Bond Valuation

Question 1

Bond

Answer 1

Owner of a bond is entitled to a fixed set of cash payments in the future.

• Interest paid annually or semi-annually during the life of the bond
• Principal is repaid on redemption

Question 2

Yield to Maturity

Answer 2

• YTM refers to the rate of return the investor will earn if the bond is held to maturity. It is also known as bondholder’s expected rate of return.
• It is the IRR of the cash flows

YTM = Discount rate that equates the present value of the future cash flows with the current market price of the bond.

Question 3

Current Yield

Answer 3

It is the ratio of the coupon payment to the bond’s current market price.

Current Yield= annual interest payment/ current market price of the bond

Question 4

Total Yield

Answer 4

Current yield + capital gain/ loss from sale of bond

Question 5

Relationship 1

Answer 5

• The value of a bond is inversely related to changes in the investor’s present required rate of return (based on the market interest rate).
• As market interest rates increase, the bondholder’s required return increases. The coupon is fixed.
• The yield to maturity must equal the required return.
• The value of the bond decreases

Question 6

Relationship 2

Answer 6

The market value of a bond will be:

• less than the par value if the investor’s required rate of return is above the coupon rate (at a discount)
• above par value if the investor’s required rate of return is below the coupon rate (at a premium)
• at par value if the investor’s required rate of return is equal to the coupon rate (at par).

Question 7

Relationship 3

Answer 7

Changes in interest rates will cause a:

• Small change in short term cash flows
• Larger impact on long term cash flows
• Price of long term bonds is affected more by changes in the interest rate than the price of short term bonds.

Question 8

The term structure of interest rates

Answer 8

-The relationship between short and long term interest rates.
-Short and long term rates do not always move in parallel.
-The yield curve is a graphical representation of the term structure of interest rates
-Normal is upward sloping:
Long term rates are higher than short term rates

Question 9

Risk facing bondholders

Answer 9

Default risk

• Risk that the bond issuer will not pay the coupon or will be unable to repay the principal
• Bond ratings provide reassurance about the default risk
• Highly rated bonds (AAA) rarely default.

Interest rate risk
-If the interest rate in the market rises the value of the bonds (which have a fixed coupon) will fall