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# sm19 - CHAPTER 19 THE ANALYSIS AND VALUATION OF BONDS...

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CHAPTER 19 THE ANALYSIS AND VALUATION OF BONDS Answers to Questions 1. The present value equation is more useful for the bond investor largely because the bond investor has fewer uncertainties regarding future cash flows than does the common stock investor. By investing in bonds with relatively no default risk (i.e., government securities) the investor can value a bond based primarily on expected cash flows (coupon rate and par value), required return (market yield), and the number of periods in the investment horizon (maturity date). Each of these factors can be incorporated into the present value equation. By contrast, common stocks have no stated maturity date and the valuation process is predominantly an estimate of future earnings. Although the present value method can be used for common stock analysis by estimating dividend payments and change in price over a given time frame, the uncertainties involved are much greater. 2. The most crucial assumption the investor makes is that cash flows will be received in full and reinvested at the promised yield. This assumption is crucial because it is implicit in the mathematical equation that solves for promised yield. If the assumption is not valid, an alternative method must be used, or the calculations will yield invalid solutions. 3(a). RFR is the riskless rate of interest, I is the factor for expected inflation, and RP is the risk premium for the individual firm. 3(b). The model considers the firm’s business conditions. The risk of not breaking even would be reflected in the model through changes in the variable RP. This uncertainty would change the nature of the frequency distribution for earnings. 4 . The expectations hypothesis imagines a yield curve that reflects what bond investors expect to earn on successive investments in short-term bonds during the term to maturity of the long-term bond. The liquidity preference hypothesis envisions an upward-sloping yield curve owing to the fact that investors prefer the liquidity of short-term loans but will lend long if the yields are higher. The segmented market hypothesis contends that the yield curve mirrors the investment policies of institutional investors who have different maturity preferences. 5. CFA Examination I (June 1982) 5(a). The term structure of interest rates refers to the relationship between yields and maturities for fixed income securities of the same or similar issuer. Expectations regarding future interest rate levels give rise to differing supply and demand pressures in the various maturity sectors of the bond market. These pressures are reflected in differences in the yield movements of bonds of different maturity. 19 - 1

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The “term structure of interest rates,” or “yield curve,” will normally be upward sloping in a period of relatively stable expectations. The theoretical basis for the upward sloping curve is the fact that investors generally demand a premium, the longer the maturity of the issue, to cover the risk through time, and also to compensate for the greater price volatility of longer maturity bonds.
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