CFA L1 ClassNotes Sample

Study Session 16
Fixed Income Analysis and

Valuation
CFA_L1V2_Class_Lecture_Notes.indb 211
11/20/2012 12:20:00 PM
11/20/2012 12:20:00 PM
Kaplan, Inc.
flows (e.g., call features, put features,

prepayment options, and sinking fund
provisions)
Uncertainty about coupon amounts
(
(e.g.,
floating-rate
fl ti
t coupons))
Uncertainty about cash flows due to
conversion options or exchange options
Uncertainty about timing of principal cash
Introduction to the
Valuation of Debt Securities
Difficulties in Estimating the

Cash Flow Stream
LOS 56.b Describe

CFAI p. 448, Schweser p. 87
Fixed Income Investments
56. Introduction to the

Valuation of Debt
Securities
Fixed Income:
Analysis and Valuation
Introduction to the
Introduction to the
Term to maturity = 3 years

Par = $1,000
Coupon = 8% annual coupon
Discount rate 12%
Kaplan, Inc.
Valuing an Annual-Pay Bond Using

a Single Discount Rate
LOS 56.c Calculate

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Bond value = present value of future cash flows,

coupons and principal repayment
coupons,
1. Estimate cash flows
2. Determine the appropriate discount rate
The risk factors in Study Session 15 all require
increases in yield, including liquidity risk, interest
rate risk, call/prepayment risk, credit risk/default
risk, etc.
3. Calculate present values of promised cash flows
3-Step Bond Valuation Process
LOS 56.a Explain

Study Session 16 Fixed Income Analysis and Valuation
212
11/20/2012 12:20:01 PM
Introduction to the
80
80
N = 6; I/Y = 6; PMT = 40; FV = 1,000;

CPT PV = 901.65
PMT = coupon / 2 = $80 / 2 = $40

N = 2 # of years to maturity = 3 2 = 6
I/Y = discount rate / 2 = 12 / 2 = 6%
FV = par = $1,000
Same (8% 3-year) Bond With a

Semiannual-Pay Coupon
Kaplan, Inc.
1,000
80
T3
7-2
Introduction to the
T2
T1
LOS 56.c Calculate

Kaplan, Inc.
T0
8% Annual-Pay Bond Cash Flows
LOS 56.c Calculate

Introduction to the
Introduction to the
6-2
Kaplan, Inc.
901.65
40
40
40
40
40
1040
1
2
3
4
5
1.06 1.06
1.06
1.06
1.06
1.066
8% 3-Year Bond With Semiannual

Coupon Payments
LOS 56.c Calculate

Kaplan, Inc.
CPT PV = $903.93
N = 3; I/Y = 12; PMT = 80; FV = 1,000;
80
80
80 1,000
903.933
903 933
1
2
(1.12) (1.12)
(1.12)3
Bond Value: 8% Coupon, 12% Yield
LOS 56.c Calculate

213
11/20/2012 12:20:02 PM
1.04
Introduction to the
$790.31
Kaplan, Inc.
11 - 3
3. What is the value after 2 years if the yield does

not change?
2. What is the value after 1 year if the yield does not

change?
A 6%,, 10-year
y
semiannual coupon
p bond has a YTM
of 8%
1. What is the price of the bond?
Value Change as Time Passes

Problem
Kaplan, Inc.
Mathematically:
1,000
TVM Keys:
N = 3 2 = 6, PMT = 0, FV = 1,000,
I/Y = 8 / 2 = 4
CPT PV = 790.31
$ ,
$1,000
par
p value zero-coupon
p bond matures in
3 years and with a discount rate of 8%
9-2
Introduction to the
Calculate a Zero-Coupon Bond

Price
LOS 56.c Calculate

Maturity
M
maturity
Kaplan, Inc.
12 - 3
I/Y = 6% N = 6 FV = 1,000 PMT = 40

CPT PV = $901.65
I/Y = 4% N = 6 FV = 1,000 PMT = 40

CPT PV = $1,000.00
At 8%:
At 12%:
I/Y = 2% N = 6 FV = 1
1,000
000 PMT = 40
CPT PV = $1,112.03
At 4%:
Price-Yield Relationship
Semiannual-Pay 8% 3-year Bond
Introduction to the
10
A discount bond (e.g., 8%

bond trading at YTM of 12%)
Time
3 years
Time to maturity
trading at YTM of 8%)

A discount bond ((e.g.,
g , a 8% bond tradingg
at YTM of 12%)
A par value bond (e.g., a 8% bond trading

at A
YTM
8%) bond (e.g., 8% bond
par of
value
LOS 56.e Calculate

Kaplan, Inc.
$901.65
901.654
1,000.00
$1,000.00
$1,112.03
1,142.430
8% bond,
premiumbond
p
bond(e.g.,
(g ga 8%
8%bond trading at
AA premium
(e(e.g.,
3 years to
t
bond of
trading
YTM
3%) at YTM of 4%)
Introduction to the
Price Change as Maturity

Approaches
LOS 56.d Explain

214
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Introduction to the
12 mo.
18 mo.
Kaplan, Inc.
15
Buy the bond for $984, strip it, sell the pieces for a
total of $986.55, keep the arbitrage profit = $2.55
30
30
1030
986.55
2
3
1.025
0 5 1.03
1 03
035
11.035
6 mo.
Valuing the Pieces Using Spot

Rates
LOS 56.f Explain/Demonstrate/Describe

Kaplan, Inc.
Dealers can separate a coupon Treasury security

into separate cash flows (i.e.,
(i e strip it)
it). If the total
value of the individual pieces based on the
arbitrage-free rate curve (spot rates) is greater or
less than the market price of the bond, there is an
opportunity for arbitrage.
The present value of the bonds
bond s cash flows
(pieces) calculated with spot rates is the
arbitrage-free value
13
Introduction to the
Arbitrage-Free Bond Prices

Introduction to the
5%
6%
7%
0 5 years
0.5
1.0 years
1.5 years
3.5%
3.0%
2 5%
2.5%
14
Kaplan, Inc.
16
cash flows or combine the individual cash

flows into a bond
If the bond is priced less than the arbitrage free
value: Buy the bond, sell the pieces
If the bond is priced higher than the
arbitrage-free value: Buy the pieces,
pieces make a
bond, sell the bond
Dealers can strip a T-bond into its individual
Arbitrage Process
Introduction to the
$1030
$30
$30
Semiannual
Cash flow
rate
(per $1,000)

Kaplan, Inc.
Annual rate
Maturity
V l cash
Value
h flows
fl
using
i ((annual)
l) spott rates
t
of 6 months = 5%, 1 year = 6%, 1.5 year = 7%
Market price of a 1.5-year 6% Treasury note is $984
Arbitrage-Free Pricing Example

215
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Kaplan, Inc.
Cash flow yield
Yield to worst
Yield to put
Yield to refunding
Yield to call
Yield to maturity
Current yield
IRR-based
IRR
based yields
Nominal yield (stated coupon rate)
19
Yield Measures, Spot

Rates, and Forward Rates
Traditional Measures of Yield
LOS 57.b Calculate/Interpret/Explain

57. Yield Measures, Spot

Rates, and Forward
Rates
Fixed Income:

18

60
60
1060
2
1 YTM 1 YTM 1 YTM3
Kaplan, Inc.
Priced at a discount YTM > coupon rate
PV = 943; CPT I/Y = 8.22%
TVM functions: N = 3; PMT = 60; FV = 1,000;
943
20
Consider a 6%, 3-year, annual-pay bond priced at $943
YTM for an Annual-Pay Bond

Kaplan, Inc.
1. Coupon interest
2. Capital gain or loss when principal is repaid
3. Income from reinvestment of cash flows
Sources of Bond Return
LOS 57.a Describe

216
11/20/2012 12:20:04 PM

Kaplan, Inc.
21
23 - 2

Equivalent Yields Problem
coupon 1
coupon 2
coupon N + par value
....
2
N
1+ YTM
YTM
1+
1+ YTM
2
2
2
An annual pay bond has a YTM of 14%.

The BEY for this bond is:
A. 13.54%.
B. 13.86%.
C. 14.49%.
Kaplan, Inc.
price =
With semiannual coupon payments, YTM is

2 the
th semiannual
i
l IRR
YTM for a Semiannual-Pay Bond



22
Annual coupon payment

Current price
Kaplan, Inc.
Current yield =
80
= 8.873% YTM = 12%
901.65
24
For an 8%, 3-year (semiannual-pay) bond priced at 901.65
Current yield =
Current Yield
(Ignores Movement Toward Par Value)

Kaplan, Inc.
Note: BEY for short-term securities in Corporate

Finance reading is different
The YTM for a semiannual-pay bond is called a

Bond Equivalent Yield (BEY)
CPT I/Y = 2%; YTM = 2 2% = 4%
N = 6; PMT = 25; FV = 1,000; PV = 1,028;
A 3-year, 5% Treasury note is priced at $1,028
Semiannual-Pay YTM Example

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Yield to Call Problem
N = 4 PMT = 25 FV = 1,010 PV = 1,028

CPT I/Y = 2.007% 2 = 4.014% = YTC
If it is callable in two years at 101, what is the

YTC?
N = 20 PMT = 25 FV = 1,000 PV = 1,028

CPT I/Y = 2.323% 2 = 4.646% = YTM
Kaplan, Inc.
25 - 3
27 - 5

Consider a 10-year, 5% bond priced at $1,028

What is the YTM?
Kaplan, Inc.
For a bond trading at a premium, order the

coupon (nominal) yield
yield, current yield
yield, and YTM
from smallest to largest.
Yield Measures Problem


putt date
d t for
f par and
d number
b off periods
i d tto
the put date for N
Cash flow yield is a monthly IRR based on
the expected cash flows of an amortizing
(mortgage) security
For YTP, substitute the put price at the first
Kaplan, Inc.
26
28

Yield to Put and Cash Flow Yield

Kaplan, Inc.
callll d
date
t ffor par and
d number
b off periods
i d tto th
the
first call date for N
Use yield to refunding when bond is currently
callable but has refunding protection
Yield to worst is the lowest of YTM and the
YTCs for all the call dates and prices
For YTFC, substitute the call price at the first
Yield to First Call or Refunding

218
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Kaplan, Inc.
1.08 1 2 = 7.846%
Annual-pay YTM is 8%
8%, what is the equivalent
semiannual-pay YTM (i.e., BEY)?
29
31

Annual-Pay YTM to
Semiannual-Pay YTM
LOS 57.d Calculate/Interpret

Kaplan, Inc.
1. Assumes held to maturity

y ((call,, put,
p ,
refunding, etc.)
2. Assumes no default
3. Assumes cash flows can be reinvested at
the computed yield
4 Assumes
4.
A
flat
fl t yield
i ld curve (t
(term structure)
t t )
Assumptions and Limitations of

Traditional Yield Measures
LOS 57.b,c Calculate/Interpret/Explain/Describe


Kaplan, Inc.
Semiannual yield is 8 / 2 = 4%. Annual-pay

equivalent (EAY) is:
Semiannual pay YTM (BEY) is 8%

Semiannual-pay
8%, what is the
annual-pay equivalent?
0.08
1 2 1 8.16%
30
32

Semiannual-Pay YTM to
Annual-Pay YTM

Kaplan, Inc.
Other things being equal, a coupon bonds

reinvestment
i
t
t risk
i k will
ill increase
i
with:
ith
Higher couponsmore cash flow to
reinvest
Longer maturitiesmore of the value of the
investment is in the coupon cash flows and
interest on coupon cash flows
Factors That Affect Reinvestment Risk
LOS 57.c Describe

219
11/20/2012 12:20:05 PM
BEY = 2 1.73 = 3.46%
Kaplan, Inc.
25
25
1,025
+
+
= 993.09
2
1.0173
(1.0226)
(1.0276)3
35
Use the spot rates we calculated to value a 5%

18
18-month
th T
Treasury note.
t
Valuing a Bond With Spot Rates
LOS 57.e Describe/Calculate

33

1,020
1 = 2.26%, BEY = 2 2.26 = 4.52%
975.34
Kaplan, Inc.
?=
20
1,020
20
1,020
+
= 995 995
= 975.34 =
2
1.0173
1.0173
(1+?)
(1+?)2
1-year 4% T-note is priced at 99.50
1.73%
1,022.5
1 = 2.76%, BEY = 2 2.76 = 5.52%
942.37

34
Kaplan, Inc.
36
Nominal spreads are just differences in YTMs

Zero-volatility (ZV) spreads are the (parallel)
spread to Treasury spot-rate curve to get PV =
market price
Equal amounts added to each spot rate to get
price
PV = market p
Nominal and Zero-Volatility Spreads
LOS 57.f Explain

Kaplan, Inc.
By bootstrapping, we calculated the 1-year spot

rate = 4.52% and the 1.5-year spot rate = 5.52%
?=
22.5
22.5
1,022.5
22.5
22.5
1,022.5
+
+
= 986 986
= 942.37 =
1.0173 (1.0226)2 (1 + ?)3

1.0173
(1.0226)2
(1+?)3
1.5-year 4.5% T-note is priced at 98.60
6-month T-bill price is 98.30, 6-month discount rate is
1,000
= 983
1.0173
Begin with prices for 6-month, 1-year, and 18-month

Treasuries:

Begin with prices for 6-month, 1-year, and 18-month

Treasuries:

Theoretical Treasury Spot Rates

Theoretical Treasury Spot Rates

220
11/20/2012 12:20:06 PM


1+S3 = (1 + S1 )(1+1F1 )(1+1F2 )

3
1+S3 = (1 + S1 )(1+2F1 )2
3
1+S3 = (1 + S2 )2 (1+1F2 )
Kaplan, Inc.
39
Cost of borrowing for 3 years at S3 should equal cost of:

Borrowing for 1 year at S1, 1 year at 1F1,
1 and 1 year at
F
1 2
Borrowing for 1 year at S1 and for 2 years at 2F1
Borrowing for 2 years at S2 and for 1 year at 1F2
37

Spot Rates and Forward Rates
LOS 57.g Explain/Calculate

Kaplan, Inc.

Kaplan, Inc.
40
Approximation: 3 5% 2 4% = 15% 8% = 7%
1+ S3 3 1= F so, 1.053 1= 7.03%

1 2
1.042
1+ S2 2
S2 = 4% , S3 = 5% , calculate 1F2
Forward Rates From Spot Rates

38
is the two-period rate, one period from now
2F1
Kaplan, Inc.
is the one-period rate, two periods from now
1F2
Must use OAS for debt with embedded options
is the one
one-period
period rate
rate, one period from now
1F1
Option cost > 0 for callable

callable, < 0 for putable
is the current one-period rate S1
1F0
Notation for one-period forward rates:
Forward rates are N-period rates for

b
borrowing/lending
i /l di att some date
d t iin th
the future
f t
Forward Rates

Option cost in yield% = ZV spread% OAS%
Option-adjusted spreads (OAS) are spreads that

take out the effect of embedded options on yield
yield,
reflect yield differences for differences in risk and
liquidity
Option-Adjusted Spreads
LOS 57.f Explain

221
11/20/2012 12:20:07 PM

1 = 2F2 so,
1.05 4
1.04 2
1 = 6.01%

41
Kaplan, Inc.
1+S1
1+S2 2
1+S3 3
43
40
40
1040
1,014.40
1.03
1
03 (1.03)(1.035)
(1 03)(1 035) (1
(1.03)(1.035)(1.04)
03)(1 035)(1 04)
Value a 4%, 3-year annual-pay bond
1-year rate is 3.0%; 1F1 = 3.5%; 1F2 = 4.0%
Valuing a Bond With Forward Rates

Kaplan, Inc.
is an annual rate, so we take the square root

above and divide by two for the approximation
2F2
12% / 2 = 6%
Approximation:
pp
4 5% 2 4% = 20% 8% = 12%
1+S4 4
1+S2 2
S2 4%, S4 5%, Calculate 2F2
Forward Rates From Spot Rates

Forward Rates Problem

Approximation : (4 + 5 + 5.5) = 4.833

3
Kaplan, Inc.
44 - 3
Current 1-year spot rate is 6%, 2-year spot rate

i 7%,
is
7% and
d3
3-year spott rate
t is
i 6%.
6% The
Th 1-year
1
forward rate for a loan 2 years from now is
closest to:
A. 6%.
B. 5%.
C. 4%.
Kaplan, Inc.
[(1.04)(1.05)(1.055)] 3 1 = S3 = 4.8314%
3-period spot rate =
Example: S1 = 4.0%, 1F1 = 5.0%, 1F2 = 5.5%
[(1+ S1 )(1+1 F1 )(1+1 F2 )] 3 1 = S3
Spot rate is geometric mean of forward rates
42

Spot Rates From Forward Rates

222
11/20/2012 12:20:07 PM
Kaplan, Inc.
90.79
100 00
100.00
110.67
7%
8%
YTM
Price falls at a decreasing

rate as yields increase.
9%
For an option-free bond,

the price-yield curve is
convex toward the origin.
47
Introduction to the
Measurement of Interest Rate Risk
Option-Free Bond Price-Yield

Curve
Price (% of par)
LOS 58.b,c Describe

58. Introduction to the

Measurement of
Interest Rate Risk
Fixed Income:
Introduction to the
Negative Convexity
Callable bond
Positive Convexity
Negative
convexity
YTM
Kaplan, Inc.
48
Callable bond = option-free value call option
Call price
Call option
value
Option-free bond
Price (% of par)
46
Introduction to the
Callable Bond Value
LOS 58.b,c Describe

Kaplan, Inc.
sensitivity of bond/portfolio values to changes in YTM

Limited scenarios (parallel yield curve shifts)
Provides a simple summary measure of interest rate risk
Duration/convexity approach: Gives an approximate
interest rate change scenario

Good valuation models provide precise values
Can deal with parallel and non-parallel shifts
Time consuming; many different scenarios
Full valuation approach: Re-value every bond based on an
Measuring Interest Rate Risk
LOS 58.a Distinguish/Explain

223
11/20/2012 12:20:08 PM
Introduction to the
y
49
YTM
Put option
value
Introduction to the
Option-free bond
Putable bond
Less interest rate

sensitivity
Kaplan, Inc.
current price
50 basis
points
51 - 2
V+
Interest rates 50 bp, new price is 104.414
V
104 414 95
104.414
95.848
848
8.57
2 100 0.005
Effective duration is:
Interest rates 50 bp, new price is 95.848
A 15-year, option-free bond, annual 8% coupon,

trading at par
par, 100
100. Calculate effective duration
based on:
Effective Duration Example

Kaplan, Inc.
Put price
Price (% of par)
Price-Yield for Putable Bond
LOS 58.b,c Describe

Introduction to the
Introduction to the
50
Change in YTM
V V
2(V0 )( y)
Price at YTM + y
Kaplan, Inc.
52- 1
Our 8%, 15-year par bond has a duration of 8.57

Duration effect = D y
If YTM increases 0.3% or 30 bp, bond price
decreases by approximately:
8.57 0.3% = 2.57%
Using Duration
LOS 58.e Calculate

Kaplan, Inc.
Current price
Duration
Price at YTM y
Computing Effective Duration

224
11/20/2012 12:20:08 PM
53
Introduction to the
Kaplan, Inc.
55
Present value-weighted average of the number

off years until
til coupon and
d principal
i i l cash
h flows
fl
are to be received
Slope of the price-yield curve (i.e., first
derivative of the price-yield function with
respect to yield)
Approximate percentage price change for a 1%
change in YTM: The best interpretation!
Duration Interpretation
LOS 58.f Distinguish/Explain

Kaplan, Inc.
for market yield, yield up duration down

Effective duration allows for cash flow
changes as yield changes, must be used for
bonds with embedded options
54
Introduction to the
Kaplan, Inc.
56
Duration of a portfolio of bonds is a portfolio

value-weighted
l
i ht d average off th
the durations
d ti
off
the individual bonds
DP = W1D1 + W2D2 ++ WnDn
Problems arise because the YTM does not
change
g equally
q
y for everyy bond in the p
portfolio
Bond Portfolio Duration
LOS 58.g Calculate/Explain

Kaplan, Inc.
based on the promised cash flows and ignore call

call,
put, and prepayment options
Effective duration can be calculated using prices
from a valuation model that includes the effects of
embedded options (e.g., call feature)
For option-free
option free bonds
bonds, effective duration is very
close to modified duration
For bonds with embedded options, effective
duration must be used
Both Macaulay duration and modified duration are
Introduction to the
Macaulay duration is in years

Duration off a 5-year, zero-coupon bond is 5
1% change in yield, 5% change in price
Modified duration adjusts Macaulay duration

Effective Duration
Introduction to the
Duration Measures

225
11/20/2012 12:20:09 PM
8%
9%
57 - 3
Introduction to the
10%
Actual price-yield
curve
Price estimates based
on a duration of 9.42
YTM
Prices based on duration

are underestimates of
actual prices
Kaplan, Inc.
59
y = 0.5%
So our convexity adjustment is +0.131% for a
yield increase or for a yield decrease
Assume convexity of the bond = 52.4

Convexity (y)2 = 52.4(0.005)2 = 0.00131
+ Convexity (y)2
To adjust for the for the curvature of the bond

price yield relation,
price-yield
relation use the convexity effect:
Convexity Effect
LOS 58.h Describe/Estimate

Kaplan, Inc.
$828.41
$822.47
$908.00
$993.53
$1,000.00
Price
Convexity adjustment improved both estimates!
Duration only = 4.285% Actual = 4.195%
8.57
8 57 (0.005)
(0 005) + 52.4
52 4 (0.005)
(0 005)2 = 4.154%
4 154%
For a yield increase of 0.5%, we have:
Duration only = +4.285% Actual = +4.457%
8.57 (0.005) + 52.4 (0.005)2 = +4.416%
For a yield decrease of 0.5%, we have:
Kaplan, Inc.
58
60
Introduction to the
Duration-Convexity Estimates

Kaplan, Inc.
Recall our 8%, 15-year par bond with duration =

8 57
8.57
For a 50 bp change in yield, price change
based on duration is: 8.57 0.5% = 4.285%
Actual increase when YTM 0.5% = 4.457%
Actual decrease when YTM 0.5% =
4.195%
Increase underestimated, decrease
overestimated
Introduction to the
Duration-based estimates of new bond prices are

below actual prices for option-free
option free bonds

Convexity Adjustment
Introduction to the
The Convexity Adjustment

226
11/20/2012 12:20:10 PM
Kaplan, Inc.
63
Kaplan, Inc.
64 - 2
If YTM increases by 0.5%, a 5% par bond will

d
decrease
iin price
i tto 95
95.5,
5 and
d if YTM d
decreases
by 0.5% the price will increase to 105.3. The
effective duration is:
A. 9.0.
B. 9.8.
C. 4.5.
Introduction to the
62
Combine duration with yield volatility to

analyze
l
iinterest
t
t rate
t risk
i k
Bond with lower duration can have greater
price sensitivity to interest rate changes than
a bond with higher duration, if its yield
volatility is significantly greater
Value-at-risk considers both duration and
yield volatility
Kaplan, Inc.
Effective Duration Problem
Introduction to the
61
Impact of Yield Volatility
LOS 58.k Describe

Kaplan, Inc.
A measure of interest rate risk often used with

portfolios
tf li is
i the
th price
i value
l off a basis
b i point
i t
PVBP is the change in $ value for a 0.01%
change in yield
Duration 0.0001 portfolio value = PVBP
Example: A bond portfolio has a duration of
5.6 and value of $900,000
PVBP = 5.6 0.0001 $900,000 = $504
Introduction to the
Like modified duration, modified convexity

assumes expected cash flows do not change
when yield changes
Effective convexity takes into account changes
in cash flows due to embedded options, while
modified convexity does not
The difference between modified convexity and
effective convexity mirrors the difference between
modified duration and effective duration
LOS 58.j Calculate/Explain

Price Value of a Basis Point
Introduction to the
Modified and Effective Convexity
LOS 58.i Distinguish

227
11/20/2012 12:20:11 PM
Kaplan, Inc.
65 - 2
Bond has a modified duration of 7.8 and a

convexity
it off 140.
140 If its
it yield
i ld tto maturity
t it iincreases
by 80 bp, the approximate change in price is:
A. 6.24%.
B. 7.14%.
C. 5.34%.
5.34%.
Duration and Convexity Problem
Introduction to the
228
11/20/2012 12:20:11 PM
Fundamentals of
Credit Analysis
Kaplan, Inc.
68
to default risk-free
risk free bond of similar maturity
Wider spread lower price;
narrower spread higher price
Spread risk: Risk of spread widening
Credit migration
g
(downgrade)
(
g
) risk: Issuer
becomes less creditworthy
Market liquidity risk: Receive less than
market value when selling bond
Yield spread (in basis points) quoted relative
Credit-Related Risks
LOS 59.a Describe

59. Fundamentals of Credit

Analysis
Fixed Income:
Fundamentals of
Credit Analysis
67
Kaplan, Inc.
69
different seniority or priority of claims

First lien/mortgage > second lien/mortgage
Secured > unsecured
Senior > junior > subordinated
Issues may combine these features
Example: senior secured > junior secured
All debt in same category ranks pari passu
(with same priority of claims)
Fundamentals of
Credit Analysis
Different bonds from same issuer may have
Seniority Ranking
LOS 59.b Describe/Explain

Kaplan, Inc.
pay interest or principal

Default risk: Probability of default
Loss severity: Amount or percentage of
principal and interest lost if borrower defaults
Expected
p
loss = default risk loss severity
y
Recovery rate = 1 loss severity in %
Credit risk: Risk of losses if borrower fails to
Credit-Related Risks
LOS 59.a Describe

229
11/20/2012 12:20:12 PM
Fundamentals of
Credit Analysis
A2
Kaplan, Inc.
Baa3
BBB
BBB
A+
A1
Baa2
AA
Aa3
AA
Aa2
BBB+
AA+
Aa1
A3
AAA
Aaa
Baa1
S&P, Fitch
Moodys
Investment Grade
B3
B2
B1
Ba3
Ba2
Ba1
Moodys
B+
BB
BB
BB+
S&P, Fitch
Caa3
Caa2
Caa1
C
D
CC
72
CCC
CCC
CCC+
S&P, Fitch
In default
Moodys
Ca
70
Fundamentals of
Credit Analysis
Non-Investment Grade
Credit Ratings
LOS 59.c Distinguish/Describe

Kaplan, Inc.
strictly in bankruptcy
Creditors may negotiate different outcome
to limit delays and bankruptcy-related
costs to issuing firm
Bankruptcy court may order different
outcome
Priority of claims is not always followed
Priority of Claims in Bankruptcy
LOS 59.b Describe/Explain

Fundamentals of
Credit Analysis
Kaplan, Inc.
71
Credit Ratings Problem
73 - 2
Fundamentals of
Credit Analysis
Topper, Inc. has a CFR of Ba2. Toppers

subordinated
b di t d d
debentures
b t
are least
l
t likely
lik l to
t be
b
rated:
A. Ba1.
B. Ba2.
C. Ba3.
Kaplan, Inc.
rating, applies to senior unsecured debt

Corporate credit rating (CCR): Applies to
specific debt issue; may be notched up or
down from CFR
Rating agencies: Moodys, S&P, Fitch

Corporate
C
family
f
rating (C
(CFR):
) Issuer credit
Credit Ratings
LOS 59.c Distinguish/Describe

230
11/20/2012 12:20:12 PM
Capacity
74
Fundamentals of
Credit Analysis
Kaplan, Inc.
76
supplier power, buyer power Also covered in

Equity Valuation
Industry fundamentals
Growth prospects, cyclicality
Company fundamentals
Competitive position, operating history,
strategy/execution
Leverage and coverage ratios
Industry structure
Rivalry, new entrants, substitute products,
LOS 59.e Explain

Kaplan, Inc.
mortgages)
Issuer-specific risks may be unpredictable
(litigation, natural disasters, leveraged buyouts)
Prices/spreads
p
adjust
j
faster than credit ratings
g
Ratings assess default risk
Spreads reflect expected loss
Kaplan, Inc.
77
to capital spending may imply insufficient

investment, low quality assets
Stock price < book value may also indicate
low quality assets
Intangible assets that can be sold (patents,
intellectual property) may have value as
collateral
Fundamentals of
Credit Analysis
75
Examine depreciation expense: High relative
Collateral
LOS 59.e Explain

Kaplan, Inc.
Character
Capacity: Ability to pay on time and in full
Collateral: Value of assets
Covenants: Legal stipulations of bond issue
Character: Management integrity
Four Cs: Capacity, Collateral, Covenants,
Fundamentals of
Credit Analysis
Credit rating may change: Downgrade, upgrade

Rating agencies make mistakes (subprime
(
LOS 59.e Explain

Components of Credit Analysis
Fundamentals of
Credit Analysis
Risks in Relying on Credit Ratings
LOS 59.d Explain

231
11/20/2012 12:20:13 PM
Fundamentals of
Credit Analysis
Fundamentals of
Credit Analysis
78
Kaplan, Inc.
coverage ratios
Profit and cash flow metrics:
EBITDA, EBIT
Funds from operations
Free cash flow before/after dividends
80
Credit analysts focus on leverage ratios and
Financial Ratios in Credit Analysis
LOS 59.f Calculate/Interpret

Kaplan, Inc.
interest and principal on time

time, insure pledged
assets, pay taxes)
Negative: Actions issuer may not take (issue
more debt, pledge same assets)
Goal is to protect bondholders without unduly
constraining firms operations
Affirmative: Actions issuer must take (pay
Covenants
LOS 59.e Explain

Fundamentals of
Credit Analysis
79
Kaplan, Inc.
81
(underfunded pensions, off-balance-sheet

liabilities, DTLs expected to reverse)
Debt-to-capital, debt-to-EBITDA:
Higher
g
ratio higher
g
leverage
g
May adjust capital for writedown of goodwill
FFO-to-debt: Higher ratio lower leverage
Higher leverage higher credit risk

Adjust debt to include all obligations
Leverage Ratios

Kaplan, Inc.
Bankruptcies, restructurings
Accounting policies: Aggressiveness, frequent
restatements
Fraud or other legal
g p
problems
Actions that favor equity holders over
bondholders (e.g., special dividends)
Fundamentals of
Credit Analysis
Management ability to develop sound strategy

Managements
past performance:
f
Character
LOS 59.e Explain

232
11/20/2012 12:20:13 PM
Fundamentals of
Credit Analysis
Kaplan, Inc.
$4,000 ($3,500)
Total capital
$40
Interest expense
$1,900
$300
FFO
Total debt
$550
York, Inc.
EBIT
$6,500
$2,700
$160
$800
$1,800
Zale, Inc.
84
$6,000 ($5,800)
$2,600
$100
$600
$1,400
Industry
Average
Recommended analyst adjustments:

Include operating lease obligations, net pension liabilities
in total debt
Calculate debt-to-capital ratios with and without goodwill
Example: Credit Quality
LOS 59.g Evaluate

Kaplan, Inc.
obligations
Higher coverage lower credit risk
EBITDA-to-interest expense
EBIT-to-interest expense: More
conservative
82
Fundamentals of
Credit Analysis
Measures earnings relative to interest
Coverage Ratios

Fundamentals of
Credit Analysis
$6,500
$2,500
$160
$850
$2,250
Zale, Inc.
$6,000
$2,400
$100
$600
$1,400
Industry
Average
43.3% (44.8%)
23.1%
14.0
Industry
Average
Kaplan, Inc.
85
line with their industry average

Adjusting for all obligations, York is more leveraged (lower
FFO/debt, higher debt/capital) then Zale and the industry
average; Zale is less leveraged than the industry average
Therefore, Zale appears more creditworthy then York
41.5%
29.6%
14.1
Zale, Inc.
York and Zale have interest coverage (EBIT / interest) in
47.5% (54.3%)
FFO / debt
Debt / capital
13.8
15.8%
EBIT / interest
York, Inc.
83
Fundamentals of
Credit Analysis
LOS 59.g Evaluate

Kaplan, Inc.
Industry averages are goodwill $200, PV of operating leases $200,

and no net pension asset or liability
Zale has a net pension liability of $200 and no operating leases
York has goodwill of $500 and operating lease obligations with a

present value of $900
$1,000
$4,000
$40
Interest expense
Total capital
$300
FFO
Total debt
$550
EBIT
York, Inc.
LOS 59.g Evaluate

233
11/20/2012 12:20:14 PM
Kaplan, Inc.
86
Return Impact Problem
88 - 2
Fundamentals of
Credit Analysis
A bond with a duration of 6.5 has an estimated

convexity
it off 0.634.
0 634 If the
th b
bonds
d yield
i ld spread
d
widens by 50 basis points, the impact on the
investors return is closest to:
A. 3.17%.
B. 3.25%.
C. 3.33%.
Kaplan, Inc.
than for higher-quality bonds

Factors affecting yield spreads:
Credit cycle
Economic conditions
Market performance, including equities
Broker/dealer capital
Supply of new issues
Kaplan, Inc.
Increase focus on loss severity

Sources of liquidity:
Balance sheet cash (most reliable)
Working capital
Cash flow from operations
Bank credit
Equity issuance
Asset sales (least reliable)
87
89
Fundamentals of
Credit Analysis
Higher default risk than investment grade
High Yield Bonds
LOS 59.j Explain

Kaplan, Inc.
Adjust convexity to 32.7
Scale convexity based on duration squared

Duration = 44, Convexity = 21
21.8:
8: Okay
Duration = 5, Convexity = 0.327:
Return impact Modified Duration Spread

+ 1/2 Convexity (Spread)2
Return impact = percent change in price

For option-free
f
bonds:
Fundamentals of
Credit Analysis
Yield spread = credit spread + liquidity premium

Tend to be more volatile for
f lower-quality bonds
LOS 59.i Calculate

Return Impact of Spread Changes
Fundamentals of
Credit Analysis
Yield Spreads: Level and Volatility
LOS 59.h Describe

234
11/20/2012 12:20:14 PM
Fundamentals of
Credit Analysis
Kaplan, Inc.
92
bond back to issuer if issuer is acquired

Restricted subsidiaries: Designated to
support holding company debt (no structural
subordination)
Limitation on liens: Limits amount of
secured debt
Restricted payments to equity holders
Kaplan, Inc.
93
unwilling sovereign to pay its debts

Bonds may be denominated in local currency
or foreign
g currency
y
Higher default risk (lower credit rating) for
foreign currency debt because government
must acquire foreign currency
Issued by national governments (sovereigns)

Analyze ability and willingness to pay debts
Bondholders have no means of forcing an
Fundamentals of
Credit Analysis
91
Analyze covenants
Change
C
off control put: Bondholder may put
LOS 59.j Explain

Kaplan, Inc.
Sovereign Bonds
Fundamentals of
Credit Analysis
90
intermediate holding companies, subsidiaries

Structural subordination: Subsidiaries must
service own debt before upstreaming
dividends to parent Holding company debt
is effectively subordinated to subsidiary debt
Fundamentals of
Credit Analysis
Analyze corporate structure

Debt may be issued by holding company,
High Yield Bonds
LOS 59.j Explain

High Yield Bonds
LOS 59.j Explain

Kaplan, Inc.
including stress scenarios

Analyze debt structure
Estimate leverage, loss severity for each level
of seniority
Top-heavy
p
y capital
p
structure: High
g p
proportion
p
of
secured bank debt less ability to increase
borrowing in stress scenario higher default
probability, lower recovery rate for unsecured
Project future earnings and cash flows,
High Yield Bonds
LOS 59.j Explain

235
11/20/2012 12:20:15 PM
Fundamentals of
Credit Analysis
94
Fundamentals of
Credit Analysis
Kaplan, Inc.
96
analyze employment, per-capita income,

depth and breadth of tax base
Sales taxes, capital gains taxes are cyclical
Long-term
g
obligations
g
((e.g.,
g , pensions)
p
)
Inconsistent financial reporting requirements
Revenue bonds: Analyze project
Debt service coverage: Revenue / payments
General obligation bonds

Tax revenue depends on local economy:
Analysis of Municipal Bonds
LOS 59.j Explain

Kaplan, Inc.
repay debts
Economic prospects: Growth rate; per-capita
income; demographics
International investment position: Forex
reserves, external debt
Fi
Fiscal
l flexibility:
fl ibilit Ability,
Abilit willingness
illi
tto iincrease
taxes, decrease spending to service debts
Monetary flexibility: Central bank credibility;
ability to pursue domestic objectives
Institutional effectiveness: Commitment to
Analysis of Sovereign Bonds
LOS 59.j Explain

95
Kaplan, Inc.
N = 16, PMT = 30, FV = 1,000, I/Y = 4% PV = 883.48
3. What is the value after 2 years if the yield does

not change?
N = 18, PMT = 30, FV = 1,000, I/Y = 4% PV = 873.41
2. What is the value after 1 year if the yield does not

change?
N = 20, PMT = 30, FV = 1,000, I/Y = 4% PV = 864.10
A 6%,, 10-year
y
semiannual coupon
p bond has a YTM
of 8%
1. What is the price of the bond?
Introduction to the
Value Change as Time Passes

Solution
Kaplan, Inc.
national level (not sovereigns)

General obligation: Full faith and credit of
municipality
Revenue bonds: Serviced by revenues from
project financed by bonds
Fundamentals of
Credit Analysis
Issued by governments or agencies below
Municipal Bonds
LOS 59.j Explain

236
11/20/2012 12:20:15 PM
Yield to Call Solution

2( 1.14 1) = 0.1354
Kaplan, Inc.
N = 4 PMT = 25 FV = 1,010 PV = 1,028

CPT I/Y = 2.007% 2 = 4.014% = YTC
If it is callable in two years at 101, what is the

YTC?
N = 20 PMT = 25 FV = 1,000 PV = 1,028

CPT I/Y = 2.323% 2 = 4.646% = YTM
Consider a 10-year, 5% bond priced at $1,028

What is the YTM?
Kaplan, Inc.
A. 13.54%.
An annual pay bond has a YTM of 14%.

The BEY for this bond is:
Equivalent Yields Solution

Forward Rates Solution

Kaplan, Inc.
3 6 2 7 = 18 14 = 4
Current 1-year spot rate is 6%, 2-year spot rate

i 7%,
is
7% and
d3
3-year spott rate
t is
i 6%.
6% The
Th 1-year
1
forward rate for a loan 2 years from now is
closest to:
1.06 3
1 = 0.04028 = 4.028%
1.07 2
C. 4%.
Kaplan, Inc.
YTM is less than current yield for premium

bond (movement towards par is negative)
C
Current
t yield
i ld iis lless th
than coupon ((nominal)
i l) yield
i ld
For a bond trading at a premium, order the

coupon (nominal) yield
yield, current yield
yield, and YTM
from smallest to largest.
Annual coupon
Current yield =
Bond price
for premium bond, price > par
Yield Measures Solution

237
11/20/2012 12:20:16 PM
Credit Ratings Solution
Fundamentals of
Credit Analysis
Kaplan, Inc.
A. Ba1.
If debt with lower seniority is notched,
it will be notched downward
CFR reflects senior unsecured debt
Topper, Inc. has a CFR of Ba2. Toppers

subordinated
b di t d d
debentures
b t
are least
l
t lik
likely
l to
t be
b
rated:
Kaplan, Inc.
B. 9.8.
Return Impact Solution
Fundamentals of
Credit Analysis
7.8(0.0080) +140(0.0080)2 =
0.0624 + 0.00896 = 5.344%
Kaplan, Inc.
6.5(0.0050) + 1/2 (63.4)(0.0050)2 = 3.17%
A. 3.17%.
A bond with a duration of 6.5 has an estimated

convexity
it off 0
0.634.
634 If the
th b
bonds
d yield
i ld spread
d
widens by 50 basis points, the impact on the
investors return is closest to:
Kaplan, Inc.
C. 5.34%.
Bond has a modified duration of 7.8 and a

convexity
it off 140
140. If its
it yield
i ld tto maturity
t it increases
i
by 80 bp, the approximate change in price is:
If YTM increases by 0.5%, a 5% par bond will

d
decrease
iin price
i tto 95.5,
95 5 and
d if YTM d
decreases
by 0.5% the price will increase to 105.3. The
effective duration is:
105.3 95.5
= 9.8
98
2(100)(0.005)
Duration and Convexity Solution
Introduction to the
Effective Duration Solution
Introduction to the
238
239
c l a s s
d i s c u s s i o n
q u e s t i o n s
1.
Joe Schmidt, CFA, has calculated the arbitrage-free value of a Treasury bond trading for $93.00 to
be $95.67. How can Schmidt benefit from the mispricing and how much is the profit based on a
U.S.$1million trade (assuming no transactions costs or taxes)?
A. Buy the bond and sell the stripped zero-coupon pieces for an arbitrage profit of $26,700.00.
B. Buy the bond and sell the stripped zero-coupon pieces for an arbitrage profit of $28,702.50.
C. Buy the stripped zero-coupon pieces and sell the reconstituted bond for an arbitrage profit of
$28,702.50.
2.
An investor purchases a 5-year, A-rated, 7.95% coupon, semiannual-pay corporate bond at a yield to maturity of 8.20%. The bond is callable at 102 in three years. The bonds yield to call is closest to:
A. 8.3%.
B. 8.6%.
C. 8.9%.
3.
An investor is considering purchasing one of three 5-year bonds with the following characteristics.
Bond
Interest
A Semiannual
B
Annual
C
Monthly
Coupon
6.50%
6.25%
6.35%
Price
98.54
97.33
97.72
Which of the bonds would the investor most likely prefer?

A. Bond A.
B. Bond B.
C. Bond C.
4.
George Sanchez, CFA, just bought some AA rated, 9% coupon, semiannual-pay U.S. corporate bonds for
clients portfolios for 101.50. The bonds mature in ten years. Sanchez is concerned that he will only be
able to reinvest the coupon payments at 6% over the life of the bonds. If he is correct, what return will his
clients receive if they hold the bonds until maturity?
A. 3.97%.
B. 6.36%.
C. 7.93%.
11/20/2012 12:20:16 PM
240
5.
Given the following information about a 6-month zero-coupon bond and two bonds paying coupons
semiannually:

Maturity (years)
Coupon
Price

0.5

96.99

1.0
7.0%
100.00

1.5
7.5%
100.00
Yield-to-
Maturity
6.30%
7.00%
7.50%
Periodic Coupon
Cash Flow
$
3.50
3.75
The annual spot rates for the next two 6-month periods (1.0 year and 1.5 years) using bootstrapping are
closest to:
A. 3.51% and 3.76%.
B. 7.02% and 7.52%.
C. 7.07% and 7.47%.
6.
The following table of zero-coupon Treasury rates is given.

Maturity Six-Month Spot Rates

0.5
4.00

1.0
4.80

1.5
5.50

2.0
6.10

2.5
?
Forward Rates
?
?
?
7.90
9.10
Presented on a bond equivalent basis, the 6-month forward rate 12 months from now and the 30-month
spot rate are closest to:

A.
B.
C.
7.
Forward
3.45%
6.90%
6.90%
30-Month Spot
6.70%
8.50%
6.70%
Given the following Eurodollar forward rates:

One-year spot rate
One-year forward rate 1 year from now
One-year forward rate 2 years from now
6.45%
6.15%
5.90%
What is the value of a 3-year, 6% coupon Eurodollar bond?

A. 98.81.
B. 99.53.
C. 100.21.
11/20/2012 12:20:16 PM
241
8.
Jack is considering purchasing a bond that is currently priced at 85.50. However, he is concerned about
interest rate volatility over the next 18 to 24 months. After performing a scenario analysis, Jack computed
the following prices for the bond assuming a 50bp movement in rates.
Interest Rate Change
+50 bp
50 bp
Bond Price
82.51
88.63
This bonds effective duration is closest to:

A. 3.6.
B. 6.0.
C. 7.2.
9.
A 6-year, 7% coupon, straight bond has an effective duration of 4 and an effective convexity of 11.79. If
interest rates increase by 25 basis points across the entire yield curve, the price of the bond will most likely:
A. decrease by more than 1%.
B. decrease by less than 1%.
C. increase by less than 1%.
10. A 14-year corporate bond with a 3.50% coupon is priced at $102.79. This bonds duration is 6.6 and its
convexity is 62.7. If the bonds credit spread narrows by 75 basis points, the impact on the bondholders
return is closest to:
A. 4.79%.
B. 4.95%.
C. 5.13%.
11/20/2012 12:20:16 PM
242
C l a s s
1.
d i s c u s s i o n
s o l u t i o n s
The bond is priced below its arbitrage-free value. Therefore, Schmidt can buy the bonds for their
market price, strip them into zero-coupon components, and sell those components. Thus, each
coupon payment and the principal payment at maturity are treated as individual zero-coupon bonds.
By doing this, Schmidt realizes a risk-free arbitrage profit of $26.70 per bond ($956.70 $930.00).
$1 million will buy 1,075 bonds (rounding because Schmidt cannot buy a fraction of a bond), which
will yield a total risk-free arbitrage profit of $28,702.50 ($26.70 1,075).
A is incorrect. Schmidt would buy the bonds for their market value and sell the stripped zerocoupon components, but the risk-free arbitrage profit is calculated incorrectly. The value is based on
purchasing the bonds at par (i.e., 1,000 bonds purchased at par, yielding a risk-free arbitrage profit of
$26.70 each). Schmidt would not buy the bonds at par but at their market price.
C is incorrect. Schmidt would buy the stripped zero-coupon components and sell the reconstituted
bond only if the market price of the bond exceeded its arbitrage-free value. The arbitrage profit
calculation is correct.
2.
First determine the price paid for the bond:

N = 5 2 = 10; I/Y = 8.20 / 2 = 4.10; PMT = 7.95 / 2 = 3.975; FV = 100; CPT PV = 98.99
Then use this value and the call price and date to determine the yield to call:
N = 3 2 = 6; PMT = 7.95 / 2 = 3.975; PV = 98.99; FV = 102; CPT I/Y = 4.4686 2 = 8.937
3.
Since the timing of each bonds cash flows is different, we must compare them on an effective annual
yield basis.
EAY = (1 + rp )m 1
Bond A: has a BEY of 6.85%: 98.54 PV; 6.5 / 2 = 3.25 PMT; 100 FV; 10 n (N); Solve for i
(CPT I/Y) = 3.425. The BEY is simply the periodic rate 2. The EAY is (1 + periodic Rate)2 1 =
(1.03425)2 1 = 6.97%.
Bond B has an EAY of 6.90% [97.33 PV; 6.25 PMT; 100 FV; 5 n (N); Solve for i (CPT I/Y)].
Note for annual bonds, the yield is already annualized. Therefore, BEYannual-pay = EAYannual-pay.
Bond C has a periodic yield of 0.574% [97.72 PV; 6.35 / 12 = 0.52917 PMT; 100 FV; 5 12 = 60
n (N); Solve for i (CPT I/Y)] and an EAY of (1.00574)12 1 = 7.1%.
Bond C has the highest EAY and is therefore the preferred bond.
11/20/2012 12:20:16 PM
243
4.
The first step is to calculate the future value of the bonds cash flows assuming the reinvestment rate
Sanchez expects. Since the bonds make semiannual coupon payments, calculate the future value of
twenty payments of $4.50 each reinvested at 3%. Add to that the repayment of principal at maturity
to determine the future value of all cash flows from the bonds:
F.V. of $4.50/period for 20 periods at a 3.0% reinvestment rate
Repayment of principal at maturity
Future value of all cash flows
= $120.92
= 100.00
$220.92
Next, calculate the periodic return as the interest rate that will turn 101.50 (the present value of the
bond as a percentage of par) into 220.92 over 20 periods:
HP12C:
101.5 PV 220.92 CHS
FV 20
TIBA2+:
101.5 PV 220.92 +/
FV 20
CPT
= 3.965%
I/Y
= 3.965%
Thus, the periodic return is 3.965%.

Finally, calculate the bond equivalent return as twice (for semiannual payments) the periodic return:
2 3.965 = 7.93%
A is incorrect. Rather than calculating the future value of the coupon payments reinvested at 3.0%
semiannually, this figure simply uses the total of the coupon payments, $90.00.
C is incorrect. 3.97% is the periodic true return. Double this figure to arrive at 7.93%.
5.
To determine the hypothetical spot rate for the maturity of a coupon-paying bond, assume that each
cash flow (coupon payments and principal payment at maturity) is a zero-coupon bond. Discount
those cash flows with the known spot rates until the maturity date and solve for that rate.
For the 1-year (2-period) bond, use the known 1-period spot rate and solve for the 1-year spot rate:
100 =
3.50
103.50
+
(1.0315) (1 + x )2
(1 + x )2 =
103.50
= 1.0714
100 3.3931
x = (1.0714 )1/2 1 = 3.51%

Since the result is for one period (six months), it must be doubled to determine the annual spot rate:
r2 = 2(3.51%) = 7.02%
For the 1.5-year (3-period) bond, use the known 1- and 2-period spot rates and solve for the
3-period spot rate:
100 =
3.75
3.75
103.75
+
+
2
(1.0315) (1.0351)
(1 + x )3
11/20/2012 12:20:21 PM
244
(1 + x )3 =
103.75
= 1.1172
100 3.6355 3.500
x = (1.1172 )1/3 1 = 1.0376 1 = 3.76%

Since the result is for one period (six months), it must be doubled to determine the annual spot rate:
r3 = 2(3.76%) = 7.52%
6.
An investor can either invest at the 1.5 maturity spot rate or invest at the 1.0 maturity and roll the
investment over one more period at the 6-month forward rate 12 months from now. The calculation
is shown below:
m+t
(1 + rm+t )
= (1 + rm ) (1 +t f m )
1
r3 3 r2 2
1 + = 1 + 1 + 1 f 2
2
2
2
(1.0275)3 = (1.024)2 (1 +1 f 2 )
1f2
= 0.0345 2 = 6.90%
The 30-month spot rate can be solved using a similar approach. Spot rates are geometric averages of
forward rates, therefore:
5
(1 + r5 ) = (1 + r4 )4 (1 +1 f 4 )1
5
(1 + r5 ) = (1.0305)4 (1.0455)
5
(1 + r5 ) = 1.11790
1/5
r5 = (1.1790) 1
= 0.03348 2 = 6.70%
7.
Because spot rates are geometric averages of forward rates, each of the bonds cash flows can be
discounted by the compounded forward rates to arrive at the bonds price. Recall that a Eurodollar
bond makes annual coupon payments. So, the value of the bond can be computed as follows:
C3 + Pm
C1
C2
P=
+
+
(1 + r1 ) (1 + r1 )(1 + 1 f1 ) (1 + r1 )(1 + 1 f1 )(1 + 1 f 2 )
6
106
6
=
+
+
(1.0645) (1.0645)(1.0615) (1.0645)(1.0615)(1.0590)
= 5.6364 + 5.3099 + 88.5817 = 99.53
8.
With the value (price) of the bond for a 50 bp rate change already calculated, this problem simply
requires that you plug the values into the effective duration formula.
DE =
P P+
88.63 82.51
=
= 7.16
2P0r
2(85.50)(0.005)
11/20/2012 12:20:22 PM
245
9.
10. C
Without calculating any numbers, the effect of this parallel shift in the yield curve can be discerned
from the relationship between the change in the price of a bond and its duration and convexity.
Duration suggests the bond price will decrease by approximately 4 0.25%, or approximately 1%.
However, due to convexity, the change in the price of the bond will be slightly less than the 1%
implied by its duration.
Return impact duration change in spread + 1/2 convexity (change in spread)2
6.6 0.0075 + 1/2 62.7 (0.0075)2 = 0.0513 = 5.13%.
11/20/2012 12:20:22 PM

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Study Session 16

Fixed Income Analysis and

flows (e.g., call features, put features,

Uncertainty about timing of principal cash

Difficulties in Estimating the

LOS 56.b Describe

Fixed Income Investments

56. Introduction to the

Term to maturity = 3 years

Valuing an Annual-Pay Bond Using

LOS 56.c Calculate

Bond value = present value of future cash flows,

3-Step Bond Valuation Process

LOS 56.a Explain

Study Session 16 Fixed Income Analysis and Valuation

N = 6; I/Y = 6; PMT = 40; FV = 1,000;

PMT = coupon / 2 = $80 / 2 = $40

Same (8% 3-year) Bond With a

LOS 56.c Calculate

8% Annual-Pay Bond Cash Flows

LOS 56.c Calculate

8% 3-Year Bond With Semiannual

LOS 56.c Calculate

N = 3; I/Y = 12; PMT = 80; FV = 1,000;

Bond Value: 8% Coupon, 12% Yield

LOS 56.c Calculate

Study Session 16 Fixed Income Analysis and Valuation

3. What is the value after 2 years if the yield does

2. What is the value after 1 year if the yield does not

Value Change as Time Passes

Calculate a Zero-Coupon Bond

LOS 56.c Calculate

I/Y = 6% N = 6 FV = 1,000 PMT = 40

I/Y = 4% N = 6 FV = 1,000 PMT = 40

A discount bond (e.g., 8%

trading at YTM of 8%)

A par value bond (e.g., a 8% bond trading

LOS 56.e Calculate

Price Change as Maturity

LOS 56.d Explain

Study Session 16 Fixed Income Analysis and Valuation

Valuing the Pieces Using Spot

LOS 56.f Explain/Demonstrate/Describe

Dealers can separate a coupon Treasury security

Arbitrage-Free Bond Prices

LOS 56.f Explain/Demonstrate/Describe

cash flows or combine the individual cash

Dealers can strip a T-bond into its individual

LOS 56.f Explain/Demonstrate/Describe

Market price of a 1.5-year 6% Treasury note is $984

Arbitrage-Free Pricing Example

LOS 56.f Explain/Demonstrate/Describe

Study Session 16 Fixed Income Analysis and Valuation

Cash flow yield

Nominal yield (stated coupon rate)

Yield Measures, Spot

Traditional Measures of Yield

LOS 57.b Calculate/Interpret/Explain

Fixed Income Investments

57. Yield Measures, Spot

Yield Measures, Spot

Yield Measures, Spot

Priced at a discount YTM > coupon rate

PV = 943; CPT I/Y = 8.22%