a. What are the key features of a bond?

Some of the key features of bond are given below Par value:

The par value is the stated face value of the bond; for illustrative purposes we generally assume a par value of $1,000, although any multiple of $1,000 (for example,$5,000) can be used. The par value generally represents the amount of money the firm borrows and promises to repay on the maturity date. Coupon Rate:

Coupon Rate is the stated annual interest rate on a bond. For example, a bond has $1,000 par value, and $100 in interest is supposed to be paid each year. The bonds coupon interest is $100, so its coupon interest rate is $100/$1,000 = 10 percent. The $100 is the yearly rent on the $1,000 loan. Maturity date:

Maturity date is a specified date on which the par value of a bond must be repaid. Bonds generally have a specified maturity date on which the par value must be repaid. For example, a bond, which was issued on January 3, 2002, will mature on January 2, 2017; thus, had a 15-year maturity at the time they were issued. Call Provision:

Call Provision is a provision in a bond contract that gives the issuer the right to redeem the bonds under specified terms prior to the normal maturity date. Sinking Fund Provision:

Sinking fund provision A provision in a bond contract that requires the issuer to retire a portion of the bond issue each year.

a. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky? Call Provision: A call provision is a provision in a bond contract that gives the issuing corporation the right to redeem the bonds under specific terms prior to the normal maturity date. The call provision generally states that the company

must pay the bondholders an amount greater than the par value it those bonds are being called. The additional amount, which is called a call premium, is often set equal to one years interest if the bonds are called during the year, and the premium declines at a constant rate of interest payment each year therefore. Sinking Fund Provision: A sinking fund provision is a provision in a bond contract that requires the issuer to retire a portion of the bond issue each year. A sinking fund provision facilitates the orderly retirement of the bond. Whether these provisions make bond more or less risky: The Call privilege is valuable to the firm but potentially detrimental to the investor, especially if the bonds were issued in a period when interest rates were cyclically high. Therefore, bonds with a call provision are riskier than those without a call provision. Accordingly, the interest rate on a new issue of callable bonds will exceed that on a new issue of non callable bonds. On the other hand, though, the sinking funds are designed to protect the bondholders by ensuring that an issue is retired in an orderly fashion, it must be recognized that will at times work to the detriment of bondholders. On balance, however, that have a sinking fund are regarded as being safer than those without such a provision, so at the time they are issued, sinking fund bonds have lower coupon rates than otherwise similar bonds without sinking funds.

b. How is the value of any asset whose value is based on expected future cash flows determined? The value of an asset is merely the present value of its expected future cash flows. If the cash flows have widely varying risk, or if the yield curve is not horizontal, which signifies that interest rates are expected to change over the life of the cash flows, it would be logical for each periods cash flow to have a different discount rate. However, it is very difficult to make such adjustments; hence it is common practice to use a single discount rate for all cash flows. The discount rate is the opportunity cost of capital, which is the rate of return that could be obtained on alternative investment of similar risk.

c. How is the value of a bond determined? What is the value of 10-year, $1000 par. value bond with a 10 percent annual coupon if its required rate of return is 10 percent.

The value of a bond is the present value both of future interest to be received and the par or the maturity value of the bond. The process for valuing a bond requires three essential elements: 1. The amount and timing of the cash flows to be received by the investor. 2. The time to maturity of the loan, and 3. The investors required rate of return. Given these elements, we can compute the value of the bond, or the present value.
Given that, par value/ Future Value = $ 1000 Number of years to mature (n) = 10 yrs Coupon Rate (CR) = 10% Required Rare of Return (ke) = 10% Value of the bond = ? Now,

Coupon PMT

= FV CR

= 1000 0.10 = 100 We know, PVB = PMT1-1(1+i)ni+FV(1+i)n = 100 1-1(1+0.10)100.10+1000(1+0.10)10 = 1000

a. (1) What would be the value of the bond described in part d if, just after it has been issued, the expected inflation rate rose by 3 percentage points, assuming investors to require a 13 percent return? Would we now have a discount or a premium bond?

Given that, par value/ Future Value = $ 1000 Number of years to mature (n) = 10 yrs Coupon Rate (CR) = 10% Required Rare of Return (ke) = 13% Now,

Coupon PMT

= FV CR

= 1000 0.10 = 100 We know, PVB = PMT1-1(1+i)ni+FV(1+i)n = 100 1-1(1+0.13)100.13+1000(1+0.13)10 = $ 837.21 In a situation like this, where the required rate of return, ke, rises above the coupon rate, the bonds value fall below par. Therefore, we have now a discount bond.

e. (2)

What would happen to the bonds value if inflation fall, and kd declines to 7 percent? Would we now have a premium or a discount bond?

Given that, par value/ Future Value = $ 1000 Number of years to mature (n) = 10 yrs Coupon Rate (CR) = 10% Required Rare of Return (ke) = 7% Now,

Coupon PMT

= FV CR

= 1000 0.10 = 100 We know, PVB = PMT1-1(1+i)ni+FV(1+i)n = 100 1-1(1+0.07)100.07+1000(1+0.07)10 = $ 1210.71 In this situation, when the required rate of return falls below the coupon rate, the bonds value rises above par, or to a premium. So, we would now have a premium bond.

e. (3)

What would happen to a 10 year bond over time if the required rate of return remained at 13 percent, or if it remained at 7 percent?

f. (1)

What is the yield to maturity on a 10-year, 9 percent annual coupon, $ 1000 par value bond that sells for $887.00? That sells for $1134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between kd and the bonds coupon rate? Given that, Par value/ Face value (FV) = $1000 Market Value (MV) = $887.00 Number of years to mature (n) = 10 yrs Annual Coupon Rate (CR) = 9% Yield to maturity (YTM) = ?

Now, Coupon PMT = FV CR

= 1000 0.09 = 90

We know, YTM = C+FV-MVnFV+MV2 = 90+1000-887101000+8872 = 0.1074 = 10.74%

Again when sells for 1134.20 YTM = C+FV-MVnFV+MV2 = 90+1000-1134.20101000+1134.202 = 0.0718 = 7.18% The market value of a bond will be less than par value if the investors required rate of return is above the coupon interest rate. Discount bond: CR < YTM (kd) The bond will be valued above par value if the investors required rate of return is below the coupon interest rate. Premium bond: CR > YTM (kd)

e. (2)

What are the total returns, the current yield, and the capital gains yield for the discount bond? (Assume the bond is held to maturity and the company does not default on the bond.)

From the previous question we found that, Par value/ Face value (FV) = $1000 Market Value (MV) = $887.00 Number of years to mature (n) = 10 yrs Annual Coupon Rate (CR) = 9%

The total return is actually the yield to maturity (YTM) So,

YTM = C+FV-MVnFV+MV2 = 90+1000-887101000+8872 = 0.1074 = 10.74%

We know that,
bond

Current Yield = Annual Coupon Interest PaymentCurrent market price of the = 90887 = 0.1015 = 10.158%

Capital gain yield, The value of the bond of a 9 year, 9% annual coupon Rate, when its YTM is 10. 74% is

f. What is interest rate risk? Which bond has more interest rate risk, an annual payment 1-year bond or a 10 year bond? Why? Interest rate risk is actually the risk of decline in a bonds price due to an increase in interest rates. The table given below gives the values for a 10 percent, annual coupon bond at manifold values of kd. 1 year Kd 5% 10% $1048 4.8% 1000 -4.48% 15% 956 749 1000 -25.2% Maturity Change 10-year 1386 38.6% Change

We can see that a 5 point increase in k causes the value of the 1-year bond to decline by only 4.4%, but the 10-year bond declines in value by more than 25%. Thus, it is obvious that a 10-year bond has more interest rate risk.

g. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year or a 10 year bond? Reinvestment rate risk is defined as the risk that a decline in interest rates will lead to a decline in income from bond portfolio. More specifically, this is the risk that the cash flows will have to be reinvested in the future at rates lower than that of today. For instance, assume that someone has won a lottery and now have $ 500000. He /she plans to invest the money and then to live on the income from the investment. Then he/she buys a one year bond with a YTM of 10%. His/her income will be $50000 during the first year. Later after one year, he/she will receive the principle $ 500000 when the bond matures, and he/she is prone to reinvest this amount. If rates have fallen to 3%, then his/her income would fall from $500000 to $ 15000. On the contrary, if he/she had bought 30-year bonds that yielded 10%, his/her income would be remained constant at $ 50000 per year. So, visibly, buying bonds that has short maturity carries reinvestment rate risk. T should be remembered that long term maturity bonds also have reinvestment rate risk as well, but the risk applies only to the coupon payment, not to the principle amount. Now, it can obviously said that a 1-year bond has more reinvestment risk than a 10-year bond.
h. How does the equation for valuing the bond change if

semiannual payments are maid? Find the value of a 10-year, semiannual payment bond, 10 percent coupon bond if nominal kd = 13%
i.

Suppose you could buy, for $ 1000, either a 10 percent, 10year, annual payment bond or a 10 percent, 10-year, semiannual payment bond. They are equally risky. Which would you prefer? If $ 1000 is the proper price for the semiannual bond, what is the equilibrium price for the annual payment bond?

j. Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of $ 1000 is currently selling for $ 1135.90, producing a nominal yield to maturity of 8 percent. However the bond can be called after 4 years for a price of $ 1050. (1)What is the bonds nominal yield to call (YTC)?

Given that, Par value/Face Value = $1000 Coupon Rate (CR) = 10% Number of years to mature (n) = 10 Market value of the bond (MV) = $1135.90 Yield to Maturity (YTM) = 8% Bond can be called after 4 for a price of $1050. Now, Coupon PMT = FV CR

= 1000 0.1 = 100

PVB = PMT21-1(1+i2)nx2i2+FV(1+i)n = 100 1-1(1+0.10)100.10+1000(1+0.10)10 = 1000

(2)If you bought this bond, do you think you would be more likely to earn the YTM or YTC? Why?

Since the coupon rate is 10% and YTC

e. Does the yield to maturity represent the promised or expected return on the bond? The yield to maturity is the rate of return earned on a bond if it is held to maturity. It can be viewed as the bonds promised rate of return, which is the return that investors will receive if all the promised payments are maid. The yield to maturity equals the expected rate of return only if The probability of debt is zero The bond cannot be called. For bonds where there is some default risk, or where bonds may be called, there is some probability that the promised payment to maturity will not be received, in which cases, the promised yield to maturity will differ from the expected return.
e. These bonds were rated AA-by S&P. Would you consider these

bond investment grade of junk bond? These bonds would be investment grade bonds. Triple-A, Double-A, and triple-B bonds are considered investment grade. Double-B and lower rated bonds are considered speculative, or junk bonds, since they have a significant probability of going into default. Many financial institutional are prohibited from buying junk bonds.

f. What factors determine a companys bond rating?

Bond ratings are based on both qualitative and quantitative factors. Some of them are listed below. I. Financial Performance: Determine by ratios such as Debt, TIE, and current ratios II. Provisions in the bond contract:

Secured vs Unscured bond Senior vs Subordinate debt Guarantee Provisions Sinking Fund Provisions Debt Maturity

III. Other Factors:

Earning Stability Regulatory Environment Potential Product Accounting Policy

e. If this firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments?