Chapter 7: Debt Valuation

Question 1

Cut-Off between IG and not IG Bonds

Answer 1

BBB, Baa, BBB = IG, so anything with A or 3 letters B is investment grade

Question 2

What factors are assessed when providing credit ratings

Answer 2

• Likelihood of default
• Payment priority of an issue following default
• Projected recovery that an investor would expect to receive if it defaults
• Financial stability

Question 3

What are yields

Answer 3

• a way of identifying the return achieved from a particular financial instrument

Question 4

Flat yield

Answer 4

• measures the return from achieving the coupons alone
  Flat yield = Gross annual coupon/Market Price * 100%

Question 5

How do interest rates impact bond prices?

Answer 5

When interest rates rise, bond prices will fall.

Question 6

What are the tax implications on the bond?

Answer 6

• income tax payable on the coupon but no tax on the gain

Question 7

What is the difference between the clean and the dirty price?

Answer 7

Accrued interest
* The dirty price will keep on increasing during the six month period between coupon payments

Question 8

What is the ex-coupon date and how long is it?

Answer 8

The date on and after which a buyer of a bond is not entitled to receive the next coupon payment
* For UK Gilts it is 7 business days

Question 9

How is the dirty price affected in the ex-coupon period?

Answer 9

It is less than the clean price since the buyer is losing the interest income

Question 10

How do coupons affect bond prices?

Answer 10

• Low coupon bonds are more volatile than high coupon bonds because with a small coupon, more of its return is locked up in the redemption payment far away in time –> more exposed to interest rate changes

Question 11

How does remaining life affect bond prices?

Answer 11

For two bonds with the same coupon, but different redemption rated, the longer dated bond will be the most volatile.

Question 12

How does yield affect the sensitivity of a bond?

Answer 12

The lower the yield of a bond, the more sensitive it is to any changes in that yield

Question 13

How is Macaulay duration calculated?

Answer 13

• it is the weighted average maturity of a bond, where the weights are the relative discounted cash flows for each period
• Σ (PV Cash flows x time to cash flows) / Σ PV cash flows
• For a 0 coupon bond, the Macaulay duration will be equal to the bond’s maturity

Question 14

Modified duration - what it is + calculation?

Answer 14

• Estimates how much a bond’s price will change if there is a 1% change in yield
• Modified duration = Duration / (1 + present yield)