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Chapter 9 FIXED INCOME SECURITIES: VALUATION AND RISKS

Chapter 9 FIXED INCOME SECURITIES: VALUATION AND RISKS. Why are bonds viable investment alternatives? What are the risks faced by bond investors? How bonds are priced? What are the basic bond pricing theorems? How can interest rate risk be measured? How can credit risk be evaluated?

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Chapter 9 FIXED INCOME SECURITIES: VALUATION AND RISKS

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  1. Chapter 9FIXED INCOME SECURITIES: VALUATION AND RISKS • Why are bonds viable investment alternatives? • What are the risks faced by bond investors? • How bonds are priced? • What are the basic bond pricing theorems? • How can interest rate risk be measured? • How can credit risk be evaluated? • How are bond risk and required return related? Contemporary Investments: Chapter 9

  2. Why bonds? • Income • Potential for capital gains • Paper versus real losses • Diversification • Tax advantages Contemporary Investments: Chapter 9

  3. Figure 9.1 – Yield on Long-Term Treasury Bonds vs. the Dividend Yield from the S&P500 Contemporary Investments: Chapter 9

  4. Risks associated with investing in bonds • Credit risk • Interest rate risk • Reinvestment risk • Purchasing power risk • Call risk • Liquidity risk • Foreign exchange risk Contemporary Investments: Chapter 9

  5. Bond valuation • Basics of bond pricing • Identifying the bond’s cash flows • Bond price is present value of its cash flows • Semiannual coupons • Accrued interest Contemporary Investments: Chapter 9

  6. Bond valuation – Cont. • Yield-to-maturity • Relationship between coupon rate and yield to maturity • Current yield • Yield to call • Actual return versus yield to maturity Contemporary Investments: Chapter 9

  7. Figure 9.2 - Reinvestment Rate and the Actual Rate of Return for a Bond Contemporary Investments: Chapter 9

  8. Five bond pricing theorems • Bond prices move inversely to changes in interest rates • Bonds with longer maturities are more price sensitive • Price sensitivity increases at a decreasing rate • Bonds with lower coupon rates are more price sensitive • A price increase caused by a decrease in interest rates is larger than a price decrease caused by an increase in interest rates of the same magnitude Contemporary Investments: Chapter 9

  9. Figure 9.3 – Bond Price vs. Yield to Maturity Contemporary Investments: Chapter 9

  10. Figure 9.4 – Price Sensitivity and Maturity Contemporary Investments: Chapter 9

  11. Figure 9.5 – Price Sensitivity and Coupon Rate Contemporary Investments: Chapter 9

  12. Figure 9.6 – Price Changes for Increase and Decrease in Yield Contemporary Investments: Chapter 9

  13. Assessing interest rate risk • What is duration? • Finding a bond’s duration • Duration and price sensitivity • Duration and price changes Contemporary Investments: Chapter 9

  14. Figure 9.7 – Relationship Between Duration and Maturity Contemporary Investments: Chapter 9

  15. Figure 9.8 – Relationship Between Duration and Coupon Rate Contemporary Investments: Chapter 9

  16. Figure 9.9 – Relationship Between Duration and Yield to Maturity Contemporary Investments: Chapter 9

  17. Credit risk • Bond ratings • Description of bond ratings • Determinants of bond ratings • Bond ratings and default rates • Graham & Dodd on credit risk and bond selection Contemporary Investments: Chapter 9

  18. Risk and required return for bonds • General relationship (equation 9.8) r = f (i, ∆p, ir, rr, dr, cr, lr, fxr) • Bond yields and maturity • Bond yields and credit risk Contemporary Investments: Chapter 9

  19. Figure 9.10 – Yield Spread Between T-Bonds and T-Bills Contemporary Investments: Chapter 9

  20. Figure 9.11 – Quality Yield Spreads in the U.S. Capital Markets Contemporary Investments: Chapter 9

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