EXAM 2

True or false: Commercial paper is less liquid than T-bills.

True

What are the 3 disadvantages to a call risk?

1. Cash flow pattern cannot be known with certainty 2. Investor is exposed to reinvestment risk 3. Bond's capital appreciation potential will be reduced

What are the 7 economic indicators?

1. GDP 2. Unemployment Rate 3. CPI (Consumer Price Index) 4. Sentiment 5. Retail Sales 6. Housing Starts 7. Durable Goods Orders

Why is the T-bill rate often used as the risk-free rate?

1. High volume 2. Very liquid (actively traded) 3. Perceived low default risk → Backed by full faith and credit of the US Government

What are Treasury Inflation Protected Securities (TIPS)

1. On January 29, 1997, the Treasury issued for the first time Treasury securities that adjust for inflation (TIPS) 2. Coupon rate = real rate 3. Adjust principal based on inflation every 6 months

What is a discount bond?

A bond that is issued for less than its par (or face) value, or a bond currently trading for less than its par value in the secondary market.

What is a premium bond?

A bond that sells above its par value. When going rate of interest is below the coupon rate

What is term structure?

A comparison of the yields on securities with different maturities, assuming default likelihood is the same

What are municipal bonds (tax-free)?

Are issued by state and local governments either to fund short-term deficits or to finance long-term capital projects - Have varying default risk - Interest payments are tax deductible, so investors are willing to accept a lower coupon rate than a comparable corporate bond

What type of risk increases as interest rates fall: call risk or default risk?

Call risk

For a premium bond and constant yield, does the bond experience a capital gain or capital loss as it approaches maturity?

Capital loss

What is price risk?

Change in price due to changes in interest rates

__________ bonds may be exchanged for another security of the issuing firm at the discretion of the bondholder

Convertible

What are corporate bonds (taxable)?

Corporate bonds are long-term bonds issued by corporations - Minimum size is $1,000 and typically pay semiannual interest

All else equal, as coupon rate rises, does duration increase or decrease?

Decrease

If yield rises, does duration increase or decrease?

Decrease

What is market segmentation theory?

Different investors prefer different market segments. Each market segment (short-term, long-term) has its own supply and demand curve - Insurance companies and pension funds prefer LT bonds

What is duration?

Duration tells us how much a bond price changes for a given change in yield - The concept of duration is based on the slope of the price-yield relationship - the weighted-average time to maturity (measured in years) on a financial security - measures the sensitivity (or elasticity) of a fixed-income security's price to small interest rate changes - captures the coupon and maturity effects on volatility.

True or false: Buying a discount bond is always better than buying a premium bond.

False

True or false: When interest rates rise, corporate debt issuance rises.

False

What is private placement?

Firm finds a small group of institutional buyers for the bonds. Issuers of privately placed issues tend to be less well known and yields on privately placed debt issues are higher than those on publicly offered bonds

Commercial paper is a discount instrument. The commercial paper rate is higher than that on Treasury bills for the same maturity. Why?

Higher credit risk and lower liquidity

If coupon rate falls, does duration increase or decrease?

Increase

What does duration do with maturity?

Increases

What kind of relationship is there between coupon rate and duration?

Inverse relationship

What kind of relationship is there between yield and duration

Inverse relationship

Under unbiased expectations theory, if the market expects interest rates to fall, will the yield curve be normal or inverted?

Inverted

What is firm commitment underwriting?

Investment bank buys bonds from issuer at a fixed price and resells bonds to investors at a higher price

What is a best efforts offering?

Investment bank does not buy bonds but acts as a placing agent on a fee basis related to its success on placing the issue

What is convexity?

Is a measure of the curvature of the price-yield relationship - Once you include duration and convexity, you can achieve a more accurate estimate of price change even for large changes in yield - The second derivative of the price-yield relationship measures the change in slope (convexity)

According to liquidity premium theory, what type of securities have greater liquidity risk: long-term or short-term bonds?

Long-term bonds

What is the liquidity premium theory?

Longer maturity securities have higher liquidity risk - LT bond yields > ST bond yields, upward sloping yield curve - Investors are compensated with a risk premium for investing in LT bonds

Is price risk greater for high or low coupon bonds?

Low coupon bonds

What is the commercial paper market?

Money market mutual funds are the major commercial paper investors - Despite the fact that the commercial paper market is larger than markets for other money market instruments, no active secondary trading activity

Which type of bond has the higher yield?

Non-investment grade

What is commercial paper?

Short-term (usually <= 270 days) unsecured promissory note issued by a corporation to raise short-term cash, often for working capital needs - High credit quality firms can often borrow at a lower rate with commercial paper than through bank loans - Sold in denominations of $100,000, $250,000, $500,000, or $1 million

What happens to discount bonds as they approach maturity?

The discount bond will eventually rise in price to $1,000 - For the discount bond, you have a capital gain which offsets the lower coupon payment

What is credit risk?

The probability that the borrower will fail to pay some of the interest or principal

Credit ratings

The ratings agency assigns a qualitative rating that reflects the probability of default. The credit spread is heavily influenced by this rating - Individual investors and institutional bond investors rely primarily on nationally recognized rating companies that perform credit analysis and issue their conclusions in the form of ratings- - Rating agencies use techniques to analyze information on companies and bond issues in order to estimate the ability of the issuer to live up to its future contractual obligations

What is call risk?

The risk that a callable bond will be called when interest rates fall - Many bonds include a provision that allows the issuer to retire or "call" all or part of issue before the maturity date

What is liquidity risk?

The risk that in order to sell the security quickly, the seller has to offer a very low price - Measure of liquidity risk - the spread between bid price and ask price quoted by a dealer. The wider the spread, the greater the liquidity risk - Bonds with lower liquidity trade with higher yields because they are more difficult to sell quickly for a fair price (thus are more risky)

What is the unbiased expectations theory?

The yield curve reflects the market's expectations of future short-term rates - 2-year bond yield = Yield on investing in two successive 1-year bonds - However, unbiased expectations theory does not explain the persistent upward slope of the yield curve.

What happens to premium bonds as they approach maturity?

They will eventually fall in price to $1,000 because the last cash flow is $1,000 in principal (plus the last coupon payment) - For the premium bond, you have a capital loss which offsets the higher coupon payment.