Bond Valuation Flashcards
coupon rate - definition
the periodic interest payment received by a bond holder
par value
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
length of time to maturity
the time remaining until the bond holder receives the par value
“number of periods” to maturity
market interest rates
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
coupon rate - formula
coupon rate = (coupon payment)/(par)
current yield - formula
current yield = (coupon payment)/(price of the bond)
yield to maturity
the compounded rate of return if an investor buys a bond today and holds it to maturity
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?
N= 7x12 I/Y= ? PV= -950 PMT= (1,000x0.1125)/2 FV = 1,000
CPT I/Y (then x2) = 12.34%
yield to call
the compounded rate of return if an investor buys a bond today and the bond is called (retired) by the issuer
difference between YTM and YTC
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
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?
N = 5x12 I/Y = ? PV = -1,200 PMT = (1,000x0.12)/2 FV = 1,050
CPT I/Y (then x2) = 7.91%
if a bond is selling at a discount, what is the order (from highest to lowest) of the rates?
yield to call
yield to maturity
current yield
nominal yield
“Call Mom’s Cell Now!”
what is accrued interest?
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
liquidity preference theory
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
market segmentation theory
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
according to the market segmentation theory, when supply is greater than demand at a given maturity, are rates high or low?
rates are low
according to the market segmentation theory, when demand is greater than supply at a given maturity, are rates high or low?
rates are high
expectations theory
the yield curve reflects investors’ inflation expectations
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?
when inflation is expected to be higher in the future, long-term yields are higher than short-term yields (normal curve)
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?
when inflation is expected to be lower in the future, long-term yields will be lower than short-term yields (inverted curve)
unbiased expectations theory (UET)
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
what is bond duration?
the weighted average maturity of all cash flows
the moment in time the investor is immunized from interest rate risk and reinvestment rate risk
if duration is bigger, is the bond more or less sensitive to interest rate changes?
the bigger the duration, the more sensitive
what should the duration be for an investor to be effectively immunized?
the duration should equal the investor’s time horizon
what is the duration of a zero-coupon bond?
the duration is equal to the maturity
as the coupon rate increases, bond duration … ?
as the coupon rate increases, bond duration decreases
as the coupon rate decreases, bond duration … ?
as the coupon rate decreases, bond duration increases
as yield to maturity increases, bond duration … ?
as yield to maturity increases, bond duration decreases
as yield to maturity decreases, bond duration … ?
as yield to maturity decreases, bond duration increases
what is convexity?
a concept that actually measures the difference in price between what duration estimates and the actual price change of a bond
what is a tax swap bond strategy?
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
what is a barbell bond strategy?
involves owning both short-term and long-term bonds
what is a laddered bond strategy?
requires purchasing bonds with varying maturities
as bonds mature, new bonds are purchased with longer maturities than what is outstanding in the portfolio
what is the benefit of a laddered bond strategy?
helps to reduce interest rate risk because bonds are held until maturity
what is a bullet bond strategy?
purchasing bonds that have very little payments during the interim period and then a lump-sum payment at some specified date in the future
when is it best to use a bullet bond strategy?
when the investor has a large payment due on a liability at some future date
what is preferred stock?
has both equity and debt features
what is the tax advantage of preferred stock?
corporations receive a 50-65% deduction of dividends based on percentage of ownership of the company paying the dividends
conversion value
the value of a convertible bond in terms of the stock into which the bond can be converted
what is the formula for conversion value?
CV = (par / conversion price) * (price of the common stock)
capitalized value - formula
capitalized value = (NOI) / (capitalization rate)
how to calculate net operating income (NOI)
gross rental receipts \+ non-rental income - vacancy and collection losses - total expenses \+ interest expense \+ depreciation expense = NOI