Chapter 8

influence of coupon rate on bond price sensitivity

-A zero-coupon bond is most sensitive to changes in the required rate of return. -The price of a bond that pays all of its yield in the form of coupon payments is less sensitive to changes in the required rate of return.

impact of the discount rate on bond valuation

-The appropriate discount rate for valuing any asset is the yield that could be earned on alternative investments with similar risk and maturities. -High risk securities have higher discount rates.

impact of the timing of payments on bond valuation

-Timing affects the market price of a bond -Funds received sooner can be reinvested to earn additional returns

impact of inflationary expectation : Bond Price

-if the level of inflation is expected to increase(decrease), there will be upward(downward) pressure on interest rates and hence on the required rate of return on bonds. -inflationary expectations are partially dependent on oil prices and exchange rate movements.

impact of money supply growth: Bond Price

-increased MS=increased loanable funds. if demand of loanable funds is not affected, the increased MS should put downward pressure on interest rates. meaning rise in bond prices. -high inflation = large increase in demand for loanable funds. cause increase in interest rates and lower bond prices.

change in economic growth : Credit risk

-strong economic growth can improve a forms cash flows and reduce probability of default. -weak economic conditions tend to reduce a firms cash flows and increase the probability of default.

changes in credit risk premium over time

-yields among securities are highly correlated. -difference between the corporate and treasury bond yields widened during periods when the economy was weak.

impact of budget deficit : Bond Price

An increase in the budget deficit can put upward pressure on interest rates. An increase in borrowing by the federal government can indirectly affect the required rate of return on all types of bonds.

Influence of Maturity on Bond Price Sensitivity

As interest rates decrease, long-term bond prices increase by a greater degree than short-term bond prices.

modified duration

Can be used to estimate the percentage change in the bond's price in response to a 1 percentage point change in bond yields

valuation of bonds with semiannual payments

First, divide the annual coupon by two Second, divide the annual discount rate by two Third, double the number of years

systemic risk

The potential for a major disruption in the function of an entire market or financial system.

Assume that the value of a financial institution's liabilities equals that of its assets. If the durations of its asset portfolio are ____ than the durations of its liability portfolio, then the market value of the assets is ____ interest-rate sensitive than the market value of the liabilities. a. greater; more b. greater; equally c. greater; less d. less; equally e. B and D

a

Bond price elasticity is the percentage change in bond prices divided by the percentage change in the required rate of return. a. True b. False

a

Duration is a measure of bond price sensitivity. a. True b. False

a

If bonds are held to maturity, the return to the bondholder is known with certainty. a. True b. False

a

International diversification of bonds reduces the sensitivity of a bond portfolio to any single country's interest rate movements. a. True b. False

a

The long-term, risk-free interest rate is driven by inflationary expectations, economic growth, the money supply, and the budget deficit. a. True b. False

a

The market price of a bond is partly determined by the timing of the payments made to bondholders. a. True b. False

a

Impact of Issuer Characteristics on the Credit Risk Premium

a bonds price can be affected by factors such as change in capital structure.

duration

a measurement of the life of a bond on a present value basis. the longer a bond's duration, the greater sensitivity to interest rate changes.

An increase in either the risk-free rate or the general level of the risk premium on bonds results in a higher required rate of return and therefore causes bond prices to increase. a. True b. False

b

If the coupon rate of a bond is above the investor's required rate of return, the price of the bond should be below its par value. a. True b. False

b

In a laddered strategy, investors create a bond portfolio that will generate periodic income that can match their expected periodic expenses. a. True b. False

b

In general, most bonds have annual payments. a. True b. False

b

In the ________ strategy, funds are allocated to bonds with a short term to maturity and bonds with a long term to maturity. a. laddered b. barbell c. interest rate d. matching e. None of these choices are correct.

b

The larger the investor's ____ relative to the ____, the larger the ____ of a bond with a particular par value. a. coupon rate; required rate of return; discount b. required rate of return; coupon rate; discount c. required rate of return; coupon rate; premium d. none of the above

b

Which of the following statements is incorrect? a. If the coupon rate of a bond is above the investor's required rate of return, the present value of the bond should be above the par value. b. If the coupon rate of a bond is below the investor's required rate of return, the present value of the bond should be above the par value. c. If the coupon rate of a bond is equal to the investor's required rate of return, the present value of the bond should be equal to the par value. d. If the coupon rate of a bond is below the investor's required rate of return, the present value of the bond should be below the par value. e. All of these statements are correct.

b

par bonds

bonds issued at par value

premium bonds

bonds selling above par value

discount bonds

bonds selling below par value

As interest rates increase, long-term bond prices a. increase by a greater degree than short-term bond prices. b. increase by an equal degree as short-term bond prices. c. decrease by a greater degree than short-term bond prices. d. decrease by an equal degree as short-term bond prices. e. decrease by a smaller degree than short-term bond prices.

c

Assume that the Federal Reserve just announced that it intends to increase money supply growth. Thus, interest rates will definitely a. decrease. b. increase. c. either increase or decrease. d. remain constant. e. None of these choices are correct.

c

Many financial institutions rely heavily on debt to fund their operations, and they are interconnected by virtue of financing each other's debt positions. Therefore, if one institution cannot pay its debts, it may create cash flow problems for several other institutions. The risk created by this situation is known as a. lending risk. b. repayment risk c. interest rate risk. d. systemic risk.

d

the price of a bond

it the present value of the cash values of the cash flows that will be generated by the bond, namely periodic interest or coupon payments and the principle at maturity.

estimation errors using modified duration

relying on modified duration to estimate the percentage change in the price of a bond may lead to overestimating the price decline when rates rise and underestimating the price when rates fall

impact of economic growth: Bond Price

strong economic growth tends to generate upward pressure on interest rates, while weak economic conditions put downward pressure on rates.

Impact of Debt Maturity on the Credit Risk Premium

tends to be larger for bonds that have a longer term to maturity (more time available for company default conditions to change).

bond convexi

the actual responmse of the bonds price to a change in bond yields is convex. -convexity is more pronounced for bonds with long maturities, and low to no coupons.

Bond Price Elasticity

the sensitivity of bond prices to changes in the required rate of return

duration of a por

the weighted average of bond duration's weighted according to relative market value.