Bonds and Debt Securities
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Questions and Answers

What is a characteristic of a zero-coupon bond?

  • It has a maturity period of less than a year.
  • It provides regular coupon payments to the investor.
  • It can be converted into a predetermined number of stocks in the future.
  • It does not provide any coupon payments to the investor. (correct)

    • What happens to the bond price when the market interest rate increases?

  • The bond price remains the same.
  • The bond price becomes zero.
  • The bond price increases.
  • The bond price decreases. (correct)

    • What is the effect of a decrease in YTM on the bond price?

  • The bond price increases. (correct)
  • The bond becomes worthless.
  • The bond price decreases.
  • The bond price remains the same.

    • What type of bond is issued by a state government or government agencies?

    <p>Municipal Bond</p> Signup and view all the answers

    What happens to the bond price as time to maturity increases, if the coupon rate is higher than YTM?

    <p>The bond price increases.</p> Signup and view all the answers

    What type of bond gives the seller the option to buy the bond back in the future?

    <p>Callable Bond</p> Signup and view all the answers

    What reflects the market's required return on a bond?

    <p>Yield to Maturity (YTM)</p> Signup and view all the answers

    What happens to the bond price when the yield to maturity increases?

    <p>The bond price decreases</p> Signup and view all the answers

    What is the characteristic of a bond that has a coupon rate lower than its yield to maturity?

    <p>Discount bond</p> Signup and view all the answers

    What happens to the bond price as time to maturity decreases?

    <p>The bond price increases</p> Signup and view all the answers

    What is the term for the separate trading of registered interest and principal securities?

    <p>Strip</p> Signup and view all the answers

    What occurs when the present value of a bond is greater than the present value of its strips?

    <p>Arbitrage opportunities are present</p> Signup and view all the answers

    What type of risk occurs when interest rates decrease, and an investor can reinvest the coupons at the market yield?

    <p>Reinvestment risk</p> Signup and view all the answers

    What is the effect of inflation on bond prices?

    <p>Inflation decreases bond prices</p> Signup and view all the answers

    What is the risk of suffering a loss if an investor desperately needs to sell their bond before maturity?

    <p>Liquidity risk</p> Signup and view all the answers

    Which type of bond is characterized by a coupon rate that is related to movements in inflation?

    <p>Indexed Bond</p> Signup and view all the answers

    What happens to the bond price when the market interest rate falls, and the coupon rate is higher than the YTM?

    <p>The bond price increases</p> Signup and view all the answers

    What is the effect of a decrease in market interest rates on the YTM of a bond?

    <p>The YTM decreases</p> Signup and view all the answers

    Which type of bond is characterized by a coupon rate that is lower than its YTM?

    <p>Discount Bond</p> Signup and view all the answers

    What happens to the bond price when the time to maturity increases, and the coupon rate is lower than the YTM?

    <p>The bond price decreases</p> Signup and view all the answers

    What is the relationship between the coupon rate and YTM when a bond is sold at a premium?

    <p>The coupon rate is higher than the YTM</p> Signup and view all the answers

    What is the effect of a decrease in the time to maturity on the bond price, when the coupon rate is higher than the YTM?

    <p>The bond price decreases</p> Signup and view all the answers

    What happens to the bond price when the coupon rate is equal to the YTM?

    <p>The bond price will be equal to its face value.</p> Signup and view all the answers

    What is the result of arbitrage opportunities being present in the market?

    <p>The market is inefficient, and the securities are priced incorrectly.</p> Signup and view all the answers

    Which type of risk is negatively related to price risk?

    <p>Reinvestment risk</p> Signup and view all the answers

    What is the effect of a decrease in interest rates on reinvestment risk?

    <p>It decreases the reinvestment risk.</p> Signup and view all the answers

    What happens to the total of the PV of interest and principle cashflows if arbitrage opportunities are absent?

    <p>It will be equal to the bond's face value price.</p> Signup and view all the answers

    What is the effect of an increase in YTM on the bond price, when the coupon rate is lower than the YTM?

    <p>The bond price will decrease.</p> Signup and view all the answers

    What is the characteristic of a bond with a coupon rate higher than its YTM?

    <p>It is a premium bond.</p> Signup and view all the answers

    What is the effect of a decrease in interest rates on price risk?

    <p>It decreases the price risk.</p> Signup and view all the answers

    Which active trading strategy involves investing in a bond with a shorter time to maturity than the investment time horizon, with the intention of rolling over into a new bond at a higher return when interest rates increase?

    <p>Rollover strategy</p> Signup and view all the answers

    What is the key assumption required for the rollover strategy to be effective?

    <p>Upward sloping yield curve</p> Signup and view all the answers

    Which active trading strategy involves increasing or decreasing portfolio duration based on forecasted changes in interest rates?

    <p>Duration management</p> Signup and view all the answers

    What is the primary objective of riding the yield curve?

    <p>To benefit from the upward sloping yield curve</p> Signup and view all the answers

    Which of the following is an example of a passive trading strategy?

    <p>Buying and holding bonds until maturity</p> Signup and view all the answers

    What is the primary risk associated with the rollover strategy?

    <p>Reinvestment risk</p> Signup and view all the answers

    When would an investor use duration management to decrease portfolio duration?

    <p>When interest rates are expected to increase</p> Signup and view all the answers

    When yields are stable or decrease, what happens to the bond price as its time to maturity decreases?

    <p>The bond price increases.</p> Signup and view all the answers

    What strategy involves selling the bond before maturity to capture a capital gain?

    <p>Sell before maturity</p> Signup and view all the answers

    On an upward sloping yield curve, what happens to the yield as the bond's time to maturity decreases?

    <p>The yield decreases.</p> Signup and view all the answers

    What is the main reason why the barbell strategy tends to be more successful than the bullet strategy?

    <p>It is more subject to convexity.</p> Signup and view all the answers

    When the yield curve is flattening, which strategy tends to outperform?

    <p>Barbell strategy</p> Signup and view all the answers

    What happens to the barbell strategy when there are larger parallel changes in the yield curve?

    <p>It becomes more profitable.</p> Signup and view all the answers

    When long-term rates are increasing (decreasing) by more than short-term rates when yields increase (decrease), which strategy tends to outperform?

    <p>Bullet strategy</p> Signup and view all the answers

    What is the primary advantage of the barbell strategy over the bullet strategy?

    <p>It is more affected by parallel changes in the yield curve.</p> Signup and view all the answers

    What is the primary assumption of the rollover strategy?

    <p>Interest rates will increase in the future</p> Signup and view all the answers

    An investor expects interest rates to decrease in the future. What should they do to their portfolio duration?

    <p>Increase it</p> Signup and view all the answers

    What is the primary objective of riding the yield curve?

    <p>To take advantage of the upward sloping yield curve</p> Signup and view all the answers

    What is the primary risk associated with the rollover strategy?

    <p>Reinvestment risk</p> Signup and view all the answers

    What happens to the bond price as its time to maturity decreases, assuming yields are stable?

    <p>It increases</p> Signup and view all the answers

    What is the key characteristic of the duration management strategy?

    <p>It involves adjusting portfolio duration based on forecasted changes in interest rates</p> Signup and view all the answers

    Which of the following is NOT a characteristic of the passive management strategy?

    <p>It requires frequent forecasting of interest rates</p> Signup and view all the answers

    What is the primary objective of riding the yield curve strategy?

    <p>To benefit from the higher yields associated with the longer time to maturity at the time of purchase</p> Signup and view all the answers

    Which strategy is more profitable when the yield curve is steepening and long-term rates are increasing by more than short-term rates?

    <p>Bullet strategy</p> Signup and view all the answers

    What happens to the bond price when its time to maturity decreases, assuming yields are stable or decrease?

    <p>The bond price increases</p> Signup and view all the answers

    Which strategy involves selling the bond before maturity to capture a capital gain?

    <p>Sell before maturity strategy</p> Signup and view all the answers

    What is the primary advantage of the barbell strategy over the bullet strategy?

    <p>It benefits from more convexity</p> Signup and view all the answers

    What happens to the yield as the bond's time to maturity decreases on an upward sloping yield curve?

    <p>The yield decreases</p> Signup and view all the answers

    When the yield curve is flattening, which strategy tends to outperform?

    <p>Barbell strategy</p> Signup and view all the answers

    What happens to the barbell strategy when there are larger parallel changes in the yield curve?

    <p>It tends to outperform</p> Signup and view all the answers

    What is the primary assumption of the Pure Expectations Theory?

    <p>Investors' expectations of future short-term interest rates are reflected in current long-term interest rates</p> Signup and view all the answers

    An investor is subject to which type of risk when interest rates decrease and they can reinvest the coupons at the market yield?

    <p>Reinvestment Risk</p> Signup and view all the answers

    What happens to the bond price when the yield to maturity decreases, assuming the coupon rate is higher than the YTM?

    <p>The bond price increases</p> Signup and view all the answers

    What type of risk is associated with selling a bond before maturity at a discounted price?

    <p>Liquidity Risk</p> Signup and view all the answers

    What happens to the bond price as time to maturity decreases, assuming yields are stable?

    <p>The bond price decreases</p> Signup and view all the answers

    What is the effect of inflation on bond prices?

    <p>Bond prices decrease</p> Signup and view all the answers

    What is the primary objective of riding the yield curve?

    <p>To maximize returns</p> Signup and view all the answers

    What is the relationship between price risk and reinvestment risk?

    <p>They are negatively related</p> Signup and view all the answers

    Which of the following statements about the yield curve is true?

    <p>A downward-sloping yield curve indicates that investors expect interest rates to decrease in the future.</p> Signup and view all the answers

    According to the Pure Expectations Theory, what determines long-term interest rates?

    <p>The market's expectation of future short-term interest rates.</p> Signup and view all the answers

    What is the main difference between the Liquidity Preference Theory and the Market Segmentation Theory?

    <p>The Liquidity Preference Theory focuses on the compensation for time, while the Market Segmentation Theory focuses on supply and demand in different market segments.</p> Signup and view all the answers

    What is the relationship between a bond's duration and its price sensitivity to interest rate changes?

    <p>A positive relationship, meaning that a higher duration leads to higher price sensitivity.</p> Signup and view all the answers

    What is the implication of Macaulay's Duration?

    <p>A higher duration implies higher exposure to interest rate risk.</p> Signup and view all the answers

    Which of the following theories explains the shape of the yield curve?

    <p>The Pure Expectations Theory and the Liquidity Preference Theory.</p> Signup and view all the answers

    What is the characteristic of a bond with a higher duration?

    <p>It has a higher sensitivity to interest rate changes.</p> Signup and view all the answers

    What is the primary advantage of the Preferred Habitat Theory?

    <p>It provides a framework for investors to make investment decisions based on their preferred time maturity.</p> Signup and view all the answers

    What is the primary purpose of convexity in bonds?

    <p>To provide a more accurate estimate of price changes in response to interest rate movements.</p> Signup and view all the answers

    Which of the following statements is TRUE about convexity and duration?

    <p>Convexity and duration have a positive relationship.</p> Signup and view all the answers

    What is the effect of a higher time to maturity on a bond's convexity?

    <p>Convexity increases as time to maturity increases.</p> Signup and view all the answers

    Which of the following bonds would have a higher convexity?

    <p>A 10-year bond with a 5% coupon rate and a 4% yield to maturity.</p> Signup and view all the answers

    What is the primary advantage of the barbell strategy over the bullet strategy?

    <p>The barbell strategy tends to outperform the bullet strategy when the yield curve is flattening.</p> Signup and view all the answers

    When would an investor use duration management to increase portfolio duration?

    <p>When interest rates are expected to decrease.</p> Signup and view all the answers

    What is the primary risk associated with the rollover strategy?

    <p>Reinvestment risk.</p> Signup and view all the answers

    What happens to the bond price when yields decrease, and the bond has a high convexity?

    <p>The bond price increases more than a bond with low convexity.</p> Signup and view all the answers

    Which of the following strategies involves selling the bond before maturity to capture a capital gain?

    <p>Realized gain strategy.</p> Signup and view all the answers

    Study Notes

    Bonds

    • Bonds are long-term debt securities issued by corporations and governments to raise capital.
    • Investors pay the initial cost (face value) and receive periodic interest payments (coupon) and the face value back at maturity.
    • Types of bonds include:
      • Zero-coupon bonds: no interest payments, only face value at maturity.
      • Convertible bonds: can be converted into a predetermined number of stocks.
      • Indexed bonds: coupon rate is tied to inflation.
      • Callable bonds: issuer can buy back the bond from the investor.
      • Perpetual bonds: no maturity date.
      • Treasury bonds: issued by the federal government.
      • Municipal bonds: issued by state or local governments.

    Bond Pricing and YTM

    • YTM (Yield to Maturity) reflects the market's required return on the bond.
    • If the market requires a higher return than the bond's coupon rate, the bond's price will drop (discount).
    • If the market requires a lower return than the bond's coupon rate, the bond's price will increase (premium).
    • Changes in market interest rates affect YTM and bond prices.

    Relationship Between YTM, Coupon Rate, and Time to Maturity

    • Premium bond: coupon rate is higher than YTM, sold at a price above face value.
    • Discount bond: coupon rate is lower than YTM, sold at a price below face value.
    • When YTM decreases, the bond price increases, decreasing the effective annual return.
    • When YTM increases, the bond price decreases, increasing the effective annual return.

    Characteristics of Bonds

    • Par value bond: coupon rate equals YTM.
    • Discount bond: coupon rate is lower than YTM.
    • Premium bond: coupon rate is higher than YTM.

    Strips

    • Strips are separate trading of registered interest and principal securities.
    • Investors can sell components of their bonds.
    • Common in Treasury bonds (federal government).
    • The total of the PV of interest and principal cashflows should equal the bond's face value price.

    Arbitrage

    • If PV Bond = PV of all Strips, no arbitrage opportunities present.
    • If PV Bond > PV of all Strips, arbitrage opportunities are present.
    • If PV Bond < PV of all Strips, arbitrage opportunities are present.

    Risks

    • Reinvestment risk: occurs when interest rates go down, and investors can reinvest coupons at a higher market yield.
    • Price risk: occurs when interest rates go up, and investors are forced to sell before maturity.
    • Inflation risk: inflation erodes bond returns, especially if investors are subject to price risk.
    • Liquidity risk: investors may suffer losses if they need to sell their bond before maturity at a low price.

    Bonds

    • Bonds are long-term debt securities issued by corporations and governments to raise capital.
    • Investors pay the initial cost (face value) and receive periodic interest payments (coupon) and the face value back at maturity.
    • Types of bonds include:
      • Zero-coupon bonds: no interest payments, only face value at maturity.
      • Convertible bonds: can be converted into a predetermined number of stocks.
      • Indexed bonds: coupon rate is tied to inflation.
      • Callable bonds: issuer can buy back the bond from the investor.
      • Perpetual bonds: no maturity date.
      • Treasury bonds: issued by the federal government.
      • Municipal bonds: issued by state or local governments.

    Bond Pricing and YTM

    • YTM (Yield to Maturity) reflects the market's required return on the bond.
    • If the market requires a higher return than the bond's coupon rate, the bond's price will drop (discount).
    • If the market requires a lower return than the bond's coupon rate, the bond's price will increase (premium).
    • Changes in market interest rates affect YTM and bond prices.

    Relationship Between YTM, Coupon Rate, and Time to Maturity

    • Premium bond: coupon rate is higher than YTM, sold at a price above face value.
    • Discount bond: coupon rate is lower than YTM, sold at a price below face value.
    • When YTM decreases, the bond price increases, decreasing the effective annual return.
    • When YTM increases, the bond price decreases, increasing the effective annual return.

    Characteristics of Bonds

    • Par value bond: coupon rate equals YTM.
    • Discount bond: coupon rate is lower than YTM.
    • Premium bond: coupon rate is higher than YTM.

    Strips

    • Strips are separate trading of registered interest and principal securities.
    • Investors can sell components of their bonds.
    • Common in Treasury bonds (federal government).
    • The total of the PV of interest and principal cashflows should equal the bond's face value price.

    Arbitrage

    • If PV Bond = PV of all Strips, no arbitrage opportunities present.
    • If PV Bond > PV of all Strips, arbitrage opportunities are present.
    • If PV Bond < PV of all Strips, arbitrage opportunities are present.

    Risks

    • Reinvestment risk: occurs when interest rates go down, and investors can reinvest coupons at a higher market yield.
    • Price risk: occurs when interest rates go up, and investors are forced to sell before maturity.
    • Inflation risk: inflation erodes bond returns, especially if investors are subject to price risk.
    • Liquidity risk: investors may suffer losses if they need to sell their bond before maturity at a low price.

    Active Trading Strategies

    • Active management involves forecasting yield curve changes to make investment decisions
    • Investors must predict changes in interest rates to adjust their portfolio

    Passive Trading Strategies

    • Passive management involves a "buy and hold" approach, where investors hold bonds until maturity
    • minimal effort required from investors

    Duration Management

    • Investors can adjust their portfolio duration based on forecasts of interest rate changes
    • Increase or decrease portfolio duration to respond to expected changes in interest rates

    Rollover Strategy

    • Invest in a bond with a shorter tenure than the investment time horizon
    • Expect interest rates to increase, allowing for reinvestment in a higher-yielding bond
    • Only works if interest rates are forecast to increase

    Riding the Yield Curve

    • Invest in a bond with a longer time to maturity (TTM) than the investment time horizon
    • Only works for upward-sloping yield curves
    • Take advantage of the bond's increasing value as its TTM decreases
    • Sell before maturity for a capital gain

    Barbell and Bullet Strategies

    • Bullet strategy: invest in bonds with similar maturity dates
    • Barbell strategy: invest in low-risk, low-maturity bonds and high-risk, high-maturity bonds
    • Both strategies can profit from changes in interest rates, but the barbell strategy is more successful due to convexity
    • The barbell strategy is superior in cases of parallel shifts and flattening curves, while the bullet strategy is superior in cases of steepening curves

    Active Trading Strategies

    • Active management involves forecasting yield curve changes to make investment decisions
    • Investors must predict changes in interest rates to adjust their portfolio

    Passive Trading Strategies

    • Passive management involves a "buy and hold" approach, where investors hold bonds until maturity
    • minimal effort required from investors

    Duration Management

    • Investors can adjust their portfolio duration based on forecasts of interest rate changes
    • Increase or decrease portfolio duration to respond to expected changes in interest rates

    Rollover Strategy

    • Invest in a bond with a shorter tenure than the investment time horizon
    • Expect interest rates to increase, allowing for reinvestment in a higher-yielding bond
    • Only works if interest rates are forecast to increase

    Riding the Yield Curve

    • Invest in a bond with a longer time to maturity (TTM) than the investment time horizon
    • Only works for upward-sloping yield curves
    • Take advantage of the bond's increasing value as its TTM decreases
    • Sell before maturity for a capital gain

    Barbell and Bullet Strategies

    • Bullet strategy: invest in bonds with similar maturity dates
    • Barbell strategy: invest in low-risk, low-maturity bonds and high-risk, high-maturity bonds
    • Both strategies can profit from changes in interest rates, but the barbell strategy is more successful due to convexity
    • The barbell strategy is superior in cases of parallel shifts and flattening curves, while the bullet strategy is superior in cases of steepening curves

    Relative Valuation

    • Asset prices are compared to similar assets in the market
    • Standardized prices create price multiples

    Bond Pricing

    • As time to maturity decreases, bond price increases
    • As time to maturity increases, bond price decreases
    • When YTM decreases, bond price increases, reducing effective annual return
    • When YTM increases, bond price decreases, increasing effective annual return

    Reinvestment Risk

    • Reinvestment risk occurs when interest rates decrease and bond prices are at a premium
    • Investors benefit from higher yields and can buy at a discount

    Price Risk

    • Price risk occurs when interest rates increase and bond prices are low
    • Investors are affected if they need to sell before maturity
    • Investors benefit from lower yields and higher bond prices

    Inflation Risk

    • Inflation decreases bond prices and ultimately returns
    • Inflation risk is relevant when investors are subject to price risk

    Liquidity Risk

    • Liquidity risk occurs when investors need to sell before maturity
    • Investors suffer losses due to selling at a discounted price

    Pure Expectations Theory

    • Pure Expectations Theory assumes the current yield curve reflects investors' expectations of future short-term interest rates
    • Yield curve slopes upwards if interest rates are expected to increase and downwards if interest rates are expected to decrease

    Yield Curve Shapes

    • Upward-sloping yield curve indicates expected stronger economic growth and higher inflation
    • Inverted yield curve indicates expected slower economic growth or recession
    • Yield curve shape is determined by market expectations of future interest rate movements

    Liquidity Preference Theory

    • Investors are compensated for time and risk
    • Investors face reinvestment risk if they don't need to sell and price risk if they must sell

    Market Segmentation Theory

    • Investors have specific preferences for bond maturity
    • Supply and demand shift yields for each market segment

    Preferred Habitat Theory

    • Investors have preferred bond maturities and may take alternative opportunities
    • Investors consider investment duration, price risk, and tolerance

    Duration

    • Duration measures a bond's price sensitivity to interest rate changes
    • Duration increases with time to maturity
    • Duration is higher for bonds with lower coupon rates and lower YTM
    • Duration has a positive relationship with price sensitivity to interest rate changes

    Convexity

    • Convexity measures the sensitivity of a bond's duration to changes in interest rates
    • Convexity captures the non-linear relationship between a bond's price and yield
    • Convexity increases with lower coupon rates, lower YTM, and higher TTM
    • Convexity provides a more accurate estimate of price changes in response to interest rate movements

    Duration and Convexity

    • Duration and Convexity have a positive relationship
    • Convexity is beneficial, providing more gains when yields decrease and less losses when yields increase
    • Duration increases interest rate risk, while convexity is beneficial

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    Explore the world of bonds, including types such as zero-coupon, convertible, indexed, and callable bonds. Learn how bonds work and their characteristics.

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