Finance Week 5

Question 1

What are bonds?

Answer 1

To raise money for long-term investment, governments and corporations issue new bonds and sell them to investors on the bond market. It is a security that obligates the issuer to make payments to bondholder.

Question 2

What does issuer of a new bond receive?

Answer 2

Receives proceeds from selling bond to investors

Question 3

What does investor in a bond receive?

Answer 3

Gets interest payments and repayment of the bond at maturity date

Question 4

What risk do you run by buying bonds from corporation?

Answer 4

Bonds issued by corporation come with the risk that corporation runs into bankruptcy & defaults on obligation to pay interest & bond amount at maturity.

Question 5

What is the bond market?

Answer 5

Where bonds are issues, bought and sold

Question 6

What is the coupon rate of the bond?

Answer 6

Annual interest payment as percentage of the face value of the bond. Not the interest rate

Question 7

What is the face value of a bond?

Answer 7

Amount repaid at maturity

Question 8

How do you find the value of a bond?

Answer 8

Annual coupon payments are an annuity and face value is a single cash flow. So calculate the PV of the annuity and the PV of the face value.

Question 9

What is semi-annual coupon rate and where is it popular

Answer 9

US bonds have semi annual coupon payments in the US

Question 10

What is the relationship between bond values and interest rates?

Answer 10

Bond values vary with interest rates that investors use to calculate value of the bond. Bond prices are in an inverse relationship to interest rates. When interest rates rise, bond prices fall. (because interest rates in denominator)

Question 11

What is interest rate risk?

Answer 11

Bonds are subject to interest rate risk- this is the risk that bond prices change because interest rate changes.

Question 12

What do bondholders hope happens with interest rates?

Answer 12

Bondholders hope interest rates fall so value of a bond increases

Question 13

Which type of bonds are more sensitive to interest rate risk?

Answer 13

Bonds with long maturities

Question 14

What is the YTM?

Answer 14

Yield to maturity is the measure for bonds return that accounts for coupon payments and any capital gain/loss. It is the discount rate at which PV of bonds cash flows equals bonds price.

Question 15

What is current yield?

Answer 15

It is the measure for a bonds return and it is the annual coupon payment / price - bad as only accounts for coupon payments and not for capital gain/loss

Question 16

What does the yield curve plot?

Answer 16

Relationship between YTM and time to maturity. Investors look at this to see whether short/ long term bonds offer higher yields

Question 17

Why are yield curves usually upsloping?

Answer 17

Yield curves are up-sloping meaning that long term bonds offer higher yields- this is because investors require a higher yield for long term bonds as they are more sensitive to interest rate changes

Question 18

What is default risk?

Answer 18

Risk the issuer of a bonds defaults on their obligations to make coupon payments or repay face value.

Question 19

What is default premium?

Answer 19

It is the additional yield bond investors require for being exposed to default risk

Question 20

What are T bills?

Answer 20

Treasury bills are short term government bonds issued by the US treasury with maturities of a year or less. T-bills do not pay a coupon and sell at a price below their face value. The US government issues these bonds to finance infrastructure projects (school or roads)

Question 21

If asked about a value of 9-month T bill and given an annual interest rate what do you do?

Answer 21

Find the effective annual rate which is = (1+ monthly rate) ^ 12 - 1 but rearrange

Question 22

In calculations do you use coupon rate or interest rate?

Answer 22

Use coupon rate to find monthly payments only and real interest rate for calculations of future cash flows

Question 23

What do you do if coupon payments are every 6 months?

Answer 23

Find the interest rate for 6 month period by first finding the monthly rate and then doing this (1+ monthly rate)^6 - 1 to find the interest rate for every 6 months. Then ensure to half the coupon payments and double the time period.

Question 24

What arises from differences in coupon and interest rates?

Answer 24

If interest and coupon rate are same, then value of bond is same as face value and bond sells at par. If the interest rate is larger than coupon rate, value of bond is smaller and bonds sells at a discount. If interest rate is smaller than coupon rate of bond, value of bonds is larger than its face value and bond sells at a premium.

Question 25

How do you calculate YTM on a financial calculator?

Answer 25

Make n = the time period, i is what we are trying to find, the PV is the market price of the bond (negative), The PMT is the coupon payment and the FV is the face value. Push i to get final answer.

Question 26

What do you do if asked about a bond with a coupon rate and YTM and that it is a 4 year bond, how much will it be worth in one year?

Answer 26

in 1 year, the bond will be a 3-year bond and pay same coupon and same FV so calculate PV of bond with t = 3

Question 27

What do you do if calculated YTM of a bond that pays semi annual coupons?

Answer 27

Can calculate YTM for a one year period so can compare to other bonds. Do this by ytm = (1 + r)^2 - 1

Question 28

If asked how much a firm raises from issuing new bonds what do you do?

Answer 28

Calculate the PV of 1 bond and multiply it by number of bonds sold

Question 29

If asked how much a firm has to pay at maturity what do you do?

Answer 29

fave value * # bonds

Question 30

What bond value changes when interest rates change?

Answer 30

PV

Question 31

True or false a bonds rate of return is equal to its coupon payment / price paid

Answer 31

FALSE