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FIN20040 - Foundations of Finance > Bond Valuation > Flashcards

Bond Valuation Flashcards

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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
Q

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

A

price of bond will be above par

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26
Q

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

A

Price of bond will be below par

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27
Q

Define a discount bond

A

bond that sells for below its face value

28
Q

Define a premium bond

A

bond that sells for more than its face value

29
Q

How to calculate the coupon rate paid semi annually

A

(Coupon rate x Face value) / 2

30
Q

How to calculate the interest rate for semi annual bonds

A

r%/2

31
Q

How to calculate amount of periods in a bond that pays semi annually

A

t years x 2 = no. of semi annual periods

32
Q

Define interest rate risk

A

The risk that arises for bond holders as a result of fluctuating interest rates is called interest rate risk

33
Q

What does the amount of interest rate risk depend on?

A

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
Q

What are the two components of the rewards of a bond

A

Fixed interest payments, price changes in bond

35
Q

Define an indenture

A

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
Q

What must the trustee appointed by the corporation to represent the bond holders regarding bond features

A

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
Q

What terms of a bond are included in an indenture?

A 
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
Q

Explain and define protective covenant

A

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
Q

What is meant by security as a term of a bond

A

It details if assets have been pledged on debt as collateral

40
Q

What is meant by rating as a term of a bond

A

Companies possibility of default - Ex: AAA has a strong capacity to pay back the debt

41
Q

What is meant by sinking fund as a term of a bond

A

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
Q

What is meant by call provision as a term of a bond

A

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
Q

What is meant by deferred call provision as a term of a bond

A

Prohibits a company from redeeming bond prior to a certain date - bond is call protected

44
Q

Define registered form bond

A

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
Q

Define bearer form bond

A

Means bond is issued without recording the owners name. Payment is made to whomever holds the bond

46
Q

Define unsecured bond

A

Unsecured debt security with maturity of 10+ years

47
Q

Define note bond

A

Unsecured debt security with maturity under 10 years

48
Q

Define real rate

A

Rate of return adjusted for inflation. Its the percentage change in your buying power

49
Q

Define nominal rate

A

Also known as quoted rate - rate of return not adjusted for inflation. Percentage change in the amount of cash you have

50
Q

What does the fisher affect examine

A

Relationship between nominal returns, real returns and inflation

51
Q

In fisher effect formula what does R, r and h stand for

A

R- Nominal rate
r- real rate
h- inflation rate

52
Q

What is the formulae for the fisher effect

A

1 +R = (1 + r) x (1 +h)

53
Q

What is a formulae for the approximate relationship between nominal returns, real returns and inflation

A

R = r + h (approx)

54
Q

What is the relationship between nominal rates of default free, pure discount securities and time to maturity?

A

True time value of money (One single payment in the future)

55
Q

Why would bonds with identical risk, liquidity and tax characteristics have different interest rates?

A

Their time to maturity is different

56
Q

When calculating Present value what must you ensure in case of inflation

A

Discount nominal cash flows at the nominal rate OR Discount real cash flows at the real rate

57
Q

Define interest rate risk premium

A

Compensation investors demand for bearing that risk

58
Q

Define inflation premium

A

Portion of a nominal interest rate that represents compensation for expected future inflation

59
Q

What can term structure of interest rates look like graphically

A

Upward sloping - common

Downward sloping - very uncommon, reflects market view that recession is coming

60
Q

Why are longer term rates higher than shorter term rates in an upward sloping structure of interest rates

A

Interest rate risk increases at a decreasing rate

Inflation is expected to rise over time

61
Q

Define taxability premium

A

Portion of a nominal interest rate that represents compensation for unfavourable tax status

62
Q

Define liquidity premium

A

Portion of a nominal interest rate that represents compensation for lack of liquidity

63
Q

Define treasury yield curve

A

Plots yields of treasury notes and bonds to maturity

64
Q

Define Default risk premium

A

Portion of a nominal interest rate that represents compensation for the possibility of default

65
Q

What is the difference between treasury yield curve and term structure of interest rates?

A

Almost the same - Term structure is based on pure discount bonds, yield curve is based on coupon bond yields

66
Q

What do yields represent combined effects of - what effects the yield

A 
Real rate of interest
expected future inflation
Default risk
Taxability
Lack of liquidity
Interest rate risk
67
Q

What sort of bonds are not very liquid

A

Corporate bonds are not as liquid as say government bonds

FIN20040 - Foundations of Finance (9 decks)

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