Money and Banking: Exam Two Study Guide Bonds What is a bond? A promise or an agreement to make payments in the future, they are used by corporations and different branches of the government to borrow money. Bonds are used as a debt instrument What is a coupon bond? Can you calculate its coupon rate, coupon payment and its price?
A very common bond where one makes annual coupon payments on the percentage of the bond’s face value A promise from the issuer of the bond, to make a series of periodic interest payments called coupon ayments, plus a principal payment at maturity A debt instrument that requires multiple payments of interest on a regular basis, such as semiannually or annually, and a payment of the face value at maturity Face Value – the amount to be repaid by the bond issuer (the borrower) at maturity Maturity – the length of time before the bond expires and the issuer makes the face value payment to the buyer Coupon Rate Coupon Payment / Face Value The coupon rate is the value of the coupon expressed as a percentage of the face value of the bond Coupon Payment Coupon Rate x Face Value The coupon is the annual fixed dollar amount of interest paid by the issuer of the bond to the buyer Price Face Value/(l +i)An + Coupon Payment/(l +i)An What is a consol? Can you calculate its price? A security that makes annual interest payments (at a constant interest) forever Consol Price Annual Payment / i Makes periodic/annual interest payments forever, never repaying the principal that was borrowed What is a zero-coupon bond? A bond with a 0% coupon rate A type of bond that has a 0% coupon rate, therefore there are no coupon payments Example: Treasury Bills
Be sure that you can calculate yield to maturity, current yield and holding period return Yield to Maturity “Interest to maturity’, interest earned if the bond is held until it is mature Price = The interest rate that makes the present value of the payments from an asset equal to the asset’s price today Current Yield Short-term measure of yield that ignores capital gains or losses Current Yield ??” Coupon Payment / Purchase Price I ne value 0T tne coupon expressed as a percentage 0T tne current prlce 0T Holding Period Return For investment horizons between 1 year and maturity date HPR = Current Yield + Percent Change in Bond Price (Coupon Payment/Purchase Price) + (Selling Price-purchase Price/Purchase Price) If the bond’s price = face value, then the coupon rate = current yield = yield to maturity. What if the price > face value? What if the price < face value?
When price < face value, coupon rate < current yield < yield to maturity When price > face value, coupon rate > current yield > yield to maturity How is the current yield different from the yield to maturity? They are both measurements on the rate of return on a bond, but the yield o maturity is the yield the bondholders receive if they hold the bond until its date of maturity, when the final principal payment is made. A current yield is the yield investors expect in the current time period, but it ignores the capital gain or loss that arises when the price at which the bond is purchased differs from its face value. How is the holding period return different from current yield and yield to maturity?
The holding period return is the return of buying a bond and selling it before it matures, it differs from the yield to maturity because the yield to maturity is the yield ondholders receive when they do hold the bond to its maturity date It differs from the current yield because the current yield is simply the rate bondholders expect in a certain time period. The current yield is used to calculate the holding period return, but the holding period return must also take into account the change in price between the time of the purchase and the time of the sale So, unlike current yield, the holding period return DOES recognize capital gain and loss Review the factors that shift the demand and/or supply curves for bonds. Five Shifts in Demand
An increase in wealth results in an increase in demand An increase in risk results in a decrease in demand An increase in liquidity results in an increase in demand An increase in stocks results in a decrease in demand (for bonds) An increase in expected inflation results in a decrease in demand Shifts in Supply Curves for Bonds An increase in bond price makes bond finance more lucrative An increase in government borrowing results in an increase in supply A decrease in business conditions results in a decrease in supply An increase in tax incentives esults in a decrease in supply An increase in expected inflation results in an increase in supply Be sure that you can illustrate the impact of each shock on price, quantity and the interest rate. Name and briefly explain the three types of risk associated with bonds. Default Risk The risk that the bond issuer will fail to make payments of interest or principal The risk of missing a promised payment Inflation Risk The risk of prices fluctuating unexpectedly. For example, if inflation increases, the real interest rate will decrease, which would make borrowers happy and lenders sad.
And vice versa Interest Rate Risk If there is an increase in interest, there is a capital loss The risk of interest rates changing unexpectedly. If the interest rate increase, the bond price decreases. And tne more likely Interest rates are to cnange, tne larger tne rlsK 0T n0101ng a Dona, which would cause a decrease in demand for bonds What information does a bond rating convey to investors? Bond ratings assign grades to bond issuers based on their creditworthiness Bond Rating – a single statistic that summarizes a rating agency’s view of the issuer’s likely bility to make the required payments on its bonds They assess creditworthiness of issuers and assign ratings Categories Investment Grade Highest quality, lowest risk AAA, AA, A, BBB Speculative Missed payments.
Possible, but no immediate default risk Highly Speculative Clear, default risk CCC, CC, C, D Speculative and Highly Speculative are Non-lnvestment Grades Fallen Angels – debt that was once investment grade, but was downgraded (because the issuer fell on hard times) New Firms – to little is known about their creditworthiness What is a Junk bond? Name and briefly explain the two types of Junk bonds. A Junk bond is a high yield bond, it is very risky because they could miss a payment so there is usually a higher interest rate (bonds rated below BBB) Bonds with a higher risk, they are anything below bond rating: BBB Non-lnvestment Grade Bonds Fallen Angels – debt that was once investment grade, but was downgraded (because the issuer fell on hard times) New Firms – to little is known about their creditworthiness What is commercial paper? How is it different from a bond? Very similar to a short-term bond Usually 5