Ch05SolutionsManual.docx
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Ch05SolutionsManual.docx
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Ch05SolutionsManual
Chapter5
Bonds,BondValuation,andInterestRates
ANSWERSTOEND-OF-CHAPTERQUESTIONS
5-1a.Abondisapromissorynoteissuedbyabusinessoragovernmentalunit.Treasurybonds,sometimesreferredtoasgovernmentbonds,areissuedbytheFederalgovernmentandarenotexposedtodefaultrisk.Corporatebondsareissuedbycorporationsandareexposedtodefaultrisk.Differentcorporatebondshavedifferentlevelsofdefaultrisk,dependingontheissuingcompany'scharacteristicsandonthetermsofthespecificbond.Municipalbondsareissuedbystateandlocalgovernments.Theinterestearnedonmostmunicipalbondsisexemptfromfederaltaxes,andalsofromstatetaxesiftheholderisaresidentoftheissuingstate.Foreignbondsareissuedbyforeigngovernmentsorforeigncorporations.Thesebondsarenotonlyexposedtodefaultrisk,butarealsoexposedtoanadditionalriskifthebondsaredenominatedinacurrencyotherthanthatoftheinvestor'shomecurrency.
b.Theparvalueisthenominalorfacevalueofastockorbond.Theparvalueofabondgenerallyrepresentstheamountofmoneythatthefirmborrowsandpromisestorepayatsomefuturedate.Theparvalueofabondisoften$1,000,butcanbe$5,000ormore.Thematuritydateisthedatewhenthebond'sparvalueisrepaidtothebondholder.Maturitydatesgenerallyrangefrom10to40yearsfromthetimeofissue.Acallprovisionmaybewrittenintoabondcontract,givingtheissuertherighttoredeemthebondsunderspecificconditionspriortothenormalmaturitydate.Abond'scoupon,orcouponpayment,isthedollaramountofinterestpaidtoeachbondholderontheinterestpaymentdates.Thecouponissonamedbecausebondsusedtohavedatedcouponsattachedtothemwhichinvestorscouldtearoffandredeemontheinterestpaymentdates.Thecouponinterestrateisthestatedrateofinterestonabond.
c.Insomecases,abond'scouponpaymentmayvaryovertime.Thesebondsarecalledfloatingratebonds.Floatingratedebtispopularwithinvestorsbecausethemarketvalueofthedebtisstabilized.Itisadvantageoustocorporationsbecausefirmscanissuelong-termdebtwithoutcommittingthemselvestopayingahistoricallyhighinterestratefortheentirelifeoftheloan.Zerocouponbondspaynocouponsatall,butareofferedatasubstantialdiscountbelowtheirparvaluesandhenceprovidecapitalappreciationratherthaninterestincome.Ingeneral,anybondoriginallyofferedatapricesignificantlybelowitsparvalueiscalledanoriginalissuediscountbond(OID).
d.Mostbondscontainacallprovision,whichgivestheissuingcorporationtherighttocallthebondsforredemption.Thecallprovisiongenerallystatesthatifthebondsarecalled,thecompanymustpaythebondholdersanamountgreaterthantheparvalue,acallpremium.Redeemablebondsgiveinvestorstherighttosellthebondsbacktothecorporationatapricethatisusuallyclosetotheparvalue.Ifinterestratesrise,investorscanredeemthebondsandreinvestatthehigherrates.Asinkingfundprovisionfacilitatestheorderlyretirementofabondissue.Thiscanbeachievedinoneoftwoways:
Thecompanycancallinforredemption(atparvalue)acertainpercentageofbondseachyear.Thecompanymaybuytherequiredamountofbondsontheopenmarket.
e.Convertiblebondsaresecuritiesthatareconvertibleintosharesofcommonstock,atafixedprice,attheoptionofthebondholder.Bondsissuedwithwarrantsaresimilartoconvertibles.Warrantsareoptionswhichpermittheholdertobuystockforastatedprice,therebyprovidingacapitalgainifthestockpricerises.Incomebondspayinterestonlyiftheinterestisearned.Thesesecuritiescannotbankruptacompany,butfromaninvestor'sstandpointtheyareriskierthan"regular"bonds.Theinterestrateofanindexed,orpurchasingpower,bondisbasedonaninflationindexsuchastheconsumerpriceindex(CPI),sotheinterestpaidrisesautomaticallywhentheinflationraterises,thusprotectingthebondholdersagainstinflation.
f.Bondpricesandinterestratesareinverselyrelated;thatis,theytendtomoveintheoppositedirectionfromoneanother.Afixed-ratebondwillsellatparwhenitscouponinterestrateisequaltothegoingrateofinterest,rd.Whenthegoingrateofinterestisabovethecouponrate,afixed-ratebondwillsellata"discount"belowitsparvalue.Ifcurrentinterestratesarebelowthecouponrate,afixed-ratebondwillsellata"premium"aboveitsparvalue.
g.Thecurrentyieldonabondistheannualcouponpaymentdividedbythecurrentmarketprice.YTM,oryieldtomaturity,istherateofinterestearnedonabondifitisheldtomaturity.Yieldtocall(YTC)istherateofinterestearnedonabondifitiscalled.Ifcurrentinterestratesarewellbelowanoutstandingcallablebond'scouponrate,theYTCmaybeamorerelevantestimateofexpectedreturnthantheYTM,sincethebondislikelytobecalled.
h.Corporationscaninfluencethedefaultriskoftheirbondsbychangingthetypeofbondstheyissue.Underamortgagebond,thecorporationpledgescertainassetsassecurityforthebond.Allsuchbondsarewrittensubjecttoanindenture,whichisalegaldocumentthatspellsoutindetailtherightsofboththebondholdersandthecorporation.Adebentureisanunsecuredbond,andassuch,itprovidesnolienagainstspecificpropertyassecurityfortheobligation.Debentureholdersare,therefore,generalcreditorswhoseclaimsareprotectedbypropertynototherwisepledged.Subordinateddebentureshaveclaimsonassets,intheeventofbankruptcy,onlyafterseniordebtasnamedinthesubordinateddebt'sindenturehasbeenpaidoff.Subordinateddebenturesmaybesubordinatedtodesignatednotespayableortoallotherdebt.
i.Adevelopmentbondisatax-exemptbondsoldbystateandlocalgovernmentswhoseproceedsaremadeavailabletocorporationsforspecificusesdeemed(byCongress)tobeinthepublicinterest.Municipalitiescaninsuretheirbonds,inwhichaninsurancecompanyguaranteestopaythecouponandprincipalpaymentsshouldtheissuerdefault.Thisreducestherisktoinvestorswhoarewillingtoacceptalowercouponrateforaninsuredbondissuevis-a-visanuninsuredissue.Bondissuesarenormallyassignedqualityratingsbymajorratingagencies,suchasMoody'sInvestorsServiceandStandard&Poor'sCorporation.Theseratingsreflecttheprobabilitythatabondwillgointodefault.Aaa(Moody's)andAAA(S&P)arethehighestratings.Ratingassignmentsarebasedonqualitativeandquantitativefactorsincludingthefirm'sdebt/assetsratio,currentratio,andcoverageratios.Becauseabond'sratingisanindicatorofitsdefaultrisk,theratinghasadirect,measurableinfluenceonthebond'sinterestrateandthefirm'scostofdebtcapital.Junkbondsarehigh-risk,highyieldbondsissuedtofinanceleveragedbuyouts,mergers,ortroubledcompanies.Mostbondsarepurchasedbyinstitutionalinvestorsratherthanindividuals,andmanyinstitutionsarerestrictedtoinvestmentgradebonds,securitieswithratingsofBaa/BBBorabove.
j.Therealrisk-freerateisthatinterestratewhichequalizestheaggregatesupplyof,anddemandfor,risklesssecuritiesinaneconomywithzeroinflation.Therealrisk-freeratecouldalsobecalledthepurerateofinterestsinceitistherateofinterestthatwouldexistonveryshort-term,default-freeU.S.Treasurysecuritiesiftheexpectedrateofinflationwerezero.Ithasbeenestimatedthatthisrateofinterest,denotedbyr*,hasfluctuatedinrecentyearsintheUnitedStatesintherangeof2to4percent.Thenominalrisk-freerateofinterest,denotedbyrRF,istherealrisk-freerateplusapremiumforexpectedinflation.Theshort-termnominalrisk-freerateisusuallyapproximatedbytheU.S.Treasurybillrate,whilethelong-termnominalrisk-freerateisapproximatedbytherateonU.S.Treasurybonds.NotethatwhileT-bondsarefreeofdefaultandliquidityrisks,theyaresubjecttorisksduetochangesinthegenerallevelofinterestrates.
k.Theinflationpremiumisthepremiumaddedtotherealrisk-freerateofinteresttocompensatefortheexpectedlossofpurchasingpower.Theinflationpremiumistheaveragerateofinflationexpectedoverthelifeofthesecurity.Defaultriskistheriskthataborrowerwillnotpaytheinterestand/orprincipalonaloanastheybecomedue.Thus,adefaultriskpremium(DRP)isaddedtotherealrisk-freeratetocompensateinvestorsforbearingdefaultrisk.Liquidityreferstoafirm’scashandmarketablesecuritiesposition,andtoitsabilitytomeetmaturingobligations.Aliquidassetisanyassetthatcanbequicklysoldandconvertedtocashatits“fair”value.Activemarketsprovideliquidity.Aliquiditypremiumisaddedtotherealrisk-freerateofinterest,inadditiontootherpremiums,ifasecurityisnotliquid.
l.Interestrateriskarisesfromthefactthatbondpricesdeclinewheninterestratesrise.Underthesecircumstances,sellingabondpriortomaturitywillresultinacapitalloss,andthelongerthetermtomaturity,thelargertheloss.Thus,amaturityriskpremiummustbeaddedtotherealrisk-freerateofinteresttocompensateforinterestraterisk.Reinvestmentrateriskoccurswhenashort-termdebtsecuritymustbe“rolledover.”Ifinterestrateshavefallen,thereinvestmentofprincipalwillbeatalowerrate,withcorrespondinglylowerinterestpaymentsandendingvalue.Notethatlong-termdebtsecuritiesalsohavesomereinvestmentrateriskbecausetheirinterestpaymentshavetobereinvestedatprevailingrates.
m.Thetermstructureofinterestratesisthe
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