Theory Midterm 2

A bond issued by the UK debt management office, denominated in british pounds and sold in the United Kingdom is what kind of bond

(domestic bond)

A bond issued by Sony in Japan, denominated in US dollars but not registers with the SEC, and sold to an institutional investor in the Middle East is what kind of bond

(eurobond)

A bond issues by LG group from SOuth Korea, denominated in British pounds, and sold in the United Kingdom is what kind of bond

(foreign bond)

A bond issued by Wal-Mart from the US, denominated in US dollars, and sold in various countries in the North America, Europe, the Middle East, Asia Pacificm and the Eurobond market

(global bond)

% Change in Price of a Bond

- (-D) x change in yield - If the change in yield is a decrease, then it is a negative - If the change in yield is a increase, then it is positive

Dollar Duration

- (-D) x market value x change in yield - If the change in yield is a decrease, then it is a negative - If the change in yield is a increase, then it is positive

Floating Coupon Rate

- (FRNs) or floaters pay a floating rate of interest that includes two components: - Reference rate - resets periodically as it changes the coupon rate and the coupon payment change accordingly. A widely used re - Spread or margin - typically constant and based on the issuer's creditworthiness at issuance (the higher the credit quality, the lower the spread). Expressed in basis points (bps)

Basis point is how much?

- A basis point is equal to 0.01% (there are 100 basis points in 1%)

Define a bond:

- A bond is a debt security that allows bond issuers to borrow money from investors - A bond is a contract that legally obligates the issuer to make specified payments to the bondholder at specified payments to the bondholder at specified future dates. Bonds are known as fixed income securities - Failures to pay interest or principal payments in a timely manner is an act of default - The most prevalent means of raising capital globally

Perpetuity

- A stream of equal cash flows that occur at regular intervals and last forever - An example of this is a british government bond called a consol

Annual vs Semi Annual

- Annual - Do not need to adjust N, I, or PMT - Semi annual - N x 2, Interest/2, PMT/2 - If the question asks for N, after calculating, you divide by 2 to convert to annual format - If the question asks for I/YR, after calculating, you multiply by 2 to convert to annual format - If the question asks for PMT, after calculator, you multiply by 2 to convert ti annual format

Different Months Compounded

- Annual = 1 - Semiannual = 2 - Quarterly = 4 - Monthly = 12 - Daily = 365 - Compounded interest problems have no Payment

Classification of Interest Rates: Anuual Percentage Rate (APR)

- Annual percentage rate (APR) is known as quoted or stated rate and ignores compounding effects - APR = periodic interest rate x months compounded

Annuity due

- Annuity due: annuity whose payments occur at the beginning of each period, BGN mode

What are the key features of a bond: Currency denomination

- Bonds can be issued in any currency, but most often in either euros or US dollars. The currency of issue may affect bond attractiveness. - If the currency is not liquid or freely traded, or if the currency is very volatile relative to major currencies, investment in that currency will not appeal to many investors - Dual Currency Bonds - make coupon payments in one currency and pay the par value at maturity in another currency.

Explain Callable Bonds

- Callable bond gives the issuer the right to redeem all or part of the bond before the maturity date - Callable bonds protect the issuer against a decline in interest rates. This decline can come either from market interest rates falling or from the issuer's credit quality improving. If market interest rates fall or credit quality improves, the issuer of a callable bond has the right to replace an old, expensive bond issue with a new, cheaper bond issue. - Callable bonds present investors with a higher level of reinvestment risk than non-callable bonds. Therefore, callable bonds have to offer a higher yield and sell at a lower price than otherwise similar non-callable bonds.

Explain convertible bonds`

- Convertible bonds give their owners the right to exchange the bonds for a pre-specified number of shares of stock anytime up and including the maturity date of the bond. - Bondholder: - Convert into equity, Downside protection, Yield advantage - Issuer: - Reduced interest expense, Elimination of debt - Young, small, high-growth firms

What are the key features of a bond: COUPON INTEREST RATE

- Coupon rate (nominal rate) - interest rate that the issuer agrees to pay each year until maturity - Frequency of coupon payments - Most bonds pay interest every 6 months, but can pay it monthly, quarterly, or annually

Classification of Interest Rates: Effective annual rate (EAR)

- Effective annual rate (EAR) is the annual rate of interest actually being earned, considering compounding - If M = 1 then EAR = APR - if M > 1, then ?

What are the key features of a bond: Issuer (corporate sector)

- Financial issuers: banks and insurance companies - Non-financial issuers: BP, Genera; Electric

Foreign bonds

- Foreign bonds- bonds that are issued and traded in a specific country, denominated in the currency of that country and issued by entities that are incorporated in another country - Ex: toyota issues bonds denominated in US dollars in the US

Explain Flat Price and Full Price of a Bond

- Full price = flat price + accrued interest - Full price is also called the dirty price - Flat price is also called the clean price - Accrued interest is the coupon payment for the period times the fraction of the period that has passed since the last coupon payment - Accrued interest = (coupon payment/12) x months since last payment - Total duration is usually 6 months

Distinguishing between Perpetuities

- If gives you payment per year then regular perpetuity - If payment grows or declines then growing perpetuity

What are the key features of a bond: PRIORITY OF CLAIM ON ASSETS AND INCOME

- If the borrowing firm is unable to repay the debt in accordance with the bond indenture, the bondholders can force the firm into bankruptcy. - In the case of insolvency, the claims of the debtholders must be honored before those of the firm's stockholders

Non-Annual Cash Flows

- If the question asks for compounded interested annually, semiannually, quarterly, monthly, or daily - Interest needs to be divided by how much it is compounded - N needs to be multiplied by how much it is compounded

Interest Rate Risk

- Interest rate (price) risk is the risk that the price of a debt security that will fall as result of increase in interest rates - Inverse effects: bond price is inversely related to market interest rate (YTM) and when the YTM increases, the bond price decreases - Maturity effect: all other things being equal, the longer the time to maturity, the greater the interest rate risk - Coupon effect: all other things being equal, the lower the coupon rate, the greater the interest rate risk - Convexity effect: all other thing sbeing equal, the percentage price changes is greater (absolute value) when the market discount rate goes down when it goes up

What are the key features of a bond: Maturity

- Maturity date - date when the issuer is obligated to redeem the bond by paying the outstanding principal amount - Tenor (term-to-maturity - the time remaining until the bond's maturity date - Maturities range from overnight to 30 years or longer - Money market securities - one year or less - Capital market securities - longer than one year - Perpetual bonds - no stated maturity date (ex: consols)

Duration

- Measure of interest rate risk and measures the sensitivity of the return on a bond will be in regards to changes in interest rates - The formula is (price of bond when the yield decreases by small amount - price of bond when its yield increases by a small amount) / (2 x current price of the bond x the small amount by which the yield is increased by; usually in basis points) - i would just personally write this on a cheat sheet

Time Value of Money

- Money today is worth more in the future - Time value of money is the difference in value between money today vs the future

Annuity Defintion

- Most car loans, mortgages, and some bonds are annuities

Uneven Cash Flows

- Multiple cash flows that are not equal and do not occur at equal intervals - Both conditions must be present in order to be considered as a cash flow

Interest Conversion on the Calculator

- NOM = annual percentage rate (APR) - C/Y = months compounded - EFF = effective annual rate (EAR)

Ordinary annuity

- Ordinary annuities: annuity whose payments occur at the end of each period, END mode

What are the key features of a bond: PAR VALUE

- Par value (face value, principal, maturity value) is the amount of principal the issuer must pay back to the bondholder on the maturity date - bonds can have any par value - Bond prices are quoted as percentage of par value

`Classification of Interest Rates: Periodic Rate

- Periodic rate is the amount of interest charged per period - Periodic interest rate formula - APR/M and M is number of times compounded

What are the key features of a bond: Issuer (government)

- Supranational organizations: world bank - National governments: United States or Japan - Local governments: State, Region, or City - Quasi-government entities: postal services

What are the key features of a bond: bond indenture

- The legal agreement between the issuer of a bond and its bondholders that set forth the obligations of the borrowers and the rights of the bondholders - The bond indenture may run 100 pages or more in length and describes the details of a bond issue: terms of repayment, collateral, protective covenants, default provisions, etc

Key relation ships of bonds

- The value of a bond is inversely related to changes in the market's required yield to maturity - When market interest rates increase, the value of the bond decreases, and vice versa - The market value of a bond will be less than the par value if the yield to maturity is above the coupon interest rate and will be valued above par value if the yield to maturity is below the coupon interest rate - As the maturity date approaches, the market value of a bond approaches its par value

Present and Future Value

- The value of a cash flow that is moved forward in time is its future value and the process of moving a cash flow forward is called compounding - The value of a cash flow that is moved backwards in time is called present value and the process of moving it back is called discounting

What is a zero coupon bond

- Zero coupon bonds or pure discount bonds - Do not pay interest Issued at a discount to par value and redeemed at par - Interest is implied and equal to the difference between the par value and the purchase price

Eurobonds

- bonds issued and traded in the eurobond market - Issued internationally, to investors in more than one country - Underwritten by an international syndicate - a group of financial institutions from different jurisdictions - Can be denominated in any currency. Generally, not issued in the country that issues the currency in which they are denominated, Therefore, not under the jurisdiction of that country - Usually unregistered. Might be subject to the registration requirements (if any) in the country in which issued - Less regulated than domestic and foreign bonds and usually unsecured. Trustee does not keep record of who owns the bond - Named in accordance with the currency in which denominated: e.g. eurodollar bond - denominated in US $ but not issued in US

Global bonds

- bonds issued simultaneously in the eurobond market and in at least one domestic bond market - Ex: bonds issued and traded simultaneously in the US market (yankee bonds) and in the eurobond market - Issuing bonds in several markets at the same time ensures that there is sufficient demand for large bond issues, and that the bonds can be purchased by all in investors, no matter where the investors are located - only very large, high quality, regular bond issuers can access the global bond market

Domestic Bonds

- bonds that are issued and traded in a specific country denominated in the currency of that country, and issued by entities that are incorporated in that country - Ex: Ford issues bonds denominated in US dollars in the US

Current yield formula and definition

- coupon/price - the bond interest rate as a percentage of the current price of the bond

Yield to maturity formula and definition

- current yield + capital gains yield - an estimate of what an investor will receive if the bond is held to its maturity date

What is implied interest

- difference between the par value and the purchase price - Ex: if the par value is $1,000 and the purchase price is $950, the implied interest is $50

Yield to Maturity (YTM) or Yield to Redemption

- discount rate that equates the present value of the bond's expected cash flows until maturity with the bond's price - Estimate of a bond's expected return: annual return that an investor would earn on a bond he purchases today and holds until maturity

conversion premium

- is the percentage difference between the conversion price of the convertible bonds and the current stock price - Conversion Premium = (Conversion Price - Stock Price) / Stock Price

conversion price

- is the price per share at which the convertible bond can be converted into shares. The conversion price is equal to the par value divided by the conversion ratio. - Conversion Price = Par value / Conversion Ratio

conversion ratio

- measures the number of shares the bondholder receives when the bond is converted - Conversion Ratio = # of shares

Loan Amortization: Steps

- step 1: find PMT by inputting N, I/Y, PV, and FV (FV is always 0) - step 2: find interest by taking your beginning balance aka current balance and multiplying by the interest rate - step 3: find principal repaid by taking your PMT in step 1 and subtracting your interest in step 2 Step 4: find the ending balance by subtracting the beginning aka current balance and the principal Step 5: repeat until the ending balance is 0

Capital gains yield formula and definition

- yield to maturity - current yield - the bond price appreciation as a percentage of the current

Timeline

A linear representation of the timing of potential cash flows and helps visualize financial problems

A (blank) is a debt security that allows bond issuers to borrow money from investors. It is a contract that legally obligates the issuer to make specified payments to the bondholder at specified future dates. It is known as the fixed-income security

Bond

Calculating Coupon Rate, not Coupon Payment

Coupon payment / par value (usually 1,000) then multiply by 100 to get to %

(Blank) is the percentage of par value that is paid out as interest. Can be fixed or floating.

Coupon rate

Cash flow types: Uneven Cash Flows

Different cash flows that can occur ar random times

Callable Bond Parts: Call Date

Earliest time a bond might be called

A bond will sell at a discount when the yield to maturity is (blank) than the coupon rate

Higher

Bond (blank) is the legal agreement between the issuer of a bond and its bondholders that sets forth the obligations of the borrower and the rights of the bondholders

Indenture

Higher interest rates mean what

Lower present value

Cash flow types: Annuity

Multiple equal cash flows of the same payment over a finite period of time

Compound interest formula

PV (1+interest)^N

Simple Interest Formula

PV x interest rate

(Blank) is the amount of principal the issuer must pay back to the bondholder on the maturity date. In general, corporate bonds are issued in denominations of $1,000. This amount can be much greater for government bonds.

Par value

Bond prices are quoted as a percentage of (blank)

Par value

Plan Vanilla Bond

Plain vanilla bond or conventional bond pays a fixed rate of interest. The coupon payment does not change during a bond's life

A bond quote above 100 means that the bond is trading above par and is a (blank) bond, while a bond quote below 100 means that the bond is trading below par and is (blank) bond

Premium, discount

Growing perpetuity

Present value of a growing perpetuity = PMT/(interest - growth)

Regular perpetuity

Present value of regular perpetuity = PMT/interests

Cash flow types: Lump Sum

Recieve one single cash flow

Key Words that Hint at Begin Mode

Starting today, payments occur immediately, first day of the year, starting today, beginning of the year

What are the two formulas for computing YTM?

YTM = CY + CGY YTM = r +IP + DRP + LP + MRP

the general expression for the yield on any debt security

YTM = rRF + IP + DRP + LP + MRP

From the following, what is true about yield to maturity? - the rate that equates price of the bond with the discounted cash flows - the expected rate to be earned if the bond is held to maturity - the rate that is used to determine the market price of the bond - equal to the current yield for bonds priced at par

all are correct

Current yield

annual coupon payment / price of a bond

Callable Bonds: American Style Call

any time starting on the first call date

What are the key features of a bond: Issuer (private individuals)

celebrity bond

What are the key features of a bond: Yield Measures

current yield and yield to maturity

If market interest rates rise, the value of bonds

decrease

DRP (default risk premium)

default risk measures the likelihood that a firm will be unable to pay the principal and interest on a bond in accordance with the bond indenture. Bond ratings are used to measure default risk: the lower the grade of a bond, the higher its yield to maturity

YTM is greater than coupon then it is a

discount

Basic Definitions: FV

ending amount of the investment after N periods

IP (inflation premium)

expected inflation risk

Basic Definitions: I/Y

growth rate earned per period, entered as a number in the calculator and not as a decimal

Interest rate risk

is the chance of loss because of changing interest rates. The relationship between bond prices and interest rates is inverse. If market interest rates rise, the value of bonds will fall

MRP (maturity risk premium)

long - term bonds have greater interest rate risk than short term bonds. For example, a bond that matures in one month is much more predictable and thus less risky than a bond that matures in 10 years

LP (liquidity or marketability premium)

marketability risk refers to the difficulty of trading a bond. Most bonds do not trade in an active secondary market. The majority of bond buyers hold bonds until maturity. Trading volume is used to measure marketability

Basic Definitions: N

number of periods involved in analysis

Callable Bonds: Bermuda Style Call

on specified dates following the call protection period (usually coupon payment dates)

Callable Bonds: European Style Call

only once on the call date

Basic Definitions: PV

original amount invested at the beginning of the first period

YTM is less than the coupon then it is a

premium

Callable Bond Parts: Call Price

price paid to bondholders when bond is called

Callable Bond Parts: Call Protection Period

prohibits issuer from calling a bond early in its life

rRF (risk free rate)

rate on a security that is free of all risks

Callable Bond Parts: Call Schedule

specifies the dates and prices at which the bond may be called

For bonds, the PV is always negative

true

True/ False: there is an inverse relationship between bonds' quality ratings and their required rate of returns. Thus, the required return is lowest for AAA rated bonds, and required returns increase as the ratings get lower.

true

Whenever a problem says "invest (blank) amount, the calculator input should be positive

true