Chapter 6: Valuing Bonds

Question 1

The Law of One Price

Answer 1

• implies that the price of a security in a competitive market should be the present value of the cash flows an investor will receive from owning it
• directly relates to the return of a bond and its price
• guarantees that the risk-free interest rate equals the yield to maturity on such a bond

Question 2

Bond

Answer 2

is a security sold by governments and corporations to raise money from investors today in exchange for the promised future payment

Question 3

Face Value

Answer 3

• the notional amount of a bond used to compute its interest payments
• generally due at the bond’s maturity
• aka par value or principal amount
• default: $1000

Question 4

Value of a Bond

Answer 4

• the PV of the bonds cash flow
• = coupons + face value

Question 5

Coupons

Answer 5

the promised interest payments of a bond

Question 6

Coupon Rate

Answer 6

• the percent of a bond’s face value paid out as coupons over a one-year period
• indicates the percentage of face value paid out as coupons each year
• expressed as an APR, is set by the issuer and stated on the bond certificate
• does not = discount rate
• does not change during life of the bond

Question 7

Zero-coupon Bond

Answer 7

• a bond that makes only one payment at maturity
• always sells at a discount (a price lower than face value)
• no CPN/PMT
• aka pure discount bonds
• treasury bills

Question 8

Treasury Bills

Answer 8

short-term (with a maturity of up to one year), zero-coupon debt, issued by the Government of Canada to provide financing for the government

Question 9

Discount

Answer 9

• price lower than the face value
• the amount by which a cash flow exceeds its present value
• if a coupon bond trades at a discount, an investor will earn a return both from receiving the coupons and from receiving a face value that exceeds the price paid for the bond

Question 10

Discount Rate

Answer 10

• used to discount all cash flows arising from the bond, interest (coupons payments), and the principal repayment
• both interest and discount rates determine its present value

Question 11

Yield to Maturity

Answer 11

• the IRR of a bond is called its yield to maturity (or yield)
• the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond

Question 12

Par

Answer 12

• a bond is selling at par if the price is equal to the face value
• when a bond trades at a price equal to its face value, it is said to trade at par

Question 13

Premium

Answer 13

• a bond is selling at a premium if the price is greater than the face value
• if a coupon bond trades at a premium it will earn a return from receiving the coupons but this return will be diminished by receiving a face value less than the price paid for the bond

Question 14

When the bond price is greater than face value

Answer 14

• say its above par or at a premium
• coupon rate > yield to maturity

Question 15

When the bond price is equal to face value

Answer 15

• say its at par
• coupon rate = yield to maturity

Question 16

When the bond price is less than face value

Answer 16

• say its below par or at a discount
• coupon rate < yield to maturity

Question 17

Rise in interest rates and bond yield

Answer 17

bond prices falls

Question 18

Fall in interest rates and bond yield

Answer 18

bond prices rise

Question 19

Bond’s Duration

Answer 19

• measures the sensitivity of a bond’s price to changes in interest rates
• the value-weighted average maturity of a bond’s cash flow

Question 20

Bonds with high durations

Answer 20

highly sensitive to interest rate changes

Question 21

Bonds with low durations

Answer 21

less sensitive to interest rate changes