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Zara MahmoodRobertsFE101Chapter 6: BondsBOND TERMINOLOGYBond is a security sold by governments and corporations to raise money from investors today in exchange for a promised future paymentBond Certificate – States the terms of a bond as well as the amounts and dates of all payments to be made- Payments on the bond are made until a final repayment dateMaturity Date – The final repayment date of a bondTerm – Time remaining until the repayment dateBonds typically make two types of payments to their holders- Face value – notional amount we use to compute the interest paymentso Typically repaid at maturity\Generally denominated in standard increments- Coupons – The promised interest payments of a bond, paid periodically until the maturity date of the bondo Interest payments on bond are called coupon paymentsExchange coupon for payment in past (today electronic)- Coupon Rate – Determines the amount of each coupon payment of a bondo Expressed as an APR set by issuer and stated on bond certificateZERO-COUPON BONDSNot all bonds have coupon paymentsZero-Coupon bonds – A bond that makes only one payment at maturity- Simplest type of bond only cash value is face value of bond at maturity dateTreasury Bills – US government bonds with a maturity of up to one year (zero coupon bonds)- STRIPS general name for risk-free zero coupon bondo Separately Tradable Registered Interest and Principal SecuritiesZero-Coupon Bond Cash FlowsOnly two cash flows if we purchase and hold a zero-coupon bond- Pay the bonds current market price at time of purchase- At maturity date – receive the bond’s face value o Bond pays no direct interest investor is compensated for the time value of their money by purchasing the bond at a discount to its face value Present value of future cash flow is less than cash flow itself Prior to maturity date – zero-coupon bond price is always less than face valueZara MahmoodRobertsFE101Pure Discount Bond – Zero-coupon bonds- Trade at a price lower than face value (discount)Yield to Maturity of a Zero-Coupon BondCan calculate the rate of return of buying a bond and holding it until maturity- Zero-coupon bond, price is cost of the bondo Rate of return is the discount rate that makes the present value of the future cash flow received equal to the cost of the bondYield to Maturity (YTM) – The rate of return of an investment in a bond that is held to its maturity date, or the discount rate that sets the present value of the promised bond payments equal to the current market price for the bond- YTM for zero-coupon is return you will earn by receiving the promised face value paymentRisk-Free Interest RatesLaw of One Price guarantees that the risk-free interest rate equals the yield to maturity on such a bond - Zero-coupon risk-free bond the risk-free interest rate or spot interest rateSpot Interest Rate – default-free, zero-coupon yields- Rates are offered on the spot at that point in time- Risk free interest rates correspond to the yields of risk-free zero-coupon bondsZero-Coupon Yield Curve – A plot of the yield of risk-free zero-coupon bonds (STRIPS) as a function of the bond’s maturity date- Can use a bond’s yield to compute its price- Zero-coupon price is equal t the present value of the bond’s face value, discounted at the bond’s yield to maturityCOUPON BONDSCoupon Bonds – Bonds that pay regular coupon interest payments up to maturity, when the face value is also paid- Two types of coupon securities are currently traded in financial markets- Treasury Notes – have original maturities from 1-10 years- Treasury Bonds – Have original maturities of over 10 yearso Original maturity is the term of the bond at the time it was originally usedCoupon Bond Cash FlowsInvestors return on a zero-coupon bond- Buying it at a discount to its principal valueReturn on a coupon bond- Any difference between the purchase price and the principal value- Its periodic coupon paymentsZara MahmoodRobertsFE101Yield to Maturity of a CouponCan determine its yield to maturityYield to maturity of the bond is the single discount rate that equates the present value of the bond’s remaining cash flows to its currentprice- Coupon bonds have many cash flowso No simple formula to solve forYTM directly Use calcCoupon Bond Price QuotesPrices and yields are often usedinterchangeably- Yield is independent of the face value of bondo Advantage of yield over priceWHY BOND PRICES CHANGEZero-coupon bonds always trade for a discount- Coupons may trade at a discount or at a premiumPremium – A price at which coupon bonds trade that is greater than their face valuePar – A price at which coupon bonds trade that is equal to their face valueInterest Rate Changes and Bond PricesIf bond sells at par return is only coming from coupons the bond pays- Bond’s coupon rate will exactly equal its YTMInterest rates fluctuate yield that investors demand to invest in bonds will also change- Trading at a discount – trading below paro Earn a return from receiving coupons and from receiving face value that exceeds price paido YTM will exceed its coupon rate- Trading at a premium – trading above paro Return from coupon is diminished by receiving a face value less than paid priceo YTM is less than its coupon rateInterest rates and bond yields rise bond prices will fallInterest rates and bon yields fall bond prices will rise-***Always move in the opposite directionZara MahmoodRobertsFE101Time and Bond PricesEffect of time on the price of a bond- As next payment grows nearer, price of the bond increaseso Reflects the increasing present value of the cash flow- Price drops abruptly after the payment is madeo Pattern continues for the life of the bondInterest Rate Risk and Bond PricesEffect of time on bond prices is predictable- Unpredictable changes in interest rates will also affect bond priceso Bonds with different characteristics will respond differently to changes in interest rates Some bonds react more strongly than othersInvestors view long-term loans as riskier than short-term loans- Same is true for short and long term bondsBond Prices in PracticeBond prices are subject to the effects of both the passage of time and changes in interest rates- Bond prices converge to the bond’s face value due the time effecto Simultaneously move up and down due to unpredictable changes in bond yields- Prior to maturity the bond is exposed to

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