Explain the components of a discount/interest rate?

Answer 1

Two ways to answer this question:
First, you can break down the variables in a bond to the base components:

1. Term. How long cash flows on the bond lasts and if cash payments are irregular/delayed.

2. Periods. How many compounding periods are in a year. This varies from continual (infinite) to non-compounding (1 = simple interest rates)

3. Coupon. Non-principle amounts paid in the interim term.

4. Principle. The face value of the bond.

5. Discount/premium. The extra amount paid or cut from the initial price to lower/raise the total yield on the bond. For example, a $1,000 10-year bond annual paying bond with a 10% coupon yielding 10% will be worth $1,000 initially. If the same bond is sold for $1,100, the extra 100 lowers the yield on the bond investment.

6. Embedded options. Bonds sometimes come with embedded options like calls and puts. These have to be stripped out, valued through option-pricing models like Black-Scholes, so you can get to the true interest rate without the option.

Secondly, you can answer this by using terms like a credit rating agency. Here are the components:

a. Risk free rate. The interest rate given no default risk (e.g. the US 10 year T-bill rate).

b. Sovereign risk. The premium given to a bond for the inherent risk of the underlying assets operating in a foreign country.

c. Agency risk. The risk attached to the agency/company underwriting the bond. Basically, it's the risk that the company will default and/or go bankrupt.

d. Currency risk. This is the risk associated with the bond being denominated in a foreign currency and/or being located in a different country. For example, Japanese yen bonds rates are extremely low, meaning that the currency risk premium is negative.