Bond Valuation

Question 1

coupon rate - definition

Answer 1

the periodic interest payment received by a bond holder

Question 2

par value

Answer 2

the principal amount ($1,000 on bond issues, unless stated otherwise)

the amount that will be repaid to bond investors at the end of the loan period

Question 3

length of time to maturity

Answer 3

the time remaining until the bond holder receives the par value

“number of periods” to maturity

Question 4

market interest rates

Answer 4

the yield that is currently being earned in the marketplace on comparable securities

the rate used to discount a bond to determine what it is currently selling for in the market

Question 5

coupon rate - formula

Answer 5

coupon rate = (coupon payment)/(par)

Question 6

current yield - formula

Answer 6

current yield = (coupon payment)/(price of the bond)

Question 7

yield to maturity

Answer 7

the compounded rate of return if an investor buys a bond today and holds it to maturity

Question 8

practice problem: What is the yield to maturity of a bond that is selling at a 5% discount to par, paying 11.25% interest, and maturing in 7 years?

Answer 8

N= 7x12
I/Y= ?
PV= -950
PMT= (1,000x0.1125)/2
FV = 1,000

CPT I/Y (then x2) = 12.34%

Question 9

yield to call

Answer 9

the compounded rate of return if an investor buys a bond today and the bond is called (retired) by the issuer

Question 10

difference between YTM and YTC

Answer 10

YTM (yield to maturity) uses the number of periods to maturity

YTC (yield to call) uses the number of periods until the bond is retired

Question 11

practice problem: What is the yield to call of a bond that is selling at $1,200, paying 12% interest, semi-annually, and maturing in 10 years, if the bond is callable in 5 years at $1,050?

Answer 11

N = 5x12
I/Y = ?
PV = -1,200
PMT = (1,000x0.12)/2
FV = 1,050

CPT I/Y (then x2) = 7.91%

Question 12

if a bond is selling at a discount, what is the order (from highest to lowest) of the rates?

Answer 12

yield to call

yield to maturity

current yield

nominal yield

“Call Mom’s Cell Now!”

Question 13

what is accrued interest?

Answer 13

when purchasing a bond, the buyer pays the seller the interest that has accrued since the last interest payment

the buyer is entitled to a deduction equal to the amount of accrued interest paid to the seller

Question 14

liquidity preference theory

Answer 14

the yield curve results in lower yields for shorter maturities because some investors prefer liquidity and are willing to pay for liquidity in the form of lower yields

long-term yields should be higher than short-term yields because of the added risks associated with longer-term maturities

Question 15

market segmentation theory

Answer 15

the yield curve depends on supply and demand at a given maturity, and there are distinct markets for given maturities with distinct buyers and sellers at each maturity

Question 16

according to the market segmentation theory, when supply is greater than demand at a given maturity, are rates high or low?

Answer 16

rates are low

Question 17

according to the market segmentation theory, when demand is greater than supply at a given maturity, are rates high or low?

Answer 17

rates are high

Question 18

expectations theory

Answer 18

the yield curve reflects investors’ inflation expectations

Question 19

according to the expectations theory, when investors believe inflation will be higher in the future, what is the relationship between long-term and short-term yields?

Answer 19

when inflation is expected to be higher in the future, long-term yields are higher than short-term yields (normal curve)

Question 20

according to the expectations theory, when investors believe inflation will be lower in the future, what is the relationship between long-term and short-term yields?

Answer 20

when inflation is expected to be lower in the future, long-term yields will be lower than short-term yields (inverted curve)

Question 21

unbiased expectations theory (UET)

Answer 21

today’s longer term interest rates have imbedded in them expectations about future short term interest rates

long term rates are geometric averages of current and expected future short term rates

Question 22

what is bond duration?

Answer 22

the weighted average maturity of all cash flows

the moment in time the investor is immunized from interest rate risk and reinvestment rate risk

Question 23

if duration is bigger, is the bond more or less sensitive to interest rate changes?

Answer 23

the bigger the duration, the more sensitive

Question 24

what should the duration be for an investor to be effectively immunized?

Answer 24

the duration should equal the investor’s time horizon

Question 25

what is the duration of a zero-coupon bond?

Answer 25

the duration is equal to the maturity

Question 26

as the coupon rate increases, bond duration … ?

Answer 26

as the coupon rate increases, bond duration decreases

Question 27

as the coupon rate decreases, bond duration … ?

Answer 27

as the coupon rate decreases, bond duration increases

Question 28

as yield to maturity increases, bond duration … ?

Answer 28

as yield to maturity increases, bond duration decreases

Question 29

as yield to maturity decreases, bond duration … ?

Answer 29

as yield to maturity decreases, bond duration increases

Question 30

what is convexity?

Answer 30

a concept that actually measures the difference in price between what duration estimates and the actual price change of a bond

Question 31

what is a tax swap bond strategy?

Answer 31

involves selling a bond that has a gain and a bond that has a loss which offset each other

also could involve selling a bond that has a loss position and just buying a new bond

Question 32

what is a barbell bond strategy?

Answer 32

involves owning both short-term and long-term bonds

Question 33

what is a laddered bond strategy?

Answer 33

requires purchasing bonds with varying maturities

as bonds mature, new bonds are purchased with longer maturities than what is outstanding in the portfolio

Question 34

what is the benefit of a laddered bond strategy?

Answer 34

helps to reduce interest rate risk because bonds are held until maturity

Question 35

what is a bullet bond strategy?

Answer 35

purchasing bonds that have very little payments during the interim period and then a lump-sum payment at some specified date in the future

Question 36

when is it best to use a bullet bond strategy?

Answer 36

when the investor has a large payment due on a liability at some future date

Question 37

what is preferred stock?

Answer 37

has both equity and debt features

Question 38

what is the tax advantage of preferred stock?

Answer 38

corporations receive a 50-65% deduction of dividends based on percentage of ownership of the company paying the dividends

Question 39

conversion value

Answer 39

the value of a convertible bond in terms of the stock into which the bond can be converted

Question 40

what is the formula for conversion value?

Answer 40

CV = (par / conversion price) * (price of the common stock)

Question 41

capitalized value - formula

Answer 41

capitalized value = (NOI) / (capitalization rate)

Question 42

how to calculate net operating income (NOI)

Answer 42

gross rental receipts
\+ non-rental income
- vacancy and collection losses
- total expenses
\+ interest expense
\+ depreciation expense = NOI