Chapter 6 review questions:
- What is the real rate of interest? Differentiate it from the nominal rate of interest for the risk-free asset, a 3-month U.S. Treasury Bill?
The real rate of interest is an adjusted interest to remove inflation effects. It differs in terms of its effect on inflation.
- What is the term structure of interest rates, and how is it related to the yield curve?
It is the association between maturity and bond rates with the same risk levels. The yield curve is the name of the relationship between maturity and bond rates.
- For a given class of similar-risk securities, what does each of the following yield curves reflect about interest rates: (a) downward sloping, (b) upward sloping, and (c) flat? What is the “normal” shape of the yield curve?
A downward slope is identified as a regular curve and shows that the long-term interest rate is greater than the short term.
Upward sloping means the inversion of the short term is bigger than the long term.
Flat means that there is no difference in maturity.
- Briefly describe the following theories of the general shape of the yield curve: (a) expectations theory, (b) liquidity preference theory, and (c) market segmentation theory?
- Expectations theory states that the yield curve is affected by anticipations of interest rates. Therefore when the yield is upwards, the investors anticipate rates increase and vice versa.
- Liquidity preference theory means that investors need short term securities whereas insures want to sell long term when all things are the same.
- Market segmentation theory states that there is the separation of both markets and an upward slopping curve indicates that there is demand in both sections.
- List and briefly describe the potential issuer- and issue-related risk components that are embodied in the risk premium. Which are the purely debt-specific risks?
Business risk-is it acceptable for business?
Financial risk-does it pays handsomely?
Interest rate risk- will the rates differ?
Provision risk- is what I kept aside adequate?
Debt-specific risks
Default risk-Will it is given back?
Contractual provision risk-How much do I need to set aside?
- What are typical maturities, denominations, and interest payments of a corporate bond? What mechanisms protect bondholders?
Typical maturity is ten to thirty years, denominations are $1000 and interest payments arrive twice a year.
The bond contract gives rights to the holder and bond insurer.
- Differentiate between standard debt provisions and restrictive covenants included in a bond indenture. What are the consequences if a bond issuer violates any of these covenants?
Standard debt provision is the regulations that the issuer of the bond must adhere to them. Restrictive covenants are the regulations the borrower must adhere to so that the risk on their issuer is mitigated.
The issuer has the right to demand instant repayment of any date in case of any violations.
- How is the cost of bond financing typically related to the cost of short-term borrowing? In addition to a bond’s maturity, what other major factors affect its cost to the issuer?
Financing costs are bigger than the short term borrowing costs. The factors outside the maturity that has impacts on the bond cost are its money cost, risk of the issuer, and size.
- What is a conversion feature? A call feature? What are stock purchase warrants?
Conversion feature refers to the ability of bondholders to change bonds into the common stock of issuers.
A call feature is the issuer’s ability to re-buy their bonds before maturity.
Stock purchase warrants provide the holders of the rightful warrants with the capability of buying a particular amount of common stock at a particular price for a certain period.
- What is the current yield for a bond? How are bond prices quoted? How are bonds rated, and why?
The yearly payment divided by the bond’s recent price is equal to its yield. Bond prices are held closely and they are not easily available as they are quoted by the name of the company, coupon rate, and date of maturity, price, and yield to maturity.
- Compare the basic characteristics of Eurobonds and foreign bonds?
Eurobonds are given by a foreign borrower in a different currency than where the bond was bought. The bonds which are bought and used only in the country it was bought in comparison to the foreign bond.
- Why is it important for financial managers to understand the valuation process?
Knowledge of how to assign values in the middle of different risks helps in making a good decision.
- What are the three key inputs to the valuation process?
Risk measure, the flow of cash and scheduling
- Does the valuation process apply only to assets that provide an annual cash flow? Explain
It doesn’t since it applies to things that provide payment yearly, semiannually, and occasionally or once. All techniques come with different risks but are still regarded as the source of value.
- Define and specify the general equation for the value of any asset, Vo.
The asset’s value at time zero is found by dividing the addition of every flow of cash in that year by 1+ the needed return rate raised to the power of the year.
- What procedure is used to value a bond that pays annual interest? Semi-annual interest?
The current value function in Excel for all.
- What relationship between the required return and the coupon interest rate will cause a bond to sell at a discount? At a premium? At its par value?
If the return rate value is greater than par and traded at a discount. Therefore, when return is less than its rate traded at a premium and when return is equal to rate it goes for par.
- If the required return on a bond differs from its coupon interest rate, describe the behavior of the bond value over time as the bond moves toward maturity.
The bond’s value will approach par value as time continues and the date of maturity nears.
- As a risk-averse investor, would you prefer bonds with short or long periods until maturity? Why?
The short term is preferred because it is not affected by changes in the market which shows that it carries less risk.
- What is a bond’s yield to maturity (YTM)?
Yield to maturity refers to the compound annual rate of return made when a bond is bought on an agreed day and detained till maturity. In the Excel list, the money moves and use the IRR function.