chp 6

Question 1

define bond indenture

Answer 1

states the terms of a bond as well as the amounts and dates of all payments to be made

Question 2

define maturity date of the bond

Answer 2

final repayment date of the bond

Question 3

define term of bond

Answer 3

the time remaining until the repayment date

Question 4

define coupons (of a bond)

Answer 4

the promised interest payments of a bond

Question 5

define the face value or principal of the bond

Answer 5

the notional amount we use to compute the coupon payments - usually face value is repaid at maturity

Question 6

how is the amount of coupon payment determined by

Answer 6

the coupon rate of the bond

Question 7

how is the coupon rate set

Answer 7

set by the issuer and stated on the bond indenture

Question 8

what’s the coupon rate of a bond

Answer 8

the percentage of face value paid out as coupons each year

Question 9

what’s the formula to coupon payment

Answer 9

CPN = (coupon rate x face value)/number of coupon payments per year

Question 10

what’s a zero-coupon bond

Answer 10

a bond that doesn’t make coupon payment

investor only receives the face value of the bond on the maturity date

Question 11

what makes up a majority of zero-coupon bond

Answer 11

treasury bills

Question 12

are zero coupon bonds traded at a discount

Answer 12

yes they are always traded at a price lower than the face value bs investor is compensated for the time value of the money

they are called pure discount bonds

Question 13

what’s the yield to maturity

Answer 13

of a bond is the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond

Question 14

what’s the IRR of an investment in a zero coupon bond

Answer 14

the rate of return that investors will earn on their money if they buy the bond at its current price and hold it to maturity

Question 15

what’s the formula of yield to maturity of n-year zero coupon bond

Answer 15

YTM = (FV/P)^(1/n) -1

Question 16

why would investors have a negative yield

Answer 16

in times of negative yields, investors have their money in bonds bc of the safety and convenience that it’s worth the negative yield

Question 17

can bonds be traded at premium or on par

Answer 17

yes

premium = price greater than their face value

par = price equal to their face value

Question 18

what’s the relationship between the bond prices and yields

Answer 18

if a bond trades at a discount, it’s YTM will exceed its coupon rate

if a coupon bond’s yield to maturity exceeds its coupon rate, the present value of its cash flows at the yield to maturity will be less than its face value and the bond will trade at a discount

Question 19

what happens to an investor’s return from a bond with a coupon that trades at a premium to its face value

Answer 19

investor’s return from the coupons is diminished by receiving a face value less than the price paid for the bond

Question 20

when does a bond trade at a premium

Answer 20

when it’s YTM is less than its coupon rate

Question 21

when does a bond trade at a price equal to its face value

Answer 21

when its coupon rate is equal to its yield to maturity

Question 22

when does a bond trade at a price less than its face value

Answer 22

when its coupon rate is less than its YTM

Question 23

why does the market price of a bond change over time?

Answer 23

1. bond gets closer to its maturity date - PV of bond’s remaining cash flows changes as the time to maturity decreases
2. changes in market interest rates affect the bond’s YTM and its price

Question 24

how much does the price of a bond drop per coupon period

Answer 24

usually drops by the amount of the coupon

for a bond trading at a premium, the price drop when a coupon is paid will be larger than the price increase between coupons, so the bond’s premium will tend to decline as time passes.

If the bond is trading at a discount, the price increase between coupons will exceed the drop when a coupon is paid, so the bond’s price will rise and its discount will decline as time passes.

Ultimately, the prices of all bonds approach the bonds’ face value when the bonds mature and their last coupon is paid.

Question 25

what’s the relationship between interest rates and bond yields

Answer 25

as interest rates and bond yields rise, bond prices will fall and vice versa.

Question 26

how does the sensitivity of a bond’s price change to interest rates

Answer 26

depends on the timing of its cash flows

shorter-maturity, zero-coupon are less sensitive to changes in interest rates than are longer-term, zero-coupon bonds

bonds with higher coupons rates are les sensitive to interest rate changes than identical bonds with lower coupon rates

Question 27

define a bond’s duration

Answer 27

the sensitivity of bond’s price to changes in interest rates

the value-weighted average maturity of a bond’s cash flows.

higher the duration the more sensitivity the bond is to interest rates

Question 28

define the dirty price of a bond

Answer 28

the actual cash price or value of a bond computed by determining the present value of the bond’s remaining cash flows

Question 29

define the clean price of a bond

Answer 29

bond’s cash price less an adjustment for accrued interest, the amount of the next coupon payment that has already accrued

clan price = dirty price - accrued interest

Question 30

what’s the formula to accrued interest

Answer 30

coupon amount x (days since last coupon payment/days in current coupon period)

immediately before a coupon payment is made, the accrued interest will equal the full amount of the coupon, whereas immediately after the coupon payment is made, the accrued interest will be zero.

Question 31

what happens to bond prices in actuality

Answer 31

bond prices are subject to the effects of both the passage of time and changes in interest rates. Bond prices converge to the bond’s face value due to the time effect, but simultaneously move up and down due to unpredictable changes in bond yields.

Question 32

what happens to cash flows as the coupon increases

Answer 32

earlier cash flows become relatively more important than later cash flows in the calculation of the present value.

Question 33

define the coupon paying yield curve

Answer 33

a plot of the yield of coupon bonds of different maturities

Question 34

define benchmark bonds

Answer 34

specific bond issues that are used by the bank of canada and practitioners

Question 35

what are corporate bonds

Answer 35

bonds issued by corporations

Question 36

define credit risk

Answer 36

the risk of default by the issuer of any bond that is not default free; an indication that the bond’s cash flows are not known with certainty

Question 37

How does the credit risk of default affect bond prices and yields?

Answer 37

Because the cash flows promised by the bond are the most that bondholders can hope to receive, the cash flows that a purchaser of a bond with credit risk expects to receive may be less than that amount. As a result, investors pay less for bonds with credit risk than they would for an otherwise identical default-free bond.

Because the yield to maturity for a bond is calculated using the promised cash flows, the yield of bonds with credit risk will be higher than that of otherwise identical default-free bonds.

Question 38

what’s the formula of a expected return fo a 1 year zero-coupon bond

Answer 38

expected return: (expected cash flow/price) - 1

Question 39

is the YTM of a defaultable bond equal to the expected return of investing in the bond

Answer 39

it is not equal Because we calculate the yield to maturity using the promised cash flows rather than the expected cash flows, the yield will always be higher than the expected return of investing in the bond

Question 40

how to determine the price of a bond

Answer 40

discount this expected cash flow using a cost of capital equal to the expected return of other securities with equivalent risk

Question 41

what’s the relationship between YTM and expected bond return

Answer 41

Note that the bond’s price decreases, and its yield to maturity increases, with a greater likelihood of default. Conversely, the bond’s expected return, which is equal to the firm’s debt cost of capital, is less than the yield to maturity if there is a risk of default. Moreover, a higher yield to maturity does not necessarily imply that a bond’s expected return is higher

Question 42

define investment grade bonds

Answer 42

bonds in the top 4 categories of creditworthiness with a low risk of default

Question 43

what are bonds in the bottom five categories of creditworthiness

Answer 43

speculative bonds, junk bonds, high-yield bonds bc their likelihood to default is high

Question 44

what does the rating of creditworthiness for bonds dependent on

Answer 44

The rating depends on the risk of bankruptcy as well as the bondholders’ ability to lay claim to the firm’s assets in the event of such a bankruptcy. Thus, debt issues with a low-priority claim in bankruptcy will have a lower rating than issues from the same company that have a high priority in bankruptcy or that are backed by a specific asset such as a building or a plant.

Question 45

what’s the different between the yields of various bonds and gov’t of canada yields

Answer 45

default spread or credit spread

Question 46

define credit spread

Answer 46

the difference between the yield of a risky bond and riskless bond that are otherwise identical in their features

Credit spreads fluctuate as perceptions regarding the probability of default change.

Question 47

where is credit spreads higher in

Answer 47

Note that the credit spread is higher for bonds with lower ratings and therefore a greater likelihood of default.

Question 48

define sovereign bonds

Answer 48

bonds issued by national governments

Question 49

why does the prices and yields of sovereign debt behave much like corporate debt

Answer 49

Because most sovereign debt is risky

The bonds issued by countries with high probabilities of default have high yields and low prices.

Question 50

sovereign debt vs corporate debt

Answer 50

Unlike a corporation, a country facing difficulty meeting its financial obligations typically has the option to print additional currency to pay its debts. Of course, doing so is likely to lead to high inflation and a sharp devaluation of the currency. Consequently, debt holders carefully consider inflation expectations when determining the yield they are willing to accept because they understand that they may be repaid in money that is worth less than it was when the bonds were issued.

Question 51

why do defaults occur from countries

Answer 51

either because the necessary inflation/devaluation would be too extreme, or sometimes because of a change in political regime