Expert answer:finance discussion and responses week7
Solved by verified expert:this is a 2 part assignment first answer the questions with 300 words min and APA style for discussion post then write responses to 2 other students discussion posts with 100 words each, the other students posts are also an example on how the initial post should be done. Write the responses as if you talking directly to the other person not as 3rd person.
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This a 2 part assignment first answer the questions below with 300 words min and APA style
citation. Then the second part is to write 2 student responses to the below discussion discussions
posted by fellow students with 100 words min.
PART1
1.What are the implications of Malkiel’s bond price theorems to bond investors? Which two bond
variables are of major importance in assessing bond price changes?
2.Explain the concept of immunization. What role, if any, does duration play in this concept?
3.Find an article about a bond default and provide your thoughts as to what the main problems were.
Part 2
Student #1 Tiffanie
As bond prices change inversely to interest rates, investors constantly remember the
correlation between bond prices and bond yields. As such, bond prices change inversely to
market yields. When the level of required yields demanded by investors on new issues changes,
the required yields on all bonds already outstanding will also change. In order for these yields
to change, the value of these bonds must also change. This inverse relationship is the
foundation for comprehending, valuing, and managing bonds (Jones, 2013).
Investors are confronted with uncertainty from realized returns over bonds as interest rates
change over time. The strategy of protecting or mitigating a portfolio against interest rate risk is
immunization. This is one method of a structured portfolio strategy, its purpose is to have a
portfolio attain the performance of a target that has been outlined beforehand (Jones, 2013).
To illustrate how the strategy works, the interest rate risk can be thought of as being comprised
of two parts:
1. The price risk, caused from the inverse correlation between bond prices and required rates of
return.
2. The reinvestment rate risk, caused from the ambiguity about the rate at which the future
coupon income can be reinvested.
The two aspects of interest rate risk move in opposite trends, if interest rates rise, reinvestment
rates rise, while the price of the bond declines. If interest rates decline, reinvestment rates
decline, while the price of the bond rises (Jones, 2013).
Immunization includes protecting and mitigating a bond portfolio against interest rate risk by
stopping two aspects of interest rate risk, reinvestment rate risk and price risk (Jones, 2013).
The article I found is about East Cleveland residential housing bonds default. There were funds
to sufficiently cover interest on $5 million of residential housing bonds allotted for an East
Cleveland project. The rating agency had formerly downgraded the bonds down a few times to
junk over the projects poor operational performance. S&P revealed that the project’s coverage
of projected potential losses was highly in danger, signaling a low degree of recovery of
principal to bondholders in the case of a default (Colomer, 2017).
Reference:
Jones, C. P. (2013). Investments analysis and management (12th ed.). Hoboken, NJ:Wiley.
Colomer, N. (2017, Sep 12). East cleveland residential housing bonds default. Bond Buyer
Retrieved from http://proxy.cityu.edu/login?url=https://search-proquestcom.proxy.cityu.edu/docview/1937501727?accountid=1230
Student #2 Melly
Malkiel’s bond price theorems, immunisation concept, and bond default article. Attachment
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1.
What are the implications of Malkiel’s bond price theorems to bond investors? Which
two bond variables are of major importance in assessing bond price changes?
Bond prices change due to movements of market interest rates and bond yields. Understanding
the factors that influence the price of a bond, such as interest rate changes, are important for
successful bond management. Burton Malkiel’s bond valuation model helps understand the
relationship between bond prices and yields – bond prices and yields are inversely related.
Bond prices and bond yields move in opposite directions. When bond prices go up, that means
yields are going down; when bond prices go down, this means yields are going up.
Mathematically, this is because yield is equal to annual coupon payments or price paid for
bond. A decrease in price is thus a decrease in the denominator of the equation, which in turn
results in a larger number (Malkiel, 1962).
Accordingly, the two bond variables of major importance in assessing price changes are coupon
and maturity. Changes in bond prices are directly related to time of maturity. As interest rates
change, the prices of long-term bonds will change more than short-term, everything else being
equal. Long term bond prices fluctuate more than do short-term bond prices. On the other
hand, changes in interest rates affect bond prices by influencing the discount rate. Bond price
fluctuations (volatility) and bond coupon rates are inversely related. In order to obtain
maximum impact from an expected change in interest rates, investors should purchase low
coupon, long maturity bonds (Jones, 2013).
2.
Explain the concept of immunization. What role, if any, does duration play in this
concept?
Immunization is the strategy to immunize (i.e. protect) a portfolio against large interest rate
movements by canceling out price risk and reinvestment rate risk, through the use of duration.
With portfolio immunization – if interest rates go up, reinvestment rates go up while the prices
of the bonds go down; if interest rates go down, reinvestment rates go down while the prices of
the bonds go up. Immunization is a dedicated-portfolio strategy used to manage a portfolio
with the goal of achieving a pre-specified rate of return over a certain period of time.
Therefore, when the portfolio duration is equal to the pre-determined investment horizon, it is
possible in principle to immunize or protect a portfolio against interest rate risk. Immunization
strategy has the characteristics of both active and passive strategies (Jones, 2013).
However, it is well known that one of the main drawbacks of immunization strategies against
interest rate risk is the fact that they are based on a particular hypothesis about the behavior of
the yield curve. Thus, if interest rates shift in a way different from the assumed, immunization
may fail to guarantee the promised return at the end of the investor holding period (Diaz,
Gonzalez, & Navarro, 2006).
3.
Find an article about a bond default and provide your thoughts as to what the main
problems were.
I found a recent article about China’s latest bond default as a cautionary tale for investors
(Bloomberg News, 2017). China has recently opened up some of its huge domestic bond
markets but so far overseas involvement has been limited. Although Chinese government has
done the best to prevent it, a big bond market selloff could also hurt sentiment far away.
China’s sovereign debt rating triggered waves of reaction in both financial markets and policy
circles. In many cases companies in bloated sectors have not been profitable for years, and are
simply repaying old debts with new loans. Companies in troubled sectors will become more
difficult to raise money. If the government is willing to let companies fail, borrowers should
take more responsible attitude in future, and creditors should be more discriminating about
who they lend to, and at what price. Chinese banks are already reluctant to extend new credit
to companies in sectors slated for reform. Eventually, it might cause mark-to-market losses for
bond owners, and sharply higher borrowing costs for enterprises.
Reference
Bloomberg News. (2017). China’s Latest Bond Default is a Cautionary Tale for Investors.
Retrieved from https://www.bloomberg.com/news/articles/2017-09-10/china-s-latest-bonddefault-is-a-cautionary-tale-for-investors.
Diaz, Antonio, Gonzalez, Maria de la, & Navarro, Eliseo. (2006). Bond Portfolio Immunization,
Immunization Risk and Idiosyncratic Risk: Spanish Experience. Retrieved from
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.546.3022&rep=rep1&type=pdf.
Jones, C.P. (2013). Investments analysis and management (12th ed.). Hoboken, NJ: John Wiley
& Sons, Inc.
Malkiel, Burton G. (1962). Expectations, Bond Prices, and the Term Structure of Interest Rates.
Quarterly Journal of Economics, 76(2): 197-218.
…
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