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AFM479 Lecture Notes - Lecture 9: Credit Event, Itraxx, Accrual

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lemonbeetle804
27 Dec 2019
School
University of Waterloo
Department
Accounting & Financial Management
Course
AFM479
Professor
John D'Amato

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Document Summary

Reference entity: the company whose default is insured against in a cds. Credit event: the default of an insured company in a cds. A failure t o make a payment as it becomes due, a restructuring of debt, or a bankruptcy. Notional principal: the total face value of the bonds that can be sold. Periodic payments: the buyer of a cds pays periodic payments to the sell until the end of the life of th e cds or until a credit event occurs. The payments are denoted by basis points of the notional principal per annuum. Physical settlement: the buyer has the right to sell the bonds to the seller at the face value. Cash settlement: the buyer has the right t o receive from the seller, in cash, the difference between the bond"s face value and the price of the cheapest deliverable bond on the market.

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Related Questions

2. Decision to Hedge with Interest Rate Swaps

Explain the types of cash flow characteristics that would cause a firm to hedge interest rate risk by

swapping floating-rate payments for fixed payments. Why would some firms avoid the use of interest rate swaps even when they are highly exposed to interest rate risk?

7. Fixed-for-Floating Swaps North Pier Company entered into a two-year swap agreement, which would provide fixed-rate payments for floating-rate payments. Over the next two years, interest rates declined. Based on these conditions, did North Pier Company benefit from the swap?

8. Equity Swap Explain how an equity swap could allow Marathon Insurance Company to capitalize on expectations of a strong stock market performance over the next year without altering its existing portfolio mix of stocks and bonds.

13. Use of Interest Rate Swaps Explain why some companies that issue bonds engage in interest rate swaps in financial markets. Why do they not simply issue bonds that require the type of payments (fixed or variable) that they prefer to make?

15. Rate-Capped Swaps Bull and Finch Company wants a fixed-for-floating swap. It expects interest rates to rise far above the fixed rate that it would pay and to remain very high until the swap maturity date. Should it consider negotiating for a rate-capped swap with the cap set at 2 percentage points above the fixed rate? Explain.

16. Forward Swaps Rider Company negotiates a forward swap, to begin two years from now, in which it will swap fixed payments for floating-rate payments. What will be the effect on Rider if interest rates

rise substantially over the next two years? That is, would Rider be better off using this forward swap than if it had simply waited two years before negotiating the swap? Explain.

19. Credit Default Swaps Credit default swaps were once viewed as a great innovation for making mortgage markets more stable. Recently, however, the swaps have been criticized for making the credit crisis worse. Why?

TRUE OR FALSE?

1. Bondholders are crditors of the issuing corporation.

2. bondholders claims on the assets of the corporation rank aheadof stockholders

3. the prices of bonds are quoted as a percentage of the bonds'market value

4. when the market rate of interest is less than the contract ratefor a bond, the
bond will sell for a premium.

5. an equal stream of periodic payments is called an annuity.

6.one reason a dollar today is worth more than a dollar 1 year fromtoday is the time
value of money.

7. if the straight-line method of amortization is used, the amountof unamortization
premium on bonds payable will decrease as the bonds approachmaturity.

8. if the amount of a bond premium on an issued 11% 4-year,$100,000 bond is $12,928, the amiannual straight-line amortizationof the premium is $1,416.

9. The issue price of zero-coupon bonds is the present value oftheir face amount.

10. if sinking fund cash is used to purchase investments,thoseinvestments are
reported on the balance sheet as marketable securities.

11. callable bonds can be redeemed by the issuing corporation atthe fair market
price of the bonds.

12. if bonds of $1,000,000 with unamortized discount if $10,000 areredeemed at 98,
the gain on redemption of bonds is $10,000

13. Amortization is the allocation process of writing off bondpremiums and discounts to interest expense over the life of thebond issue.

14. the amortization of a premium on bonds payable decreses bondinterest expense.

15. the balance in premium on bonds payable should be reported as adeduction from bonds payable on the balance sheet.

Multiple Choice:
16. one potential advantage of financing corportations through theuse of bonds rather than common stock is
a.the interest on bonds must be paid when due
b.the corporation must pay the bonds at maturity
c.the interest expense is deductable for tax purposes by thecorporation
d.a higher earnings per share is guarenteed for existing commonshareholders


17. when the corporation issuing the bonds has the right torepurchase the bonds prior to the maturity date for a specificprice, the bonds are
a. convertible bonds
b.unsecured bonds
c.debenture bonds
d.callable bonds


18.the present value of $30,000 to be received in 2 years, at 12%compounded annually is (rounded to nearest dollar)
a. $23,916
b.$37,632
c.23,700
d.30,000


19. An unsecured bons is the same as a
a. debenture bond
b. zero coupon bond
c. term bond
d. bond indenture


20. if $1,000,000 of 8% bonds are issued at 102 1/2, the amount ofcash recieved from the sale is
a.$1,080,000
b.$975,000
c.$1,000,000
d.$1,025,000


21. A corporation issues for cash $1,000,000 of 8%,20-year bonds,interest payable annually, at a time when the market rate ofinterest is 7%. the straight-line method is adopted for theamortization of bond discount or premium. which of the following istrue?
a. the carrying amount increases from its amount at issuance dateto $1,000,000 at maturity.
b. the carrying amount decreases from its amount at issuance dateto $1,000,000 at maturity.
c.the amount of annual interest paid to bondholders increases overthe 20-year life of the bonds
d.the amount of annual interest expense decreases as the bondsapproach maturity.


22. When the market rate of interest was 11%, Waverly corporationissued $1,000,000,12%,8-year bonds that pay interest semiannually.the selling price of this bond issue was
a. $1,052,310
b. $1,154,387
c.$1,000,000
d.720,495


23. The journal entry a company records for the issuance of bondswhen the contract rate is less than the market rate would be
a.debit bonds payable, credit cash
b.debit cash and discount on bonds payable, credit bondspayable
c.debit cash, credit premium on bonds payable and bondspayable
d.debit cash, credit bonds payable

24. On januaray 1,2007 the kings corporation issued 10% bonds witha face value of $100,000. the bonds are sold for $96,000. The bondspay interest semiannually on june 30 and december 31 and thematuritydate is december 31,2011. kings records straight-lineamortization of the bond discount. the bond interest expense forthe year ended dec 31,2007 is
a. $9,200
b.$9,800
c.$10,400
d.$10,800


25.If the market rate of interest is 10%, a $10,000, 12%, 10-yearbond that pays interest semiannually would sell at an amount
a.less tha face value
b.equal to face valur
c.greater thand face value
d.that cannot be determined


26. the torrez corporation issue a $1,000, 10-year bonds, 8%,$1,000 bonds dated jan 1,2007 at 97. the journal entry to recordthe issuance will show a
a.credit to discount on bonds payable for $30,000
b.debit to cash of $1,000,000
c.credit to bonds payable for $1,000,000
d.credit to cash for $970,000


27.bonds with a face amount $1,000,000 are sold at 97. the entry torecord the issuance is
a.Cash $1,000,000
Premium on bonds payable $30,000
Bonds Payable &nbõns?x.?H?mnbsp;$970,000
b.Cash $970,000
Premium on bonds payable $30,000
bonds payable $1,000,000
c.Cash $970,000
Discount on bonds payable $30,000
Bonds payable $1,000,000
d.Cash $970,000
Bonds Payable $970,000


28. the cash and securities comprising a sinking fund establishedto redeem bonds at maturity in 2015 should be classified on thebalance sheet as
a.fixed asset
b.current asset
c.intangable assets
d.investments



29. when callable bonds are redeemed below carrying value
a. gain on redemption of bonds is credited
b.loss on redemption of bonds is debited
c.retained earnings is credited
d.retained earnings is debited

The payment made each period on an amortized loan is constant, and it consists of some interest and some principal. The closer we are to the end of the loan's life, the smaller the percentage of the payment that will be a repayment of principal.

a. True

b. False

2. The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present.

a. True

b. False

3. A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if interest rates are below 10% and at a discount if interest rates are greater than 10%.

a. True

b. False

4.Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds?

a. Market interest rates decline sharply.

b. Market interest rates rise sharply.

c. Inflation increases significantly.

d. The company's financial situation deteriorates significantly.

e. The company's bonds are downgraded.

5. A 15-year bond has an annual coupon rate of 8%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 6%. Which of the following statements is CORRECT?

a. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today.

b. The bond is currently selling at a price below its par value.

c. If market interest rates decline, the price of the bond will also decline.

d. If market interest rates remain unchanged, the bond's price one year from now will be higher than it is today.

e. The bond should currently be selling at its par value.

6. Which of the following statements is CORRECT?

a. The expected return on a corporate bond will generally exceed the bond's yield to maturity.

b. If a bond's coupon rate exceeds its yield to maturity, then its expected return to investors exceeds the yield to maturity.

c. All else equal, senior debt generally has a lower yield to maturity than subordinated debt.

d. Under our bankruptcy laws, any firm that is in financial distress will be forced to declare bankruptcy and then be liquidated.

e. An indenture is a bond that is less risky than a mortgage bond.

7. Your investment account pays 6.8%, compounded annually. If you invest $5,000 today, how many years will it take for your investment to grow to $9,140.20?

Select the correct answer.

a. 10.47

b. 11.77

c. 9.17

d. 13.07

e. 7.87

8. You want to purchase a motorcycle 4 years from now, and you plan to save $3,500 per year, beginning immediately. You will make 4 deposits in an account that pays 5.7% interest. Under these assumptions, how much will you have 4 years from today?

a. $16,918

b. $19,584

c. $16,112

d. $17,763

e. $18,652

9. Suppose you earned a $135,000 bonus this year and invested it at 8.25% per year. How much could you withdraw at the end of each of the next 20 years?

Select the correct answer.

a. $14,006.84

b. $13,994.04

c. $13,997.24

d. $14,000.44

e. $14,003.64

10.Your older brother turned 35 today, and he is planning to save $30,000 per year for retirement, with the first deposit to be made one year from today. He will invest in a mutual fund that's expected to provide a return of 7.5% per year. He plans to retire 30 years from today, when he turns 65, and he expects to live for 25 years after retirement, to age 90. Under these assumptions, how much can he spend each year after he retires? His first withdrawal will be made at theend of his first retirement year.

Select the correct answer.

a. $119,069

b. $119,090

c. $119,076

d. $119,097

e. $119,083

11. Rogoff Co.'s 15-year bonds have an annual coupon rate of 9.5%. Each bond has face value of $1,000 and makes semiannual interest payments. If you require an 11% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond?

Select the correct answer.

$888.91

$882.64

$886.82

$891.00

$884.73

12. Haswell Enterprises' bonds have a 10-year maturity, a 6.25% semiannual coupon, and a par value of $1,000 . The going interest rate (rd) is 9.75%, based on semiannual compounding. What is the bond's price?

Select the correct answer.

$782.32

$787.80

$779.58

$785.06

$790.54