Fabozzi_Ch01_BMAS_7thEd

1、Chapter 1 Introduction Learning ObjectivesAfter reading this chapter, you will understandthe fundamental features of bondsthe types of issuersthe importance of the term to maturity of a bondfloating-rate and inverse-floating-rate securities1)what is meant by a bond with an embedded option and the ef

2、fect of this option on cash flowLearning Objectives(continued)After reading this chapter, you will understandthe various types of embedded optionsconvertible bondsthe types of risks faced by fixed-income investorsthe secondary market for bonds6) ways of classifying financial innovationSectors of the

3、 U.S. Bond Market Treasury sector securities issued by the U.S. government Agency sector securities issued by federally related institutions and government-sponsored enterprises Municipal sector securities issued by state and local governments bondsSectors of the U.S. Bond Market(continued) Corporat

4、e sector securities issued in the U.S. by U.S. corporations and foreign corporations Asset-backed sector securities backed by a pool of assets Mortgage sector securities backed by mortgage loansBond IndentureThe bond indenture is the contract between the issuer and the bondholder, which sets forth a

5、ll the obligations of the issuer.Overview ofBond Features Type of Issuer Term to Maturity Principal and Coupon Rate Amortization Feature Embedded Options Describing a Bond IssueThe Bond Features1. Type of Issuer there are three issuers of bondsthe federal government and its agenciesmunicipal governm

6、entscorporations2. Term to Maturity refers to the date that the issuer will redeem the bond by paying the principalThere may be provisions in the indenture that allow either the issuer or bondholder to alter a bonds term to maturity.Bond Features (continued)3. Principal and Coupon Rate Bond Principa

7、l amount that the issuer agrees to repay the bondholder at the maturity date Zero-Coupon Bond interest is paid at the maturity with the exact amount being the difference between the principal value and the price paid for the bondCoupon Rate the nominal or interest rate that the issuer agrees to pay

8、each year; the annual amount of the interest payment is called the coupon Floating-rate bonds issues where the coupon rate resets periodically (the coupon reset date) based on the coupon reset formula given by:reference rate + quoted marginBond Features (continued)4. Amortization Feature the princip

9、al repayment of a bond issue can call for eitherthe total principal to be repaid at maturity orthe principal repaid over the life of the bond In the latter case, there is a schedule of principal repayments called an amortization schedule.i. For amortizing securities, a measure called the weighted av

10、erage life or simply average life of a security is computed.Bond Features (continued)5. Embedded Options it is common for a bond issue to include a provision in the indenture that gives either the bondholder and/or the issuer an option Call provision - grants the issuer the right to retire the debt,

11、 fully or partially, before the scheduled maturity date Put provision - gives the bondholder the right to sell the issue back to the issuer at par value on designated dates Convertible bond - provides the bondholder the right to exchange the bond for shares of common stock Exchangeable bond - allows

12、 the bondholder to exchange the issue for a specified number of common stock shares of a corporation different from the issuer of the bondBond Features (continued)6. Describing a Bond Issue most securities are identified by a nine character CUSIP number CUSIP stands for Committee on Uniform Security

13、 Identification Procedures First six characters of CUSIP identify the issuer The next two characters identify whether the issue is debt or equity and the issuer of the issue The last character is a check character that allows for accuracy checking The CUSIP International Numbering System (CINS) iden

14、tifies foreign securities and includes 12 charactersRisks Associated withInvesting in BondsInterest-rate RiskReinvestment RiskCall RiskCredit RiskInflation RiskExchange Rate RiskLiquidity RiskVolatility RiskRisk RiskRisks Associated with Investing in Bonds (continued)1. Interest-Rate Risk qInterest-

15、rate risk or market risk refers to an investor having to sell a bond prior to the maturity date.qAn increase in interest rates will mean the realization of a capital loss because the bond sells below the purchase price.qInterest-rate risk is by far the major risk faced by an investor in the bond mar

16、ket.Risks Associated with Investing in Bonds (continued)2. Reinvestment RiskqReinvestment risk is the risk that the interest rate at which interim cash flows can be reinvested will fall.qReinvestment risk is greater for longer holding periods, as well as for bonds with large, early, cash flows, such

17、 as high-coupon bonds.qIt should be noted that interest-rate risk and reinvestment risk have offsetting effects.Risks Associated with Investing in Bonds (continued)3. Call RiskqCall risk is the risk that a callable bond will be called when interest rates fall.qMany bonds include a provision that all

18、ows the issuer to retire or “call” all or part of the issue before the maturity date; for investors, there are three disadvantages to call provisions:cash flow pattern cannot be known with certaintyinvestor is exposed to reinvestment riskbonds capital appreciation potential will be reduced Risks Ass

19、ociated with Investing in Bonds (continued)4. Credit Risk qCredit risk is the default risk that the bond issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and principal.qCredit spread is the part of the risk premium or spread attributable to defau

20、lt risk.qCredit spread risk is the risk that a bond price will decline due to an increase in the credit spread.Risks Associated with Investing in Bonds (continued)5. Inflation Risk qInflation risk arises because of the variation in the value of cash flows from a security due to rises in purchasing p

21、ower.qIf investors purchase a bond on which they can realize a coupon rate of 7% but the rate of inflation is 8%, the purchasing power of the cash flow falls. qFor all but floating-rate bonds, an investor is exposed to inflation risk because the interest rate the issuer promises to make is fixed for

22、 the life of the issue.Risks Associated with Investing in Bonds (continued)6. Exchange-Rate Risk qExchange-rate risk refers to the unexpected change in one currency compared to another currency.From the perspective of a U.S. investor, a non-dollar-denominated bond (i.e., a bond whose payments occur

23、in a foreign currency) has unknown U.S. dollar cash flows.The dollar cash flows are dependent on the exchange rate at the time the payments are received.The risk of the exchange rate causing smaller cash flows is the exchange rate risk or currency risk.Risks Associated with Investing in Bonds (conti

24、nued)7. Liquidity Risk qLiquidity risk or marketability risk depends on the ease with which an issue can be sold at or near its value.The primary measure of liquidity is the size of the spread between the bid price and the ask price quoted by a dealer.The wider the dealer spread, the more the liquid

25、ity risk.Risks Associated with Investing in Bonds (continued)8. Volatility Risk qVolatility risk is the risk that a change in volatility will adversely affect the price of a bond.qThe value of an option rises when expected interest-rate volatility increases.For example, consider the case of a callab

26、le bond where the borrower has an embedded option, the price of the bond falls when interest rates fall due to increased downward volatility in interest rates.Risks Associated with Investing in Bonds (continued)9. Risk RiskqRisk risk refers to not knowing the risk of a security. qTwo ways to mitigat

27、e or eliminate risk risk are: Keep up with the literature on the state-of-the-art methodologies for analyzing securitiesavoid securities that are not clearly understoodSecondary Market for BondsThe secondary market is the market where securities that have been issued previously are traded.Secondary

28、trading of common stock occurs at several trading locations in the United States: centralized exchanges and the over-the-counter (OTC) market.Secondary Market for Bonds(continued)The secondary markets in bonds throughout the world are quite different from those in stocks.The secondary markets in bon

29、ds are not centralized exchanges but are OTC markets, which are a network of noncentralized market makers.Financial Innovationand the Bond Market Since the 1960s, there has been a surge of significant financial innovations. The Economic Council of Canada classifies financial innovations into three b

30、road categories:Market-broadening instruments Risk-management instrumentsArbitraging instruments and processesFinancial Innovationand the Bond Market(continued) Market-broadening instruments Market-broadening instruments augment the liquidity of markets and the availability of funds by attracting ne

31、w investors and offering new opportunities for borrowers.Financial Innovationand the Bond Market(continued) Risk-management instruments Risk-management instruments reallocate financial risks to those who are less averse to them or have offsetting exposure.Financial Innovationand the Bond Market(cont

32、inued) Arbitraging instruments and processesArbitraging instruments and processes enable investors and borrowers to take advantage of differences in costs and returns between markets.Financial Innovationand the Bond Market(continued) Price-Risk Transferring Innovations Credit-Risk-Transferring Instruments Liquidity-Generating Innovations Credit- and Equity Generating InstrumentsFinancial Innovationand the Bond Market(continued)1. Price-Risk Transferring InnovationsPrice-risk-transferring innovations are tho