BKM14

Question 1

Bond

Issuer

Bondholder

Coupons

Answer 1

Bond: security that is used by a company to borrow money

Issuer: issues bond to the lender in return for a sum of cash

Bondholder: lender

Coupons: interest payments to the bondholder at specified dates; coupons are typically made semiannually and coupon rate is usually compounded semiannually

-bond obligates the issuer to make coupons

Question 2

Par value

Answer 2

face value of the bond

-when bond matures, issuer pays the par value to the bondholder

Question 3

Bond indenture

Answer 3

contract between bondholder and issuer; lists coupon rate, maturity date, par value

Question 4

value of bond

Answer 4

Value = Par/(1+r)^t +Coupon(1/r)[1-1/(1+r)^t ]

Question 5

Callable bonds

Answer 5

issued with call provision that allow the issuer to repurchase the bond at specific call price before the maturity date

Question 6

Refunding

Answer 6

repurchase of bond by issuer if interest rate falls as they can replace them with new bonds that have lower coupon rate

Question 7

Deferred callable bonds

Answer 7

they have initial period of call protection which is a time period in which bonds are not callable

Question 8

Put bond

Answer 8

gives option to retire the bond to the bondholder

Question 9

Convertible bond

Answer 9

provides bondholder option to exchange the bond for a specified number of share of the issuing firm

-holders of convertible bonds benefit from price appreciation of the stock and so convertible bonds offer lower coupon rates

Question 10

Floating rate bonds

Answer 10

provide interest payments that are based on current market rates

• less interest rate risk: as interest rates rise, the increase in interest offsets the higher discounting rate
• interest rate risk related to change in issuer’s financial condition still exists because the yield spread is fixed; if the financial condition deteriorates, investors would demand a greater yield premium than what the security offers

Question 11

Foreign bonds

Answer 11

issued by a borrower from a country other than the one where it is sold so it is denominated in currency of the country in which it is marketed

• a foreign firm may want to issue US denominated bonds in the US in order to acquire funds for expansion in the US

Question 12

Eurobonds

Answer 12

denominated in one currency but sold in other markets

• due to easier regulations in another country, it may make sense to issue a bond in that country to borrow USD

Question 13

Asset backed bonds, ABS

Answer 13

ABS: bonds where income from specified group of assets is used to service the debt; common type is mortgage backed security, MBS

Question 14

Index bond

Answer 14

make payments that are based on general price index or price of a specific commodity

-example: treasury inflation protected securities, TIPS are bonds issued by US treasury that are linked to the rate of inflation

**coupon@t=par value@0*Π inflation*coupon rate

Question 15

Nominal rate of return

Answer 15

based on both interest rate and price appreciation

Question 16

Real return

Answer 16

adjusts the nominal rate of return to be net of inflation

**return volatility is reduced to 0 if the real return is constant year over year -> inflation indexed bonds reduce return volatility

Question 17

investors would usually not pay exactly the quoted bond price as there is

Answer 17

interest that accrues between coupon dates that is not included in the bond price

-sale/invoice price includes the stated/flat price plus accrued interest

Question 18

sale price of bond

Answer 18

Sale price = stated price + accrued interest

Question 19

Premium bond

Answer 19

bond that is selling above the par value

Coupon > current yield > yield to maturity

Question 20

Discount bond

Answer 20

bond selling below par value

Yield to maturity > current yield > coupon

Question 21

yield to maturity

Answer 21

interest rate that produces a PV of bond payments equal to its price

-average return that investor would earn if he purchased the bond now and holds it until maturity

Question 22

yield to call

Answer 22

• if bond is callable, yield to call may be more relevant than the yield to maturity especially if it is likely to be called
• can derive yield to call by using process for YTM but use time to call for time to maturity and call price for par value

Question 23

current yield

Answer 23

annual coupon / bond price

Question 24

Realized compound return

Answer 24

may differ from YTM in situations where the reinvestment rate differs from YTM

• issue with using YTM to measure return of bond when reinvestment rates can change: investor will actually not earn the YTM
• because the future interest rates are uncertain, future reinvestment rate is unknown
• realized return cannot therefore be calculated in advance

Question 25

Horizon analysis:

Answer 25

realized compound return can be forecasted over specific holding periods

Question 26

2 offsetting risks when interest rates change:

Answer 26

• Bond prices will fall (price risk/market risk)
• Reinvested coupon income would grow (reinvestment risk)

Question 27

price appreciation from OID bonds is treated by the IRS as

Answer 27

implicit interest payment (imputed interest)

Question 28

imputed interest

Answer 28

• imputed interest ignores changes in market interest rate; it is based on initial rate when the bond was issued
• difference between IRS price in 1yr and price if interest rate fall is treated as capital gains income and taxed at capital gains tax rate in addition to imputed interest
• if bond was not sold, difference would be treated as unrealized gains
• These are treated as an implicit interest, for tax purposes. As a result, the bondholder has to pay tax each year, rather than waiting till the bond is sold or matures. The IRS is essentially accelerating the collection of the tax