Lecture 6. Financial markets: Debt market in details

finance and globalization
Bonds
Financial Instruments
Financial markets

(OTC)
An exchange centralizes the communication of bid and offer prices

to all direct market participants, who can respond by selling or buying at one of the quotes or by replying with a different quote.

Exchanges

Dealers act as market makers by quoting prices at which they will sell (ask or offer) or buy (bid) to other dealers and to their clients or customers. Price is not open to all participants equally.

Stock
Futures
Options

Bond
Forward
SWAP
+Some Stocks

lifetime of a bond
Face value/Principal/Par – nominal value of a

bond, paid at the maturity
Coupon – interest payment (% of face value) that bondholders receive during the period between issuance and maturity of the underlying bond (fixed cash flow)
Fixed coupon
Floating coupon – fixed spread over a benchmark, e.g. Fed Fund rate, LIBOR etc.
Periodicity of coupon payments – most European bonds pay coupons annually Most bonds in UK, Japan, Canada and USA pay coupons semi-annually
Fair Price – it is the present value of a bond. Bond prices are typically expressed as a percentage of face value
Market Price – actual quoted price on market
Yield to maturity (similar to IRR) – it the total return anticipated on a bond if it is held until maturity
Types of Bond Issuers – Governments, Corporates

Bonds

Financial Instruments

Financial markets

payment (C=FV*c)
c – coupon rate
FV – Face value/Principal/Par
i –

discount rate (yield on other bonds with the same level of risk)

Bonds

Financial Instruments

Financial markets

(short for Obligations Assimilables du Trésor). Suppose that in December

2008 you decide to buy a OAT with face value of €100 and 8.5% fixed coupon rate.
The OAT is maturing in December 2012. In December 2008, other medium-term French government bonds offered a return of 3.0%.
Calculate fair price of the bond.

Example 1

P = € 120.4

Assume that market price of this bond is currently € 122.0
What would you do?

Sell (short)

Bonds

Financial Instruments

Financial markets

– Periodic payments with single payment at maturity
Annuity bond –

It pays a mix of interest and principal for a finite period of time, i.e. no balloon payment at the end
Zero coupon bond – No periodic payment; single payment at maturity
Perpetuity bond – It lasts forever and only interest is paid every period (much closer to stocks)
Floating rate coupon bond –coupon depends on some interest rate (LIBOR, etc)

Bonds

Financial Instruments

Financial markets

(C=FV*c)
c – coupon rate
FV – Face value/Principal/Par
ytm – yield

to maturity (total annual return anticipated on a bond if the bond is held until it matures)

Bonds

Financial Instruments

Financial markets

for Obligations Assimilables du Trésor). Suppose that in December 2008

you decide to buy a OAT with face value of €100 and 8.5% fixed coupon rate.
The OAT is maturing in December 2012. In December 2008, other medium-term French government bonds offered a return of 4.0%.
The market price is € 122.0.
Calculate yield to maturity of the bond.

Example 1: cont’d

ytm = 2.63%

Compare the ytm with opportunity cost of capital. What would you do?

Sell (short) the bond and invest in other medium-term French government bonds offered a return of 4.0%

Bonds

Financial Instruments

Financial markets

(short for Obligations Assimilables du Trésor). Suppose that in December

2008 you decide to buy a OAT with face value of €100 and 8.5% fixed coupon rate.
The OAT is maturing in December 2012. In December 2008, other medium-term French government bonds offered a return of 3.0%.
The market price is € 122.0.
Calculate yield to maturity of the bond.

Example 1: cont’d

ytm < 3% (as we did not discount)

Bonds

Financial Instruments

Financial markets

ytm = 2.63%

a 2 year 5% annual riskless coupon bond given the

following data with par value of bond £1,000? Assume you know some facts:
1 year zero coupon Treasury bill is traded at £90,9
2 year zero coupon Treasury bill is traded at £79,7
Demonstrate your strategy (long or short), if current market price for the bond from the first question is 90% of par.

Bonds

capital gain/loss (if you sell a bond before maturity)
Rating
Duration
Fundamental analysis

(news)
Seniority of debt (Recovery rate) (Senior secured/Senior Unsecured/Subordinate)

Bonds

Financial Instruments

Financial markets

Bonds

Expected return

Risk

YTM (%)
Capital gain (%)

DUR (M.DUR -%)
Rating, News, Type
Price volatility (%)

Hold until maturity
Sell before maturity

that some of the world’s leading banks charge each other

for short-term loans.

finance (UOL study guide) pp. 26-30 (excluding The term structure

of interest rates), 32-36, 150-151

Brealey, Myers and Allen. Principles of Corporate finance. Chapter 3

Mishkin, F. and S. Eakins Financial Markets and Institutions. (Addison Wesley) Chapter 12

Essential reading for Lecture 6:

Lecture 6