Bond Valuation and Pricing Concepts
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Questions and Answers

What is the first step to set up the calculator for annual compounding?

Press 2nd P/Y, enter 1, and then press Enter.

What must you do to clear the memory of the calculator before entering new data?

Press 2nd and then CLR TVM.

What is the formula used to find the interest rate (I/Y) in the given example?

I/Y = 7.5689%

What is the face value of the bonds mentioned in Example 5?

<p>$1,000</p> Signup and view all the answers

What price should the company charge for zero-coupon bonds with a face value of $1,000?

<p>-$362.45</p> Signup and view all the answers

Face value and par value are synonymous terms.

<p>True</p> Signup and view all the answers

To determine the value of a bond at a particular point in time we use the yield to maturity, which is the market interest rate at that time for bonds with similar features.

<p>True</p> Signup and view all the answers

The value of a bond equals to the sum of the..........................of both the future................and the........................

<p>Present value; coupon payments; face value</p> Signup and view all the answers

A bond coupon payments are calculated based on the.....................when the bond is issued. However, bond valuation requires that we determine the......................

<p>Coupon rate; yield to maturity</p> Signup and view all the answers

All other things being equal, the longer the time to maturity, the...............interest rate risk, and the lower the coupon rate, the......................the interest rate risk.

<p>Greater; greater</p> Signup and view all the answers

Among the following bonds, which one has a price that is most sensitive to changes in interest rate?

<p>A 30-year, zero coupon</p> Signup and view all the answers

The yield to maturity for a bond is the bond's.................. When the market value of the bond is equal to its face value, the yield to maturity should be equal to the.................

<p>Rate of return; coupon rate</p> Signup and view all the answers

If a bond is................, the company's registrar mails the interest payment to the owner of record. However,.......................

<p>Registered; bearer</p> Signup and view all the answers

A premium bond is a bond that:

<p>Has a market value greater than the par value</p> Signup and view all the answers

When the yield to maturity is lower than the coupon rate, the bond should be:

<p>Premium bond</p> Signup and view all the answers

A bond selling for less than the face value is a...................; and a bond with the yield to maturity higher than the coupon rate is..........................

<p>Discount bond; premium bond</p> Signup and view all the answers

The written agreement between the corporation and the lender detailing the terms of the debt issue is called the bond:

<p>Indenture</p> Signup and view all the answers

A..................is an unsecured debt that generally matures in less than ten years; a..........................is an unsecured debt that generally matures in ten years or more.

<p>Note; debenture</p> Signup and view all the answers

The profit that a securities dealer earns from the purchase and the subsequent sale of a security is called:

<p>Spread</p> Signup and view all the answers

The Fisher effect addresses the relationship between:

<p>Nominal rates, real rates, and inflation rates</p> Signup and view all the answers

.......................is the right of the bond's issuer to repurchase the bond at a predetermined price prior to maturity. However, the......................is the provision prohibiting the company from redeeming the bond prior to a certain date.

<p>Call provision; deferred call provision</p> Signup and view all the answers

The account managed by the bond trustee for the purpose of the early bond redemption is the:

<p>Sinking fund</p> Signup and view all the answers

.....................governs priority of payment to creditors in the event of bankruptcy. A debt is........................when creditors must be repaid first.

<p>Subordination; senior</p> Signup and view all the answers

A...........................allows the issuer to repurchase the bond debt issue prior to maturity. In most cases, the call price will be equal to the..............................of the bond plus a............................

<p>Call provision; face value; call premium</p> Signup and view all the answers

When a bond cannot be called for a number of years after issue; this is a...", and the bond is.....................during this period.

<p>Deferred; call protected</p> Signup and view all the answers

A..................restricts actions of the bond issuer. A......................restricts the issuer actions, whereas a..................requires that certain actions be taken by the corporation.

<p>Protective covenant; negative covenant; positive covenant</p> Signup and view all the answers

The bond-ratings of Moody's and Standard and Poor's are concerned only with the possibility of...................; these bond ratings do not address the volatility of the bond price due to........................

<p>Default; interest rate risk</p> Signup and view all the answers

Bonds are rated according to the likelihood of................; high ratings indicate................probability of default.

<p>Default; low</p> Signup and view all the answers

A.......................bond makes no coupon payments and is initially priced at a deep discount from par value. A.........................bond has adjustable coupon payments, which are tied to a specific index.

<p>Zero-coupon; floating-rate</p> Signup and view all the answers

The coupon payments of a.....................bond are paid only when the firm's income is sufficient to do so. A.............Bond can be swapped (exchanged) for a fixed number of stocks.

<p>Income; convertible</p> Signup and view all the answers

A.....................bond have no default risk. A..................bond carries some default risk and is exempt from federal income taxation.

<p>Treasury; municipal</p> Signup and view all the answers

Most bond trading takes place..................., therefore it is.............to obtain data on bond prices and volumes and the bond market is considered..................

<p>Over the counter; difficult; not transparent</p> Signup and view all the answers

The price of a bond quoted net of accrued interest is the...................price; the price which includes accrued interest (and which the buyer actually pays) is the..................price.

<p>Clean; dirty</p> Signup and view all the answers

.................rates are 'observed' rates, since they are what we observe in the financial markets; these rates are not adjusted for inflation. However,................rates are rates that have been adjusted for inflation.

<p>Nominal; real</p> Signup and view all the answers

The observed relationship between short-term and long-term interest rates is known as the.....................; it is depicted graphically as the.......................

<p>Term structure of interest rates; yield curve</p> Signup and view all the answers

The........................is the portion of a nominal rate that represents compensation for unfavorable tax status. The................is the portion of a nominal rate that represents compensation for illiquidity.

<p>Taxability premium; liquidity premium</p> Signup and view all the answers

The compensation investors require to offset expected future increases in prices is generally called:

<p>Inflation premium</p> Signup and view all the answers

The portion of a bond's yield that investors require to compensate for the possibility that the bond's interest or principal might not be paid is called:

<p>Default risk premium</p> Signup and view all the answers

A par value bond is a bond having the following features: I.yield to maturity equals the coupon rate II.market price lower than the face value III.market price equal to the face value.

<p>I and III only</p> Signup and view all the answers

The current yield on a bond is defined as:

<p>The bond annual coupon divided by the current price</p> Signup and view all the answers

The yield to maturity of a bond is also the bond:

<p>Nominal rate</p> Signup and view all the answers

The interest rate risk premium is the compensation that investors require for their assumption of the risk related to:

<p>Changes in interest rates</p> Signup and view all the answers

The relationship between the nominal interest rates on default-free, pure discount securities and time to maturity; that is, the pure time value of money is called the:

<p>Term structure of interest rates</p> Signup and view all the answers

A.............................bond is a bond that pays fixed coupon payments at regular periods of time. A........................bond is a bond that is sold at a deep discount and it makes only one payment at maturity.

<p>Level-coupon; zero-coupon</p> Signup and view all the answers

A.........................is an unsecured bond, for which no specific pledge of property is made.

<p>Debenture</p> Signup and view all the answers

A bond that was previously rated as investment grade but has been downgraded to a junk bond status is called a:

<p>Fallen angel</p> Signup and view all the answers

A bond that has the features of both debt and equity, and can be exchanged for shares of stock of the issuing firm is called:

<p>Convertible bond</p> Signup and view all the answers

A bond that gives the bondholder the right to force the issuer to purchase the bond at a stated price is called:

<p>Put bond</p> Signup and view all the answers

Which one of the following statements are correct about bond market? I. Bond market is less transparent than stock market II. Bonds are generally bought from and sold to electronically-connected dealers III. Getting up-to-date prices on individual bonds is often difficult.

<p>I, II and III</p> Signup and view all the answers

The dirty price of a bond includes which of the following? I. Quoted price II. Bid price III. Accrued interest

<p>I and III</p> Signup and view all the answers

A corporate bond with a $1,000 face value quoted as 102.78 sells for................... and a $1,000 face value treasury bond quoted as 97:09 sells for:

<p>$1,027.80; $972.8125</p> Signup and view all the answers

When investors expect that interest rates in the future to be higher than the current interest rates, the graph depicting the term structure of interest rates will be:

<p>Upward-sloping</p> Signup and view all the answers

Which of the following bonds is expected to have a higher taxability premium?

<p>Corporate bond</p> Signup and view all the answers

A bond with a $1,000 face value is currently quoted as 98.42. The bond pays semi-annual payments of $45 and matures in 6 years. What is the coupon rate?

<p>9 percent</p> Signup and view all the answers

A bond with 7.5 coupon rate has a yield to maturity of 8%, 25 years to maturity, a $1,000 face value, and pays interest semi-annually. What is the amount of each coupon payment?

<p>$75.00</p> Signup and view all the answers

Last year, your bond investment has earned you an 8.25% rate of return. During that time the inflation rate was 1.75%. What is your real rate of return?

<p>6.39 percent</p> Signup and view all the answers

Last year, your bond investment has a 5.05% real rate of return and during that time the inflation rate was 3.25%. What is your actual nominal rate of return?

<p>8.3 percent</p> Signup and view all the answers

Study Notes

Face Value and Par Value

  • Face value and par value of a bond are the same thing.

Bond Valuation

  • The value of a bond is determined by the present value of all of its future cash flows, which include coupon payments and the face value.
  • The yield to maturity (YTM) is the market interest rate at a particular point in time for bonds with similar features.

Bond Coupon Payments

  • Bonds have coupon payments based on a coupon rate, determined when the bond is issued.
  • When valuing a bond, the market's required rate of return, referred to as the yield to maturity, is used, not the coupon rate.

Interest Rate Risk

  • The longer the time to maturity, the greater the interest rate risk.
  • The lower the coupon rate, the greater the interest rate risk.
  • Bonds with longer maturities and lower coupon rates have prices that are more sensitive to changes in interest rates.

Bond Pricing

  • When a bond is priced at par value, the yield to maturity equals the coupon rate.

Bond Types

  • A registered bond is a bond where the company's registrar mails the interest payment directly to the owner of record.
  • A bearer bond has coupons attached to it. The bondholder detaches a coupon and mails it to the firm to receive the interest payment.
  • A premium bond sells for more than par value (face value). The YTM is lower than the coupon rate.
  • A discount bond sells for less than par value. The YTM is higher than the coupon rate.

Bond Indenture

  • The indenture is the written agreement between the corporation and the lender detailing the terms of the debt issue.
  • A note is an unsecured debt that generally matures in less than ten years.
  • A debenture is an unsecured debt that generally matures in ten years or more.

Securities Dealer Profit

  • The profit a securities dealer earns from the purchase and subsequent sale of a security is called the spread.

Fisher Effect

  • The Fisher effect addresses the relationship between nominal rates, real rates, and inflation rates.

Callable Bonds

  • A call provision gives the bond's issuer the right to repurchase the bond at a predetermined price before maturity.
  • A deferred call provision prohibits the company from redeeming the bond before a certain date.

Sinking Fund

  • A sinking fund is an account managed by the bond trustee for the purpose of early bond redemption.

Bond Seniority

  • Seniority governs priority of payment to creditors in the event of bankruptcy.
  • A debt is subordinated when creditors must be repaid after senior creditors.

Protective Covenants

  • A protective covenant restricts actions of the bond issuer.
  • A negative covenant limits the issuer's actions.
  • A positive covenant requires certain actions to be taken by the corporation.

Bond Ratings

  • Moody's and Standard & Poor's bond ratings assess the likelihood of default, not price volatility due to interest rate risk.
  • Higher bond ratings indicate a lower probability of default.

Bond Types

  • A zero-coupon bond makes no coupon payments and is initially priced at a deep discount to par value.
  • A floating-rate bond has adjustable coupon payments tied to a specific index.
  • An income bond pays coupons only when the firm's income is sufficient to do so.
  • A convertible bond can be swapped (exchanged) for a fixed number of stocks.

Bond Market

  • Most bond trading takes place over the counter, making it difficult to obtain data on bond prices and volumes.
  • The bond market is considered not transparent.

Bond Pricing Types

  • The clean price of a bond is quoted net of accrued interest.
  • The dirty price of a bond includes accrued interest and is the price the buyer actually pays.

Interest Rates

  • Nominal rates are observed rates in financial markets and are not adjusted for inflation.
  • Real rates have been adjusted for inflation.

Term Structure of Interest Rates

  • The term structure of interest rates is the relationship between short-term and long-term interest rates.
  • The term structure is depicted graphically as the yield curve.

Yield Curve Components

  • The taxability premium is the portion of a nominal rate that compensates for unfavorable tax status.
  • The liquidity premium is the portion of a nominal rate that compensates for illiquidity.
  • The inflation premium compensates investors for expected future increases in prices.
  • The default risk premium is the portion of a bond's yield that investors require to compensate for the possibility of interest or principal not being paid.
  • The interest rate risk premium compensates investors for assuming the risk related to changes in interest rates.

Bond Characteristics

  • A par value bond has a yield to maturity equal to the coupon rate and its market price is equal to its face value.

Bond Yield Measures

  • The current yield is the bond's annual coupon divided by its current price.
  • The yield to maturity is the overall rate of return an investor can expect to earn if they hold the bond until maturity, accounting for future coupon payments and the face value.

Bond Market Transparency

  • Bond markets are generally less transparent than stock markets.
  • Bonds are mostly bought from and sold to electronically-connected dealers.
  • Getting up-to-date prices on individual bonds is difficult.

Bond Pricing

  • The dirty price of a bond includes both the quoted price and accrued interest.

Interest Rate Expectations

  • When investors expect future interest rates to be higher than current rates, the term structure of interest rates (yield curve) will be upward sloping.

Bond Taxability

  • Corporate bonds are expected to have a higher taxability premium than treasury bonds due to the higher tax liability.

Bond Price Calculation

  • The price of a bond is calculated by discounting all its future cash flows back to the present value. This involves using the yield to maturity as the discount rate.

Bond Coupon Payments

  • The coupon payment is a fixed percentage of the bond's face value, paid periodically (usually semi-annually).

Real Interest Rate

  • The real rate of return can be calculated by subtracting the inflation rate from the nominal rate of return.

Bond Market Overview

  • The bond market is a large and diverse market where bonds are traded. While it is not as transparent as the stock market, it plays a crucial role in financing businesses and governments.
  • Understanding the various types of bonds, their features, and how they are valued is essential for investors and financial professionals.

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Description

This quiz explores important concepts related to bond valuation, including face value, coupon payments, and interest rate risk. Test your understanding of how yield to maturity affects bond pricing and the significance of coupon rates in the valuation process.

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