Money And Capital Markets - Fin 431002 Spring 2013

Fin 431002Money and Capital Markets, Spring 2013 Prof. Ananth Narayan HW Assignment # 2 (Chapters 6 – 9)

Analyze key concepts from chapters 6 through 9 in the context of money and capital markets, addressing specific questions related to commercial paper ratings, repurchase agreements, foreign money market yields, T-bill yields, required rates of return on securities, foreign currency impact on yields, bond provisions and types, the effect of economic conditions on bond prices, portfolio rebalancing strategies, bond valuation and duration, as well as bond convexity. Provide thorough explanations supported by credible references, demonstrating a comprehensive understanding of each topic.

Paper For Above instruction

The complex landscape of money and capital markets encompasses a variety of financial instruments, institutions, and market behaviors that are essential for understanding modern financial systems. This paper synthesizes key concepts from chapters 6 through 9, focusing on critical areas such as commercial paper ratings, repurchase agreements, foreign currency impacts, bond features, and the influence of macroeconomic conditions on bond prices and yields. It also covers portfolio strategies, bond valuation techniques, and the implications of bond duration and convexity, all within a cohesive framework grounded in current financial theory and empirical evidence.

Commercial Paper Ratings

Commercial paper ratings serve as vital indicators of creditworthiness for short-term unsecured promissory notes issued by corporations. Credit rating agencies evaluate issuers' financial health, liquidity, and ability to meet short-term obligations, assigning ratings that guide investors in assessing risk (Standard & Poor's, 2020). These ratings help investors determine appropriate yield spreads over risk-free benchmarks, facilitating efficient capital allocation. Higher ratings imply lower default risk, allowing issuers with strong financial profiles to access funding at more favorable rates. Without such ratings, investors would face heightened uncertainty, possibly leading to capital shortages in short-term credit markets (Moody's Investors Service, 2019).

Repurchase Agreements and Yield Comparison

Repurchase agreements (repos) are short-term borrowing arrangements where securities are sold with an agreement to repurchase them at a later date. Given the collateralized nature of repos, their associated yields tend to be lower than those of unsecured commercial paper because the risk premium is reduced (Fabozzi, 2018). Typically, repo yields are close to risk-free rates, reflecting the secured lending environment. Therefore, one would expect repos to have a lower annualized yield than commercial paper, as the latter carries higher issuance risk due to its unsecured status and dependence on issuer creditworthiness (Berger & Udell, 2006).

Foreign Money Market Yield and Currency Impact

The yield on a foreign money market security can be significantly influenced by fluctuations in the foreign currency’s value. If the foreign currency declines relative to the dollar, the dollar-equivalent yield diminishes because the original currency earnings translate into fewer dollars (Madura, 2018). Conversely, an appreciation of the foreign currency increases the dollar yield on the security. This currency risk introduces an additional layer of uncertainty for investors, affecting their required returns and decision-making processes when investing in foreign short-term instruments (Froot & Thaler, 2018).

T-Bill Yield and Discount Calculations

Suppose an investor purchases a $100,000 T-bill for $98,000, maturing in 120 days. The yield can be calculated using the discount method:

Discount = ($100,000 - $98,000) = $2,000

Discount rate = ($2,000 / $98,000) = 0.02041 or 2.041% over 120 days.

Annualized yield = (0.02041 / 120) * 365 ≈ 6.2%. The T-bill’s discount rate is 2%, reflecting the difference relative to face value.

Required Rate of Return on a Security

Given a security with a par value of $10,000, selling for $8,816.60, and maturity in two years, the investor’s required rate of return can be calculated using:

Future value = Par value = $10,000

Present value = $8,816.60

Using the formula for compound interest:

$10,000 = $8,816.60 * (1 + r)^2

Solving for r yields approximately 12.3% per annum.

Effective Yield and Currency Fluctuation

An investor converting yen to dollars at 100 yen per dollar invests in a 5% yield security in yen. After one year, the spot rate shifts to 90 yen per dollar. The calculation of the effective yield considers both the interest earned and the change in exchange rate:

Initial investment = 100 yen for $1, yield = 5% in yen, so at the end of year, yen amount = 105 yen.

Converting back to dollars: 105 yen / 90 yen per dollar ≈ $1.1667.

The initial dollar amount was $1; after one year, the final amount is approximately $1.1667, indicating an effective yield of about 16.67%. This demonstrates how currency movement impacts overall returns (Shapiro, 2013).

Call Provisions and Bond Prices

Call provisions grant the issuer the right to redeem bonds before maturity, typically at a premium. They favor issuers by providing flexibility to refinance debt in declining interest rate environments. From the investor’s standpoint, call provisions introduce reinvestment risk, potentially lowering bond prices since investors face the possibility of having their bonds called away when rates are favorable (Fabozzi, 2018). Consequently, callable bonds generally trade at a lower yield than non-callable bonds to compensate for this risk.

Variable-Rate Bonds and Market Expectations

Variable-rate bonds (VRBs) adjust interest payments periodically based on benchmark rates. When interest rates are expected to decrease, these bonds are less attractive because their coupons will decline, leading investors to prefer fixed-rate bonds for higher, stable returns. Conversely, a firm expecting a rate decline might consider issuing VRBs to benefit from lower interest expenses, anticipating that future adjustable coupons will be more favorable than fixed-rate borrowing (Mishkin & Eakins, 2018).

Impact of Credit Crisis on Junk Bonds

The 2007-2008 credit crisis heightened default risk across the bond market, especially for junk bonds, which are more sensitive to economic downturns. During the crisis, default rates soared, and investors demanded higher risk premiums on new junk bond issues to compensate for elevated default risk. Existing junk bonds also experienced sharp price declines, as rating agencies downgraded many issuers, and market liquidity dried up (Tett, 2018). This environment underscored the importance of credit risk assessment in high-yield markets.

Bond Downgrades and Investor Returns

When a bond's credit rating is downgraded, its market price typically falls due to increased default risk perception. Current bondholders face capital losses if they sell, while those holding the bond to maturity may experience reduced returns if the bond is downgraded beforehand. For new investors, a downgrade might present an opportunity to purchase at a lower price, albeit with increased risk. Overall, downgrades lead to higher yields, reflecting the increased risk, and can significantly influence market liquidity and investor behavior (Elton et al., 2019).

Economic Expansion and Bond Prices

An economic expansion generally reduces the perceived credit risk of issuers, leading to higher bond prices, especially for high-rated fixed-rate bonds. As corporate performance improves, default probabilities decline, making bonds more attractive, and yields tend to decrease. However, if growth leads to rising inflation expectations, interest rates might increase, potentially offsetting some gains in bond prices. Overall, the positive impact of economic growth on bond valuation depends on the balance between improving credit risk and inflationary pressures (Fabozzi et al., 2019).

Bond Price Sensitivity to Economic Variables

Bond prices are influenced by a multitude of factors including the growth of the money supply, oil prices, and overall economic health. An increase in money supply often leads to higher inflation expectations, prompting interest rates to rise and bond prices to fall. Rising oil prices can increase production costs and inflation, similarly pushing yields upward and prices downward. Conversely, robust economic growth can tighten monetary policy, increase interest rates, and depress bond prices. Understanding these relationships is crucial for effective portfolio management (Mishkin & Eakins, 2018).

Interaction Between Bond and Money Markets

Suppose an investor expects long-term interest rates to rise significantly tomorrow. The investor might choose to decrease holdings in long-term bonds and increase cash or short-term securities (money market instruments) to avoid potential capital losses. If the market’s expectation aligns with the investor’s outlook, demand for long-term bonds will decrease, driving prices down and yields up, while money market securities will see increased demand. If the yield curve is initially flat, a rise in long-term rates will steepen the curve, reflecting higher yields for longer maturities and indicating expectations of future rate increases (Madura, 2018).

Bond Valuation Techniques

Consider a bond with a par value of $1,000, an 11% annual coupon rate, and a four-year maturity, with an investor’s required return of 11%. The bond’s price is calculated by discounting future coupons and face value at the required rate. Since the coupon rate equals the required rate, the bond’s price equals its face value, $1,000. If the required rate drops to 9%, the present value increases, reflecting a premium. For a zero-coupon bond with a 14% discount rate, the price is found by discounting the face value over the remaining period, resulting in a lower price due to the higher discount rate (Brigham & Ehrhardt, 2016).

Bond Duration and Price Sensitivity

Bond duration measures the sensitivity of a bond’s price to changes in interest rates. For example, a bond with a duration of 5 years and a yield of 9% would experience a price change of approximately 4.5% if yields increase by 1%. This linear approximation helps in risk management, illustrating how interest rate volatility impacts bond prices (Fabozzi et al., 2019).

Bond Convexity and Price-Yield Relationship

Bond convexity accounts for the curvature in the price-yield relationship, with positive convexity implying that bond prices increase at an increasing rate when yields fall and decrease at a decreasing rate when yields rise. This characteristic enables more accurate estimations of price changes for large interest rate shifts and generally benefits bondholders by reducing risk (Elton et al., 2019). Recognizing convexity helps investors better manage interest rate risk in volatile markets.

References

• Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
• Berger, A. N., & Udell, G. F. (2006). A more complete conceptual framework for SME finance. Journal of Banking & Finance, 30(11), 2945-2966.
• Fabozzi, F. J. (2018). Bond Markets, Analysis, and Strategies. Pearson.
• Fabozzi, F. J., Ma, J., & Opiela, T. P. (2019). The Handbook of Fixed Income Securities. McGraw-Hill Education.
• Elton, E. J., Gruber, M. J., Brown, S. J., & Goetzmann, W. N. (2019). Modern Portfolio Theory and Investment Analysis. Wiley.
• Mishkin, F. S., & Eakins, S. G. (2018). Financial Markets and Institutions. Pearson.
• Madura, J. (2018). Financial Markets and Institutions. Cengage Learning.
• Moody’s Investors Service. (2019). Credit Ratings and Analysis of Short-term Instruments.
• Standard & Poor's. (2020). Why Credit Ratings Matter.
• Tett, G. (2018). The Securitization Market During the Financial Crisis. Financial Times.