Finance Topic 6

Question 1

bonds

Answer 1

means by which companies and gov raise/borrow money
form of debt finance

Question 2

bond holders

Answer 2

lenders & investors

Question 3

principal amount

Answer 3

amount borrowed
nominal value/par value
since recorded on bond agreement document
face value of bond

Question 4

coupons

Answer 4

in return for lending = inv in bond receive regular interest payment of a fixed size

Question 5

size of regular coupon

Answer 5

defined by annual % rate applied to nominal amount of bond

Question 6

fixed income securities

Answer 6

since coupon lvl doesnt vary
bonds are often called ….

Question 7

irredeemable/perpeutal bond

Answer 7

unless above = investors are repaid principal amount (some amount calculated by reference to principal amount) at end of agreed lending period (maturity/redemption)

Question 8

value of bond

Answer 8

price of any fixed income security = depends on size & timing of coupon payments and time remaining to maturity

value of bond = sum of present values of remaining coupons and principal repayment
(discounting at investors required rate of return)

Question 9

relationship between coupon rate & required return
and current value and redemption amount

Answer 9

higher coupon rate = higher price/value of bond
(coupon rate & bond price = +ve associated)

higher req return = lower price/value of bond
(req return and bond price = -ve associated = inverse/non linear relationship)

Question 10

bond price and required return diagram,

Answer 10

Question 11

2 key impactors on interest rate sensitivity of value

Answer 11

= price risk
1. term to maturity (longer = greater % change in bond price following change in interest rate/req return)
2. size of coupon (bonds paying lower show higher % change in bond price following change in interest rate/req return) -> lower coupon = greater sensitivity to bond changes

Question 12

price changes

Answer 12

required return changes
price risk = sensitivity of value to changes in discount rate

Question 13

coupon factors

Answer 13

lower coupon implies = higher interest rate sensitivity (price risk)
longer maturity = implies higher interest rate sensitivity

Question 14

naive bond investing strategy

Answer 14

-investor believes interest rates will rise
- invest in lesser interest rate sensitive bonds (shorter maturity & higher coupon payment)

-investor believes interest rates will fall
- invest in greater interest rate sensitive bonds (longer maturity and lower coupon payment)

Question 15

bond yields

Answer 15

yields - often quoted for bonds
key measure = gross redemption yield (yield to maturity or total return)

Question 16

GRY

Answer 16

gross redemption yield
represents return an investor would make if held bond to maturity
IRR of cash flows associated with bond from investor/lender perspective

Question 17

conditions to hold for GRY

Answer 17

1. bond is actually to be held to maturity
   (any sale prior = give proceeds subject to mkt conditions at Time of sale)
2. GRY assumes all coupon amounts received can be reinvested at gRY rate (may not be the case, re-investment risk)
3. regular coupon payments

Question 18

re-investment risk

Answer 18

having cash flows coming out of bond dont know the market conditions

Question 19

shares returns arithmetic return equation

Answer 19

rise in value = contributes to equity investors return

Question 20

rule of the return

Answer 20

returns can never be less than -1
cant do anything worse than lose all your money which would be -1

Question 21

descriptive statistics

Answer 21

1. returns
2. deviations (historic return - expected return)
3. deviations squared = variance
4. product of deviations
5. co-variance
6. correlation

Question 22

correlation formulae

Answer 22

co variance of A & B divided by
std deviation of A x std deviation of B

Question 23

uncertainty and risk

Answer 23

actual future returns = uncertain = measures of risk quantify this
(different approaches) = no universal def of risk
-common approach = calculate amount of variation in possible returns around their mean value
-majority = adopt std dev of returns as measure of risk
-wider possible variation in share returns = lower chance actual return will be close to mean (expected) return higher std = higher risk

-std deviation of returns = measure of total risk for asset
beta = systematic risk

Question 24

portfolio theory

Answer 24

following parameters estimated
1. expected return of asset
2. risk for each asset (Std dev of return)
3. covariance of returns between each pair of assets

Question 25

total risk vs systematic risk

Answer 25

Question 26

risk free inv

Answer 26

positive return & no risk

sovereign debt (gov bonds) of developed countries, strong economies = held nearly risk free, position open to criticism

Question 27

expected return on portfolio

Answer 27

Question 28

total risk

Answer 28

risk inherent in individual stock/security specific to particular company

Question 29

systematic risk

Answer 29

risk inherent in overall mkt or particular segment of market

Question 30

diversification

Answer 30

Markowitz space
rho: +1 = perf positive correlation (form straight line)
as rho decreases more shedding of risk bows to the left
perf negative correlation = perfect smoothing

Question 31

risk averse investor

Answer 31

doesnt seek to avoid all risk (health appreciation for level of risk vs return)
- demand higher expected return to compensate for higher risk
equivalent risk = chose highest expected return
equivalent expected return = chose lowest risk

Question 32

risk hating investor

Answer 32

seek to avoid all possible risk
no care for return
choose alternative with lowest risk (zero risk) mo matter what expected returns are available

Question 33

price risk (interest rate risk)

Answer 33

potential for value of bond to fluctuate due to changes in interest rate
existing bond with fixed coupon rate = less attractive to inv compared to newly issued bonds with higher coupon rate rising interest rate env

-relevant for bonds with longer maturities, lower coupon rates, higher durations = more sensitive to interest rate changes
affects value of bond in secondary market

Question 34

reinvestment risk

Answer 34

potential uncertainty or risk associated with reinvesting periodic coupon payments /principal repayments from bond