Finance 320 Ch 10-11 terms

bond a security that obligates the issuer to make specified payments to the holder over a period of timesecurity issued in connection with a borrowing agreementborrower issues (sells) a bond to the lender for some amount of cash- bond is in essence the IOU of the borrowerarrangement obligates issuer to make specified payments to bondholder on specified dates- coupon
face value, par value payment to the bondholder at the maturity of the bondwhen bond matures- issuer repays debt by paying par value
coupon rate a bond’s annual interest payment per dollar of par valuedetermines interest payment- annual payment= coupon rate * bond’s par value
zero coupon bond a bond paying no coupons that sells at a discount and provides only a payment of par value at maturity
callable bonds bonds that may be repurchased by the issuer at a specified call price during the call period before maturitytypically come with period of protection- where the bonds are not callable
convertible bond a bond with an option allowing the bondholder to exchange the bond for a specified number of shares of common stock in the firmconversion ratio states number of shares for which each bond may be exchanged
put bonds a bond that the holder may choose to exchange for par value at some date or to extend for a given number of years
floating rate bonds bonds with coupon rates periodically reset according to a specified market ratemake interest payments tied to some measure of current market ratesalways pays approximately market rate
yield to maturity (ytm) the discount rate that makes the present value of a bond’s payments equal to its price often viewed as average rate of return that will be earned on a bond if it is bought now and held until maturity
current yield annual coupon payment divided by bond price
premium bonds bonds selling above par valuecoupon rate > current yield which is > yield to maturity
discount bonds bonds selling below par valuecoupon < current yield < ytm
realized compound return compound rate of return on a bond with all coupons reinvested until maturity
horizon analysis analysis of bond returns over a multiyear horizon based on forecasts of the bond’s yield to maturity and reinvestment rate of couponscalculate realized compound yield over multiple holding periodslonger horizon- reinvested coupons = larger component of final proceeds
reinvestment rate risk uncertainty surrounding the cumulative future value of reinvested bond coupon paymentsinterest rate changes- potentially offset by impact of price risk
investment grade bonds a bond rated BBB or better by S&P or Baa or better by Moody’smeasures bond default risk- company goes bankrupt
speculative grade or junk bonds bond rated BB or lower by S&P or Ba or lower by Moody’s or unrated bond
indenture document defining the contract between bond issuer and bondholderspecifies payment schedule, set of restrictions that protect rights of the bondholder- collateral, sinking fund, dividend policy, future borrowing etc
sinking fund a bond indenture that calls for the issuer to periodically repurchase some proportion of the outstanding bonds prior to maturityto help ensure that the commitment does not create a cash flow crisis at maturity to spread the burden over over several years buy fraction at market price or special call price
subordination clauses restrictions on additional borrowing that stipulate that senior bondholders will be paid first in the event of the bankruptcy
collateral a specific asset pledged against possible default on a bondparticular asset that bondholders receive if the firm defaultsproperty, securities, equipment
debenture a bond not backed by specific collateral unsecured- don’t provide for specific asset- credit risk
default premium the increment to promised yield that compensates the investor for default riskcorporate bondsdifference between promised yield on corporate bond and identical government bond that’s riskless on default
credit default swaps an insurance policy on the default risk of a corporate bond or loanpaid premium paid by buyer to sellerseller collects payments for term of contract but must compensate buyer for loss of bond value in the event of default
yield curve a graph of yield to maturity as a function of term to maturity
term structure of interest rates relationship between yields to maturity and terms to maturity across bondsalso relationship of yield curverelates yields to maturity to the term of each bond
expectations hypothesis theory that yields to maturity are determined solely by expectations of future short term interest rates expectations of the yield curvewhich asserts that the slope of the yield curve is attributable to expectations of changes in short term rates
forward rate the inferred short term rate of interest for a future period that makes the expected total return of a long term bond equal to that of rolling over short term bondsbreak even value
liquidity preference theory the theory that investors demand a risk premium on long term bondsterm structure theoryshorter term bonds have more liquidity than longer term- offer greater price certainty and trade in more active markets with lower bid ask spreads
liquidity premium the extra expected return demanded by investors as compensation for the greater risk of longer term bondsresulting from extra compensation investors demand for holding longer term bonds with greater price risk
Macaulys duration a measure of the effective maturity of a bond- defined as weighted average of the times until each payment with weights proportional to the present value of paymentsweight applied to each payment clearly should be related to the importance of that payment to the value of the bond
modified duration macaluy’s duration divided by 1 + yield to maturity measures interest rate sensitivity of bond
immunization a strategy to shield net worth from interest rate movements
rebalancing realigning the proportions of assets in a portfolio as needednecessary for immunization- as interest rates and asset durations continually change- managers must adjust the portfolio to realign its duration with the duration of the obligation
cash flow matching matching cash flows from a fixed income portfolio with those of an obligation automatically immunizes a portfolio from interest rate risk because the cash flow from the bond and the obligation exactly offset each other
dedication strategy refers to multiperiod cash flow matchingmanager selects either zero coupon or coupon bonds with total cash flows that match a series of obligations once and for all approach to eliminating interest rate riskonce cash flows matched- no need to rebalancededicated portfolio provides the cash necessary to pay the firm’s liabilities regardless of the eventual path of interest rates
convexity the curvature of the price yield relationship of a bondcurves with shapes such as that of the price yield relationship are said to be convex and the curvature of the price yield curve is called convexity
substitution swap exchange of one bond for a bond with similar attributes but more attractively priced exchange of one bond for a nearly identical substitutethe substituted bonds should be essentially equal coupon, maturity, quality, call features, sinking fund etcbelieve market mispriced temporarily the two bonds with the ability to make a profit
Intermarket spread swap Switching from one segment of the bond market to anotherExchange of two bonds from different sectors of the bond marketPursued when investors belieive the yield spread between two sectors of the bond market is temporarily out of line
Rate anticipation swap A switch made in response to forecasts of interest rate changesExchange of bonds with different maturitities Pegged to interest rate forecastingInvestors who believe rates will fall will swap into bonds of longer duration
Pure yield pickup swap Moving to higher yield bonds usually with longer maturities Exchange of shorter duration for a longer duration bondPursured as means of increasing return by holding higher yield longer maturity bondsInvestors willing to bear the interest rate risk this strategey entails
Tax swap Swapping two similar bonds to receive a tax benefitExploit some tax advantage
Horizon analysis Forecast of bond returns based largely on a prediction of the yield curve at the end of the investment horizonAnalyst selects a particular investment period and predicts bond yields at the end of the period

Leave a Reply

Your email address will not be published. Required fields are marked *