Incident Command System - Assignment Example

Running Header: Incident Command System Student’s Name: Instructor’s Name: Course Code & Name: Date of Submission: INTRODUCTION A bond is a security issued in connection with a borrowing arrangement; the borrower issues a bond to the lender for some amount of cash. It obligates the issuer to make semi-annual payments of interest to bond holder to life of the bond. When bond matures, the issuer repays the debt by paying the bondholder the par value where the lender receives the interest and any capital gains as the return of sacrificing the present consumption for a future investment. To value a bond, we discount its expected cash flow by appropriate discount rate. The cash flows from a bond consist of coupon payment until the maturity date plus present value of fixed payment of par value (Ericsson, J., and J. Reneby. 2005). Bond value= + Pricing of the bond depend on the type of contract used in issuing such security and it is composed of three forms that is zero coupon bond, fixed payment bond, Console of perspective and coupon bond. Zero coupon bonds is also described as pure discount bond since their price is less than their face value for example a zero bond with face value of $100 sold at $96, the difference of $4 is the interest payment to the lender. The value of a zero coupon is Bond value= Where r is the interest rate and T is the period of the bond. Fixed payment bond is where the lender is paid fixed amount of money in a regular basis and the amount consist of the payment of the principal and the interest for example in house mortgage one always pays principle amount and the interest. It is shown by, Value of the bond= T is the life of the bond. Coupon bond is borrower promises to make a series of periodic interest payment plus the principal payment at maturity of the bond. It is given by, Value of the bond= + Console of perspective is where a borrower agrees to make periodic payments forever by paying only interest and he will not pay the principal amount. Price of this bond is given by, Price of the bond= BOND YIELDS The yield on a bond reflects coupon interest earned plus any capital gain or loss realized from holding a bond to maturity. Example: If a 4 year bond with coupon rate of 5% and a par value of $1000 is selling for $900.64. The yield should reflect the coupon interest of $50 every year plus capital gain of $99.36 as the lenders return at maturity. There are two important yield measurements for the investor to gauge on the return earned from holding certain security and it includes current yield of bond and yield to maturity. 1. Current yield of a bond This measures the cash income provided by the bond as percentage of bond price. It measures the proceeds the holder receives from accepting security. Current yield of a bond is given by: Current yield proceed= × 100 Example: If a bond of face value, $100 is priced at $96.5 and annual coupon of $6.5. The bond is 20-year bond with 19 years remaining but your intention is to sell it after one year. What will be the current yield at the current price? , calculate the yield if the price fall to $80? Scenario 1 Current yield proceed= × 100 = 6.7% 6.7% shows by which rate the investor will gain return from the amount invested on the security. Therefore, he will earn an average of 6.7% of the total amount invested. Scenario 2 If price change to $80 Deviation from price= 96.5-80 =$16.5 Actual yield= ×100 = -10.36% Though investor might have gained $6.5 the real facts he has loss of $10 therefore, this measure is inefficient as a measure of bond yield since the formula does not account for capital gain or capital loss. 2. Yield to maturity. It is the yield that bondholder receives if he holds the bond to maturity or redemption period when the final payment is made. It is also defined as interest rate that makes the present value of cash flow of the bond equal to the market price. The yield to maturity is obtained by solving for Y in the equation below, P= + where, P is market price of the bond. T is the maturity period. M is maturity value of the bond. C is the coupon value of the bond. This is the present value of the interest earned after one year. This gives par value of the bond after one year. The yield to maturity is given making Y the subject of the formula. Example Consider a bond of 5% coupon rate with one-year maturity with face value of $ 100. Lets the market price of the bond at maturity be $110. Calculate the yield to maturity value. P= + P=110 C=100×5/100= 5 M=100 110= + 1+y =105/110 Y= 0.95-1 Y=-0.045 or -4.5% This shows that capital loss is incurred in the investment since market value of the same bond at the end of the one year is higher that maturity value. 3. Holding period returns yield. The yield to maturity can be different from return because the holder holding period return can sell them before maturity unlike the yield to maturity where the holder has to retain the bond until it matures. Furthermore, the price of the bond can change between the time of purchase and time of sale. Holding period return= + Example Consider a bond in the market with coupon payment of $10 with face value of $100. Assuming that the investor is planning to buy a one-year bond and holds it to maturity, market price at the maturity is $96, then the holding period return would be obtained by : Holding period return= + Therefore, holding period= + = 0.14 or 14% gain. PRICE DETERMINERS OF THE BOND MARKET It is affected by the forces of demand and supply like any other commodity in the market, Bond supply curve Bond supply curve shows relationship between price and quantity of bonds are willing to sell in a given market. The curve is slopes upwards since the holder always will sell at higher price than when the price of the bond is lower to take advantage of capital gain. For firms seeking to raise funds, the higher the bond price the more they generate funds due to lower interest rate associated with increase in price of the bond (O. Sarig and A. Warga, 1989). Shift in supply curve either to the right or to the left is caused by several factors each attached to positive or negative implication. These factors include: i. Change in government borrowing An increase in government borrowing can increase quantity of outstanding bonds it finances its deficit with bonds. Sometime the government might raise their interest rate thus causing “crowding out” of the private bonds or investment (Beaudreau, Bernard C, 2006).. This effect will increase the returns of the lender to government but on the other hand ruin the growth of private sector of a given economy. ii. Changes in the general business conditions An economy goes through various changes that is boom, recession, depression and recovery therefore, this changes the need of the economy with respect to the funds needed at any particular part of the economic cycle. For example, during boom period the government borrows the funds from the public thus causing the supply curve to shift outward this due to the fact that, increase in supply is caused by attractive returns in the bond market by reduced prices and increased interest of the bonds. Bond demand curve It shows the relationship between price and the quantity of bonds investors demand ceteris paribus. It is a negatively sloped curve since as the price fall, the reward of holding bond rises therefore, demand increases (J.W.Conard, 1959). For example: If one is holding a bond of face value $1000 with coupon rate of 10% and market price of $900, this will stimulate one to hold the bond and even buy more because one would get coupon payment of $100 and capital gain of $100. Factors that shift bond demand curve and effects to investors return. 1. Wealth As wealth increases, individual increases their investment in bonds and other securities this increases demand therefore, the market will adjust and thus reduction of interest rate and increase in bond price therefore, reduction in the returns to the investors. vice versa also applies when wealth decreases. 2. Expected inflation This causes shift of the demand curve to the right due to increase in the interest as it adjust to changes in inflation level thus reduction of investors return due to capital loss caused by reduction in price. 3. Expected returns and interest rates If the return of the bond rises relative to alternative investment, demand for bond will rise due to attractiveness of high return to the investor. 4. Risk to alternatives If the bonds become less risky to invest in compared to other forms of investment, demand for bond shift to the right since the returns are guaranteed and stable. 5. Liquidity relative to alternatives The more liquid a bond, the higher the demand for the bond since investors wish to sell their securities when the yield is high to get optimum returns. INTEREST RATE AND PRICE RELATIONSHIP The yield of the bond and the price of the bond are inversely related (R. Merton, 1974).For example, consider a 10 year zero coupon bond with face value of $100 which sale at interest of 10%. Therefore, the interest rate will be, Bond value= Bond value= Bond value= $38.55 Suppose the interest rate is 5% Bond value= Bond value= $61.39 Suppose the interest rate is 7% Bond value= Bond value= $50.83 This proves the inverse relationship that when the interest rate is increased (10%) the price of the bond decreases ($38.55) thus attractive to the investors and when the interest rate is decreased (5%), the price of the bond increases ($61.39) which is unattractive to investors. SHORT-TERM VERSES LONG-TERM BONDS. Through continuous compounding yield, prices of long-term bonds are likely to fluctuate as the yield of the bond changes; this helps the investor to choose between similar bonds but with different maturities in order to diversify their risk and increase return. The relationship between long-term bonds and short-term bond is that when the yield of long-term bond is high the short-term yield is explained by Expectation hypothesis that states, “If short-term bond yield are expected to rise over time, then long-term bond yield will exceed short-term yield.” (Huang, 2004). RISK FACED BY BOND HOLDERS i. Default risk This is the risk associated to the issuer not honoring his promise as agreed on the terms of payments. ii. Inflation risk Inflation risk experienced due to aggregate increase in the prices of products in the market, as the money value is lost. This affects the investor negatively. iii. Interest rate risk This is risk associated to changes in the interest rate of the bond from the time of purchase and the time of sell. This will result to capital loss in the value of the investment. CONCLUSION In conclusion, return to investor is influenced by many factors. Therefore, one should measure the value of the yield before making any investment decision and right models be used, since wrong results, and might ruin the decision and outcome of the investment resulting to capital losses. REFERENCE O. Sarig and A. Warga (1989). Bond Price Data and Bond Market Liquidity. Journal of Financial and Quantitative Analysis. J.W.Conard (1959). An Introduction to the Theory of Interest. University of California press. Ericsson, J., and J. Reneby (2005). Estimating Structural Bond Pricing Models. Journal of Business. Eom, Y., J. Helwege, and J. Huang, (2004). Structural Models of Corporate Bond Pricing: An Empirical Analysis, Review of Financial Studies. R. Merton (1974). On the Pricing of Corporate Debt: The Risk Structure of Interest Rates. The Journal of Finance. Beaudreau, Bernard C (2006). The Economic Consequences of Mr. Keynes: How the Second Industrial Revolution Passed Great Britain By. I Universe. Read More