Ag217 Tutorial 5

Themain characteristics of a bond are:

-The face value or principal

-The term to maturity

-The coupon rate

-The frequency of coupon paymentsA zero couponbond has no coupon and only pays the face value at expiry. A coupon bondcan have a fixed coupon where coupon payments are fixed for the life of a bondor a floating coupon, where coupon payments are based on some benchmark ratesuch as LIBOR or EURIBOR.

Risksfrom investing in bonds:

-Inflation risk

-Interest rate risk

-Credit risk

-Liquidity risk

-FX Risk

Creditratings have come under a lot of criticism since the financial crisis, and inparticular their inaccurate assessment of the creditworthiness of manysecurities. In spite of this, they are still relevant to financial marketparticipants and in the long run their rating assessments have been shown toaccurately reflect default risk. However, investors are now more likely to usecredit ratings in conjunction with other risk assessment measures, rather thansolely rely on ratings as they may have done in the past.

-Expectations theory – refers to theproposition that the long term interest rate is determined by the market’sexpectations for the short term rate plus a constant risk-premium

-Liquidity preference theory – refers tothe idea that investors prefer liquidity and so demand a premium for holdingmore liquid assets

-Market segmentation theory – refersto the idea that different maturities trade in different segments of themarket, reflecting supply and demand conditions

Themost likely explanation for the current UK yield curve, which is broadly flatfor a 2-year time horizon before exhibiting the ‘normal’ yield structure, isthat there is great uncertainty about the short term direction of the UKeconomy and the short term direction of UK interest rates.

Over the medium tolong term, however, economic conditions are expected to return to ‘normal’.

The United Kingdom has the highest averagematurity of debt stock

Reasons why the UK isable to enjoy longer maturity issuance of debt compared to the other G7countries could be the fact that it has its own central bank, and thereforecannot default on the nominal value of its debt (compared to say, the Eurozonecountries).

Moreover, the UK enjoys a favourable reputation in bond marketsbecause it has never defaulted on its debt, and its political system tends toavoid such occurrences (compared to, say, the US).

Furthermore, the UK bondmarket is highly liquid, and the dominance of London as a financial centrehelps ensure this is the case. Finally, sterling is a currency that stillenjoys some reserve currency status.

-Ridiculously high inflation in the 1980s (north of 20%) meant that investorsrequired higher interest rates to make a real return

-Bank of England independence in 1997 meant that monetary policy was takenout of the government’s control

-Lower inflation expectations – a lower bank rate is required to stimulategrowth and get inflation to the Bank of England’s 2% target

-Balance sheet recession – if firms want to pay down debt then theinterest rate required for them to borrow to invest can be very low· -Risk aversion – after the financial crisis investors might be more riskaverse, therefore demanding risk-free assets. This would push up their pricesand exert downward pressure on yields

Under the expectations hypothesis forward ratesare unbiased predictors of future spot rates. Therefore S12 and S23 are equal to the ratescalculated in (b)

Select two interest rates, one above and one below the current selling price.

(1/YTM-I/YTM(1+YTM)^T)+ 100/(1+YTM)^T

Use one of the found prices

- P1/2 +( %P2-%P1/ P2-P1 ) ^(P-P1/2)