Module 5: Debt Securities
(BUSFIN 4221 – Investments)
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| Instructor: | Andrei S. Gonçalves |
| E-mail: | Andrei_Goncalves@kenan-flagler.unc.edu |
| Website: | andreigoncalves.com/BUSFIN4221 |
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Welcome to Module 5!
Download the class slides here and the “to print” version here.
The Efficient Market Hypothesis in Module 4 states that “prices correctly incorporate all relevant information available to investors”. However, for this to be the case, investors need to know how to incorporate information into prices. You have a general idea of how this is done through the Fundamental Valuation Equation, but we may gain new insights by being more specific.
In this module, we study Debt Markets and how debt contracts are priced in financial markets. Module 5 is subdivided into three pieces:
1) Zero Coupon Bonds
Zero coupon bonds are debt contracts with only one cash flow (called Face Value), which is paid at maturity. Even though these securities are not common (at least at long horizons), they represent the building block for how to price debt contracts that pay coupons (periodic interests). We will use the zero coupon bonds to think about interest rates and how they affect bond prices and vary across maturities (longer-term contracts tend to pay higher interest rates than shorter-term ones).
2) Debt with no Default Risk
The government has a tremendous amount of debt outstanding, which is implicitly backed by future taxes (or the ability to raise new debt in the future). Because we tend to assume the U.S. government will not default on its debt, these securities are generally viewed as having no default risk. Investors still face other types of risks when investing in government bonds, though.
We will spend this section understanding how to price these bonds and how to think about their risk. The key here is that as interest rates go up, bond prices go down and this effect is stronger for longer-term bonds.
3) Debt with Default Risk
The government is not the only entity that issues debt. Households (mainly trough mortgages, student loans, and credit cards) and corporations also do. Of course, there is a non-trivial probability that households/corporations will default on their debt. Hence, we need to take that into account. In this section, we focus on this issue.
We will spend most of our time on debt issued by corporations since these are relatively easy to understand, but the principle also applies to debt issued by households. The reason why we will not focus on households is that their debt is often securitized into new (and more complex) securities. We saw an example of this when we learned about Mortgage Backed Securities (MBS) in the Financial Crisis section (Module 1). Fully understanding the details of how to price MBS and similar securities would take us an entire module.