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1

Finance

1.Discuss functions, segments & structure of financial markets   & how regulations of financial market work?

2

A $1,000 par value bond has 8 years to mature. The annual rate of coupon is at 6%, and the current annual YTM is at 10%.

a. If bond's interest is paid semiannually, how much today would you pay for the bond?

b. After purchasing the bond, Standard & Poor changes the rating on the bond from AA to BBB. What would happen to the price of the bond and why with 2 reasons?

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1ans.

The primary function of market is to act as a platform where the investor and the one who needs funds to invest can interact with each other while minimizing the intermediary cost in between. Besides acting as a platform of interaction market does provide other services like liquidity, priding of product and services and access to information to all the participants in the market. If we classify the market then we can look at it from two perspective, primary market and secondary market. Primary market is the market where the securities are sold for the first time and interaction happens between companies and the investors, secondary market is the market where the once the securities which have been issued are bought and sold the investor. The secondary market does perform one of the most important function of providing liquidity to the market. Another way to classify the market would be to classify on the basis of long-term instruments and short-term instruments. The long-term instruments are usually of longer-term duration, 5 to 10 years, they are also called capital market instruments. The short-term instruments which are of duration less than a year, also called money market instruments. The regulation in the market is very important. In every market there is a regulator, in US there is SEC which makes sure some participants are not manipulating the market and taking undue advantage at the expense of the other participant. The regulation also makes sure that participants in the market do have equal opportunity to access to information and benefit from it.

2ans.

A) Bond Price = C *[( 1 - (1+r)^-n]r + FV/(1+r)^n

Where, C = Coupon Payments

r = Yield per period

n = Number of periods

FV = Face value

Compounding = 2 [Semi-Annually]

So, Coupon Payments = Face value * COupon rate * (1/Number of Compounding)

= 1000 * 6% * (1/2)

= $30

Number of Periods = Years * Number of compounding

= 8*2

= 16

Yield per period = 10%/2

= 5%

Bond price = 30*[( 1 - (1+5%)^-16]/5% + 1000/(1+5%)^16

= 30 * [( 1 - 1.05^-16]/0.05 + 1000/(1.05)^16

= 30 * (0.541888478/0.05) + 1000/2.18287458838

= 325.1330868 + 458.111521992

= 783.244608792

Bond Price = 783.244608792

B) The Bond price is affected by the ratings of the company as it is backed by them, So, if the credit rating agency degrades the bond then,

1. Required rate of Return Increase: When the bond is degraded then it means that there is greater chance of bond to be default, so in order to compensate, the investor increase the rate of return on the bonds.

2. Price of Bond : The Price of the bond is the present value of all the cash flows and the discount rate used is the yield to maturity, so when the yield or required rate of return increases then it leads to greater discounting of cash flows leading to bond trading at lower than face value (discount).