After reading Chapter 7, in 500 words or more, explain the following two concepts: -The coupon...

After reading Chapter 7, in 500 words or more, explain the following two concepts:

-The coupon rate depends on the risk characteristics of the bond when issued.

-The impact of inflation rate on interest rates.

Expert Solution

a)

Bonds are the financial instruments for investment by investors of different categories such as retail investors, FIIs, Institutional investors and others. Corporates issue bond when they require cash to finance the upcoming projects and differencet cash requirements. The issuers to the bond receive the income known as coupon income determined as certain percentage of the face value of the bond.

The coupon rate for bonds is decided after considering the various factors prevailing in the market such as current interest rate in the market, credit worthiness of company itself, other bonds in the market, liquidity and many other features. In most of the cases, wherever the company is rated below a certain benchmark as per the credit rating agencies then the company needs to issue the bond with high coupon rate so that it can lure the investors to invest in it. Generally high rated companies issue bond with low coupon rate irrespective of the interest in the market because they have high credit worthiness comparable to the other companies.

Thus it can be concluded from above that coupon rate depends on the risk factor of the company and such risk factors play very crucial role in deciding the quantum of coupon rate of the bond.

b)

Every investor wants their return to outbeat the market returns i.e. returns beating the inflation prevailing in the market. However a risk averse investor could rarely achieve such objective as he is always willing to take lesser risk than other and ending up with lesser return. In case of fixed interest instruments, returns from such instruments can rarely outbeat the inflation rates. In other words, inflation rates always eat up the fixed interest rate instrument's income. As the fixed interest will remain the same over the tenure whereas inflation always remain unexpected and will generally end up with more difference.

Hence there is considerable quantum of impact over the interest rates in case of fixed interest rate instruments.

jeff jeffy answered 1 year ago

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