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Gaurav Pansari
CFIN - II
Dinosaur Publications
ISB Mohali
None of that. Janhit me jaari.
Contents
1.
2.
1.2.
Bond Valuation.................................................................................................................................................. 1
1.3.
1.4.
3.
Options ...................................................................................................................................................................... 4
3.1.
3.2.
Payoffs............................................................................................................................................................... 4
3.3.
3.4.
Some Trivia........................................................................................................................................................ 5
1. Bond - 007
Fancy name for a Loan which can be traded
Principal / face / par value (say Rs. 100) Base value of the bond might be different from market value1
Coupon (say Rs. 10 @ 10%) Archaic term for Interest payment.
Zero coupon - doesnt mean no interest implies that interest will be paid will the Principal (after 2 years,
you will be paid back Rs. 100 why will I buy then??? Well come to that)
Term Time period after which the principal will be paid back (2 years in our example)
Yield to maturity Required discount rate. At the current price, YTM = IRR of the bond, i.e. at YTM
discounting, price of bond = PV using YTM2
Discount all
cash flows
1
(1
1+
10
9%
(1
1
)
1+9% 2
= 17.59
1+
100
1+9% 2
= 84.17
Coupon value is absolute (Rs. 10), y is yield to maturity, or the expected return you need to invest in this
bond (say 9% is what we want from this bond), and N is Term period of bond (2 years)
o Value of coupon bond = 17.59 + 84.17 = 101.76; Value of Zero coupon = 84.174
As in above, Bond price (market value) is higher than face value if expected earnings (yield) are lower than
coupon rate5 and vice-versa.
Note: Zero coupon bonds will always6 trade below face value.
Unless Coupon rate and expected yield are same relax, coming to yield in a moment
Come back to this after the end of chapter 1
3
Daniel Craig is pretty expensive, and probably not on sale women. Well stick with financial bonds
4
Thats why youll buy the zero coupon bond The interest is implicit in the lower price you would be willing to pay
5
Pretty intuitive A jujus coupon is priced at Rs. 20 for 50% discount on a Rs. 60 burger. I will be willing to pay Rs. 30 for
coupon, which is my opportunity cost. If a bond gives me 10% when I expect 9%, I can pay more than face value for it.
6
Unless we get to a negative interest rate scenario
2
103.0
Invoice price
101.5
101.1
102.4
102.0
101.0
99.0
97.0
06-30-16
99.0
98.6
10-08-16
01-16-17
04-26-17
08-04-17
100.0
99.5
11-12-17
02-20-18
05-31-18
Realized yield11
Actual yield realized may differ from yield to maturity. YTM has an assumption that the cash flows can be reinvested
at the same rate In case the rate of reinvestment changes, the actual yield realized would change. To evaluate,
compute FV of all cash flows (@ prevalent reinvestment rate), and then compute IRR to get realized yield.
(Computation in excel)
Law of one Price
Discount rate for each period of a coupon bond can be different, if zero coupon rates are different for bonds of
different period. Therefore, in case the zero coupon rates are different for ZC bonds of different length, use that to
discount the coupon bond cash flow for that year. Say, a 1 year ZCB is at 7% while a 2 year ZCB is at 8% - to value a
coupon bond, discount cash flow of year 1 at 7% and cash flow of year 2 at 8%.
2. Bond Theory12
2.1. Some types of Bonds
Corporate Bonds Issued by corporations. Riskier than government bonds. Credit Risk (risk of default)
involved
o Notes Unsecured loans, <10 years
o Debentures Long term secured/ unsecured loans
o Mortgage Bonds secured against real property13
o Asset-backed bonds secured against any asset
Speculative Bond high risk, high return bond
By nationality
o Domestic Bond Local entity. Local Market. Foreign investor
o Foreign Bond Foreign entity. Local Market. Local investor
o Eurobond Foreign country. Not denominated in that local currency.
o Global bond issued simultaneously in various countries
o Masala and dim sum bonds Indian/ Chinese company. Rupee/renminbi denominated in foreign
countries. Repayment in dollars. Currency risk for investors.
Sovereign bonds issued by national governments
o T bills ZCB. Short term (91, 182 or 364 days)
o Cash Management bills (CMB) ZCB. Less than 91 days
o Dated security Long term. Coupon bonds (fixed or floating). Up to 40 years
Inflation indexed14 Real return promised (inflation +)
STRIPS Separate trading of registered interest and principal securities. Each coupon sold as individual bond
Callable bonds Issuer can buy back bond at pre-specified price on specified date before maturity
o Callable bond will have lower price than non-callable/ normal bond
o Yield to call same as YTM, but only till date of recall
Convertible bond Can be converted to equity by bondholder
Some Terms
Bond ratings credit risk ratings given to bonds by agencies like CRISIL. More risk would require more return
Bond covenants reduce default risk by binding bond issuers actions
12
Yawnnnnnnnn
Usually secured loans get paid before unsecured loans in case of bankruptcy.
14
Called Treasury inflation protected securities (TIPS) in US
13
3. Options15
Right to buy or sell an asset (shares mostly)
3.2. Payoffs21
Options
"CALL"
"PUT"
Long Call
Short Call
Long Put
Short Put
SP > MP
Do not use
SP < MP
Exercise
SP > MP
Buyer will not
use
15
SP < MP
Buyer will
exercise
SP > MP
Exercise
SP < MP
Do not use
SP > MP
Buyer will
exercise
SP < MP
Buyer will not
exercise
Long CALL
Long PUT
200
150
150
100
100
50
50
Stock Price
Payoff
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
200
Strike Price
Stock Price
Payoff
Strike Price
Protective Put I have a share. I buy a put. In case the share falls, I exercise the PUT right and save my
derriere
o It is same as a (call + fixed amount of cash in risk-less deposit)
Therefore, max (MP SP, 0) + SP = MP + max (SP MP, 0)
o Market Price + Strike Price = Call Premium + PV of Strike price
150
150
100
Put
100
Stock Price
50
Total
0
0
10
20
30
40
50
60
70
80
90
Call + FD Payoff
200
150
150
100
Call
100
FD
50
Total
0
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
Call Value
Increases
Decreases
Increases
Increases
Stock Price
Strike Price
Time to expiration (higher risk exposure)
Volatility of returns (higher risk to seller who doesnt have a say)
American option Premium >= European Premium
Put premium <= Strike Price
Call Premium <= Strike Price
American Call premium >= max (MP SP,0) MP being market price at the time of issue
American Put premium >= max (SP MP, 0)
22
Put Value
Decreases
Increases
Increases
Increases
Know that zero payoff here does not account for the cost of the option itself it is always a cost for the buyer