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Zorluk: ZorDebt Securities and Bond Structure

An investor buys a 15-year corporate bond trading in the secondary market at a premium price of 108. The bond pays a 6% annual coupon and is callable in 4 years at par ($1,000). If prevailing market interest rates decline significantly, which of the following choices correctly identifies the primary risk faced by the bondholder and the accurate sequence of the bond's yields ranked from lowest to highest?

  1. The primary risk is call risk; the yields ranked from lowest to highest are Yield to Call (YTC), Yield to Maturity (YTM), Current Yield (CY), and Nominal Yield (NY).Cevap
  2. B
    The primary risk is interest rate risk; the yields ranked from lowest to highest are Nominal Yield (NY), Current Yield (CY), Yield to Maturity (YTM), and Yield to Call (YTC).
  3. C
    The primary risk is call risk; the yields ranked from lowest to highest are Nominal Yield (NY), Current Yield (CY), Yield to Maturity (YTM), and Yield to Call (YTC).
  4. D
    The primary risk is credit risk; the yields ranked from lowest to highest are Yield to Maturity (YTM), Yield to Call (YTC), Current Yield (CY), and Nominal Yield (NY).

Cevap

The primary risk faced by the investor when interest rates fall is call risk, and the yield hierarchy from lowest to highest is Yield to Call (YTC), Yield to Maturity (YTM), Current Yield (CY), and Nominal Yield (NY).
When market interest rates drop, issuers are likely to call existing bonds with higher coupon rates to lower their borrowing costs, exposing the investor to call risk. Furthermore, when a bond is trading at a premium (108), the investor pays more than par value. If called early at par in 4 years, the annual loss of premium is recognized over a shorter timeframe than if held to maturity (15 years). Consequently, for a premium bond, Yield to Call (YTC) is the lowest yield, followed by Yield to Maturity (YTM), Current Yield (CY), and Nominal Yield (NY).

Adım Adım Çözüm

1
Identify the primary risk in a declining interest rate environment for a callable bond.
When market interest rates drop, bond prices rise, and issuers frequently exercise call options to redeem existing high-coupon debt and re-issue debt at lower interest rates. Thus, the bondholder faces call risk.
Issuers call bonds when refinancing becomes financially advantageous due to falling interest rates.
2
Analyze the relationship between purchase price and par value.
The bond is purchased at a market price of 108 (1,080),whichisabovepar(1,080), which is above par ( 1,000), meaning it is trading at a premium.
Premium bond pricing occurs when the stated coupon rate exceeds current prevailing market yields.
3
Determine the yield relationship (hierarchy) for a premium bond.
For a premium bond, the premium paid amortizes over time, reducing overall yield. Yield to Call (YTC) accelerates this loss over a shorter time horizon (4 years vs 15 years), making YTC the lowest yield. Therefore, YTC < YTM < CY < NY.
Accelerated premium write-off upon an early call results in the lowest return performance (YTC) for premium bonds.

Anahtar Kavram

Callable Premium Bond Dynamics and Yield Hierarchy
Tahmini Süre:2m 0s
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Konular

Debt Securities and Bond Structure

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