Mini Case

a. Bonds are defined as debt instruments in which a borrower agrees to make payments of
principal and interest on specific dates to the holders of the bond. There are several key
features of a bond and they all play a role in determining the value of the bond and how it fits
in your portfolio. They are:
(1) Fixed maturity or Limited Life Maturity can be defined as the time which the bond
matures and the holder receives the final payment of principal and interest. There are the
basic class of maturity: Short Term Maturity, intermediate maturity and Long term
Maturity. Maturity is a very important concept and feature of a bond because it indicates
the length of time in which an investor will receive interest as well as when he/she will
receive principal payments. It also affects the yield on the bond; longer maturities tend to
yield higher rates. The price of volatility of a bond is a function of its maturity
(2) Par Value /face Value This is the dollar amount the holder will receive at the bond's
maturity. It can be any amount but is typically $1,000 per bond. Par value is also known
as principle, face, maturity or redemption value. Bond prices are quoted as a percentage
of par.
(3) Coupon Rate A coupon rate states the interest rate the bond will pay the holders each
year. To find the coupon's dollar value, simply multiply the coupon rate by the par value.
The rate is for one year and payments are usually made on a semi-annual basis. Some
asset-backed securities pay monthly, while many international securities pay only
annually. The coupon rate also affects a bond's price. Typically, the higher the rate, the
less price sensitivity for the bond price because of interest rate movements.
(4) Interest Payments bonds typically offer some form of interest payment; however, this
depends on their structure: "Fixed Rate Bonds" provide fixed interest payments on a
regular schedule for the life of the bond; "Floating Rate Bonds" have variable interest
rates that are periodically adjusted; and, "Zero Coupon Bonds" do not pay periodic
interest at all, but offer an advantage in that they are can be bought at a discounted price
of the face value and can be redeemed at the face value at maturity
(5) Issue date. This is the date the bonds were issued.

b. A call provision is a clause in a bond's indenture granting the issuer the right to call, or buy
back, all or part of an issue prior to the maturity date whilst a means of repaying funds that
were borrowed through a bond issue. Callable bonds normally pay a higher yield. A sinking
fund provision is where the issuer makes periodic payments to a trustee who retires part of
the issue by purchasing the bonds in the open market.
c. If the cash flows have widely varying risk, or if the yield curve is not horizontal, which
signifies that interest rates are expected to change over the life of the cash flows, it would be
logical for each period's cash flow to have a different discount rate. However, it is very
difficult to make such adjustments; hence it is common practice to use a single discount rate
for all cash flows. The discount rate is the opportunity cost of capital; that is, it is the rate of
return that could be obtained on alternative investments of similar risk.
d. A bond has a specific cash flow pattern consisting of a stream of constant interest payments
plus the return of par at maturity. The annual coupon payment is the cash flow: pmt =
(coupon rate) (par value) = 0.1($1,000) = $100.