Topic 4: Valuing Bonds

Question 1

What is a Bond?

Answer 1

A debt investment in which an investor loans money to an entity (corporate or governmental) that burrows the funds for a defined period of time with the promise to repay the principal along with interest

Question 2

Bond Certificate

Answer 2

States the terms of the bond

Question 3

Maturity Date

Answer 3

Final repayment date

Question 4

Term

Answer 4

Time remaining until the repayment date

Question 5

Coupon

Answer 5

Promised interest payments

Question 6

Face Value

Answer 6

Notional amount used to compute interest payments

Question 7

Coupon Rate

Answer 7

Amount of each coupon payment, expressed as APR

Question 8

Coupon Payment Formula

Answer 8

Question 9

Yield to Maturity

Answer 9

Discount rate that sets the present value of the promised bond payments equal to the current market price of the bond

Question 10

Should you make coupon payments?

Answer 10

NO

Question 11

Should you sell at a discount?

Answer 11

YES ALWAYS, a price lower than face value so they are called pure discount bonds

Question 12

Yield to Maturity of a Zero-Coupon Bond FORMULA

Answer 12

Question 13

Spot Interest Rate

Answer 13

Another term for a default-free, zero-coupon yield

Question 14

Zero-Coupon Yield Curve

Answer 14

A plot of the yield of risk-free zero-coupon bonds as a function of the bond’s maturity date

Question 15

What is the Yield to Maturity of a Coupon Bond

Answer 15

The single discount rate that equates the present value of the bond’s remaining cash flows to its current price

Question 16

Yield to Maturity of a Coupon Bond Formula

Answer 16

Question 17

What are the three dynamic behaviour of Bond Prices?

Answer 17

• Discount / below par
• Par
• At premium / above par

Question 18

Explain the Discount / below par dynamic behaviour of bond prices

Answer 18

The investor will earn a return both from receiving the coupons and from receiving a face value that exceeds the price paid for the bond

• P < FV → YTM > c

Question 19

Explain the Par dynamic behaviour of bond prices

Answer 19

Most coupon bonds have a coupon rate so that the bonds will initially trade at, or very close to, par

• P = FV → YTM > c

Question 20

Explain the At premium / above par dynamic behaviour of bond prices

Answer 20

The investor will earn a return from receiving the coupons but this return will be diminished by receiving a face value less than the price paid for the bond

• P > FV → YTM < c

Question 21

What is the principle of Time and Bond prices

Answer 21

If a bond’s yield to maturity has not changed, the IRR of an investment in the bond equals its yield to maturity even if you sell the bond early

Question 22

What is Duration in terms of bonds?

Answer 22

Measures the sensitivity of a bond’s price to changes in interest rates

Question 23

Explain the relationship between Interest rates and bond prices

Answer 23

Inverse relationship

• Y ↑ = P ↓
• Y ↓ = P ↑

Question 24

What is a high duration?

Answer 24

High sensitivity to interest rate changes

Question 25

What is Low duration?

Answer 25

Low sensitivity to interest rate changes

Question 26

What factors affect bond duration?

Answer 26

- Maturity: low maturity → low duration - Coupon rate: high coupon rate → low duration

Question 27

How can the price of the Coupon bond be computed?

Answer 27

1. Replicating the Coupon Bond from the zero-coupon bonds 2. Using the zero-coupon yields

Question 28

Formula for price of a coupon bond

Answer 28

Question 29

What are Corporate Bonds?

Answer 29

Bonds issued by corporations

Question 30

What is Credit Risk?

Answer 30

Risk of default

Question 31

What are the Corporate Bond Yields?

Answer 31

- Investors pay less for bonds with credit risk than they would for an otherwise identical default-free bond → Pc < Pf - The yield of bonds with credit risk will be higher than that of otherwise identical default0free bonds yc > yf

Question 32

In terms of Corporate Yield Curves... What is a Default Spread or Credit Spread?

Answer 32

The difference between the yield on corporate bonds and Treasury yields

Question 33

Give examples of Sovereign bonds?

Answer 33

- Default Free: U.S. Treasury securities are generally considered to be default free - Not Default Free: Greece defaulted on its outstanding debt in 2012

Question 33

What are Sovereign Bonds?

Answer 33

Bonds issued by national governments

Question 34

What are War Bonds?

Answer 34

Debt securities that government issue to borrow money for military operations during wartime

Question 35

What are Green bonds?

Answer 35

Debt securities issued by organisation to finance environmental and climate-related projects