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Risk management summary
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Summary study book Risk management of Madura, Fox - ISBN: 9781408044063
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The fixed interest marketDisintermediation = companies step inside a bank and lend directly to individual
investors by issuing bonds.
Nature of debt and the equity finance
Equity investor = buying a share and will not get capital back until company is
terminated.
Debt capital= finance lent by investor to business must be repaid by specified date
2 ways of raising debt finance:
- intermediated
= raised from a bank or other financial institution
- fixed or variable terms
- short term (variable rate)
- longer term (fixed rate)
- Disintermediated
= direct offer to capital market in form of bond
- government = form of auction by agency of treasury
- corporate debt = issue arranged by merchant bank and may be underwritten
Bond = negotiable certificates of indebtedness for term greater then one year.
Bond basics
Tr = treasury bond = each bond certificate carries commitment from government to
repay the investor the principal sum (bonds par value)
Risk
- Default risk
= borrower will default on payment of interest or capital
- if this happens, bond holder can put company in hands of receivers (first step
to bankruptc)
- how much risk is measured through credit rating
- Interest risk
- interest rate increases, fixed rate bond less attractive, market price bond falls
- interest rate decreases, bond price rises
- rates fall, they are paying coupon rate
- rates rise, serving debt is cheaper then rates suggest
- Inflation risk
- cannot foresee spending power return will offer
- connected to interest rate -> high and high
- high interest & inflation -> risk of default
- Reinvestment rate risk
- rate at which investors want to reinvest their receipts from bond can vary
,How government raises bond finance
Main difference government & corporate bond = level default risk
Treasury bonds -> default risk free
- when bond is due, financed out of surplus, or more debt
Primary market for government bonds
Individuals and institutions bid on stock offered.
Once in hand, possible to trade on secondary market (stock exchange)
Tap mechanism = government places stock directly at specific institution.
Other types of government bond
Zero-coupon bonds
- short dated
- no interest payment
- offered at discount below par value
- Discount calculated = par value – issue price
------------------------------ x 100
Par value
- Useful for institutional investors who need access to capital at particular times
and are not interested in interest payments.
Index linked bonds
- Whose coupons and eventual redemption are linked to inflation rate
- Attractive to pension funds and other institutions who have to make payments
linked to inflation rate
Convertible bonds
- government offers option to covert short dated bond into longer dated bond at
specific date.
Calculating yield on bonds
Yield = discount rate that equates issue price of bond with the cash flows received by
investor over life time of bond
Formula: Vo = I I I I Par + I
------ + ------+ ----- + ----- + …… + -------
(1+r) (1+r)2 (1+r)3 (1+r)n
I = Fixed coupon payment each period
Vo = issue or current price of bond
Par = face or nominal value
R = bonds available for general public (semi-annual -> annual)
, 2 important notes to pricing bonds:
1. Interest is paid on bonds semi-annually, but it accrues to investors on daily
basis.
- If bond paying half year interest on 30 June, and 31 December is sold on 31
January, seller is entitled to 31 days interest.
- bond paying 10% per annum would accrued interest on 31 January:
10% x 31/365 x £100 = 84.93p
- clean price = calculated through discounting future coupon payments and
redemption value at yield appropriate
- dirty price = market price
2. Normally a bond trades cum div.
= investor expects to get next coupon payment at half year interval
- But, books are closed and interest goes to registered holder of bond at that
date, even if it is sold before coupon is paid.
- during interval bond goes ex-div -> purchaser of bond will not be collecting
next interest payment.
- market price = clean price + element of interest accruing to seller up to date
of sale.
- dirty price = clean price + accrued interest
- bond goes ex-div -> seller will receive next coupon payment in full and
market price will drop since seller will get part of clean price as coupon
payment
- bond goes ex-div -> dirty price = clean price – present value of coupon
payment.
The separate trading of interest and principal (STRIPS)
Stripping = stripping coupon payments from the principal to give a pure, time limited
coupon bond and a redemption only or ‘zero coupon’.
- two striped components can be traded separately.
- Only the debt management office or the bank of England is allowed to make
strips from small set of treasury bonds which are deemed strippable.
Two benefits to stripping:
1. it is possible for investors with different cash flow requirements to match the
receipts from their investments exact needs.
- pension fund equiring secure cash flow can find interesting
2. investment in strips can help mitigate reinvestment risk.
Negative:
- the market value of individual components will be more then the market value
of the original bond.
The yield curve
Designed to reveal rate of return that investors in debt market require on cash
receipts at different point of time in the future
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