Lesson

Fixed-income securities can be classified as trading at par, premium, or discount.

Practice Question #1

Which of the following factors can cause a bond to trade at a premium?

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Terms

Pricing:
The process of determining the current market value of a fixed-income security.
Par:
The face value of a bond is the amount the issuer agrees to pay the bondholder at maturity.
Premium:
When a bond is trading above its par value, it is said to be trading at a premium.
Discount:
When a bond is trading below its par value, it is said to be trading at a discount.

Practice Question #2

What is the primary difference between the yield to maturity (YTM) and the current yield of a bond?

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Historical Example

In the early 1980s, interest rates were historically high, with the Federal Reserve raising rates to combat inflation. As a result, many existing bonds were trading at significant discounts to their par value as investors demanded higher yields to compensate for the increased interest rate risk.

Practice Question #3

Which of the following risks is unique to fixed income securities, as opposed to equity securities?

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Real-World Example

Suppose an investor purchases a 10-year bond with a par value of $1,000 and a coupon rate of 5%. If interest rates rise and new bonds are issued with a 6% coupon rate, the investor's bond will likely trade at a discount to its par value, as investors will be more attracted to the higher-yielding bonds.

Practice Question #4

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Rhyme

When rates are high, bonds may sigh, trading at a discount, no lie. But when rates fall, bonds stand tall, premiums paid by one and all.

Practice Question #5

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More Detail

- Par bond relationship to changes in interest rates: A par bond is a bond trading at its face value. When interest rates change, the price of a par bond will move in the opposite direction of the change in interest rates. - Premium bond relationship to changes in interest rates: A premium bond is a bond trading above its face value. When interest rates change, the price of a premium bond will also move in the opposite direction of the change in interest rates, but the price change will be less dramatic than that of a par bond. - Discount bond relationship to changes in interest rates: A discount bond is a bond trading below its face value. When interest rates change, the price of a discount bond will move in the opposite direction of the change in interest rates, but the price change will be more dramatic than that of a par bond.

Practice Question #6

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More Detail Examples

- Par bond example: A bond with a face value of $1,000 is currently trading at $1,000. If interest rates increase, the price of this bond will decrease. - Premium bond example: A bond with a face value of $1,000 is currently trading at $1,100. If interest rates decrease, the price of this bond will increase, but not as much as a par bond. - Discount bond example: A bond with a face value of $1,000 is currently trading at $900. If interest rates decrease, the price of this bond will increase more than a par bond.

Practice Question #7

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Pitfalls to Remember

- Par bond pitfall:
Investors should be aware that even though par bonds are less sensitive to interest rate changes than discount bonds, they are still subject to interest rate risk.
- Premium bond pitfall:
Premium bonds have a higher risk of capital loss if interest rates rise, as their prices will decrease more than par bonds.
- Discount bond pitfall:
Discount bonds are more sensitive to interest rate changes, which can lead to higher price volatility and increased interest rate risk.

Practice Question #8

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Practice Question #9

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