Chapter 14: Bond Valuation and Interest Rates

Question 1

The most common type of bond, it pays a fixed interest rate and has a known maturity

Answer 1

Fixed coupon bond

Question 2

A contract between an issuer of bonds and the bond holder stating the time period before repayment, amount of interest paid, if the bond is convertible (and if so, at what price or what ratio), if the bond is callable and the amount of money that is to be repaid

Answer 2

Indenture

Question 3

The amount that is repaid when the bond matures and the principal amount is due

Answer 3

Principal value

Question 4

The face value of a bond. Generally $1000 for corporate issues, with higher denominations such as $10,000 for many government issues

Answer 4

Par amount

Question 5

The length of time until the principal amount of a bond must be repaid. In other words, the date the borrower must pay back the money he or she borrowed through the issue of a bond

Answer 5

Maturity value

Question 6

A debt security that doesn’t pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value

Answer 6

Zero coupon bond

Question 7

The most popular and most widely used form of bonds issued in the primary market. Provides a coupon and interest rate that creates a market value equal to 100% at the time of pricing

Answer 7

Fixed rate par bond

Question 8

Popular in the municipal market. The coupon and interest rate will create a market value of less than 100% at the time of pricing.

Answer 8

Fixed rate discount bond

Question 9

Provides a coupon and interest rate that creates a market value of more than 100% at the time of pricing

Answer 9

Fixed rate premium bond

Question 10

Debt that is secured by an asset

Answer 10

Asset-backed debt (collateralized debt)

Question 11

The option for an issuer to redeem bonds prior to their stated maturity at a predetermined price above par value

Answer 11

Optional redemption

Question 12

The dollar amount over the par value of a callable fixed-income debt security that is given to holders when the security is called by the issuer

Answer 12

Call premium

Question 13

The risk that companies or individuals will be unable to pay the contractual interest or principal on their debt obligations

Answer 13

Default risk

Question 14

The uncertainty related to unscheduled prepayment in excess of scheduled principal repayment

Answer 14

Prepayment risk

Question 15

The risk that an investment’s value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed income securities with different durations or hedging (through an interest rate swap)

Answer 15

Interest rate risk

Question 16

The difference in all taxable, fixed-rate debt traded in the capital markets and risk free treasury bonds

Answer 16

Spread to Treasuries

Question 17

A bond or other form of debt that takes priority over other debt securities sold by the issuer

Answer 17

Senior debt

Question 18

Debt that follows senior debt in line for claims on cash flows and assets upon liquidation

Answer 18

Subordinate debt

Question 19

The redemption schedule where bonds have maturity dates and are subject to an annual call in accordance with a pre-specified retirement schedule

Answer 19

Sinking fund redemption

Question 20

It measures the weighted average maturity of a bonds cash flows. The measure of the price sensitivity of a fixed income security to an interest rate change of 100 basis points. Calculation is based on the weighted average of the present values for all cash flows

Answer 20

Duration

Question 21

A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.

Answer 21

Yield curve (Term structure of interest rates)

Question 22

The most frequently reported yield curve compares the

Answer 22

Three month, two year, five year and 30 year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth

Question 23

Bonds that are subject to taxation

Answer 23

Taxable bonds

Question 24

This states that the yield curve is a function of expected future or forward short-term interest rates

Answer 24

The pure expectation hypothesis

Question 25

This states that long term rates are composed of expected short term rates plus a liquidity premium. Most investors prefer to hold short term bonds, so to induce them to buy long term bonds, liquidity premiums must be offered

Answer 25

The liquidity preference hypothesis

Question 26

This states that the market is composed of investors who differ in their investment requirements. Investors want to invest so that the life of their assets matches the life of their liabilities. Investors may want short term or long term bonds to invest in, depending on their preference

Answer 26

The market segmentation hypothesis (the preferred habitat hypothesis)

Question 27

Expected short term rates which over any period will reproduce the observed market rates expressed in the current day yield curve

Answer 27

Implied forward yield curve

Question 28

The rate at which the general level of prices for goods and services is rising and subsequently purchasing power is falling

Answer 28

Inflation

Question 29

A general decline in prices, often caused by a reduction in the supply of money or credit. Can be caused also by a decrease in government, personal or investment spending. This has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression

Answer 29

Deflation

Question 30

The additional amount a borrower must pay to compensate the lender for assuming default risk

Answer 30

Default premium