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FINANCE CHAPTER 10: BONDS & CHAPTER 11: INTEREST RATE RISK
Terms in this set (34)
What is Face value (or par value)?
Payment to bondholder at maturity of bond, typically $1,000.
What is a coupon?
Periodic interest payments. The coupon rate is expressed as an annual rate per dollar of par value.
Which coupon rate is most common?
Semi-annual coupons are most common. In that case, the semi-annual payments are equal to half of the annual coupon rate, times the par value.
What's a zero coupon bond and its equation?
A bond paying no coupon payments. It sells at a discount & provides only a payment of par value.
Price zero-coupon bond = $1,000/〖(1+𝑟)〗^𝑇
Predicting your realized return by making assumptions about the rate at which coupons will be reinvested.
How to calculate bond value?
Present Value of Coupon + Present Value of Par Value = Bond Value
OR coupon/(1+r)^t + par value/(1+r)^T
What's the relation between bonds and interest rates?
Bond prices are inversely related to interest rates
- Low interest rate, bond is worth more
- High interest rate, bond is worth less
What are premium bonds?
Bonds selling above par value
What are discount bonds and example?
Bonds selling below par value
- Example: zero coupon bonds
What is a bond quote?
The price at which a bond is trading. Expressed as a % of par value, with the % converted to a point scale. The price that someone is willing to pay for the bond is always given in relation to 100, or par value. A bond quote above 100 means that the bond is trading above par, while a bond quote below 100 means that the bond is trading below par.
What happens to the market value of bonds once the coupon is paid?
The market value of bonds is reduced by the coupon every time a coupon is paid resulting in a seesaw pattern for the market value of the bond.
The price that is quoted is called a..
A flat price, DO NOT include accrued interest.
What's an invoice price?
The price that is actually charged, adds accrued interest to the flat price.
What is yield to maturity?
- Definition: is the discount rate that makes the present value of the bond's cash flows equal to price.
- For bonds it is more common to follow bond's yield-to-maturity (YTM) implied by its price. (Note: IMPLIED means something that you do not observe directly, you have to calculate it.)
Why do bond quotes typically include the bond's yield in addition to its coupon rate?
Because when you purchase a bond after it has been issued, the yield-to-maturity gives you a better indication of the return that you can expect from a buy-and-hold strategy than the coupon rate
What is the yield curve?
It's the graph of the yields-to-maturity as a function of the term to maturity.
- Usually upward sloping: investors want to be compensated for the greater risk and illiquidity of long-term bonds.
What are corporate bonds subject to in terms of risk?
Corporate bonds (and other-than-U.S. Treasury bonds) are subject to credit risk or default risk
What is credit risk or default risk?
this is the risk that the issuer may not be able to make its coupon or principal payments.
What is an speculative grade or junk bond?
- a high-yield, high-risk security, typically issued by a company seeking to raise capital quickly in order to finance a takeover.
- Rated BB or lower ('B', 'CCC) by S&P, Ba or lower by Moody's, or unrated.
Whats an investment grade bond?
- relatively low risk
-Rated BBB (medium)and AAA (above) by S&P or Baa and above by Moody's.
What is a bond indenture?
Definition: Is the contract between the issuer and the bondholder. It specifies a set of restrictions (covenants) that protect the rights of the bondholders. Like: Sinking fund, Subordination of, further debt, Dividend restrictions, Collateral
What is a Credit Default Swap (CDS)?
can be purchased to protect a bondholder against the default risk of an issuer. They can be viewed as insurance policies against default risk.
Interest rate risks in short term bonds?
least sensitive -
If interest rates go down, they gain the least. If interest rates go up, they lose the least.
Interest rate risks in long term bonds?
most sensitive -
If interest rates go down, they gain the most. If interest rates go up, they lose the most.
What is one of the main strategies for an active bond portfolio manager?
to predict how interest rates will move and adjust the duration of the portfolio in consequence
If a active portfolio manager thinks interest rates will increase he will he use a shorter or longer duration?
Choose a shorter duration if he thinks interest rates will increase
If a active portfolio manager thinks interest rates will decrease he will he use a shorter or longer duration?
Choose a longer duration if he thinks interest rates will decrease
Some corporate bonds are callable and can be repurchased by the issue at?
- a specified call price
- during a call period.
What's a callable bond?
A bond that can be redeemed by the issuer prior to its maturity. Usually a premium is paid to the bond owner when the bond is called.
Also known as a "redeemable bond."
What does Treasury Inflation Protected Securities TIPS do for investors?
TIPS offer a fixed rate of return in real terms. They offer investors a true hedge against inflation: the more inflation increases, the more you receive in payments from the TIPS.
What is TIPS?
It provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.
of a bond is computed as the ratio of the annual coupon payment to the market price.
= annual coupon payment/market price
Equation for Holding Period Return (HPR)
change in price +coupon payments/initial price
Everything else equal, the __________ the maturity of a bond and the __________ the coupon, the greater the sensitivity of the bond's price to interest rate changes.
Long or short, higher or lower?
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