Fin 407 Test 2

A plain vanilla bond has a maturity of 10 years, a par value of $100, and a coupon rate of 9%. Interest payments are made annually. The market interest rate is assumed to be constant at 9%. The bond is issued and redeemed at par. The principal repayment the first year is closest to: a. $0 b. $6.58 c. $10

$0

Interest Rate Risk

-chance that investments in bonds will suffer as the result of unexpected interest rate changes Effect of changes in the prevailing market rate of interest on bond values

True statements regarding fixed income include

-liquidity issues make it difficult for investors to easily replicate fixed income indices

4 Sources of return for bonds

1) receipts of the promised coupon and principal payments on the scheduled dates, 2) reinvestment of coupon payments, 3) potential capital gains or losses on the sale of the bond prior to maturity. 4) when a bond is purchased at a premium or a discount, it adds another aspect to the rate of return. Through amortization, the bond's carrying value reaches par value at maturity.

Consider a $1 million semiannual pay, floating rate issue where the rate is reset on January 1st and July 1st each year. The reference rate is 6-month LIBOR, and the stated margin is +1.25%. If 6-month LIBOR is 6.5% on July 1st, what will the next semiannual coupon be in this issue?

6.5% + 1.25% = 7.75% (1,000,000*.0775)/2 = 38,750

Which of the following is least likely to fall under the heading of event risk with respect to fixed-income securities? a. A change in regulation b. One firm's acquisition by another c. A Federal Reserve decrease in money supply

A Federal Reserve decrease in money supply

Which of the following statements about the risks of bond investing is most accurate? a. A bond rated AAA has no credit risk. b. A bond with call protection has volatility risk. c. A U.S. Treasury bond has no reinvestment risk

A bond with call protection has volatility risk.

If interest rate volatility increases, which of the following bonds will experience a price decrease? a. A callable bond b. A putable bond c. A zero-coupon, option-free bond.

A callable bond

Which of the following 5-year bonds has the highest interest rate risk? a. A floating-rate bond b. A zero-coupon bond c. A 5% fixed-coupon bond

A zero-coupon bond

Change in value of a bond given a change in its discount rate

Bond values and bond yields are inversely related

Which of the following best describes the majority of the evidence regarding anomalies in stock returns? A. Weak-form market efficiency hold but semi-strong form efficiency does not B. Neither weak-form no semi-strong form market efficiency holds C. Reported anomalies are not violations of market efficiency but are the result if research methodologies

C. Reported anomalies are not violations of market efficiency but are the result if research methodologies The majority of evidence is that anomalies are not violations of market efficiency but are due to the research methodologies used. Portfolio management based on anomalies will likely be unprofitable after transactions costs are considered.

The type of bonds with an embedded option that would most likely sell at a lower price than an otherwise similar bond without the embedded option is a: a. putable bond b. callable bond c. convertible bond

Callable bond

Credit-linked coupon bonds

Coupon changes when the bond's credit rating changes -If companies credit ratings go up, coupon rate goes down

Step-up coupon bond

Coupon increases by specified margin at specified dates

Index-linked bonds

Coupon payments and/or principal repayment linked to a specified index

Sovereign Risk

Credit risk of a sovereign bond issued by a country other than the investor's home country

floor and caps

Floor- interest rates cannot go below the level Caps- interest rates cannot go above the level

Sinking fund arrangements

Formal plan for retiring the debt with potential disadvantages for the investors -means of repaying funds borrowed through a bond issue through periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market

Yield curve

Graphical representation of the term structure -Normal = upward-sloping L/T > S/T -Inverted = downward-sloping L/T < S/T

Market Segmentation Theory:

Investors have specific needs in terms of maturity -Yield curve reflects intersection of demand and supply of individual maturities

Payment-in-kind coupon bonds

Issuer pays interest in the form of additional amounts of the bond issue rather than cash

With a par value of $1,000, what a quote of 95 means?

It is a discount

Cash flow yield (CFY)

It is a monthly internal rate of return based on the market price of the security

The coupon rate of a floating rate note that makes payments in June and December is expressed as six-month LIBOR + 25 bps. Assuming that the six-month LIBOR is 3% at the end of June 20XX and 3.50% at the end of December 20XX, what is the interest rate that applies to the payment due in December 20XX?

Libor rate end of June + bp 3% + .25= 3.25 3.25%

Money Market securities versus capital market securities

Money market- less than 1 year, short term Capital market- longer than 1 year

Deferred coupon bonds

Pays no coupons for its first few years but then pays a higher coupon than it otherwise normally would for the remainders of its life

Yield Curve Risk

Possibility of changes in the shape of yield curve -short term and long term can change differently

Volatility Risk

Present for fixed-income securities that have embedded options, such as call options, prepayment options, or put options. Changes in interest rate volatility affect the value of these options and in turn, the price of the bonds

Credit Risk

Risk that the creditworthiness of a fixed-income security's issuer will deteriorate.

Call Risk

Risk that when interest rates fall, a callable bond investor's principal may be returned and must be reinvested at the new lower rates

Event Risk

Risks outside of the risks of financial markets; e.g. natural disasters

Liquidity Risk

Sale of a fixed income security may be made at a price less than the fair market value because of a lack of liquidity

partially amortized bond

The difference is that at either the beginning or the end of the loan, generally the end, a balloon payment must be made before the loan can be paid off. -making monthly payments on the loan for the extent of the loan will not pay the entire balance.

Yield to worst

The lowest of yield-to-maturity and the various yields to call that are possible given the call provisions of the bond

Term structure

The relationship between time to maturity and yields, all else equal -The effect of default risk, different coupons, etc. has been removed.

Which of the following is not an example of an embedded option? a. Warrant b. Call provision c. Conversion provision

Warrant

Inflation Risk

When unexpected changes in inflation lower the purchasing power of the cash flows associated with bonds

Unbiased Expectations Theory:

Yield curve reflects market's expectations of future short-term rates -Future short term rates- forward rates -Long-term rates are geometric average of current and expected short-term rates

money duration of a bond

a measure of the price change in units of the currency in which the bond is denominated.

Duration

a measure of the sensitivity of the price of a bond to a change in interest rates -larger duration number means more interest rate risk

Bullet loan

a payment of the entire principal (and sometimes interest) is due at the end of the loan term

What characteristics make for LESS interest rate risk

adding a call-called if interest rates drop, so price goes up to the call price adding a put- if interest rates go up, prices go down to put price

The present value of a firm's projected cash flows are $15 million. The break-up value of the firm if you were to sell the major assets and divisions separately would be $20 million. This is an example of what Peter Lynch would call a(n): a. stalwart b. slow growth firm c. turnaround d. asset play

asset play

A limitation of calculating a bond portfolio's duration as the weighted average of the yield durations of the individual bonds that compose the portfolio is that it: a. assumes a parallel shift to the yield curve. b. is less accurate when the yield curve is less steeply sloped. c. is not applicable to portfolios that have bonds with embedded options

assumes a parallel shift to the yield curve. -duration assumes, when there is a change in yield, those changes happens in a parallel fashion. (it is a strong assumption to make because it is not realistic) Reality is that they do no change parallel

Capital index bonds

base payment is linked to the consumer price index (principal)

Macaulay Duration

based on the expected cash flows for an option-free bond, it is not appropriate estimate of the price sensitivity of bonds with embedded options.

currency option bonds

bond that allows bondholders to choose the currency in which they receive each interest payment and principal repayment

The type of bond that allows bondholders to choose the currency in which they receive each interest payment and principal repayment is a: a. pure discount bond b. dual currency bond c. currency option bond

c. currency option bond

An example of sovereign bond is a bond issued by: a. the World Bank b. the city of New York c. the federal German government

c. the federal German government

if interest rates are expected to increase, the coupon payment structure most likely to benefit the issuer is a a. step up coupon b. inflation linked coupon c. cap in a floating rate note

cap in a floating rate note

a "buy and hold" investor purchases a fixed rate bond at a discount and holds the security until it matures. which of the following sources of return is least likely to contribute to the investors total return over the investment horizon, assuming all payments are made as scheduled? a. capital gain b. principal payment c. reinvestment of coupon payments d. all of the above

capital gain- if an investor sells before maturity and generates a profit from the bond

The U.S. Treasury offers Treasury Inflation-Protected Securities (TIPS). The principal of TIPs increases with inflation and decreases with deflation based on changes in the U.S. Consumer Price Index (CPI). When TIPS mature, an investor is paid the original principal or inflation adjusted principal, whichever is greater. TIPS pay interest twice a year based on a fixed real coupon rate that is applied to the inflation-adjusted principal. TIPs are most likely: a. capital indexed bonds b. interest-indexed bonds c. indexed-annuity bonds

capital indexed bonds

Credit spread

changes from you is the borrower -difference in yield between two bonds of similar maturity but different credit quality - For example, if the 10-year Treasury note is trading at a yield of 6% and a 10-year corporate bond is trading at a yield of 8%, the corporate bond is said to offer a 200-basis-point spread over the Treasury.

Inverse (reverse FRN) or inverse floater

coupon and interest rate have an inverse relationship interest rates go up, the coupon rate goes down

Dual-currency bonds

coupon and principal payments are made in two different currencies -base currency is the currency which the bond is issued

Floating rate notes

coupon rate changes as market rate changes -The risk is not disappearing, it's just transferring to the issuer

floaters

coupon rate changes with market rates, they need a reference rate which can be LIBOR

spot rate

current yield for a given term

Modified duration

derived from Macaulay duration and offers a slight improvement over Macaulay duration in that it takes the current YTM into account. -It is appropriate to do so because duration decreases as YTM increases -is a measure of the percentage price change of a bond given a change in its yield-to-maturity. -measures interest rate risk in terms of a change in the bond's own yield to maturity (ΔYield).

Yield to maturity

discount rate at which the sum of all future cash flows from the bond (coupons and principal) is equal to the current price of the bond. Estimated rate of return assuming it's held to the maturity date

The interest rate risk of a fixed-rate bond with an embedded call option is best measured by: a. effective duration b. modified duration c. Macaulay duration

effective duration

Plain vanilla

fixed coupon rate and known cash flows

Perpetual bonds (e.g. U.K. consols

fixed income security with no maturity date

investors who believe that interest rates will rise mot likely prefer to invest in a. inverse floaters b. fixed rate bonds c. floating rate notes

floating rate notes

a bond that is characterized by a fixed periodic payment schedule that reduces the bonds outstanding principal amount to zero by the maturity date is best described as a. bullet bond b. plain vanilla bond c. fully amortized bond

fully amortized bond

Callable bonds

gives the issuing corporation the right to call the bond back from the bond holders. -The call provision is in the favor of the bond issuer, the issuer is likely to call in the bond when interest rates have fallen. -The bond will be redeemed at a price over par, but the investor will reinvest in a lower interest-rate environment. -The firm is not going to call the bond unless its market value is been above the call price

Liquidity Premium Theory:

how people value cash relative to receiving interest over varying lengths of time. -Allows for future uncertainty -Premium required to hold long-term -Typically, liquidity premium increases as maturity increases

Interest indexed bonds

interest is related to a specific price index like the consumer price index

accrued interest

interest on a bond that has accumulated since the principal investment or since previous coupon payment -Full price accounts for accrued interest, flat does not

The put provision of a putable bond: a. limits the risk to the issuer b. limits the risk to the bondholder c. does not materially affect the risk of either the issuer or the bondholder

limits the risk to the bondholder

What characteristics make for MORE interest rate risk

longer maturity and low coupon

Which of the following index is an example of a style index?

market capitalization

Which of the following statements about duration is correct? A bond's: a. effective duration is a measure of yield duration b. modified duration is a measure of curve duration c. modified duration cannot be larger than its Macaulay duration

modified duration cannot be larger than its Macaulay duration -b/c we approximate md but with Macaulay, md is Macaulay D/ 1+ YTM (aka because of the formula)

Indexed annuity bonds

payment is indexed to consumer price index (principal and interest)

Zero-coupon (or pure discount bonds

pays no interest

. A 10-year TIPS is issued with a coupon rate of 6% and a par value of $1,000. The bond pays interest semi-annually. During the first 6 months after the bond's issuance, the CPI increases by 2%. On the first coupon payment date, the bond's: a. coupon rate increases to 8% b. coupon payment is equal to 40 c. principal amount increases to 1,020

principal amount increases to 1,020 -because it's a capital index bond, only the principal amount is affected

Reinvestment Risk

probability that an investor will be unable to reinvest cash flows (e.g., coupon payments) at a rate comparable to the current investment's rate of return -Related to call risk and prepayment risk... But in addition to the reinvestment of the principal, coupon bonds that contain neither call nor prepayment provisions will also be subject to reinvestment risk

Floating rate notes most likely pay: a. annual coupons b. quarterly coupons c. semi-annual coupons

quarterly coupons

yield to maturity

rate of return a person will receive for the bond until its maturity date (assuming it will be held until its maturity date)

A noncallable, AA-rated, 5 year zero coupon bond with a yield of 6% is least likely to have: a. interest rate risk b. reinvestment risk c. default risk

reinvestment risk

The additional risk inherent to a callable bond is best described as: a. credit risk b. interest rate risk c. reinvestment risk

reinvestment risk

Prepayment Risk

risk involved with the premature return of principal -Similar to call risk. Just as with call risk, an increase in interest rate volatility increases prepayment risk

Exchange rate Risk

risk that changes in the relative value of certain currencies will reduce the value of investments denominated in a foreign currency -also called currency risk

Putable bonds

the bondholder has the right to put the bond back, sell it back, to the bond issuer, usually on a coupon payment date

Convertible bonds

the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value -This favors the bondholder and the conversion 'sweetener' may reduce the required return.

Fully amortized bond

the principal (face value) and interest is paid down regularly over the life of the bond

effective duration

the sensitivity of the bond's price to a change in a benchmark yield curve -it measures interest rate risk in terms of a change in the benchmark yield curve (ΔCurve). -on Bloomberg, the most appropriate interest rate risk measure for bonds with embedded options -effective duration is looking at changes in the whole yield curve

Current yield

yield at the current moment and will not show the total return of the bond -Bond yield is the return an investor realizes on a bond.