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7 Jun 2019

When rates are quoted using different compounding frequencies, they result in different percentage amounts. Can you have different discount factors for the same kind of bond with the same maturity? Why?

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Nestor Rutherford
Nestor RutherfordLv2
8 Jun 2019

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Loan/deposit products use different compounding frequencies. For example, mortgage, CDs use monthly compounding. Credit cards use daily compounding, even though customers pay interest on a monthly basis. Bonds use quarterly, semiannual or annual compounding. Regardless of compounding frequencies, all the interest rates are quoted per annum (annualized). For example, 4% mortgage rate doesn’t mean the borrower pays 4% of the mortgage balance every month. He pays 4%/12 a month. Q1. Have you made any mistakes in the past with the compounding frequency/interest rate quotation? Share your story. Q2. Why do these products use different frequencies? Q3. Why do we quote all the rates per annum?

- What determines the intrinsic value of a financial security (ie. a stock, bond, etc)? - How is the intrinsic value arrived at? (ie. What kind of assumptions are required?) - How do we explain why analysts can come up with different valuations for the same company stock?

Answer these questions and show your work: •Assume that the company that you selected for the Module 1 SLP has a bond outstanding that matures in 20 years and has a coupon rate of 6.5%. The par value of the bond is $1,000. •If the yield to maturity is 8% and the bond pays interest on an annual basis, what’s the current price of the bond? Is the bond selling for a premium or discount? How can you tell? •If the yield to maturity is 8% but the bond pays interest on a semi-annual basis instead of an annual basis, what’s the current price of the bond? Is it different from the value when using annual compounding? Explain. •Now, assume that the economy enters into a recession and interest rates fall. The bond’s yield to maturity is now 5%. What’s the bond’s new price? How does the price compare with your answer in part a? Why did the bond’s value change? •A bond matures in ten years and is currently selling for $1,125. The bond pay interest annually, has a par value of $1,000, and a yield to maturity of 10.75%. What’s the bond’s current yield?

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