Loans and money issues » bonds

Bonds

admin — Thu, 18 Nov 2010 11:03:39 +0000

In its simplest form, a bond is a financial obligation of an entity that promises to pay a specified sum of money at specified future dates. The entity that promises to make the payment is called the bond issuer and is referred to as the borrower. Bond issuers include central governments, municipal/provincial governments, supranational (e.g., the World Bank), and corporations. The investor who purchases bond is said to be the lender or creditor. The promised payments that the bond issuer agrees to make at the specified dates consist of two components: interest payments and repayment of the amount borrowed.
Prior to the 1980s, bonds were simple investment vehicles. Holding aside default by the bond issuer, the investor knew how much interest would be received periodically and when the amount borrowed would be repaid. Moreover, most investors purchased bonds with the intent of holding them to their maturity date. Beginning in the 1980s, the bond world changed. First, bond structures became more complex. There are features in many bonds that make it difficult to determine when the amount borrowed will be repaid. For some bonds it is difficult to project the amount of interest that will be received periodically. Second, the hold-to-maturity investor has been replaced by the institutional investor who actively trades bonds. These new product design features in bonds and the shift in trading strategies have lead to the increased use of the mathematical techniques.

Overlooking Problems

admin — Mon, 15 Nov 2010 10:56:16 +0000

Due diligence is a difficult process from which to get good business results. It has an intensive legal and accounting aspect to it that involves large numbers of accountants and lawyers working long hours in unpleasant conditions. There is also a need for secrecy and speed, since leaks can prompt problems with securities regulators, customers, suppliers, and employees. Beyond this, many participants are either inexperienced or not sure what they are looking for. And many people do not want to be the bearer of bad news, especially as the process becomes more frenetic and the CEO and others get more excited about doing the deal. Put it all together and sometimes even major problems, including accounting and legal problems that should have been caught, slip through and blow up, usually in the year after closing.

First Order Price Risks

admin — Fri, 13 Nov 2009 14:33:40 +0000

Most basic valuation models assume that the change of the price of a financial instrument is directly proportional to the change in an underlying factor, in other words that a linear relationship exists. In many instances this is a first order approximation only and is equivalent to measuring the slope of the price graph against this factor. This ignores any effects due to curvature of the graph arising from higher order and secondary relationships:
Local currency interest rate instruments. Interest rate instruments include bonds, asset backed securities, short-term paper, forward rate agreements (FRAs) and interest rate swaps. The value of these instruments varies with the discount rate applied to their cashflows:
Risk-free rates and term spreads. The discount rates applied to risk-free government Treasury bonds and bills are based on yields-to-maturity taken from the yield curve. These yields are affected by the overall economic environment, inflationary expectations and monetary policy. Yields may change in equal amounts across all maturities or in a non-parallel way as shown by changes in term spreads. Term spreads are defined by the difference between yields on short- and long-duration risk-free instruments.
Credit and basis spreads. The discount rate applied to corporate and other non risk- free debt issues can be viewed as the yield on an equivalent risk-free instrument plus a credit spread. Credit spreads reflect the higher returns investors demand to compensate for the higher risks. In general, credit spreads tend to widen as an economy heads into recession and narrow during recovery. Individual issuer and issue credit spreads also vary depending on conditions at a single company.
Basis spreads are the spreads between benchmark rates such as those obtained from government securities and those from an interbank rate, such as LIBOR, against which floating rate debt instruments are priced.
The value of interest rate instruments is also affected by secondary factors such as the passage of time and the effects of embedded options such as those present in callable and putable bonds.
Foreign currency exposures. Exposures to foreign exchange risk may be direct, as in a US bank having an outright cash position in euros or being committed to deliver a quantity of foreign currency at some specified future date. They may also be indirect arising from positions held in other instruments priced in a foreign currency, such as bonds and equities. First order price changes are the result of changes in exchange rates. Other effects may arise because of changes in the discount rate used to value positions in foreign currency and convexity:
Spot rates. Spot rates are determined by supply and demand and by macroeconomic fundamentals. These are used to mark-to-market values of assets and liabilities concerned. Some currencies tend to move together when their economies are closely interlinked and affected by similar external factors.
Interest rate differentials. Forward rates are determined by spot rates and by the differential between foreign risk-free interest rates and those of the base currency.
Both spot and forward positions can be affected by central bank actions, by the use of managed exchange rate systems and from the imposition of capital controls.
Equity positions. Stock prices are determined by supply and demand which in turn are affected by changes in the macroeconomic and interest environment and perceptions of the intrinsic value of stocks:
Supply and demand. Stock prices in general are affected by overall demand for equities. This is, arguably, determined by changing expectations of future earnings prospects and by perceptions of the value of the discount rate, as “determined” by risk-free rates plus an equity risk premium to compensate investors for the higher risks taken. The discount rate may change as a result of changes in risk-free rates or from a widening or narrowing of the equity risk premium.
Intrinsic value. Individual stocks are affected by investor perceptions of intrinsic value. These are affected by changes in the equity market discount rate, by expectations of future earnings growth and by the perceived riskiness of returns at one company versus the equity market as a whole. This is captured by a stock-specific measure called beta. Beta affects the discount rate applied to individual stocks according to the capital asset pricing model (CAPM).
Corporate actions. Individual stock prices are also affected by corporate actions such as rights issues, special dividends, share buy-back programs, takeovers, mergers, dividend payouts and the exercise of rights and other dilutive issues.