3. Applications of discounted cash flow valuation and bond valuation Flashcards
What is a perpetuity?
A regular stream of cash flows that never ends.
What is an annuity?
A level stream of cash flows that last for a fixed number of periods.
What is a bond?
A certificate showing that a borrower owes a specified sum.
What is the maturity (or maturity date) of a bond?
The date when the issuer of a bond makes the last payment.
What is the par value of a bond?
The par/face value or principal of a bond is the payment at maturity. It does not account for the time value of money.
What are pure discount bonds and what are they also known as?
Pure discount (a.k.a. zero coupon) bonds are bonds with no interest. The borrower only pays the face value/principal at maturity.
What are level coupon bonds?
Bonds with interest/coupons. You receive interest in the form of a coupon (payment) per stated time period and the face value/principal at maturity.
What are consols?
Bonds with no maturity (perpetuity). You receive interest indefinitely.
What is a par bond?
A bond for which the coupon rate is the same as the current interest rate.
I.e., a bond that currently trades at its face value.
What is a discount bond? Why is it called that?
A bond whose coupon rate is less than the current interest rate. If the relevant interest rate increases during a bond’s lifetime, the bond will be selling at a discount because the principal and interest rate will remain fixed but the present value will be lower as the discount rate has increased.
What is a premium bond?
A bond with a coupon rate greater than the current interest rate. This is the vice versa case of the discount bond. The bond sells at a premium.
How are bond prices affected by change in interest rates?
A bond’s price will fall with a rise in interest rates, and rise with a fall in interest rates.
What is yield to maturity (YTM)?
The internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate. The total expected return if it is held until its maturity date.
The rate of return an investor would expect to get if they invested in something else of comparable risk available in the market. The discount rate used in bond present value calculations.
How is yield to maturity affected by bond price?
If the present value (market value/price) of a bond increases, the yield to maturity decreases.
