Bond & Bond Markets: An Introduction 5/26/2025 1 What is debt? It is a financial claim. Who issues it? The borrower of funds For whom it is a liability Who holds it? The lender of funds For whom it is an asset 5/26/2025 2 Difference between debt and equity? Debt does not confer ownership rights It is merely an IOU A promise to pay interest at periodic intervals And to repay the principal at a pre-specified maturity date. 5/26/2025 3 It usually has a finite life span Perpetual debt is rare but happens The interest payments are contractual obligations Borrowers are required to make payments irrespective of their financial performance 5/26/2025 4 Interest payments to be made before any dividends for equity holders. In the event of liquidation The claims of debt holders must be settled first Only then can equity holders be paid. 5/26/2025 5 Bonds and debentures are termed as Fixed Income Securities Once the rate of interest is set at the onset of the period for which it is due It is not a function of the profitability of the firm Failure to pay the promised interest will tantamount to default 5/26/2025 6 Bonds may be secured or unsecured Unsecured debt securities are termed as Debentures in the US Unsecured means no specific assets have been earmarked as collateral Secured debt requires the firm to earmark specific assets as collateral Secured debt holders enjoy priority from the standpoint of payments 5/26/2025 7 Debt securities may be negotiable or non- negotiable Negotiable securities can be traded in the secondary market Can be endorsed by one party in favor of another Examples of non-negotiable debt securities National savings certificates Conventional Time or Fixed deposits 5/26/2025 8 The most basic form of a bond is called the Plain Vanilla version. 5/26/2025 9 This is true for all securities, not just for bonds. More complicated versions are said to have `Bells and Whistles’ attached. 5/26/2025 10 These bonds are slightly different The interest rate does not remain fixed It varies each period based on the reference rate Short-term reference rate – maturity < 1 year Floating rate bonds Longer-term reference rate Variable or adjustable rate bonds 5/26/2025 11 Convertible bonds can be converted to shares of stock Callable bonds can be prematurely retired by the issuer Putable bonds can be prematurely surrendered by the holders 5/26/2025 12 It is the principal value Amount payable by the borrower to the last holder at maturity. Amount on which the periodic interest payments are calculated. A.K.A as Par Value Redemption Value Maturity Value Principal Value 5/26/2025 13 It is the time remaining in the life of the bond. The length of time for which interest has to be paid as promised. The length of time after which the face value will be repaid. A.K.A as Maturity Term Tenor 5/26/2025 14 5/26/2025 15 The periodic interest payment that has to be made by the borrower. The coupon rate multiplied by the face value gives the rupee/dollar value of the coupon. 5/26/2025 16 Most bonds pays coupons on a semi-annual basis. True in UK/US/Australia/Japan In European and Eurobond markets annual payments are the norm 5/26/2025 17 In earlier days bonds were accompanied by a booklet of post-dated coupons Each coupon could be detached and redeemed on the corresponding coupon payment date Even today bearer bonds come with coupons The bearer certificate number is mentioned on the coupon 5/26/2025 18 Bond with a face value of $1000. The coupon rate is 8% per annum paid semi- annually. So the bond holder will receive 1000 x 0.08 ___ = $40 every six months. 2 5/26/2025 19 The rate of return if an investor buys the bond at the prevailing price and holds it till maturity. In order to get the YTM, two conditions must be satisfied. The bond must be held till maturity. All coupon payments received before maturity must be reinvested at the YTM. 5/26/2025 20 At any point in time the YTM may be Greater than Less than or Equal to the Coupon Rate YTM is the IRR of a bond 5/26/2025 21 Bonds involve pure cash flows So only ONE REAL POSITIVE YTM Solution to a Non-Linear equation Solved iteratively 5/26/2025 22 A holder gets a stream of contractually promised payments. The value of the bond is the value of this stream of cash flows. Cash flows arising at different points in time cannot be added Cash flows have to be discounted 5/26/2025 23 It is a chicken and egg story If we know the yield that is required we can quote a price Once we acquire the asset at a certain price, we can work out the corresponding yield. 5/26/2025 24 A bond will pay identical coupons every period And will repay the face value at maturity. The periodic cash flows constitute an annuity. The terminal face value is a lump sum payment. 5/26/2025 25 Bond pays a semi-annual coupon of $C/2, and has a face value of $M. Assume there are N coupons left And that we are standing on a coupon date. We are assuming that the next coupon is exactly six months away. The required annual yield is y Implies that the semi-annual yield is y/2. 5/26/2025 26 The present value of the coupon stream is: 5/26/2025 27 The present value of the face value is: 5/26/2025 28 So the price of the bond is: 5/26/2025 29 IBM has issued a bond with a face value of $1,000. The coupon is 8% per year to be paid on July 15 and January 15 every year. Today is 15 July 2013 and that the bond matures on 15 January 2033. The required yield is 10% per annum. 5/26/2025 30 JJ – 01/15 FA – 01/15 MS – 01/15 AO – 01/15 MN – 01/15 JD – 01/15 5/26/2025 31 5/26/2025 32 In the example the price is less than the face value Such a bond is called a Discount Bond It is trading at a discount from the face value. The reason is that The yield is greater than the coupon 5/26/2025 33 If the yield were to equal the coupon The bond would sell at PAR Such bonds are called PAR Bonds If the yield is less than the coupon The price will exceed the face value. Such bonds are called Premium Bonds 5/26/2025 34 As we move from one coupon date to the next, if the YTM were to remain constant Par bonds would continue to trade at PAR Premium bonds will steadily decline in price Discount bonds will steadily increase in price This is called the Pull to Par Effect At maturity – ALL BONDS WILL TRADE AT PAR 5/26/2025 35 As we approach maturity the number of coupons reduces The contribution of coupons to price reduces The contribution of the PV of the face value increases For premium bonds the first effect dominates Thus the price steadily declines For discount bonds the second effect dominates Thus the price steadily increases 5/26/2025 36 26-05-2025 37 26-05-2025 38 For par bonds c = y and the change in price is zero For premium bonds c > y and the change in price is negative For discount bonds c < y and the change in price is positive 26-05-2025 39 A plain vanilla or Bullet Bond pays the entire face value at maturity in a lump sum Amortizing bonds pay the principal in installments The first payment occurs before maturity The last payment is made at maturity 5/26/2025 40 Consider a 5 year amortizing bond with a face value of $1,000 and an annual coupon of 8%. The annual cash flows are depicted below Time Cash Flow 1 80 2 80 3 330 4 310 5 540 5/26/2025 41 The first two cash flows represent interest on a principal of $1,000 The third cash flow is interest on $1,000 plus a principal payment of $250 The outstanding principal is $750 The fourth cash flow is interest on $750 plus a principal payment of $250 The outstanding principal is $500 The final cash flow is interest on $500 plus the remaining principal of $500 5/26/2025 42 Some companies issue such bonds because the assets being funded have a similar cash flow profile Second the coupon on such a bond may be lower than that of a bullet bond In the case of a bullet bond the entire principal is due at a single point in time There is greater default risk 5/26/2025 43 5/26/2025 44 Plain Vanilla bonds pay coupons every period and repay the face value at maturity. A Zero Coupon Bond does not pay any coupon interest. Issued at a discount from the face value Repays the principal at maturity. Face Value – Price, constitutes the interest for the buyer. 5/26/2025 45 Microsoft is issuing zeroes with 5 years to maturity and a face value of $10,000. The required yield is 10% per annum What should be the price? Price is the PV of the face value In practice we discount on a semi-annual basis This will give a lower price than if we were to use annual discounting 5/26/2025 46 This is to facilitate comparisons with conventional bonds 5/26/2025 47 A zero coupon bond can never sell at a premium It will always trade at a discount prior to maturity At maturity it will trade at par 5/26/2025 48 If held to maturity a ZCB will always give rise to a capital gain If sold prior to maturity there may be a capital gain or a capital loss Consider a bond with 10 years to maturity The YTM at the time of purchase was 10% The cost was $376.90 A year later it is sold at a YTM of 12% The corresponding price is $350.35 5/26/2025 49 For bonds with a given maturity ZCBs have the highest price sensitivity Bullish speculators anticipating a rate decline will fancy such bonds Investors seeking a locked in return over a long-term – such as Pension Funds Like such bonds There is an assured return if held till maturity 5/26/2025 50 A newly established issuer Or an issuer with a relatively virgin product or service Or a restructured company due to a merger or following a bankruptcy Will be perceived as more risky Investors will demand a high coupon Such firms are unlikely to have high earnings Revenues will peak only after the product/service is established 5/26/2025 51 They can ill afford high coupons They may consider a step-up coupon bond Where the coupon increases as the bond ages Assume a company can issue a plain vanilla at a coupon of 8% with a maturity of 5 years Instead, it may opt for a bond With a coupon of 6% for the first three years And a coupon of 10% for the last two years This is a Deferred Interest Security Provides the issuer with breathing room in the earlier years 5/26/2025 52 Step-ups usually are callable by the issuer on each anniversary date In the case of one-step bonds the coupon will reset once during the life of the bond In the case of multi-step bonds the coupon will reset many times These bonds generally provide a greater weighted average coupon than plain vanilla bonds 5/26/2025 53 As the coupon rate on a step-up rises over comparable rates the bond is likely to be called The investor will not receive these higher payments As compensation for the right to redeem early these bonds will provide a higher coupon However the scheduled coupon increases may not keep pace with prevailing market rates 5/26/2025 54 These are suitable for investors who believe rates will go up in the future and who value the possibility of an increasing income stream 5/26/2025 55 With these securities the bond will initially pay a higher coupon and the coupon rate will be reduced with the passage of time These are also callable in nature 5/26/2025 56 These pay coupons in the form of additional securities and not cash This offers the issuer time to prepare for cash outlays The securities used to pay interest are usually identical to the underlying securities but may at times be different 5/26/2025 57 They are used as Mezzanine Finance They rank between senior debt and equity in the capital structure Investors take more risk as compared to buyers of regular bonds – but get higher returns Issuers can conserve cash in earlier years when it is at a premium These typically mature only after all other more senior debt has matured Thus investors have to wait a long time for their principal and compounded interest to mature 5/26/2025 58 5/26/2025 59 Fully backed by the federal government of the issuing nation. Consequently, they are virtually devoid of credit risk or the risk of default. The yield on such securities is a benchmark for setting rates on other kinds of debt. 5/26/2025 60 Treasury securities are issued To finance expenses in excess of current revenues To pay interest on debt accumulated in earlier years due to deficits in those years To repay past debt issues that are currently maturing The US Treasuries market Is the largest bond market in the world Is the most liquid bond market in the world 5/26/2025 61 The Treasury issues three categories of marketable securities. T-bills are discount securities They are zero coupon securities T-notes and T-bonds are sold at face value and pay interest periodically. 5/26/2025 62 T-bills are issued with a original time to maturity of one year or less. They are Money market instruments. They have maturities of either 1, 3, 6, or 12 months at the time of issue. 5/26/2025 63 T-notes and T-bonds have a time to maturity exceeding one year at the time of issue. They are capital market instruments. T-notes have maturities ranging from 1-10 years T-bonds have an original maturity in excess of 10 years, extending up to 30 years. 5/26/2025 64 An issue may be followed later by a further issue With the same remaining time to maturity and the same coupon The issuance of further tranches is termed as a Re-opening. 5/26/2025 65 Six months ago a 10-year note was issued with a coupon of 8% per annum. Today if a note with 9 ½ years to maturity and a coupon of 8% issued it will add to the pool that is already trading in the market Thus it is a re-opening of an existing issue 5/26/2025 66 Consider the following details: Interest Rate – 2.500% High Yield – 2.605% Price – 99.5107 Accrued Interest – None Issue Date – March 31, 2020 Maturity Date – March 31. 2025 Original Issue Date – March 31, 2020 Dated Date – March 31, 2020 This is an issue of new security with a maturity of 5 years Issue date is same as the Original issue date Dated date is the first date from which coupons begin to accrue, and, in this case, same as the issue date 5/26/2025 67 Consider the following details: Interest Rate – 4.6250% High Yield – 4.7700% Price – 97.6929 Accrued Interest – 7.53798 Issue Date – April 15, 2020 Maturity Date – February 15, 2050 Original Issue Date – February 16, 2020 Dated Date – February 15, 2020 This is a reopening of an existing Treasury security On February 16, 2020, 30-yr T-Bonds were issued. On April 15, 2020, a fresh issue was made (29 years & 10 months), with the same coupon adding to the existing supply This is the import of the word reopening Issue date is 2 months after the original issue date. February 15 th was a market holiday, hence, the dated date is February 15th, the original issue date is February 16th Auction cleared at 4.770%, coupon known and hence accrued interest can be computed 5/26/2025 68 Who is a primary dealer? A PD is a dealer who is authorized to deal directly with the Central Bank of the country In the US, a PD is a bank or securities brokerdealer that directly deals with the FRBNY Importance of FRBNY In India a PD deals directly with the RBI 5/26/2025 69 5/26/2025 70 The Treasury sells bills, notes, and bonds by way of a competitive auction process. Most of the treasury securities are bought by primary dealers. Individual investors submit non-competitive bids and participate on a much smaller scale. 5/26/2025 71 Bids may be: Competitive Indicate price & quantity or yield & quantity Non-competitive Indicate only quantity Small investors and individuals generally submit non-competitive bids A non-competitive bidder may not bid for more than $5MM worth of securities in a bill or bond auction 5/26/2025 72 Primary dealers bid for their accounts and on behalf of their clients They usually submit large competitive bids Bids indicate the maximum price that the bidder is prepared to pay if it is a price-based auction Or the minimum yield that the bidder is prepared to accept if it is a yield-based auction 5/26/2025 73 The Treasury will net out the total amount of non-competitive bids The balance will be allocated to competitive bidders. There are two ways in which securities can be allotted The multiple price/yield auction mechanism French Auctions The uniform price/yield auction mechanism Dutch Auctions 5/26/2025 74 Assume that the Treasury is offering 25 billion dollars worth of T-bonds. 2 billion dollars worth of non-competitive bids have been received. So, 23 billion dollars worth of bonds are available to be offered to the competitive bidders. 5/26/2025 75 There are six competitive bidders who have submitted the following yields. The bids have been arranged in ascending order of yield. In a price-based auction the bids would have been arranged in descending order of price. 5/26/2025 76 Bidder Bid Yield 5.370 Bid Amount 3.0 bn Aggregate Amount 3.0 bn Alpha Beta 5.372 5.0 bn 8.0 bn Gamma 5.373 4.0 bn 12 bn Delta 5.375 8.0 bn 20 bn Charlie 5.375 12.0 bn 32 bn Tango 5.380 3.0 bn 35 bn 5/26/2025 77 The aggregate demand equals the amount on offer at a yield of 5.375. A multiple yield auction will lead to the following allocation. Alpha will get 3 bn at a yield of 5.370 Beta will get 5 bn at 5.372 Gamma will get 4 bn at 5.373 5/26/2025 78 At a yield of 5.375 we have only 11 bn left to allocate. There is a demand of 20 bn at this yield 8 bn from Delta and 12 bn from Charlie. Thus, we will allocate 11/20 = 55% to each bidder at this yield There will be pro-rata allocation 0.55 of 8 bn or 4.40 bn will go to Delta 0.55 of 12 bn or 6.6 bn will go to Charlie 5/26/2025 79 The highest accepted yield is called the Stop Yield or High Yield In this case it is 5.375 The ratio of bids received to the amount awarded is known as the bid to cover ratio The higher the ratio the stronger is the auction 5/26/2025 80 The second type of auction is called a uniform price/yield auction. Aggregate demand is equal to the supply at a yield of 5.375%. Thus, everyone who bid less will be allotted the quantities sought at this yield. The two bidders at 5.375 will also be awarded at this yield but on a pro-rata basis. 5/26/2025 81 Those who bid more than 5.375 will get nothing and are said to be shutout of the auction. Since 1999 the U.S. Treasury has been conducting only uniform yield auctions. 5/26/2025 82 RBI to auction green bonds in 2 tranches of ₹8,000 crore each in Jan, Feb 2023 https://www.livemint.com/econ omy/rbi-to-auction-green-bondsin-2-tranches-of-rs-8-000-croreeach-in-jan-feb11673001742031.html Some of the highlights are: It is a Uniform price auction 5% of the notified amount is reserved for retail investors (for non-competitive bidding) Eligible for 'When-Issued' trading 5/26/2025 83 The issuer has the right to call back the bond prematurely. They buy back from the holders before maturity by paying the face value. The option is with the issuer, and so it has to pay a price This price will manifest itself as a lower price for the bond as compared to a Plain Vanilla Bond. 5/26/2025 84 A lower price means a higher yield. Thus, buyers of callable bonds demand a higher yield This is because a buyer of a callable bond is exposed to cash flow uncertainty. He can never be sure as to when a bond will be recalled. 5/26/2025 85 When will a callable bond be recalled? When interest rates or required yields are falling. The issuer can call back the bonds and issue fresh bonds with a lower coupon In such a scenario holders would like to hold on They are getting a higher rate of interest. 5/26/2025 86 The call provision works in favor of the borrower and against the lender. Hence callable bonds command a lower price. The way to look at it is as follows At the time of issue, a callable bond has to carry a higher coupon Subsequently, a callable with a given coupon will have a lower price than a Plain Vanilla with the same coupon. 5/26/2025 87 A bond may be discretely callable or continuously callable A discretely callable bond may be recalled only at certain pre-specified dates For instance, the coupon dates over a period of the bond’s life A continuously callable bond may be called at any time after it becomes callable 5/26/2025 88 Freely callable bonds can be called at any time. Thus, they offer the lender no protection. Deferred Callable Bonds on the other hand do offer some protection. They have a Call Protection Period 5/26/2025 89 In practice when a bond is recalled, the issuer will pay the lender a Call Premium This is normally half-year’s or one year’s coupon The call premium acts as a sweetener That is, it makes such bonds more attractive to potential investors. 5/26/2025 90 One of the risks in a callable bond is reinvestment risk The bond will be called back when market rates are low And consequently, the proceeds will have to be invested at a lower rate of interest. 5/26/2025 91 The price appreciation potential for a callable bond In a declining interest rate environment is limited. The market will increasingly expect the bond to be redeemed at the call price as rates fall. This is referred to as Price Compression. 5/26/2025 92 Given the reinvestment risk and price compression Why would any investor want to hold such a bond? If there is sufficient compensation in the form of a higher yield, he may be willing to take the risk. 5/26/2025 93 The bondholder has the right to return the bond prematurely, and take back the face value. The option is with the bondholders and hence they have to pay an option premium. This will manifest itself as a higher bond price As compared to that of an otherwise similar plain vanilla bond. 5/26/2025 94 When will such a put option be exercised? When interest rates are rising. Holders can return the bonds and buy fresh bonds with a higher coupon At such times the issuers would prefer that the holders hold on to the bonds. 5/26/2025 95 Since the put option works in favour of the holder and against the issuer Such bonds are characterized by higher prices or lower yields. At the time of issue, a puttable will carry a lower coupon than an equivalent Plain Vanilla Subsequently a puttable will carry a higher price than a Plain Vanilla with the same coupon. 5/26/2025 96 The price at which a bond can be put by the holder acts as a floor price In a rising rate environment Since the holders can always surrender the bonds at this price They will never sell at a lower price. 5/26/2025 97 They grant the holder the right to convert the bond into a predetermined # of shares It is a Plain Vanilla corporate bond with a call option to buy the common stock of the issuer. 5/26/2025 98 The number of shares receivable on conversion is called The Conversion Ratio. The conversion privilege may extend for all or only a portion of the bond’s life. The conversion ratio may also decline over time. The conversion ratio is adjusted proportionately for stock splits and stock dividends. 5/26/2025 99 ABC Corporation has issued the following bond Maturity = 10 years Coupon rate = 8% Conversion ratio = 40 Face value = $1,000 Current market price = $900 Current share price = $20 5/26/2025 100 The conversion price = 1000 ------- = $25 40 The conversion value of a convertible bond is the value if it is converted immediately. Conversion value = Share price x Conversion Ratio 5/26/2025 101 The minimum price of a convertible bond is the greater of: Its conversion value or Its value as a bond without the conversion option. This is also called the straight value of the bond. 5/26/2025 102 To estimate the straight value, we need the required yield on a non-convertible bond with the same credit rating and similar investment characteristics. 5/26/2025 103 In our case the conversion value is $20 x 40 = $800 Assume the YTM of a comparable straight bond is 10%. Straight value = 40PVIFA(5,20)+1000PVIF(5,20) = $875.38 5/26/2025 104 What is risk? Risk is the possibility of loss arising due to the uncertainty regarding the outcome of a transaction. All bonds are exposed to one or more sources of risk. 5/26/2025 107 5/26/2025 108 AKA default risk Refers to the possibility of default by the borrower. The risk that coupon payments and/or principal payments may not be made as promised. Treasury securities are backed by the full faith and credit of the Federal government All other debt securities are exposed to credit risk of varying magnitudes. 5/26/2025 109 At the time of issue, the issuer provides information About his financial soundness and creditworthiness. This is provided in the Offer Document or the Prospectus. But every investor cannot decipher such a document Thus, in practice we have credit rating agencies. 5/26/2025 110 5/26/2025 111 They specialize in evaluating the credit quality of a bond at the time of issue. They also monitor the issuing company, throughout the life of the bond And modify their recommendations if required. The main rating agencies in the U.S. are Moody’s Investors Service Standard and Poor’s Corporation and Fitch Ratings. 5/26/2025 112 Credit Risk Highest Quality High Quality Upper Medium Medium Moody’s Ratings Aaa S&P’s Ratings AAA Fitch’s Ratings AAA Aa AA AA A A A Baa BBB BBB 5/26/2025 113 Credit Risk Moody’s S&P Fitch Somewhat Speculative Ba BB BB Speculative B B B Highly Speculative Caa CCC CCC Most Speculative Ca CC CC Imminent Default C C C Default C D D 5/26/2025 114 Credit Risk FITCH CRISIL CARE ICRA Prime AAA AAA AAA LAAA High Grade Upper Medium Lower Medium AA AA AA LAA A A A LA BBB BBB BBB LBBB 5/26/2025 115 Credit Risk FITCH CRISIL CARE ICRA Noninvestment Grade BB BB BB LBB Highly B Speculative B B LB Dangerously C C C LC D D D LD Speculative Default 5/26/2025 116 Non-investment grade bonds are also known as Speculative grade bonds Or High Yield Bonds Or JUNK Bonds JUNK bonds may be Original issue junk Or Fallen Angels 5/26/2025 117 Ratings can change over the course of time. If a rating change is being contemplated, the agency will signal its intentions. S&P will place the security on Credit Watch. Moody’s on Under Review. Fitch on Rating Watch. 5/26/2025 118 It measures the ability of the issuers to meet its commitments on time It depends on Analysis of the issuer’s financial condition and management The features of the debt security . The specified revenue sources backing the issue 5/26/2025 119 Agencies consider the following Ability of the issuer to generate cash flows in the future The level and predictability of future cash flows relative to the commitments on debt Survey done by Moody’s using data for the period 1920 to 2001 Showed that the average one-year default rate for Aaa bonds was zero However, for B rated bonds it was 6.8% In a 10-year period only 0.82% of Aaa bonds missed a payment For B rated bonds however, the figure was 43.90% 5/26/2025 120 A company can have its issue insured to enhance its credit quality. An insurance premium will have to be paid, but the coupon rate will come down. The insurance company will guarantee the timely payment of the principal and interest. 5/26/2025 121 Insured bonds will receive a rating based on the insurer’s capital and claims-paying ability. In the U.S., the buyer of an uninsured bond can buy insurance for his portfolio 5/26/2025 122 The guarantee provided by insurance companies is unconditional and irrevocable There will be no repercussions if the issue gets downgraded subsequently Issuers of insured bonds Get funds at reduced rates Get a diversified pool of investors Investors in such bonds Get an assurance of timely payments Benefit of extensive credit analysis Due diligence by the insurer Post issuance monitoring by the insurer 5/26/2025 123 Insurance facilities provide debt market access to less well known issuers They broaden the market for issuers with better credit ratings They facilitate cross-border fund raising 5/26/2025 124 5/26/2025 125 The possibility that the market may be illiquid or thin When the asset holder wants to buy or sell the security. A liquid market is characterized by a sizeable number of buyers and sellers 5/26/2025 126 In illiquid markets, buyers will have to offer a large premium over the fair value Whereas sellers will have to accept large discounts at the time of sale. Illiquid markets are characterized by large bid-ask spreads Because trades will be few and far between. 5/26/2025 127 We usually define the fair price of a security as the average of the best bid and the best ask For we know it falls somewhere between The impact cost measures the extent by which an order of a given size moves the market 128 When an order is executed we compute the weighted average price. Assume that a buy order for 1000 shares got executed as follows 200 shares at 100 300 shares at 101.50 500 shares at 101 The WAP is 100.95 129 Assume that prior to entry the best bid was 99 and the best ask was 100 The fair price is 99.50 The impact cost is defined as (WAP – FP) ÷ FP Had it been a sell order we would have defined it as (FP – WAP) ÷ FP 130 The impact cost depends on the direction of the order A sell order for 500 shares will usually not have the same impact as a buy order for 500 shares It also depends on the order size A buy order for 500 shares will have a different impact than a buy order for 1000 shares Higher the liquidity in the market lower will be the impact of an order of a specified size 131 5/26/2025 132 The interest rate or yield is the key variable of interest in debt markets. Interest rate risk is the risk that rates may move in an adverse fashion 5/26/2025 133 Interest rate risk impacts fixed income securities in two ways. All bonds with the exception of zeroes pay coupons These have to be reinvested. Reinvestment risk is the risk that market rates of interest may decline before a coupon is received. If so, the coupon will have to be reinvested at a lower than anticipated rate of interest. 5/26/2025 134 Secondly a bond may not be held to maturity. If it is sold prior to maturity, it will have to be at the prevailing market price This will be inversely related to the prevailing yield. 5/26/2025 135 Market Risk or Price Risk, is the risk that interest rates may be higher than anticipated in which case the bond will have to be sold at a lower than anticipated price. The two risks work in opposite directions. Reinvestment risk arises because rates may fall subsequently Market risk arises because rates may rise subsequently. 5/26/2025 136 5/26/2025 137 Inflation is the erosion in the purchasing power of money. Most bonds promise fixed cash flows in dollar terms. Inflation risk is the risk that the purchasing power may have eroded more than expected By the time the cash flow from the bond is received. 5/26/2025 138 High inflation will reduce the effective or Real rate of interest. The interest rate in monetary terms is called the Nominal Rate of interest. The Real Rate, is the nominal rate adjusted for changes in the purchasing power. 5/26/2025 139 From the Fisher Equation: (1+R) = (1+r)(1+) R Nominal rate r real rate inflation rate 5/26/2025 140 These are bonds whose coupons are linked to a price index. Price indices are a barometer of changes in the purchasing power of a currency. If inflation is high, so will be the index level and vice versa. 5/26/2025 141 Thus indexed bonds will offer higher cash flows during times of high inflation And relatively lower cash flows during periods of lower inflation This will ensure that the cash flow in real terms is kept at a virtually constant level. 5/26/2025 142 5/26/2025 143 For Plain Vanilla bonds, there is no uncertainty about the timing of inflows However, callable bonds can be recalled at any time. For a callable bond holder there is cash flow uncertainty He is unsure as to how many coupons he is going to get And also as to when the face value will be repaid. 5/26/2025 144 Thus holders of callable bonds will demand a premium for bearing this risk. That is why callable bonds trade at a lower price than comparable plain vanilla bonds. 5/26/2025 145 5/26/2025 146 This risk arises when the cash flows from a bond are denominated in a foreign currency. If the foreign currency depreciates in value with respect to the home currency The returns will be lower than anticipated. 5/26/2025 147 A bond promises to pay a coupon of $10 every six months. Assume that the rate of exchange is Rs 80 per dollar. So an Indian bondholder will expect to receive Rs 800 every six months. However, what if the exchange rate at the time of the coupon payment is Rs 75. If so, he will receive only Rs 750. 5/26/2025 148
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