Finance Chapter: Relative Valuation
115 Questions
0 Views

Choose a study mode

Play Quiz
Study Flashcards
Spaced Repetition
Chat to lesson

Podcast

Play an AI-generated podcast conversation about this lesson

Questions and Answers

What is the primary objective of relative valuation in asset analysis?

  • To determine if the asset is under or overvalued relative to its comparable group (correct)
  • To identify the most profitable industry segment
  • To forecast the future stock price of an asset
  • To determine the absolute value of an asset

    • What is the assumption underlying non-linearity regression in relative valuation?

  • A linear relationship between the multiple and its fundamentals (correct)
  • A correlation between the independent variables
  • A stable relationship between the multiple used and the financial variables
  • A non-linear relationship between the multiple and its fundamentals

    • What is the consequence of multi-collinearity in a regression model?

  • The model becomes unreliable
  • The coefficients of the regression become unreliable (correct)
  • The relationship between the multiple used and the financial variables becomes stable
  • The independent variables become correlated

    • Why may smaller companies trade at different multiples compared to larger companies?

    <p>Due to differences in their scale and size</p> Signup and view all the answers

    What is the implication of non-stationarity in relative valuation?

    <p>The relationship between the multiple used and the financial variables may not be stable</p> Signup and view all the answers

    Which of the following is a reason why relative valuation is quicker than discounted cash flow valuation?

    <p>It requires fewer assumptions about the future.</p> Signup and view all the answers

    What is the main issue with selecting comparable in relative valuation?

    <p>The comparable are not truly similar to the asset being valued.</p> Signup and view all the answers

    Why is the median preferred over the mean in relative valuation?

    <p>The median is a more reliable comparison point than the mean.</p> Signup and view all the answers

    What is the impact of market conditions on relative valuation?

    <p>It may result in valuations that reflect temporary market conditions rather than the intrinsic value of the asset.</p> Signup and view all the answers

    What is the issue with comparing companies or assets with different growth rates in relative valuation?

    <p>It may result in misleading conclusions.</p> Signup and view all the answers

    If the coupon rate of a bond is lower than its YTM, what happens to the bond's price?

    <p>It decreases below its face value</p> Signup and view all the answers

    What happens to the price of a bond when its time to maturity decreases?

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

    A bond's coupon rate is greater than its YTM. What type of bond is this?

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

    What is the result if the PV of a bond is greater than the PV of all its strips?

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

    When do investors benefit from reinvestment risk?

    <p>When yields increase, and bond prices decrease</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

    What is the effect of inflation on bond prices?

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

    What is the consequence of liquidity risk?

    <p>Selling at a discounted price</p> Signup and view all the answers

    What is the primary characteristic of a zero-coupon bond?

    <p>It does not offer any coupon payments over its life</p> Signup and view all the answers

    What happens to the bond price when the market interest rate rises?

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

    What is the implication of a bond being sold at a price above its face value?

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

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

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

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

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

    What happens to a bond's price as time to maturity increases, assuming the coupon rate is higher than the YTM?

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

    What is the relationship between the market's required return on a bond and its price?

    <p>The higher the market's required return, the lower the bond price</p> Signup and view all the answers

    What happens to the bond's price if the market requires a return that is higher than the bond's coupon rate?

    <p>The bond's price drops</p> Signup and view all the answers

    What type of bond will have its rate of return eroded by inflation?

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

    What is the result when the time to maturity of a bond increases, assuming the coupon rate is higher than the YTM?

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

    What type of bond can be converted into a predetermined number of stocks in the future?

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

    What happens to the bond's price when the market interest rate falls?

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

    What type of bond is issued by the federal government?

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

    What happens to the bond's YTM when market interest rates rise?

    <p>The bond's YTM increases</p> Signup and view all the answers

    What happens to the effective annual return of a bond when its YTM increases?

    <p>It increases because the bond is being bought at a lower price for the same amount of cash flows</p> Signup and view all the answers

    What is the characteristic of a bond with a coupon rate equal to its YTM?

    <p>It is a par value bond</p> Signup and view all the answers

    What is the result if the PV of a bond is less than the PV of all its strips?

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

    What happens to the bond price when interest rates decrease, assuming the coupon rate is lower than the YTM?

    <p>It increases because the bond is being bought at a higher price</p> Signup and view all the answers

    What is the implication of price risk and reinvestment risk being negatively related?

    <p>When one risk increases, the other risk decreases</p> Signup and view all the answers

    What is the consequence of selling a bond before maturity when yields are high and the price has dropped?

    <p>Investors suffer a loss due to liquidity risk</p> Signup and view all the answers

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

    <p>It decreases because the bond is being bought at a lower price</p> Signup and view all the answers

    What is the effect of inflation on bond prices, assuming the investor is subject to price risk?

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

    If a bond's coupon rate is higher than its YTM, what will happen to the bond's price as time to maturity increases?

    <p>The bond's price will increase</p> Signup and view all the answers

    What happens to the bond's YTM when market interest rates fall?

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

    What is the implication of a bond being sold at a premium?

    <p>The bond's effective annual return decreases</p> Signup and view all the answers

    What happens to the bond's price when the market interest rate rises, assuming the coupon rate is lower than the YTM?

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

    What is the characteristic of a callable bond?

    <p>The seller can buy the bond back from the investor in the future</p> Signup and view all the answers

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

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

    What is the implication of a bond's YTM decreasing?

    <p>The bond's price increases, increasing the effective annual return</p> Signup and view all the answers

    When the coupon rate of a bond is lower than its YTM, which of the following statements is true?

    <p>The bond is sold at a discount below its face value</p> Signup and view all the answers

    What happens to the bond price when the market interest rate increases, assuming the coupon rate is lower than the YTM?

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

    What is the result when the PV of a bond is equal to the PV of all its strips?

    <p>No arbitrage opportunities are present</p> Signup and view all the answers

    Which of the following types of bonds is more susceptible to reinvestment risk?

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

    What is the effect of inflation on the effective annual return of a bond?

    <p>Inflation decreases the effective annual return</p> Signup and view all the answers

    What is the relationship between the coupon rate and YTM of a premium bond?

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

    What happens to the bond price when the time 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 is the implication of price risk and reinvestment risk being negatively related?

    <p>One risk is good for investors, while the other is bad</p> Signup and view all the answers

    According to Pure Expectations Theory, what is the determining factor of long-term interest rates?

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

    What is the shape of the yield curve when investors expect stronger economic growth and potentially higher inflation in the future?

    <p>Normal (upward sloping)</p> Signup and view all the answers

    Why do investors demand higher yields for long-term bonds in a normal yield curve?

    <p>To compensate for stronger economic growth and potentially higher inflation</p> Signup and view all the answers

    What does an inverted yield curve suggest about investors' expectations?

    <p>Investors expect slower economic growth or a recession</p> Signup and view all the answers

    What is the implication of the Pure Expectations Theory for investors?

    <p>Investors should be indifferent between holding short-term or long-term securities</p> Signup and view all the answers

    What is the relationship between the yield curve and interest rate expectations?

    <p>An upward-sloping yield curve indicates increasing interest rates</p> Signup and view all the answers

    What is the driving force behind the shape of the yield curve according to Pure Expectations Theory?

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

    What does a flat yield curve indicate about the economy?

    <p>The economy is transitioning between upward and downward sloping curves</p> Signup and view all the answers

    What can be inferred from a negative forward rate?

    <p>There is an arbitrage opportunity</p> Signup and view all the answers

    According to the Liquidity Preference Theory, what do investors demand for investing for longer periods?

    <p>Extra compensation for taking on more risk</p> Signup and view all the answers

    What is the market expectation when the yield curve is upward sloping?

    <p>Short-term interest rates will increase</p> Signup and view all the answers

    What happens to bond prices when interest rates decrease?

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

    What is the relationship between spot rates and forward rates?

    <p>Spot rates are a reflection of current market expectations, while forward rates reflect future expectations</p> Signup and view all the answers

    What is the implication of reinvestment risk?

    <p>Investors are exposed to the risk of reinvesting at a lower rate</p> Signup and view all the answers

    What is the primary characteristic of a Preferred Habitat Theory?

    <p>Investors have a preferred investment duration</p> Signup and view all the answers

    Which of the following statements is true according to the Pure Expectations Theory?

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

    What does an upward-sloping yield curve typically suggest?

    <p>Investors expect higher inflation and stronger economic growth in the future.</p> Signup and view all the answers

    What is the implication of an inverted yield curve?

    <p>Investors expect lower inflation and slower economic growth in the future.</p> Signup and view all the answers

    What is the relationship between long-term interest rates and the market's expectation of future short-term interest rates?

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

    Why do investors demand higher yields for long-term bonds?

    <p>To compensate for higher inflation risk and uncertainty of rate changes.</p> Signup and view all the answers

    What is the implication of a normal yield curve?

    <p>Investors expect higher interest rates in the future.</p> Signup and view all the answers

    What is the assumption underlying the Pure Expectations Theory?

    <p>Investors are indifferent between holding short-term or long-term securities.</p> Signup and view all the answers

    When would you normally observe a flat yield curve?

    <p>When the economy is changing, either heading downwards or upwards sloping</p> Signup and view all the answers

    What does a negative forward rate suggest?

    <p>An arbitrage opportunity</p> Signup and view all the answers

    What is the main difference between spot rates and forward rates?

    <p>Spot rates are current market rates, while forward rates are market expectations of interest rates in the future</p> Signup and view all the answers

    Which theory states that investors have preferred time maturity to bonds, but may take other opportunities if available?

    <p>Preferred Habitat Theory</p> Signup and view all the answers

    What happens to the price of a bond when interest rates increase?

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

    What is the relationship between price risk and reinvestment risk?

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

    What is the implication of a negative forward rate in the yield curve?

    <p>An arbitrage opportunity</p> Signup and view all the answers

    What is the main difference between high interest rates and low interest rates?

    <p>High interest rates decrease bond prices, while low interest rates increase bond prices</p> Signup and view all the answers

    What is the relationship between a bond's duration and its coupon rate?

    <p>There is a negative relationship between a bond's duration and its coupon rate.</p> Signup and view all the answers

    What is the effect of an increase in Time to Maturity (TTM) on a bond's duration?

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

    What does Modified Duration (Dmod) represent?

    <p>The percentage change in a bond's price for a 1% increase in yield.</p> Signup and view all the answers

    What is the relationship between a bond's duration and its exposure to interest rate risk?

    <p>There is a positive relationship between a bond's duration and its exposure to interest rate risk.</p> Signup and view all the answers

    What is the effect of an increase in yield on a bond's duration?

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

    What is the relationship between a bond's duration and its Time to Maturity (TTM) and its yield?

    <p>There is a positive relationship between a bond's duration and its Time to Maturity (TTM) and a negative relationship between a bond's duration and its yield.</p> Signup and view all the answers

    What is the purpose of Convexity in bond analysis?

    <p>To capture the non-linear relationship between a bond's price and yield.</p> Signup and view all the answers

    Convexity is higher for bonds with lower YTM due to which of the following reasons?

    <p>Because the bond's price is more sensitive to interest rate changes</p> Signup and view all the answers

    What happens to the bond's modified duration when the yield increases by 1%?

    <p>It decreases by 1%</p> Signup and view all the answers

    What is the relationship between duration and convexity?

    <p>They are positively correlated</p> Signup and view all the answers

    Why do investors want more convexity in their bonds?

    <p>Because it increases the bond's price sensitivity to interest rate changes</p> Signup and view all the answers

    What is the effect of a 1% increase in yield on a bond's price, assuming the bond has high convexity?

    <p>The bond's price decreases by a small amount</p> Signup and view all the answers

    What is the consequence of having more convexity in a bond, but also having more duration?

    <p>The bond's price becomes more sensitive to interest rate changes</p> Signup and view all the answers

    What is the relationship between a bond's coupon rate and its YTM, if the bond has high convexity?

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

    What is the benefit of using convexity to estimate a bond's price change in response to interest rate movements?

    <p>It provides a more accurate estimate of the bond's price change</p> Signup and view all the answers

    What is the relationship between Macaulay's Duration (Dmac) and Time to Maturity (TTM)?

    <p>Dmac is less than or equal to TTM</p> Signup and view all the answers

    What is the effect of an increase in the yield to maturity (YTM) on a bond's Macaulay's Duration (Dmac)?

    <p>Dmac decreases</p> Signup and view all the answers

    What is the relationship between Modified Duration (Dmod) and a bond's price sensitivity to interest rate changes?

    <p>Dmod represents a percentage price change</p> Signup and view all the answers

    What is the effect of an increase in Time to Maturity (TTM) on a bond's duration?

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

    What is the purpose of Convexity in bond analysis?

    <p>To measure the sensitivity of a bond's duration to changes in interest rates</p> Signup and view all the answers

    What is the relationship between a bond's coupon rate and its Macaulay's Duration (Dmac)?

    <p>A negative relationship exists between the two</p> Signup and view all the answers

    What is the implication of a bond's duration representing a negative linear relationship?

    <p>Small changes in interest rates have a small impact on the bond's price</p> Signup and view all the answers

    What is the relationship between duration and convexity?

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

    What happens to the modified duration of a bond when its yield increases by 1%?

    <p>It decreases by approximately 1%.</p> Signup and view all the answers

    What is the effect of convexity on a bond's price change in response to interest rate movements?

    <p>It results in less price change when yields go up and more price change when yields go down.</p> Signup and view all the answers

    What is the relationship between a bond's coupon rate and its convexity, all else equal?

    <p>A lower coupon rate leads to higher convexity.</p> Signup and view all the answers

    What is the impact of an increase in time to maturity on a bond's convexity, all else equal?

    <p>Convexity increases.</p> Signup and view all the answers

    What is the effect of a decrease in yield to maturity on a bond's convexity, all else equal?

    <p>Convexity increases.</p> Signup and view all the answers

    What happens to an investor's interest rate risk when they invest in longer bonds?

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

    What is the benefit of having more convexity in a bond?

    <p>It gives investors more gains when yields decrease and less losses when yields increase.</p> Signup and view all the answers

    Study Notes

    Relative Valuation

    • Compares the price of an asset to similar or comparable assets in the market
    • Market prices are converted into standardized prices, creating price multiples

    Advantages of Relative Valuation

    • Easier to justify buying or selling decisions using relative valuation
    • Quicker and requires fewer assumptions about the future compared to discounted cash flow valuation
    • More likely to reflect market perceptions and moods

    Median Preference in Relative Valuation

    • Median is a more reliable comparison point than the mean
    • Median is unaffected by extreme outliers or non-symmetric distributions of scores
    • Generally a better representation of the true average if the sample has outliers

    Issues in Relative Valuation

    Choice of Comparable

    • Selecting appropriate comparable is subjective and can significantly affect the valuation
    • Inaccurate valuation if chosen comparable are not truly similar to the asset being valued

    Market Conditions

    • Market conditions can influence the prices of comparable
    • Valuations based on comparable might reflect temporary market conditions rather than the intrinsic value of the asset

    Differences in Growth Rates

    • Companies or assets with different growth rates might be compared
    • High-growth companies may appear overvalued compared to low-growth companies, leading to misleading conclusions

    Scale and Size of Companies

    • Comparable may differ significantly in scale and size
    • Smaller companies might trade at different multiples compared to larger companies, leading to valuation discrepancies

    Limitations of Regression Analysis

    • Non-linearity: assumes a linear relationship between the multiple and its fundamentals
    • Non-stationarity: the relationship between the multiple used and the financial variables may not be stable
    • Multi-collinearity: independent variables are correlated with each other, making coefficients unreliable

    Bonds

    • Bonds are used by corporations and governments to raise long-term capital.
    • When investing in bonds, the initial cost is paid, and then coupon (interest) is received periodically.
    • When the bond matures, the face value is returned.
    • Types of bonds include:
      • Zero-coupon bonds: no coupon payments during the bond's life, only face value at maturity.
      • Convertible bonds: can be converted into a predetermined number of stocks in the future.
      • Indexed bonds: coupon rate is related to movements in inflation.
      • Callable bonds: the seller can buy the bond back from the buyer in the future.
      • Perpetual bonds: last forever.
      • Treasury bonds: issued by the federal government.
      • Municipal bonds: issued by state governments or government agencies.

    Bond Pricing and YTM

    • YTM (Yield to Maturity) reflects the market's required return on the bond.
    • If market return > coupon rate, bond price drops (discount).
    • If market return < coupon rate, bond price increases (premium).
    • Changes in market interest rates affect YTM, leading to changes in bond prices.

    Relationship Between YTM, Coupon Rate, and Time to Maturity

    • Premium bond:
      • Coupon rate > YTM, sold at price above face value.
      • As time to maturity decreases, bond price decreases.
      • As time to maturity increases, bond price increases.
    • Discount bond:
      • Coupon rate < YTM, sold at price below face value.
      • As time to maturity decreases, bond price increases.
      • As time to maturity increases, bond price decreases.

    Characteristics of Bonds

    • Par value bond: coupon rate = YTM.
    • Discount bond: coupon rate < YTM.
    • Premium bond: coupon rate > YTM.

    Strips

    • Strips are separate trading of registered interest and principal securities.
    • Investors can sell components of their bonds.
    • Generally common in Treasury bonds.
    • The total PV of interest and principal cash flows should equal the bond's face value price.

    Arbitrage

    • If PV bond = PV of all strips: no arbitrage opportunities.
    • If PV bond > PV of all strips: arbitrage opportunities present, market is inefficient.
    • If PV bond < PV of all strips: arbitrage opportunities present, market is inefficient.

    Risks

    • Reinvestment risk: occurs when interest rates go down (bond prices are at a premium).
      • Investors can reinvest coupons at market yield.
    • Price risk: occurs when interest rates go up (bond price is low).
      • Investors are only subject to price risk if they need to sell before maturity.
    • Inflation risk: inflation causes bond prices to decrease, affecting return on bonds.
    • Liquidity risk: suffers loss if desperately needing to sell bond before maturity at a reasonable price.

    Bonds

    • Bonds are used by corporations and governments to raise long-term capital.
    • When investing in bonds, the initial cost is paid, and then coupon (interest) is received periodically.
    • When the bond matures, the face value is returned.
    • Types of bonds include:
      • Zero-coupon bonds: no coupon payments during the bond's life, only face value at maturity.
      • Convertible bonds: can be converted into a predetermined number of stocks in the future.
      • Indexed bonds: coupon rate is related to movements in inflation.
      • Callable bonds: the seller can buy the bond back from the buyer in the future.
      • Perpetual bonds: last forever.
      • Treasury bonds: issued by the federal government.
      • Municipal bonds: issued by state governments or government agencies.

    Bond Pricing and YTM

    • YTM (Yield to Maturity) reflects the market's required return on the bond.
    • If market return > coupon rate, bond price drops (discount).
    • If market return < coupon rate, bond price increases (premium).
    • Changes in market interest rates affect YTM, leading to changes in bond prices.

    Relationship Between YTM, Coupon Rate, and Time to Maturity

    • Premium bond:
      • Coupon rate > YTM, sold at price above face value.
      • As time to maturity decreases, bond price decreases.
      • As time to maturity increases, bond price increases.
    • Discount bond:
      • Coupon rate < YTM, sold at price below face value.
      • As time to maturity decreases, bond price increases.
      • As time to maturity increases, bond price decreases.

    Characteristics of Bonds

    • Par value bond: coupon rate = YTM.
    • Discount bond: coupon rate < YTM.
    • Premium bond: coupon rate > YTM.

    Strips

    • Strips are separate trading of registered interest and principal securities.
    • Investors can sell components of their bonds.
    • Generally common in Treasury bonds.
    • The total PV of interest and principal cash flows should equal the bond's face value price.

    Arbitrage

    • If PV bond = PV of all strips: no arbitrage opportunities.
    • If PV bond > PV of all strips: arbitrage opportunities present, market is inefficient.
    • If PV bond < PV of all strips: arbitrage opportunities present, market is inefficient.

    Risks

    • Reinvestment risk: occurs when interest rates go down (bond prices are at a premium).
      • Investors can reinvest coupons at market yield.
    • Price risk: occurs when interest rates go up (bond price is low).
      • Investors are only subject to price risk if they need to sell before maturity.
    • Inflation risk: inflation causes bond prices to decrease, affecting return on bonds.
    • Liquidity risk: suffers loss if desperately needing to sell bond before maturity at a reasonable price.

    Bonds

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

    Bond Pricing and YTM

    • YTM (Yield to Maturity) reflects the market's required return on the bond.
    • If YTM is higher than the coupon rate, the bond's price drops (discount).
    • If YTM is lower than the coupon rate, the bond's price increases (premium).
    • Changes in market interest rates affect YTM:
      • When interest rates rise, YTM increases, and bond prices fall.
      • When interest rates fall, YTM decreases, and bond prices rise.

    Relationship Between YTM, Coupon Rate, and Time to Maturity

    • Premium bonds: sold at a price above face value if coupon rate is higher than YTM.
    • Discount bonds: sold at a price below face value if coupon rate is lower than YTM.
    • Characteristics of bonds:
      • Par value bond: coupon rate equals YTM.
      • Discount bond: coupon rate is less than YTM.
      • Premium bond: coupon rate is greater than YTM.

    Strips

    • Strips are separate trading of registered interest and principal securities.
    • Investors can sell components of their bonds.
    • Strips are common in Treasury bonds.
    • The total PV of interest and principal cash flows should equal the bond's face value price.

    Arbitrage

    • If PV Bond = PV of all Strips, no arbitrage opportunities are 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 (bond prices are at a premium).
    • Price risk: occurs when interest rates go up (bond price is low).
    • Inflation risk: inflation causes bond prices to decrease, ultimately decreasing the return.
    • Liquidity risk: investors suffer a loss if they need to sell their bond before maturity at a discounted price.

    Pure Expectations Theory

    • The current yield curve solely reflects investors' expectations of future short-term interest rates.
    • The theory predicts future short-term rates (forward rates) based on current long-term rates.
    • If the market anticipates short-term rates will increase (decrease) in the future, the yield curve will slope upwards (downwards).
    • Long-term interest rates are determined by the market's expectation of future short-term interest rates (forward rates).

    Yield Curve Shape

    Normal - Upward Sloping

    • Short-term yields are lower than long-term yields.
    • Long-term bonds have higher yields compared to short-term bonds.
    • An upward-sloping yield curve typically suggests that investors expect stronger economic growth and potentially higher inflation in the future.
    • Investors demand higher yields for long-term bonds to compensate for risks.
    • It indicates that market participants expect interest rates to rise in the future.

    Inverted - Downward Sloping

    • Short-term bonds have higher yields compared to long-term bonds.
    • An inverted yield curve suggests that investors expect slower economic growth or a recession in the future.
    • Investors prefer long-term bonds to lock in current yields, anticipating that interest rates will fall due to economic weakness.
    • It indicates that market participants expect interest rates to decrease in the future.

    Flat Yield Curve

    • Rarely seen, only occurs when the economy is changing.
    • A flat curve indicates a transition from an upward or downward sloping curve.

    Discount Factors/Spot Rates/Forward Rates

    • Discount Factors are determined from the market price and cashflows of a bond.
    • Spot rates are obtained from discount factors and used to create a yield curve.
    • Forward rates are market expectations of interest rates in the future.
    • Comparing forward rates to spot rates indicates what the market thinks will happen in the future.
    • Use spot rate vs forward rate curve to understand market expectations.
    • Short-term bonds have less interest rate risk, while long-term bonds are more sensitive to risk.
    • Changes in interest rates affect bond prices: up = down, and vice versa.

    Arbitrage Opportunity - Negative Rates

    • A negative rate implies mispricing.
    • Buy underpriced bonds and sell overpriced bonds to take advantage of the opportunity.

    Interest Rates

    High Interest Rates

    • Decrease in bond prices, providing an opportunity for investors.

    Low Interest Rates

    • Increase in bond price, making them more valuable.
    • The shape of the yield curve is determined by market expectations of future interest rate movements.

    Liquidity Preference Theory

    • Investors are compensated for time, but also take on more risk.
    • Reinvestment risk occurs when interest rates decrease, resulting in higher bond prices.
    • Price risk occurs when interest rates increase, resulting in lower bond prices.

    Market Segmentation Theory

    • Investors have fixed preferences and only invest in bonds with specific time frames.
    • Supply and demand shift the yield for each market segment.

    Preferred Habitat Theory

    • Investors have preferred time maturity to bonds, but may take other opportunities.
    • Preferences include investment duration, price risk, or tolerance.

    Pure Expectations Theory

    • The current yield curve solely reflects investors' expectations of future short-term interest rates.
    • The theory predicts future short-term rates (forward rates) based on current long-term rates.
    • If the market anticipates short-term rates will increase (decrease) in the future, the yield curve will slope upwards (downwards).
    • Long-term interest rates are determined by the market's expectation of future short-term interest rates (forward rates).

    Yield Curve Shape

    Normal - Upward Sloping

    • Short-term yields are lower than long-term yields.
    • Long-term bonds have higher yields compared to short-term bonds.
    • An upward-sloping yield curve typically suggests that investors expect stronger economic growth and potentially higher inflation in the future.
    • Investors demand higher yields for long-term bonds to compensate for risks.
    • It indicates that market participants expect interest rates to rise in the future.

    Inverted - Downward Sloping

    • Short-term bonds have higher yields compared to long-term bonds.
    • An inverted yield curve suggests that investors expect slower economic growth or a recession in the future.
    • Investors prefer long-term bonds to lock in current yields, anticipating that interest rates will fall due to economic weakness.
    • It indicates that market participants expect interest rates to decrease in the future.

    Flat Yield Curve

    • Rarely seen, only occurs when the economy is changing.
    • A flat curve indicates a transition from an upward or downward sloping curve.

    Discount Factors/Spot Rates/Forward Rates

    • Discount Factors are determined from the market price and cashflows of a bond.
    • Spot rates are obtained from discount factors and used to create a yield curve.
    • Forward rates are market expectations of interest rates in the future.
    • Comparing forward rates to spot rates indicates what the market thinks will happen in the future.
    • Use spot rate vs forward rate curve to understand market expectations.
    • Short-term bonds have less interest rate risk, while long-term bonds are more sensitive to risk.
    • Changes in interest rates affect bond prices: up = down, and vice versa.

    Arbitrage Opportunity - Negative Rates

    • A negative rate implies mispricing.
    • Buy underpriced bonds and sell overpriced bonds to take advantage of the opportunity.

    Interest Rates

    High Interest Rates

    • Decrease in bond prices, providing an opportunity for investors.

    Low Interest Rates

    • Increase in bond price, making them more valuable.
    • The shape of the yield curve is determined by market expectations of future interest rate movements.

    Liquidity Preference Theory

    • Investors are compensated for time, but also take on more risk.
    • Reinvestment risk occurs when interest rates decrease, resulting in higher bond prices.
    • Price risk occurs when interest rates increase, resulting in lower bond prices.

    Market Segmentation Theory

    • Investors have fixed preferences and only invest in bonds with specific time frames.
    • Supply and demand shift the yield for each market segment.

    Preferred Habitat Theory

    • Investors have preferred time maturity to bonds, but may take other opportunities.
    • Preferences include investment duration, price risk, or tolerance.

    Macaulay's Duration

    • Measures a bond's price sensitivity to changes in interest rates (yields)
    • Duration increases as Time to Maturity (TTM) increases, exposing the bond to more price risk
    • Properties:
      • Less than or equal to TTM
      • Higher for bonds with lower coupon rates (all else equal)
      • Higher for bonds with lower Yield to Maturity (YTM) (all else equal)
      • Higher for bonds with higher TTM (all else equal)

    Modified Duration

    • Adjusts Macaulay's Duration for a bond's yield
    • Represents a percentage change in a bond's price
    • Example: Dmod of 2.23 means a 1% increase (decrease) in yield results in a 2.23% decrease (increase) in bond price

    Implications of Duration

    • Positive relationship between duration and price sensitivity to interest rate changes
    • Positive relationship between TTM and duration
    • Negative relationship between coupon rate and duration
    • Two bonds with the same modified duration have the same percentage price change sensitivity to yields
    • Duration represents a negative linear relationship, with small changes having little impact but larger changes affecting the yield curve

    Convexity

    • Measures the sensitivity of a bond's duration to changes in interest rates
    • Captures the non-linear relationship between a bond's price and yield
    • Properties:
      • Higher for bonds with lower coupon rates (all else equal)
      • Higher for bonds with lower YTM (all else equal)
      • Higher for bonds with higher TTM (all else equal)
    • Convexity accounts for the curvature of the yield curve, providing a more accurate estimate of price changes
    • The more convexity, the less price change when yields increase, and more price change when yields decrease

    Summary of Duration and Convexity

    • Duration and Convexity have a positive relationship
    • Convexity is desirable, as it provides more gains when yields decrease and less losses when yields increase
    • Duration increases interest rate risk, while convexity reduces it
    • To achieve more convexity, one must invest in longer bonds, which increases duration.

    Macaulay's Duration

    • Measures a bond's price sensitivity to changes in interest rates (yields)
    • Duration increases as Time to Maturity (TTM) increases, exposing the bond to more price risk
    • Properties:
      • Less than or equal to TTM
      • Higher for bonds with lower coupon rates (all else equal)
      • Higher for bonds with lower Yield to Maturity (YTM) (all else equal)
      • Higher for bonds with higher TTM (all else equal)

    Modified Duration

    • Adjusts Macaulay's Duration for a bond's yield
    • Represents a percentage change in a bond's price
    • Example: Dmod of 2.23 means a 1% increase (decrease) in yield results in a 2.23% decrease (increase) in bond price

    Implications of Duration

    • Positive relationship between duration and price sensitivity to interest rate changes
    • Positive relationship between TTM and duration
    • Negative relationship between coupon rate and duration
    • Two bonds with the same modified duration have the same percentage price change sensitivity to yields
    • Duration represents a negative linear relationship, with small changes having little impact but larger changes affecting the yield curve

    Convexity

    • Measures the sensitivity of a bond's duration to changes in interest rates
    • Captures the non-linear relationship between a bond's price and yield
    • Properties:
      • Higher for bonds with lower coupon rates (all else equal)
      • Higher for bonds with lower YTM (all else equal)
      • Higher for bonds with higher TTM (all else equal)
    • Convexity accounts for the curvature of the yield curve, providing a more accurate estimate of price changes
    • The more convexity, the less price change when yields increase, and more price change when yields decrease

    Summary of Duration and Convexity

    • Duration and Convexity have a positive relationship
    • Convexity is desirable, as it provides more gains when yields decrease and less losses when yields increase
    • Duration increases interest rate risk, while convexity reduces it
    • To achieve more convexity, one must invest in longer bonds, which increases duration.

    Studying That Suits You

    Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

    Quiz Team

    Description

    Learn about the concept of relative valuation, its advantages, and how it's used to compare asset prices in the market. Understand the median preference in relative valuation and its applications.

    More Like This

    Relative Valuation in Finance
    18 questions

    Relative Valuation in Finance

    AppreciableCarnelian23 avatar
    AppreciableCarnelian23
    Relative Valuation in Finance
    70 questions

    Relative Valuation in Finance

    TimeHonoredYtterbium avatar
    TimeHonoredYtterbium
    Relative Valuation and Bond Pricing
    60 questions

    Relative Valuation and Bond Pricing

    TimeHonoredYtterbium avatar
    TimeHonoredYtterbium
    Relative Valuation Concepts
    39 questions

    Relative Valuation Concepts

    SumptuousSakura5976 avatar
    SumptuousSakura5976
    Use Quizgecko on...
    Browser
    Open
    Browser
    Browser