CH 10

Question 1

What is the formula and equation for “bond value”?

Answer 1

Bond value = Present value of coupons + Present value of par value

Bond value = [sum.of] ( (coupon / ( 1+r)^t) + (par value / (1+4)^T) )

Where:

T = maturity date
t = amount of periods per year 
r = discount rate

Question 2

What is the formula and equation for “bond price”?

Answer 2

Bond Price = coupon x annuity factor (r,T) + Par value x PV factor (r,T)

Bond Price = coupon x [1/r] (1 - (1 / (1+r)^T) ) + Par value x ( 1 / ( (1+r)^T) )

Question 3

Define “yield to maturity” and how do we calculate it?

Answer 3

It is often viewed as a measure of the average rate of return that will be earned on a bond if it is bought now and held until maturity.

To calculate the yield to maturity, we solve the bond price equation for the interest rate given the bond’s price.

YTM = (C + ((F-P)/n ))/ ((F+P)/2)

Question 4

Define “current yield”?

Answer 4

Annual coupon divided by bond price.

Question 5

Define “premium bonds”.

Answer 5

Bonds selling above par value.

Question 6

Define “discount bonds”.

Answer 6

Bonds selling bellow par value.

Question 7

Define “reinvestment rate risk”.

Answer 7

Uncertainty surrounding the cumulative future value of reinvested bond coupon payments.

Question 8

Define HPR?

Answer 8

The holding period return is the total return from income and asset appreciation over a period of time expressed as a percentage.

HPR = Holding period Return

Question 9

How do you calculate the HPR?

Answer 9

Holding-period Return = (Income + (Price1 - Price0))/ Price0

Question 10

What is a treasury strip?

Answer 10

A bond where all of its coupons are stripped into individual stand-alone essentially zero-coupon bond, with the final payment of principal being treated as a another stand-alone zero-coupon security.

Question 11

What are the key ratios used to evaluate bond safety?

Answer 11

1) Coverage ratio: Ratio of company earnings to fixed costs.
2) Leverage ratios: debt to equity ratio.
3) Liquidity ratios: ‘current ratio’ (current assets/current liabilities) and the ‘quick ratio’ (current assets excluding inventories/ current liabilities).
4) Profitability ratios: ‘return in assets’ (earnings before interest and tax/ total assets) and ‘return on equity’ (net income/equity).
5) Cash flow-to-debt ratio: the ratio of total cash flows to outstanding debt.

Question 12

Define ‘indenture’.

Answer 12

The document defining the contract between the bond issuer and the bondholder.

Question 13

Define ‘sinking funds’.

Answer 13

A bond indenture that calls for the issuer to periodically repurchase some proportion of the outstanding bonds prior to maturity.

Question 14

Define ‘debenture’.

Answer 14

A bond now backed by specific collateral.

Question 15

Define ‘credit default swap’.

Answer 15

An insurance policy on the default risk of a corporate bond or loan.

Question 16

Define “term structures of interest rates”.

Answer 16

The relationship between yields to maturity and terms to maturity across bonds.

Question 17

Define ‘expectations theory’.

Answer 17

The theory that yields to maturity are determined solely by expectations of future short-term interest rates.

In essence higher yields on long term bonds are higher than short term to compensate for changing interest rates, so Return should equalize across bonds of all maturities.

Question 18

Define the ‘forward rate’.

Answer 18

The inferred short-term rate of interest for a future period that makes the expected total return of a long-term bond equal to that of rolling over short-term bonds.

Question 19

What is the formula for the ‘forward rate’?

Answer 19

(1+ y )^n = (1+y )^n-1 (1+f )
n n-1 n

Where:
* f = forward rate
n

• n = n-period zero coupon bond
• yn = interest rate on n-period bond
• y = interest rate on n-1 period bond
  n - 1

Question 20

Define the ‘liquidity preference theory’.

Answer 20

The theory that investors demand a risk premium on long-term bonds.

The yield curve will be upward sloping even in the absence of increasing expected returns of future rates.

Question 21

Define the ‘liquidity premium’.

Answer 21

The yield spread demanded by investors as compensation for the greater risk of longer-term bonds.

Question 22

Provide the formula for the ‘liquidity premium’.

Answer 22

The liquidity premium is measured as the spread between the forward rate of interest and the expected short rate.

Liquidity premium = fn - E(rn)

Where:
fn = the forward rate at time n
E(rn) = Expected short rate at time n