1) What are a bond’s key features?
a) The promises of the bond issuer and the rights of the bondholders are set forth in great detail in a bond’s indenture.
b) The term to maturity of a bond is the number of years the debt is outstanding or the number of years remaining prior to final principal payment. The maturity date of a bond refers to the date that the debt will cease to exist, at which time the issuer will redeem the bond by paying the outstanding balance.
c) The par value of a bond is the amount that the issuer agrees to repay the bondholder at or by the maturity date.
d) The coupon rate, also called the nominal rate, is the interest rate that the issuer ...view middle of the document...
This call provision grants the issuer an option to retire all of part of the issue prior to the stated maturity date, and hence increase reinvestment risk, call and prepayment risk for bondholders.
g) An indenture may require the issuer to retire a specified portion of issue each year. This is referred to as a sinking fund requirement. The alleged purpose of the sinking fund provision is to reduce credit risk. This kind of provision for debt payment may be designed to retire all of a bond issue by maturity date, or it may be designed to pay only a portion of the total indebtness by the end of the term. If only a portion is paid, the remaining principal is called a balloon maturity.
3) How is the value of any asset whose value is based on expected future cash flows determined?
h) Present value models estimate the intrinsic value of an asset as the present value of the future benefits expected to be received from the asset. In present value models, benefits are often defined in terms of cash flows by the asset in the future, and available to the asset owner.
4) How is a bond’s value determined? What is the value of a 10 year, $1000 par value bond with a 10% annual coupon if its required return is 10%?
i) The fundamental principle of financial asset valuation is that its value equals to the present value of its expected cash flows. This principle applies regardless of the financial asset. Thus the valuation of bonds involves the following steps:
i) Estimate the expected cash flows, such as coupon payment, embedded options such as put or call, and principal repayment
ii) Determine the appropriate interest rate or interest rates (required rate of return) that should be used to discount the cash flow.
iii) Calculate the present value of the expected cash flows found in step (i) using the interest rate or interest rates determined in step (ii)
j) For the example given, since the required rate of return is equal to the coupon rate, hence the price of the bond would be equal to the par value.
5) Three questions
k) What is the value of a 13% coupon bond that is otherwise identical to the bond described in question (4)? Would we now have a discount or premium bond?
iv) Using a financial calculation, set n = 10, PMT = 130, FV = 1000, INT = 10, we will get PV = 1184.34
v) Since the market rate is 10%, lower than the coupon rate, we would expect the 13% annual coupon bond to be selling at a premium.
l) What is the value of a 7% coupon bond with these characteristics? Would we now have a discount or premium bond?
vi) Using a financial calculation, set n = 10, PMT = 70, FV = 1000, INT = 10, we will get PV = 815.66
vii) Since the market rate is 10%, higher than the coupon rate, we would expect the 7% annual coupon bond to be selling at a discount.
m) What would happen to the values of the 7%, 10% and 13% coupon bonds over time...