25 multiple choice May use calculator Exam Two Chapters 10 6 12 and 7 Contract Between Bondholder Issuer o In addition to specifying a payment schedule the bond indenture which is the document defining the contract between the bond issuer and the bondholder also specifies a set of restrictions that protects the rights of the bondholders Such restrictions include provisions relating to collateral sinking funds dividend policy and further borrowing The issuing firm agrees to these so called protective covenants in order to market its bonds to investors concerned about the safety of the bond issue The coupon rate maturity date and par value of the bond are part of the bond indenture o Sinking fund a bond indenture that calls for the issuer to periodically repurchase some proportion of the outstanding bonds prior to maturity Differs from the call provision because the firm can only repurchase a certain amount of the bond issue at the sinking fund call price and the sinking fund call price is above par value o Subordinate clauses restrictions on additional borrowing that stipulate that senior bondholders will be paid first in the event of bankruptcy o Collateral A specific asset pledged against possible default on a bond o Debenture a bond not backed by specific collateral o Credit risk of unsecured bonds depends on the general earning power of the firm o Subordinated Debenture Bond a class of unsecured bond that in the event of liquidation is prioritized lower than other classes of debt o It is an unsecured loan with no collateral This class of debt carries higher risk but also pays higher interest than other classes It is a type of junior debt o 2nd tier Calculate HPR o HPR is a key measurement of investor s is the success rate at which their funds have grown during the investment period rate of return over a given investment period Depends on the increase or decrease in the price of the share over the investment period as well as on any dividend income the share has provided Ending price Beginning price Cash dividend Beginning price 25 multiple choice May use calculator Treasury Bond Price From Listed Quoted Price o Note that Treasury bills which mature in a year or less are quoted differently from bonds T bills are quoted at a discount from face value with the discount expressed as an annual rate based on a 360 day year For example you will get a 0 07 90 360 1 75 discount when you purchase the T bill o A bond s dollar price represents a percentage of the bond s principal balance otherwise known as par value In its simplest form a bond is a loan and the principal balance or par value is the loan amount So if a bond is quoted at 99 29 and you were to buy a 100 000 two year Treasury bond you would pay 99 906 25 Explanation A bond s price consists of a handle and 32nds The two year Treasury s handle is 99 and the 32nds are 29 We must convert those values into a percentage to determine the dollar amount we will pay for the bond To do so we first divide 29 by 32 This equals 90625 We then add that amount to 99 the handle which equals 99 90625 So 99 29 equals 99 90625 of the par value of 100 000 which equals 99 906 25 o The two year Treasury is trading at a discount which means that it is trading at less than its par value If it were trading at par its price would be 100 If it were trading at a premium its price would be greater than 100 o Remember that when you buy a bond you buy more than principal balance you also buy coupon payments Different types of bonds make coupon payments at different frequencies Coupon payments are made in arrears o Many investments are taxed differently For example with bonds some may be taxed federally only some may be taxed at the state level only and some may be taxed both at the state and federal level o There are issuers of bonds in addition to Treasury and private corporations such as state and local governments that issue municipal bonds whose interest payments are tax free Others include Fannie Mae Freddie Mac Farm Credit Agencies etc Taxable Tax Free Yields 25 multiple choice May use calculator o An aside bonds lower yields because of taxation Premium Discounted Bonds o See below with current yield section Calculate Risk Premium o o The formula for risk premium sometimes referred to as default risk premium is the return on an investment minus the return that would be earned on a risk free investment The risk premium is the amount that an investor would like to earn for the risk involved with a particular investment The risk of the market is referred to as systematic risk In contrast unsystematic risk is the amount of risk associated with one particular investment and is not related to the market As an investor diversifies their investment portfolio the amount of risk approaches that of the market Systematic and unsystematic risk and their relation to returns is where the many clich s about diversifying your investment portfolio is derived o The risk premium of a particular investment using the capital asset pricing model is beta times the difference between the return on the market and the return on a risk free investment o As noted earlier the return on the market minus the return on a risk free investment is called the market risk premium From here the capital asset pricing model can be rewritten a Components to Consider for a Portfolio Expansion o Spoken about in almost every answer indirectly or directly Calculate Reward to Variability Ratio AKA Sharpe Ratio or Risk to Variability Ratio o The Sharpe ratio is calculated by subtracting the risk free rate such as that of the 10 year U S Treasury bond from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns The ex ante Sharpe ratio formula is 25 multiple choice May use calculator Notice that the numerator is risk premium o The Sharpe ratio tells us whether a portfolio s returns are due to smart investment decisions or a result of excess risk Although one portfolio or fund can reap higher returns than its peers it is only a good investment if those higher returns do not come with too much additional risk The greater a portfolio s Sharpe ratio the better its risk adjusted performance has been A negative Sharpe ratio indicates that a risk less asset would perform better than the security being analyzed Not sure if we need to calculate standard deviation but if we do then here s how you do it just in case you couldn t remember Work out the Mean