Week Three
Mathematics of Finance Revisited
Short, medium and longterm debt
Structure of the money markets.
Interest bearing securities
Discount securities.
Securitisation
Viney Chapters 8, 9 and 10
2
Objectives
Relationship between price and yield for a financial asset
Review the concept of holding period yields
Explain shortterm interest rate volatility and longterm
interest rate price volatility.
Distinguish between discount and interest bearing
securities
Explain the process of securitisation.
3
Introductory concepts
Financial market calculations operate according to a
set of market conventions
Example: interest rates are quoted per annum and
to 2 decimal places
Example : coupon payments on fixed interest
securities are usually 6monthly. Australian
Government bonds always pay interest and mature
on the 15
th
of the month.
Example : British empire countries use 365 days in a
year. USA/Euro countries use 360 days
4
Students Please Note
If you are not longer familiar with these
concepts review the examples in the text.
It is assumed that you can manage these
calculations.
5
Introductory concepts  continued
Nominal interest rate: the annual simple
percentage rate of return taking no account
of compounding.
Effective interest rate: the annual percentage
cumulative rate of return after including
compounding effects
You are expected to know how to calculate
these!
6
Introductory concepts  continued
7
Introductory concepts  continued
Securities with maturity less than one year
are quoted on a per annum basis adjusted
for the number of days to maturity
Example: a 90day bill with 9% pa. nominal
rate has a per period rate of:
0.09 x 90/365 = 0.0222 (or 2.22%)
8
Discount securities
Definition: a security sold at a price below its face
value. There are no other cash flows.
The profit to the investor is the difference between
the face value (F) and the price (P). It is known as
the discount.
eg: an investor buys a bank bill with face value
$100,000 for $98,000. The discount is FP = $2000.
This is also the expected return.
9
Holding period yield (HPY)
HPY is the yield on securities sold in the secondary
market prior to maturity
Shortterm money market securities (e.g. Tnotes)
may be sold prior because
Intended shortterm management of surplus cash held by
investor
The investors cash flow position has unexpectedly changed
and cash is needed
A better rate of return can be earned in an alternative
investment
10
Holding period yield (HPY) (cont.)
The yield to maturity is the yield obtained by
holding the security to maturity
The HPY is likely to be different from the
yield to maturity
11
Holding period yield (HPY) (cont.)
The HPY will be
Greater than the yield to maturity when the
market yield declines from the yield at purchase
i.e. interest rates have declined and the price of
the security increases
Less than the yield to maturity when the market
yield increases from the yield at purchase i.e.
interest rates have increased and the price of the
security decreases
12
ShortTerm Debt cont
Commercial Bills
A bill of exchange is a discount security issued
with a face value payable at a future date
A commercial bill is a bill of exchange issued to
raise funds for general business purposes
A bankaccepted bill is a bill issued by a
corporation that incorporates the name of a bank
as acceptor
13
ShortTerm Debt cont
Calculating priceyield known
A company decides to fund it shortterm inventory
needs by issuing a 30day bankaccepted bill with a
face value of $500,000.
Having approached two prospective discounters, the
company has been quoted yields of 9.52 per cent
per annum and 9.48 per cent per annum.
Which quote should the company accept, and what
amount will the company raise?
14
134.23 $496
365
30
* 0948 . 1
1
* 000 , 500
or
118.04 $496
365
30
* 0952 . 1
1
* 000 , 500
=




.

\


.

\

+
=




.

\


.

\

+
ShortTerm Debt cont
15
ShortTerm Debt cont
Calculations cont
In the previous example a company issued a 30day bank
accepted bill with a face value of $500,000.
The bill was discounted at a yield of 9.48 per cent per annum,
representing a price of $496,134.23.
After seven days the discounter sells the bill in the shortterm
money market for $497,057.36.
Assume the bill is not traded again in the market, calculate the
yield to the original discounter and to the holder at maturity.
16
Calculating yield (cont.)
Yield to original discounter:
Yield to holder at maturity:
9.70%
7
500 36
134.23 496
134.23) 496 057.36 (497
=
9.39%
23
500 36
057.36 497
057.36) 497 000.00 (500
=
+
= ) 1 ( ]
) 1 ( 1
[
(Example also in Viney 8.10)
19
LongTerm Debt cont
Calculations: Fixed Interest Securities (cont.)
Price of a fixed interest bond at coupon date
(cont.)
Current corporate bond yields in the market are 8 per cent per
annum.
An existing corporate bond with a face value of $100,000, paying
10 per cent per annum with halfyearly coupons, and exactly six
years to maturity, would be sold at a price of:
20
Calculations: Fixed Interest
Securities (cont.)
a
b
9385.07 $10
925.37 $46 459.70 $62 Price
925.37 $46
]
0.04
12
0.04) (1 1
$5000[
coupons
plus
459.70 $62
12
0.04) 000(1 $100
value face
=
+ =
=
+
=
=
+ =
PV
PV
21
On The Calculator
Make sure payments are set to 1 per year
N = 6 * 2 = 12
I/Yr = 8/2 = 4
PMT 10%x100,000/2 = 5,000
FV = 100,000
PV = 109,385.07
Why is the PV negative?
22
Relationship Between Price and
Yield
The relationship between price and yield is
inverse
Thus as the yield of the security rises, the
price falls
As the yield of the security falls, the price
rises
23
Relationship Between Price and
Yield cont
An example;
Calculate the price of the following security
(assume $1,000 face value)
90 day bank bill at a yield of 4.5%
recalculate at a yield of 4.25%
180 day bank bill at a yield of 4.50%
Recalculate at a yield of 4.25%
24
Relationship Between Price and
Yield cont
Now calculate the percentage change in
price of both the securities
Which has had the bigger change?
Why?
25
Term/Yield 90 Days 180 Days
4.50% $989.03 $978.29
4.25% $989.63 $979.47
Per Cent Change 0.061% 0.121%
Relationship Between Price
and Yield cont
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Relationship Between Price and Yield
on Bonds
Another example;
Calculate the price of the following security
(assume $1,000 face value)
Coupon 6.5%. Maturity 5 years. Current yield
4.5%
recalculate at a yield of 4.25%
Coupon 6.5%. Maturity 10 years. Current yield
4.5%
recalculate at a yield of 4.25%
27
Relationship Between Price and Yield
on Bonds cont
Calculate the percentage change in price for
both
Which has had the bigger change?
28
Term/Yield 5 years 10 years
4.50% $1088.66 $1159.64
4.25% $1100.40 $1181.75
Per Cent Change 1.0747% 1.915%
Relationship Between Price and
Yield on Bonds cont
29
Tender vs Tap System
Tender
Issuer announces the amount and terms under
which they wish to issue new securities
Interested parties have a set time by which they
must state how much and at what price they are
prepared to buy the new securities.
Highest bidder application is filled. Allocation
continues to bidders in order of price until all
new issue is allocated.
30
Tender System cont
Objective of bidder
To obtain all new securities required without
paying too much
To ensure that the price paid is so low that an
allocation is not received
Objective of issuer
To receive as high a price as possible
31
Tender System cont.
Advantages
Receive all funds required at a market price
Disadvantages
No control over price paid (unless a reserve price
is set or the issue is underwritten)
32
Tap System
Tap System
Issuer announces the amount, terms and price at
which they will issue new securities
Interested parties have a set time by which they
may make application for the securities
All allocations are filled as long as the window is
still open and that there are securities to be
issued.
33
Tap System cont
Advantages
Seller sets the price of the security
Disadvantages
If the set price and terms are not attractive the
issuer may not receive all the funds required.
34
Securitization
Securitized bonds: a packaging of small
incomegenerating assets into a large fixed
interest (assetbacked) security
Example: housing loans
35
Securitization  continued
How securitization works
36
Securitization  continued
Enhancement: increases marketability improving on
the risk of a security and increasing its credit rating
Involves various steps, for example
Primary Mortgage Insurance
Pool Insurance
Maturity refinance
Cash flow guarantees
But will reduce return due to cost of guarantees
See Viney p 417 420 for more information
37
Securitization  continued
Why securitize?
 better risk management
 diversify funding base
 balance sheet management
 product diversification
What Role has Securitisation
Played in the Current GFC?
38
39
In Conclusion
In this lecture we have
Reviewed the pricing of securities
Discussed the important relationship between
price and yield
The process by which fixed income securities are
first issued
The process and rationale for securitization.
40
Next Week  Week Four
Interest Rate Markets continued
Market participants and reasons for trading
Price behaviour
The impact of maturity date
The risk and term structures of interest rates
Trading strategies and rate forecasting
Viney Chapter 13
Assignment
Gives a practical insight into the mechanics
and operations of the
Foreign exchange
Equity and
Interest rate markets
By trading futures contracts in each market.
41
Futures Contracts
Foreign exchange as traded on the CME.
Each contract has a face value of AUD100,000
ASX S&P 200 SPI as traded on the ASX
Each contract has a face value of $25 * points
Interest rates (bonds and bank bills) as
traded on the ASX
Bank bill face value $1m
Bond face value $100,000
42
Limits
Closing position not to exceed 50 contracts
at any time.
Limit of 1 trade per week.
Limit of 1 zero position
43
Short Selling
How can I sell something I dont own?
44
Reporting
Stage 1
Weekly iJournal in MyECU blog.
Team mates to comment on your blog
This should be the start of your final written
report.
Stage 2
Weekly in class discussion by sector
One person to write up notes in blog in MyECU
45
Stage 3
Final report
Part 1 Report to the Board of Directors (28/35)
Cover letter
Executive summary
Theory
Weekly discussion based on your blogs
Part 2 Assessment of your assignment (3.5/35)
Part 3 Reflection (3.5/35)
46
Questions
47