Finance Test 2

A contract issuer promises specific payments

To the holder

Indenture =

Contract

Maturity Date

Date of last payment. (Pays Par + Coupon)

Coupon Rate/ Coupon

Coupon periodic payment

Sinking Fund

Firms set aside a pretermined amount according to a schedule, money then used to pay for the bond

Collateral

An asset that pledged to a bond that helps from defaulting.

In case of defaulting

Asset is sold to pay the bond

Seniority

Senior bond paid first. Junior paid next.

Call feature

Gives issuer right to buy bond before maturity at “call premium /call price”

Conversion feature

Allows holders to exchange bond for a pre determined # of shares of common stock

Restrictive Conventants

Set of provisions that prevents the actions of shareholders. Protects bond holders

Value

Sum of present values of future cash flows

If Par not given

Assume it’s $1,000

Premium

V > Par

r < Cr

Discount

V < Par

r > Cr

Current Yield (CY)

Annual Coupon / Bond Price

Yield to maturity

The rate of return the investor will earn if two conditions are satisfied 1) Bond is held until maturity 2) Each coupon is reinvested at a rate equal to the yield to maturity.

Risk can be measured using

Standard deviation

Fisher effect

Nominal rate = Real rate + Expected Inflation / n

If it’s a treasury bond don’t use

Liquidity premium and default risk premium

As interest rates increase business are ? Willing to demand loans

Less

If the federal reserve were to sell short term treasury securities, everything else being constant, What would happen to short term interest rates and bond prices

Prices would decrease and interest rates would increase

Randomly adding securities to a portfolio

Reduces total risk by lowering the diversifiable risk

The risk of a portfolio is

1) Could be measured by standard deviation

2) Could be measured by the CAPM beta

3) is reduced considerably if the assets included in the portfolio have a low or negative correlation (close to -1)

IPO =

Initial Public Offering

Primary market

Securities are created and sold for the first time. Proceeds go to the insurer. Ex: IPO

Secondary Market

Where investors trade existing securities among themselves. Ex: NASDAQ & NYSE

Interest rate =

The cost of borrowing money or the reward for saving it expressed as a percentage of the total amount

Interest rates come from

1) Supply & Demand 2) Inflation expectations 3) Central bank policies

Risk premium =

Additional return an investor expects from a risky investment

Risk premuim formula

Risk premium = Expected return of risky asset - Risk free rate

Yield Curve

A line that plots yields (interest rates) of bonds having equal credit quality but different maturity rates

Yield curve X & Y axis

X: Maturity (Years)

Y: Yield

On the maturity date

The bond pays both the coupon and the par value

Which of these give bonds higher yields

1) Junior Bond

2) Callalable

These are riskier