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Financial Economics > L3 - Bond Valuation > Flashcards

L3 - Bond Valuation Flashcards

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1
Q

What is Bond valuation?

A

The determination of the fair price of a bond

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2
Q

What is the value/price of a bond computed as?

A

The PV of expected future cash flows from the bond

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3
Q

What is the discount rate used to compute the PV of cash flows?

A

Market discount rate

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4
Q

What is the formula for calculating the bond price given the market discount rate?

A

PV = PMT/(1+r) + PMT/()1+r)^2 +…+ (PMT+FV)/(1+r)^N
- PMT = coupon payment per period
- r = required rate of return per period
- N = no. of evenly spaced periods to maturity

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5
Q

What is the most common way to measure market discount rate?

A

The YTM of bonds

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6
Q

What does YTM equate?

A

The PV of cash flow payments received from a debt instrument with its value today

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7
Q

What is the Price of a coupon bond, with YTM i, face = FV and maturity in n years?

A

P = (C/i)[1 - 1/(1+i)^n] + FV/(1+i)^n

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8
Q

What is YTM?

A

The YTM is the rate of return on the bond to an investor provided on 3 conditions

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9
Q

What are the 3 conditions to of the YTM on a bond?

A
  • The investor holds the bond to maturity
  • The issuer does not default on coupon or principal payments
  • The investor is able to reinvest coupon payments at that same interest rate as the original YTM
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10
Q

What is the YTM also known as?

A

The Promised Yield

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11
Q

When is a bond said to be traded at a premium?

A
  • If the bond price is higher than par value
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12
Q

What causes a bond price to be traded at a premium, i.e., the bond price is higher than the par value?

A

When the coupon rate is greater than the market discount rate

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13
Q

When is a bond said to be traded at a discount?

A

When the bond price is lower than par value

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14
Q

What causes a bond price to be traded at a discount, i.e., the bond price is lower than par value?

A

When the coupon rate is less than the market discount rate

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15
Q

When is a bond said to be traded at par?

A

When the bond price is equal to par value

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16
Q

What causes a bond to be traded at par, i.e., the bond price is equal to par value?

A

When the coupon rate is equal to the market discount rate

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17
Q

What type of relationship is there between the price of the bond and the discount rate?

A

An inverse relationship

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18
Q

When is a bond traded at discount and premium?

A
  • Discount if YTM > Coupon rate
  • Premium if YTM < Coupon rate
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19
Q

What happens to the price of the bond as it approaches maturity?

A

It approaches face value

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20
Q

What is the Inverse Effect?

A

A bond’s price is inversely related to the market discount rate

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21
Q

What is the Maturity Effect?

A

Other things equal, the longer the maturity of the bond, the more sensitive its price is to changes in the discount rate

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22
Q

What the the Coupon Effect?

A

For the same term to maturity, a lower coupon bond is more sensitive to changes in the market discount rate than a higher coupon bond

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23
Q

What are the 2 offsetting types of interest rate risk?

A
  • Coupon reinvestment risk
  • Market price risk
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24
Q

What is the Interest rate risk?

A

The risk that the interest rate will increase, reducing the bond price

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25
What is Reinvestment risk?
The risk that the interest rate will fall, reducing the rate at which CFs are reinvested
26
What does Quoted price does not include?
The interest that accrues between coupon payment dates
27
What must a buyer pay the seller if a bond is purchased between coupon payments?
The buyer must pay the seller for accrued interest
28
What 2 things components does a bond price consist of?
- Flat (clean) price (Pc) - Accrued interest (AI)
29
What is the sum of flat price and accrued interest equal to?
The full (dirty) price (Pf)
30
What is the formula for Accrued interest?
AI = t/T x PMT - t = no of days from last coupon payment to the settlement date = T = no of days in the coupon period - PMT is the coupon payment per period
31
What is the 30/360 day count common for?
Corporate bonds
32
What is the Actual/actual common for?
Government bonds
33
How can the Full Price of a fixed-rate bond between coupon payment dates be computed?
Can be computed as its value on the last coupon payment date multiplied by one plus the periodic discount rate (r) compounded over the period of time remaining that has elapsed since the last coupon payment: PV(full) = PV x (1+r)^(t/T)
34
What is the PV of a pure discount bond?
PV = Face Value / (1+r)^T
35
What is an advantage of zero coupon bonds in contrast with plain vanilla bonds?
They do not have any reinvestment risk
36
What do we assume when calculating the PV of a plain vanilla bond?
That every coupon will be reinvested at the YTM until the maturity of the bond
37
What is the maturity on perpetual bonds?
Infinite maturity
38
How is the PV of a perpetual bond calculated?
PV = D/r - D = periodic coupon payment of the bond - r = discount rate applied to the bond
39
What is a Contingency Provision?
A clause in a legal document that allows for some actions if the event or circumstance does occur
40
Under what heading are the common contingency provisions found?
Embedded options
41
What are some common types of bonds with embedded options?
- Callable bonds - Putable bonds - Convertible bonds
42
What do callable bonds give the issuer?
The right to redeem (or call) all or part of the bond before its maturity
43
What are 2 advantages a callable bond gives the issuer?
This call option offerrs the issuer the ability to take advantage of: - a decline in market interest rates and/or; - An improvement in its creditworthiness
44
Why do callable bonds expose investors to a higher level of reinvestment risk than non-callable bonds?
If bonds are called, bondholders would have to reinvest proceeds at the new (lower) interest rates
45
Would a bondholder pay more for a callable bond or a non-callable bond?
A bondholder would pay less for a callable bond than for an otherwise identical non-callable bond
46
How is the Value of embedded call option calculated?
Value of embeddede call option = Value of noncallable bond - Value of callable bond
47
What would an issuer of a callable bond have to do in order to get investors to purchase it?
The issuer would have to pay more (in the form of a higher coupon or higher yield)
48
How is the yield on callable bond calculated?
Yield on callable bond = yield on noncallable bond + embedded call option cost
49
What do Putable bonds give bondholers the right to?
Gives bondholders the right to sell (or put) the bond back to the issuer at a predetermined price on specified dates
50
What does an embedded put option offer bondholders protection against?
Offers bondholders protection against an increase in interest rates; i.e., if interest rates increase (decreasing the value of the bond), they can sell the bond back to the issuer at a pre-specified price and then reinvest the principal at (higher) newer interest rates
51
Would a bond pay more for a Putable or non-Putable bond?
A bondholder would pay more for a Putable bond than for an otherwise identical non-putable bond
52
How is Value of embedded put option calculated?
Value of embedded put option = Value of putable bond - Value of nonputable bond
53
Would an issuer pay out more or less on a Putable bond or a non-Putable bond?
The issuer would pay out less (in the form a lower coupon/yield) on a Putable bond
54
How is Yield on putable bond calculated?
Yield on putable bond = yield on nonputable bond - embedded put option cost
55
What does a Convertible bond gives the bondholder the right to?
The right to convert the bond into a prespecified number of common shares of the issuer
56
What can a Convertible bond be viewed as?
A combination of a straight bond and an embedded call option on the issuer's stock
57
Why are Convertible bonds attractive to investors?
- The conversion option allows them to benefit from price appreciation of the issuer's stock - On the other hand, if there is a decline in the issuer's share price, the price of the convertible bond cannot fall below the price of an otherwise identical straight bond
58
What are features of convertible bonds as a result of their attractive features?
Convertible bonds offer a lower yield and sell at higher prices than similar bonds without the conversion option
59
What are advantages of convertible bonds for the issuer?
Yields on convertible bonds are lower than yields on otherwise identical bonds without the conversion option. Further, if the conversion option is exercised, debt is eliminated
60
What is Matrix Pricing?
An estimation process used for finding the market price of bonds that are not actively traded
61
In matrix pricing, what are market discount rates extracted from?
In matrix pricing, market discount rates are extracted from comparable bonds )i.e., bonds with similar time-to-maturity, coupon rate, and credit quality)
62
When can Matrix Pricing also be used?
When underwriting new bonds to estimate the required yield spread over the benchmark rate on the bonds to be issued
63
What is the current/running yield equal to?
The bond's annual coupon amount divided by its current price (not par value), expressed as a %
64
What is the formula for Current Yield?
Current Yield = Annual Coupon Payment / Bond Price
65
Why is current yield a better indicator than YTM of short-term profitability?
Because it is based on the market value or purchase price rather than the par value of a bond
66
What does the Effective Annual Rate (Effective Annual Yield) on a fixed-rate bond depend on?
Depends on the assumed number of periods in the year, which is known as the periodicity of the stated annual rate or stated annual yield
67
What is a general formula to convert yields based on different periodicities?
(1 + APRm/m)^m = (1 + APRn/n)^n - not APR times m/n, it is a way of denoting the annual percentage rate in which there is either m/n number of payments/compounding periods per year
68

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