56 Questions
Why is the median preferred over the mean in relative valuation?
Because the median is a more reliable comparison point unaffected by extreme outliers or non-symmetric distributions
What is a potential issue in relative valuation when selecting comparables?
The comparable companies may differ significantly in scale and size
What is the primary purpose of a pro forma in finance?
To make assumptions and projections of financial results
What is the main goal of relative valuation?
To determine whether an asset is under or overvalued relative to its comparable group
Which of the following is a weakness of top-down analysis?
It can overlook firm-specific factors
What is a potential issue with non-linear regression in relative valuation?
It assumes a linear relationship between the multiple and its fundamentals
What is the primary benefit of relative valuation?
It is quicker and requires fewer assumptions about the future
What is the main benefit of convertible bonds?
They can be converted into a predetermined number of stocks in the future
What happens to the price of a bond when market interest rates rise?
The price of the bond decreases
What is the primary difference between top-down analysis and bottom-up analysis?
Top-down analysis starts with the overall economy, while bottom-up analysis starts with a specific company
What is the primary advantage of using relative valuation in investment decisions?
It is easier to justify investment decisions using relative valuation
What is the relationship between YTM, coupon rate, and time to maturity?
As YTM increases, bond price decreases, and time to maturity increases
What is a characteristic of a callable bond?
The issuer can buy it back from the investor
What is the primary weakness of bottom-up analysis?
It takes more time to analyze individual companies
What is the primary purpose of standardizing prices in relative valuation?
To create price multiples for comparison
What is the main difference between a Treasury bond and a Municipal bond?
The issuer of the bond, federal government versus state government
Why is relative valuation more likely to reflect market perceptions and moods?
Because it is based on market prices, which reflect market perceptions and moods
What happens to the bond price when the market requires a lower return than the bond's coupon rate?
The bond price increases
When the yield to maturity (YTM) of a bond increases, what happens to the bond's price?
The bond price decreases
What is the main characteristic of a premium bond?
Coupon rate is greater than YTM
What is the result of arbitrage opportunities in the bond market?
The market is inefficient, and the securities are priced incorrectly
What is the relationship between price risk and reinvestment risk?
They are negatively related
What happens to bond prices when interest rates increase?
Bond prices decrease
What is the assumption of the Pure Expectations Theory?
The current yield curve reflects investors' expectations of future short-term interest rates
What is the typical shape of the yield curve when investors expect stronger economic growth and higher inflation in the future?
Normal
What is the main characteristic of a strip?
A separate trading of registered interest and principal securities
What is the effect of inflation on bond prices?
Inflation causes bond prices to decrease
What type of risk is associated with selling a bond before maturity at a reasonable price?
Liquidity risk
What is indicated by a flat yield curve?
Market participants expect interest rates to decrease in the future
What is the purpose of comparing forward rates to spot rates?
To determine the market expectations of interest rates in the future
What happens to bond prices when interest rates increase?
Bond prices decrease
What is the implication of a negative forward rate?
There is an arbitrage opportunity
According to the liquidity preference theory, what is the compensation for investors for taking more risk?
Extra return for longer-term investments
What is the relationship between Macaulay's duration and the time to maturity of a bond?
Dmac is directly proportional to TTM
What is the effect of an increase in yield on the duration of a bond?
Duration decreases
What is the purpose of modified duration?
To determine the percentage change in a bond's price due to a change in yield
What is the main difference between Macaulay's duration and modified duration?
Dmac is unadjusted, while Dmod is adjusted for yield
What is the preferred habitat theory related to?
Investors' preference for bond duration
What happens to the bond's price when you sell it before maturity and yields are stable?
It increases
What is the benefit of 'riding the yield curve down'?
Benefiting from the higher yields associated with the longer TTM
What is the primary advantage of a Barbell strategy?
Protection against short-term rates increasing
What happens to the bond's TTM as you hold it?
It decreases
What is the primary characteristic of a Bullet strategy?
Investing in bonds with similar maturity dates
What is the primary difference between a Barbell and a Bullet strategy?
Investing in bonds with different maturities vs. similar maturities
What is the primary advantage of a Butterfly strategy?
Combining a Bullet and a Barbell strategy
What is the assumption in a Barbell strategy regarding interest rates?
Interest rates will increase
What is the relationship between a bond's duration and its price sensitivity to interest rate changes?
Positive relationship
What happens to a bond's duration when the coupon rate increases, assuming all else is equal?
Duration decreases
What is the primary purpose of convexity in bond analysis?
To capture the non-linear relationship between a bond's price and yield
Which of the following statements is true about convexity?
Convexity is higher for bonds with higher TTM
What is the approximate percentage change in a bond's modified duration for every 1% increase in yield?
0.5%
What is the primary advantage of an active trading strategy in bond investing?
It allows investors to forecast yield curve changes
What is the primary goal of a duration management strategy?
To modify the portfolio's duration based on forecasted changes in interest rates
What is the primary condition required for a rollover strategy to be successful?
Interest rates are forecast to increase
What is the primary advantage of a riding the yield curve strategy?
It allows investors to benefit from decreasing interest rates
What is the primary condition required for a riding the yield curve strategy to be successful?
The yield curve is upward sloping
Study Notes
Topic 5: Pro Forma and Top-Down/BOTTOM-UP Analysis
- Pro forma: used to make assumptions and projections of financial results.
- Top-down analysis:
- Start looking at overall economy, then gradually work on a specific company.
- Strengths: comprehensive holistic view of market and macroeconomic factors, useful in incorporating industry trends, economic factors, and market dynamics.
- Weaknesses: easy to overlook firm-specific factors affecting valuation of company.
- Bottom-up analysis:
- Start looking at specific firm/company, then gradually work on overall economy.
- Strengths: comprehensive analysis of individual companies, focus on firm-specific fundamentals, competitive positioning, growth aspects, and financial performance.
- Weaknesses: takes more time, may have delays in missing out on returns.
Topic 7: Relative Valuation
- Relative valuation: compares price of an asset to prices assessed by the market for similar or comparable assets.
- Why relative valuation is popular:
- Easier to justify buying or selling decisions using relative valuation.
- Faster and requires fewer assumptions about the future compared to discounted cash flow valuation.
- Issues in relative valuation:
- Choice of comparable: selecting appropriate comparable is subjective and can significantly affect valuation.
- Market conditions: market conditions can influence prices of comparable.
- Differences in growth rates: companies or assets with different growth rates may be compared.
Topic 8: Bonds
- Bonds:
- Raise long-term capital issued by corporations and governments.
- Investor pays initial cost (price) and receives coupon (interest) periodically, then face value at maturity.
- Types of bonds:
- Zero-coupon bond: no coupon payments, only face value at maturity.
- Convertible bond: can be converted into a predetermined number of shares in the future.
- Indexed bond: coupon is related to movements in inflation.
- Callable bond: seller can buy back the bond from the investor in the future.
- Perpetual bond: lasts forever.
- Treasury bond: issued by federal government.
- Municipal bond: issued by state government or government agencies.
- Bond pricing and YTM:
- YTM reflects the market's required return on the bond.
- If market requires a higher return than the bond's coupon rate, the bond's price will drop (discount).
- If market requires a lower return than the bond's coupon rate, the bond's price will increase (premium).
Topic 9: Pure Expectations Theory and Yield Curve
- Pure Expectations Theory:
- Assumes current yield curve reflects investors' expectations of future short-term interest rates.
- Predicts future short-term rates (forward rates) based on current long-term rates.
- Yield curve shapes:
- Normal (upward sloping): short-term yields are lower than long-term yields, indicating economic growth and higher inflation expectations.
- Inverted (downward sloping): short-term yields are higher than long-term yields, indicating slower economic growth or recession expectations.
- Flat: rarely seen, indicating a change in economy.
Topic 10: Duration and Convexity
- Macaulay's Duration:
- Measures sensitivity of a bond's price to changes in interest rates.
- Properties: Dmac ≤ TTM, higher for bonds with lower Crate and YTM, higher for bonds with higher TTM.
- Modified Duration:
- Represents a percentage change in a bond's price.
- Properties: positive relationship with TTM, negative relationship with coupon rate and YTM.
- Convexity:
- Measures sensitivity of a bond's duration to changes in interest rates.
- Properties: higher for bonds with lower Crate, lower YTM, and higher TTM.
Topic 11: Active and Passive Trading Strategies
- Active trading strategies:
- Require forecasting yield curve changes or divestment depending on the prediction.
- Passive trading strategies:
- Little effort required from the investor, aiming to buy and hold bonds until maturity.
- Duration management:
- Increase or decrease portfolio duration based on forecasted changes in rates.
This quiz covers the concept of pro forma analysis in finance, including its use in making assumptions and projections of financial results, and the top-down approach to analysis. It also explores the strengths and weaknesses of this method.
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