EIFM Seminar 2 – week commencing Oct 18th 2021
Question 1: A bond is a security that is issued in connection with a borrowing arrangement. The borrower issues (i.e., sells) a bond to the lender for some amount of cash and the bond is the “IOU” of the borrower. The contract between the issuer and the bondholder is called the bond indenture. The coupon rate, maturity date, and par value of the bond are part of the bond indenture.
Could you use the above terms to describe the following bond to a potential bond investor? The bond is issued by the UK Treasury, with a coupon rate of 5%, a maturity of 30 years, a par value of £1,000 and one coupon instalment per year.
If the bond in part a) is currently trading at £1,200, could you work out its yield to maturity (YTM) using Excel?
Could you explain the concept of YTM to a potential bond investor? How does the YTM calculated in part b) compare with the bond’s coupon rate?
Question 2: When economists use the word “interest rate” they often mean the yield to maturity (YTM). So a rise in interest rate also means a rise in YTM, which is the average return from holding a bond to its maturity. However, when investors believe market interest rate is likely to rise in the near future, they often rush to sell bonds or stay away from bonds for the time being. What’s the rationale for this behaviour?
Question 3: Consider a bond with a par value of £1,000, a coupon rate of 10%, a maturity of 29 years and one coupon instalment per year. Suppose the market interest rate of this bond is 20%. Could you work out its market price using the following formula?
Question 4: A financial advisor has just given you the following advice: “Long-term bonds are a great investment because their interest rate is over 20%.” Is this financial advisor necessarily right?
Question 5: Consider a bond with a par value of £1,000, a coupon rate of 10%, a maturity of 5 years and one coupon instalment per year. The market interest rate is currently 10%. Suppose you buy the bond today with the view to sell it in a year’s time. What would be your return on the bond if interest rate were to rise to 20% in a year’s time?