debt securities and bond securities

• why institution issue debt securities?


  need of capital
• debt securities issued by companies?


  secured bonds

  debentures

  subordinated bonds

  convertible companies

  zero coupon bonds
• bonds are bought by investors/ parties who possess money

  institutional investors

  [1] banks

  [2]insurance companies

  [3] pension funds

  individual investors - need fixed cash flows at regular investors
• Determining bond market price

  Consider forces of demand and supply
• Bond market prices


  • Bond A - Rs 100
  • Bond B - Rs 150
• Intrinsic/Theoretical value of a bond


  The present value of the future cash flows paid by the bond
• Investment decision making


  1. Assess value of investment based on future cash flows

  2. Compare market price with intrinsic value
• bond X

  intrinsic value - rs60

  maket value - rs50

  buyer- intrinsic value is greater than market value

  the bond is underpriced/undervalued and an investor should buy the bond.

  seller- a seller who has estimated the bond is worth rs60 . he will sell at a price above rs60 and at worst at rs60 but he will not sell below rs 60.
• bond x

  instrinsic value - rs60

  market value - rs60

  the bond is fairly priced . normally the buyer will buy and the seller will normally sell.
• bond x

  intrinsic value - rs60

  market value - rs70

  buyer- the bond is overvalued/overpriced in the bond market and an investor should not buy the bond.

  seller - the seller would be selling when market price is superior to intrinsic value.
• the instrinsic value is equal to the present value of the future cash flows paid by the bond that is the present value value of the coupons and the nominal amount when calculating the present value.

  formulae - $present value- future value/(1+r)number of year$
• what would be used as the discount rate?


  the particular discount rate is used for calculating the intrinsic value of an asset is the REQUIRED RATE OF RETURN[k].

  the required rate of return is an estimation of the return that an investor will ask for a financial product.
• coupon rate is used to calculate coupon payment.the coupon's pay will be re invested at another interest rate , normally the required rate of return when considering the intrinsic value of the bond. the [k] will normally be estimated by [1]risk level [2]inflation [3] time period of investment
• intrinsic value formulae - $c/[1+k]1 +$$c/[1+k]2+$$c/[1+k]3+$$c/[1+k]4+$$c/[1+k]5$
• Yield to maturity (YTM)


  The average return or the interest rate that is actually being paid on the bond
• YTM


  The interest at which the coupon is reinvested up until maturity date
• YTM can be compared with the required rate of return


  To take an investment decision
• If the required rate of return (k) is greater than YTM

  The investor will not undertake the investment
• When the required rate of return (k) and YTM are equal

  The investor will normally undertake the investment
• When the required rate of return (k) is less than the YTM


  The investor will be undertaking the investment
• YTM


  The discount rate which when used for calculating the present value of future cash flows of the bond will give a present value equal to the market price of the bond
• market price of bond - $c/[1+ytm]1 +$$c/[1+ytm]2+$$c/[1+ytm]3+$$c/[1+ytm]4+$$c/[1+ytm]5$
• the market price represents the price at which the financial product is actually selling in the market . it would be establish through forces of demand and supply. to take an investment decision we need to find if in the market the financial product is over , under or fairly priced.

  INTRISIC VALUE - PRESENT VALUE OF FUTURE CASH FLOWS OBTAIN FROM THE ASSET

  themarket interst rate of the bond represents the interest rate at which coupons are being reinvested up until maturity . the YTM is an average of the market interest rate.
• between 2 coupon payment when investor 2 purchases the bond he will be obtaining the whoe of the next coupon payment . so thr market price or full price [dirty] paid by investor 2 takes into consideration that part of the next coupon goes to investor 1. the part of the coupon that should hav gone to investor 1 is called accrued interest.

  the CLEAN PRICE would represent the price of the bond paid by the investor 2 when the accrued interest is removed