Case: Corning Inc., Zero coupon convertible Bonds
Cornhill needs funds to the order of $ 3.6 billion in cash to complete the acquisition of Pirelli. The company currently is planning to come up with an equity issue to raise $ 2.1375 billion at $ 71.25 per share. The remaining part of the fund requirements is furbished using zero coupon convertible debentures due in 2015, priced at $ 741.923 per $ 1,000 principal amount. This offering price yields 2% p.a. compounded semi-annually. Corning is raising the requirement using a combination of debt and equity to preserve the Debt/capitalisation ratio for the company. Corning by using this strategy would preserve the current Debt/Capitalisation ratio and also expand it’s equity base on conversion enabling it to raise further debt. If Corning uses only debt mode of financing it’s Debt/Capitalisation increases to 44.06% and it could lower it’s credit rating leading to higher cost of debt. Also raising the entire amount using equity is not viable as Corning would lose on the tax savings that it gains using debt mode of financing and also raising the entire amount via equity would dilute the per share earnings of the company. This would not be viewed in positive light by the investors.

DebtEquityCapitalisationDebt/Capitalisation
Current2093.97852.29946.121.05%
Using proposed plan4106.49930.214036.629.25%
Using only Debt6184.47852.214036.644.06%
Using only Equity2093.911942.714036.614.92%
Value of the convertible bond.
The value of the convertible bond can be calculated by summing up its value broken up into the value of it as a straight bond and the various options associated with the convertible bond. VCB = VSB + VCO - VRO + VPO + VOMA

VCB = Value of the convertible option, VSB = Value as a straight bond, VCO = Value of convertible option, VRO = Value of redemption option, VPO = Value of put option, VOMA = Value of put in case of M&A Vsb319.6457

...
Mid Term – October 2014
Bond Pricing
Qu 1:
Time to Maturity ZeroCoupon Rate Discount Factor
1 5% 2 6% 3 7% 4 8% 5 9% Give the formula for the discount factor in terms of the zerocoupon rate. Use the formula to fill in the discount factors in the table above (you can write the formula or using excel calculate the numerical value).
Assume that the government wishes to issue a new 5 year bond priced at 100 (called a par couponbond as it is priced at par i.e. the price is the same as the face value) given the current rates in the above table what coupon will the bond have? If you don’t have excel given the answer in terms of the formula that you needed to fill the above table.
You are advised to make use of the upward sloping yield curve by taking a one year rolling loan and investing at the five year rate. What are the risks of following this strategy?
Bond Duration
Qu 2:
What is the Macaulay duration of a zerocouponbond maturing at time T? The Macaulay duration of a perpetual bond with yield y is given by (1+y)/y.
Consider a bond portfolio consisting of 2 bonds where the proportion of assets in bond i (i=1,2) is given by wi so total portfolio is P = w1 P1+w2 P2. Given the Macaulay Duration of...

...of one dollar
delivered in half-year n, i.e., of a zerocouponbond which pays $1 in half-year n. In the next
two columns there are the cash flows of two bonds, A and B. Essentially, bond A pays a 20%
semi-annual coupon and bond B pays a 10% semi-annual coupon. Both bonds mature in 2.5
years, when each also pays its principal of 100. Assume semi-annual compounding.
Half
Year
1
2
3
4
5
n
Bond A Bond B
.95
.91
.87
.80
.70
10
10
10
10
110
5
5
5
5
105
A. Calculate the price of each bond assuming there are no arbitrage opportunities in the
market. (That is, calculate the present value of each of the bonds.)
B. Now suppose that in fact bond A is traded at $111.97 while bond B is traded at
$91.41. Are there arbitrage opportunities in the market? If yes, how would you take
advantage of them? [Assume that zerocouponbonds are traded.]
C. Calculate the yields to maturity (or the interest/discount rates rn) from the discount
factors n given above (i.e., from the prices of the above zerocouponbonds). Plot
these against the time to maturity t of the bonds. This is the term structure of interest
rates or the yield curve based on...

...ConvertibleBonds
A convertiblebond is a bond that can be converted into shares of common stock. Therefore, these are two sources of value for this security: the value of the bond components, and the value from possibly converting the security into shares of common stock. Features of a ConvertibleBond The basic features of a convertiblebond can be illustrated by a hypothetical example. On November 1, 2003 ("today"), Apple, had $400 million in 8.80 percent (annual payments) convertiblebonds due in 2013. The bonds are convertible into the common stock of Apple anytime before the maturity at a conversion price of $50.00 per share. Because each bond had a face value of $1,000, the holder of a Apple convertiblebond could exchange that bond for $1,000/50 = 20 shares of Apple common stock. The number of shares received for each bond, 20 in this example, is called the conversion ratio. The conversion ratio is found by dividing par value by the conversion price. Of course, the conversion price (and conversion ratio) must be established when the bond is issued. When Apple issued its convertiblebonds, its common stock was trading at $32.625 per share. The conversion price of...

...The characteristic of a convertiblebond
The convertiblebond is one kind of equity-linked bonds. The term of the bond entitles bondholder to convert bonds into shares of the company or another company in the same group, at an agreed-upon conversion price, among a fixed period. The reason why it is made in this form is that the issuer can benefit from four aspects as follow,
(1) better terms. A convertiblebond have a lower interest rate, less restrictive covenants or the subordination of bondholders' claims to those of other unsecuried creditors. As W Klein pointed out, the issuance of convertiblebonds allows the company to raise money in a cheaper way while the company's appearance as a good credit risk will not be impaired.
Exception in eurobonds: it always contain a put option entitling the investor to call for repayment at certain point in order to give the investor a better rate of return. This would help to remove the risk of a fall in the value of the shares.
(2) Longer maturity. Since longer conversion period gives investors a longer time to exercise the conversion right, which makes the option worth more, therefore the company can successfully issue bonds with a longer maturity than otherwise being acceptable. A longer maturity means the company will not have the pressure on reserving...

...Analysis of ConvertibleBonds
DECEMBER 14, 2008
in FINANCE MANAGEMENT
With the repeal of the Capital Issues Control Act and the enactment of SEBI Act in 1992, the rules of the game applicable to convertiblebonds have changed. As per SEBI guidelines issued in June 1992, the provisions applicable to fully convertiblebonds and partially convertible binds are as follows:
* The conversion premium and the conversion timing shall be predetermined and stated in the prospectus.
* Any conversion partial or full will be optional at the hands of the bond holder, if the conversion takes place at or after 18 months but before 36 months from the date of allotment.
* A conversion period of more than 36 moths will not be permitted unless conversion is made optional with ‘put’ and ‘call’ options
* Compulsory credit rating will be required if the conversion period for fully convertiblebonds exceeds 18 months.
From the SEBI guidelines it is clear that convertiblebonds in India presently can be of three types:
(a) Compulsorily convertiblebonds which provide for conversion within 18 months.
(b) Optionally convertiblebonds which provide for conversion within 36 months.
(c) Bonds which provide for conversion after 36 moths but which carry...

...= $0.3 to (4.5 – 0.3) $42 per bushel.
4.25
(a)
the six-month zero-couponbond rate is calculated as follows:
Rm=[m*(FV-PV)]/PV
Rm=[2*(100-98)]/98=0.0482
Then this is converted into a continuously compounding rate:
Rc=m*ln(1+Rm/m)
Rc=2*ln(1+0.0482/2)=0.04763
The 1 year zero-couponbond rate is calculated as follows:
Rm=[1*(100-95)]/95=0.05263
Then this is converted into a continuously compounding rate:
Rc=1*ln(1+0.05263/1)=0.05129
The 1.5 year zero-couponbond rate is calculated as follows:
The 2.0 year zero-couponbond rate can be calculated as follows:
(b)
the forward rates can be calculated as follows:
For instance, the 1F2 rate is calculated:
0.5-1 year:
1-1.5 years:
1.5-2.0 years:
(c)
c=(100-100d)m/A 100=Ac/m+100d
6-months, the par yield of the bond:
M=2, d=e-0.04763*0.5=0.9765, A=e-0.04763*0.5=0.9765
12-months, the par yield of the bond:
M=2, d= d=e-0.05129*1.0 =0.9500, A= e-o.o4763*0.5+ e-0.05129*1.0=1.9265
18-months, the par yield of the bond:
M=2, d= d=e-0.05436*1.5 =0.92595, A= e-o.o4763*0.5+ e-0.05129*1.0+ e-0.05436*1.5=2.8482
24-months, the par yield of the bond:
M=2, d=...

...The corporate bond market is “thin” compared to the market for money market securities or corporate stocks.
a) true
Prices in the corporate bond market tend to be less volatile than prices of securities sold in markets with greater trading volumes.
a) False
All other things being equal, a given change in the interest rates will have a greater impact on the price of a low-couponbond than a higher-couponbond with the same maturity.
a) True
If investors believe inflation will be increasing in the future, the prevailing yield will be downward sloping.
a) false
The real rate of interest varies with the business cycle, with the highest rates seen at the end of a period of business expansion and the lowest at the bottom of a recession.
a) True
Bond price: Briar Corp is issuing a 10-year bond with a coupon rate of 7 percent. The interest rate for similar bonds is currently 9 percent. Assuming annual payments, what is the present value of the bond? (Round to the nearest dollar.)
Years to maturity = n = 10
Coupon rate = C = 7%
Annual coupon = $1,000 x 0.07 = $70
Current market rate = i = 9%
Present value of bond = PB
Bond price: Jane Thorpe has been offered a seven-year bond issued by Barone, Inc., at a price of 943.22. The...

...cause shift in the demand and supply of securities. (Ch 2 pages 21-23)
Financial Market operates just like any other market. There is demand for certain financial goods and that creates supply. Sometimes financial institutions come up with special creations to increase demand, to boost certain sales, sometimes it’s done to mask and re-package bad product (but that is another story). So financial market really isn’t that different form say commodity market.
Q3. Make a distinction between inside money and outside money. (See Ch 3, pages 4
1-44)
Inside money is money that is issued by FIs usually in a form of debt. Inside money is a liability to the one who issues it. It is known fact that net amount of inside money in an economy is zero, but most of the money circulating in economy is exactly inside money. Outside money is held in the positive net amounts, it is not a liability. Government issued money, gold, backed-up foreign securities – these are the examples of outside money.
Q4 Select the incorrect statement(s) from the following (This question carries 1 mark)
(a)The simple equation that can be used to predict how the Federal Reserve will change interest rates is known as the Taylor rule
(b) The periodic payments on equity securities are called interest payments
(c) The periodic payments on debt securities are called dividends.
(d)Investors who wish to reduce their risk should diversify
(e)Both ‘b’ and ‘c’
Q5 Select the correct...