The Efficient Market Hypothesis (EMH) by Eugene Fama in 1970 states: “In an efficient market, the price of an asset accurately reflects all available information.”
The level of market efficiency depends on: The ‘type’ of information incorporated into price and the ‘speed’ with which new information is incorporated into price.
(Heakal, R. 2016).
2. The corporate bond market and 3 different types of corporate bonds.
The bonds market is where the issuance and trading of debt securities (a negotiable or tradable liability or loan) takes place.
Debenture: This is a document issued acknowledging debt at a given rate of interest. It is unsecured debt, supported only by a good credit rating of the issuer. The debenture holder is the company’s creditor, who in the case of liquidation of the company, will be paid before shareholders
(Vikram Books, 2014).
Mortgage Bond: This is backed by a property mortgage that can be sold in order to reimburse the bond should a default arise
(Dictionary, m, 2016).
Collateral Trust Bond: Secured by stock and or bonds owned by the issuer, collateral value is generally 20%-30% higher than bond value. The holder becomes the creditor for proceeds from stock and bonds, if not satisfied.
(Megginson, W. and Smart, S. 2009).
3. The mechanics of calculating the value of a bond and why bond prices vary negatively with interest rate movements.
The principle behind the valuating bond is that its value is equal to the present value for its expected cash flow.
Three steps are followed:
1. Estimation the expected cash flows.
2. Determine an appropriate interest rate.
3. Calculate the present value of the expected cash flows by using the interest rate.
E.g.: A 5 year bond with intertest payment of £70 and a maturity value of £1,000 and a discount rate of 5%.
For the first four years the cash flow is going to be 70, but on the fifth year it would be 1,070. Thus, in order to calculate the future value of the bond the PV of each has to be added:
The reason why bond prices vary with interest rate movement, is because when the interest rate changes, the discount rate changes, hence each year the present value of the bond is affected.
(Investopedia, 2012).
4. Distinguish between a bond’s coupon rate, yield to maturity, effective annual yield and be able to calculate their values.
(Maturity: date when the issuer must pay the face value paid by bond buyer/ Face Value: value of the bond at maturity)
a) Coupon rate → is the actual yearly interest received on the bond bought based on its par/face value.
(Moussa, C. 2011).
Equation:
Coupon rate (C)= annualized interest or coupon (i) / Par value of bond (p).
b) Yield to maturity → is the real total return that the investor can anticipate on a bond that is held until its maturity and if all payments are made as scheduled (Expressed in annual rate)
Equation:
C (coupon/interest payment) – F (face value) – P (price) – n (Years to maturity)
E.g.: If bond held has a par/face value of £1000 for £920 at 8% interest with maturity at 15 years. Coupon interest per year is thus £8 (8% x £100)
(WikiHow. 2015).
Result:
(The result is in %)
c) Effective annual yield of a bond → the yield on an investment considering effects of compounding in a year. (Compounding here assumes the bondholder invests the coupon as soon as the payment is received to generate earnings)
Formula: (1+i/n)^n-1
i = the stated annual interest rate
n = the number of compounding periods in one year
E.g. if annual rate is 10%, and you compound monthly (12 months), this results in 10.47% as effective annual interest rate
(Investopedia, 2004).
5. Interest rate risk on bonds, and importance of bond theorems
Theorem 1: Bond prices have an inverse relationship with interest rates.
E.g.: If you bought a bond at 1000£ (interest 5%/ maturity 5 years), the value of that bond is exactly what was initially paid of it.
If interest rates rise to 7%, the bond value you bought is worth less then when you bought it with a 5% coupon: Because, if an investor pays the same amount of 1000£ and buys a bond that has a higher interest rate, it would be illogical to pay 1000£ for the bond you bought with a lower interest offering bond. Thus your bond value decreases.
Theorem 2: The longer the maturity of the bond the more sensitive it is to changes in interest rates.
Theorem 3: The price changes resulting from equal absolute increases in YTM are not symmetrical.
Theorem 4: The lower a bonds’ coupon, the more sensitive its price will be to given changes in interest rates.
(Moussa, C. 2011).
6. Discuss the concept of default risk and how to compute a default risk premium.
The concept of default risk follows the notion that in the case of a credit event, where the debtor might go bankrupt, fail to pay, etc. the creditor is backed by charging an initial rate of return that corresponds to the debtors level of risk. The higher the risk, the higher the rate of return and vice versa. Credit events can happen unexpectedly and therefore the effects cannot be known until the event has happened, hence cover is required.
Default Risk Premium Calculation:
DPR = idr – irf
idr is the interest rate (yield) on a security that has default risk
irf is the interest rate (yield) on a risk-free security.
7. Describe the factors that determine the level and shape of the yield curve
Yield curves take three main forms: normal, inverted and flat. A normal yield curve is a short-term yield being lower than long term yields (line upwards). On the contrary, if short-term yield is more than a long-term yield (line pointing down) then the curve is inverted. The last one is a flat yield, only seen when there is barely any recognizable difference between both short and long-term yields.
(Investopedia, 2003)
There are three theories that try to explain why these curves are shaped in any of these ways. First, “expectations theory” which states the predictions of upcoming short-term interests rates create a positive yield curve. Second, the “liquidity preference hypothesis” reveals that investors are more likely to refer to higher liquidity of short-term debt and any obstruction of a positive yield curve will be looked upon as a short fad. The last theory is the “segmented market hypothesis” the prediction that certain investors limit themselves to specific maturity intervals which therefore makes the yield curve sustain its prevailing predecessors.
(Investinganswers.com, 2016).
8. Define a Lease and specify the rights and obligations of each party of each party to the lease.
A Financial Lease is a procedure in raising capital or investments to pay for certain equipment, utilities, etc. (Assets). In this agreement, there are two parties involved. These include a ‘lessee’ (customer) who selects the asset (as well as assuming all risks), which the ‘lessor’ (financier) “provides the funds to purchase that asset.”
(Careerride.com, 2016).
Obligations to the lessee are, during the lease period, to pay for rentals, for any repairs, insurance, and maintenance of the asset. Rights to the lessee include, during the lease period, to assume full ownership of the asset or equipment by paying a bargain cost or a “repurchase price” and all economic benefits. Primary obligation to the lessor is to finance the asset. Rights of ownership include of obtaining a large part or all cost of the asset with additional interest from the rent paid by the lessee.
(Cimc.com, 2016).
9. Distinguish between a sales-type lease, a direct lease, and a sale and lease back.
Direct (Financing) Lease –The lessor (usually a financial institution) buys an asset and leases it to the lessee.
Sales-Type Lease – This has the same accounting for a direct lease, however sales profit is recognized upon the lease’s inception.
Sale and Lease Back – This occurs when a seller sells an asset but leases it back straight away, often to create cash flow when dealing with other investments.
(Investopedia.com, 2014)
10. Compute the cost of leasing in a perfect market.
“In a perfect market, the cost of leasing is equivalent to the cost of buying and reselling the asset” (Megginson, W. and Smart, S. 2009).
PV (Lease Payments) = Purchase Price – PV (Residual Value)
E.g.: The purchase price of an asset is £40,000 and the (certain) residual value of the asset is £12,000 and there is 0% chance that the lessee will default on the lease. If the risk free APR is 6% with monthly compounding, what is the monthly payment amount for a 6-year lease in a perfect capital market?
Because all cash flows are risk free we can discount them using the risk free interest rate 6% / 12 = 0.5% per month.
PV = 40,000 – (12,000/1.005^72)=31620.37
What monthly lease value has this present value? Determine the lease payment as an annuity. Because the first lease payment is immediate we can view the lease as an initial payment of L, hence we can use the Annuity formula
(P = r(PV)/1-(1+r)^-n) to Find L so that:
P or L = Payment, r = rate per period, n = number of periods.
31620.37 = L+L x 1/0.005 (1–1/1.005^72) = L x (1+1/0.005(1–1/1.005^72))
Solve for L:
L = 31620.37/ 1+1/0.005 (1-1/1.005^72) = $157.86 per month.
(Berk, J. and DeMarzo, P, 2016) – Values are not taken from source.
11. Define the 4 types of options available for the lessee to obtain ownership of the asset at the end of the lease.
“A fair market value (FMV) lease gives the lessee the option to purchase the asset at its fair market value at the termination of the lease.”
“In a fair market value cap lease, the lessee can purchase the asset at the minimum of its fair market value and a fixed price (the “cap”).”
“In a $1.00 out lease, ownership of the asset transfers to the lessee at the end of the lease for a nominal cost of $1.00.”
“In a fixed price lease, the lessee has the option to purchase the asset at the end of the lease for a fixed price that is set in the lease contract.”
Berk, J. and DeMarzo, P. (2011).