Bond Return and Yield Curve Theories

Questions and Answers

What happens to bond yields when interest rates rise?

They fluctuate randomly

They decrease

They increase (correct)

They remain unchanged

When interest rates fall, how do bond prices react?

They decrease

They increase (correct)

They become volatile

They remain constant

If a bond's coupon rate is fixed at 3%, what occurs if the market interest rate rises?

The bond price must increase

The coupon payments decrease

The bond price must decrease (correct)

The yield becomes irrelevant

In the case of a 1% increase in interest rates, what is the price change of a 3% bond?

It decreases by 4.49% Signup and view all the answers

What does a bondholder receive when market interest rates change?

The original coupon rate Signup and view all the answers

What calculation method is used to determine the percentage change in yield when interest rates increase?

(Ending Value − Beginning Value) / Beginning Value × 100 Signup and view all the answers

What is the effect on the yield of a bond if the price of the bond is lowered?

Yield increases Signup and view all the answers

What happens to bond prices when interest rates rise?

Bond prices decrease Signup and view all the answers

Which type of bonds is generally more volatile in terms of price percentage change?

Longer-term bonds Signup and view all the answers

What is the relationship between bond yields and bond prices?

They have an inverse relationship Signup and view all the answers

What is the primary focus of sell-side fixed-income trading?

Investment dealer transactions Signup and view all the answers

During a bond price decrease, what happens to the bond yield assuming the coupon rate remains constant?

It increases Signup and view all the answers

When do Government of Canada T-bills settle?

On the initial trade date Signup and view all the answers

What does the upward sloping yield curve indicate according to the expectations theory?

Interest rates are expected to rise. Signup and view all the answers

How does interest on a bond accrue in relation to settlement dates?

From the previous interest payment date up to and including the settlement date Signup and view all the answers

What role do bond indexes serve in the bond market?

They act as performance measurement tools for bond portfolio managers Signup and view all the answers

According to the liquidity preference theory, why do investors prefer short-term bonds?

They are more liquid and less volatile in price. Signup and view all the answers

What does a humped yield curve indicate about future interest rates?

Rates are expected to rise and then fall. Signup and view all the answers

Under what condition will an investor venture into longer-term bonds according to liquidity preference theory?

If there is sufficient compensation for the increased risks. Signup and view all the answers

How can the yield curve reflect market consensus about expected future interest rates?

By indicating the direction of future rates. Signup and view all the answers

What does the statement 'one-year rates at 4% and two-year rates at 5%' imply for future interest rates?

One-year bond rates are expected to increase to 6%. Signup and view all the answers

Which theory does not provide an explanation for a downward sloping yield curve?

Liquidity preference theory. Signup and view all the answers

What is the main focus of market segmentation theory in the fixed-income market?

The specific term sector preferences of institutional players. Signup and view all the answers

What does the equation $2 Year Return = 1 Year Return (Year 1) * 1 Year Return (Year 2)$ illustrate?

The compounding effect of returns over multiple years. Signup and view all the answers

What is the change in price for Bond B if its duration is 5 and the interest rate drops by 0.75%?

3.0% Signup and view all the answers

Which of the following is NOT a service provided by sell-side institutions in fixed-income trading?

Managing client portfolios Signup and view all the answers

If the duration of a bond increases, what is the expected change in its price for a given interest rate change?

The price will decrease more than before. Signup and view all the answers

What is primarily discussed in the courses IMT, PMT, and WME?

The calculation and implications of bond duration. Signup and view all the answers

How do sell-side and buy-side operations typically differ?

Sell-side handles the creation of financial products, while buy-side utilizes them. Signup and view all the answers

If a bond has a duration of 4 and the interest rates increase by 1.2%, what is the expected change in its price?

-4.8% Signup and view all the answers

What is the main role of investment bankers in the bond market?

Structure new debt issues. Signup and view all the answers

Why might the duration of a bond change over time?

Due to both market conditions and the bond's characteristics. Signup and view all the answers

What is a key disadvantage of using duration as a measure of interest rate sensitivity?

It assumes a linear relationship between interest rates and price. Signup and view all the answers

In fixed-income trading, what primarily happens on the buy side?

Investment management and portfolio building. Signup and view all the answers

What is the primary function of the retail desk?

To help advisors by sourcing products and providing market commentary Signup and view all the answers

What is usually necessary for executing large trades or dealing with illiquid securities?

Phone communication with the trading desk is required Signup and view all the answers

What distinguishes firms with a large institutional dealing desk from those without?

Access to a wider range of securities in their internal inventory Signup and view all the answers

What do inter-dealer brokers primarily do?

Act solely as agents to match institutional buyers and sellers Signup and view all the answers

How do inter-dealer brokers contribute to price discovery?

By studying the demand and supply in the market Signup and view all the answers

Which of the following tasks is NOT typically performed by inter-dealer brokers?

Facilitating direct consumer purchases Signup and view all the answers

What role does a proprietary trading system play for advisors?

It allows for automatic execution of trades entered by advisors Signup and view all the answers

What is one characteristic of firms that do not have a large institutional dealing desk?

They must build their own inventory of products Signup and view all the answers

Which statement is accurate regarding the trading volumes in Canada?

The majority of fixed-income trading volumes flow through inter-dealer brokers Signup and view all the answers

What function do inter-dealer brokers perform in relation to trade execution?

They facilitate execution and settlement for institutional trades Signup and view all the answers

Study Notes

Bond Return Calculation

2 Year Return is calculated as: 2 Year Return = 1 Year Return (Year 1) × 1 Year Return (Year 2).
Given rates: 1 Year Return (Year 1) = 4% and 2 Year Return = 5%, the calculation derives a future one-year rate of approximately 6%.

Expectations Theory

An upward sloping yield curve suggests expectations of rising interest rates.
A downward sloping yield curve indicates expected falling rates.
A humped curve signifies that rates may increase before decreasing.

Liquidity Preference Theory

Investors favor short-term bonds for their liquidity and reduced volatility.
Longer-term bonds are considered if compensated adequately for risks associated with liquidity and price volatility.
This theory cannot satisfactorily explain a downward sloping yield curve.

Market Segmentation Theory

Involves institutional players focusing on specific term sectors within the fixed-income market.

Bond Prices and Interest Rates Relationship

Bond prices and yields have an inverse relationship: as interest rates rise, bond yields increase while prices decrease.
For bonds, yields and interest rates are synonymous.
Price adjustments occur since coupon rates remain constant.

Bond Price Sensitivity

Price sensitivity of bonds depends on duration; longer-duration bonds can be more volatile.
An example shows a 5-year bond experiences a 2.5% price change with a 0.50% interest rate drop.

Bond Market Trading

Trading involves two sides: sell side (investment dealers) and buy side (institutional clients).

Sell Side Functions

Sell side handles the creation, marketing, and trading of fixed-income products.
Investment bankers assist with structuring and introducing new debt issues.

Trading in Non-Institutional Firms

Smaller firms may rely on external trading desks to build product inventories rather than having large internal inventories.

Role of Inter-Dealer Brokers

Brokers facilitate trades between institutional buyers and sellers, aiding in price discovery and execution.
They enhance market transparency and execute trades in the wholesale bond market.

Price Movement Dynamics

Price volatility is greater in longer-term and lower coupon rate bonds.
Interest on bonds is accrued post prior payment to the settlement day.

Bond Indexes

Used for assessing the performance of the bond market or specific segments.
Serve as benchmarks for bond portfolio managers and in the construction of bond index funds.

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Description

This quiz explores the calculations and theories related to bond returns, including the Bond Return Calculation, Expectations Theory, Liquidity Preference Theory, and Market Segmentation Theory. It simplifies complex concepts and encourages understanding of how interest rates influence bond pricing and investment strategies.