Exam #2 Flashcards
What is the first principle of financial securities valuation?
The present value of expected future cash flows.
What is a bond?
A legally binding agreement between a borrower and a lender.
What is the par value of a bond?
The face amount paid at maturity, typically $1,000.
What is a coupon rate?
The stated interest rate, generally fixed, used to determine coupon payments.
How are bonds traded?
In electronic markets.
What do you need to value a level-coupon bond?
Coupon payment dates and time to maturity
Coupon payment per period and face value
Discount rate
What is the formula for the value of a coupon bond?
The present value of the coupon payment annuity + present value of the face value.
How are bond values and interest rates related?
They are inversely related: when interest rates rise, bond values fall, and vice versa.
What is YTM (Yield to Maturity)?
The discount rate that equates the bond price with the present value of its future cash flows.
How does bond price change based on YTM?
YTM < coupon rate: Bond trades at a premium.
YTM = coupon rate: Bond trades at par.
YTM > coupon rate: Bond trades at a discount.
What is price risk?
The change in bond price due to changes in interest rates.
Which bonds have more interest rate risk?
Long-term bonds have more risk than short-term bonds.
Low coupon rate bonds have more risk than high coupon rate bonds.
What are zero-coupon bonds?
Bonds with no periodic interest payments; YTM comes from the difference between the purchase price and par value.
What are Treasury securities and their maturity periods?
T-bills: Less than 1 year
T-notes: 1 to 10 years
T-bonds: Greater than 10 years
What is debt?
No ownership interest, creditors have legal recourse, interest is tax-deductible.
What is equity?
Ownership interest, stockholders vote, dividends are not tax-deductible and are not a firm liability.
Can an all-equity firm go bankrupt?
No, because it has no debt obligations.
What is the real rate of interest?
The change in purchasing power.
What is the nominal rate of interest?
The quoted interest rate, including inflation.
What is the Fisher Effect formula?
(1 + R) = (1 + r)(1 + h)
R = nominal rate
r = real rate
h = expected inflation rate
What is the approximation formula for the Fisher Effect?
R ≈ r + h
If the required real return is 8% and expected inflation is 3%, what is the nominal rate?
Nominal rate ≈ 8% + 3% = 11%
What are the six factors affecting bond yields?
Real interest rate
Inflation premium
Interest rate risk premium
Default risk premium (based on bond ratings)
Taxability premium (municipal vs. taxable bonds)
Liquidity premium (less liquid bonds have higher yields)
