Valuing Bonds

Question 1

What is a bond?

Answer 1

A bond is a security sold by governments and corporations to raise money from investors today in exchange for promised future payments

Question 2

What is a bond certificate?

Answer 2

A bond certificate describes the amounts and dates of all payments to be made

Question 3

What is the maturity date of a bond?

Answer 3

The maturity date is the date at which the final repayment of a bond is made

Question 4

What is the term of a bond?

Answer 4

The term of a bond is the time until the final repayment date

Question 5

What are the coupon payments of a bond?

Answer 5

The coupon payments are the promised interest payments on a bond

Question 6

What is the Face Value or Principal Value of a bond?

Answer 6

This is the notional amount used to compute interest payments

Question 7

What is the Coupon Rate?

Answer 7

This is the amount of each coupon payment

Question 8

What is the equation for calculating coupon payments

Answer 8

CPN= (Coupon Rate*Face Value)/ Number of Coupon Payment per Year

Question 9

What is a zero coupon bond?

Answer 9

A zero coupon bond is one which does not make coupon payments. The only cash payment the investor receives is the face value of the bond at the maturity date.

Question 11

What is the Yield to Maturity (YTM) of a bond?

Answer 11

-IRR of a bond
-The discount rate that sets the present value of the promised bond payments equal to the current market price of the bond

Question 12

What is the equation for the price of a zero coupon bond?

Answer 12

-P= FV/(1+YTMn)^n

Question 13

What is the equation for YTM?

Answer 13

YTMn= [(FV/P)^1/n]-1

Question 14

What is the relationship between the risk free interest rate and zero coupon bonds?

Answer 14

-Risk free interest rate = YTM

Question 15

What are coupon bonds?

Answer 15

Pay investors face value at maturity + regular interest payments

Question 16

What are the difference between treasury notes and treasury bonds?

Answer 16

-Treasury notes have a maturity of less than 10 years
-Treasury bonds have a maturity of more than 10 years

Question 17

What is the equation for the price of a coupon bond?

Answer 17

-P= (CPN/y)*(1-1/[(1+y)^n]) + FV/[(1+y)^n]
-Can be conceptualised as an annuity + one off payment

Question 18

What is meant if bonds trade at a discount?

Answer 18

-YTM>CPN
-An investor will receive a return both from receiving coupons and receiving a face value payment that exceeds the initial price paid

Question 19

What is meant if bonds trade at a premium?

Answer 19

-YTM<CPN
-Investor’s return from coupons is diminished by receiving a face value less than the price paid for the bond

Question 20

What is meant if bonds trade at par value?

Answer 20

-YTM=CPN
-Most issuers choose a coupon rate so that bonds will initially trade at or very close to par

Question 21

What is the relationship between bond prices and bond term?

Answer 21

-Price increases as the term increases
-Between coupon payments the prices of all bonds rise at a rate equal to the yield to maturity

Question 22

How does the price of a bond change with coupon payments?

Answer 22

-The price of the bond will decrease by the amount of each coupon payment
-Premium: Price drop when coupons are paid exceed the price increase between coupons
-Discount: Price increase between coupon payments exceed the price drop when a coupon is paid

Question 23

What do the price of all bonds tend towards as they approach maturity?

Answer 23

Face value

Question 24

What is the relationship between interest rates, bond yields and bond prices?

Answer 24

-As interest rates and bond yields rise, bond prices fall
-High YTM –> High discount rate –> Reduction in PV and bond price

Question 25

What is the duration of a bond?

Answer 25

-The sensitivity of a bond's price to changes in interest rates -Shorter maturity zero coupon bonds are less sensitive to changes in interest rates than higher maturity bonds

Question 26

How can you model the cash flows of a coupon bond?

Answer 26

-Modelled using a series of zero coupon bonds -Each coupon payment is matched to a zero coupon bond -Face value of zero coupon bond = coupon payment -Term= time remaining to maturity date -Law of One Price means that the price of the portfolio of zero-coupon bonds must be equal to the price of the coupon bond

Question 27

What is the equation for valuing a coupon bond using zero-coupon yields?

Answer 27

P= PV(Bond Cash Flows)= Sum [CPN/(1+YTM)^n]

Question 28

What is the yield to maturity of a coupon bond?

Answer 28

The weighted average of the yields of the zero-coupon bonds of equal and shorter maturities

Question 29

How does the yield of coupon bonds vary with coupon rates?

Answer 29

Higher coupon payments means earlier cash flows become relatively more important than later cash flows in the calculation of present value

Question 30

What does an upward sloping yield curve indicate?

Answer 30

The YTM decreases with the coupon rate of the bond

Question 31

What does a downward sloping yield curve indicate?

Answer 31

The YTM increases with coupon rates

Question 32

What is the key difference between corporate bonds and treasury bonds?

Answer 32

Corporate bonds might default

Question 33

What is the risk of default called?

Answer 33

The credit risk

Question 34

How are corporate bond yields calculated?

Answer 34

-Calculated using promised cash flows -Therefore, the cash flows an investor expects to receive may be less than the bond yield -Investors therefore pay less for bonds with higher credit risks -The yields of corporate bonds will be higher than those of identical, risk free bonds

Question 35

What is the price of a corporate bond with no credit risk?

Answer 35

P= Face Value/ (1+YTM)

Question 36

What is the price of a corporate bond with a given risk of default?

Answer 36

P= (Risk Free % of Face Value)/ (1+YTM)

Question 37

How do you calculate the price of a corporate bond where it is uncertain if the company will default?

Answer 37

-Discount cash flows using the cost of capital -Cost of capital= debt cost of capital + risk premium -Expected return= Debt cost of capital

Question 38

How do you know if there is a risk of default with a corporate bond?

Answer 38

If the firm's debt cost of capital is less than the YTM

Question 39

What are sovereign bonds?

Answer 39

-Bonds issued by national government -Risky so behaves like corporate debt -Countries can print more money to pay debt, however this can cause inflation which would devalue the payment to investors