Congratulations. You have been promoted to vice president and director of your m
ID: 2727379 • Letter: C
Question
Congratulations. You have been promoted to vice president and director of your mid-size firm’s pension fund management team located in Cincinnati, OH. Before you have even had the opportunity to settle into your new office, your senior vice president tapped you to take her place and present an investment seminar to "a group of investment decision-makers" comprised of government analysts from all over the tri-state area but that is the extent of the information you’ve been provided. After doing some quick research, you’ve identified that the specific target audience for this presentation is composed primarily of individuals with little or no professional investment experience who are attending this seminar to build their skills. In order to address the range of information these individuals need to know and the likely range of questions that may crop up, you’ll need to be able to: 1.Describe the essential characteristics of a bond and how these characteristics interact to determine bond value, inclusive of how both the interest rate and coupon rate influence bond value and pricing. 2.Summarize call provisions and sinking fund provisions. Explain how these types of provisions individually make bonds more or less risky for a) an investor, and b) the issuer. 3.The value of an asset whose value is based on expected future cash flows is determined by the present value of all future cash flows the assets will generate. Given the case scenario and target audience provided, select and discuss a simple asset situation that could apply to exemplify this concept. 4.Define what it means when a bond is callable. Provide two measures you can review to understand what type of returns to expect if the bond is called or if it is not called.
Explanation / Answer
1.
Bonds that are issued or traded at discount, par or premium give return from both coupon payments and face value of bond. In discounted bond investor earns when bond reach to its face value at the time of maturity.
Coupon bonds may trade at discount, par or premium, return from coupon bonds through coupon payments till and at the time of maturity receive face value of the bond. So, if bond trades at discount, its yield to maturity will exceed its coupon rate.
In other words, discount coupon bonds that are traded at discounted rate lower than face value and investor get coupon payments till maturity and at the time of maturity receive face value of the bond. In premium bonds investor receives coupon payments till maturity and at the time of maturity receive face value of the bond. In both of the case investors earn coupon payment and at time of maturity receive face value.
In the case of discounted zero coupon bond investor purchase a bond less than its face value and sell them at par or its face value.
Zero coupon bonds are pure discounted bonds that matures on date n provides a risk free return over the same period.
In any risk free zero coupon bonds their interest rate is yield to maturity of the bond. Zero coupon bonds is a discounted bond investor will earn from holding the bond to maturity and receive the promised face value payments. Zero coupon bonds do not make any coupon payments before maturity. The only cash payment the investor receives is the face value of the bond on the maturity date.
2.
Callable bond is different from regular bond. Today corporate and financial institution issued these bonds. These bonds are issued to protact themselves from the change in interest rate. They fix certain time called lock-in period for the call options to be exercised in the callable bond so the investors are protected till the time bonds are due for calls.
In callable bonds investors get difficulty to get back their called bonds from the issuers in case of falling interest rate in the market. This option gives the issuer the opportunity to pay the debts before the maturity date when interest rate is falling in the callable period.
Sinking fund is a part of bond and preferred stock that issued as a regular bond but keep a account aside for the purpose of redeeming the bonds or shares. In sinking fund account is formed so that sinking fund payment will go in that account at the time of redemption. Sinking fund payments are mostly fixed in amount.
3.
Present value of future cash flows tell us the present value of bond's maturity. If the present value of bond maturity isless than the the bond issued price then the bond investment is vain. If the present value of future bond price is more than the bond issued value then the investment is fruitfull. And investor should go for the bond investment.
4.
Callable bond s givethe right to the issuer to redeem the bond prior to the maturity date.
In callable bonds investors get difficulty to get back their called bonds from the issuers in case of falling interest rate in the market. This option gives the issuer the opportunity to pay the debts before the maturity date when interest rate is falling in the callable period.This risk protaction is not available in the regular bond.