Bond Valuation and T-bills Quiz

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Questions and Answers

What occurs when the yield of a 3% bond rises to 4%?

The bond pays out $4 per $100 of par value.

The bond becomes more volatile than shorter-term bonds.

The price of the bond increases to 104.74.

The price of the bond drops to 95.51. (correct)

How is the overall yield affected when the price of a bond increases due to falling interest rates?

It remains the same because the bond is priced at par.

It fluctuates based on market demand.

It increases due to higher interest income.

It decreases due to a capital loss. (correct)

Which statement is true regarding the relationship between bond maturity and price volatility?

All bonds maintain the same level of volatility regardless of maturity.

Longer-term bonds have fixed prices regardless of market conditions.

Longer-term bonds are more volatile in price than shorter-term bonds. (correct)

Shorter-term bonds are more volatile than longer-term bonds.

If a new buyer pays $95.51 for a bond originally valued at $100, what will be the interest income received?

$3 per $100 of par value. Signup and view all the answers

What must happen to the price of a bond when its yield falls to 2%?

It must increase to 104.74. Signup and view all the answers

At what interest rate will a 3%, ten-year bond and a 5-year bond both be priced at par?

3% Signup and view all the answers

What is the combined yield when paying $95.51 for a bond yielding 3%?

4% Signup and view all the answers

What component is affected by the price drop of a bond as its yield increases?

Gain on the purchase price increases. Signup and view all the answers

What is a common misconception regarding bond pricing and yield?

Bond volatility increases with shorter maturities. Signup and view all the answers

What happens to the capital gain when a bond is purchased for less than par value?

Capital gain increases with fall in interest rates. Signup and view all the answers

How does the price change of a lower-coupon bond compare to a higher-coupon bond when yields rise?

It drops more sharply than the higher-coupon bond. Signup and view all the answers

What effect does the time to maturity have on the volatility of a bond?

Bonds lose volatility as they approach maturity. Signup and view all the answers

What was the price of the 3% five-year bond when yields decreased to 2%?

$104.74 Signup and view all the answers

What happens to the pricing relationship when comparing a 3% bond with a 2% bond, assuming all other factors are constant?

The 3% bond shows greater price stability. Signup and view all the answers

When market rates increase from 3% to 4%, what was the percentage price change for the 2% five-year bond?

−4.58% Signup and view all the answers

What is the formula used to calculate the semi-annual approximate YTM on the bond?

$4.50 + $0.4038 / 98.35 × 100 Signup and view all the answers

What is the impact of lower coupon rates on bond price percentage changes?

They create more volatile price changes compared to higher coupon rates. Signup and view all the answers

Which factor heavily influences the yield to maturity (YTM) of a bond?

The difference between the purchase price and face value Signup and view all the answers

How is the annual approximate YTM derived from the semi-annual approximate YTM?

By multiplying the semi-annual YTM by 2 Signup and view all the answers

In the given example of XYZ Corp., what does the 'Coupon' refer to?

The annual income generated from the bond Signup and view all the answers

What essential assumption is made when calculating the yield to maturity?

Coupon payments are reinvested at the same YTM Signup and view all the answers

Why might the current yield and YTM differ?

They apply different formulas based on varying assumptions Signup and view all the answers

Given the Price of $80 and Maturity Price of $100, what contributes to overall yield?

The coupon payment and the price difference Signup and view all the answers

What is the key measure for assessing an investment in a bond?

Yield to maturity Signup and view all the answers

Which of the following is NOT included in a bond quote?

The risk-free rate of return Signup and view all the answers

Which is NOT true about the financial calculator's YTM output?

It is always higher than the approximate YTM. Signup and view all the answers

What is included in the fair price of a bond?

The present value of its principal and the present value of its coupons Signup and view all the answers

At a discount rate of 10%, what is the calculated value of the bond?

$96.77 Signup and view all the answers

What components determine the return of a Treasury bill?

Difference between purchase price and maturity value Signup and view all the answers

Which of the following statements about the yield on a T-bill is incorrect?

Yield is derived from the interest paid during the interim. Signup and view all the answers

What does the current yield measure?

The relationship between the cash flows and the current market price Signup and view all the answers

In the yield calculation formula for a T-bill, what does the term 'Term' represent?

The days until maturity, measured in days Signup and view all the answers

What would be the yield on an 89-day T-bill purchased for a price of 99.5?

2.061% Signup and view all the answers

Which aspect does not affect the calculation of a bond's current yield?

Original purchase price of the bond Signup and view all the answers

What does the formula for calculating the yield on a T-bill include?

Price, term, and maturity value Signup and view all the answers

What primarily influences the price of a bond when demand exceeds supply?

The yield to maturity (YTM) Signup and view all the answers

Which theory explains the relationship between inflation, nominal interest rates, and real interest rates?

Fisher Effect Signup and view all the answers

What affects the term structure of interest rates?

Supply and demand dynamics Signup and view all the answers

When market interest rates increase, what is likely to happen to existing bond prices?

They will decrease in price Signup and view all the answers

What is the principal factor that determines the yield to maturity (YTM) of a bond?

Current market interest rates Signup and view all the answers

What can cause variations in the yield curve?

Investor expectations regarding future interest rates Signup and view all the answers

What happens to the yield of a bond if its price rises due to increased demand?

Yields decrease Signup and view all the answers

How is the yield curve generally shaped when investors expect economic growth?

It slopes upward Signup and view all the answers

Which of the following statements regarding the interaction of borrowers and lenders is true?

The interaction determines the overall level of interest rates Signup and view all the answers

Which factor does NOT influence the level of interest rates at different terms to maturity?

The issuance method of bonds Signup and view all the answers

Study Notes

Present Value of a Bond

Fair price of a bond includes present value of its principal and coupons.
At a 10% discount rate, the bond's value is $96.77 ($29.0844 + $67.6839).

Treasury Bills (T-bills)

T-bills are short-term securities sold at a discount and mature at par value.
Returns come from the difference between purchase price and maturity value.
Investor earnings from T-bills are taxed as interest income.
Yield calculation formula for T-bills:
- Yield = ((100 - \text{Price}) / \text{Price} \times (365 / \text{Term}) \times 100)
Example: An 89-day T-bill bought at 99.5 yields 2.061%.

Current Yield on Bonds

Current yield focuses on cash flows and current market price, excluding original investment amount.
Formula to calculate current yield is applicable to both bonds and stocks.
Example calculation yields an approximate YTM of 4.9842% for a bond priced at $96.77.
Annual approximate YTM calculated as 9.9684% (4.9842% × 2).

Yield to Maturity (YTM)

YTM reflects average return if a bond is purchased today and held until maturity, assuming coupon payments are reinvested at the same YTM.
Higher differences between bond price and maturity value affect overall YTM.
Example highlights YTM of 12.50% for XYZ Corp 7% bond when bought at 80.00.

Term Structure of Interest Rates

Market forces of supply and demand affect bond trading prices and YTM.
Excess demand results in higher prices and lower YTM.
Bond prices are also influenced by current market interest rates.

Factors Affecting Interest Rates

The Fisher Effect illustrates the relationship between inflation rate, nominal interest rate, and real interest rate.
Changes in bond yield influence pricing:
- If yield rises, bond price decreases.
- If yield falls, bond price increases.

Impact of Maturity

Long-term bonds exhibit greater price volatility than short-term bonds.
As bonds approach maturity, their volatility and price changes lessen over time.

Impact of Coupon Rate

Lower-coupon bonds are more sensitive to price changes compared to higher-coupon bonds.
Price effects from interest rate changes are more pronounced in lower-coupon bonds.
Data shows that a 1% increase in yield results in a greater price decline for a 2% coupon bond versus a 3% coupon bond.

Summary

Understanding bond pricing and yields is crucial for investment decisions.
Yields are influenced by prevailing market conditions, bond characteristics, and investor actions related to maturity and coupon rate.

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Description

Test your knowledge on the present value of bonds, Treasury Bills, and the calculation of current yield and yield to maturity. This quiz covers essential financial concepts and formulas important for understanding bond investments. Dive in and see how well you grasp these topics!