1.

The risk of loss resulting from the issuer failing to make full and timely payment of
interest is called: credit risk

 Risk is always associated with any event where there is profit or loss.
 Credit risk is the probability of a financial loss resulting from a borrower's
failure to repay a loan. Essentially, credit risk refers to the risk that a
lender may not receive the owed principal and interest, which results in
an interruption of cash flows and increased costs for collection. Lenders
can mitigate credit risk by analyzing factors about a borrower's
creditworthiness, such as their current debt load and income. Credit risk
is the potential for a lender to lose money when they provide funds to a
borrower.
 Consumer credit risk can be measured by the five Cs: credit history,
capacity to repay, capital, the loan's conditions, and associated collateral.
 Consumers who are higher credit risks are charged higher interest rates
on loans.
 Your credit score is one indicator that lenders use to assess how likely
you are to default.

2. If the bond price is higher than its par (face) value, the bond’s _coupon____ rate is
_higher___ than _discount____ rate:
A bond discount is the difference between the face value of a bond and the price for which it sells.
The face value, or par value, of a bond is the principal due when the bond matures. Bonds are sold at
a discount when the market interest rate exceeds the coupon rate of the bond[1] . In order to
calculate how the amount of the bond discount, you need to need to calculate the present value of
the principal and the present value of the coupon payments.
Key Concept]
Price of bonds = Present value of principal + Present value of interest payments
Interest to be paid each period is determined by coupon rate (stated interest rate) for that period.
Present value calculation is based on market interest rate.

[Exercise 1]
On January 1, 2011, Company A issues long-terms bonds which are due on January 1, 2016. Interest is
paid semiannually on January 1 and July 1 each year. Face amount of bonds is $500,000 with stated
interest rate (coupon rate) of 10%. At the time of issuance, market interest rate is 12%. What will be
the price of bonds issued by Company A?

[Solution to Exercise 1]
Market interest rate = 12%
Market interest rate for a semiannual period = 12% / 2 = 6%
r = 0.06 (per semiannual period),
n = 10 (semiannual periods)

Present value of principal

= $500,000 x Present value factor for a single payment (6%, 10 periods)
= $500,000 x 0.5584
= $279,200

Interest payment each semiannual period

= $500,000 x 5%
 = $25,000
(Coupon rate for a semiannual period = 10% / 2 = 5%.)

Present value of interest payments

= Interest payment each semiannual period
x Present value factor for an ordinary annuity (6%, 10 periods)
= ($500,000 x 5%) x 7.3601
= $184,002

Price of bonds
= Present value of principal + Present value of interest payments
= $279,200 + $184,002
= $463,202
The bonds will be sold at a $36,798 discount from the face amount.
($500,000 - $463,202 = $36,798)

5. All else constant (ceteris paribus), you would expect that bond price
_decreases___ when the yield to maturity _increases___.
Bonds have an inverse relationship to interest rates. When the cost of borrowing
money rises (when interest rates rise), bond prices usually fall, and vice-versa.
 Most bonds pay a fixed interest rate that becomes more attractive if
interest rates fall, driving up demand and the price of the bond.
 Conversely, if interest rates rise, investors will no longer prefer the lower
fixed interest rate paid by a bond, resulting in a decline in its price.
 Zero-coupon bonds provide a clear example of how this mechanism
works in practice.

What happens to bonds when interest rates rise?

Most bonds and interest rates have an inverse relationship.
When rates go up, bond prices typically go down, and when
interest rates decline, bond prices typically rise. This is a
fundamental principle of bond investing, which leaves
investors exposed to interest rate risk—the risk that an
investment's value will fluctuate due to changes in interest
rates.

The relationship between interest rates and bond prices can

be a little confusing at first, but it's important to understand so
you can make informed investment decisions when
considering bonds and other fixed income products.
If you intend to hold the bond to maturity, interest rate risk
may be less of a concern for you as it'd be for someone who
might need to sell the bond before it reaches maturity and may
be forced to sell at a discount to par value, or below the
bond's initial purchase price.

Most bonds are issued at or near par value, usually $1,000.

The issuer receives this money when the bonds are first
offered and, in return, promises to pay investors a stated fixed
interest rate (the "coupon rate") at regular intervals with the
intent of returning that initial investment of $1,000 back to
bondholders at maturity.

After a bond is issued, it can be traded in the secondary

market, causing the bond's price to fluctuate depending on
supply and demand, changes in interest rates, and any news
about the financial health of the issuer that could impact its
ability to honor the obligations of the bond.

When interest rates rise, existing bonds paying lower interest

rates become less attractive, causing their price to drop below
their initial par value in the secondary market. (The coupon
payments remain unaffected.) Current bond yields are
calculated by dividing the annual interest payment by the
bond's current price (current yield = annual coupon ÷ bond
price). So, when the bond price drops, its yield increases,
making it competitive against newer bonds paying higher
rates.

Reinvestment Risk:
Reinvestment risk refers to the possibility that an investor will be unable to
reinvest cash flows received from an investment, such as coupon payments or
interest, at a rate comparable to their current rate of return. This new rate is
called the reinvestment rate.
For example, an investor buys a 10-year $100,000 Treasury note (T-note) with
an interest rate of 6%. The investor expects to earn $6,000 per year from the
security. However, at the end of the first year, interest rates fall to 4%.

If the investor buys another bond with the $6,000 received, they would receive
only $240 annually rather than $360. Moreover, if interest rates subsequently
increase and they sell the note before its maturity date, they stand to lose part of
the principal.
 In addition to fixed-income instruments such as bonds, reinvestment risk also affects
other income-producing assets such as dividend-paying stocks.
Callable bonds are especially vulnerable to reinvestment risk. This is because
callable bonds are typically redeemed when interest rates begin to fall. Upon
redeeming the bonds, the investor will receive the face value, and the issuer has
a new opportunity to borrow at a lower rate. If they are willing to reinvest, the
investor will do so receiving a lower rate of interest

9. To cover the first year’s total college tuition payments for her two-children, a
mother will make a payment of Rs 1,000,000 five years from now. How much does
she need to invest today to meet the first tuition goal if the investment earns 6% per
annum compounded annually (chose the nearest answer given in Rs).
a. 747,000 b. 200,000 c. 1,340,000 d. 188,679 e. 445,000
Ans: A

10. You are considering investment in a financial instrument that will pay nothing for
first three years (starting t=1), but then it will pay $20,000 per year for the next two
years. If your required rate of return is 8% compounded annually, how much will you
pay for this instrument today (choose the closest answer given in $)?
a. 35,600 b. 28,300 c. 31,700 d. 27,200
Ans: B

11. An investment of Rs 500,000 today that grows to Rs 800,000 after six years has
an annual interest rate closest to:
a. 7.5% compounded continuously b. 7.7% compounded monthly c. 8.0%
compounded semi-annually d. 8.2% compounded quarterly
Ans: C

12. A bank quotes an interest rate of 4% per annum. If that rate is equal to an
effective annual rate of 4.08%, then the bank is compounding interest:
a. monthly b. quarterly c. semi-annually d. annually
Ans: A

13. For any fixed rate debenture, since all variables except YTM are constant, the
bond's price during the bond's life will change only if YTM changes.
a. True b. False
Ans: False (as bond approaches maturity its price approaches par value).
A bond is fixed-rate security or investment vehicle. The interest rate to a bond
investor or purchaser is a fixed, stated amount; however, the bond's yield, which
is the interest amount relative to the bond's current market price, fluctuates with
the price. As the bond's price varies, the price is described relative to the original
par value, or face value; the bond is referred to as trading above par value
or below par value.
The need to change the yield to reflect current market conditions drives
the price changes. Unfavorable developments demand higher yields, so
bond prices must fall. In the same way, improvements in the company's
situation allow it to raise

Factors That Influence Bond Prices

Three factors that influence a bond's current price are the credit rating of
the issuer, market interest rates, and the time to maturity. As the bond nears
its maturity date, the bond price naturally tends to move closer to par value.

Why Would You Pay More Than Face Value for a Bond?
An investor might pay more than face value for a bond if the interest rate/yield
they will receive on the bond is higher than the current rates offered in the bond
market. In essence, the investor is paying more to receive higher returns.

Is Par Value the Same As Face Value?

Yes, par value and face value are the same and both refer to the amount
received by the investor at maturity, not the value at the time of its issue since
bonds can be issued at a discount. Par value is most often used concerning
bonds. Bonds are typically issued with par values of $1,000 or $100.

Is Par Value the Same As Bond Price?

Par Value and Bond price can be the same at issue, but it is not always the
case.

The price of a bond can change over time before it reaches maturity. When this
happens, the price of a bond is not the same as the par value. The price of the
bond is often then quoted at its par value.

The Bottom Line

The most important difference between the face value of a bond and its price is
that the face value is fixed, while the price varies due to outside influences . The
amount set for face value remains the same until the bond reaches maturity. On
the other hand, bond prices can change dramatically.

Theoretically, a spectacular decline in credit quality can send the bond price to
zero. In actual practice, secured bondholders are paid first when a business is
liquidated, so some funds are usually recovered. Repeated interest rate hikes
can also take a toll on bond prices. Finally, there is some good news on time to
maturity. Bond prices normally approach the face value, or par value, as they
approach maturity.

What Is Yield to Maturity (YTM)?

The term yield to maturity (YTM) refers to the total return anticipated on a bond if
the bond is held until it matures. Yield to maturity is considered a long-term bond
yield but is expressed as an annual rate. In other words, it is the internal rate of
return (IRR) of an investment in a bond if the investor holds the bond until
maturity, with all payments made as scheduled and reinvested at the same rate.
KEY TAKEAWAYS
 Yield to maturity is the total rate of return that will have been earned by a
bond when it makes all interest payments and repays the original
principal.
 YTM is essentially a bond's internal rate of return if held to maturity.
 Calculating the yield to maturity can be a complicated process, and it
assumes all coupon or interest payments can be reinvested at the same
rate of return as the bond.
 A bond's YTM is different from its coupon rate, which is the total amount
of income it pays for the length of time it's held.
 YTM calculations usually don't account for taxes paid on a bond.

14. Given the annual coupon rate of 6.5% and semi-annual coupon payment
frequency, the effective annual rate on the bond is: (up to 2 decimals).
a. 6.09% b. 6.11% c. 6.04% d. none
Ans: D

15. Longer maturity bonds will always be worth more that shorter maturity bonds if
the coupon rates on the bonds are same, and the YTM on the bonds are the same.
a. True b. False
Ans: B (discount bonds and premium bonds will exhibit different behavior).
https://www.youtube.com/watch?v=14Q6C9hA0yE

Zero Coupon Bond

Zero coupon bonds are bonds that do not pay interest during the life of the bonds.
Instead, investors buy zero coupon bonds at a deep discount from their face value,
which is the amount the investor will receive when the bond "matures" or comes due.

The maturity dates on zero coupon bonds are usually long-term—many don’t mature
for ten, fifteen, or more years. These long-term maturity dates allow an investor to plan
for a long-range goal, such as paying for a child’s college education. With the deep
discount, an investor can put up a small amount of money that can grow over many
years.

Investors can purchase different kinds of zero coupon bonds in the secondary markets
that have been issued from a variety of sources, including the U.S. Treasury,
corporations, and state and local government entities.

Because zero coupon bonds pay no interest until maturity, their prices fluctuate more
than other types of bonds in the secondary market. In addition, although no payments
are made on zero coupon bonds until they mature, investors may still have to pay
federal, state, and local income tax on the imputed or "phantom" interest that accrues
each year. Some investors avoid paying tax on the imputed interest by buying
municipal zero coupon bonds (if they live in the state where the bond was issued) or
purchasing the few corporate zero coupon bonds that have tax-exempt status.