavorable market movements. –It is the.
PVfirm = PVdebt+ PVStock
Interest Rate Risk. Interest Rate Risk: Income Side Interest Rate Risk – The risk to an institution's income resulting from adverse movements in interest.
The Bond Market Chapter 22.
1. 2 Duration Duration is the weighted average of the times that the principal and interest payments are made. where t is the time of payment C t is the.
Lecture 10: Understanding Foreign Exchange Exposure
Chapter 8 Valuing Bonds. 8-2 Chapter Outline 8.1 Bond Cash Flows, Prices, and Yields 8.2 Dynamic Behavior of Bond Prices 8.3 The Yield Curve and Bond.
Bond Portfolio Management Strategies
Bond Valuation Essentials of Corporate Finance Chapters 4 & 6 Materials Created by Glenn Snyder – San Francisco State University.
Yield Curves and Term Structure Theory. Yield curve The plot of yield on bonds of the same credit quality and liquidity against maturity is called a yield.
1 Finance School of Management Objective Explain the principles of bond pricing Understand the features that affect bond prices Chapter 8. Valuation of.
BOND PRICES AND INTEREST RATE RISK
Financial Instruments
Bond Prices and Yields. Objectives: 1.Analyze the relationship between bond prices and bond yields. 2.Calculate how bond prices will change over time.
Bonds: Analysis and Strategy
CHAPTER FOUR BOND FUNDAMENTALS A 1 3 © 2001 South-Western College Publishing.
McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 16 Managing Bond Portfolios.
1 FIN 2802, Spring 08 - Tang Chapter 16: Managing Bond Portfolios Fina2802: Investments and Portfolio Analysis Spring, 2008 Dragon Tang Lecture 12 Managing.
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license.
Copyright © 2011 Pearson Prentice Hall. All rights reserved. Chapter 8 Valuing Bonds.
Introduction to Derivatives
Chapter 10 Swaps FIXED-INCOME SECURITIES. Outline Terminology Convention Quotation Uses of Swaps Pricing of Swaps Non Plain Vanilla Swaps.
1 Bond:Analysis and Strategy Chapter 9 Jones, Investments: Analysis and Management.
Bond Prices Over Time Yield to Maturity versus Holding Period Return (HPR) Yield to maturity measures average RoR if investment held until bond.
6-1 Lecture 6: Valuing Bonds A bond is a debt instrument issued by governments or corporations to raise money The successful investor must be able to:
Financial Markets and Institutions
CHAPTER 5 BOND PRICES AND RISKS. Copyright© 2003 John Wiley and Sons, Inc. Time Value of Money A dollar today is worth more than a dollar in the future.
INVESTMENTS | BODIE, KANE, MARCUS Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin CHAPTER 20 Futures, Swaps,
1 CHAPTER TWO: Time Value of Money and Term Structure of Interest.
©2009, The McGraw-Hill Companies, All Rights Reserved 3-1 McGraw-Hill/Irwin Chapter Three Interest Rates and Security Valuation.
Chapter Sixteen Physical Capital and Financial Markets.
Chapter 12 Supplement A: Fixed-Income Securities Chapter 12 Supplement A Fixed-Income Securities.
CHAPTER FOUR BOND FUNDAMENTALS Practical Investment Management Robert A. Strong.
CHAPTER 5 BOND PRICES AND INTEREST RATE RISK. Learning Objectives Explain the time value of money and its application to bonds pricing. Explain the difference.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 7 (Conti.) Global Bond Investing.
Lecture 5 Valuing Bonds Professor Paul Howe. Professor Paul Howe.5-2 Lecture Outline 5.1 Bond Cash Flows, Prices, and Yields 5.2 Dynamic Behavior of Bond.
Chapter 18 - The Analysis and Valuation of Bonds.
Bond Valuation and Risk
Fundamentals of Corporate Finance Chapter 6 Valuing Bonds Topics Covered The Bond Market Interest Rates and Bond Prices Current Yield and Yield to Maturity.
CHAPTER 5 BOND PRICES AND INTEREST RATE RISK. Copyright© 2006 John Wiley & Sons, Inc.2 The Time Value of Money: Investing—in financial assets or in real.
1 Chapter 06 Understanding Financial Markets and Institutions McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
©2007, The McGraw-Hill Companies, All Rights Reserved 2-1 McGraw-Hill/Irwin Chapter Two Determinants of Interest Rates.
Fundamentals of Corporate Finance Chapter 6 Valuing Bonds Topics Covered The Bond Market Interest Rates and Bond Prices Current Yield and Yield to Maturity.
Chapter 6 Valuing Bonds. Copyright ©2014 Pearson Education, Inc. All rights reserved Bond Cash Flows, Prices, and Yields Bond Terminology –Bond.
Bonds and Yield to Maturity. Bonds A bond is a debt instrument requiring the issuer to repay to the lender/investor the amount borrowed (par or face value)
Class Business Upcoming Homework. Duration A measure of the effective maturity of a bond The weighted average of the times (periods) until each payment.
1 Chapter 8: Valuation of Known Cash Flows: Bonds Copyright © Prentice Hall Inc Author: Nick Bagley, bdellaSoft, Inc. Objectives Value contracts.
Bonds and Their Valuation 7-1 Chapter 7. Bond Market Bond Market Size – US : $31.2 Trillion (2009) – World : $82.2 Trillion (2009) Types of Bond: Government.
1 FIN 2802, Spring 08 - Tang Chapter 15: Yield Curve Fina2802: Investments and Portfolio Analysis Spring, 2008 Dragon Tang Lecture 11 Bond Prices/Yields.
Securities Analyst Program
Analysis and Management of Bond
Chapter 6 Learning Objectives
The term structure of interest rates
12. Understanding Floating Rate and Derivative Securities
INVESTMENT ANALYSIS & PORTFOLIO MANAGEMENT
Financial Risk Management of Insurance Enterprises
Chapter 8 Valuing Bonds.
Bond Valuation Chapter 6.
Valuation of Bonds Bond Key Features
IV. Fixed-Income Securities
Presentation transcript:

Identification of Risk Factors

Market Risk and Credit risk Market risk is defined as the risk of fluctuations in portfolio values due to volatility in market price. Absolute and Relative risk Absolute risk is measured in dollars terms – used for bank trading portfolios. Relative risk is measured relative to benchmark index – used for pension funds that are given the task of beating a benchmark group.

Source of Market Loss – Bond and Equity Bond A bond value is defined as the present value of the bond’s payments discounted by the yield to maturity. yield to maturity is the annual yield promised to investor who will hold the bond to maturity.

Bond Valuation Numerical Example A bond with $1,000 notional value, 8% coupon and 5 years to maturity is traded with 10% yield to maturity. Bond’s Payments 54321year payment

Yield to Maturity and Bond Price y P 5 years bond 10 years bond

Yield to Maturity and Bond Price Every things else are equal, the sensitivity of the bond price movement to movements in yields increases as: The yields are lower The time to maturity is longer The coupon rate is lower Duration Duration is a measure of the sensitivity of the bond price movement to movement in yields. Duration is measured as the weighted maturity of each payment, where the weights are proportional to the present value of the cash flow.

Thus, where D* is modified duration and D*P is also known as the dollar duration. This sensitivity is sometimes expressed in dollar value of a basis point:

Numerical Example A bond with $1,000 notional value and 8% coupon and 3 years to maturity is traded with 10% yield to maturity. Bond’s Payments 321year 1,08080 payment

The modified Duration is: This implies that increasing of 1% in the yield will cause to:

Spot and Forward Rates The yield curve is the relationship between the yield to and the time to maturity. The yield described by the spot rates, S T, which are derived from zero-coupon bond prices with different maturity. Prices of zero-coupon bonds with different maturity Price ($)Time to Maturity

Forward Rates Forward rates, F t,T are the rate on investment that start at a future date t to time T. Example An investor who wishes to invest for 2 years has two alternatives: 1.Buying two years bond with a spot rate S 2 2.Buying one year bond with a spot rate S 1, and roll over the investment by entering to forward contract to buy in the next year a one year bond with a forward rate F 1,2.

123 0 S1S1 S3S3 S3S3 F 1,2 F 2,3 F 1,3

Forward Rates Since the two portfolios must have the same payoff, we can infer F 1,2 form: and in general:

Default Risk Premium – Spreads Over Treasuries Corporate bonds have an additional risk factor over government bonds - the risk of default. Default Risk – firm’s failure to pay the coupon payment and/or the par value at maturity. It causes the yields for corporate bonds to exceed those for Treasury bonds – the difference known as the spread over Treasury The higher the risk of default, the lower the firm’s bond rating, the lower the bond’s market price, and the higher its yield.

Bond Rating DescriptionS&PMoody’s Very high qualityAAAAaa High quality: Very strong financial positionAAAa High capacity to pay interest and principle, but more sensitive to the economic conditions AA Medium quality: the capacity to pay may change with economic conditions BBBBaa Junk Bonds Low quality – provide high yields but are very speculative BBBa The price fluctuations are relatively largeBB Very speculative bondsCCCCaa Very poor quality: No interest is being paidCC Debt that is in defaultDD

Default Risk Premium – Spreads Over Treasuries For a given maturity, the lower the bonds rating, the higher its yield to maturity DRP

Fixed-Income Risk Fixed income risk arises from potential movement in the level of bond yields. The Fixed income risk can be measured either as return volatility or yield volatility:

Fixed-Income Portfolio Risk The major problem with individual bonds is that there may not be sufficient history to measure their risk. Therefore, we model the movement in each corporate bond yield by: A movement in Treasury zero-coupon rates with a closest maturity - z j A movement in the DRP of the credit rating class to which it belong - s k. The remaining component, e i, which assumed to be independent across the bonds.

The movement in the bond price is: DVBP is the total dollar value of a basis point for the associated risk factor. 3M 5Y 10Y20Y Treasury BBB Specific bond z z+s z+s+e

Summing across the portfolio and collecting terms across the common risk factors: Thus, a portfolio may consist of N=100 corporate bonds, but we can summarize the yield risk only with j=5 government bonds.

The total variance:

Numerical Example DVBP ($M) RatingYears to Maturity Bond -0.2A A BBB zz BBBA 158 ss Change in Basis Points at Time t Portfolio Composition

Equity Portfolio Risk The different market risk can be measured by the volatility of the major indexes. S&P500 HSI DAX Nikkei 225

Equity Portfolio Risk The diagonal model is a statistical decomposition of the return of the stock i into a market-wide return and a residual which called the specific risk.

Equity Portfolio Risk The diagonal model assumes that all specific risks are uncorrelated. Thus, any correlation between two stocks must come from the joint effect market. Therefore, with a large portfolio the specific risk should cancel each other, and the only remaining risk is the general market risk.

Equity Portfolio Risk The portfolio variance is: Suppose, is equally weighted and the residual variance are the same for all stocks:

Factor Model The one factor model may miss common industry effects. Adding factors, such as industry factors to the model improves the precision of the individual stock return, and decreases the error term. The factors X are assumed to be independent

Currency Risk Currency risk arise from potential movement in the value of foreign currencies. Currency risk includes currency specific volatility and correlations across currencies, and devaluation risk. It arises in the following environments: A pure currency float A currency devaluation A change in the exchange rate regime Currency risk is also related to the interest rate risk – Often, interest rate are raised in effort to stem the depreciation of the local currency.

Exchange Rates Volatility Against the USD Country Argentina Canada Britain Hong Kong Japan Euro South Afr.