Credit spreads and the valuation of non-treasury securities, Financial Management

It is not easy to determine the theoretical value of non-treasury securities. However, we can use the treasury spot rate for the valuation of non-treasury security. To find the value of non-treasury securities, there is a need to add some premium (yield spread) to reflect the additional risk in the treasury spot rate. The rate comes after such addition is used to discount the cash flows of non-treasury security. The addition of all discounted cash flows is the value of non-treasury security. For example, assume that 5-year treasury spot rate is 7% and the appropriate yield spread for non treasury security is 175 basis points. In such a case, all cash flows will be discounted at treasury spot rate plus 175 basis points i.e. 8.75% (7% + 175 basis points).

As we studied in the previous chapter that credit spread increases with maturity. So taking fixed spread for valuing non-Treasury securities is not appropriate. This is the one main disadvantage of this approach.  To overcome this drawback, dealer firms typically use term structure of credit spreads. These firms estimate a term structure for credit spread for each credit rating and market sector. The typical term structure of credit spread increases with maturity. The term structure is not same for all credit rating. Generally, lower credit rating leads to steeper term structure of credit spreads.

When the credit spreads for a given credit ration and market sector are added to treasury spot rates, the resulting term structure is used to value the bonds of issuers with that credit rating in that market sector. This term structure is known as a benchmark spot rate curve or benchmark zero-coupon rate curve.

Table 1 represents the calculation for valuing non-treasury security using benchmark spot rate curve.

Table 1: Calculation of Arbitrage-Free Value of Hypothetical 7% 5-year 

Non-Treasury Security Using Benchmark Spot Rate Curve

(a)

(b)

(c)

(d)

(e)

(f = d + e)

(g)

Period

Years

Cash Flow
 in Rs.

Spot Rate in %

Credit Spread
in %

Benchmark
Spot
Rate in %

PV in Rs.

1

0.5

3.5

2.7589

0.15

2.91

3.4498

2

1.0

3.5

3.0356

0.15

3.19

3.3911

3

1.5

3.5

3.2856

0.25

3.54

3.3208

4

2.0

3.5

3.5563

0.25

3.81

3.2458

5

2.5

3.5

3.8659

0.35

4.22

3.1533

6

3.0

3.5

4.1068

0.40

4.51

3.0620

7

3.5

3.5

4.3574

0.45

4.81

2.9639

8

4.0

3.5

4.6012

0.45

5.05

2.8669

9

4.5

3.5

4.9812

0.55

5.53

2.7380

10

5.0

103.5

5.1225

0.60

5.72

78.0589

Arbitrage-Free Value of a 7% 5-Year Non-Treasury Security is              

106.2504

The column (e) represents the term structured credit spread. The addition of spot rate and credit spread gives the Benchmark spot rate given in column (f). The last column shows the present value of the cash flow. The last row of this column shows the Arbitrage-Free Value of a 7% 5-Year Non-Treasury Security.    

Posted Date: 9/10/2012 6:24:21 AM | Location : United States







Related Discussions:- Credit spreads and the valuation of non-treasury securities, Assignment Help, Ask Question on Credit spreads and the valuation of non-treasury securities, Get Answer, Expert's Help, Credit spreads and the valuation of non-treasury securities Discussions

Write discussion on Credit spreads and the valuation of non-treasury securities
Your posts are moderated
Related Questions
DISCUSS THE APPLICABILITY OF OPERATING CYCLE IN VEGETABLE GROWING.

Filer Manufacturing has 8.9 million shares of common stock outstanding. The current share price is $59, and the book value per share is $4. Filer Manufacturing also has two bond is

a) Stockpiles refers to the accumulated (or excess level of) supply Ford motor vehicles, i.e. too much production given the level of demand. The purpose is to prevent possible shor

Q. What is Cost Recovery Method? Cost Recovery Method - METHOD OF REVENUE RECOGNITION that identifies profits after costs are entirely recovered. Normally used only when the to

Tax-backed debt obligations are the debt instruments issued by counties, states, cities, towns, special districts and school districts. These are secured by some

Buying and Selling Securities One of the key features that may occur while investing in financial markets is that sometimes investors overlook the essential factors they should c

What is the primary advantage to a corporation of investing some of its funds in working capital?  By investing in working capital a firm acquires the liquidity it needs helpin

Purpose of Issue CDs benefit both issuers and investors. From the issuers (banks) point of view, CDs are issued foreseeing the advantages over conventional deposits. The motives

What are some of the government needs imposed on a public corporation that are not imposed on a private, closely held corporation? Public corporations should submit audited finan

Determine the factors of auditors When anticipating to apply analytical review as a substantive procedure, auditors determine a number of factors like: Factor