Top-Down Analysis in Finance

Top-Down Analysis vs. Bottom-Up Analysis

• Top-Down Analysis:
  • Start with the overall economy and gradually move to a specific company
  • Strengths: comprehensive holistic view, incorporates industry trends, economic factors, and market dynamics
  • Weaknesses: may overlook firm-specific factors, sensitive to changes in economic conditions
• Bottom-Up Analysis:
  • Start with a specific firm/company and gradually move to the overall economy
  • Strengths: comprehensive analysis of individual companies, focuses on firm-specific fundamentals, competitive positioning, growth aspects, and financial performance
  • Weaknesses: time-consuming, may miss out on broader market trends

Relative Valuation

• Definition: compares the price of an asset to prices of similar or comparable assets
• Standardization: converts market prices into standardized prices, creating price multiples
• Popularity: easier to justify buying or selling decisions, quicker than discounted cash flow valuation, reflects market perceptions and moods
• Median preferred over mean: more reliable comparison point, unaffected by extreme outliers or non-symmetric distributions

Issues in Relative Valuation

• Choice of Comparable: subjective, can significantly affect valuation
• Market Conditions: influences prices of comparables, may reflect temporary market conditions rather than intrinsic value
• Differences in Growth Rates: high-growth companies may appear overvalued compared to low-growth companies
• Scale and Size: smaller companies may trade at different multiples compared to larger companies

Bond Characteristics

• Par Value Bond: coupon rate = YTM
• Discount Bond: coupon rate < YTM
• Premium Bond: coupon rate > YTM
• Strips: separate trading of registered interest and principal securities
• Arbitrage: occurs when PV Bond ≠ PV of all Strips

Bond Pricing and YTM

• YTM reflects the market's required return on the bond
• Bond price: increases when market requires lower return, decreases when market requires higher return
• Interest Rate Changes: affects YTM, bond price, and coupon rate

Pure Expectations Theory

• Assumptions: current yield curve reflects investors' expectations of future short-term interest rates
• Predicts future short-term rates (forward rates) based on current long-term rates
• Yield Curve Shape: normal (upward sloping), inverted (downward sloping), or flat

Discount Factors, Spot Rates, and Forward Rates

• Discount Factor: determined from market price and cash flows of a bond
• Spot Rate: obtained from discount factor
• Forward Rate: market expectations of interest rates in the future

Interest Rates and Yield Curve

• High interest rates: decrease bond prices, provide opportunities for investors
• Low interest rates: increase bond prices, make them more valuable
• Shape of yield curve: determined by market expectations of future interest rate movements

Liquidity Preference Theory and Market Segmentation Theory

• Liquidity Preference Theory: investors are compensated for time, but get extra if they invest for longer
• Market Segmentation Theory: investors will never change their preference, supply and demand shift the yield for each market segment

Duration and Convexity

• Macaulay's Duration: measures sensitivity of a bond's price to changes in interest rates
• Properties: Dmac ≤ TTM, higher for bonds with lower Crate, lower YTM, and higher TTM
• Modified Duration: adjusts for bond's yield, represents a percentage change in bond price
• Convexity: measures sensitivity of a bond's duration to changes in interest rates
• Properties: higher for bonds with lower Crate, lower YTM, and higher TTM

Active and Passive Trading Strategies

• Active Trading Strategies: requires forecasting yield curve changes or divesting depending on the prediction
• Passive Trading Strategies: requires little from the investor, aims to buy and hold bonds until maturity

Duration Management and Rollover Strategy

• Duration Management: increase or decrease portfolio duration based on forecasted changes in rates
• Rollover Strategy: invest in a bond with a shorter TTM than the investment time horizon, then roll into a new investment with a higher return

Riding the Yield Curve

• Invest in a bond with a longer TTM than the investment time horizon
• Take advantage of the upward sloping yield curve, selling the bond before maturity for a capital gain

Barbell and Bullet Strategies

• Barbell: invest in low-risk, low-maturity bonds and high-risk, high-maturity bonds
• Bullet: invest in bonds with similar maturity dates
• Barbell is generally more successful than a bullet, especially for larger parallel changes in the yield curve

Macaulay's Duration

• Measures the sensitivity of a bond's price to changes in interest rates (yields)
• Duration looks at price risk: if yields increase, price decreases
• Duration increases as Time to Maturity (TTM) increases, exposing the bond to more price risk

Properties of Macaulay's Duration

• Dmac is less than or equal to TTM
• Dmac is higher for bonds with lower coupon rate (all else equal)
• Dmac is higher for bonds with lower yield to maturity (YTM) (all else equal)
• Dmac is higher for bonds with higher TTM (all else equal)

Inverse Relationship between Dmac and Coupons/YTM

• Higher yield results in lower Dmac

Positive Relationship between Dmac and TTM

• Higher TTM results in higher duration

Modified Duration

• Modified version of Dmac, adjusting for the bond's yield
• Dmod represents a percentage change in a bond price
• Example: Dmod of 2.23 means a 1% increase (decrease) in yield results in a 2.23% decrease (increase) in bond price

Implications of Duration

• Positive relationship between a bond's duration and price sensitivity to interest rate changes
• Positive relationship between TTM and duration
• Negative relationship between coupon rate and duration
• Two bonds with the same Dmod have the same percentage price change sensitivity to yields
• Duration represents a negative linear relationship, with small changes having little effect, but gradually becoming less linear as interest rates increase

Convexity

• Measures the sensitivity of a bond's duration to changes in interest rates
• Captures the non-linear relationship between a bond's price and yield
• Accounts for the curvature of the yield curve
• Using convexity with duration provides a more accurate estimate of price changes in response to interest rate movements

Properties of Convexity

• Convexity is higher for bonds with lower coupon rate (all else equal)
• Convexity is higher for bonds with lower YTM (all else equal)
• Convexity is higher for bonds with higher TTM (all else equal)
• More convexity results in less price change when yields go up and more price change when yields go down

Summary of Duration and Convexity

• Duration and Convexity have a positive relationship
• Convexity is beneficial: provides more gains when yields decrease and less losses when yields increase
• Duration increases interest rate risk, while decreasing duration reduces risk
• Investors want more convexity, but it comes with higher duration, which requires investing in longer-term bonds

Pure Expectations Theory

• Assumes current yield curve reflects investors' expectations of future short-term interest rates
• Predicts future short-term rates (forward rates) based on current long-term rates
• Yield curve shape reflects market expectations:
  • Upward sloping: investors expect higher short-term rates in the future
  • Downward sloping: investors expect lower short-term rates in the future

Yield Curve Shape

Normal - Upward Sloping

• Short-term yields are lower than long-term yields
• Long-term bonds have higher yields due to higher exposure to uncertainty and inflation risk
• Indicates market expectations of stronger economic growth and potentially higher inflation in the future

Inverted - Downward Sloping

• Short-term bonds have higher yields compared to long-term bonds
• Indicates market expectations of slower economic growth or a recession in the future
• Investors prefer long-term bonds to lock in current yields, anticipating lower interest rates in the future

Flat Yield Curve

• Rarely seen, only during economic shifts
• Indicates a transition from upward to downward sloping or vice versa

Discount Factors/Spot Rates/Forward Rates

• Discount factor is determined from market price and cash flows of a bond
• Forward rates reflect market expectations of future interest rates
• Comparing forward rates to spot rates indicates market expectations of future bond yields
• Spot rate vs forward rate curve indicates market expectations of future bond yields

Arbitrage Opportunity - Negative Rates

• Negative rates imply mispricing
• Buying underpriced bonds and selling overpriced bonds can exploit arbitrage opportunities
• Example: Bond X with yield 1.066 and Bond Y with yield 1.0263

Interest Rates

• High interest rates decrease bond prices, providing opportunities for investors
• Low interest rates increase bond prices, making them more valuable
• Yield curve shape is determined by market expectations of future interest rate movements

Other Theories

Liquidity Preference Theory

• Investors are compensated for time and take on extra risk with longer investments
• Reinvestment risk and price risk are key considerations

Market Segmentation Theory

• Investors have fixed preferences for specific bond maturities
• Supply and demand shift yields in each market segment

Preferred Habitat Theory

• Investors have preferred time maturity for bonds, but may take other opportunities
• Preferences include investment duration, price risk, or tolerance