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Unformatted text preview: CHAPTER 14: BOND PRICES AND YIELDS PROBLEM SETS 1. a) Catastrophe bond – A bond that allows the issuer to transfer “catastrophe risk” from the firm to the capital markets. Investors in these bonds receive a compensation for taking on the risk in the form of higher coupon rates. In the event of a catastrophe, the bondholders will give up all or part of their investments. “Disaster” can be defined by total insured losses or by criteria such as wind speed in a hurricane or Richter level in an earthquake. b) Eurobond – A bond that is denominated in one currency, usually that of the issuer, but sold in other national markets. c) Zero-coupon bond – A bond that makes no coupon payments. Investors receive par value at the maturity date but receive no interest payments until then. These bonds are issued at prices below par value, and the investor’s return comes from the difference between issue price and the payment of par value at maturity. d) Samurai bond – Yen-dominated bonds sold in Japan by non-Japanese issuers. e) Junk bond – A bond with a low credit rating due to its high default risk. They are also known as high-yield bonds. f) Convertible bond – A bond that gives the bondholders an option to exchange the bond for a specified number of shares of common stock of the firm. g) Serial bonds – Bonds issued with staggered maturity dates. As bonds mature sequentially, the principal repayment burden for the firm is spread over time. h) Equipment obligation bond – A collateralized bond in which the collateral is equipment owned by the firm. If the firm defaults on the bond, the bondholders would receive the equipment. i) Original issue discount bond – A bond issued at a discount to the face value. j) Indexed bond – A bond that makes payments that are tied to a general price index or the price of a particular commodity. k) Callable bond – A bond which allows the issuer to repurchase the bond at a specified call price before the maturity date. l) Puttable bond – A bond which allows the bondholder to sell back the bond at a specified put price before the maturity date. 14-1 2. The bond callable at 105 should sell at a lower price because the call provision is more valuable to the firm. Therefore, its yield to maturity should be higher. 3. Zero coupon bonds provide no coupons to be reinvested. Therefore, the investor's proceeds from the bond are independent of the rate at which coupons could be reinvested (if they were paid). There is no reinvestment rate uncertainty with zeros. 4. A bond’s coupon interest payments and principal repayment are not affected by changes in market rates. Consequently, if market rates increase, bond investors in the secondary markets are not willing to pay as much for a claim on a given bond’s fixed interest and principal payments as they would if market rates were lower. This relationship is apparent from the inverse relationship between interest rates and present value. An increase in the discount rate (i.e., the market rate) An increase in the discount rate (i....
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