1) Bond Prices and yields (Chapter 14)

Question 1

What is a bond?

Answer 1

A long term debt instrument used for raising long term finance

Question 2

What does the borrower/issuer pay? (2)

Answer 2

Pays interest and the principal amount

Question 3

What does the lender/investor receive? (2)

Answer 3

Receives coupons & the principal amount

Question 4

Why study bonds? (4)

Answer 4

1. It’s a big market: Bigger than equities from a global point of view
2. It’s an important source of finance :Especially to those institutes that can’t issue equities, Government.
3. Diversification option
4. Offers attractive returns :Sometimes better than equities

Question 5

What is the current repo rate?

Answer 5

8.25%

Question 6

What is the prime lending rate?

Answer 6

11.75%

Question 7

What is the difference between a loan and a bond? (2x2)

Answer 7

Loan:
1) Cannot be traced
2) Can be paid immediately

Bond:
1) Can be traced on secondary market
2) Cannot be settled immediately

Question 8

What occurs during a bond transaction?

Answer 8

At bond issuance date:
- Investor pays issuer the bond selling price
- Issuer hands over bond certificate
In subsequent periods:
-Issuer pays investor coupon/interest payments
- Issuer pays investor the principal at end of bond term

Question 9

What are the features of the face value (par, principal, nominal, redemption) of a bond? (4)

Answer 9

• Set by company & fixed
• Paid/received when bond matures
• Determine coupon payment
• Function of how much company want to raise

Question 10

What are the features of the time to maturity? (3)

Answer 10

• Set by the company & fixed
• Shows lifespan of the bond
• Function of company’s financial position to pay the face value

Question 11

What are the features of coupon rates and payments? (3)

Answer 11

• Rate determines the payments
• Coupon payment = Coupon Rate × Face Value
• Set by company & fixed

Question 12

What are the features of yield to maturity (Discount rate, interest rate, Required rate of return) (YTM) ? (3)

Answer 12

• Represents the return required by investors on the bond
• Used as a discount rate
• Fluctuates with market conditions

Question 13

What are the features of price (intrinsic value, fair value) ? (5)

Answer 13

• What you pay to buy the bond
• Used as a discount rate
• Fluctuates with market conditions
• Price not always = to face value
• Issuer will always try ensuring that it is by setting coupon rate = to YTM
• PV of coupon payments and face value

Question 14

Where do you get the YTM or how do investors come up with it?

Answer 14

Similar instruments
▪ Similar maturity, risk profile, interest bearing

Question 15

Why is YTM always fluctuating? (2)

Answer 15

Driven by the level of interest rates & interest rate changes:
- Interest rates increase, YTM also increase (directly proportional)
- Bonds are interest bearing instruments ; affected by interest rate changes (General level of interest rates increases bond yields also increase)

Question 16

What is the key driver of interest rate changes? (3)

Answer 16

1) The repo rate changes by central bank
2) default risk
3) political risk

Question 17

Define the repo rate (2)

Answer 17

• The repo rate is the interest rate at which the Reserve Bank of South Africa lends money to
  commercial banks.
• The repo rate is key benchmark interest rates in SA.

Question 18

How does increasing the repo rate defend the exchange rate? (4)

Answer 18

• An increase in the repo rate means the cost of borrowing money increases. That leads to less expenditure.
• In general, when inflation is high, it makes a currency weaker, suppressing investment, and thus negatively impacting the exchange rate.
• When inflation is low, a currency is stronger, improving its exchange rate.
• Therefore, an increase in repo rate is done to control inflation and ultimately defend the rand

Increase in repo rate -> Increase in borrowing costs ->less expenditure

Question 19

How is foreign investment impacted by the repo rate? (3)

Answer 19

Foreign investment through increase yields from repo rate changes:

• Higher interest rates in a country can increase the value of that country’s currency relative to nations offering lower interest rates.
• In order to get local interest-bearing instruments, they need to convert to local currency which raises the demand and with that the exchange rate for local currency

Increase in yield -> Higher interest rate -> Increased demand -> Appreciation of local currency

Question 20

Define the prime rate

Answer 20

Also known as the prime lending rate, the prime rate is the interest rate at which commercial banks lend to their most credit worthy clients or prime clients.

Question 21

In South Africa the prime rate is a function of the repo rate plus a spread of ____%.

Answer 21

3.5%

Question 22

What is the relationship between repo and prime rate? (2)

Answer 22

• Bond interest rates are typically linked to prime so that banks can maintain their profit margins if the Reserve Bank changes the repo rate.
• If the repo rate goes up, prime goes up, and the amount you pay on your bond climbs. If the repo rate goes down, prime goes down, and you get to share in those savings. (Directly proportional)

Question 23

What is a Hawkish stance? (2)

Answer 23

o The financial world has come to associate the hawk with aggressive monetary policy that favours higher interest rates in order to curb inflation.
o A hawkish Federal Reserve makes policy decisions that strive to reduce rising prices, maintain healthy levels of employment, and thus avoid recession.

Question 24

What is a Dovish stance? (2)

Answer 24

• Dovish (or accommodative) policy is the opposite of hawkish and favours expansionary monetary policy to achieve maximum levels of employment.
• This is done by cutting down the repo rate.