Fair value

Fair value of a bond denotes a monetary value (fair price) that represents the value of the bond computed using its objective constituents. Let us look at the formula of the bond value with semiannual payments:

Fair value formula^[4]

where:

· PRICE is fair value

· settlement is the bond’s settlement date (date the security was purchased)

· maturity is the bond’s maturity date

· rate is the bond’s annual coupon rate

· yld is the bond’s yield to maturity (YTM)

· redemption is the bond’s redemption value per $100 face value (usually $100)

· frequency is the number of coupon payments per year

· basis is the type of day count basis to use

· DSC is number of days from settlement to next coupon date

· E is number of days in coupon period in which the settlement date falls

· N is number of coupons payable between settlement date and redemption date

· A is number of days from beginning of coupon period to settlement date

The fair value of a bond is based only on one measure that is estimated subjectively. It is called yield to maturity (in the sequel referred to as YTM) or required rate of return. All other variables are objective and can be taken exactly without any analysis. Given that, the problem of bond’s fair value estimation is tight bound to the estimation of its YTM.

YTM is the internal rate of return (IRR) of a bond and determines the level of yield of this bond. However, it’s defined by the extent of risks on this particular bond rather than its price. YTM for bonds consist of the market-formed component (which is determined by the market) and the component determined by the company’s financial situation.

This company-determined component includes liquidity premium (LP) and default risk premium (DRP). The first summand, the liquidity premium, is the premium incurred from the costs to sell this security. The rare this security is, the higher this liquidity premium will be, and vice versa. The default risk premium is the premium that follows because of the risk of default (refusal or appears in payment) on this security. The more unstable financial situation the company has, the higher the default risk premium will be. In order to measure the level of this risk, there exist several credit ratings (namely Fitch, S&P, Moody’s). In our paper we use the Fitch’s credit ratings system in order to measure credit rating for bonds.

Since the maturity risk (MR) and default risk grow across time, their premiums, the maturity risk premium (MRP) and default risk premium grow across time to maturity correspondingly. It is essential not to confuse the time to maturity of a bond with the life length of a bond (bond period), which is calculated as a period between the date of issue and the date of maturity. Given that, YTM is (at least theoretically) a growing function of the time to maturity parameter.

As we have already mentioned, the credit rating is another factor affecting YTM. Therefore, there are two parameters that YTM depends on: time to maturity and financial situation of the firm. The second one is partly described by the credit rating systems, but as it doesn’t change frequently, the current state of the firm is another force affecting YTM and price.

In this paper we performed the analysis of fair value based on the YTM estimation. Two approaches we applied:

Estimation of YTM of competitors in the media industry (in the sequel referred to as Industry)

Estimation of YTM via composite bond rate for the market as whole (in the sequel referred to as Composite)

Further we describe both approaches thoroughly.

Date: 2015-01-29; view: 1045