Bond Valuation Flashcards
What is the market discount rate?
The rate of return required by investors given the risk of the bond investment. It is also called required yield, or the required rate of return.
What are deficient or excess coupons?
When the YTM isn’t equal to the coupon rate which creates a discount or a premium to the par value.
What is the yield-to-maturity?
The internal rate of return on the cash flows - the uniform interest rate such that when the future cash flows are discounted at that rate, the sum of the present values equals the price of the bond. It is an implied single-market discount rate.
A bond investor will earn a rate of return on a bond equal to its YTM if the investor holds the bond to maturity, if the issuer makes full coupon and principal payments on scheduled dates and if the investor reinvests all coupon payments at the same YTM.
When a bond is priced between coupon payments, its price has two components: the flat price and the accrued interest. The sum of the parts is the full price, which is also known as the invoice or dirty price. The flat price is also called the clean price.
How to calculate accrued interest?
( t / T ) * Coupon Payment of that period
Only the clean price is affected by YTM
What are two approaches for day counting?
Actual / Actual
30 / 360
What is the inverse relationship between YTM and bond prices?
The price of a fixed-rate bond will change as the interest rate used to discount future cash flows changes. For any time-value-of-money calculation, a higher discount rate results in a lower present value for any fixed future cash flow and a lower discount rate results in a higher present value. Therefore, bond yields-to-maturity and prices move in opposite directions. = inverse relationship
What is the coupon effect?
The size of bond coupon cash flows affects how much a bond’s price will change for a given yield change for bonds of the same maturity. The lower a bond’s coupon, the higher the proportion of total cash flow that occurs at maturity. Discounting this final cash flow by the factor magnifies the impact of a given change in the discount rate relative to bonds, whose final cash flow is a smaller proportion of the total.
What is the maturity effect?
The time-to-maturity of a bond also affects a bond’s price/yield relationship. Generally, all else equal, a longer-term bond has a greater percentage price change than a shorter-term bond when the market discount rates change by the same amount. The maturity effect is the result of the higher N for the longer-maturity bond.
Bond prices change with the passage of time, even if the market discount rate remains the same. As time passes, so as N approaches zero, the bondholder comes closer to receiving the par value at maturity, provided the issuer does not default. Bond prices are “pulled to par”, so a bond’s price sold at a discount goes up and vice versa.
What is the convexity effect?
The percentage change in a bond’s price will also vary depending on how the yield changes. The percentage price increase is greater, in absolute value, than the percentage price decrease. This implies that the relationship between bond prices and yields is not linear but curved/convex.
