What interest rates, which may be fixed

What are bonds? What
are their features and how are they traded?

Siegel and Yacht (2009) state that “bonds are debt. The bond
issuer borrows by selling a bond, promising the buyer regular interest payments
and then repayment of the principal at maturity” (p. 286). Basically, to borrow
money an issuer sells a promise to repay borrowed money later on, and that they
will pay regular interest payments.

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!


order now

Bonds will always have a return because “a bond is a formal
contract to repay borrowed money with interest at fixed intervals” (Siegel
& Yacht, 2009, p. 286). Bonds can have a negative return, but for the vast
majority of bonds there is a positive return. The return is based on the bonds’
interest rates, which may be fixed at the time of purchase (a fixed interest
rate) or pegged to “rates on debt of comparable companies” (Siegel & Yacht,
2009, p. 286), which would be a floating interest rate. Other notable features
of a bond are covenants (“conditions that the borrower must meet to protect
bondholders”), the issue price (“the price you pay to buy the bond when it is
first issued”) and the maturity date (“when the issuer of the bond has to repay
you”) Siegel and Yacht, 2009, p. 286-287. 

Bonds are traded on bond markets, and can be obtained through
a broker, from large institutional investors, from a bank, or in the case of
the United States, directly from the Treasury Department.

What are stocks? What
are their features and how are they traded?

“Stocks or equity securities are shares of ownership. When
you buy a share of stock, you buy a share of the corporation”, state Siegel and
Yacht (2009, p. 287). By owning shares of stock, you are “buying a share of
a company’s future profits” (Siegel & Yacht, 2009, p. 287). Essentially,
people pay money to purchase small amounts of a company. If someone owns the
majority of shares, then they have the right to control how business operations
take place.

Shares may or may not generate returns. If a company profits,
the share price may go up so that the owner may sell it for a higher price, and/or
it may pay out dividends, which are amounts of cash or shares of stock that the
company gives the stockholder because they own stock in the company. A company
might not profit, however, and the share price would go down (and no dividends
would be paid out). “To raise capital”, state Siegel and Yacht (2009),
“corporations issue shares” (p. 287).

Stocks are traded in a public market: the stock exchange.
There are many stock exchanges around the world where stocks are traded.

How do you calculate
an annual rate of return?

To calculate an annual rate of return, you use the equation
“Income + (Ending value – Original value) ÷ Original value = percentage rate
of return” (Siegel & Yacht, 2009, p. 300), where the purchase price is the
original value, the price a year after the purchase date is the ending value
(because we are looking for annual
rate of return), and income is any dividends earned on the investment. 

You buy a share of
stock for $100 and it pays no dividend. A year later the market price is $105.
What is the rate of return?

Following Siegel and Yacht’s formula of “Income + (Ending
value – Original value) ÷ Original value = percentage rate of return” (2009,
p. 300), we input the given information to get $0 + ($105 – $100) ÷ $100 to
get a 5% rate of return. 

You buy a share of
stock for $100 and a year later the market price is $105 and it pays a dividend
of $2. What is the return?

Following Siegel and Yacht’s formula of “Income + (Ending
value – Original value) ÷ Original value = percentage rate of return” (2009,
p. 300), we input the given information to get $2 + ($105 – $100) ÷ $100 to
get a 7% rate of return.  

 

Reference

Siegel, R. &
Yacht, C. (2009). Personal Finance.
Saylor Foundation. Licensed under Creative Commons CC BY-NC-SA 3.0.