Chapter 6.1, Problem 6.1ACQ

What are the cash flows associated with a bond?

Summary Introduction

To discuss: The cash flows from a bond.

Introduction:

Cash flow refers to the transfer of cash from one entity to another. The cash inflow refers to the receipt of cash, and the cash outflow refers to the payment of cash. For example, the investor will have a cash outflow when he or she purchases a bond. The investor will have a cash inflow when he or she receives interest payments annually and the principal amount after maturity.

A bond refers to the debt securities issued by the governments or corporations for raising capital.

Explanation of Solution

The investor receives two types of cash flows from a bond. They are as follows:

• Annuity component or the coupons:

  There is a coupon rate for each bond. The coupon refers to the interest payments on the bond’s face value. The investor receives the coupon every year until the date of maturity. Hence, interest receipts or coupon receipts are the cash flows from a bond.

• Lump sum amount or the face value of the bond:

  The borrower has to repay the face value of the bond received during the issue of the bond to the investor. The borrower does not return the face value until maturity. In the year of maturity, the borrower pays a lump sum amount to repay the face value of the bond. This cash flow occurs on the date of maturity.

Conclusion

A bond refers to the debt securities issued by the governments or corporations for raising capital. The coupon payments and the return of face value at maturity are the two cash flows from a bond.