Midterm Flashcards
(42 cards)
What is a Bond?
A long-term contract between a borrower (issuer) and its lenders/bondholders, where the issuer promises to pay interest and principal on specific dates.
What is Par Value (Face Value)?
The stated face value of a bond, typically $1,000, representing the amount the issuer borrows and repays at maturity.
What is the Coupon Interest Rate?
The stated annual interest rate on a bond, multiplied by the par value to determine the dollar amount of interest paid (coupon payment).
What is a Call Provision?
A bond feature that allows the issuer to redeem the bond before its maturity date, usually if interest rates decline. It generally requires paying a call premium to the investor.
What are Sinking Funds?
A provision to pay off a bond issue over its life rather than all at maturity, reducing risk to investors and shortening average maturity.
When does a bond sell at a ‘discount’?
When the going market rate of interest (rd) rises above the bond’s coupon interest rate.
When does a bond sell at a ‘premium’?
When the going market rate of interest (rd) declines below the bond’s coupon interest rate.
What is Yield to Maturity (YTM)?
The expected rate of total return earned on a bond held to maturity, assuming no default risk or call.
What is Yield to Call (YTC)?
The expected rate of return earned on a callable bond, assuming it is called at the first call date. Relevant for premium bonds.
What is the formula for the Nominal (Quoted) Interest Rate (rd) components?
rd = r* + IP + DRP + LP + MRP (Real risk-free rate + Inflation premium + Default risk premium + Liquidity premium + Maturity risk premium).
What is the Real Risk-Free Rate (r*)?
The rate of return on a riskless security if no inflation is expected.
What is the Inflation Premium (IP)?
A component of the nominal interest rate that compensates bondholders for losing purchasing power due to expected inflation.
What is Default Risk Premium (DRP)?
A component of the nominal interest rate that compensates bondholders for the risk that the issuer will not pay interest or principal on time.
What are ‘Junk Bonds’?
Noninvestment-grade bonds (e.g., BB or lower ratings) that have a high default risk.
What is Interest Rate Risk?
The risk that rising market interest rates will cause a bond’s price to fall. (Higher for long-term bonds).
What is Reinvestment Rate Risk?
The risk that future cash flows from a bond (e.g., coupon payments) will have to be reinvested at lower rates, reducing income. (Higher for short-term bonds).
What is a Yield Curve?
A graph showing the relationship between interest rates (or yields) and maturities for bonds of similar risk.
What is Insolvency?
The condition where a business cannot meet its financial obligations.
What is ‘Stand-Alone Risk’?
The risk of an investment in isolation, pertaining to the probability of earning a return less than expected.
What measure of stand-alone risk considers both risk and return, allowing for comparison across different investments?
Coefficient of Variation (CV) = Standard deviation / expected return.
What is a ‘Risk Premium’?
The compensation that risk-averse investors require for taking on more risk, representing the excess return on a risky asset over a risk-free asset.
What does a Correlation Coefficient (ρ) of -1.0 between two assets imply for portfolio risk?
Complete risk reduction is possible; combining them can eliminate all risk.
What is ‘Market Risk’ (Systematic Risk)?
Economy-wide random events that affect almost all assets and cannot be eliminated by diversification.
What is ‘Diversifiable Risk’ (Unsystematic Risk)?
Random events affecting a single security or small groups of securities, which can be significantly reduced through diversification in a large portfolio.
