Week 6 - Valuation of Financial Assets - Bonds Flashcards
(16 cards)
Bond
A bond is a debt instrument sold by the issuer to the investor in exchange for a promise to pay periodic interest payments and repayment of the principal at maturity
Bond Certificate
states the contractual terms of the bond
Face Value
is the principal to be repaid
Maturity Date
when the face value is to be repaid
Term
time remaining until the maturity date
Coupon
promised interest payments of a bond, paid periodically until the maturity date. Usually paid semi-annually, but the frequency is specified in the bond certificate
Coupon rate
determines the amount of each coupon payment, the coupon rate, expressed as an APR, is set by the issuer –> contractual –> set when the bond is issued
Yield to Maturity (YTM)
the rate of return earned from investing in the bond that is held to the maturity date
CPN
Calculate the price and yield to maturity of a zero-coupon bond
- Only two cash flows:
- The bond’s market price at the time of purchase
- The bond’s face value at maturity
- Suppose a one-year, risk free (default free), zero coupon bond with a $100,000 face value has an in initial price of $96,618.36
- If you purchased this bond and held it to maturity you would have the following cash flows:
Yield to Maturity
Essentially, the YTM is the discount rate that sets the present value of the promise bond payments equal to the current market price of the bond
Coupon Bonds
- Pay face value at maturity, and
- Pay regular coupon interest payments
- Bond = package of coupons which make up an annuity + principal of bond
- The price P of a coupon bond is the present value of the bond’s cash flows
- Where the cash flows are discounted by the bond’s yield to maturity y
P = PV (coupons) + PV (face value)
P = PV (annuity) + PV (single cash flow)
Zero-coupon bonds
always trade for a discount (to face value)
Coupon bonds
may trade at a discount or at a premium (a price greater than their face value)
Analyse why bond prices change over time
- Most issuers of bonds choose a coupon rate so that the bonds will initially trade at, or very close to, pay (i.e. at the bond’s face value)
- After the issue date, the market price of a bond generally changes over time for two reasons:
- As time passes, the bond gets closer to its maturity date. Holding fixed the bond’s yield to maturity, the present value of the bond’s remaining cash flows changes as the time to maturity decreases
- At any point in time, changes in market interest rates affect the bond’s yield to maturity and its price (the present value of the remaining cash flows)
- If a bond sells at part (price = face value), the only return investors will earn is from the coupons that the bond pays
- Therefore, the bond’s coupon rate will exactly equal it’s yield to maturity
- As interest rates in the economy fluctuate, the yields that investors demand will also change - changes in yields will affect the price investors are willing to pay to purchase a bond
- Interest rates up –> prices down (discount)
- Interest rates down –> prices up (premium)
- A higher yield to maturity means that investors demand a higher return for investing. They apply a higher discount rate to the bond’s remaining cash flows, reducing their present value and, hence, the bond’s price
- The reverse holds when interest rates fall. Investors then demand a lower YTM, reducing the discount rate applied to the bond’s cash flows and raising the price
Therefore, as interest rates and bond yields rise, bond prices will fall, and vice versa, so that interest rates and bond prices always move in the opposite dirrection
Explain how credit risk effects the expected return from holding a corporate bond
Interest rate risk measures the change in a bond’s price due to a change in interest rates.
Bonds with different characteristics will respond differently to changes in interest rates:
* Long-term bonds have more interest rate risk than short-term bonds
Low coupon rate bonds have more interest rate risk than high coupon rate bonds
