Arbitrage-Free Valuation of a Fixed Income Security
Arbitrage free valuation is an approach that determines bond values based on the assumption that arbitrage opportunities do not exist. The arbitrage-free valuation model is based on the law of one price, which states that two goods, which are perfect…
Maturity Structure of Yield Volatilities
Bond managers must quantify interest rate volatilities for bonds with embedded options because their values depend on the level of interest rate volatilities. Additionally, mitigating the effect of interest rate volatilities on a bond’s price volatility is part of risk…
Measuring Bond Exposure
Shaping risk is the sensitivity of a bond’s price to changes in the shape of the yield curve. An active bond investor trades based on the predicted shape of the yield curve. Yield curve risk is the bond portfolio exposure…
Developing Interest Rate Views Using Macroeconomic Variables
Key economic factors and market events influence interest rate dynamics such as the curvature, level, and steepness of the yield curve and changes in spot versus forward rates. Fixed-income traders use implied forward rates as market-neutral reference points. Active fixed…
Traditional Theories of the Term Structure of Interest Rates
The term structure is a relationship between interest rates and maturities of similar quality bonds. A yield curve is a graphical representation of the term structure of interest rates. The following theories explain the term structure of interest rates and…
Discount Rate Selection in Relation to Cash Flows
When discounting cash flows analysts should use the discount rate that is consistent with the type of cash flow being discounted. A cash flow to equity should be discounted at the required rate of return on equity. When a cash…
The Weighted Average Cost of Capital
A company’s cost of capital is the overall required rate of return of a company’s suppliers of capital, estimated using the company’s weighted average required rates of return for the different sources of capital. For a company with creditors and…
The Required Return on Equity: International Issues
There are two major issues when estimating the required return of equities in a global context: Exchange rates. Data and model issues in emerging markets. There are difficulties in the estimation of the required return and risk premium in emerging…
Strengths and Weaknesses of Methods for Estimating the Required Return
CAPM Strenghts and Weaknesses The CAPM is a simple and widely accepted method of estimating the cost of equity. Beta is readily obtainable for a wide range of securities and it can be estimated easily when not available. For individual…
