Bond Pricing

Question 1

How are bonds priced?

Answer 1

Sum of discounted cash flows

Question 2

What is the relationship between yield and price?

Answer 2

Negative / Inverse

Question 3

What does Price = when Y = C

Answer 3

100

Question 4

What is the PV of an irredeemable?

Answer 4

C/R

Question 5

What is the PV of a zero coupon bond?

Answer 5

P/(1+r)^n

Where P is the nominal value of the bond

Question 6

How do you price an Index Linked Bond?

Answer 6

1) Calculate Real yield (nominal yield / nominal inflation)
2) Discount bond as normal using real yield
3) multiply price by index ratio

Question 7

What is an cum-coupon bargain?

Answer 7

Purchasing a bond before it pays a coupon. You pay a dirty price to effectively compensate the holder for the time they held the bond as they won’t receieve the coupon.

Question 8

What is an ex-coupon bargain?

Answer 8

Buying a bond ex-coupon. You do not receive the coupon payment but the seller will rebate you slightly for the coupon you should be owed.

Question 9

What is flat yield, what does it measure?

Answer 9

Flat yield is Annual Coupon / Price * 100

Measures cash return as a percentage of the selling price.

Question 10

Benefits / Disadvantages of Flat yield?

Answer 10

+ Good for income minded investors
- Does not work for FRNs
- Does not take into account redemption gain / loss
- Does not factor in time value of money.

Question 11

What is japanese GRY? Who uses is?

Answer 11

Japanese GRY = Coupon+((100-Clean Price) / Yrs to Maturity ) / Clean Price

Takes into account all returns e.g. income and redemption - therefore someone holding until maturity would use it.

Question 12

What is gross redemption yield?

Answer 12

A full measure gain (coupon and redemption) effectively the current IRR of the bond which would discount it to its current price.

Calculated through interpolation

Question 13

Japanese GRY vs GRY?

Answer 13

JGRY overstates the effect of a gain or loss to redemption

But JGRY is easy to calculate and works as a quick reference point for the interpolation process

GRY is more accurate and thus a more appropriate measure for total return on a bond.

Question 14

Shortcomings of GRY?

(Ytm/irr)

Answer 14

Assumes interest rates remain constant and reinvestment can be made at the same level through the life of the bond.

Can’t take into account if the bond is sold earlier than at maturity.

Question 15

What is net redemtion yield and who is i t useful for

Answer 15

Similar to GRY but considers after tax cash flows

Useful for the long term tax paying investor.

Only coupon is taxable - no cgt on redemption - thus low coupon bonds which trade cheap are attractive to higher rate tax payers

Question 16

What is the formula for Net Redemption Yield?

Answer 16

Flat Yield * (100-Ta Rate)+(100-clean price) / yrs to maturity ) / Clean price

Question 17

What is the formula for FRN price?

Answer 17

Next Coupon + 100 / (1+r)^n

Next Coupon / Price = Yield

Question 18

What are the two methods for valuing a convertible bond?

Answer 18

1) Dividend Valuation Model
2) Crossover (income based)

Question 19

When should the crossover method be used?

Answer 19

The crossover method is used when there is no predetermined conversion date

(most useful when a bond can mature between two dates)

Question 20

How is a convertible priced using the dividend valuation model?

Answer 20

1) Calculate Future Share price (share price * (1+g)^n)
2) Future Value = Future share price * conversion ratio
3) Calculate price as normal (future value = final value to be discounted)