Valuing Bonds Flashcards
What is a bond?
A bond is a security sold by governments and corporations to raise money from investors today in exchange for promised future payments
What is a bond certificate?
A bond certificate describes the amounts and dates of all payments to be made
What is the maturity date of a bond?
The maturity date is the date at which the final repayment of a bond is made
What is the term of a bond?
The term of a bond is the time until the final repayment date
What are the coupon payments of a bond?
The coupon payments are the promised interest payments on a bond
What is the Face Value or Principal Value of a bond?
This is the notional amount used to compute interest payments
What is the Coupon Rate?
This is the amount of each coupon payment
What is the equation for calculating coupon payments
CPN= (Coupon Rate*Face Value)/ Number of Coupon Payment per Year
What is a zero coupon bond?
A zero coupon bond is one which does not make coupon payments. The only cash payment the investor receives is the face value of the bond at the maturity date.
What is the Yield to Maturity (YTM) of a bond?
-IRR of a bond
-The discount rate that sets the present value of the promised bond payments equal to the current market price of the bond
What is the equation for the price of a zero coupon bond?
-P= [FV/(1+YTMn)]^n
What is the equation for YTM?
YTMn= [(FV/P)^1/n]-1
What is the relationship between the risk free interest rate and zero coupon bonds?
-Risk free interest rate = YTM
What are coupon bonds?
Pay investors face value at maturity + regular interest payments
What are the difference between treasury notes and treasury bonds?
-Treasury notes have a maturity of less than 10 years
-Treasury bonds have a maturity of more than 10 years
What is the equation for the price of a coupon bond?
P= (CPN/y)*(1-1/[(1+y)^n]) + FV/[(1+y)^n]
What is meant if bonds trade at a discount?
-YTM>CPN
-An investor will receive a return both from receiving coupons and receiving a face value payment that exceeds the initial price paid
What is meant if bonds trade at a premium?
-YTM<CPN
-Investor’s return from coupons is diminished by receiving a face value less than the price paid for the bond
What is meant if bonds trade at par value?
-YTM=CPN
-Most issuers choose a coupon rate so that bonds will initially trade at or very close to par
What is the relationship between bond prices and bond term?
-Price increases as the term increases
-Between coupon payments the prices of all bonds rise at a rate equal to the yield to maturity
How does the price of a bond change with coupon payments?
-The price of the bond will decrease by the amount of each coupon payment
-Premium: Price drop when coupons are paid exceed the price increase between coupons
-Discount: Price increase between coupon payments exceed the price drop when a coupon is paid
What do the price of all bonds tend towards as they approach maturity?
Face value
What is the relationship between interest rates, bond yields and bond prices?
-As interest rates and bond yields rise, bond prices fall
-High YTM –> High discount rate –> Reduction in PV and bond price
What is the duration of a bond?
-The sensitivity of a bond’s price to changes in interest rates
-Shorter maturity zero coupon bonds are less sensitive to changes in interest rates than higher maturity bonds
How can you model the cash flows of a coupon bond?
-Modelled using a series of zero coupon bonds
-Each coupon payment is matched to a zero coupon bond
-Face value of zero coupon bond = coupon payment
-Term= time remaining to maturity date
-Law of One Price means that the price of the portfolio of zero-coupon bonds must be equal to the price of the coupon bond
What is the equation for valuing a coupon bond using zero-coupon yields?
P= PV(Bond Cash Flows)= Sum [CPN/(1+YTM)^n]
What is the yield to maturity of a coupon bond?
The weighted average of the yields of the zero-coupon bonds of equal and shorter maturities
How does the yield of coupon bonds vary with coupon rates?
Higher coupon payments means earlier cash flows become relatively more important than later cash flows in the calculation of present value
What does an upward sloping yield curve indicate?
The YTM decreases with the coupon rate of the bond
What does a downward sloping yield curve indicate?
The YTM increases with coupon rates
What is the key difference between corporate bonds and treasury bonds?
Corporate bonds might default
What is the risk of default called?
The credit risk
How are corporate bond yields calculated?
-Calculated using promised cash flows
-Therefore, the cash flows an investor expects to receive may be less than the bond yield
-Investors therefore pay less for bonds with higher credit risks
-The yields of corporate bonds with be higher than those of identical, risk free bonds
What is the price of a corporate bond with no credit risk?
P= Fave Value/ (1+YTM)
What is the price of a corporate bond which is certain to default?
P= (Risk Free % of Face Value)/ (1+YTM)
How do you calculate the price of a corporate bond where it is uncertain if the company will default?
-Discount cash flows using the cost of capital
-Cost of capital= debt cost of capital + risk premium
-Expected return= Debt cost of capital
How do you know if there is a risk of default with a corporate bond?
If the firm’s debt cost of capital is less than the YTM
What are sovereign bonds?
-Bonds issued by national government
-Risky so behaves like corporate debt
-Countries can print more money to pay debt, however this can cause inflation which would devalue the payment to investors
