Bond Markets

Question 1

What are bonds?

Answer 1

Financial instrument that pay a positive interest rate but cannot be used for transactions.

Question 2

Explain how bond prices are determined?

Answer 2

• Interest rate of the bond is inferred from the price
• One year bond that promises to pay £100 a year from now
• Price of bond £Pbt
• IRt = £100 - £Pbt / £Pbt

Question 3

Relation of price and interest rate of bond.

Answer 3

Higher price of bond = lower interest rate of bond

Question 4

How do bonds differ?

Answer 4

• Default risk
• Maturity

Question 5

What is default risk?

Answer 5

• The risk the issuer of the bond will not pay back the full amount promised by the bond

Question 6

What is a bond’s maturity?

Answer 6

• The length of time over which it promises to make payments to the holder of the bond
• E.g. a bond that promises to pay £100 in six months has a maturity of six months

Question 7

Decipher between short term and long term maturity.

Answer 7

• <1 year maturity = short term bond
• > 1 year maturity = long term bond

Question 8

What is Yield to Maturity?

Answer 8

The constant interest rate that makes the pdv of future payments on the bond equal to the price of the bond today

Question 9

What is the arbitrage process?

Answer 9

• Expected returns on two assets must be the same
• If this were not the case, investors would purchase the asset the higher return and sell the one with the lower return

Question 10

What is the yield curve?

Answer 10

The relation between the yield to maturity and the maturity of a bond.

Question 11

What does an upward sloping yield curve mean?

Answer 11

• Long term interest rates are higher than short term interest rates
• Financial markets expect short term rates to be higher in the future

Question 12

What does a downward sloping yield curve mean?

Answer 12

• Long term interest rates are lower than short term interest rates
• Financial markets expect short term rates to be lower in the future

Question 13

What are government bonds?

Answer 13

Bonds issued by government agencies

Question 14

What are corporate bonds?

Answer 14

Bonds issued by firms

Question 15

How are bond ratings issued?

Answer 15

• Standard’s and Poor’s
• Moody’s Investors Service

Question 16

What is the risk premium?

Answer 16

The difference between the interest rate paid on a given bond and the interest rate paid on the bond with the highest rating.

Question 17

What are junk bonds?

Answer 17

Bonds with high default risk

Question 18

What are discount bonds? What is the face value of a bond in context?

Answer 18

• Bonds that promise a single payment at maturity
• Face value is the name of the single payment of the bond

Question 19

What is a coupon bond?

Answer 19

Bonds that promise multiple payments before maturity and one payment at maturity