Already have an account? Get multiple benefits of using own account!
Login in your account..!
Remember me
Don't have an account? Create your account in less than a minutes,
Forgot password? how can I recover my password now!
Enter right registered email to receive password!
The main drawback of the tradition approach of valuation is that it discounts every cash flow using the same discount rate. For example, let us take 5-year (7.00 per cent) Treasury security (maturing in 2010). The cash flow per Rs.100 of par value would be a payment of Rs.3.50 every six months and Rs.103.50 tenth 6-month period from now. However, the best way to see the 5-year 7% security is as a package of zero-coupon bonds whose maturity value and date is the amount and date of cash flow respectively. Thus, 5-year, 7% security should be viewed as 10 zero-coupon bond. The main reason is that it does not allow a market participant to realize an arbitrage profit by taking apart or "stripping" a security and selling off the stripped securities at a higher aggregate value it would cost to purchase the security in the market. This approach is known as an arbitrage-free valuation approach.
The difference between the traditional and arbitrage-free valuation approach is explained in the table 5.
Table 1: Comparison of Traditional Approach and Arbitrage-Free Valuation Approach in 7% Treasury Security
Period (6 month each)
Discount (Base Interest) Rate
Cash Flows per Rs. 100 of par value
Traditional Approach
Arbitrage-Free Valuation Approach
1
5-year Treasury rate
1-period Treasury spot rate
3.5
2
2-period Treasury spot rate
3
3-period Treasury spot rate
4
4-period Treasury spot rate
5
5-period Treasury spot rate
6
6-period Treasury spot rate
7
7-period Treasury spot rate
8
8-period Treasury spot rate
9
9-period Treasury spot rate
10
10-period Treasury spot rate
103.5
Under traditional approach interest rate on the bond is the yield of 5-year treasury security. In arbitrage-free approach the interest rate for a cash flow is the theoretical rate that the treasury security has to pay if it issued as a zero-coupon bond with maturity date equal to the maturity date of the cash flow. So, it is necessary to decide the theoretical rate that the treasury security has to pay on a zero coupon for each maturity. Zero-coupon treasury rate is also known as 'Treasury Spot Rate'. In the next chapter, we will understand how to calculate the treasury spot rate. When the value of a bond is calculated based on spot rate, the resulting value is known as arbitrage-free value.
What do you meant by market-based and bank-based financial systems? Market-based versus bank-based financial systems implications. The presence of market-based and bank-base
Q. What do you signify by Investment Decisions? Investment Decision: - The most significant function of financial management isn't only the procurement of external funds for th
Analysis of the financial statements and accounting policies of "Panera" Bread company, in APA format, containing: Financial Statements -Discuss the main financial statemen
Ask queswtion #Minimum 100 words accepted# what are the characteristics of debt finance? What are the similarities and differences between debt finance and ordinary share capital
Explain Zero coupon bonds The bonds that are sold at a discount from face value and do not pay any coupon interest over their life are known as Zero coupon bonds. At maturity t
A callable bond is the sale of a call option by the investor to the issuer as it allows the issuer to repurchase the bond from the time it becomes callable until
how to get the expected growth rate?
Explain what is meant by the incremental cash flows of a capital project. Incremental cash flows are defined by the change in total firm cash inflows and cash outflows which ca
An accounting technique that identifies the activities that a firm does, and then allocates indirect costs to products. An activity based costing (ABC) system finds the relationshi
Zero base budgets: this is a new technique, which was first used by the US Department of Agriculture in 1961. Texas instruments, an MNC, have used it in the private sector. But,
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!
whatsapp: +91-977-207-8620
Phone: +91-977-207-8620
Email: [email protected]
All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd