Bond Markets Analysis and Strategies 8th Edition by Frank J. Fabozzi Solution manual

 
4. Explain whether or not an investor can determine today what the cash flow of a floating-rate bond will be.
 
Floating-rate bonds are issues where the coupon rate resets periodically based on a general formula equal to the reference rate plus the quoted margin. The reference rate is some index subject to change. The exact change is unknown and uncertain. Thus, an investor cannot determine today what the cash flow of a floating-rate bond will be in the future.
 
5. Suppose that coupon reset formula for a floating-rate bond is: 1-month LIBOR + 130 basis points.
 
(a) What is the reference rate?
                                                       
The reference rate is the 1-month LIBOR.
 
(b) What is the quoted margin?
 
The quoted margin is the 130 basis points (or 1.30%).
 
(c) Suppose that on coupon reset date that 1-month LIBOR is 2.4%. What will the coupon rate be for the period?
 
The coupon reset formula is: 1-month LIBOR + 130 basis points. So, if 1-month LIBOR on the coupon reset date is 2.4%, the coupon rate is reset for that period at 2.40% + 1.30% = 3.70%..
 
6. What is a deferred coupon bond?
 
Deferred-coupon bonds are coupon bonds that let the issuer avoid using cash to make interest payments for a specified number of years. There are three types of deferred-coupon structures: (1) deferred-interest bonds, (2) step-up bonds, and (3) payment-in-kind bonds.
 
7. What is meant by a linker?
 
A linker is a bond whose interest rate is tied to the rate of inflation. The U.S. Treasury issues linkers, and they are referred to as Treasury Inflation Protection Securities (TIPS).
 
8. Answer the below questions.
 
(a) What is meant by an amortizing security?
 
The principal repayment of a bond issue can be for either the total principal to be repaid at maturity or for the principal to be repaid over the life of the bond. In the latter case, there is a schedule of principal repayments. This schedule is called an amortization schedule. Loans that have this amortizing feature are automobile loans and home mortgage loans. There are securities that are created from loans that have an amortization schedule. These securities will then have a schedule of periodic principal repayments. Such securities are referred to as amortizing securities.
 
(b) Why is the maturity of an amortizing security not a useful measure?
 
For amortizing securities, investors do not talk in terms of a bond’s maturity. This is because the stated maturity of such bonds or securities only identifies when the final principal payment will be made. For an amortized security, the repayment of the principal is made through multiple payments over its maturity and not just at the end of its term to maturity. Thus, the maturity is not a useful measure in terms of identifying when the principal is repaid.
 
9. 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.
 
10. What does the call provision for a bond entitle the issuer to do?
 
A call provision grants the issuer the right to retire the debt, fully or partially, before the scheduled maturity date.
 
11. Answer the below questions.
 
(a) What is the advantage of a call feature for an issuer?
 
Inclusion of a call feature benefits bond issuers by allowing them to replace an old bond issue with a lower-interest cost issue if interest rates in the market decline. A call provision effectively allows the issuer to alter the maturity of a bond. The right to call an obligation is included in most loans and therefore in all securities created from such loans. This is because the borrower typically has the right to pay off a loan at any time, in whole or in part, prior to the stated maturity date of the loan.
 
(b) What are the disadvantages of a call feature for the bondholder?
 
From the bondholder’s perspective, there are three disadvantages to call provisions. First, the cash flow pattern of a callable bond is not known with certainty. Second, because the issuer will call the bonds when interest rates have dropped, the investor is exposed to reinvestment risk (i.e., the investor will have to reinvest the proceeds when the bond is called at relatively lower interest rates). Finally, the capital appreciation potential of a bond will be reduced, because the price of a callable bond may not increase much above the price at which the issuer will call the bond.