Lecture 3: Valuation of Bonds and Stocks Flashcards
what are bonds?
Bonds are financial assets, that represent debt, and pay fixed incomes (payoffs) at specific dates, known in advance, and a final payoff at the maturity
- The seller (i.e., the issuer) borrows money by selling the bonds
- The buyer (i.e., the lender) knows in advance the exact amount they will receive and the payment date
What are coupon bonds?
Bonds that pay periodic/regular cash flows until the maturity plus a final cash flow at the maturity of the bond, are called coupon bonds.
What are zero coupon bonds?
Bonds that have only a final cash flow at the maturity of the bond, are called zero coupon bonds
What is the face value?
Face Value or Principal Value
The final payoff at the maturity of the bond (known in advance)
What is the principal value?
Face Value or Principal Value
The final payoff at the maturity of the bond (known in advance)
What are coupon payments?
Periodic payments of the bond
- The coupon payment is (usually) fixed (known in advance).
What is the maturity of a bond?
The Maturity of a bond is the length of life of a bond (or the number of years it takes to pay the face value).
What is YTM?
The YTM is the market interest rate (and the appropriate discount rate)
What is the Bond Internal Rate of Return (IRR) ?
The Bond Internal Rate of Return (IRR) is the interest rate that equates the PV of bond’s future cash flows with the bond’s current price
What is the Yield-to-Maturity (YTM) ?
YTM is the interest rate that equates the PV of bond’s future cash flows with the bond’s current price
What is interest rate risk for bonds?
Interest rate risk is the possibility that a bond’s value will decrease due to a change in interest rates.
This is because bond prices and interest rates have an inverse relationship, meaning that when interest rates rise, bond prices fall.
What are the risks of investing in a bond?
Interest Rate Risk
- if you can buy a bond with a higher you dont want one with a lower interest rate.
Inflation Risk
- May affect the purchasing power of bond payoffs
(coupon + face value)
Credit Issues (Default Risk)
- The likelihood that a company cannot repay its obligations (coupon + face value)
What are the two types of stock?
The Two types of stocks are:
Preferred stocks (they receive dividends first, but NO voting power)
Common stocks (they receive dividends after, but have voting power)
What is a primary market?
When companies want to raise new capital, they can attract investors by issuing new shares
at a Primary market (IPO)
What is secondary market?
Usually investors trade stocks in stock exchanges as a Secondary market.
