Bonds Flashcards
Discount
Bond will sell at a discount when Coupon Rate < YTM, Because:
* People can get higher return on investments at current
market rate
Premium
Bond will sell at premium when Coupon Rate > YTM,
People cant get a higher return anywhere else
Par value
A bond will be selling at par value when CR = YTM
Zero coupon bonds
Pay no coupon rate
Therefore price is always at a discount
* As the only return is capital gains
no face value at maturity
Yield to maturity
Investors will only earn this if the asset is held to maturity and all
coupons/cash flows are reinvested at the YTM rate
Yield to call
Maturity is first call date
And face value is the call price
Realised Compound Yield
(Ending Wealth/purchase price)1/n – 1
Premiums
These will get lower in value as time goes on, This is because there are less cash flows in the future
Discounts
These will get higher in value as time goes on
This is because there is less time to weight before they get the
capital gains
Bond prices move inversely to
interest rates
A long term bonds price will be affected more than a short term
bonds price
As this is true: As bond length increases, so does volatility of
price to yield
* However, as the length increase the volatility increases
at a diminishing rate (slope – note a straight line)
A bond with a low coupon rate will have a greater change in price
compared to a bond with a higher coupon rate
However this also increases at a diminishing rate (slope – note
a straight line
the higher the coupon rate (Coupons) the higher the weight on the CF inbetween, and therefore a
lower duration (shorter)
Duration for zero coupon bonds =
maturity
Coupon bonds duration
Duration increases with maturity (at a decreasing rate)
o The higher the coupon rate, the shorter the duration
all bonds: duration
The higher the YTM, the shorter the duratio
YTM = actual bond price
Where as the duration is a straight line at a tangent to the bond price slope
Immunization:
This is the act of setting the duration of the bond (portfolio) equal to the
investor’s investment horizon
When interest rates rise
Price you can sell you bonds for falls
But coupon payments can be reinvested at a higher rate
Immunization eliminates interest rate risk by offsetting price risk against
reinvestment risk
realised annual return will not change as the
interest rate does
The higher the credit risk/default risk of a stock:
The higher the premium required for that bond
Spot Rate
The current known/quoted yield on a zero coupon bond for n periods
Forward Rate:
Yield specified now for a purchase of a zero coupon bond at a future date for
n periods from THAT date
Expected Rate
The yield that is expected to be at time t+ k (k periods from now) on a zero
coupon bond for n periods to maturity
term structure
- Shows what is expected of the market derived by the relationship between
Yields to maturity and term to maturity
(Pure) Expectations Theory
This is the theory that expected (future) spot rate = Forward Rate
- This is because long rates are determent by expected future short rate
Expectations Theory’s Explanation
Difference in expected spot rate and forward rate:
It explains it that the loan rate (spot rate) is wrong, as it is the
loan rate that will reflect future expectation
Expectation theory: Upward Sloping: Expected Boom
Long term bonds have higher yields as future short
term rates are expected to increase
he illiquidity preference brings it higher
Expectation theory: Downward Sloping: Expected Recession
- Future expected rates are lower than the current spot
rates
offset the illiquidity
premium
Therefore the difference between expected spot rate and
forward rate is more than premium
Expectation theory: Hump:
*
Expects it to be higher in the near future, but in the
long run it will go down
multiple expectations
Expectation Theory: Flat:
The future is expected to be the same as current spot
rates
Market Segmentation Theory:
The idea that the shape of the yield curve is determined by the supply and
demand of securities within each maturity range
Market Segmentation Theory: Excess supply of bonds over demand for long-term maturities
Firms want to borrow for long term
Lenders want to lend at short term
Upward Sloping
Market Segmentation Theory: Excess supply over demand for short-term maturities
Downward Sloping:
Market Segmentation Theory: Excess supply over demand for intermediate-term maturities
Hump shape:
