AFM101 Chapter Notes - Chapter 11: Market Rate

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lilacmouse857

26 Jun 2018

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM101

Professor

Donna Psutka

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AFSA Education

o Cash interest payments – payments are computed by multiplying the principal amount

times the coupon rate. The bond contract specifies if the payments are made quarterly,

semi-annually or annually

 Coupon rate – stated rate of interest on bonds

- The market determines the current cash equivalent of future interest and principal payments by

using present value concepts (from chapter 10)

- Present value of the bond = present value of the principal + present value of the interest

payments

- Market interest rate aka yield or effective-interest rate – the current rate of interest on a debt

when incurred, it should be used in computing the present value

- Present value can be the same as par, above par (premium) or below par (discount)

- Bond premium – the difference between the selling price and par when the bond is sold for

more than par

- Bond discount – the difference between the selling price and par when the bond is sold for less

than par

How to Calculate Present Value of Principal

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝑃

(1 + 𝑖)

- P = Principal

- i = the market interest rate per period (may not be the annual rate)

- n = number of compounding periods

Or, if you have the table of values:

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝑃 × 𝑣𝑎𝑙𝑢𝑒 𝑓𝑟𝑜𝑚 𝐴𝑝𝑝𝑒𝑛𝑑𝑖𝑥 10𝐶. 1 𝑢𝑠𝑖𝑛𝑔 𝑖 𝑎𝑛𝑑 𝑛

How to Calculate Present Value of an Ordinary Annuity

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑 ×

1 − 1

(1 + 𝑖)

𝑖

- Interest paid = interest paid each period (cash paid) *this uses stated interest rate

- i = the market interest rate per period

- n = number of compounding periods

Or, if you have the table of values:

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑 × 𝑣𝑎𝑙𝑢𝑒 𝑓𝑟𝑜𝑚 𝐴𝑝𝑝𝑒𝑛𝑑𝑖𝑥 10𝐶. 2 𝑢𝑠𝑖𝑛𝑔 𝑖 𝑎𝑛𝑑 𝑛

Bonds Issued at Par

- Market rate of interest = stated interest rate

- When effective rate of interest = stated rate of interest, present value of the future cash =

bond’s par value

- On the date of issue, bond liabilities are recorded at the present value of future cash flows

Journal entry to record the issue of the bond:

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Document Summary

Afsa education: cash interest payments payments are computed by multiplying the principal amount times the coupon rate. The bond contract specifies if the payments are made quarterly, semi-annually or annually. Coupon rate stated rate of interest on bonds. The market determines the current cash equivalent of future interest and principal payments by using present value concepts (from chapter 10) Present value of the bond = present value of the principal + present value of the interest payments. Market interest rate aka yield or effective-interest rate the current rate of interest on a debt when incurred, it should be used in computing the present value. Present value can be the same as par, above par (premium) or below par (discount) Bond premium the difference between the selling price and par when the bond is sold for. Bond discount the difference between the selling price and par when the bond is sold for less more than par than par.

Related Questions

The yield to maturity on a bond is __________________ .

	a.	below the coupon rate when the bond sells at a discount, and above the coupon rate when the bond sells at a premium.
	b.	the discount rate that will set the present value of the future cash payments of interest and principal equal to the bond price.
	c.	based on the assumption that any payments received are reinvested at the coupon rate.
	d.	none of the above.

indigooyster495

QUESTION 1 The largest investors in corporate bonds are life insurance companies and pension funds. True False 5 points QUESTION 2 Most secondary market transactions for corporate bonds take place through dealers in the over-the-counter (OTC) market. True False 5 points QUESTION 3 The value (or price) of a bond is the present value of its expected future cash flows. True False 5 points QUESTION 4 Bond prices decline when the interest rate decreases. True False 5 points QUESTION 5 The face or par value for bonds is the amount paid to bondholders at maturity and is usually equal to $1,000. True False 5 points QUESTION 6 The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments equal to the price of the bond. True False 5 points QUESTION 7 Zero coupon bonds have no coupon payments so they sell for more than their par value. True False 5 points QUESTION 8 Interest rate risk is the risk that bond prices will fluctuate when the interest rate changes. True False 5 points QUESTION 9 US Treasury securities are considered risky investments because the coupon payments are unpredictable. True False 5 points QUESTION 10 Bonds are very difficult to value because their future cash flows are very difficult to predict. True False 5 points QUESTION 11 If the bond's coupon rate is equal to the market rate then the bond will sell at a price equal to its face value greater than its face value less than its face value equal to its foreign currency value, e.g., its price in British pounds 5 points QUESTION 12 When calculating the price of a bond that pays a semiannual coupon one needs to use double the number of years until maturity for the number of payments use half the annual coupon payment use half the annual rate of return as the discount rate all of the above 5 points QUESTION 13 The yield to maturity of a bond is the discount rate that makes the present value of the coupon and principal payments more than the price of the bond equal to zero equal to the price of the bond less than the price of the bond 5 points QUESTION 14 Which one of the following statements is true? All else equal long-term bonds have lower price volatility than short-term bonds. There is an inverse relation between bond prices and market interest rates. All else equal short-term bonds are more risky than long-term bonds. All else equal US government bonds are more risky than corporate bonds. 5 points QUESTION 15 An investor owns a 10-year US government bond with a 9 percent coupon rate. If the yield-to-maturity on the bond is 8 percent then this bond is selling for its par value. a discount. a premium. its face value. 5 points QUESTION 16 BA Corp is issuing a 10-year bond with a coupon rate of 8 percent and a par value of $1,000. The market interest rate on similar bonds is currently 6 percent. If the coupon payments are made annually, what is the value of this bond? 5 points QUESTION 17 Knight, Inc. has issued a 3-year bond with a $1,000 par value and an annual coupon rate of 6 percent. The current market rate of interest is 5 percent. What is the value of this bond if the coupon payments are made semiannually? 5 points QUESTION 18 Diane Carter is interested in buying a 5-year zero coupon bond with a face value of $5,000. If the market interest rate on these types of bonds is currently 9 percent, what is the current price of this bond? 5 points QUESTION 19 Rudy Sandberg wants to invest in 4-year bonds that are currently priced at $933.76. The bonds have a coupon rate of 6 percent and annual coupon payments. If the par value of the bonds is $1,000, what is the bond's yield-to-maturity? 5 points QUESTION 20 You own a 5-year bond with a face value of $1,000 and a coupon rate of 5 percent with annual payments. The bond is currently worth $810.46. If market interest rates remain unchanged, what will be the value of the bond next year when there are 4 years left until maturity?

Bond valuation

The process of bond valuation is based on the fundamental concept that the current price of a security can be determined by calculating the present value of the cash flows that the security will generate in the future.

There is a consistent and predictable relationship between a bondâs coupon rate, its par value, a bondholderâs required return, and the bondâs resulting intrinsic value. Trading at a discount, trading at a premium, and trading at par refer to particular relationships between a bondâs intrinsic value and its par value. These result from the relationship between a bondâs coupon rate and a bondholderâs required rate of return.

Remember, a bondâs coupon rate partially determines the interest-based return that a bond (might/will)...........pay, and a bondholderâs required return reflects the return that a bondholder(would like/is obligated).............to receive from a given investment.

The mathematics of bond valuation imply a predictable relationship between the bondâs coupon rate, the bondholderâs required return, the bondâs par value, and its intrinsic value. These relationships can be summarized as follows:

â¢	When the bondâs coupon rate is equal to the bondholderâs required return, the bondâs intrinsic value will equal its par value, and the bond will trade at par.
â¢	When the bondâs coupon rate is greater to the bondholderâs required return, the bondâs intrinsic value will (be less than/exceed/equal)................ its par value, and the bond will trade at a premium.
â¢	When the bondâs coupon rate is less than the bondholderâs required return, the bondâs intrinsic value will be less than its par value, and the bond will trade (at a premium/at par/at a discount).............................

For example, assume Liam wants to earn a return of 5.00% and is offered the opportunity to purchase a $1,000 par value bond that pays a 8.75% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bondâs intrinsic value(Link to the formula : http://q4pws.aplia.com/q4pws/rest/1.0/image/image9594/img.png?data=q4%3AREMOTE_URL%3Ahttp%3A%2F%2Faplia-prod-webjboss-372923237.us-east-1.elb.amazonaws.com%2Fproblemsetassets%2Fq4_export%2Ffinance%2Fq4problems%2F3061500.08.xml%2CV5%2C291%2C1%2CSTUDENT%2CSTUDENT%2C0%2Cq4pws-aplia-7.6.4-G2f8d8babd91356776c6b2ec65d5e2a2153b4d346-B36-2015.12.16-03%3A57-PM-PST&oauth_signature=jG%2Fu63kSgI9xRhXign5JItWfpAQ%3D&oauth_version=1.0&oauth_nonce=3573483745&oauth_signature_method=HMAC-SHA1&oauth_consumer_key=q4-callback&oauth_timestamp=1454953012

Complete the following table by identifying the appropriate corresponding variables used in the equation.

unknown --------------------- variable name ---------------------variable value

A --------------------- (Bondholders required return/Bonds annual coupon payment/Bonds semiannual coupon payment)---------------------($21.88/$65.63/$87.50/$43.75)

B--------------------- (Bonds par value/bonds annual coupon payment/semiannual coupon payment) ---------------------$1000

C--------------------- semiannual required return -------------------- ($5.75/$3.81/$4.38/$2.5)

Based on this equation and the data, it is (reasonable/unreasonable)...................to expect that Liamâs potential bond investment is currently exhibiting an intrinsic value greater than $1,000.

Now, consider the situation in which Liam wants to earn a return of 5.75%, but the bond being considered for purchase offers a coupon rate of 8.75%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of ($757/$866/$1407/$1082).................is (equal to/greater than/less than).............................its par value, so that the bond is trading at (par/a discount/a premium)..............................

Given your computation and conclusions, which of the following statements is true?

(a)When the coupon rate is greater than Liamâs required return, the bond should trade at a discount.

(b)A bond should trade at a par value when the coupon rate is greater than Liam's required return

(c) When the coupon rate is greater than Liamâs required return, the bond's intrinsic value will be less than it's par value

(d) When the coupon rate is greater than Liamâs required return, the bond should trade at a premium

AFM101 Chapter Notes - Chapter 11: Market Rate

AFM101 Full Course Notes

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