Bond Valuation & Interest Rates

Question 0

Why do some bonds sell at a discount?

Answer 0

A bond will sell at a discount if the coupon rate is lower than the required return on a bond, since it provides insufficient coupon payments compared to that required by investors on other similar bonds.

** When the YTM > coupon rate

Question 1

Why do some bonds sell at a premium over par value?

Answer 1

A bond will sell at a premium if the coupon rate is higher than the required return on a bond, since it provides periodic income in the form of coupon payments in excess of that required by investors on other similar bonds.

**A bond trades at a premium when its coupon rate is higher than prevailing interest rates. (In other words, when the coupon rate > the YTM)

Question 2

When do bonds sell at par value?

Answer 2

For a bond to sell “at par” means that it is selling at full face value. When a bond sells at full face value, the coupon rate (or the bond yield) is equal to the yield to maturity (YTM) ~ since bond interest does not compound.

Question 3

What is the relationship between the price of a bond and it’s yield to maturity (YTM)?

Answer 3

~The bond price is the present value of the cash flows from a bond.

~ The YTM is the interest rate used in valuing the cash flows from a bond.

Question 4

What is the relationship between the current yield & YTM for premium bonds?

Answer 4

Current yield > YTM

Question 5

What is the relationship between the current yield & YTM for discount bonds?

Answer 5

YTM > Current yield

Question 6

What is the relationship between the current yield & YTM for bonds selling at par value?

Answer 6

Current yield = YTM

Question 7

What is a bond’s current yield?

Answer 7

A bond’s annual coupon divided by its price

Question 8

What is the maturity on a 10 percent coupon bond that sells for par value?

Answer 8

The maturity is indeterminate. A bond selling at par can have any length of maturity.

Question 9

What is a bond’s yield to maturity (YTM)?

Answer 9

The interest rate required in the market on a bond.

The YTM takes into account the bond’s current market price, par value, coupon interest rate and time to maturity.

Question 10

Is the yield to maturity (YTM) on a bond the same thing as the required return?

Answer 10

YTM is the required rate of return on a bond expressed as a nominal annual interest rate. For noncallable bonds (locked interest rates), the YTM & required rate of return are used interchangeably.

Question 11

Is the yield to maturity (YTM) the same thing as the coupon rate?

Answer 11

Nooooooope. Unlike yield to maturity & required return, the coupon rate is not a return used as the interest rate in bond cash flow valuation. It is a fixed percentage of par over the life of the bond used to set the coupon payment amount.

Question 12

If a bond is purchased and held to maturity, then YTM is the ________ or _______ on the investment.

Answer 12

Return or yield

Question 13

Bond ratings do what?

Answer 13

Assess default risk

Question 14

What is the definition of a Bond?

Answer 14

A promise to make periodic interest payments for a set number of years, followed by payment of the face value.

Question 15

What are the “parts” of a bond?

Answer 15

1. Face value or par value~ amount repaid at maturity ($1,000)
2. Maturity~ time until face value is repaid.
3. Coupon~ periodic interest payment
4. Coupon rate~ annual coupon / face value
5. Yield to maturity~ market rate of return on the bond
6. “Current yield”~ annual coupon / price

Question 16

Longer-term bonds have more interest rate risk than ____________.

Answer 16

Shorter-term bonds

Question 17

Lower coupon rate bonds have more interest rate risk than ________________.

Answer 17

Higher coupon rate bonds

Question 18

Bond prices & bond yields move in what direction of each other?

Answer 18

Opposite

Question 19

What are the 6 bond features?

Answer 19

1. Bond Indenture
2. Face Value
3. Security
4. Seniority
5. Call Provision
6. Bond Covenants

Question 20

How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes.

This sensitivity depends on what 2 things?

Answer 20

1. The time to maturity <> the *longer the time to maturity, the greater the interest rate risk
2. The coupon rate <> the *lower the coupon rate, the greater the interest rate risk

Question 21

What’s the difference between real & nominal rates?

Answer 21

Nominal rates - called “nominal” because they have NOT been adjusted for inflation.

Real rates - rates that have been adjusted for inflation.

Question 22

What is a simple definition of the Fisher Effect?

Answer 22

The relationship between nominal returns, real returns, and inflation.

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

R –> nominal rate of return on dollars invested
r –> real rate of return on goods & services we can
buy with $)
h –> inflation rate