Finance 325 Chapter 7

7.1a- What are the cash flows associated with a bond?

- Coupons- the stated interest payment made on a bond - Face value- principle amount of a bond that is repaid at the end of the term, par value - Coupon rate- annual coupon divided by the face value of a bond Maturity- number of years until the face value is paid

7.5b- In general, what are bid and ask prices?

-Bid is the willing to pay for a security -Asked price is the price a dealer is willing to take for a security

7.7b- What is the Treasury yield curve?

A plot of yields on Treasury notes and bonds relative to maturity Shape of yield curve reflects the term structure of interest rates.

7.2c- What is a sinking fund?

A sinking fund is an account managed by the bond trustee for the purpose of repaying the bonds. The company makes annual payments to the trustee, who then uses the funds to retire a portion of the debt. Some sinking funds start about 10 years after the initial issuance Some sinking funds establish equal payments over the life of the bond Some high-quality bond issues establish payments to the sinking fund that are not sufficient to redeem the entire issue.

7.1b- What is the general expression for the value of a bond?

Bond Value = PV of the coupons + PV of the face value Bond value = C (1-1/(1+r)^t)/r + F/(1+r)^t

7.3b- What is a junk bond?

Low grade bonds; rated below investment grade

7.6a- What is the difference between a nominal and a real return? Which is more important to a typical investor?

Nominal rates are called "nominal" because they have not been adjusted for inflation Real rates are rates that have been adjusted for inflation

7.3a-What does a bond rating say about the risk of fluctuations in a bond's value resulting from interest rate changes?

Nothing, they are not dependent

7.6b- What is the Fisher effect?

The relationship between nominal returns, real returns and inflation

7.7a- What is the term structure of interest rates? What determines its shape?

The relationship between short & long interest rates. It tells us what nominal interest rates are on default free, pure (no risk& single payment) discount bonds of all maturities. Long term rates are higher than short term rates- upward sloping; When short term rates are higher- downward sloping; the real rate of interest and the rate of inflation; interest rate risk

7.2b- What is the indenture? What are protective covenants? Give some examples

The indenture is the written agreement between the corporation (the borrower) and its creditors. "Deed of trust". Legal document made for tedious reading, but includes, the basic terms of bonds, total amount of bonds issued, description of property used as security, the repayment arrangements, the call provisions, details of the protective covenants. Protective Covenant- part of the indenture or loan agreement that limits certain actions a company might otherwise wish to take during the term of the loan. Negative covenant: limits or prohibits actions the company might take.. limit the amount of dividends it pays according to some formula, firm cannot pledge any assets to other lenders, the firm cannot merge with another firm, the firm cannot sell or lease any major assets without approval by the lender, and the firm cannot issue additional long-term debt Positive covenant: specifies an action the company agrees to take or a condition the company must abide by... the company must maintain its working capital at or above some specified minimum level, the company must periodically furnish audited financial statements to the lender, the firm must maintain any collateral or security in good condition