Question

1. (a.) What is the underlying principle of valuation? (3)

(b). Why is it critical for us to learn the concept of (security) valuation? (3)

1. (a). What is a bond, who buys/sells them, and why? (2+2+2)

(b). What are the five characteristics of a typical bond? (5)

1. What cash flow(s) are expected by bondholders? Why is bond a “fixed income” security? (2+1)

Answer 1

(a) the underlying principle of valuation is that the value of an asset is the present value of the expected future cash flows. Valuation can be affected by corporate earnings of the organisation.

(b) It is critical to understand the security valuation because it is necessary to make a decision about the price of a security on the basis of scientific analysis.On the basis of securities valuation, the investors buy underpriced securities and sell overpriced securities.

(a) A bond is a debt or security, which is issued by the issuer to raise money. The issuer can be a government, municipality or a corporation. When we buy a bond, we lend money to the corporation and in return of which we get the principal at the end of maturity of the bond and interest which are fixed monthly payments.

(b) The 5 main characteristics of bonds are :

• par value : the principal amount of the bond that the investor will receive at the end of the maturity of the bond.
• maturity : the date when the bond matures.
• coupon payments: it is the interest that the issuer promises to pay the bondholder.
• issuers: The issuers can be government or corporations , the government bonds are high quality bonds.
• rating agencies:Rating agencies assign ratings to the bonds, from AAA to D and from Aaa to C.

It is called fixed income security because it promises fixed payments of cash flows at fixed dates.The cash flows are the coupon payments received every month, plus the principal and coupon at the end of the maturity date of the coupon.