Full valuation approach, Financial Management

Assignment Help:

When a manager measures the interest rate exposure, he would be interested in analyzing the exposure to a set of changing interest rate. The process of re-valuation of a bond or bond portfolio for a given interest rate change scenario is known as full valuation approach or scenario analysis.

For example, assume that a fund manager has Rs.1 crore par value position in a 12% coupon 25 years option free bond. Current value of the bond at 8% yield to maturity is Rs.142.70. To assess the exposure due to rise in the yield, the fund manager decides to look at how the bond value will change with the change in the yield. Let us take into consideration the following scenarios:

  1. When the yield increase is by 75 basis points, then the new yield is 8% + 75 basis points = 8.75%.

  2. When the yield increase is by 150 basis points, then the new yield is  8% + 150 basis points = 9.5%.

  3. When the yield increase is by 300 basis points, then the new yield is 8% + 300 basis points = 11%.

The change in the market value of the bond position due to rise in the yield is given in Table 1.

Table 1: Full Valuation Approach to Assess the Interest Rate Risk of Bond Position

Scenario

Yield Change (bps)

New Yield

(%)

New Price

(Rs.)

New Market Value (Rs.)

% Change in the Market Value

Current Position

-

8

142.70*

1,426,991,048

-

1

75

8.75

132.58

1,325,809,791

-7.09

2

150

9.50

123.59

1,235,939,443

-13.39

3

300

11.00

108.42

1,084,217,447

-24.02

* New Prices =  1826_new prices.png

 % Change in Market Value =  779_new prices1.png

= 12 PVIFA(8.75%, 25) + 100 PVIF(8.75%, 25)

= 120.3 + 12.28 = 132.58.

In the case of portfolio, each bond is valued for a given scenario and then the total value of the portfolio is computed for the scenario. For example, assume that the fund manager has got 2 option free bonds: (a) 12% coupon, 25-years bond (b) 7% coupon 5-years bond.  He has one crore rupees par value long-term investment in a 12% bond. The current market price of this bond at 8% yield is Rs.142.70. He has Rs.50 lakh par value short-term investment in 7% bond. The current price of this bond at 6% yield is Rs.104.21. The fund manager wants to assess the exposure for the portfolio, having these two securities, in the event the yield of both bonds increases by 75, 150 and 300 basis points. The change in the market value of 7% and 12% bond is given in Tables 2 and 3 respectively. The Table 4 shows the market value of the portfolio and percentage change in the market value of the portfolio.          

Table 2: Market Value of the 5-years 7% Bonds for the Three Scenarios

Scenario

Yield Change
(bps)

New Yield

(%)

New Price

(Rs.)

New Market Value (Rs.)

Current Position

-

6

104.21

521,061,819

1

75

6.75

101.03

505,159,738

2

150

7.50

97.98

489,885,288

3

300

9.00

92.22

461,103,487

Table 3: Market Value of the 25-years 12% Bonds for the Three Scenarios

Scenario

Yield Change (bps)

New Yield

(%)

New Price

(Rs.)

New Market Value (Rs.)

Current Position

-

8

142.70

1,426,991,048

1

75

8.75

132.58

1,325,809,791

2

150

9.50

123.59

1,235,939,443

3

300

11.00

108.42

1,084,217,447

Table 4: Market Value of the Bonds Portfolio for the Three Scenarios

Scenario

Yield Change (bps)

Market Value of

% Change in the Market Value

Bond 1
(Rs.)

Bond 2
(Rs.)

Portfolio
(Rs.)

Current Position

-

521,061,819

1,426,991,048

1,948,052,867

-

1

  75

505,159,738

1,325,809,791

1,830,969,529

-6.01

2

150

489,885,288

1,235,939,443

1,725,824,731

-11.41

3

300

461,103,487

1,084,217,447

1,545,320,934

-20.67

In the previous example, we have seen that yield of both the bonds change by the same number of basis points.  Now we will see one more example where yield curve of both the bonds does not change in parallel fashion.

We will take the previous example with certain modification. Let us say the yield of both bonds changes in the following manner:

Table 5

Scenario

Change in yield of
5-years bond (bps)

Change in yield of
25-years bond (bps)

1

  75

  35

2

150

  95

3

300

160

Now we will see how market value of these bonds and the portfolio containing these bonds change. Tables 6 and 7 show the market value of the 5-years and  25-years bond in different scenarios.

Table 6: Market Value of the 5-years 7% Bonds for the Three Scenarios

Scenario

Yield Change

(bps)

New Yield

(%)

New Price

(Rs.)

New Market Value

(Rs.)

Current Position

-

6

 104.21

521,061,819

1

  75

6.75

101.03

505,159,738

2

150

7.50

97.98

489,885,288

3

300

9.00

92.22

461,103,487

Table 7: Market Value of the 25-years 12% Bonds for the Three Scenarios

 

Scenario

Yield Change
(bps)

New Yield

(%)

New Price

(Rs.)

New Market Value (Rs.)

Current Position

-

8.0

142.70

1,426,991,048

1

  35

8.35

137.83

1,378,257,177

2

  95

8.95

130.08

1,300,806,436

3

160

9.60

122.47

1,224,725,873

Table 8 given below shows the market value and change in the market value of the bond in different scenarios.

Table 8: Market Value of the Bonds Portfolio for the Three Scenarios

Scenario

Yield Change (bps)

Market Value of

% Change in the Market Value

Bond 1
(Rs.)

Bond 2

(Rs.)

Portfolio
(Rs.)

Current Position

  -

521,061,819

1,426,991,048

1,948,052,867

-

1

  75

505,159,738

1,378,257,177

1,883,416,915

-3.32

2

150

489,885,288

1,300,806,436

1,790,691,724

-8.08

3

300

461,103,487

1,224,725,873

1,685,829,360

-13.46

Now we can say that full valuation approach can be used for any scenario to evaluate the exposure of a bond or portfolio due to change in interest rate. But the main drawback with this approach is that it is very time consuming for a portfolio having a large number of bonds; and even with a few bonds also it is the same as it is complex. Managers do not want to revalue the whole portfolio or a bond to know the exposure due to change in interest rate. They want one method which tells them how portfolio or a bond will change if rate changes. Before dealing with is it some other measures or approaches per valuation. Let us understand price volatility characteristics of bonds.


Related Discussions:- Full valuation approach

Finance, a) Describe five factors that should be taken into account by a bu...

a) Describe five factors that should be taken into account by a businessman in making the choice between financing by short-term and long-term sources.

Explain the concept of competitive advantage, There are dissimilar views on...

There are dissimilar views on how an organisation can gain competitive advantage, but contemporary research is placing greater emphasis on the resource-based view. Expl

Investment banker, The Role of Merchant Banker The issuer appoints the ...

The Role of Merchant Banker The issuer appoints the Merchant Banker (or Investment Banker) to undertake the issue activity. A Merchant Banker performs multiple functions during

Gordon`s dividend capitalisation model , Considering the following informat...

Considering the following information, what is the price of the share as per Gordon’s Model? Details of the Company Net sales Rs.120 lakhs Net profit margin 12.5% Outstandin

Eurobond, Eurobond A corporate bond denominated in U.S. dollars or oth...

Eurobond A corporate bond denominated in U.S. dollars or other hard currencies and sold to investors outside the country whose currency is used. Eurobonds have become an impor

Internal rate of return (irr), Internal Rate of Return (IRR) : This rat...

Internal Rate of Return (IRR) : This rate attempts to find the earnings rate, which equates the current value of the streams of earnings to the investment outlay. IRR is descri

Break-even point, Break-Even Point The measure of products or services...

Break-Even Point The measure of products or services organizations must sell for its revenue from sales to equal its cost of production for the same number of units. Hence, se

Calculate the total present value of the tax shield, Nortel is considering ...

Nortel is considering the purchase of a new  call routing system.  The system will cost $50M to purchase, an additional $7M to install, and will last for 30 years.  The CCA rate as

What is dependent care expenses, Q. What is Dependent Care Expenses? De...

Q. What is Dependent Care Expenses? Dependent Care Expenses - Qualified child care expenses would allow a taxpayer this computed credit against tax. Amounts can be found on the

Payout policy, mini-case chapter 15:payout policy Megginson, Smart, Graham

mini-case chapter 15:payout policy Megginson, Smart, Graham

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd