Chapter 6 Fin 370

What is a bond rating?

A bond rating is a classification provided by several companies that assess the creditworthiness of bonds and make this information available to investors. By consulting these ratings, investors can assess the creditworthiness of a particular bond issue. The ratings therefore encourage widespread investor participation and relatively liquid markets. The two best-known bond-rating companies are Standard & Poor's and Moody's.

What risk does an investor in a default-free bond face if he or she plans to sell the bond prior to maturity?

An investor in a default-free bond will face the interest rate risk if she plans to sell the bond prior to maturity. If she chooses to sell and the bond's yield to maturity has decreased, then she will receive a high price and earn a high return. If the yield to maturity has increased and the bond price is low at the time of sale, she will earn a low return.

There are two reasons the yield of a defaultable bond exceeds the yield of an otherwise identical default-free bond. What are they?

Because the yield must be higher to compensate for the risk of not receiving the required cash flows and to compensate for the fact that the expected cash flow is lower than the required cash flows

How do you calculate the price of a coupon bond from the prices of zero-coupon bonds?

Because we can replicate a coupon-paying bond using a portfolio of zero-coupon bonds, the price of a coupon-paying bond can be determined based on the zero-coupon yield curve using the Law of One Price. In other words, the information in the zero-coupon yield curve is sufficient to price all other risk-free bonds.

If a bond's yield to maturity does not change, how does its cash price change between coupon payments?

Between coupon payments, the prices of all bonds rise at a rate equal to the yield to maturity as the remaining cash flows of the bonds become closer. But as each coupon is paid, the price of a bond drops by the amount of the coupon.

Why do sovereign debt yields differ across countries?

Investors consider inflation expectations and default risk when determining the yield they are willing to accept on the sovereign bonds, thus the yields differ due to differing inflation expectations and default risk.

How do you calculate the price of a coupon bond from the yields of zero-coupon bonds?

Since zero-coupon bond yields represent competitive market interest rate for a risk-free investment with a term equal to the term of the zero-coupon bond, the price of a coupon bond must equal the present value of its coupon payments and face value discounted at these the zero-coupon bond yields.

Explain why two coupon bonds with the same maturity may each have a different yield to maturity.

The coupon bonds with the same maturity can have different yields depending on their coupon rates. The yield to maturity of a coupon bond is a weighted average of the yields on the zero-coupon bonds. As the coupon increases, earlier cash flows become relatively more important than later cash flows in the calculation of the present value.

How does a bond's coupon rate affect its duration—the bond price's sensitivity to interest rate changes?

The higher the coupon rate, all else equal, the lower the duration.

The risk-free interest rate for a maturity of n-years can be determined from the yield of what type of bond?

The risk-free interest rate for a maturity of n-years can be determined from the yield of a default free zero-coupon bond with the same maturity. Because a default-free, zero-coupon bond that matures on date n provides a risk-free return over the same period, the Law of One Price guarantees that the risk-free interest rate equals the yield to maturity on such a bond.

What is the relationship between a bond's price and its yield to maturity?

The yield to maturity of a bond is the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond. Thus, the bond price is negatively related to its yield to maturity. When the interest rate and the bond's yield to maturity rise, the bond price will fall (vise versa).

What options does a country have if it decides it cannot meet its debt obligations?

To avoid default, a country has the option to print additional currency to pay its debts, but, doing so is likely to lead to high inflation and a sharp devaluation of the currency.