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# Fixed Income, Study Guide for Quiz 1 BU.232.720.W4.SP16

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This 2 page Study Guide was uploaded by Kwan on Thursday January 28, 2016. The Study Guide belongs to BU.232.720.W4.SP16 at Johns Hopkins University taught by Philip Giles in Spring 2016. Since its upload, it has received 59 views. For similar materials see Fixed Income in Finance at Johns Hopkins University.

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Date Created: 01/28/16

Thursday, January 28, 2016 Key Points I • The price of a bond is the present value of the bond’s expected cash ﬂows, the discount rate being equal to the yield offered on comparable bonds. For an option- free bond, the cash ﬂows are the coupon payments and the par value or maturity value. The higher (lower) the required yield, the lower (higher) the price of a bond. • For a zero-coupon bond, there are no coupon payments. The price of a zero-coupon bond is equal to the present value of the maturity value, where the number of periods used to compute the present value is double the number of years and the discount rate is a semiannual yield. • Abond’s price changes in the opposite direction from the change in the required yield. The reason is that as the required yield increases (decreases), the present value of the cash ﬂow decreases (increases). • Abond will be priced below par, at par, or above par depending the bond’s coupon rate and the yield required by investors. When the coupon rate is equal to the required yield, the bond will sell at its par value. When the coupon rate is less (greater) than the required yield, the bond will sell for less (more) than its par value. • Over time, the price of a premium or discount bond will change even if the required yield does not change.Assuming that the credit quality of the issuer is unchanged, the price change on any bond can be decomposed into a portion attributable to a change in the required yield and a portion attributable to the time path of the bond. • The price of a ﬂoating-rate bond will trade close to par value if the spread required by
the market does not change and there are no restrictions on the coupon rate. • The price of an inverse ﬂoater depends on the price of the collateral from which it is
created and the price of the ﬂoater. • Accrued interest is the amount that a bond buyer who purchases a bond between
coupon payments must pay the bond seller. The amount represents the coupon interest earned from the time of the last coupon payment to the settlement date of the bond.
1 Thursday, January 28, 2016 Key Points II • For any investment, the yield or internal rate of return is the interest rate that will make the present value of the cash ﬂows equal to the investment’s price (or cost). The same procedure is used to calculate the yield on any bond. • The conventional yield measures commonly used by bond market participants are the current yield, yield to maturity, yield to call, yield to sinker, yield to put, yield to worst, and cash ﬂow yield. • The three potential sources of dollar return from investing in a bond are coupon interest, reinvestment income, and capital gain (or loss). • Conventional yield measures do not deal satisfactorily with all of these sources. The current yield measure fails to consider both reinvestment income and capital gain (or loss). The yield to maturity considers all three sources but is deﬁcient in assuming that all coupon interest can be reinvested at the yield to maturity. The risk that the coupon payments will be reinvested at a rate less than the yield to maturity is called reinvestment risk. • The yield to call has the same shortcoming; it assumes that the coupon interest can be reinvested at the yield to call. The cash ﬂow yield makes the same assumptions as the yield to maturity, plus it assumes that periodic principal payments can be reinvested at the computed cash ﬂow yield and that the prepayments are actually realized. • Total return is a more meaningful measure for assessing the relative attractiveness of a bond given the investor’s or the portfolio manager’s expectations and planned investment horizon. • The change in yield between two periods can be calculated in terms of the absolute yield change or relative (percentage) yield change.
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