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Example of Zero Coupon Bond Formula

In the event of a default, the buyer receives the face value of the bond or loan from the protection seller. In this, A is the protection buyer and B is the protection seller.

Coupon Rate

If the reference entity does not default, the protection buyer keeps on paying bps of Rs 50 crore, which is Rs 50 lakh, to the protection seller every year. On the contrary, if a credit event occurs, the protection buyer will be compensated fully by the protection seller.

The settlement of the CDS takes place either through cash settlement or physical settlement. For cash settlement, the price is set by polling the dealers and a mid-market value of the reference obligation is used for settlement. There are different types of credit events such as bankruptcy, failure to pay, and restructuring.

Bankruptcy refers to the insolvency of the reference entity. Failure to pay refers to the inability of the borrower to make payment of the principal and interest after the completion of the grace period. Restructuring refers to the change in the terms of the debt contract, which is detrimental to the creditors.

What does Coupon Rate mean?

If the credit event does not occur before the maturity of the loan, the protection seller does not make any payment to the buyer. CDS can be structured either for the event of shortfall in principal or shortfall in interest. There are three options for calculating the size of payment by the seller to the buyer. Fixed cap: The maximum amount paid by the protection seller is the fixed rate. Variable cap: The protection seller compensates the buyer for any interest shortfall and the limit set is Libor plus fixed pay.

No cap: In this case, the protection seller has to compensate for shortfall in interest without any limit. The modelling of the CDS price is based on modelling the probability of default and recovery rate in the event of a credit event. Although used for hedging credit risks, credit default swap CDS has been held culpable for vitiating financial stability of an economy.

This is particularly attributable to the capital inadequacy of the protection sellers. Counter-party concentration risk and hedging risk are the major risks in the CDS market. It is the periodic rate of interest paid by bond issuers to its purchasers. For example, if you have a year- Rs 2, bond with a coupon rate of 10 per cent, you will get Rs every year for 10 years, no matter what happens to the bond price in the market.

Description: The government and companies issue bonds to raise money to finance their operations. When you buy a bond, the bond issuer promises periodic annually or semi-annually interest payments on the money invested at the coupon rate stated in the bond certificate.

What’s the Difference Between Premium Bonds and Discount Bonds?

The bond issuer pays the interest annually until maturity, and after that returns the principal amount or face value also. Coupon rate is not the same as the rate of interest. An example can best illustrate the difference. Suppose you bought a bond of face value Rs 1, and the coupon rate is 10 per cent. Every year, you'll get Rs 10 per cent of Rs 1, , which boils down to an effective rate of interest of 10 per cent. However, if you bought the bond above its face value, say at Rs 2,, you will still get a coupon of 10 per cent on the face value of Rs 1, It means you'll still get Rs But, since you bought the bond at Rs 2,, the rate of interest this time would only be 5 per cent Rs of Rs 2, Likewise, if you bought the bond below its face value, say at Rs , you'll still receive Rs every year, but this time the interest rate would be 20 per cent Rs of Rs Consequently, bonds are sometimes referred to as debt securities.

Since bond issuers know you aren't going to lend your hard-earned money without compensation, the issuer of the bond the borrower enters into a legal agreement to pay you the bondholder interest.

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The bond issuer also agrees to repay you the original sum loaned at the bond's maturity date, though certain conditions, such as a bond being called, may cause repayment to be made earlier. The vast majority of bonds have a set maturity date—a specific date when the bond must be paid back at its face value, called par value. Bonds are called fixed-income securities because many pay you interest based on a regular, predetermined interest rate—also called a coupon rate—that is set when the bond is issued.

A bond's term , or years to maturity, is usually set when it is issued.

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Bond maturities can range from one day to years, but the majority of bond maturities range from one to 30 years. Bonds are often referred to as being short-, medium- or long-term. Generally, a bond that matures in one to three years is referred to as a short-term bond. Medium- or intermediate-term bonds are generally those that mature in four to 10 years, and long-term bonds are those with maturities greater than 10 years.

The borrower fulfills its debt obligation typically when the bond reaches its maturity date, and the final interest payment and the original sum you loaned the principal are paid to you. Not all bonds reach maturity, even if you want them to. Callable bonds are common. They allow the issuer to retire a bond before it matures. Call provisions are outlined in the bond's prospectus or offering statement or circular and the indenture—both are documents that explain a bond's terms and conditions.

While firms are not formally required to document all call provision terms on the customer's confirmation statement, many do so.

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When you buy municipal securities , firms are required to provide more call information on the customer confirmation than you will see for other types of debt securities. You usually receive some call protection for a period of the bond's life for example, the first three years after the bond is issued. This means that the bond cannot be called before a specified date.

After that, the bond's issuer can redeem that bond on the predetermined call date, or a bond may be continuously callable, meaning the issuer may redeem the bond at the specified price at any time during the call period.

Before you buy a bond, always check to see if the bond has a call provision, and consider how that might impact your investment strategy. A bond's coupon is the annual interest rate paid on the issuer's borrowed money, generally paid out semiannually. The coupon is always tied to a bond's face or par value, and is quoted as a percentage of par. Many bond investors rely on a bond's coupon as a source of income, spending the simple interest they receive.

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You can also reinvest the interest, letting your interest gain interest. If the interest rate at which you reinvest your coupons is higher or lower, your total return will be more or less.

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