4) Bond valuation

Question 1

What is bond valuation?

Answer 1

The process involves finding the present value of the future benefits (cash flows) of the asset.

Question 2

What are the types of bonds? (4)

Answer 2

1) Vanilla Bonds
2) Zero coupon bonds
3) Callable bonds
4) Putable bonds

Question 3

Determine the ______ of a bond by _______________-valuing its future cash flows (DCF method).

Answer 3

value
present

Question 4

What cash flow components does a vanilla bond have? (2)

Answer 4

• A steady stream of coupon payments (an annuity)
• The repayment of the face value at maturity (a single payment)

Question 5

What formula is used to price a bond?

Answer 5

Question 6

What investment decision should be made if:
1) Fair value = market price
2) Fair value < market price
3) Fair value > market price

Answer 6

1) Hold
2) Overvalued-short sell
3) Undervalued- Buy

Question 7

What does the ‘r’ in the formula mean? (3)

Answer 7

• 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

Question 8

What is the yield to maturity derived from?

Answer 8

The yield to maturity is derived from yields of comparable securities in the market. (YTM is derived from yields of SIMILAR bonds)

Question 9

How is the YTM of, derived? :
- Corporate bonds (3)
- Government bonds (2)

Answer 9

• 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.

Question 10

Usually questions are quoted semi-annually, if so what formula is used to price the bond?

Answer 10

Question 11

What is the relationship between bond price and yield?

Answer 11

Inverse relationship between bond prices and yields – Convex Shape, Positive Convexity

Question 12

Why is there an inverse relationship between bond price and yield?

Answer 12

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.

Question 13

What does a change in YTM without a change in price mean? (2)

Answer 13

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

Question 14

What if:
- Coupon rate = YTM
- Coupon > YTM
- Coupon < YTM

Answer 14

• Bond Price = Face Value, trading at par
• Bond Price > Face Value, trading at a premium
• Bond Price < Face Value, Trading at a discount

Question 15

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.

Answer 15

conex
appreciation
coupon

Question 16

True or false, price of bonds will pull away from par value as it approaches maturity

Answer 16

False, Price of bonds will pull towards par value as it approaches maturity

Question 17

How does par, premium and discount bond prices change over time? (3)

Answer 17

Par bond, price remains constant
Premium price decreases over time
Discount bond, price increases over time

Question 18

Given the above, state two reasons why bond price may change (only 2, nothing else)

Answer 18

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

Question 19

What is valuing a bond between coupon dates? (2)

Answer 19

• Valuing between coupon dates delas with fractions of a period (i.e., 225/365 days)
• Therefore, deal with accrued interest

Question 20

What is accrued interest? (3)

Answer 20

• 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

Question 21

What happnes when a bond is bought/sold in between coupon dates? (2)

Answer 21

• Buyer & seller deserve a portion for the days held; Split proportionally
• But accrued interest will either go to buyer OR seller; Compensate each other

Question 22

Trade BEFORE ex-coupon date: ___ -coupon

Answer 22

cum

Question 23

What is the ex-coupon date? (3)

Answer 23

• 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

Question 24

Trade On or _______ ex-coupon date: __-coupon

Answer 24

after
ex