Fixed Income Instruments Overview
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Questions and Answers

What does the yield curve allow investors to determine about bonds?

  • The duration of a bond's cash flow
  • The relative pricing of other bonds of different classes
  • The implied return from a given investment (correct)
  • The fixed cash flows of all bonds

Which of the following statements about floating rate bonds is true?

  • The coupon value is influenced by market interest rates (correct)
  • You know the full cash flow schedule upon purchase
  • They have a variable maturity date
  • The coupon payments are fixed for the life of the bond

How is the price of a floating rate bond generally affected at reset dates?

  • It decreases below par value
  • It will generally be close to par value (correct)
  • It begins to reflect future interest rate movements
  • It remains unaffected by market interest rates

What does the term 'interest-rate risk' primarily refer to for floating rate bonds?

<p>The risk related to the next coupon payment (D)</p> Signup and view all the answers

Which part of the cash flow for a floating rate bond changes based on market conditions?

<p>The variable part of the coupon (D)</p> Signup and view all the answers

What primarily determines the term spread between long-term and short-term interest rates?

<p>Expected future inflation and economic growth (B)</p> Signup and view all the answers

How is the duration of a portfolio containing a spread and a zero-spread floater calculated?

<p>By using the weighted sum of each component's duration (B)</p> Signup and view all the answers

What condition would cause the yield curve to be nearly flat?

<p>Investors/borrowers show no concern about the maturity of bonds (A)</p> Signup and view all the answers

What does an upward-sloping yield curve generally indicate regarding future interest rates?

<p>Future interest rates are expected to be higher than current rates (B)</p> Signup and view all the answers

What does the yield to maturity (YTM) of a bond represent?

<p>The expected fixed rate of return if the bond is held to maturity (D)</p> Signup and view all the answers

What does the dirty price of a bond include?

<p>The full price including accrued interest from the last coupon (C)</p> Signup and view all the answers

What role do government bonds play in constructing a reliable yield curve?

<p>They are highly liquid and available in various forms (B)</p> Signup and view all the answers

Which statement is true about the clean price of a bond?

<p>It is the price quoted in the market, excluding accrued interest (A)</p> Signup and view all the answers

Under what conditions can YTM be considered accurate?

<p>If the bond is held until maturity and no payments default (C)</p> Signup and view all the answers

What is needed to compute the present value of cash flows for a bond?

<p>The cost of capital or discount rate to apply (A)</p> Signup and view all the answers

What is a bull-spread strategy primarily used for?

<p>To profit from a substantial increase in stock price (C)</p> Signup and view all the answers

In which scenario would creating a short straddle be most profitable?

<p>When expecting stable stock prices (C)</p> Signup and view all the answers

What effect do increasing interest rates have on the prices of call and put options?

<p>Call option prices increase while put option prices decrease (D)</p> Signup and view all the answers

What is the primary purpose of hedging with a put option?

<p>To protect against downside risk of an asset (B)</p> Signup and view all the answers

Which strategy involves buying both a call and a put with the same strike price?

<p>Straddle (A)</p> Signup and view all the answers

In an interest rate swap, what type of payments does party A make to party B?

<p>Fixed rate payments (C)</p> Signup and view all the answers

What is the primary risk associated with the payments in an interest rate swap after the first payment date?

<p>Uncertainty due to changing LIBOR rates (A)</p> Signup and view all the answers

In a currency rate swap, what does party A do?

<p>Makes payments in one currency to party B (A)</p> Signup and view all the answers

What characterizes a commodity swap?

<p>Payments depend on the price of an underlying commodity (B)</p> Signup and view all the answers

What is a feature of European options compared to American options?

<p>They can only be exercised at expiration (C)</p> Signup and view all the answers

Which of the following statements about the payoff of an option is true?

<p>The payoff corresponds to the underlying asset's price at expiration (C)</p> Signup and view all the answers

What is the right granted by a call option?

<p>To purchase the underlying asset at a predetermined price (C)</p> Signup and view all the answers

What differentiates an American option from a European option?

<p>American options allow for exercise on or before expiration (A)</p> Signup and view all the answers

What type of securities are backed by loans such as auto loans and student loans?

<p>Asset-Backed Securities (ABS) (A)</p> Signup and view all the answers

Which of the following describes a Collateralized Debt Obligation (CDO)?

<p>A structured product pooling various types of debt into tranches (C)</p> Signup and view all the answers

What is the main characteristic of preferred stocks?

<p>They provide fixed dividends and predictable income streams. (D)</p> Signup and view all the answers

Which type of bonds offers protection against inflation by adjusting principal and interest payments?

<p>Inflation-Linked Bonds (C)</p> Signup and view all the answers

What best describes Floating Rate Notes (FRNs)?

<p>Bonds that have variable interest rates tied to benchmarks. (C)</p> Signup and view all the answers

What differentiates Eurobonds from Foreign Bonds?

<p>Eurobonds are issued in a currency other than the country of issue. (C)</p> Signup and view all the answers

What is the nature of Zero-Coupon Bonds?

<p>They are issued at a discount and mature at par. (C)</p> Signup and view all the answers

Which of the following best describes Convertible Bonds?

<p>Bonds that can be converted into fixed amounts of company's equity shares. (A)</p> Signup and view all the answers

Flashcards

Bond's Value

The present value of all future cash flows generated by a bond, representing its fair market price.

Yield to Maturity (YTM)

The annualized rate of return an investor can expect to receive if they hold a bond until maturity, assuming all payments are made on time.

Face Value

The amount a bondholder will receive at the bond's maturity date.

Dirty Price

The full price of a bond, including accrued interest, paid by a buyer between coupon dates.

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Clean Price

The price of a bond quoted on an exchange, excluding accrued interest, for a bond traded between coupon dates.

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Asset-Backed Securities (ABS)

Securities backed by loans other than mortgages, like auto loans, credit cards, or student loans.

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Collateralized Debt Obligations (CDOs)

Complex products that pool various types of debt, categorize them by risk, and create tranches with different yields.

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Preferred Stocks

Corporate stocks that offer predictable income streams through fixed dividends, similar to bonds.

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Convertible Bonds

Bonds that can be converted into company shares at a predetermined ratio.

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Inflation-Linked Bonds

Bonds where the principal and interest payments are adjusted for inflation, like TIPS.

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Floating Rate Notes (FRNs)

Bonds with variable interest rates tied to a benchmark rate.

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Foreign Bonds

Bonds issued by a foreign entity in a domestic market.

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Eurobonds

Bonds issued in a currency different from the issuer's country.

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Yield Curve Pricing

Using the yield curve to determine the present value of future cash flows from a bond, discounting each cash flow at a different rate based on its maturity.

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Floating-Rate Bond

A bond with a variable coupon that resets periodically based on a reference rate (usually LIBOR) plus a fixed spread.

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Reset Date

The date when a floating-rate bond's coupon rate is reset based on the current reference rate.

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Spread (Floating-Rate Bond)

A fixed percentage added to the reference rate to determine the floating-rate bond's coupon rate.

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Interest-Rate Risk (Floating-Rate Bonds)

The risk that changes in interest rates will affect the value of a floating-rate bond, primarily in the period before the next coupon payment.

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Term Spread

The difference between long-term and short-term interest rates. Long-term interest rates are usually higher than short-term rates, so the term spread is typically positive.

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Yield Curve

A curve that shows the relationship between interest rates and their time to maturity. It depicts how interest rates vary for bonds with different maturity dates.

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Upward-Sloping Yield Curve

When interest rates are higher for longer maturities. This typically indicates investors expect higher future interest rates.

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Why is the yield curve rarely flat?

Investors and borrowers care about the maturity of bonds because they anticipate changes in the economy (inflation, growth, etc.), have different risk attitudes, and hold different types of assets.

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Interest Rate Swap

An agreement where two parties exchange fixed and floating interest rate payments on a notional principal for a set period.

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LIBOR

The average interest rate offered by major global banks on interbank deposits. It's used as a benchmark for floating interest rates.

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Currency Rate Swap

An agreement where two parties exchange payments in different currencies for a set period.

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Commodity Swap

An agreement where two parties exchange fixed payments for payments based on the price of a commodity.

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Call Option

A right to purchase an asset at a specific price (exercise price) on or before a specific date.

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Put Option

A right to sell an asset at a specific price (exercise price) on or before a specific date.

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European Option

An option that can only be exercised on the expiration date.

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American Option

An option that can be exercised on or before the expiration date.

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What is a bull-spread?

A trading strategy using options where you buy a call option with a lower strike price (K1) and sell a call option with a higher strike price (K2). This strategy profits when the underlying asset price rises significantly.

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What is a bear-spread?

The opposite of a bull-spread. You buy a call option with a higher strike price (K2) and sell a call option with a lower strike price (K1). This benefits when the underlying asset price falls.

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What is a straddle?

An options trading strategy where you buy both a call and a put option with the same strike price (K), close to the current price of the underlying asset. You profit if the price moves significantly in either direction.

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What is a short (naked) straddle?

The opposite of a straddle. You sell both a call and a put option with the same strike price (K), close to the current asset price. You profit if the price stays stable, as both options expire worthless.

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How does interest rate affect call and put options?

An increase in interest rate increases the price of a call option and decreases the price of a put option. This is because the higher the interest rate, the lower the present value of the strike price, which is the cost of exercising the option.

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Study Notes

Fixed Income Instruments

  • Fixed income refers to investments that pay fixed interest or dividends until maturity, returning the principal at maturity.
  • Examples include bonds (government, corporate, municipal), Treasury bills, certificates of deposit (CDs), and fixed-rate preferred stocks.
  • Fixed income security markets help determine interest rates and prices of other securities.

Characteristics of Fixed Income Instruments

  • Regular Income: Investors receive fixed or variable payments at regular intervals (monthly, semi-annually, annually).
  • Principal Repayment: The instrument's face value is returned at maturity.
  • Lower Risk: Compared to equities, fixed-income investments generally offer less risk due to steady cash flows and priority in liquidation.
  • Credit Risk: The risk that the issuer may default on its obligations. Higher credit quality (e.g., government bonds) typically means lower risk but also lower returns.

Risks Associated with Fixed Income

  • Interest Rate Risk: The value of a fixed-income investment can decline as interest rates rise, impacting the price of existing bonds.
  • Credit Risk: The risk that the issuer will default on interest payments or fail to return the principal.
  • Inflation Risk: Inflation can decrease the purchasing power of future interest payments and principal repayments.
  • Reinvestment Risk: Reinvesting interest or principal payments may result in lower returns compared to the initial investment's yield.

Active and Passive Management

  • Active Management: Outperforming the market using strategies like duration management, credit selection, and yield curve positioning.
  • Passive Management: Replicating the performance of a fixed-income index, emphasizing low cost and broad exposure.

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UE 2 - Capital Markets and Financial Instruments PDF

Description

Explore the fundamentals of fixed income instruments, including their characteristics, types, and the risks involved. This quiz covers various aspects such as regular income, principal repayment, and the differences in risk profiles between these investments and equities.

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