WEEK 5 - Bonds

Question 1

What is a Bond?

Answer 1

Debt instrument, issued by a borrower for a fixed period of time, paying interest known as a coupon which is fixed at issue date and is paid periodically until it is redeemed at maturity, at which time the principal amount is repaid

Question 2

How can we classify bonds

Answer 2

• In terms of the nature of the bond
• Can classify based on place of issue
• Can classify by issuer

Question 3

What are the variety of forms bonds come in?

Answer 3

• Straight, plain vanilla or bullet bonds
• Zero coupon bonds
• Floating-rate or variable-rate bonds
• Index-linked bonds
• Convertible bonds

Question 4

What are the differing classifications of Bonds based on place of issue?

Answer 4

-Domestic Bonds
-Foreign Bonds
-Eurobonds
(Issued in a currency outside that country)
e.g. Bond issued in US in GBP

Question 5

What are the differing issuers of Bonds?

Answer 5

Central governments and -government agencies

• State and local governments
• Companies
• Supranational institutions (eg. World Bank)

Question 6

What are the 3 big credit rating agencies?

Answer 6

• Moodies
• Standard and Poor (S&P)
• Fitch

Question 7

How does the credit rating agency scale work?

Answer 7

AA= Minimal Risk

All the way down to D which indicated a company/country defaulted

Question 8

What the Current Types of Gilts?

Answer 8

Conventional gilts, for example: 1 1/2% Treasury Gilt 2047

Index-linked Gilts:
Coupon and Redemption increases with inflation

Gilt Strips:
breaking it down into its individual cash flows can be traded separately as zero coupon bonds

E.G. a three-year gilt will have seven individual cash flows: six (semi-annual) coupon payments and a principal repayment.

Question 9

How do you calculate Perpetual Bonds?

Answer 9

PV = C/R

Where:

• PV: Present Value of bond
• C: The coupon rate x Nominal (par) value of the bond
• R: Discount Rate

Question 10

How do you calculate the Conventional Bond?

Answer 10

PV =
PV(P) = C(1/R-1/R(1+R)t) + V/(1+R)t

Where V is the par value

Where t is to the power of

Question 11

What are the historic type of Gilts?

Answer 11

• Undated gilts
• Double-dated conventional gilts
• Floating rate gilts

Question 12

How do you calculate the interest yield?

Answer 12

Coupon/ Market Price

Question 13

What are the issues to calculating the Interest Yield?

Answer 13

Doesn’t take into consideration:

• Time value of money
• No way to see capital gain/loss

Question 14

What is the Redemption Yield? (Also known as Yield to Maturity)

Answer 14

The discount rate such that the present value of all the cash inflows from the bond (interest plus principal) is equal to the bond’s current market price

Question 15

How do you calculate the redemption yield?

Answer 15

YTM = (C+ F-P/N)/(F+P)/2

Where:

• C = Coupon Rate
• F = Face Value
• P = Current Price
• N = Number of Years

CHECK NOTES FOR CLEARER PRESENTATION OF CALCULATION

Question 16

How do you calculate spot rates?

Answer 16

Finding R1:
P= C+V/ 1 +R1
Simply just rearrange

Finding R2:
P= C/1+R1 + C+V/ (1+R2)2
Simply just rearrange

Finding R3:
P = C/1+R1 + C/(1+R2)2 + C+V/ (1+R3)3
Simply rearrange

ETC.

Question 17

EXAMPLE OF CALCULATING SPOT RATE

Answer 17

SEE IN NOTES

Question 18

EXAMPLE OF VALUING BONDS

Answer 18

SEE IN NOTES

Question 19

What is a Zero Coupon Bond?

Answer 19

• Have only one payment on maturity

- Pure Discount Bond

Question 20

How do you calculate zero coupon bonds?

Answer 20

P0 = 100/ (1 + Rt) t
- Where Rt = tth period spot rate

But can also use:
P0 = 100/ (1+ R) t
- Where r = Yield to maturity

Therefore, Spot Rate equals yield to maturity for zero coupon bonds

Question 21

How do we calculate Forward Rates?

Answer 21

Focusing on £100 in 2 years:

Step 1: Find Present Value of £100 one year from now (PV):

• Use Discount Rate f 1,2 where 1,2 indicates that this is a rate from year one to year two. We refer to it as a forward rate:

PV = £100/ (1+ F 1,2)

Step 2: Find present value of PV0 of PV1:

PV0 = PV1/ (1+R1)

F 1,2 = 100 / PV0 (1+R1)

Question 22

What is the Interest Rate Hypothesis?

Answer 22

Made up of:
- Interest Rate Hypothesis:
That the forward rate is simply the forecast of future spot rates

• Liquidity Premium
  Lenders prefer to lend short time and borrowers prefer to borrow over a long time
• Inflation Premium
  Inflation risk is the greatest concern to investors
  Inflation can only be accurately forecasted only in short term. In order to lend for longer, investors require investment premium

-Market Segmentation
Demand and Supply of bonds of differing maturities will vary.