HW_1___NewKey_Solutions - AEM 426 Fixed Income Securities...

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1 ANSWERS TO HOMEWORK QUESTIONS - HW #1 Answers for Chapter 1: Questions 4, 13, & 19 4. What is the cash flow of a l0-year bond that pays coupon interest semiannually, has a coupon rate of 7%, and has a par value of $l00,000? The principal or par value of a bond is the amount that the issuer agrees to repay the bondholder at the maturity date. The coupon rate multiplied by the principal of the bond provides the dollar amount of the coupon (or annual amount of the interest payment). A 100year bond with a 7% annual coupon rate and a principal of $100,000 will pay semiannual interest of (0.07/2)*($100,000) = $3,500 for 10*(2) = 20 periods and at the end of the last period will pay back the principal of $100,000. 13. What is a bond with an embedded option? A bond with an embedded option is a bond that contains a provision in the indenture that gives either the bondholder and/or the issuer an option to take some action against the other party. For example, the borrower may be given the right to alter the amortization schedule for amortizing securities. An issue may also include a provision that allows the bondholder to change the maturity of a bond. An issue with a put provision included in the indenture grants the bondholder the right to sell the issue back to the issuer at par value on designated dates. 19. Comment on the following statement: Credit risk is more than the risk that an issuer will default. There are risks other than default that are associated with investment bonds that are also components of credit risk. Even in the absence of default, an investor is concerned that the market value of a bond issue will decline in value and/or the relative price performance of a bond issue will be worse than that of other bond issues. The yield on a bond issue is made up of two components: (1) the yield on a similar maturity Treasury issue and (2) a premium to compensate for the risks associated with the bond issue that does not exist in a Treasury issue-referred to as a spread. The part of the risk premium or spread attributable to default risk is called the credit spread. The price performance of a non-Treasury debt obligation and its return over some investment horizon will depend on how the credit spread of a bond issue changes. If the credit spread increases-investors say that the spread has "widened"-the market price of the bond issue will decline. The risk that a bond issue will decline due to an increase in the credit spread is called credit spread risk. This risk exists for an individual bond issue, bond issues in a particular industry or economic sector, and for all bond issues in the economy not issued by the U.S. Treasury. AEM 426: Fixed Income Securities HW #1 - Answers
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