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Investment Planning > Bond Valuation > Flashcards

Bond Valuation Flashcards

1
Q

Calculate YTM for a bond paying 10% interest or $100/yr, market price is $876, 5-year period to maturity, matures at par or $1000

A
  • EXAM TIP: Always assume semi-annual compounding unless told otherwise in the question
  • Answer: I/YR = 13.49%
    • PV: -876
    • N: 10
    • PMT: 50
    • FV: 1000
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2
Q

What is the YTM of a bond selling at a 5% discount to par, paying 11.25% interest, and maturing in 7 years?

A
  • i = 12.34%
    • N: 14
    • PV: -950
    • PMT: (1000 x 0.1125) ÷ 2
    • FV: 1000
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3
Q

Joe purchased a bond for $880 with a 9% coupon. He sold the bond after one year when it was paying a current yield of 10%. What is the holding period return?

A
  • 12.5%
    • Step 1:
      • Current Yield: 0.10 = $90 / Purchase Price
        • Price = $90/.10 = $900
    • HPR = SP - PP +- Cash Flows ÷ Purchase price
      • $900 - $880 + $90 / $880 = 12.5%
  • EXAM TIP: similar questions on CFP exam frequently!
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4
Q
  • What is the relationship between Current Rate, Current Yield, YTM and YTC when a 20 year bond is trading at a current price of $1200 with a CR of 10% callable in 5 years at $1050?
A
  • CR, CY, YTM, YTC
    • CR: 10%
    • CY: 8.3%
    • YTM: 7.98%
    • YTC: 6.16%
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5
Q

What is the relationship between Current Rate, Current Yield, YTM and YTC when a 20 year bond is trading at a current price of $1000 with a CR of 10% callable in 5 years at $1050?

A
  • YTM,CY,CR,YTC
    • YTM: 10%
    • CY: 10%
    • CR: 10%
    • YTC: 10.78%
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6
Q

What is the relationship between Current Rate, Current Yield, YTM and YTC when a 20 year bond is trading at a current price of $800 with a CR of 10% callable in 5 years at $1050?

A
  • CR: 10%
  • CY: 12.50%
  • YTM: 12.79%
  • YTC: 16.74%
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7
Q
  • What is the Exam Tip for the yield ladder or order of yields for a bond selling at a discount?
A
  • “When shopping, if you see a discount “Call Mom’s Cell Now”
    • Yield to Call
    • Yield to Maturity
    • Current Yield
    • Nominal Yield
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8
Q
  • What is the Liquidity Preference Yield Curve Theory?
A
  • Lower yields for shorter maturities because investors prefer liquidity and are willing to pay for that in the form of lower yields
  • Also, longer-term yields have more risk and should be higher
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9
Q

What is the Market Segmentation Yield Curve Theory?

A
  • yield curve depends on supply and demand at a given maturity
    • supply > demand at a given maturity, rates are low; rates will have to increase for demand to increase
    • supply < demand at a given maturity, rates are high; rates will have to decrease for demand to drive demand down
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10
Q

What is the Expectations Yield Curve Theory?

A
  • Yield curve reflects investors inflation expectations
    • Typically, investors are uncertain or believe inflation will be higher in the future, long-term yields are higher than short-term yields
    • If inflation is expected to be lower in the future long-term rates will be lower than short-term rates, resulting in an inverted yield curve
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11
Q

What is the Unbiased Expectations Theory?

A
  • Related to the term structure of interest rates
  • Today’s longer term rates have imbedded in them expecations about future short term interest rates
    • Long term rates are geometric averages of current and expected future shorter-term interest rates
  • Formula (on exam sheet)
    • 1RN = [(1+1R1)(1+E(2r1))…(1+E(Nr1))]1/N - 1
    • example on page 101
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12
Q

Describe Bond Duration:

A
  • The weighted average maturity of all cash flows
    • The bigger the duration, the more price sensitive/volatile the bond is to interest rate changes
    • Duration is the moment in time the investor is immunized from interest rate risk and reinvestment rate risk
    • Modified Duration: a bond’s price sensitivity to changes in interest rates
    • A bond portfolio should have a duration equal to the investor’s time horizon to be effectively immunized
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13
Q

Q1: What is the relationship between a bonds term and duration?

Q2: What is the relationship between a bonds coupon rate/YTM and duration?

A
  • A1: DIRECT: is term increases/decreases, duration will increase/decrease
  • A2: INVERSE: as CR/YTM increase, duration will decrease; as CR/YTM decrease, duration will increase
    • EXAM TIP: “Coupon rate and yield are INterest rates and there is an INverse relationship.”
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14
Q

How do you calculate a bonds duration using the two methods?

A
  1. Formula provided on CFP exam sheet, p102
  2. Calculate Duration using Present Value of Cash Flows Chart
    1. Create chart with headings Payment Period (N), Amount of Payment, Period x Payement (FV) and PV of (period x payment)
    2. Calculate the PV for each year, years X payment amount, in last year include bond maturing plus interest payment
    3. Total all years
    4. Add total to bond current value to find duration
    5. on page 103 of IP book
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15
Q

Consider a bond with a $1000 par value, five years to maturity, with a 6% annual coupon. The YTM is 8% and the bond is selling for $920.15. What is the duration of the bond?

A
  1. Use formula from exam sheet, Answer: 4.4 years
  2. Calculate Duration using the PV of Cash Flows Chart

Payment Period (Amount of Period x PV of

(N) Payment) Payment (FV) (Period x PMT) calculator:

1 $60 $60 $55.56 N=Payment Period

2 $60 $120 $102.88 i=8

3 $60 $180 $142.89 PV=?

4 $60 $240 $176.41 PMT=0

5 $1060 $5300 $3607.49 FV={period x pmt)

$4084.83

$4084.83 ÷ $920.15 = 4.4 years

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16
Q
  • What is the Duration assumption?
  • Is it accurate?
A
  • That there is a linear relationship between a change in interest rates and a bond’s price change.
  • No, the actual price change of a bond is NOT linear, it’s curve-linear
17
Q

What is convexity?

A
  • A concept that actually measures the difference in price between what Duration “estimates” and the “actual” price change of the bond
18
Q
  • What does Duration to a good job of estimating?
  • What does Duration to a bad job of estimating?
A
  • The price change of a bond for small changes in interest rates
  • The price change of a bond for large changes in interest rates
19
Q
  • What does Duration do when interest rates decrease?
  • What does Duration do when interest rates increase?
A
  • Understates the price appreciation when interest rates decrease
  • Overstates the price depreciation when interest rates increase
20
Q
  • Describe various Bond Strategies:
A
  • Tax Swap
    • sell a bond with a gain and a bond with a loss to offset
    • Sell a bond with a loss and buy a replacement
  • Barbells
    • Own both short-term and long-term bonds
    • When interest rates move, only one set of positions need to be sold and restructured
  • Laddered Bonds
    • Purchasing bonds with varying maturities
    • As bonds mature, new bonds are purchased with longer maturities than what is outstanding in the portfolio
  • Bullets
    • Have very little payments during interim period, then a lump sum at a specified date in the future
    • Bost bonds will mature around the same time period
    • Zero-coupon, Treasuries, and corporates most likely candidates since they have little or no coupon during period and payoff comes at a date in the future
    • Typically used when an investor has a baloon payment due on a liability at some future date
21
Q

Describe Preferred Stock:

A
  • Has both equity and debt features
    • Debt:
      • Stated par value
      • Stated dividend as a percentage of par
        • ex. 5% dividend with par value of $20=20X5%=$1 per sh
    • Equity
      • Price of preferred stock may move with price of common stock
22
Q
  • Q1: What are the unique features of preferred stock?
  • Q2: What is a tax advantage?
A

A1:

  • Dividend does not fluctuate like a common stock dividend
  • No maturity date like a bond
  • Price more closely tied to interest rates than common stock

A2:

  • Corporations receive a 50 or 65% deduction of dividends (preferred or common stock) based on percentage ownership of the company paying the dividends for tax years beginning after December 31, 2017 (covered in tax module)
23
Q
  • Q1: Describe Convertible Bonds:
  • What is the formula for Conversion Value?
A
  • A1: One of the primary benefits of convertible bonds is that even if the stock does not perform well, the investor has a floor built in.
    • The floor is the par value of the bond if held to maturity
  • A2:
    • CV = PAR/CP X Ps
      • ​​Ps = the price of the common stock
      • CP is the conversion price
      • (1000 ÷ CP) is the conversion ratio or the number of shares the convertible can be converted into
  • EXAM TIP: Formula no longer on CFP Exam Sheet
24
Q

Describe Property Valuation:

A
  • A formula to determine how much an investor is willing to pay for a piece of property
    • Just a restatement of the dividend yield formula
  • FORMULA
    • Capitalized Value = Net Operating Income (NOI) / Capitalization rate
    • Capitalized rate = NOI ÷ Cost
25
Q

How do you calculate Net Operating Income (NOI)

A

Gross Rental Receipts

+ Non-Rental Income

= Potential Grosss Income (PGI)

- Vacancy & Collection Losses

= Effective Gross Income (EGI)

- Total (Cash Operating) Expenses

= Net Income

+ Interest Expense

+ Depreciation Expense

= Net Operating Income

  • Cash operating expenses does not include depreciation or amortization, which are not cash expenses. It also excludes payments on debt service since this is a financing expense, not an operating one
26
Q
A

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