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FIN20040 - Foundations of Finance > Bond Valuation > Flashcards

Bond Valuation Flashcards

1
Q

Define a bond

A

Bonds are issues by countries or corporations to raise money (debt)

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2
Q

Explain how a loan or bond works

A

Loans and bonds are assets and instruments of debt. They do not present ownership but a loan of funds.
Holders of assets/ creditors get paid in regular interest payments by issuer of asset and then get paid original lump sum at the end

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3
Q

For a corporation what is significant about interest on debt

A

The corporation’s payment of interest on debt is fully tax deductible and is a business expense

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4
Q

If firm does not pay back debt what happens?

A

It is a liability to the firm and creditors can claim the firms assets

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5
Q

Define the maturity of long term debt

A

Time remaining with outstanding balance

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6
Q

Define unfunded debt

A

short term debt

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7
Q

What is the difference between public issue and private placed debt

A

Private is placed directly with lender. The parties involved decide terms

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8
Q

Explain how equity securities/assets work

A

Common stocks (shares) are assets and instruments of equity. They represent ownership of the firm. The holders of equity assets and instruments usually get paid in varying amount of money,depending upon the earnings of the firm. - Dividends dont get paid every period

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9
Q

What is significant for a firm when financing by equity with tax

A

dividends are not tax deductible

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10
Q

Define a coupon

A

Stated interest payment made on a bond

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11
Q

Define coupon rate

A

Annual coupon divided by the face value of a bond

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12
Q

Define face value

A

Principal amount that is repaid at the end of the term - par value

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13
Q

Define maturity

A

Specified date when the principal amount of a bond is paid

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14
Q

Define YTM or Yield to Maturity

A

Rate required in the market by investor on a bond - current rate of reward required by the market

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15
Q

What is the law of one price

A

How to value a bond

PV of Face Value + PV of Annuity(coupon) = Bond value

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16
Q

Why would bond value adjust and change

A

If coupon rate and market yield are different to each other. Bond value takes into account expected cash flow to bond holders and any interest changes (The cashflows stay the same so the value changes depending on interest)

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17
Q

If bond value is less than PV of Face value + PV of annuity what does that mean

A

Bond is a bargain and will be in high demand

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18
Q

If bond value is more than PV of Face value + PV of annuity what does that mean

A

Bond is not a good deal and price will drop with no demand

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19
Q

What does F stand for

A

Face value

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20
Q

What does C stand for

A

coupon paid per period

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21
Q

What does t stand for

A

periods to maturity

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22
Q

What does r stand for

A

yield per period

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23
Q

What is the formula for bond value

A

C x [(1-(1/((1+r)^t))/r] + (F/((1+r)^t))

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24
Q

What is the expected price of bond if the coupon rate = market rate

A

Price of bond will be equal to the face value of the bond

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25
What is the expected price of bond if the coupon rate > market rate
price of bond will be above par
26
What is the expected price of bond if the coupon rate < market rate
Price of bond will be below par
27
Define a discount bond
bond that sells for below its face value
28
Define a premium bond
bond that sells for more than its face value
29
How to calculate the coupon rate paid semi annually
(Coupon rate x Face value) / 2
30
How to calculate the interest rate for semi annual bonds
r%/2
31
How to calculate amount of periods in a bond that pays semi annually
t years x 2 = no. of semi annual periods
32
Define interest rate risk
The risk that arises for bond holders as a result of fluctuating interest rates is called interest rate risk
33
What does the amount of interest rate risk depend on?
How sensitive its price is to interest rate changes •Sensitivity depends on: 1.The time to maturity (longer time = more risk) 2.The coupon rate(lower rate = more risk)
34
What are the two components of the rewards of a bond
Fixed interest payments, price changes in bond
35
Define an indenture
The written agreement between the corporation and the lender detailing the terms of the debt issue - legal document, Usually, a trustee is appointed by the corporation to represent the bondholders.
36
What must the trustee appointed by the corporation to represent the bond holders regarding bond features
The trust company must:1. Make sure the terms of the indenture are obeyed2. Manage the sinking fund 3. Represent the bondholders in default – that is, if the company defaults on its payments to the
37
What terms of a bond are included in an indenture?
``` Amount of issue Date of Issue Maturity Face value Annual coupon Offer price Coupon payment dates Security Sinking fund Call provision Call price Rating protective covenants ```
38
Explain and define protective covenant
Protective covenants limit certain actions that might be taken in term for a loan, protecting lenders interest. Negative covenant - prohibits action and positive/affirmative covenants means company agrees to take some action
39
What is meant by security as a term of a bond
It details if assets have been pledged on debt as collateral
40
What is meant by rating as a term of a bond
Companies possibility of default - Ex: AAA has a strong capacity to pay back the debt
41
What is meant by sinking fund as a term of a bond
An account managed by trustee for early bond redemption - It sets aside funds every year for debt repayment - only to be spent on debt
42
What is meant by call provision as a term of a bond
Call provision means corporation have an option to repurchase a bond at a specified price prior to maturity. Call price > Par value to thank investors for taking the risk. It benefits the company as allows them to take advantage of market rates
43
What is meant by deferred call provision as a term of a bond
Prohibits a company from redeeming bond prior to a certain date - bond is call protected
44
Define registered form bond
Common for corporate bonds - Form of issue in which registrar of company records ownership of each bond payment is made directly to the owner on record
45
Define bearer form bond
Means bond is issued without recording the owners name. Payment is made to whomever holds the bond
46
Define unsecured bond
Unsecured debt security with maturity of 10+ years
47
Define note bond
Unsecured debt security with maturity under 10 years
48
Define real rate
Rate of return adjusted for inflation. Its the percentage change in your buying power
49
Define nominal rate
Also known as quoted rate - rate of return not adjusted for inflation. Percentage change in the amount of cash you have
50
What does the fisher affect examine
Relationship between nominal returns, real returns and inflation
51
In fisher effect formula what does R, r and h stand for
R- Nominal rate r- real rate h- inflation rate
52
What is the formulae for the fisher effect
1 +R = (1 + r) x (1 +h)
53
What is a formulae for the approximate relationship between nominal returns, real returns and inflation
R = r + h (approx)
54
What is the relationship between nominal rates of default free, pure discount securities and time to maturity?
True time value of money (One single payment in the future)
55
Why would bonds with identical risk, liquidity and tax characteristics have different interest rates?
Their time to maturity is different
56
When calculating Present value what must you ensure in case of inflation
Discount nominal cash flows at the nominal rate OR Discount real cash flows at the real rate
57
Define interest rate risk premium
Compensation investors demand for bearing that risk
58
Define inflation premium
Portion of a nominal interest rate that represents compensation for expected future inflation
59
What can term structure of interest rates look like graphically
Upward sloping - common | Downward sloping - very uncommon, reflects market view that recession is coming
60
Why are longer term rates higher than shorter term rates in an upward sloping structure of interest rates
Interest rate risk increases at a decreasing rate | Inflation is expected to rise over time
61
Define taxability premium
Portion of a nominal interest rate that represents compensation for unfavourable tax status
62
Define liquidity premium
Portion of a nominal interest rate that represents compensation for lack of liquidity
63
Define treasury yield curve
Plots yields of treasury notes and bonds to maturity
64
Define Default risk premium
Portion of a nominal interest rate that represents compensation for the possibility of default
65
What is the difference between treasury yield curve and term structure of interest rates?
Almost the same - Term structure is based on pure discount bonds, yield curve is based on coupon bond yields
66
What do yields represent combined effects of - what effects the yield
``` Real rate of interest expected future inflation Default risk Taxability Lack of liquidity Interest rate risk ```
67
What sort of bonds are not very liquid
Corporate bonds are not as liquid as say government bonds

FIN20040 - Foundations of Finance (9 decks)

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