Bond pricing

Question 1

Because bonds are debt, issuers are … and holders are …

Answer 1

Because bonds are debt, issuers are debtors and holders are creditors

Question 2

What is the indenture and what does it give?

Answer 2

Indenture is the contract between the issuer and the bondholder that details the coupon rate, maturity date, and par value.

Question 3

What is the par value and it’s common value in the UK and US?

Answer 3

The par value is the value repaid at maturity, and is typically £100 in the UK and $1000 in the US.

Question 4

What are callable bonds?

Answer 4

Callable bonds are bonds that can be repurchased at any time before the maturity date

Question 5

What are convertible bonds?

Answer 5

Convertible bonds are bond that the holder can exchange for shares in the company at any time

Question 6

What are puttable bonds?

Answer 6

Puttable bonds give the bondholder the option to retire or extend the bond

Question 7

What are floating rate bonds?

Answer 7

Floating rate bonds are bonds with an adjustable coupon rate

Question 8

What type of relationship do bond prices and yields have?

Answer 8

Bond prices and yields have an inverse relationship.

Question 9

What is the link between the length of maturity and the sensitivity of the bond’s price to changes in interest rates?

Answer 9

The longer the length of maturity of a bond, the higher the sensitivity of the bond’s price to changes in interest rates

Question 10

What is the formula for present value factor?

Answer 10

The formula for present value factor is:

1/(1+r)^T

Question 11

What is the Yield to maturity?

Answer 11

The yield to maturity is the yield required for the future value of all future payments to be equal to the current bond price.

Question 12

What does YTM assume?

Answer 12

YTM assumes that all bond coupons can be reinvested at the YTM rate

Question 13

What is the current yield?

Answer 13

The current yield is the bond’s coupon payment as a function of it’s current price, which may be different from it’s par value.

Question 14

For which priced bond is c > current yield > YTM?

Answer 14

For bonds selling at a premium, c > current yield > YTM

Question 15

What is holding period return?

Answer 15

Holding period return is the yield on an investment over a certain time period, for example a quarter.

Question 16

What are 2 bond ratings companies?

Answer 16

Two bond ratings companies are Moody’s and Standard & poor

Question 17

What rating are Investment grade or junk bonds?

Answer 17

Investment grade bonds are BBB or above, and bonds below this rating are considered “junk” bonds

Question 18

What information can be implied from the yield curve?

Answer 18

The yield curve can reveal expectations of future short term interest rates

Question 19

What relationship does the yield curve display?

Answer 19

The yield curve displays the relationship between the maturity of a bond and a given interest rate

Question 20

What does an upward sloping yield curve give evidence of?

Answer 20

An upward sloping demand curve is evidence that short-term rates are going to be higher next year

Question 21

Why do investors require a risk premium to hold a long-term bond?

Answer 21

Investors require a risk premium to hold a long term bond because they are more sensitive to interest rate movements and carry a higher risk

Question 22

What does this liquidity premium compensate short-term investors for?

Answer 22

This liquidity premium compensates short-term investors for assuming long term risk

Question 23

What does the segmented market theory come from?

Answer 23

Segmented market theory comes from the observation that many investors and debt issuers seem to have strong preference for debt of a certain maturity

Question 24

What is a reason/example for segmented markets?

Answer 24

An example/reason for segmented markets is a company investing in warehouses or infrastructure, who need a more long-term debt structure.

Question 25

What does market segmentation theory argue?

Answer 25

Market segmentation theory argues that investors are sufficiently risk averse and that they operate only in their desired maturity spectrum

Question 26

Under expectations theory, what is observed long term rates a function of?

Answer 26

Under expectations theory, the observed long term rates are a function of both today’s short term rates and expected future short term rates

Question 27

Under expectations theory, long term and short term securities are perfect …

Answer 27

Under expectations theory, long and short term securities are perfect substitutes

Question 28

Premium theory states long term bonds are more …

Answer 28

Liquidity premium theory states long term bonds are more risky

Question 29

Premium theory says investors will demand what for what? Why does premium theory state the yield curve has an upward bias?

Answer 29

Premium theory states that investors will demand a higher risk premium for taking on more risk/buying a longer maturity bond. It states that the yield curve has an upward bias because of this

Question 30

What’s the difference between forward rates and expected future short-term rates?

Answer 30

The difference between forward rates and expected future short term rates are that forward rates have liquidity premium built in

Question 31

What happens to the yield curve as we move to longer maturities?

Answer 31

As we move towards longer dated maturities, the yield curve rises/slopes upwards.

Question 32

What 3 reasons mean a longer maturity result in the inclusion of a new higher forward rate?

Answer 32

• Markets are segmented
• Higher expectations for forward rates
• Liquidity premium