Cash, Bonds and Gilts

Question 1

What is the calculation for the conversion premium?

What is the conversion premium?

Answer 1

(Market price of convertible stock/ conversion ratio x market price of ordinary shares) - 1 x 100

This calculation identifies the extra cost to an investor of accessing shares through converting, compared with putchasing the shares at the current price in the market.

Remember, if an investor converts before expiry, there is the loss of income under the bond element to consider and loss of option value.

Question 2

What is the priority order of payment for those owed money by a company. should it go into liquidation?

Answer 2

1. Liquidators’ fees
2. Fixed charge holders
3. Preferential creditors
4. Floating charge holders
5. Unsecured creditors
6. Subordinated creditors
7. Preference share holders
8. Ordinary shareholders

Question 3

What does capital cover calculate and what does it show?

Answer 3

• Capital cover calculates the number of times that the value of a company’s assets covers the repayment of a particular priority debt.

Step 1 - Rank liabilities in order they are repaid

Step 2 - Calculate cumulative amount of debt for each liability

Step 3 - Divide total assets available to cover the debt by each cumulative level

Question 4

As a rule of thumb longer dated bonds are more volatile than shorter dated bonds.

Low coupon bonds are more volatile than high coupon bonds.

However if we have a low coupon bond with a short duration, or a long duration bond with a high coupon - how do we determine the risk, or price sensitivity of the bonds?

Macauley duration

Answer 4

Macauley duration measures the sensitivity of the price of a bond to a change in interest rates. It is the weighted average time to receipt of the returns from holding a bond.

Question 5

Clean price vs dirty price?

Answer 5

In the market, bond prices (such as those in the FT) are ‘clean prices’. But the actual price paid in the market is called the dirty price.

The difference between the clean and the dirty price (the real or actual price in the market) is the accrued interest that the bond holder becomes entitled to on the next distribution date - or the seller is losing by selling before the distribution date. The dirty price compensates for this loss.

Dirty price = clean price + accrued interest (AI) at point of sale

AI = coupon x days from last coupon/ days between coupons

Question 6

Sensitivity of bond prices - the extent to which the price of a bond moves is determined by its?

Answer 6

• Coupon
  
  • The smaller the coupon the more the bonds price will move for a given interest rate change: low coupon bonds are more volatile than high coupon bonds
• Redemption period
  
  • For two bonds with the same period it will be the longer dated that is the most volatile.
  • Long (dated) and low (yield) bonds are the most ‘volatile’ or sensitive to price movements.

Question 7

Macaulay duration - what is it?

Answer 7

• One way of measuring bond sensitivity is the Macaulay Duration (or Duration)
• Relative measure that reveals how sensitive a bond is compared to other bonds.
• Higher number = more sensitive

Duration is not the same as term to redemption. Duration reflects the time it would take for the investor to get back their purchase price in present value money, but is ALSO used as a measure of sensitivity.

However, the more common measure of sensitivity is the Modified Duration

Question 8

Modified duration - what is it?

Formula?

Answer 8

• MD is the most important measure of bond sensitivity
• MD of a bond estimates how much a bond price will change if there is a change in interest rates/ yields.
• Quantifies the sensitivity of the bond price to changes in GRY

MD = D / 1 + r

Where D is the bonds duration and r is its present yield

Change in bond price = -MD x change in GRY x current price