Reference no: EM132227368

Bond:

Almost every individual, corporation, and government entity has participated in the bond market in one form or another. Some call bonds "boring" because of their characteristics and return-generating potential, but that description is simply not the case. Bonds come in a vast array of different instruments. Additionally, transactions in the bond markets are made in substantial absolute amounts. Bottom line, bond-like instruments are fundamental to financial markets. Hence, it is important to know the various characteristics associated with bonds, as well as how one values these fundamental financial market securities.

I would like you to remember a couple of things when you are reading this material. First, bond instruments usually list what they plan to repay investors, and when they plan to repay them. So, when conducting valuation exercises, bond instruments are straightforward applications of time value of money principles. Secondly, although bonds come in a wide variety of characteristics, they are valued using tried and true time value of money techniques. Financial decisions have a lot to do with evaluating a numerator and denominator, so do not forget about the basic time value of money principles. They will serve you well throughout this course, and for a long time after you complete this material.

Basic Bond Characteristics

Although bonds come in many shapes and sizes, they share many of the following characteristics.

Time to Maturity

One of the characteristics of bonds is that they have a finite life. (Granted, there are some bonds that exist in perpetuity, console bonds, but forget about those types of securities for the moment.) A finite lived security is simply a security that ceases to exist after a certain period of time. So, with respect to bond securities, time to maturity indicates how much "life" a bond has left, e.g. 2 years, 3 years, 17 years, 29 years, etc.

Maturity Date

The maturity date of a bond is the date that a bond ceases to exist. It is the date on which the bond makes its final payment to investors. The maturity date is a specific date listed on the calendar: June 17, 2025, or October 8, 2018 for example.

Principal Value

The principal value of the bond is also known as the face or par value of the bond. The principal is the amount that gets repaid at the maturity of the bond. In this class, assume principal value is $1,000 per bond, unless otherwise indicated.

Coupon

In addition to principal, a bond may also pay a coupon, which is a periodic payment based on a proportion of the face value of the security. The coupon amount is quoted as a coupon rate, which is stated in percentage of principal to be paid annually. Most bonds, however, pay their coupons semi-annually, which is the convention you should assume in this class, unless otherwise indicated. The amount paid semi-annually is nothing other than half the annual amount. As an example, suppose a bond pays a 5% coupon semi-annually. What that statement means is that 5% of the principal value will be paid on an annual basis. In the case of a $1,000 face value bond, a 5% coupon rate translates into $50 annual payment (0.05 x $1,000), or $25 every six months.

Caveat: Bonds that do not pay periodic coupons have a special name—zero-coupon bonds. Zero-coupon bonds are nothing other than securities promising to pay a single payment, e.g. principal, at maturity.

Yield To Maturity

Yield to maturity measures the return bond investors receive if they hold the bond to maturity.

Stocks

When firms wish to raise capital, they do so either by issuing bonds, or they can issue equity. Just in case you need to be excited about the topic, this section is all about STOCKS!! WOOHOO!!! Haven't you always wanted to make a killing in the stock market? IF all you had to do was wish it... Bottom line take away you should think about while reading this material is "What are some of the ways I can formulate a reasonable value for stocks?" The answer to that question does not specifically indicate you "know" the correct value, it simply provides somewhat of a sanity check on how valuation levels are determined.

The terms equity, shares, stock, common, will be used interchangeably when included in this material. No matter what you call it, you should think equity represents at minimum two items:

1. ownership in a firm

2. an opportunity to take part in the good fortune of a firm

In the event of full default, shareholders can suffer the same fate as bond-holders, e.g. they can lose everything invested. In the event of spectacular firm performance, however, shareholders have access to SUBSTANTIAL gains not attainable by those owning bonds. Hence, the attraction to learning about stocks.

There is one caveat in this section regarding preferred stock. Preferred shares are financial instruments that in some senses act like bonds, and in other senses, act like stocks. For instance, a preferred share pays a level dividend to its owner. The "fixed" payment structure resembles that of bonds. Preferred shareholders, however, are not paid until after bond holders. So in that sense, preferred stock has an intermediate residual claim on a firm's assets which resembles that of common shares. Preferred shareholders are paid prior to common shareholders, but after bond holders; hence, the intermediate residual claim characteristic.

Required:

1. Why do you think investors want to own stocks instead of bonds, besides the opportunities to earn superior returns? Write 100 wrods.

2. What preference do you have regarding owning stocks vs. bonds? Why do you have that preference? Write 100 wrods.

3. How many different stocks and or bonds do you own? Do you have a diversified portfolio? Write 50 wrods.

Please write in your own words.