Finance Chapter on Bonds and Stocks
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Questions and Answers

What is the primary characteristic that differentiates convertible bonds from nonconvertible ones?

  • Convertible bonds have higher coupon rates.
  • Convertible bonds can be exchanged for stock. (correct)
  • Convertible bonds offer fixed coupon payments.
  • Convertible bonds have shorter maturity periods.
  • Under what condition is it more profitable for bondholders to convert their convertible bonds into shares?

  • When the stock price is £30. (correct)
  • When the stock price is £40.
  • When the stock price is £20.
  • When the stock price is £10.
  • What do puttable bonds allow bondholders to do?

  • Convert the bond into stock anytime.
  • Reclaim the principal only after a specified number of years.
  • Extend the life of the bond under certain conditions. (correct)
  • Change the interest rate on the bond.
  • What is a significant risk associated with floating-rate bonds?

    <p>Their interest rates may not adjust according to the firm’s financial condition.</p> Signup and view all the answers

    How do preferred stockholders rank compared to common stockholders and bondholders when it comes to dividend distribution?

    <p>Preferred stockholders rank higher than common stockholders but below bondholders.</p> Signup and view all the answers

    What happens if a company fails to pay preferred stock dividends?

    <p>The dividends owed will accumulate over time.</p> Signup and view all the answers

    What describes the market conversion value of a convertible bond?

    <p>The potential value of the bond if converted to shares at current stock price.</p> Signup and view all the answers

    Which of the following is an advantage of floating-rate bonds?

    <p>They pay interest rates that reset periodically.</p> Signup and view all the answers

    What does the current yield of a bond consider?

    <p>The bond’s current price and coupon payments</p> Signup and view all the answers

    Which of the following is NOT a limitation of the Holding Period Return (HPR)?

    <p>It reflects both coupon payments and capital gains/losses</p> Signup and view all the answers

    How is Yield to Maturity (YTM) best defined?

    <p>The present value of future cash flows discounted at the bond's price</p> Signup and view all the answers

    What key factor does Yield to Maturity assume regarding coupon payments?

    <p>Coupons are reinvested at the same rate as YTM</p> Signup and view all the answers

    What is a major drawback of calculating Yield to Maturity?

    <p>It requires knowledge of future price changes</p> Signup and view all the answers

    What is the primary factor affecting the Yield to Maturity (YTM) of a bond?

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

    When a bond's current yield is greater than its YTM, what does this indicate about the bond's price relative to par value?

    <p>The bond’s price is lower than par value</p> Signup and view all the answers

    What is one primary feature of callable bonds?

    <p>They allow issuers to repurchase the bond before maturity.</p> Signup and view all the answers

    What happens to a premium bond if held to maturity?

    <p>It results in a capital loss</p> Signup and view all the answers

    What does the term 'discount bond' refer to?

    <p>A bond that provides lower coupon payments</p> Signup and view all the answers

    Which characteristic distinguishes convertible bonds from other bond types?

    <p>They allow bondholders to exchange bonds for shares of the firm.</p> Signup and view all the answers

    Why might a company choose to issue callable bonds?

    <p>To allow the company to repurchase the bond at a lower market rate.</p> Signup and view all the answers

    Which statement best describes the holding period return?

    <p>It considers both income and capital gains or losses.</p> Signup and view all the answers

    What is a key reason bond prices move towards par value as maturity approaches?

    <p>The time value of money stabilizes</p> Signup and view all the answers

    What type of bonds are tax-free at the interest payment level?

    <p>Municipal bonds</p> Signup and view all the answers

    In a competitive market, what must bonds of the same maturity and risk profile provide?

    <p>The same fair rate of return</p> Signup and view all the answers

    Which company issued a bond with a 100-year maturity that can be redeemed in 30 years?

    <p>Walt Disney</p> Signup and view all the answers

    If a bond has 60 semi-annual coupon payments remaining, how can we determine its interest rate?

    <p>By setting the present value of cash flows equal to its current price</p> Signup and view all the answers

    Which of these statements about bonds is true?

    <p>Most corporate bonds have a maturity period between 7 to 30 years.</p> Signup and view all the answers

    What is the conversion ratio in convertible bonds?

    <p>The par value of the bond divided by the conversion price.</p> Signup and view all the answers

    What is a major drawback for investors when bonds are called?

    <p>They can no longer earn interest on the bond.</p> Signup and view all the answers

    What happens to a bond's price that is currently trading at a premium as time passes?

    <p>The price will decrease.</p> Signup and view all the answers

    What do zero-coupon bonds typically sell for before maturity?

    <p>At a discount from par value.</p> Signup and view all the answers

    How is the price of a zero-coupon bond calculated?

    <p>By dividing the par value by $(1 + r)^n$.</p> Signup and view all the answers

    Which property is NOT true for a list?

    <p>Lists are immutable.</p> Signup and view all the answers

    What is a characteristic of negative indexing in Python lists?

    <p>It allows access to elements starting from the end of the list.</p> Signup and view all the answers

    What is the primary return for investors in zero-coupon bonds?

    <p>Price appreciation upon maturity.</p> Signup and view all the answers

    What does the variable 'r' represent in the zero-coupon bond pricing formula?

    <p>The interest rate applicable to the bond.</p> Signup and view all the answers

    Which statement about lists in Python is correct?

    <p>Elements can be accessed using their index.</p> Signup and view all the answers

    What components make up the discount rate used to compute present value in bond pricing?

    <p>Risk-free rate, expected inflation premium, and risk-premium</p> Signup and view all the answers

    If a bond has a coupon rate of 8% and pays coupons semi-annually, how much is each payment if its par value is $1,000?

    <p>$40</p> Signup and view all the answers

    What is the bond price when the market interest rate equals the coupon rate?

    <p>Equal to the par value</p> Signup and view all the answers

    In the formula for bond pricing, what does the term 'Coupon x Annuity factor(r,T)' represent?

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

    What is the appropriate formula to calculate the present value of the par value of a bond?

    <p>Par Value / (1 + r)^T</p> Signup and view all the answers

    How many total coupon payments are made for a bond with a maturity of 30 years and semi-annual payments?

    <p>60</p> Signup and view all the answers

    When annual market interest rate is 8% for a bond with an 8% coupon rate, what is the yield effect on the bond's market price?

    <p>The price remains at par value</p> Signup and view all the answers

    What formula would you use to calculate the bond price when given the coupon payment and market interest rate?

    <p>Coupon x Annuity factor(r,T) + Par Value x (1 / (1 + r)^T)</p> Signup and view all the answers

    Study Notes

    Bond Definitions and Terminology

    • A bond is a security issued for borrowing arrangements.
    • The borrower sells bonds to lenders for cash.
    • The issuer agrees to make payments (coupons) to the bondholder.
    • At maturity, the nominal value is repaid.

    Bond Terminology

    • Par value (face or nominal value): The payment to the bondholder at maturity.
    • Coupon rate: The bond's interest payments relative to its par value.
    • Bond indenture: The contract between the issuer and bondholder.
    • Accrued interest: The prorated share of an upcoming coupon payment when a bond is purchased between coupon payments.

    Bond Coupons

    • A bond with a par value of $1,000 and an 8% coupon rate may sell for $1,000.
    • The bondholder is entitled to 8% of the par value (or $80 per year) for the bond's life.
    • Payments are usually in two semi-annual installments.
    • At maturity, the issuer repays the par value ($1,000).

    Bonds as a Form of Debt

    • Bonds are a form of debt.
    • Interest payments are tax-deductible for firms.
    • Issuers are borrowers, while bond buyers are lenders.
    • Bonds offer borrowers access to a larger pool of lenders, which leads to better pricing.
    • Bonds can easily be traded in the secondary market.
    • Bonds have more standardized payment structures compared to bank loans.

    Bond Prices

    • Bonds are often issued at par (the price equals the par value).
    • Zero-coupon bonds are sold at a discount.
    • Bond prices depend on market conditions after issuance.

    Accrued Interest Example

    • Suppose an 8% bond with $40 semi-annual coupon payments has 30 days since the last coupon payment.
    • The accrued interest would be $6.59.
    • Invoice price = flat price + accrued interest

    How Bonds are Traded

    • Primary market issuance: Governments and corporations issue bonds to raise capital.
    • Secondary market trading: Bonds are typically traded among investors in the over-the-counter (OTC) market after initial issuance.
    • Dealers buy and sell bonds from their own inventory, providing liquidity to the market.
    • Many bonds are traded OTC, rather than formal exchanges.

    Bond Types by Issuer

    • Government bonds (US Treasury notes and bonds; other countries have similar bond types.): Government bonds are generally considered safe investments because they are backed by the government.
    • Agency bonds: Issued by government agencies or mortgage-related agencies.
    • Municipal bonds: Issued by local government institutions; interest payments are often tax-free.
    • Corporate bonds: Issued by corporations; Maturity duration is usually a range from 7 to 30 years, but there are also longer term options.

    Bond Types by Characteristics

    • Callable bonds: Allow the issuer to repurchase the bond at a specific call price before the maturity date.
    • Convertible bonds: Allow the bondholder to exchange a bond for a specified number of the firm's shares.
    • Puttable bonds: Give bondholders the option to exchange the bond for its par value at a specified date or to extend the bond's life.
    • Floating-rate bonds: Adjust the interest rate periodically according to a prevailing market rate.
    • Preferred stock: Considered an equity investment, but frequently included within fixed income, as it typically pays a fixed dividend.

    International bonds

    • Foreign bonds: Issued by a borrower from a country other than where the bond is sold. Denominated in the currency of the country where it's marketed.
    • Eurobonds: Denominated in one currency, and sold in other national markets.

    Innovation in the Bond Market

    • Inverse floaters: Coupon rates move in the opposite direction of general interest rate movements.
    • Asset-backed bonds: Income from a specified group of assets is used to service the debt.
    • Catastrophe (CAT) bonds: A form of insurance securitization where investors receive higher coupon rates for taking on risk; bondholders lose all or part of their investment in the event of a catastrophe.

    Indexed bonds

    • Indexed bonds make payments tied to a general price index or a commodity's price.
    • Examples include Treasury Inflation-Protected Securities (TIPS).

    Credit Risk

    • Credit risk (default risk): The risk that a bond will not repay all promised payments.
    • Rating companies: Moody's, Standard & Poor's, and Fitch.
    • Rating categories: AAA (or Aaa) to lower ratings (speculative-grade bonds or junk bonds)
    • Determines of bond safety: Coverage ratios, leverage ratios, liquidity ratios, profitability ratios, and cash flow to debt ratios.
    • Bond indentures: Set of restrictions (protective covenants) that safeguard bondholders from default. These may include sinking funds, subordination clauses, dividend limitations, and collateralization.
    • Credit spread: The difference between the yield-to-maturity (YTM) of a corporate bond and the YTM of an otherwise identical government bond.

    Bond Pricing

    • Bond value is the present value of its cash flows.
    • Discount rate encompasses the risk-free rate, expected inflation premium, and risk premium; it used to compute the present value.
    • Bond pricing and the coupon rate and market interest rate relationship: Bonds sell at par if the coupon rate equals the market interest rate; if the coupon rate is lower, the bond sells at a discount; if higher, the bond sells at a premium.

    Bond Profitability Measures

    • Total bond return: The overall return from holding a bond over a period. It’s the sum of income component (periodic coupon payments) and capital gains or losses (difference between purchase and sale prices, or face value at maturity).
    • Current yield: Annual coupon payment divided by the current bond price; simple measure of profitability, but ignores capital gains and losses.
    • Holding period return (HPR): The rate of return over a particular holding period; depends on the bond’s price at the end of the period and is difficult to compare across different bonds with different holding periods and maturities; the rate of return is only forecastable.
    • Yield to maturity (YTM): The interest rate that equates the present value of a bond's payments to its price; most commonly used measure of bond profitability; it assumes that coupon payments will be reinvested at the same yield.

    Bond Prices Over Time

    • Bond prices generally converge to par value at maturity.
    • Premium bonds often have higher coupon payments but may result in capital losses if purchased above par and held to maturity.
    • Discount bonds offer lower coupon payments, but the potential for capital gains as the price rises to maturity.

    Zero-Coupon Bonds

    • Zero-coupon bonds only pay a lump sum at maturity.
    • US Treasury Bills are an example. Zero coupon's price falls during the time until maturity, owing to the time value of money.

    Python Lists and For-Loops

    • Lists: Ordered, modifiable collections of mixed datatypes.
    • For-loops: Repeatedly execute a block of code for items in sequences or iterables (e.g., lists). They are used to automate repetitive tasks and are useful when dealing with a large number of items.

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    Description

    This quiz covers key concepts related to bonds and preferred stocks, including convertible and floating-rate bonds. Test your understanding of bondholder rights, risks, and financial calculations like Yield to Maturity. Perfect for finance students seeking to solidify their knowledge in investment securities.

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