Question-31: For MBS and ABS why it is difficult to determine the future cashflow?

Answer: In case of MBS and ABS there are possibilities of pre-payment and that can be any random date. Hence, their cashflow is not in advanced.

Question-32: What do you mean by required yield?

Answer: Any investor who is looking for a yield by investing in a particular bond is known as required yield. And to determine the required yield an investor use the comparable bond in the market. Which is of the same feature and credit quality and maturity.

Question-33: Why it is considered that effective annual interest rate is higher than annual interest rate in case of interest is paid semi-annually?

Answer: Because usually, whatever interest rates are expected those are specified in the annual interest rate. But the actual cashflows are semi-annual and which results in the effective annual interest rate is high. You can assume cashflow received at six months would be re-invested and which can fetch additional return.

Question-34: What is the formula to calculate the present value of semi-annual coupon on fixed rate bond?

Answer: Below is the complicated formula

C*[(1-{1/(1+i)^n})/i] + M/(1+i)^n

C= Semi-annual coupon payment in currency

n= number of cycles (number of years *2)

i=Fixed Interest rates (Annually interest rate/2)

M=Maturity Value

Example: 8% interest rate, 10 years to maturity and $1000 par value and required yield is 10%

So

C=$40 ($80/2)= Semi-annual coupon payment

n=20 (10*2) periods

i=required interest/2=5%=0.05

M=$1000

Which results in, if every value is put in the formula = $875.38

Hence, you can say that present value or price of the bond should be $875.38 for considering all the future cashflows. If you are expecting 10% yield on the bond. If you pay more than this your yield would reduce and if you get at lesser price, it means you would realize more yield if held till maturity.

Now, let say you change your required yield to 7% then what is the present value of the bond. Only “i” would change to 0.035

Then bond price comes to = 1,071.06

It means it is fine even you pay more than $1000 for this bond to buy, because it can still give 7% yield or more of you buy at $1071 or less and keep till maturity.

Note: This calculation is for the option free bond and various other factors are not considered.

Question-35: What is the relationship between yield and bond price?

Answer: As you have seen bond price would move in opposite direction of the required yield. If you need more yield then bond price should reduce and similarly if you reduce your required yield then bond price would increase. The only variable you can change is the bond price or required yield. Because Bond coupon and maturity remain fixed. Hence, f you create a graph between price and required yield it would create a convex shape.