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Westminster International University in Tashkent

COURSEWORK

Level: Economics

Fixed Interest Securities and Related Derivatives

2011-2012

COURSEWORK

Contents

• Introduction
• Indenture and Covenants
• Analysis of specific risks
• Theoretical Treasury Spot Rates
• Nominal Spread, Z-Spread and OAS
• Current Yield, PVBP, Duration and Convexity Analysis
• Price Sensitivity Analysis
• Total Return Analysis
• Estimation of Future Fair Value of the Bond
• Conclusion
• Bibliography
• Appendix
• Introduction
• This paper contains critical analysis of Morgan Stanley's corporate bond. Starting from basic information of the bond, report includes itself different types of risk that associated with investing in bond, price sensitivity analysis at different scenarios, calculation and analysis of total dollar return and future fair value of the bond. It is important to mention that all calculations were made by using characteristics of the bond at 08 June 2012 (Execution time 16:07:31).
• Indenture and Covenants
• http://www.sec.gov/Archives/edgar/data/895421/000090514807007196/efc7-2707_emailform424b2.htm
• http://cxa.gtm.idmanagedsolutions.com/finra/BondCenter/BondDetail.aspx?ID=NjE3NDRZQUQw

Analysis of specific risks

Liquidity risk

This type of risk appears when investor will have to trade a bond below its true value where the true value is specified by a recent transaction. Morgan Stanley Co. explains that because of liquidity risk they will be unable to finance their operations due to a loss of access to the capital markets or meet difficulty in liquidating their assets.

Market risk

The price of a corporate bond will change in the contrasting direction from a change in interest rates: As interest rates increase, the price of a bond will fall, as interest rates fall, the price of a bond will increase. Morgan Stanley Co. says that their results of operations may be substantially affected by market fluctuations due to global and economics conditions such as: effect of market conditions, mainly in the global equity, fixed income, credit and commodities markets, containing corporate and mortgage lending and commercial real estate markets.

Credit risk

This type of risk denotes to the risk of loss arising from borrower or counterparty nonpayment when a borrower, counterparty or obligor does not meet its requirements. Morgan Stanley Co. suffers credit risk in traded securities and loan pools whereby the value of these assets may vary based on recognized or expected defaults on the original obligations or loans.

Operational risk

Operational risk refers to the risk of monetary or other loss, or harm to a firm's reputation, consequential from insufficient or failed internal processes, people, resources, systems or from other internal or external events. Morgan Stanley Co. faces the risk of operational failure or closure of any of the clearing agents, contacts, clearing houses or other financial intermediaries they use to ease their securities transactions. In the case of a failure or improper operation of their or a third party's systems or inadequate or unapproved action by third parties or company's employees, they could suffer financial loss, damage to their liquidity, a disturbance of their businesses, regulatory sanctions or harm to reputation.

Legal or Regulatory risk

Legal and compliance risk contains the risk of disclosure to fines, punishments, judgments, injuries and/or settlements in connection with governing or legal actions as a result of non-compliance with appropriate legal or regulatory obligations or litigation. Legal risk also comprises contractual and commercial risk such as the risk that counterparty's performance requirements will be unenforceable. Morgan Stanley Co. is a subject to general regulation by U.S. federal and state regulatory agencies and securities exchanges and by regulators and exchanges in each of the main markets where they run, and face the risk of investigations and proceedings by governmental and self-regulatory organizations in all countries in which they conduct their business.

Event risk

The capability of an issuer to make interest and principal payments is completely and suddenly changed by a natural or industrial accident or a takeover or corporate reformation. Certainly, Morgan Stanley Co. is not aware of this type of risk.

Inflation risk

Also called purchasing-power risk appears because of the dissimilarities in the worth of cash flows from a security because of inflation, as measured in terms of purchasing power.

Theoretical Treasury Spot Rates

In order to calculate treasury spot rates, the treasury yield curve rates were taken of 8 June 2012 which are the followings:

http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

To fill missing yields a linear extrapolation method was used. Solver tool in MS Excel was used to transform Treasury yields into theoretical spot rates.A bit later, spot rates are used to calculate bond price and spread. A very important assumption here is that value of Treasury coupon security is alike to series of zero-coupon Treasury securities with analogous to bond's cash flows.

As it can be seen from the graph above, yield curve is upward sloping, which means yields are supposed to increase with the increase in periods of Treasury securities.

Nominal Spread, Z-Spread and OAS

Nominal spread shows the difference between the cash flow yield and the yield on a comparable Treasury security. Consequently, nominal spread indicates the amount of compensation for credit, liquidity and option risk to the bond. Conversely, as it uses YTM, it skips term structure of interest rates and their volatility.

Therefore, Z-spread is calculated to find the spread an investor will acquire by investing in bond until maturity. As Z-spread considers the whole spot rate curve so it accounts for volatility of interest rates. It is important to mention that Z-spread (0,04801) is higher than nominal spread (0,04009) because of upward-sloping yield curve. There was no purpose for calculating Option-Adjusted Spread because it is equal to Z-spread as chosen bond does not have any embedded options.

Current Yield, PVBP, Duration and Convexity Analysis

Current yieldis expressed at the current full price of a bond rather than its face value and represents the return an investor would realize if he or she purchased the bond and held it for a year. In fact, this measure is relevant only for 08June 2011, as price of the bond always changes and makes the measure incorrect. Price value of basis pointshows that if interest rate is increased by 1 basis point, price of the bond will change by 0.0513, which indicates that price is sensitive to changes in interest rates. However, PVBP is not such a common measure as duration. Duration is a measure of the estimated sensitivity of a bond's price to interest rate changes. More definitely, it is the approximate percentage change in value for a 100 basis point change in interest rates. Modified durationindicates that 100 basis points change in interest rates will lead to change in price by about 5%. So both PVBP and duration show that interest rate risk for this bond is high. However, duration is only a good approximation of the percentage price change for small changes in yield. In order to estimate the sensitivity of a bond's price change to large changes in yield, convexity measure is used.

Since, duration and convexity were calculated using YTM measure,which is impractical in its assumption of uniform discount rate, they are not very accurate.Thus, approximate duration and convexity were calculated using arbitrage free bond valuation model(more details in appendix).

As it can be seen from the table, approximate duration also indicates high interest rate risk. Current full price is going to change by 4.5% for a 1% change in interest rate.

price morgan bond risk

Price Sensitivity Analysis

This part of coursework was also made by using arbitrage free valuation approach. As for calculation of bond's approximate duration and convexity 100 b. p. was used so here we can see 6 different scenarios with different basis points. In fact, all scenarios are showing high price sensitivity of our bond. So even here we can find a proof that the chosen bond is risky to invest because results of the prices from b. p. change is larger than b. p. itself. So I would recommend to the investor to hold this bond until the maturity if interest rate increase is expected. If investor decides to hold the bond for a short period of time expecting increase in interest rate, he is more likely going to lose money. However, it is important to mention that small changes in interest rates are not such a big danger to the investment.

Total Return Analysis

For the analysis of total return, seven different conditions were assumed. As it can be seen, the highest return (6.55%) can be obtained if interest rate increases by 100 basis points. From here, we can understand the nature of interest rates: if there is large decrease in interest rates, it will lead to loss of investor's money and an increase in interest rates will lead to increase in investor's wealth. Moreover, purchase price of the bond also plays an enormous role in gaining return. As it can be seen from the table, under all conditions investor is going to obtain a return from the bond. However, investor will have that return if he or she holds bond until the maturity date because bond's selling price may change due to time. So, keeping the bond for a short time is not advised.

Estimation of Future Fair Value of the Bond

Bond's fair value can be calculated by using theoretical spot rates after six month period. In order to construct such theoretical spot rates, the forecasts of Kamakura Corporation were used.

http://www.kamakuraco.com/Portals/0/Images/Blog/06212012/05.JPG

The reason for choosing six month period for forecasted yields can be explained in this way: if investor has some amount of money and he or she wants to buy some gift for New Year the appropriate solution is to buy a bond at 8 June 2012 and hold it six month till December.

In order to calculate theoretical spot rates, the same method was used as before (Solver tool in MS Excel).

The graph above shows that current and forecasted spot rate curves are almost at the same magnitude. In six month period, spot rates are going to increase which will lead to decrease in bond's price.

Using the same technique (Arbitrage free bond valuation) and keeping Z-spread constant, bond's price for 31 December 2012 was obtained.

As price of the bond is expected to decrease, investor is going to face a loss. However, change in price is not significant. It is important to take interest rate risk into consideration. Nevertheless, investor can not be guaranteed that forecasts will occur, there is possibility that market interest rates may differ.

Conclusion

To conclude, analysis showed that bond is risky to invest. Moreover, effective duration and convexity, as well as scenario analysis exhibit bond's high price sensitivity. Consequently, uncertainty of future bond fair value is high. However, it is advised to risk-averse investor to hold the bond till the maturity date, because increase in interest rate influences reinvestment income which will lead to higher total return. It is not recommended to investor to buy bond now and sell it after six month period because forecasts are showing that price of the bond is going to decrease which may lead to capital loss. Anyways, any decision made by investor is dependent on his or her risk preference and forecasts.

Bibliography

1. Donald R. van Deventer, 2012. June 22, 2012 Friday Forecast. Donald R. van Deventer's Kamakura blog, [blog] 22 June. Available at: <http://www.kamakuraco.com/Blog/tabid/231/EntryId/418/June-22-2012-Friday-Forecast.aspx> [Accessed 23 June 2012]

2. Fabozzi, F.J. and Mann, S.V., 2005. The Handbook Of Fixed Income Securities. 7^th ed. New York: McGraw-Hill

3. Fabozzi, F.J., 2000. Bond Markets, Analysis and Startegies. 4^th ed. Upper Saddle River: Prentice Hall

4. Financial Industry Regulatory Authority, 2011. GS.AOK Bond Detail. [online]

5. Morgan Stanley, 2007. Global Medium-Term Notes, Series F. [online]

6. U.S. Department of Treasury, 2012. Daily Treasury Yield Curve Rates. [online]

7. United States securities and exchange commission, 2011. Form 10-K [pdf]

Appendix

Theoretical spot rate calculation

In order to find missed yields for treasury yield curve rates, linear extrapolation has been used:

During calculation, cash flows, for example, from 1-year security were discounted to find unknown 1-year spot rate that equates discounted cash flows to maturity value of 100. MS Excel's Solver tool helped to calculate spot rates without doubt.

YTM calculation

The formula that was used for calculation:

where

where

Z-Spread Calculation

For z-spread calculation the same method was used as above, but instead of YTM, spot rate plus z- spread was put

Current Yield, PVPB, Duration and Convexity

where

Duration

Macaulay duration in half years 10,28 (1069.283/104.0113)

Macaulay duration in years 5,14

Modified duration 4,99

Convexity

Convexity in years 119,66

Convexity in half years 29,91

Approximate duration and convexity

New prices were calculated through Arbitrage free bond valuation model.

Arbitrage free bond valuation model

In fact it is the same operation where z-spread was found. However, there is change in required yield. This model was used in order to calculate effective duration and convexity and to do a scenario analysis.

Total return

whereh is length of the investment horizon (in semiannual periods).

An example below is finding coupon plus interest on interest, when there is no change in required yield.

Bond's fair value

Theoretical spot rates were calculated in the same way as before. However, bond's new price or fair value was calculated by using new spot rates, other accrued interest with less periods.

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