Week 6: Fixed income security

Question 1

What is a bond?

Answer 1

a bond is loan from an investor to a borrower such as a company or government.

Question 2

Advantages of using bonds:

Answer 2

1) Does not dilute the value of existing shareholdings- unlike issuing additional shares.
2) Enabling more cash to be retained in the business- as redemption date for bonds can be several years after the issue date.

Question 3

Disadvantages of bonds:

Answer 3

1) Regular interest payments to bondholders.
2) bondholder restrictions.
3) Having to comply with various listing rules.
4) potential for share value reducing if profits decline- this is because bond interest payments take precedence over dividends.

Question 4

Bond types:

Answer 4

1) Straight-bond
2) Zero coupon bond/ pure discount bond
3) Deferred- coupon bond
4) Perpetuity bond

Question 5

What is a straight-bond?

Answer 5

Fixed-rate, only the last instalment including the principal.
Low risk as you get a stable amount of the money during the time.

Question 6

What is a zero-coupon bond?

Answer 6

No periodic interest but have a single payment at maturity.
High risk as there is no payback until the end. but usually have higher returns.

Question 7

What is a deferred-coupon bond?

Answer 7

Permit the issuer to avoid interest payment obligations for a certain period.
High risk, high reward.
No payback in the beginning, but higher payback at maturity.

Question 8

What is a perpetuity bond?

Answer 8

Last forever and only pay interest. Found mostly in the UK,. Do not receive your principle back.

Question 9

What are the two categories international bonds are divided into?

Answer 9

1) Foreign bonds
2) Eurobonds

Question 10

What is a foreign bond?

Answer 10

Bonds are issued by a borrower from a country other than the one in which the bond is sold.
e.g. German firm sells a dollar-denominated bond in the US.

Question 11

What is a Eurobond?

Answer 11

Bonds that are denominated in one currency, but sold in other national markets.
e.g. The Eurodollar market refers to dollar-denominated bonds sold outside the US.

Question 12

What is the relationship between bond prices and yields?

Answer 12

Negative relationship: larger yields mean lower bond prices
It is non-linear: The shape of the curve implies that an increase in the interest rate results in a price decline that is smaller than the price gain resulting from a decrease of equal magnitude in the interest rate.

Question 13

What is the relationship between interest rate and price?

Answer 13

Inverse relationship between these two. When interest rate decreases, price goes up.

Question 14

What Duration risk ?

Answer 14

The measure of the sensitivity of the price of the bond to a change in interest rate.
Higher duration= Higher volatility.

Question 15

What does modified duration measure?

Answer 15

The sensitivity of bond prices to yield changes.

Question 16

Why does a pure discount bond/ zero coupon bond have higher interest rate?

Answer 16

This is because they are more risky- this is because they receive no money until maturity.

Question 17

What is an annuity?

Answer 17

Pay the same amount of money each year until maturity.

Question 18

what is yield/ yield to maturity?

Answer 18

Yield is the earnings generated over a period of time.

Yield to maturity is total returns anticipated if bond is held to maturity.

Question 19

Whats the relationship between bond price and yeilds?

Answer 19

Inverse. As yields increase , bond prices fall.

An increase in a bond’s yield to maturity results in a smaller price change than a decrease in yield of equal magnitude.

Question 20

Are long-term or short-term bonds more sensitive to interest rate changes?

Answer 20

Long-term

Question 21

Are prices of low-coupon or high coupon bonds more sensitive?

Answer 21

Low-coupon bonds are more sensitive.