5.Describe the type of returns one could one expect with a callable bond trading

Question

5.Describe the type of returns one could one expect with a callable bond trading at a premium price and provide your rationale. Explain the significance of the designation "premium price." Discuss why or why not a callable bond trading at a premium price would be an appropriate investment for the target audience’s organizations.

6.Select an example scenario appropriate to the seminar’s target audience Write a general expression for the yield on a probable debt security (rd) and define these terms in regards to that hypothetical security: real risk-free rate of interest (r*), inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP).

Explanation / Answer

5. There are basically two types of return one could expect with a callable bond. YTM, which is provided by every bond and YTC(Yield to call), which is only provided by a callable bond. it is the yield of a bond, which is applicable only if you were buy and hold the bond until its call date. This yield is only valid if the bond is called prior to the call date.

In this sceanrio, both types of return can be expected as the bond is selling at "premium", which means the current market price of the bond is higher than its par value. This situation only holds true, if the interest rate offered by the bond is higher than prevailing interest rates in the market.

A callable bond trading at a premium price would be an appropriate investment as it carries both returns as the issuer is most likely to call the bond back & will pay the call premium.

6. Real risk-free rate of interest: It is the risk free interest after adjusting the inflation rate. For example, let's assume the risk free rate of interest is 5% and inflation rate is 2%, so the real risk-free rate of interest will be 3% (5%-2%)

Inflation Premium: An inflation premium is the part of prevailing interest rates that results from lenders compensating for expected inflation by pushing nominal interest rates to higher levels.

Default risk premium: A default premium is the additional amount a borrower must pay to compensate the lender for assuming default risk. A default premium is generally paid by all companies or borrowers indirectly, through the rate at which they must repay their obligation.

Liquidity Premium: This is a premium which comes into the picture, when an asset is not easily convertable into cash. For such security, investors demand an additional premium to compansate the illiquidity of the asset.

Maturity Risk Premium: It is simply the extra yield that an investor will earn with a longer duration of maturity.

Related Questions

Navigate

• Browse (All)
• Browse 5
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.