4) Bond valuation Flashcards
Chapter 14
What is bond valuation?
The process involves finding the present value of the future benefits (cash flows) of the asset.
What are the types of bonds? (4)
1) Vanilla Bonds
2) Zero coupon bonds
3) Callable bonds
4) Putable bonds
Determine the ______ of a bond by _______________-valuing its future cash flows (DCF method).
value
present
What cash flow components does a vanilla bond have? (2)
- A steady stream of coupon payments (an annuity)
- The repayment of the face value at maturity (a single payment)
What formula is used to price a bond?
What investment decision should be made if:
1) Fair value = market price
2) Fair value < market price
3) Fair value > market price
1) Hold
2) Overvalued-short sell
3) Undervalued- Buy
What does the ‘r’ in the formula mean? (3)
- r = yield to maturity
- Rate of return that rational investors require on that particular bond
- Used to discount future cash flows of a bond to get the fair price
What is the yield to maturity derived from?
The yield to maturity is derived from yields of comparable securities in the market. (YTM is derived from yields of SIMILAR bonds)
How is the YTM of, derived? :
- Corporate bonds (3)
- Government bonds (2)
- YTM of a corporate bond
1) Similar corporate bonds (Perfectly similar take the yield, if not adjust for spread, Less liquid adds the spread)
2) Comparable government bonds + spread
3) Look at the prime +/- the spread. (Default risk and time) - YTM of government bond
1) Comparable government bonds +/- spread.
2) Look at prime/repo rate.
Usually questions are quoted semi-annually, if so what formula is used to price the bond?
What is the relationship between bond price and yield?
Inverse relationship between bond prices and yields – Convex Shape, Positive Convexity
Why is there an inverse relationship between bond price and yield?
The negative relationship exists to ensure that existing bonds continue to offer the return that is demanded by investors/the return equal to similar bonds.
What does a change in YTM without a change in price mean? (2)
A change in YTM or interest rates, without a corresponding change in price means existing bonds will
offer a return that is different from (1) what investors want and (2) what similar NEW bonds are
offering
What if:
- Coupon rate = YTM
- Coupon > YTM
- Coupon < YTM
- Bond Price = Face Value, trading at par
- Bond Price > Face Value, trading at a premium
- Bond Price < Face Value, Trading at a discount
Bond price and yield relationship is not linear it is ________. Positive Convexity means greater price _____________________ than depreciation. Therefore, investors look for lower __________ bonds to maximise the higher the convexity.
conex
appreciation
coupon
True or false, price of bonds will pull away from par value as it approaches maturity
False, Price of bonds will pull towards par value as it approaches maturity
How does par, premium and discount bond prices change over time? (3)
Par bond, price remains constant
Premium price decreases over time
Discount bond, price increases over time
Given the above, state two reasons why bond price may change (only 2, nothing else)
1) A change in yields due to the following factors:
▪ A change in the level of interest rates in the economy.
▪ A change in the perceived credit quality of the issuer. etc.
2) A change in time for discount and premium bond
What is valuing a bond between coupon dates? (2)
- Valuing between coupon dates delas with fractions of a period (i.e., 225/365 days)
- Therefore, deal with accrued interest
What is accrued interest? (3)
- Interest earned but not collected (for next coupon)
- Assumed to be earned equally throughout the period
- Arises because both buyer & seller held the bond during the coupon period
What happnes when a bond is bought/sold in between coupon dates? (2)
- Buyer & seller deserve a portion for the days held; Split proportionally
- But accrued interest will either go to buyer OR seller; Compensate each other
Trade BEFORE ex-coupon date: ___ -coupon
cum
What is the ex-coupon date? (3)
- Ex-coupon is the date when the issuer of the coupon closes their books
- Close their books to prepare to pay the next coupon
- Once the next coupon is paid the books are open
Trade On or _______ ex-coupon date: __-coupon
after
ex
