time value of money - valuing debt instruments

Question 1

What are Debt Instruments?

Answer 1

Debt instruments allow firms and governments to borrow money from investors and, therefore, they are issued in order to raise funds for operations. Further, debt instruments have contractually agreed upon terms for:

–Interest payments; and,
–The repayment of the debt.

Question 2

Types of Debt Instruments

what is the price of these instruments equal to?

Answer 2

–Coupon-paying bonds; and,
–Zero-coupon bonds (types of discount securities): Note that instruments such as bills are examples of **short-term zero-coupon bonds. **

equal to the present value of all cash flows associated with the instrument.

Question 3

Coupon-Paying Bonds:

Answer 3

coupon-paying bond is a contract under which the borrower agrees to:

–Pay the lender periodic interest (c) for a pre-defined number (n) periods. More specifically:

• •The periodic interest payment is known as a coupon payment (C), which is equal to the coupon rate multiplied by the face value (or cF); and,

•Coupons are almost always paid on a semi-annual basis.
Repay the principal (or face value, F) of the instrument at a pre-defined maturity date

Question 4

Cash Flows Associated with Coupon-Paying Bonds:

Answer 4

Question 5

Zero-Coupon Bonds:

Answer 5

zero coupon bond does not pay coupons during its life. Instead, only the face value (F) is repaid at the end of n periods
–Because no coupon payments are made, these instruments are issued for a price below their face value;
–The difference between the issue price and the face value represents the interest accruing to the holder of the instrument over its life; and,
–Because zero-coupon bonds are always issued for a price lower than their face value, they are also known as discount securities.

Question 6

Cash Flows Associated with Zero-Coupon Bonds

Answer 6

Question 7

the main types of bonds issued by two major issuers namely

Answer 7

–Governments; and,
–Corporations.

Question 8

government debt securities are issued by

Whose obligations are they?

Answer 8

The Treasury Department

these securities are obligations of the Commonwealth Government, thus considered to have no default risk

Question 9

. The two main types of debt instruments issued by the Australian Government are:

Answer 9

1. Treasury Notes
2. Treasury bonds

Question 10

what are treasury notes?

Answer 10

: These are zero-coupon bonds with maturities of up to 6 months. Therefore, treasury notes only involve the repayment of the face value at maturity; and

Question 11

what are treasury bonds?

Answer 11

• These are coupon-paying bonds
• maturities of up to 10 years.
• payment of regular (six-monthly) coupons as well as the repayment of the face value at maturity.

Question 12

four major types of corporate bonds

Answer 12

1. Bank accepted bills
2. mortgage bonds
3. debentures
4. convertible bonds

Question 13

Bank Accepted Bills

Answer 13

• are short-term debt instruments that do not pay coupons
• the only cash flow is the repayment of face value at the bill’s maturity

-Typically having maturities of 90 days to 180 days
–the repayment of the face value at maturity is guaranteed by the accepting bank

Question 14

Mortgage bonds

Answer 14

• secured by property including real estate or buildings.
• in the event of default, the property can be sold and the proceeds used to repay bond holders

Question 15

Debentures:

Answer 15

coupon bonds which, similar to mortgage bonds, are secured by tangible assets

Question 16

Convertible bonds

Answer 16

are debt instruments that can be exchanged for shares in the corporation

Question 17

price of a coupon-paying bond (B) given a required rate of return on debt or yield equal to r_d is simply calculated

Answer 17

Question 18

Bond prices that are quoted in the financial media follow a several important reporting conventions, including

Answer 18

–Face value amounts: Bond prices are quoted as if the face value was $100. Therefore, if a bond with a face value of $100,000 has a reported price of 95.00, its actual value is 95% of $100,000 or $95,000; and,
–Coupon payments: The majority of coupon-paying bonds pay coupons semi-annually. Further, coupon rates and yields are quoted as annual nominal rates compounded semi-annually.

Question 19

unless told otherwise

Answer 19

–assume coupons are paid semi-annually and face value is $100.

Question 20

How to determine whether a bond’s price will exceed its face value?

Answer 20

by comparing its percentage yield to it’s percentage coupon rate.

–c > r_d if and only if B > F;
–c = rd if and only if B = F; and,
–c < r_d if and only if B < F.

Question 21

Answer 21

Question 22

how to calculate C (Coupon Payment)?

Answer 22

C= Coupon rate x Face value / Number of coupon payments per year

Question 23

the price of a zero-coupon bond maturing in n periods is calculated as follows:

Answer 23

Question 24

Quotation Conventions for Zero-Coupon Bonds:

Answer 24

–Face Value: As was the case with coupon-paying bonds, zero coupon bond prices are quoted as if the face value is $100; and,
–Bank Accepted Bill Yields: Bank Accepted Bill Yields are quoted on a nominal basis, with the price able to be computed simply by discounting the face value of the bill at the periodic rate.

Question 25

The price of a zero-coupon bond that matures in 3 years given a required return of 10% p.a. is calculated as:

Answer 25

Question 26

The price of a 90-day bank accepted bill quoted as having a yield of 8% p.a. is calculated as:

Answer 26

Question 27

1. 10 year bond yield

Answer 27

Question 28

1. . 5 year bond yield

Answer 28

Question 29

1. 180 day dealers bill rate

Answer 29

Question 30

1. 90 day dealers bill rate

Answer 30

Question 31

what is a bond?

Answer 31

a debt instrument

• issued by borrower, who promises to pay coupons to the bondholder, in addition to the face value when the bond matures

Question 32

what is par value?

Answer 32

face value

this is the amount the bond issuer has to pay to the bondholder on the maturity date

Question 33

what are other terminologies for required rate of return?

r_d

Answer 33

expected rate of return

yield to maturity

discount rate

Question 34

what are zero coupon bonds also called?

Answer 34

pure discount bonds, as they always trade at a discount (price below face value)

Question 35

what are treasury-indexed bonds?

Answer 35

medium-long term securities for which the face value of the security is adjusted for movements in CPI

Question 36

what does it mean when a bonds is traded at par?

Answer 36

the price of the bond is close to or at par (at the bond’s face value)

Question 37

benefit for investor if they purchase a bond that is at discount (below par)?

Answer 37

investor will earn a return from

• receiving coupons
• receiving a face value> price paid for bond

Question 38

when the bond price is above par or at a premium,

Answer 38

coupon rate > yield to maturity (required rate of return)

Question 39

when the bond price is below par or at a discount,

Answer 39

coupon rate < yield to maturity

Question 40

what happens when interest rate rises?

Answer 40

Interest rates rise, bond yields rise

as a higher discount rate is applied to bond’s remaining cash flows –> present value is reduced –> fall in bond’s price

Question 41

what happens to the bond prices when interest rate falls?

Answer 41

investors demand a lower yield to maturity –> reducing the discount rate applied to the bond’s cash flows and raising the bond price

Question 42

relationship between the coupon rate of bond and its yield to maturity

Answer 42

when coupon rate of the bond is > yield to maturity, it is trading at a premium

coupn rate= yield to maturity, trades at par

Coupon rate < yield to maturity, trades at a discount

Question 43

why are Australian securities risk free?

Answer 43

no chance government will fail to pay the interest and default on bonds

Question 44

what is the risk of default?

what is used to compensate this?

Answer 44

credit risk

yield of bonds with credit risk will be higher to compensate for the credit risk, also investors pay less for bonds with credit risk

Question 45

what are bonds in the top four categories referred to?

Answer 45

1. investment grade bonds (low default risk)

Question 46

what are bonds in the bottom 5 categories referred to?

Answer 46

1. speculative bonds
2. Junk bonds
3. High-yield bonds

Due to high risk of default

Question 47

what does the bond rating depend on?

Answer 47

risk of bankrupty

whether the bondholder has made a claim on the firm’s assets in the event of bankruptcy

Question 48

what is credit or default spread?

Answer 48

difference between the yields of the corporate bonds and that of the Treasury’s

as creditworthiness of corporate bonds decrease –> credit spread on the bonds increase

Question 49

what is yield to maturity?

Answer 49

rate of return of investing in the bond and holding it to maturity

Question 50

What will happen to the price of the bond immediately after a coupon is paid? Why?

Answer 50

The price of the bond will fall by exactly $4.00. This is because the price of the instrument is the present value of the future cash flows given by the instrument. Immediately before the coupon payment, the price would reflect the imminent coupon payment of $4.00 (as it is about to be paid, the present value of this cash flow is $4.00). Following the coupon payment, it would no longer form part of the future cash flows of the instrument and this would be reflected by the price decreasing by $4.00.

Question 51

if your share is 9.50 and the shares in VC Limited are currently trading at $10.00, do they represent a good investment from your perspective? Why?

Answer 51

No, they don’t as the value to you of a share in VC Limited is $9.50 (ie this is what you would be willing to pay for a share in the company), but they are trading at a price higher than this, namely $10.00.