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Overview of Bond Market Value and Expected Return

Question:

Discuss about the Valuation and risk assessment of participating life.

Bond market value

Expected return on bond

a)

 $800.00

= (1000-800)/800

= 25.00%             

b)

 $950.00

= (1000-950)/950

= 5.26%

c)

 $1,000.00

= (1000-1000)/1000

= 00.00%

d)

 $1,250.00

= (1000-1250)/1250

= -20.00%


The above table mainly helps in depicting the overall returns, which could be provided from the bond if market price ranges from $800 to $1,250. This evaluation mainly indicates that changes in market value of the bond also alters the overall expected return of the bond, which could be generated by the investor. In addition, when the market price of the bond is at the levels of $800 then the retune is at the levels of 25%, as the investors can invest less and get $1000 in maturity time. Moreover, the return directly reduces to 5.26% when the overall market value of bond is at $950. This is only possible as the overall return from the investment of the investor is reduced, as it will only get a return of $50 in maturity. Moreover, the market value of bond is at the level of $1,000 will have 0% return from investment, as no profit will be incurred by the investor. Lastly, increment in bond value to $1,250 will lead to be loss of 20%, which will be incurred by the company (Ballotta and Kyriakou 2015).

Particulars

Value

Bond price

 $                               1,000.00

Expected return

20%

Market price of the bond

1000 / (1+20%)

Market price of the bond

 $                                   833.33


The table mainly helps in detecting the overall market price of bond, which is derived with the help of expected return formula. In addition, the overall market price of bond has declined to $833.33, as expected return from the zero-compound bond is at the levels of 20%. This relevant market value of zero coupon bond mainly needs to decline from the actual par value of the bond for supporting the expected return of the investor. This would also help in understanding the financial viability of the investment, which would be conducted from investment. In this context, Bond and Brown (2017) mentioned that with the help of expected return formula investor can detect the minimum bond price in which they will be interested in buying the bond. On the other hand, Chandra (2017) criticises that bond valuation are subject to the credit rating, which could in turn help in detecting the actual value of bond. Investors mainly uses expected return measures for zero coupon bonds, as there are no yearly payments conducted by the issuer.

The above figure mainly depicts the overall demand and supply section of the bond, which could help in understanding the reason behind price of bond. In addition, the changes in shift of demand and supply are conducted due to some factors. These factors are depicted as follows.

Factors influencing the cause behind the shift in demand curve:

Figure 1: Depicting shift in demand curve of bond due to increase in wealth

(Source: As created by the author)

Increase in wealth: The overall increment in wealth of investors also shifts the demand curve of bonds, as purchasing power of the investors relatively increases. In addition, the increment in wealth is only possible when economy is growing, which raises the demand of bonds among potential investors. This is due to the increment in wealth, which allow investors to support high investment in the bond market. Moreover, investors tend to invest in riskless investment if extra capital in sitting ideal, which in turn helps in improving the level of profitability (Eckert, Gatzert and Martin 2016).

Factors Influencing Shift in Demand Curve

Figure 2: Depicting shift in demand curve of bond due to decrease in expected return

(Source: As created by the author)

Decrease in the expected return: The decline in expected return on investment is relatively conducted when interest rates are lower than bond payments. The demand curve mainly shifts to right in the expectation of lower interest rate than the interest paid by bonds. The investors mainly see bond as an adequate investment opportunity, which could provide higher return from investment. This directly leads to the shift in demand curve of bonds, which is represented in the above figure.

Figure 3: Shift in demand curve of bond due to decrease in expected inflation rate

(Source: As created by the author)

Decrease in expected inflation rate: The decline in expected inflation rate would also help in shifting the demand curve of bonds, as inflation erodes the benefits, which is presented by bond investment. Therefore, increasing inflation rate directly erodes maximum of the return, which is presented by investment such as shares, interest, and bond payments. Hence, the decline in inflation rate could eventual boosts investments, as investors would be willing to increase their rate of return from investment, when inflation does not erode the returns (Givoly, Hayn and Katz 2017).

Figure 4: Shift in demand curve of bond due to decrease in risk

(Source: As created by the author)

Decrease in risk: The overall decline in risk of bonds mainly help in shifting the demand curve to right, as investors are willing to buy bonds having lower risk. In addition, the demand of bond increases, when investors believe that investment in bond is risk less and payments will be provided by the issuer. Hence, the bonds become more stable and safer if risk is reduced, which motivates the investors to buy more bonds. This safer conduction of the bonds mainly shifts demand curve to right, as more investors are keen on investment in bonds (Grant 2017).

Factors influencing the cause behind the shift in supply curve:

Figure 5: Shift in supply curve of bond due to increase in expected profits

(Source: As created by the author)

Increase in expected profits: The expectation of increment in profit of organisation mainly increases the trend of bond supply, as companies are willing to take up more debt to support its expansion process. In addition, the increased profit from a business could only be achieved if adequate expansion is conducted to increase productivity and customer base. Moreover, companies mainly increase the level of bond issue, when they expect that by using the bond investment they could improve the level of profitability and productivity (Jordan 2014).

Figure 6: Shift in supply curve of bond due to decrease in business taxes

(Source: As created by the author)

Decrease in business taxes: The decline in business taxes also helps in reducing the overall expenses and improves their investment capacity. In addition, companies are mainly provided with high level of investment capital, which is obtained by the reduction in taxes obtained by companies. Hence, relevant shift in bond supply is obtained, when demand of bonds among companies increases exponentially due to the low expenses incurred in taxes. Therefore, companies increasing demand mainly raise the level of supply of bonds in the market, which in turn shifts the supply curve of bonds (Liang, Zhao and Zhang 2016).

Figure 7: Shift in supply curve of bond due to increase in expected inflation rate

(Source: As created by the author)

Increase in expected inflation rate: The increment in bond supply is witnessed when expected inflation rate tends to rise over time. This increment in inflation rate mainly erodes the actual debt value over time, where bond issuer tends to give reduced amount back to the lender. Hence, more companies will issue bonds in the market, which in turn will shift the demand curve due to the drastic increment in supply of bonds in the market (Qin and Linetsky 2017).

Figure 8: Shift in supply curve of bond due to increase in government borrowings

(Source: As created by the author)

Increase in government borrowings: The relevant increment in borrowings of government also raises the level of bonds in the market, as government spending rises. The issue of government bonds is only conducted, when spending increases the overall tax collected. Each year US government issues bond to compensate its rising expenses, where the increment in bond supply shifts the due to the rising bond issues conducted by governments. Therefore, increment in bond supply from government shifts the overall supply curve to right, which changes the price equilibrium of the bond (Stephen 2015).

Reference:

Ballotta, L. and Kyriakou, I., 2015. Convertible bond valuation in a jump diffusion setting with stochastic interest rates. Quantitative Finance, 15(1), pp.115-129.

Bond, P.H. and Brown, P.K., 2017. Rating valuation: principles and practice. Routledge.

Chandra, P., 2017. Investment analysis and portfolio management. McGraw-Hill Education.

Eckert, J., Gatzert, N. and Martin, M., 2016. Valuation and risk assessment of participating life insurance in the presence of credit risk. Insurance: Mathematics and Economics, 71, pp.382-393.

Givoly, D., Hayn, C. and Katz, S., 2017. The changing relevance of accounting information to debt holders over time. Review of Accounting Studies, 22(1), pp.64-108.

Grant, D., 2017. Comparing Three Convertible Debt Valuation Models. Business Valuation Review, 36(1), pp.32-41.

Jordan, B., 2014. Fundamentals of investments. McGraw-Hill Higher Education.

Liang, J., Zhao, Y. and Zhang, X., 2016. Utility indifference valuation of corporate bond with credit rating migration by structure approach. Economic Modelling, 54, pp.339-346.

Qin, L. and Linetsky, V., 2017. Long?Term Risk: A Martingale Approach. Econometrica, 85(1), pp.299-312.

Stephen, S.A., 2015. Enhancing the Learning Experience in Finance Using Online Video Clips. Journal of Financial Education, pp.103-116.

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