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Bonds Chapter 10 investment finance
Terms in this set (132)
Long-term debt issued by private corporations typically paying semi-annual coupons and returning the face value of the bond at maturity
may be repurchased by the issuer at a specified call price during the call period.
corporate bonds that can be exchanged at the owner's discretion into common stock of the issuing company
Give bondholders the right but not the obligation to sell their bonds back to the issuer at a predetermined price and date. These bonds generally protect investors from interest rate risk.
bonds with coupon rates periodically reset according to a specified market rate
stock whose holders are guaranteed priority in the payment of dividends but whose holders have no voting rights.
floating rate preferred stock is becoming more popular.
dividend is not normally tax deductible.
Sold by foreign borrower, denominated in currency of the country of issue
Payable in a currency not native to the country in which it is issued
Bonds issued in the currency of the issuer's country but sold in other national markets are called
Coupon rate falls when interest rates rise
income from specified assets used to service debt
issuers can pay interest in cash or additional bonds
Higher coupon rates to investors for taking on risk.
Bonds that the issuer need not repay if there is a specified event, such as a large earthquake, causing large insurance claims
payments tied to general price index/ price of particular commodity
PV of coupons + Present par value (coupon/(1+r)^t) + (par value/(1+r)^t)
bond pricing falls as
market interest rate rises
bond interest rate fluctuations are
a primary source of bond market risk
bonds with longer maturities are
more sensitive to fluctuations in interest rate
inverse relationship between bond price and
yield to maturity
the interest rate that equates the present value of payments received from a credit market instrument with its value today
Bond's annual coupon interest divided divided by purchase price; measure of a bond's return
when the coupon rate is higher than the interest rate, this is above par.
when the coupon rate is lower than the interest rate, it is below par value
is the price at which the issuing company may choose to repurchase a security before its maturity date. value of bond at which it is normally paid back at end of maturity
yield to call
The time until call replaces the time until maturity (call price replaces par value.
Premium bonds more likely to be called than discount bonds.
Forecast of bond returns based largely on prediction of yield curve at end of investment horizon
reinvestment rate risk
uncertainty surrounding cumulative future value of reinvested coupon payments
yield to maturity vs. holding period
yield to maturity measures the average rate of return if investment held until bond matures. Holding period is the rate of return over a particular investment period, depending on the market price a the end of the period.
STRIPS (Separate trading of registered interest and principal of securities
oversees the creation of a zero-coupon bond from coupon bearing notes and bonds.
investment grade bond
rated BBB and above by S&P or Baa and above by Moody's
speculative grade or junk bond
rated BB or lower by S&P, Ba or lower by Moody's, or unrated
Bond ratings class
First two are from standard & poor's and second two are from Moody's
Very high quality(AAA, AA, Aaa, Aa) High quality (A BBB, A, Baa) Speculative (BB, B, Ba, B) Very poor (CCC, D, Caa, C)
What determines bond safety?
Coverage ratios (company earnings to fixed costs) Leverage ratio (debt to equity)
Liquidity ratios [(Current: current assets and liabilities; Quick (assets excluding inventories to liabilities)]
Profitability ratios (measures rate of return on asset or equity)
Cash flow to debt ratio (total cash flow to outstanding debt
legal agreement between the bond issuers and bond investors
a company sets aside a certain sum of money each year to pay the debt, this money may be used to retire a few bonds each year, or it may be set aside to accumulate until the issue matures
Restriction on additional borrowing stipulating senior bond holder is paid first event of bankruptcy
Is an unsecured bond; no assets are specifically pledged to guarantee repayment as collateral
is the maximum possible yield to maturity of bond
The increment to promised yield that compensates the investor for default risk
credit default swaps CDS
financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit even
Forward rate is a term used in both bond and currency trading to represent the current expectations of future bond interest rates or currency exchange rates
According to the liquidity preference theory of the term structure of interest rates, an increase in the yield on long-term corporate bonds versus short-term bonds could be due to _______.
an increase in expected interest rate volatility
The price on a Treasury bond is 104:21, with a yield to maturity of 3.45%. The price on a comparable maturity corporate bond is 103:11, with a yield to maturity of 4.59%. What is the approximate percentage value of the credit risk of the corporate bond?
4.59%-3.45% = 1.14%
The price of a bond (with par value of $1,000) at the beginning of a period is $980 and at the end of the period is $975. What is the holding-period return if the annual coupon rate is 4.5%?
[45 + (975-980)]/980 = .0408 or 4.08%
A coupon bond that pays interest of 4% annually has a par value of $1,000, matures in 5 years, and is selling today at $785. The actual yield to maturity on this bond is
Use calculator and enter:
N = 5 1000 = FV -785 = PV 40 = PMT compute I/Y
A callable bond pays annual interest of $60, has a par value of $1,000, matures in 20 years but is
callable in 10 years at a price of $1,100, and has a value today of $1055.84. The yield to call on this
use calc to enter:
N = 10 1100 = FV -1055.84 = PV 60 = PMT compute I/Y = 6.000
You buy a bond with a $1,000 par value today for a price of $875. The bond has 6 years to maturity
and makes annual coupon payments of $75 per year. You hold the bond to maturity, but you do not
reinvest any of your coupons. What was your effective EAR over the holding period?
First you take 1000 + 6(75) = 1450 = FV
N=6 PV=-875 PMT = 0
compute I/Y => 8.7827
If the quote for a Treasury bond is listed in the newspaper as 99:08 bid, 99:11 ask, the actual price at
which you can sell this bond given a $10,000 par value is _____________.
[99+(08/32)/100] x 10,000 = 9925.00
Consider two bonds, A and B. Both bonds presently are selling at their par value of $1,000. Each
pays interest of $120 annually. Bond A will mature in 5 years, while bond B will mature in 6 years. If
the yields to maturity on the two bonds change from 12% to 14%, _________.
both bonds will decrease in value but bond B will decrease more than bond A
If you are holding a premium bond, you must expect a _______ each year until maturity. If you are
holding a discount bond, you must expect a _______ each year until maturity. (In each case assume
that the yield to maturity remains stable over time.)
capital loss; capital gain
TIPS offer investors inflation protection by ______________ by the inflation rate each year
increasing both the par value and the coupon payment
is a measure of a bond's sensitivity to interest rate changes. The higher the bond's duration, the greater its sensitivity to the change (also know as volatility) and vice versa.
Low Tech Company has an expected ROE of 10%. The dividend growth rate will be ________ if the firm follows a policy of paying 40% of earnings in the form of dividends.
.10 x (1-.4) = .06 or 6%
ROE x (1- Payout ratio %) = Dividend growth rate
(ROE = return on equity)
Music Doctors Company has an expected ROE of 14%. The dividend growth rate will be ________ if the firm follows a policy of paying 60% of earnings in the form of dividends.
ROE x (1- Payout ratio %) = Dividend growth rate
.14 x (1-.6) = .056 or 5.6%
Xlink Company has an expected ROE of 15%. The dividend growth rate will be _______ if the firm follows a policy of plowing back 75% of earnings.
Dividend Growth rate = ROE x Plowback
.15 x .75 = .1125 or 11.25%
The plowback ratio is a fundamental analysis ratio that measures the amount of earnings retained after dividends have been paid out.
Measures the amount of dividends that are paid out as a percentage of earnings.
PVGO (present value of growth opportunities)
Intrinsic value = (EPS / k) - PVGO
ROE - Required Rate of Return
(price per share - earnings) / K
K= required rate of return for the market capitalization rate
If PVGO is negative, then the company will ________, but its overall ROE will _________, and with it, its ________.
still grow; decline: stock price
Therefore, the company should distribute most of its earnings as _________, since that will yield the greatest return for _________.
Sum of Present Value of Future Cash Flows -OR- Sum of Present Value of Dividends + Present Value of Stock Sale Price
Capitalization Rate (K)
k = rf + B(ERM-rf)
Risk free + beta(Expected return on market - risk free rate)
Dividend Yield + Capital Gains Yield
The required rate of return (aka capitalization rate) is the rate of return required by investors to compensate them for the risk of owning the security.
This capitalization rate can be used to price a stock as the sum of its present values of its future cash flows in the same way that interest rates are used to price bonds in terms of its cash flows.
The price of a bond ________
is the sum of the present value of its future interest payments discounted by the market interest rate.
low coupon bonds are more ________
sensative to interest rates
as the years to maturity increases, the price of the bond is __________
time in years until bond is paid off
Duration (sensitivity to interest rate changes) always increases with _______
Maturity for bonds at or above par.
Zero-coupon bond duration is?
Time to maturity
when a coupon price is lower, the bonds _______ and interest rate _______ is higher
Duration of perpetuity (how much it pays forever)
(1+interest rate) / interest rate or (1+y) / y
A preferred stock will pay a dividend of $2.75 in the upcoming year, and every year thereafter, i.e., dividends are not expected to grow. You require a return of 10% on this stock. Use the constant growth DDM (Dividend discount model) to calculate the intrinsic value of this preferred stock.
$2.75 / .1 = $27.5
Intrinsic value = dividend / required rate of return
The curvature of the price-yield relationship of a bond
Why do investors like convexity
Bonds with greater curvature gain more in price when yield falls than they lose when yields rise.
more convexity = greater price increase.
Swapping a seemingly identical bond for one that is currently thought to be undervalued.
Switching from one segment of bond market to another
A company paid a dividend last year of $1.75. The expected ROE for next year is 14.5%. An appropriate required return on the stock is 10%. If the firm has a plowback ratio of 75%, the dividend in the coming year should be
ROE x plowback = 10.87%
$1.75 x (1 + .1087) = $1.94
Suppose that the average P/E multiple in the oil industry is 20. Dominion Oil is expected to have an EPS of $3.00 in the coming year. The intrinsic value of Dominion Oil stock should be ____
3 x 20 = 60
An analyst has determined that the intrinsic value of HPQ stock is $20 per share using the capitalized earnings model. If the typical P/E ratio in the computer industry is 25, then it would be reasonable to assume the expected EPS of HPQ in the coming year is _____.
$20 (1/25) = $0.80.
or 20/25 = .8
Risk Metrics Company is expected to pay a dividend of $3.50 in the coming year. Dividends are expected to grow at a rate of 10% per year. The risk-free rate of return is 5% and the expected return on the market portfolio is 13%. The stock is trading in the market today at a price of $90.00. What is the market capitalization rate (k) for Risk Metrics?
3.5/90 + .1 = .139 or 13.9%
The market capitalization rate on the stock of Flexsteel Company is 12%. The expected ROE is 13% and the expected EPS are $3.60. If the firm's plowback ratio is 50%, the P/E ratio will be _______
g = 13% × 0.5 = 6.5%; .5/(.12−.065) = 9.09
rate anticipation swap
Switch made in response to forecasts of interest rate changes - if rates may increase
pure yield pickup swap
Swapping low-coupon bonds into higher coupon bonds.
Swapping two similar bonds to receive a tax benefit.
A coupon bond which pays interest of $50 annually, has a par value of $1,000, matures in 5 years, and is selling today at a $84.52 discount from par value. The current yield on this bond is __________.
50/(1000-84.52) = 5.46%
A coupon bond which pays interest semi-annually, has a par value of $1,000, matures in 5 years, and has a yield to maturity of 8%. If the coupon rate is 10%, the intrinsic value of the bond today will be __________.
fv= 1000 10 = n 4 = i/y 50=pmt compute PV = 1081.1
You purchased a 5-year annual interest coupon bond one year ago. Its coupon interest rate was 6% and its par value was $1,000. At the time you purchased the bond, the yield to maturity was 4%. If you sold the bond after receiving the first interest payment and the bond's yield to maturity had changed to 3%, your annual total rate of return on holding the bond for that year would have been __________. (this exam probably wont be this hard)
total return comes from coupon and capital gain. First find out the price that you paid to buy:
V = 60/0.04[1-1/(1+0.04)5] + 1000/(1+0.04)^5 V = 1,089
Then find out the price that you can sell for: V = 60/0.03[1-1/(1+0.03)^4] + 1000/(1+0.03)^4 = V = 1,111.5
Total return = (1111.5+60-1089)/1089 = 7.58%
You wish to earn a return of 10% on each of two stocks, A and B. Each of the stocks is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends is 6% for stock A and 5% for stock B. Using the constant growth DDM, the intrinsic value of stock A __________.
Will be higher than the intrinsic value of stock B
DDM (Dividend Discount Models)
assumes that dividends will grow at a constant rate
DDM applies that a stock value is greater if....
There are larger dividends per share.
Lower market capitalization rate, k.
Higher expected growth rate of dividends.
Two stage DDM
dividend discount model in which dividend growth is assumed to level off only at some future date
Multistage growth models
allow dividends per share to grow at several different rates as firm matures
ratio of P/E multiple to earnings growth rate
Riskier stocks have ______ P/E multiples, and ________ required RoR, k
The planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income.
how to estimate stock at horizon date
combine P/E analysis and the DDM
Price to book
indicates how aggressively market values firm
Price to sales
this is for start ups with no earnings
FCFF (free cash flow for firm)
EBIT (1-corporate tax rate) + depreciation - capital expenditures - increase NWC (net working capital)
FCFE (free cash flow to equity holders)
FCFF - Interest expense x (1-Tc) + increases in net debt
a contract for buying stock at a particular price until a specified future date
predetermined also known as exercise price
purchase price of an option
the right to sell an asset at a specified exercise price on or before a specified expiration date
in the money
an option where exercise would generate a positive cash flow
out of the money
an option which, if exercised, would produce a negative cash flow, for this reason they are never exercised
at the money
An option where the exercise price equals the asset price
options: most trading occurs on _______
organized exchanges. (ease of trading and liquid secondary market)
can be exercised on or before its expiration
can be exercised only at expiration
option clearing corporation
The clearinghouse for options trading, jointly owned by the exchanges on which the stock options are traded. requires option writers to post margin.
call/put based on stock market index
Similar to regular options, but the deliverable is just a futures contract (instead of an asset or commodity)
Holder has right to buy or sell a futures contract using a futures price as the exercise price. Cash settlement is used
Foreign currency options
a contract giving the option purchaser (the buyer) the right, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period (until the maturity date)
interest rate options
Traded on fixed income securities like Treasuries, CDs. Options on several interest rate futures are also traded
Own the underlying and own a put. Provides downside protection while retaining the upside potential
Writing a call on an asset together with buying the asset
a combination of a call and a put, each with the same exercise price and expiration date. (you are hoping the stock fluctuates in either direction more than the option price)
strategy: a combination of 2 or more calls (or 2 or more puts) on the same stock w differing exercise prices or times to maturity
strategy: brackets the value of a portfolio between 2 bounds. buy shares of the stock, buy protective puts, and sell calls against the holding
Bonds that the issuing company can redeem (buy back) at a stated dollar amount prior to maturity.
gives bondholder or preferred stockholder the right to exchange the bond or preferred stock for a fixed number of shares of common stock
option issued by firm to purchase shares of firms stock
loan arrangements that require the borrower to put up collateral to guarantee the loan will be paid back. nonrecourse loan
leveraged equity and risky debt
Any time corporation borrows money, maximum possible collateral for loan is total of firm's assets
Payoff profiles based on the average price of the security over the life of the option
Currency translated options
Have either asset or exercise price denominated in foreign currency
Have fixed payoffs that depend on whether a condition is satisfied by the price of the underlying assets
the stock price minus the exercise price. profit that could be attained by immediate exercise of the money call option
difference between the options price and the intrinsic value
Premium - intrinsic value
hedge ratio or delta
The number of shares of stock required to hedge the price risk of holding one option
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