Stocks and Bonds: Introduction and Valuation

Question 1

Basic terminology/name:

Answer 1

• Bonds are often called fixed-income securities.
• They are so named as the cashflows they deliver to an investor, as well as the dates that these cashflows will arrive, tend to be known (fixed) in advance.

Question 2

Basic structure/how it works:

Answer 2

• A bond is a security issued by a borrower (i.e. the issuer) and purchased by an investor.
• The bond contract obligates the issuer to make pre-specified payments to the bondholder at pre-specified future dates.
• Upon issue, the investor is obliged to pay the issuer the bond price.

Question 3

Different payment schedules will give …

Answer 3

Different bond types.

Question 4

Bonds are borrowing/lending arrangements formalised in contractual form:

Answer 4

• The bond issuer is raising money (borrowing).
• The investor has delivered some money to the issuer (a loan) and expects to see this money repaid (with interest) over time.

Question 5

Bond markets relative to equity markets

Answer 5

Bond markets are around 50% larger in size than equity markets.

Question 6

A K-year zero-coupon bond =

Answer 6

A K-year zero promises the purchaser a single payment, called the face value or par value, K years from the current date. The date of the payment is called the maturity date and K is the time to maturity.

Example:

• A 5-year zero has a face value of £10,000 and is priced at £9750.
• If one was to purchase the bond then;
• One would suffer an immediate cash outflow of £9750
• One would be promised a cash inflow of £10,000, 5 years from today.

Question 7

A K-year coupon bond =

Answer 7

A K-year coupon bond promises the investor periodic cashflows;

• At regular intervals until maturity the bondholder receives a coupon payment: these payments could be made annually, semi-annually or quarterly.
• These coupon payments are usually the same at every payment date.
• The ratio of the total annual coupon payment to the face value is called the coupon rate.
• On the maturity date, the bondholder receives both a coupon payment and the face value.

Question 8

Example:

Bond A is a zero-coupon bond with face value of £100 and 2 years to maturity.

The cashflow will be like:

Answer 8

Question 9

Example:

Bond B has annual coupon payments and coupon rate 6%, with face value of £100 and 2 years to maturity.

The cashflow will be like:

Answer 9

Question 10

Example:

Bond C is a bond with semi-annual coupon payments and coupon rate 5% , with face value of £100 and 2 years to maturity.

The cashflow will be like:

Answer 10

Question 11

A real world example: UK gilts

Answer 11

Question 12

It is much more common to talk about bonds using their …

Answer 12

Yield to maturity or redemption yield rather than their price.

Question 13

Yield to maturity: definition =

Answer 13

The YTM is the constant, hypothetical discount rate that, when used to compute the PV of a bond’s cashflows, gives you the bond’s market price as the answer.

Question 14

Yield to maturity, structure:

Answer 14

• The YTM is just a transform of the bond price.
• We talk about YTMs rather than prices as prices can be very different across bonds due to differing coupon rates, but yields are annual discount rates and thus much more easily compared.
• A higher bond price must mean a lower YTM and vice versa.

Question 15

Bonds: Yield to Maturity II

Example 1:

Answer 15

Question 16

Bonds: Yield to Maturity II

Example 2:

Answer 16

Question 17

Yield to maturity formula

Answer 17

Question 18

Yields, prices and coupon rates I

Answer 18

Coupon rates are fixed at the issue date of a bond, while prices and thus YTMs can vary through the bond’s lifetime.

If after the issue of a bond, the general level of discount rates in the economy rose then we would expect;

• Bond yields to rise
• Bond prices to fall

Question 19

Yields, prices and coupon rates II

Answer 19

• If the coupon rate on a bond is greater than the YTM, then the price of the bond will be above par (or face value).
• If a bond’s coupon rate is below the YTM, then the bond’s price will be below par.

So, for example, in a world of positive interest rates, zero coupon bonds must always be priced below par.

Question 20

Stockholders are…

Answer 20

The owners of the firm. They have the right to vote on company policy and strategy (at AGMs and EGMs), whereas bond holders do not. They are entitled to the residual cashflows from the firm’s operations.

Question 21

Common Stock=

Answer 21

Security representing a share in the ownership of a corporation.

Question 22

Initial Public Offering =

Answer 22

The first sale of stock in a corporation to the public.