which interest rate are they talking about?
Many model components require a "risk-free rate" or the treasury bond rate. This is also true when they talk about spread. the spread between the 3 month corporate bond and the treasury.
Are they talking about the coupon rate or the yield to matury?
coupon.
Def the yield to maturity. The coupon rate doesn't change once it's set. That means that coupon doesn't always accurately reflect the appropriate amount of return given the risk. If you used the coupon, you'd get some pretty crazy interest rates for the 30 year treasuries that were set in the 80s. Also, if you take a look at the yield curve, you'll see that all the points are plotted using the ytm.
Don't think orbithal has ever built a model before, because the debt spreads that you get from the desk are absolutely coupon / "alternative-debt" rates.
I think perhaps this question is a two-parter:
When we refer to the risk free rate in say, a valuation model, we're talking about the current YTM, not coupon rate. For instance, let's say we're putting together a cost of equity for a project that has a period of 10 years. We want the current yield on the appropriate 10 year risk free bond: that is, the interest rate given the decrease/increase in price due to changing market conditions, inflation expectations, reinvestment, etc., etc. Think about it this way: if we were calculating the cost of equity (using the CAPM let's say) for this 10 year project, the coupon on that 10 year bond would never change (save for new issues, but this is not set directly by the market, its set by the treasury, based on the market. The YTM by definition, is).
Orbithal mentioned the coupon is fixed, of course. The YTM is based on current market conditions, including offerings on yields of other bonds in the market.
As for spreads, I don't know. b2, could you elaborate? I'm interested and curious to know why they send you coupon rates. Wouldn't the spread between the coupon on the risk-free and the coupon on the corporate bond never change? I thought the desk would be trading on the changing expectations in the market as based on the YTM: ie, when the market improves and credit is strong for a company/inflation expectations are low/reinvestment risk is low, etc. the YTM spread of the corporate bond and comparable treasury converge. Can you explain why they send alternative debt rates, if these are coupon based and never changing?
For instance:
The coupon spread between a 10-year GE bond issued 1/10/2002 and a 10 year Tbond issued on the same date never changes.
Any insight you could provide would be appreciated, thanks.
Right, I'm fairly sure Jason was referring to your typical valuation model...b2, maybe you're talking about other models? I'm also wondering about Alphaholics question...
When you ask the desk for a spread, you are inputting it into the model as a static input that remains the same over the [ ] year period, as of current L or T upon the date of the transaction. The rate doesn't fluctuate according to changes in L / T. I didn't bother reading Alphaholics inanely long post, because I have better things to do than argue with a Managing Analyst... erm... I mean, Managing Prospective.
I'm talking about financing an M&A or whatever transaction, when you are modeling out capstruct optimization, CoC, A/D, etc. and you're stress testing the various financing scenarios. The debt spread is the coupon that you'd be paying w/ debt financing, as such, the output remains constant over the life of the model.
Appreciate the clarification, though being a douchebag is unecessary.
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