FINA 395 Chapter Notes - Chapter 6: Contract, Zero-Coupon Bond, Cash Flow

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28 Jun 2016

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Value of financial securities = pv of expected future cash flows. To value bonds and stocks we need to: Discount future cash flows at an appropriate rate: The rate should be appropriate to the risk presented by the security. A bond is a legally binding agreement between a borrower (bond issuer) and a lender (bondholder): Specifies the size and timing of the cash flows: Consider a government of canada bond listed as 5. 000 december 2018. The face value of the bond is ,000. Coupon payments are made semi-annually (june 30 and december 31 for this particular bond). Since the coupon rate is 5. 000 the payment is . 00. On january 1, 2015 the size and timing of cash flows are: Bond value is determined by the present value of the coupon payments and face value. We have to identify the size and timing of cash flows. Discount rates are inversely related to present (i. e. , bond) values.

Related Questions

QUESTION 1 The largest investors in corporate bonds are life insurance companies and pension funds. True False 5 points QUESTION 2 Most secondary market transactions for corporate bonds take place through dealers in the over-the-counter (OTC) market. True False 5 points QUESTION 3 The value (or price) of a bond is the present value of its expected future cash flows. True False 5 points QUESTION 4 Bond prices decline when the interest rate decreases. True False 5 points QUESTION 5 The face or par value for bonds is the amount paid to bondholders at maturity and is usually equal to $1,000. True False 5 points QUESTION 6 The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments equal to the price of the bond. True False 5 points QUESTION 7 Zero coupon bonds have no coupon payments so they sell for more than their par value. True False 5 points QUESTION 8 Interest rate risk is the risk that bond prices will fluctuate when the interest rate changes. True False 5 points QUESTION 9 US Treasury securities are considered risky investments because the coupon payments are unpredictable. True False 5 points QUESTION 10 Bonds are very difficult to value because their future cash flows are very difficult to predict. True False 5 points QUESTION 11 If the bond's coupon rate is equal to the market rate then the bond will sell at a price equal to its face value greater than its face value less than its face value equal to its foreign currency value, e.g., its price in British pounds 5 points QUESTION 12 When calculating the price of a bond that pays a semiannual coupon one needs to use double the number of years until maturity for the number of payments use half the annual coupon payment use half the annual rate of return as the discount rate all of the above 5 points QUESTION 13 The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments more than the price of the bond equal to zero equal to the price of the bond less than the price of the bond 5 points QUESTION 14 Which one of the following statements is true? All else equal long-term bonds have lower price volatility than short-term bonds. There is an inverse relation between bond prices and market interest rates. All else equal short-term bonds are more risky than long-term bonds. All else equal US government bonds are more risky than corporate bonds. 5 points QUESTION 15 An investor owns a 10-year US government bond with a 9 percent coupon rate. If the yield-to-maturity on the bond is 8 percent then this bond is selling for its par value. a discount. a premium. its face value. 5 points QUESTION 16 BA Corp is issuing a 10-year bond with a coupon rate of 8 percent and a par value of $1,000. The market interest rate on similar bonds is currently 6 percent. If the coupon payments are made annually, what is the value of this bond? 5 points QUESTION 17 Knight, Inc. has issued a 3-year bond with a $1,000 par value and an annual coupon rate of 6 percent. The current market rate of interest is 5 percent. What is the value of this bond if the coupon payments are made semiannually? 5 points QUESTION 18 Diane Carter is interested in buying a 5-year zero coupon bond with a face value of $5,000. If the market interest rate on these types of bonds is currently 9 percent, what is the current price of this bond? 5 points QUESTION 19 Rudy Sandberg wants to invest in 4-year bonds that are currently priced at $933.76. The bonds have a coupon rate of 6 percent and annual coupon payments. If the par value of the bonds is $1,000, what is the bond's yield-to-maturity? 5 points QUESTION 20 You own a 5-year bond with a face value of $1,000 and a coupon rate of 5 percent with annual payments. The bond is currently worth $810.46. If market interest rates remain unchanged, what will be the value of the bond next year when there are 4 years left until maturity?

Bond valuation

The process of bond valuation is based on the fundamental concept that the current price of a security can be determined by calculating the present value of the cash flows that the security will generate in the future.

There is a consistent and predictable relationship between a bondâs coupon rate, its par value, a bondholderâs required return, and the bondâs resulting intrinsic value. Trading at a discount, trading at a premium, and trading at par refer to particular relationships between a bondâs intrinsic value and its par value. These result from the relationship between a bondâs coupon rate and a bondholderâs required rate of return.

Remember, a bondâs coupon rate partially determines the interest-based return that a bond (might/will)...........pay, and a bondholderâs required return reflects the return that a bondholder(would like/is obligated).............to receive from a given investment.

The mathematics of bond valuation imply a predictable relationship between the bondâs coupon rate, the bondholderâs required return, the bondâs par value, and its intrinsic value. These relationships can be summarized as follows:

â¢	When the bondâs coupon rate is equal to the bondholderâs required return, the bondâs intrinsic value will equal its par value, and the bond will trade at par.
â¢	When the bondâs coupon rate is greater to the bondholderâs required return, the bondâs intrinsic value will (be less than/exceed/equal)................ its par value, and the bond will trade at a premium.
â¢	When the bondâs coupon rate is less than the bondholderâs required return, the bondâs intrinsic value will be less than its par value, and the bond will trade (at a premium/at par/at a discount).............................

For example, assume Liam wants to earn a return of 5.00% and is offered the opportunity to purchase a $1,000 par value bond that pays a 8.75% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bondâs intrinsic value(Link to the formula : http://q4pws.aplia.com/q4pws/rest/1.0/image/image9594/img.png?data=q4%3AREMOTE_URL%3Ahttp%3A%2F%2Faplia-prod-webjboss-372923237.us-east-1.elb.amazonaws.com%2Fproblemsetassets%2Fq4_export%2Ffinance%2Fq4problems%2F3061500.08.xml%2CV5%2C291%2C1%2CSTUDENT%2CSTUDENT%2C0%2Cq4pws-aplia-7.6.4-G2f8d8babd91356776c6b2ec65d5e2a2153b4d346-B36-2015.12.16-03%3A57-PM-PST&oauth_signature=jG%2Fu63kSgI9xRhXign5JItWfpAQ%3D&oauth_version=1.0&oauth_nonce=3573483745&oauth_signature_method=HMAC-SHA1&oauth_consumer_key=q4-callback&oauth_timestamp=1454953012

Complete the following table by identifying the appropriate corresponding variables used in the equation.

unknown --------------------- variable name ---------------------variable value

A --------------------- (Bondholders required return/Bonds annual coupon payment/Bonds semiannual coupon payment)---------------------($21.88/$65.63/$87.50/$43.75)

B--------------------- (Bonds par value/bonds annual coupon payment/semiannual coupon payment) ---------------------$1000

C--------------------- semiannual required return -------------------- ($5.75/$3.81/$4.38/$2.5)

Based on this equation and the data, it is (reasonable/unreasonable)...................to expect that Liamâs potential bond investment is currently exhibiting an intrinsic value greater than $1,000.

Now, consider the situation in which Liam wants to earn a return of 5.75%, but the bond being considered for purchase offers a coupon rate of 8.75%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of ($757/$866/$1407/$1082).................is (equal to/greater than/less than).............................its par value, so that the bond is trading at (par/a discount/a premium)..............................

Given your computation and conclusions, which of the following statements is true?

(a)When the coupon rate is greater than Liamâs required return, the bond should trade at a discount.

(b)A bond should trade at a par value when the coupon rate is greater than Liam's required return

(c) When the coupon rate is greater than Liamâs required return, the bond's intrinsic value will be less than it's par value

(d) When the coupon rate is greater than Liamâs required return, the bond should trade at a premium

Fill in the blank using a number of terms listed below (@1 point per question).

Beta coefficient, Bonds, CAPM, Cash flows, Change, CV, Convertible bonds, Correlation, Correlation coefficient, Debenture, Discount, Diversifiable risk, Expected return, Interest rate risk, Inverted, Junk Bonds, Market risk, More, Normal, Opposite, Probability distribution, Ratings, Reinvestment rate risk, Risk, Risk averse investor, Risk premium, Standard deviation

When interest rates move up or down, bond prices move in the _________________ direction.

_____________ are referred to as non-amortized debt, which means interest is paid regularly during the term, usually semiannually, whereas repayment of principal does not occur until the maturity date.

The longer a bond has to maturity, _______________ sensitive the bondâs price is to changes in market interest rates. This is called ________________________.

Bonds with short maturities expose investors to high ____________________, which is the risk that income from a bond portfolio will decline because cash flows received from bonds will be rolled over at lower interest rates.

A bond with an annual coupon payment of $100 originally sold at par for $1,000. Market interest rates are currently 12%. This bond would be selling at a _____________ in order to compensate the purchaser for the below market coupon rate.

Once a bond has been issued, if the holder of the bond retains it until maturity the market value of the bond may ________________, but the ________________ will not.

An unsecured bond is referred to as a(n) __________________.

____________________ can generally be issued at somewhat lower interest rates than regular bonds.

Double-B and lower bonds are speculative, to be called _______________.

Bonds are assigned _____________ that reflect the probability of their going into default. The higher it is, the lower its risk and therefore its interest rate.

When the yield curve slopes upward, it is said to be _______________, because it is like this most of the time. Conversely, a downward-slopping yield curve is termed ______________.

FINA 395 Chapter Notes - Chapter 6: Contract, Zero-Coupon Bond, Cash Flow

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