Bonds

Question 1

Define “market rate risk”.

Answer 1

The risk of loss in the market value of outstanding bonds and other fixed rate instruments as a result of an increase in the market rate of interest during the life of the outstanding instrument. If the market rate of interest increases after an instrument is issued, the market value of the instrument will decrease.

Question 2

Describe the yield to maturity for bonds (also called the expected rate of return).

Answer 2

The rate of return required by investors as implied by the current market price of the bonds; determined as the discount rate that equates present value of cash flows from the bonds with the current price of the bonds.

Question 3

Define “bond maturity”.

Answer 3

The time at which the issuer repays the par value to the bondholders.

Question 4

Define “bonds”.

Answer 4

Long-term promissory notes wherein the borrower, in return for buyers’/lenders’ funds, promises to pay the bondholders a fixed amount of interest each year and to repay the face value of the note at maturity.

Question 5

Define a “bond indenture”.

Answer 5

The bond contract, setting forth such terms as face amount of bond coupon or stated interest rate, maturity date, etc.

Question 6

How is the selling price of a bond determined?

Answer 6

As the sum of the present value of future cash flows from:
1. Periodic interest - PV of an annuity
2. Maturity face value - PV of $1
Both discounted using market rate of return

Question 7

Describe the calculation of the current yield on a bond.

Answer 7

The ratio of annual interest payments to the current market price of the bond. It is computed as:
Annual interest payment/Current market price