Fixed Income Markets Quiz

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Questions and Answers

What happens to the price of a bond as its time-to-maturity approaches zero?

The price decreases to zero

The price fluctuates randomly

The price becomes less than par value

The price increases to par value (correct)

What is the difference between the flat price and full price of a bond?

Full price is always higher than flat price by a constant amount

Flat price includes accrued interest, while full price does not

Flat price is the quoted price excluding accrued interest, while full price includes it (correct)

There is no distinction between flat price and full price

Which method is commonly used for counting days in corporate bonds?

Actual/365

30/365

30/360 (correct)

Actual/actual

What describes the 'pull to par' effect?

The tendency of a bond price to move towards its par value as maturity approaches Signup and view all the answers

What is the primary reason for the difference between clean price and dirty price in bond trading?

The presence of accrued interest Signup and view all the answers

What is the primary purpose of accrued interest in bond transactions?

To cover the coupon the seller earned but has not yet received. Signup and view all the answers

In matrix pricing, which factors must comparable bonds share?

Maturities, coupon rates, and credit quality. Signup and view all the answers

How is the yield on a fixed-rate bond with a maturity of less than one year typically expressed?

Annualized but not compounded. Signup and view all the answers

When calculating the full price of a bond, what components are included?

Flat price plus accrued interest. Signup and view all the answers

What method is utilized in matrix pricing to estimate the price of illiquid bonds?

Using the average yield of comparable traded bonds. Signup and view all the answers

What is the relationship between coupon rates and bond pricing in matrix pricing?

Similar coupon rates help derive accurate prices. Signup and view all the answers

Which of the following is true about the yield measures for fixed-rate bonds with maturities greater than one year?

They are expressed as annualized and compounded yields. Signup and view all the answers

What is the key benefit of using matrix pricing for illiquid bonds?

It provides a method to estimate market discount rates. Signup and view all the answers

What does the implied forward rate represent?

Market expectations of future short-term interest rates Signup and view all the answers

How is the implied forward rate calculated?

From the relationship between different spot rates Signup and view all the answers

What role do yield spreads play in fixed-income security analysis?

They help investors understand changes in bond prices and yields-to-maturity Signup and view all the answers

What does a credit curve illustrate?

Changes in an issuer's credit spreads across different maturities Signup and view all the answers

Which of the following best describes benchmark yield?

A base rate often linked to government bond yields Signup and view all the answers

Why might forward rates be used instead of spot rates in bond valuation?

They can be derived from spot rates and offer alternative valuation methods Signup and view all the answers

What is primarily reflected by credit spreads?

The additional yield required for credit risk compensation Signup and view all the answers

Which factor does benchmark yield NOT typically reflect?

Customer preferences for bond types Signup and view all the answers

What does the yield curve represent?

The relationship between yield and time to maturity for bonds of the same quality. Signup and view all the answers

Which type of yield curve typically indicates expectations of future interest rate increases?

Normal Yield Curve Signup and view all the answers

What is a par curve in bond valuation?

A sequence of yields-to-maturity where each bond is priced at par value. Signup and view all the answers

Which statement accurately defines forward rates?

Forward rates represent future expected interest rates implied by current spot rates. Signup and view all the answers

What is typically a characteristic of an inverted yield curve?

Shorter-term yields are higher than longer-term yields. Signup and view all the answers

How are spot rates used in bond pricing?

Spot rates are applied to discount each cash flow to determine the bond's price. Signup and view all the answers

What is the importance of understanding the shape of the yield curve?

To gauge market expectations regarding future economic conditions and interest rate movements. Signup and view all the answers

Which of the following factors does NOT influence the shape of yield curves?

Investor's personal income level Signup and view all the answers

What is the primary characteristic of money market instruments?

They are short-term debt securities. Signup and view all the answers

What differentiates the discount rate from the add-on rate in money market instruments?

The discount rate deducts interest from the face value at issuance. Signup and view all the answers

Why is it important to convert between discount rates and add-on rates?

To make accurate yield comparisons between different instruments. Signup and view all the answers

What does the term 'spot rates' refer to in bond pricing?

The yields on zero-coupon bonds maturing at specific dates. Signup and view all the answers

What is no-arbitrage pricing in the context of bond valuation?

Calculating prices to avoid arbitrage opportunities. Signup and view all the answers

Which of the following instruments typically uses an add-on rate for interest calculation?

Certificates of deposit (CDs) Signup and view all the answers

What is the implication of using discount rates in money market instruments?

They understate the true yield compared to add-on rates. Signup and view all the answers

How do money market instruments differ from long-term debt securities?

Money market instruments have shorter maturities and use simple interest yields. Signup and view all the answers

Study Notes

Flat Price, Accrued Interest and Full Price

In fixed income markets, the quoted price (flat price) is the clean price without accrued interest.
The price paid for a bond is the full price which is the flat price plus accrued interest.
Accrued interest is the interest earned by the seller but not yet received.
Accrued interest is calculated using the following formulas:
- Days in accrued period / Days in coupon period * Coupon payment
- Accrued Interest Formula: Accrued Interest = (Days in accrued period / Days in coupon period) * Coupon payment.
30/360 used for corporate bonds, Actual/Actual used for government bonds when calculating accrued interest.

Matrix Pricing

Matrix pricing is a method to estimate the price of illiquid or newly issued bonds.
This method uses the quoted prices of comparable bonds, taking into account maturities, coupon rates, and credit quality.
The average yield is calculated from comparable bonds and used to price the illiquid bond.

Yield Measures for Fixed-Rate Bonds

Yield measures are standardized to compare bonds with varying maturities.
For maturities greater than 1 year, annualized and compounded yield-to-maturity is used.
For maturities less than 1 year, the yield is annualized but not compounded.

Constant-Yield Price Trajectory

The constant-yield price trajectory illustrates the change in the price of a bond over time.
This trajectory shows how the price of a bond approaches par value as maturity approaches zero.

Money Market Instruments

Money market instruments are short-term debt securities with maturities ranging from overnight to a year.
Money market instruments use simple interest yield measures (unlike bonds).
There are two main types of interest rates:
- Discount Rate: Interest is deducted from face value at issuance.
- Add-On Rate: Interest is added to the principal at maturity.
Discount rates understate the true yield compared to add-on rates for the same instrument.

Spot Rates, Yield Curves, and Forward Rates

Spot rates are zero-coupon bond yields for specific maturities. These are used for no-arbitrage pricing.
Yield curves display the relationship between yield to maturity and bond quality.
- Normal Yield Curve: Longer-term yields are higher than shorter-term yields.
- Inverted Yield Curve: Shorter-term yields are higher than longer-term yields (often seen as a predictor of recession).
- Flat Yield Curve: Similar yields across all maturities.
Forward rates are implied future interest rates derived from current spot rates. These are essential for understanding market expectations of future interest rate movements.
Implied forward rate links the return on a shorter-term zero-coupon bond to the return on a longer-term zero-coupon bond.
Bonds can be valued using the forward curve.

Yield Spreads

Credit spreads are the additional yield required to compensate investors for credit risk. These differ across credit ratings and maturities.
Credit Curve demonstrates an issuer’s credit spreads across different maturities.
Yield Spreads Over Benchmark Rates: Yield spreads are crucial for understanding fixed-income security analysis. Benchmark yields are typically government bond yields reflecting macroeconomic factors such as inflation and economic growth.

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Description

Test your knowledge on flat price, accrued interest, and matrix pricing in fixed income markets. This quiz covers essential concepts such as clean price, full price, and the methods for estimating the price of bonds. Understanding these topics is crucial for anyone involved in bond investing.