CH 15, 16) The Term Structure of Interest Rates and Managing Bond Portfolios

If you want to obtain a forward loan that begins in year 3 and ends in year 5, you would issue a ______-year zero-coupon bond and buy a ______-year zero.

5;3

T/F: For a horizon equal to the portfolio's duration, price risk and reinvestment risk are precisely equal. True false question.TrueFalse

False note: are precisely offsetting

T/F: The analysis that accounts for patterns of interest rates for different-term assets and the term structure of interest rates focuses on the structure of interest rates for discounting cash flows at different maturities.

True

T/F: Immunization needs rebalancing but dedication doesn't.

True: Dedication is a once-and-for-all approach to manage interest rate risk

According to the expectations hypothesis, the forward rate ________________ the market consensus for the future short rate. a) equals b) is less than c) does not have a definitive relationship with d) is greater than

a)

Bond index funds are ____________. a) both exchange-traded and mutual funds b) only exchange-traded funds c) only mutual funds

a)

Fund P is a pension fund managing retirement portfolios for state employees, and the duration of their liability is 30 years. Fund P is immunized from interest rate risk if _________________ and they continue to rebalance their portfolio. a) the asset duration is also 30 years b) at least 30% of their assets are short-term bonds c) they construct an equally weighted portfolio of stocks and short-term bonds d) their assets include stocks that can provide inflation hedge

a)

Holding the coupon rate constant, a bond's duration ____________ increases with its time to maturity. a) usually b) never c) always

a)

If there is a positive liquidity premium and expected short interest rates are constant, then the yield curve will have ______ slope. a) positive b) zero c) negative

a)

Security P is a perpetuity, and Security Z is a zero coupon bond that has 15 years remaining until maturity. Both securities have a yield of 5%. The duration of Security P ________________. a) is longer than the duration of Security Z b) is the same as the duration of Security Z c) is shorter than the duration of Security Z d) cannot be defined as perpetuities have no maturity

a)

When the coupon rate of a bond decreases, its duration _______________. a) increases b) remains the same c) decreases

a)

_____________ can be an inappropriate goal in an ______________ environment. a) immunization, inflationary b) inflation, immunized

a)

Bond H and Bond L are zero-coupon bonds that have 10-years remaining until maturity, but Bond H has a higher yield to maturity than Bond L. Bond H's duration is ______________ Bond L's duration. When the yields of both bonds increase by 50 basis points, the percentage drop in bond price will be _____________. a) the same as; greater for Bond L than Bond H b) the same as; the same for both bonds c) shorter than; the same for both bonds d) shorter than; greater for Bond L than Bond H

a) bc its interest rate is lower, so it has a greater percentage change in value

Active management is only expected to earn ______________ returns if the analyst's information or insight is superior to that of the market.

abnormal

Select all that apply... Which statements about immunizing a bond portfolio are correct? a) A bond portfolio will not remain immunized if the manger does not buy and sell securities to rebalance the portfolio. b) An immunized portfolio is not subject to credit risk. c) Immunization does not involve attempts to identify undervalued bonds. d) If interest rates do not change, portfolio duration will remain the same over time.

answers: a) and c) notes: 1. Bonds in an immunized portfolio my default 2. as the portfolio matures, its duration will change 3. as maturity and prevailing interest rates change, a bond manager must rebalance

Select all that apply... What would contribute to the negative slope of a yield curve? a) Decreasing expected short rates b) Increasing expected short rates c) Positive liquidity premium d) Negative liquidity premium

answers: a) and d)

Select all that apply... Which of the following statements regarding duration is true? a) Duration seldom increases with maturity for bonds selling at par or a premium to par b) holding the coupon rate constant, a bond's duration generally increases with its time to maturity c) The property of duration corresponds to Malkiel's third relationship.

answers: all except a)

Select all that apply... Which of the following statements illustrate why convexity is generally considered a desirable trait? a) Investors will have to pay higher prices and accept lower yields to maturity on bonds with greater convexity. b) Bonds that are more convex enjoy greater price increases and smaller decreases when interest rates fluctuate by larger amounts. c) Bonds with greater curvature gain more in price when yields fall than they lose when yields rise.

answers: all except a) note: a) is true but does not illustrate why convexity is considered desirable

Select all that apply... Which statements about the interest rate sensitivity of bonds are correct? a) As yields increase, bond prices fall. b) Prices of long-term bonds tend to be less sensitive to interest rate changes than prices of short-term bonds. c) The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases. d) An increase in a bond's yield to maturity results in a smaller price change than a decrease in yield of equal magnitude

answers: all except b) not correct: b) bc they tend to be more sensitive

Select all that apply... For what reasons is duration a key concept in fixed-income portfolio management? a) It is a simple summary statistic of the effective average maturity of the portfolio. b) It is used to determine the interest rate sensitivity of a portfolio. c) It is a simple measure of the degree of credit (or default) risk of a security. d) It turns out to be an essential tool in immunizing portfolios from interest rate risk.

answers: all except c)

Select all that apply... Which statements are true of bond market indexing? a) Indexes may include thousands of securities. b) Many bonds are very thinly traded, c) Index funds typically hold all of the bonds in the index. d) Bonds are dropped from the index as they approach maturity and replaced with new issues.

answers: all except c)

Select all that apply... Agencies that act as pass through agencies include: a) Freddie Mae b) Fannie Mac c) Freddie Mac d) Fannie Mae

answers: c) and d)

Select all that apply... Which of the following are the sources of potential value only used in active bond management? a) Dedication b) Immunization c) Identifying mispriced bonds d) Interest rate forecasting

answers: c) and d) note: for both passive and active -- dedication and immunization

According to the expectations hypothesis, an upward-sloping yield curve indicates that investors are expecting __________ in interest rates. a) a decrease b) an increase c) no change

b)

Bond A is a 10-year zero-coupon bond with yield to maturity of 10%. Bond B is a 15-year semi-annual coupon bond with yield to maturity of 10% and duration of 10 years. If the yields of both bonds increase to 10.25%, what can we reasonably predict? a) The bonds will experience very different percentage changes in price. b) The bonds will have a similar percentage change in price. c) We need more information to determine the relative effects of the interest rate change.

b)

For an upward sloping yield curve, a(n) __________ average forward rate must be added to the other previously observed rates in order to increase the yield to maturity a) increasing b) above- c) decreasing d) below-

b)

If two bonds have the same present value of cash flows but differ in their convexity, the one with greater convexity would be expected to have ______________ the one with lower convexity. a) the same price as b) a higher price than c) a lower price than

b)

The percentage change in a bond's price from a change in interest rates is best approximated by the negative of the product of the change in the bond's yield to maturity and ______________. a) 1 - coupon rate b) modified duration c) maturity d) duration

b)

A contract signed now for a loan that would not begin until a later date would be likely to use the _____________. a) real interest rate b) spot rate c) forward interest rate d) future short rate

c)

Consider a bond that makes a series of annual coupon payments and matures in four years. How should the term structure be used to value the bond? a) The average interest rate on annual zero-coupon bonds maturing in four or fewer years should be used. b) The yield on a four-year zero coupon bond should be used to discount all cash flows. c) Zero-coupon bonds with a maturity matching each payment date should be used.

c)

Holding interest rates constant, for bonds selling at par or at a premium to par, duration _____________ increases with time to maturity. a) usually b) never c) always

c)

If an investor follows the principle of ______________ _______________ ____________, the portfolio is automatically immunized from interest rate risk because the cash flow from the bond and the obligation exactly offset each other.

cash flow matching

The curvature of the price-yield relationship of a bond is its ________________.

convexity

An analyst who selects a particular holding period and predicts the yield curve at the the end of that period is doing what form of interest rate forecasting? a) holding period analysis b) vertical analysis c) yield curve analysis d) horizon analysis

d)

Many banks have a natural mismatch between the maturities of assets and liabilities; liabilities are primarily short-term deposits and assets are mostly long-term loans. This characteristic can make banks suffer serious decreases in net worth when ______________. a) stock prices rise unexpectedly b) stock prices drop sharply c) interest rates decrease unexpectedly d) interest rates increase unexpectedly

d)

The liquidity premium compensates ______-______ investors for the uncertainty about the price at which they will be able to sell their ____-____ bonds at the end of the year. a) long-term; long-term b) long-term; short-term c) short-term; short-term d) short-term; long-term

d)

Dedication is not as widely used as immunization because __________________. a) it is hard to find undervalued bonds b) it is less accurate when managing interest rate risk in bond portfolios c) it needs more frequent rebalancing d) it imposes a severe constraint on bond selection

d) There is no need for rebalancing with a dedication strat.

In cases when cash flows are not known, as because of embedded optionality, the sensitivity of a bond to interest rate changes is described by _____________ duration. Macaulay's effective modified

effective

If the yield to maturity of a bond increases, then its sensitivity to interest rate changes _____________. rises falls is unaffected

falls

When interest rates are uncertain, the interest rate that will actually be in effect for a given period that begins at a later time is termed the _____________ _______________ rate.

forward interest (or future short)

Ms. Olson is managing a bond portfolio and her investment horizon is 3 years. If she tries to predict bond yields at the end of the 3 year period, calculate the future bond price based on the prediction, and also consider coupon income in order to obtain a forecast of the total return during her holding period, she is doing __________________ analysis.

horizon

The difference between the predicted change in a bond's price using duration with and without accounting for convexity will be larger when the interest rate change is _______________ and the bond is ______________ convex. large; more small; more small; less large; less

large; more

The compensation for holding a less-traded bond, defined as the difference between the forward rate and the expected future short interest rate, is the _____________ ____________.

liquidity premium

In the region of ___________ convexity, the price-yield curve exhibits an unattractive asymmetry.

negative

When the price-yield curve lies below its tangency line, as may be the case for a callable bond, the curve is said to have ___________ convexity.

negative

Securities that first pass through the agencies Fannie Mae or Freddie Mac are referred to as _____________-_____________.

pass-throughs

The two sources of risk faced by fixed-income investors that cancel out when portfolio duration is chosen appropriately are ___________ risk and _______________ rate risk.

price; reinvestment

The graph of the relationship between yield to maturity and time to maturity for zero-coupon bonds is referred to as the _____________ yield curve.

pure

As interest rates and asset durations change, a manager must ________________ the portfolio to realign its duration with the duration of the obligation.

rebalance

The current interest rate appropriate for discounting a cash flow of some given maturity, in other words the rate that prevails today for a zero-coupon bond of that maturity, is the _____________ rate.

spot

The _________________ swap is an exchange of one bond for a nearly identical substitute.

substitution

The pattern of interest rates appropriate for discounting cash flows of various maturities is the ____________ ____________ of interest rates.

term structure

The duration of a ________-__________ bond equals its time to maturity.

zero-coupon