S1 - bond valuation

Question 1

what are bonds

Answer 1

a bond is a security sold by the governments or corporations to raise money form investors in exchange for the promised future payments
Maturity - the length of time remaining until the repayment date
Face value - amount of money that must be repaid at the end of the bonds life
Coupon rate - interest rate set by the bond issuer as the promised interest payments
Issued in primary market but can be traded on secondary
Less risky than equity
Bondholders above shareholders if going bankrupt

Question 2

how can you ensure debt from a bond is repaid

Answer 2

collateral specific company assets can be linked to the debt and lender can claim these if the company reneges on the debt repayments
Covenants can be written in to the contracts

Question 3

what are debt covenants

Answer 3

protect lenders
Prevent the company taking actions that will increase the risk of default on the debt
If breached, debt may become repayable immediately
Tools that allow them to enforce and define rules

Question 4

what are the types of debt covenants

Answer 4

positive = actions borrowed must do
Negative = prohibit borrower from doing certain action
Financial = specific financial condition to be satisfied

Question 5

how do shares and bonds work with tax

Answer 5

pay interest on bonds and then tax
Pay tax and then pay dividends
Debt is cheaper than equity

Question 6

what is bond rating

Answer 6

bonds are generally rated in terms of their credit risk
Judges the quality and creditworthiness
Higher rating = lower interest rate and less risk
Determines entity ability to remain liquid
AAA to BBB-
US government debt is thought of as risk free

Question 7

what are open markets

Answer 7

Open market operations change the monetary policy and money supply
Buys and sells treasury bills to change money in economy
Aim to reach a specific interest rate - federal funds rate. Effects the rates - changes loans demanded
Stimulate economy, purchase treasury bills from banks - more reserves, lower interest rate - expansionary
Decrease money supply and reserves - increase interest rates, slow down inflation - contractionary

Question 8

what are the bond lengths

Answer 8

short = less than 5 years
Medium = 5 - 15 years
Long = more than 15 years

Question 9

what are the types of bonds

Answer 9

corporate bonds - issued by a company
Government issued
Municipal - issued by local governments
Debentures - unsecured by collateral and backed by creditworthiness and reputation of issuer
Zero coupon - doesn’t pay interest
Eurobonds - bonds issued in another currency

Question 10

what are call and put provisions

Answer 10

bonds can have call provisions - issuers can call back bonds - higher yield than comparable noncallable bonds to compensate lenders
Bonds can have put provisions - bondholders can resell a bond back to issuer and have lower yield a they can cancel the debt

Question 11

what is bond value

Answer 11

= PV(coupon payments) + PV(face value)
c/1+r + c/(1+r)^2 + … + FV/(1+r)^n

Question 12

what is YTM

Answer 12

Yield to maturity
the discount rate that sets the value of the bond equal to the current market price of the bond
What could be earned if kept until maturity
Accounts for future coupons at present value today
YTM = discount rate when C, FV and P are given
Bond prices and market interest rates move on opposite directions
Coupon rate = YTM, price = par value
Coupon rate > YTM, price > par value
Coupon rate < YTM, prive < par value
As interest rate rises, bond value falls
Bondholders hope interest rates fall so bond prices rise and they can sell bonds for a higher price in the market

Question 13

what is the Macaulay duration

Answer 13

weighted average maturity of the cash flows of a bond
PV of cash flow / bond price
PV = 1/(1+r)^t
R = rate for that period
T = period

Question 14

what is modified bond duration

Answer 14

tells investors how much a bonds price might change when interest rates change
How much risk they face from interest rate changes
ModD = D / (1+YTM/K)
Price change % = -1 x ModD x change of YTM

Question 15

what is term structure

Answer 15

relationship between maturity and yield is the yield curve
Relationship between short and long term rates of interest for investments that are riskless
Upward sloping = current long term rate > current short term rate (short term to rise)
Flat = long term = short term (short term to stay the same)
Downward sloping = long term < short term (short term to decline)

Question 16

what are the explanations for different yield curves

Answer 16

expectations theory
liquidity theory
inflation risk theory

Question 17

what is the expectations theory

Answer 17

investing in a succession of short term bonds gives exactly the same expected return as investing in a long term bond
Equilibrium will be established when 1r2 = f2
Expected future spot rate is equal to the forward rate for that time period
Only reason for rising term structure is that investors expect short term rates to rise

Question 18

what is the liquidity theory

Answer 18

short dated bonds are less sensitive to interest rate changes than long dated bonds
Liquidity preference hypothesis is based upon the choices investors have regrading bonds with different maturities
Short date fixed rate securities enable investors to move their investments to exploit the greatest yields and protect their capital
Long dated fixed rate redeemable bonds lock investors to a given rate of interest over a long period. If yields were to change in that time this exposes investors to capital risk
Investors demand a liquidity premium for holding a long dates bond

Question 19

what is the inflation risk theory

Answer 19

assume that investors are risk averse and are uncertain about the future rate of inflation
Investors demand a premium fir holding long term bonds
Investing in short term bonds protects form inflation

Question 20

what is risk of default

Answer 20

yield curve additional factor related coupon yield bonds
Credit risk that their return is not actually delivered
Investors are risk averse and demand a risk premium for undertaking credit risk