Lecture 4 - Valuing Bonds Flashcards
What is the price of a bond?
The present value of all cash flows generated by the bond (i.e. coupons and face value) discounted at the required rate of return.
When the market interest rate exceeds the coupon rate…
Bonds sell for less than face value.
When the market interest rate is below the coupon rate…
Bonds sell for more than the face value.
When the interest rate rises, the present value of the payments to be received by the bondholder…
Falls and bond prices fall.
Conversely, a decline in the interest rate…
Increases the present value of the payments to be received by the bondholder and bond prices increase.
What do interest rate changes affect?
The present value of the coupon payments but not the coupon payments themselves.
If the market interest rate falls…
The price of bonds rise.
If the market interest rate rises…
The price of bonds fall.
Any changes in interest rates has a greater impact on the price of long term bonds than…
The price of short term bonds.
What is the current yield?
Annual coupon payment divided by bond price.
What is yield to maturity?
The discount rate that equates the bond’s price to the present value of all its promised future cash flows.
What are premium bonds?
Bonds selling above par value. Investors who buy a bond at premium must absorb a capital loss over the life of the bond, so the return on these bonds is always less than the bond’s current yield. Coupon rate > current yield > YTM.
What are discount bonds?
Bonds selling below par value. Investors in discount bonds receive a capital gain over the life of a bond, so the return on these bonds are always greater than the bond’s current yield. Coupon rate < current yield < YTM.
What is the rate of return?
Total income per period per dollar invested.
If interest rates rise, what will the relationship between rate of return and YTM be?
The rate of return will be less than the yield to maturity.
If interest rates fall, what will the relationship between rate of return and YTM be?
The rate of return will be greater than the yield to maturity.
What does YTM measure?
The rate of return you will earn if you buy a bond today and hold it till maturity.
What does the yield curve show?
It plots the relationship between the yield to maturity and time to maturity.
What are spot interest rates?
They are the discount rates for default free, zero coupon bonds. Interest rate fixed on a loan that is made today.
What is the term structure of interest rates?
The set of spot rates for all possible future dates.
What does the current yield not measure?
The bond’s total rate of return. It overstates the return on premium bonds and understates that of discount bonds.
What does the current yield measure?
It focuses on the current income and ignores prospective price increases or decreases.
What are forward rates?
Interest rates fixed on a loan to be made at a later date. It is also known as future yield on a bond. It is a forecast of a future spot rate.
What is expectation hypothesis?
In well functioning markets, investments in short maturity bonds must offer the same expected returns as an investment in a single long maturity bond. Relatively high yields on long term bonds reflect expectations of future increases in rates.
What is the liquidity preference theory?
Long term bonds are subject to greater interest rate risk than short term bonds. Investors in long term bonds might require a risk premium to compensate them for bearing the risk.
What is a normal yield curve?
A normal yield curve is upward sloping. Longer maturity bonds have a higher yield compared with shorter term bonds due to the risk associated with time.
What is an inverted yield curve?
An inverse yield curve is downward sloping. The shorter term yields are higher than longer term yields, which can be a sign of upcoming recession. An inverse yield curve might be expected when interest rates are high but expected to fall.
What is a flat yield curve?
The shorter and longer term yields are very close to each other, which is also a predictor of an economic transition.
In the presence of inflation, an investor’s real interest rate is always…
Less than nominal interest rate.
