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CPN CPN + CPN+ Par) : Maturity or YTM. The YTM Is The Interest Rate For Which The PV of

This document outlines key concepts and terminology related to bonds. It discusses bond characteristics such as coupon rates, bond prices, yields and how they are calculated. Bond prices vary inversely with changes in market interest rates. The yield to maturity is a better estimate of expected return than current yield. The document also covers the yield curve and how it is impacted by expectations of future interest rates. It defines default risk premium as the difference between the yield of a risky bond versus a Treasury bond of similar maturity, which accounts for the market's expected default loss.

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46 views3 pages

CPN CPN + CPN+ Par) : Maturity or YTM. The YTM Is The Interest Rate For Which The PV of

This document outlines key concepts and terminology related to bonds. It discusses bond characteristics such as coupon rates, bond prices, yields and how they are calculated. Bond prices vary inversely with changes in market interest rates. The yield to maturity is a better estimate of expected return than current yield. The document also covers the yield curve and how it is impacted by expectations of future interest rates. It defines default risk premium as the difference between the yield of a risky bond versus a Treasury bond of similar maturity, which accounts for the market's expected default loss.

Uploaded by

RachelMayaMalau
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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CHAPTER OUTLINE, KEY CONCEPTS AND TERM

I.

Bond Characteristics
A. Terminology
1. A bond is a debt security that obligates the borrower or issuer to
make specified payments (periodic interest payments and return of
principle) to the lender or investor.
2. The bond promises to pay periodic interest or coupon to the
bondholder at the contract rate of interest, called the coupon rate,
plus return the face value principle amount borrowed at maturity.
3. For a fixed coupon rate bond, the coupon rate stays the same
throughout the life of the bond. The coupon rate is the market rate,
or discount rate, at the time the bond is issued. Thereafter, the
market rate may vary; the coupon rate, which determines the
periodic interest payment, stays the same.

II.

Bond Prices And Yields


A. Bond Pricing
1. The price of a bond is the sum of the present values of the interest
payment annuity plus the present value of the single cash flow or
face value, usually $1000, at maturity. Using a financial calculator,
solve for the present value with the coupon annuity expresses as a
payment; the face value at maturity expressed as a single future
value (FV).
2. Bond prices are quoted in the financial press as a percentage of
their face value. Government bonds are quoted in 32 nd after the
decimal; corporate bonds are quoted in eighths.
3. When the coupon rate equals the discount rate, the PV price equals
the original face value. When market rates of interest are greater
(less) than the coupon rate, the PV of the bond is less (greater) than
the face value.
4. Bond coupons are usually paid semiannually. To calculate the price
of the bond on a semiannual basis, halve the coupon annuity
payment and double the maturity of the bond.

PV =

( cpn+ par )
cpn
cpn
+
++
1
2
(1+r ) (1+r )
(1+r )t

B. The Yield To Maturity


1. The current yield, calculated by dividing the annual coupon
interest by the price of the bond, is a rough approximation of the
expected return on the bond. The current yield assumes that one
will hold the bond forever or that the bond is a perpetuity.
2. A better estimate of the expected return on the bond is the yield to
maturity or YTM. The YTM is the interest rate for which the PV of
the bond cash flows (coupons and face value) equals the bond

price. The YTM is the approximate market rate of return and


assumes that one will hold the bond until maturity.
3. The two separate cash flows of the bond, the coupon and the face
value, require that one estimate the YTM as in any equation with
more than one unknown (two r values). Most financial calculators
calculate the YTM, solving for r or I.
4. Bond coupon rates, for fixed rate bonds, determine the amount of
annual coupon and remain the same over the life of the bond.
Market interest rates, discount rates, and current borrowing rates
change every day. Bond prices vary to give the new bond buyer the
market rate of return.
C. Interest Rate Risk
1. Bond prices (PV) vary inversely with changes in market interest
rates.
2. The longer (shorter) the maturity of the bond, the greater (less) the
change in the bond price for every change in bond discount rates.
3. If the bond is sold before maturity, the seller will receive the market
price which, depending on the direction of market rates since the
bond was issued, will be higher or lower than face value. This is one
dimension of interest rate risk or the variability of return from the
expected YTM caused by selling the bond before maturity.
4. The actual rate of return earned on the bond investment or the
holding period return on the bond may be higher or lower than the
YTM.
D. Reading The Financial Pages
1. Government bond quotations list prices in terms of percent of face
value with the value after the decimal representing the remainder
in 32nds. Corporate bonds are quoted with the remainder in eights.
Convert the fraction to decimal, add to the percentage price quote,
and multiply by the face value, usually $1000, to determine the
dollar price.
2. The prices of governments and other dealer traded bonds are
quoted on a bid (price dealer will buy the bond) and ask (price the
dealer will sell the bond) basis.
E. The Yield Curve
1. The yield curve is a plot of an issuers, such as the U.S.
Government, bond yields (YTM) by time to maturity.
2. Expectations of future interest rates has a significant impact upon
the shape of the yield curve, while time risks, such as interest rate
risk, may also explain the shape of the yield curve.
F. Default Risk

1. The market yield to maturity on bonds, other than U.S. Treasury


bonds, include a credit risk premium, or added yield to cover the
markets expected default loss on risk bonds.
2. The credit risk premium is the difference between the yield on a
risky bond and a U.S. Treasury bond of similar maturity.
3. The higher the expected loss in yield from the risky bond, the
higher the credit risk premium.
4. Bond rating firms, like Moodys and Standard and Poors, rate the
default risk of risky bonds.
5. High investment grades are in the range from AAA to BBB;
speculative or junk bonds are rated below BBB.
6. The vertical yield difference between securities of varying default
risk is the default risk premium.

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