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Encyclopedia of Financial Models, 3 Volume Set by Frank J. Fabozzi

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Relative Value Analysis of Fixed-Income Products

STEVEN V. MANN, PhD

Professor of Finance, Moore School of Business, University of South Carolina

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

Abstract: Valuation of fixed-income products employs one of two basic methods—discounted cash flows and relative value. Methods using discounted cash flows require several assumptions to be used as inputs but produce a precise valuation result. The tools of relative value analysis are less ambitious. They help us discern differences in value between two similar bonds on a relative basis. Relative value analysis investors make statements such as “Bond X is cheaper than Bond Y.” Relative value tools range in complexity from yield spreads to asset swap spreads and the credit default swap basis.

There are two basic approaches to the valuation of fixed-income products. The discounted cash flow method seeks to value a bond given assumptions about cash flows, reference yield curves, risk premiums, and so on. Given these inputs, the bond's value is determined. Once computed, this value is compared to the prevailing market price and a rich/cheap determination can be made. The alternative method, relative valuation, is less ambitious and not surprisingly more popular.

Tools of relative value analysis, when properly interpreted, give the user some clues about how similar bonds are currently valued in the market on a relative basis. This battery of tools allows us to ...

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