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Questions and Answers
What is the purpose of standardising prices in relative valuation?
What is the purpose of standardising prices in relative valuation?
What happens to the bond price when the yield to maturity decreases?
What happens to the bond price when the yield to maturity decreases?
What type of risk occurs when interest rates go down and bond prices are at a premium?
What type of risk occurs when interest rates go down and bond prices are at a premium?
What happens to the bond price when interest rates go up?
What happens to the bond price when interest rates go up?
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According to the Pure Expectations Theory, what do current long-term rates predict?
According to the Pure Expectations Theory, what do current long-term rates predict?
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What type of risk is an investor subject to if they need to sell their bond before maturity?
What type of risk is an investor subject to if they need to sell their bond before maturity?
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According to the Pure Expectations Theory, what is the primary factor that determines long-term interest rates?
According to the Pure Expectations Theory, what is the primary factor that determines long-term interest rates?
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Which of the following statements is true about an upward-sloping yield curve?
Which of the following statements is true about an upward-sloping yield curve?
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What is the primary assumption of the Liquidity Preference Theory?
What is the primary assumption of the Liquidity Preference Theory?
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What is the relationship between a bond's duration and its price sensitivity to interest rate changes?
What is the relationship between a bond's duration and its price sensitivity to interest rate changes?
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What is the relationship between a bond's Time to Maturity (TTM) and its duration?
What is the relationship between a bond's Time to Maturity (TTM) and its duration?
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According to Macaulay's Duration, what happens to a bond's price when interest rates increase?
According to Macaulay's Duration, what happens to a bond's price when interest rates increase?
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What is the primary purpose of convexity in bond analysis?
What is the primary purpose of convexity in bond analysis?
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What happens to a bond's duration when yields decrease?
What happens to a bond's duration when yields decrease?
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What is the relationship between convexity and duration?
What is the relationship between convexity and duration?
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What is the effect of higher convexity on a bond's price?
What is the effect of higher convexity on a bond's price?
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Which of the following bonds has higher convexity, all else equal?
Which of the following bonds has higher convexity, all else equal?
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What is the effect of increasing time to maturity on a bond's convexity?
What is the effect of increasing time to maturity on a bond's convexity?
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When does the barbell strategy tend to outperform the bullet strategy?
When does the barbell strategy tend to outperform the bullet strategy?
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What is the benefit of having higher convexity in a bond portfolio?
What is the benefit of having higher convexity in a bond portfolio?
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Which of the following is NOT a characteristic of an upward-sloping yield curve?
Which of the following is NOT a characteristic of an upward-sloping yield curve?
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According to the Market Segmentation Theory, what determines the yield for each market segment?
According to the Market Segmentation Theory, what determines the yield for each market segment?
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What is the relationship between a bond's Macaulay's Duration and its Time to Maturity (TTM)?
What is the relationship between a bond's Macaulay's Duration and its Time to Maturity (TTM)?
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According to the Preferred Habitat Theory, what determines an investor's preference for a particular bond?
According to the Preferred Habitat Theory, what determines an investor's preference for a particular bond?
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What is the primary implication of Macaulay's Duration?
What is the primary implication of Macaulay's Duration?
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What is the key difference between the Liquidity Preference Theory and the Market Segmentation Theory?
What is the key difference between the Liquidity Preference Theory and the Market Segmentation Theory?
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What is the primary reason why convexity is higher for bonds with lower YTM, all else equal?
What is the primary reason why convexity is higher for bonds with lower YTM, all else equal?
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What is the implication of a bond having a higher duration and higher convexity?
What is the implication of a bond having a higher duration and higher convexity?
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When does the bullet strategy tend to outperform the barbell strategy?
When does the bullet strategy tend to outperform the barbell strategy?
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What is the effect of an increase in time to maturity on a bond's duration and convexity?
What is the effect of an increase in time to maturity on a bond's duration and convexity?
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What is the primary advantage of having higher convexity in a bond portfolio?
What is the primary advantage of having higher convexity in a bond portfolio?
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Which of the following statements is true about the relationship between a bond's duration and convexity?
Which of the following statements is true about the relationship between a bond's duration and convexity?
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What is the primary reason why convexity is important in bond analysis?
What is the primary reason why convexity is important in bond analysis?
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What is the implication of a bond having a lower yield to maturity, all else equal?
What is the implication of a bond having a lower yield to maturity, all else equal?
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What is the primary impact of a decrease in yield to maturity on an investor's effective annual return?
What is the primary impact of a decrease in yield to maturity on an investor's effective annual return?
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Which type of risk is an investor exposed to when interest rates rise and bond prices are low?
Which type of risk is an investor exposed to when interest rates rise and bond prices are low?
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According to the Pure Expectations Theory, what do investors' expectations of future short-term interest rates reflect?
According to the Pure Expectations Theory, what do investors' expectations of future short-term interest rates reflect?
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What is the impact of inflation on bond prices and returns?
What is the impact of inflation on bond prices and returns?
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What happens to a bond's price when time to maturity increases?
What happens to a bond's price when time to maturity increases?
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What is the primary consequence of being unable to liquidate a bond at a reasonable price due to high yields and low bond prices?
What is the primary consequence of being unable to liquidate a bond at a reasonable price due to high yields and low bond prices?
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If the market expects short-term rates to increase in the future, what shape will the yield curve take?
If the market expects short-term rates to increase in the future, what shape will the yield curve take?
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According to the Liquidity Preference Theory, what do investors receive extra compensation for?
According to the Liquidity Preference Theory, what do investors receive extra compensation for?
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What is the primary implication of Macaulay's Duration?
What is the primary implication of Macaulay's Duration?
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According to the Market Segmentation Theory, what determines the yield for each market segment?
According to the Market Segmentation Theory, what determines the yield for each market segment?
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What is the relationship between a bond's Time to Maturity (TTM) and its duration?
What is the relationship between a bond's Time to Maturity (TTM) and its duration?
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What does an upward-sloping yield curve typically suggest about the expectations of market participants?
What does an upward-sloping yield curve typically suggest about the expectations of market participants?
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What is the relationship between convexity and a bond's price sensitivity to interest rate changes?
What is the relationship between convexity and a bond's price sensitivity to interest rate changes?
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What is the effect of an increase in time to maturity on a bond's duration and convexity?
What is the effect of an increase in time to maturity on a bond's duration and convexity?
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When does the barbell strategy tend to outperform the bullet strategy?
When does the barbell strategy tend to outperform the bullet strategy?
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What is the primary advantage of having higher convexity in a bond portfolio?
What is the primary advantage of having higher convexity in a bond portfolio?
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Which bond has higher convexity, all else equal?
Which bond has higher convexity, all else equal?
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What is the primary implication of Macaulay's Duration?
What is the primary implication of Macaulay's Duration?
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What is the effect of higher convexity on a bond's price when yields decrease?
What is the effect of higher convexity on a bond's price when yields decrease?
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What is the relationship between convexity and duration?
What is the relationship between convexity and duration?
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What is the primary implication of the relationship between bond price and time to maturity?
What is the primary implication of the relationship between bond price and time to maturity?
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When is an investor subject to both price risk and reinvestment risk?
When is an investor subject to both price risk and reinvestment risk?
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What is the primary consequence of inflation on bond prices and returns?
What is the primary consequence of inflation on bond prices and returns?
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According to the Pure Expectations Theory, what reflects the current yield curve?
According to the Pure Expectations Theory, what reflects the current yield curve?
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What is the primary implication of a bond's price increasing when the yield to maturity decreases?
What is the primary implication of a bond's price increasing when the yield to maturity decreases?
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What type of risk is an investor exposed to when they are unable to liquidate a bond at a reasonable price due to high yields and low bond prices?
What type of risk is an investor exposed to when they are unable to liquidate a bond at a reasonable price due to high yields and low bond prices?
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Study Notes
Relative Valuation
- In relative valuation, asset prices are compared to market prices of similar assets.
- Market prices are standardized to create price multiples.
Bond Pricing
- As time to maturity decreases, bond price increases or decreases (contradictory statements).
- When yield to maturity (YTM) decreases, bond price increases, decreasing effective annual return.
- When YTM increases, bond price decreases, increasing effective annual return.
Risks
Reinvestment Risk
- Occurs when interest rates decrease (bond prices are at a premium).
- Good for investors if yields increase, bad if yields decrease.
Price Risk
- Occurs when interest rates increase (bond price is low).
- Good for investors if yields decrease, bad if yields increase.
- Investors only subject to price risk if they need to sell before maturity.
Inflation Risk
- Inflation causes bond prices to decrease, decreasing returns.
- Investors subject to price risk are affected.
Liquidity Risk
- Occurs when investors need to sell bonds before maturity at a discounted price due to high yields and low prices.
Pure Expectations Theory
- Assumes current yield curve reflects investors' expectations of future short-term interest rates.
- Predicts future short-term rates based on current long-term rates.
- Long-term interest rates are determined by expected future short-term interest rates.
Yield Curve
Normal - Upward Sloping
- Short-term yields are lower than long-term yields.
- Investors expect stronger economic growth and higher inflation in the future.
- Higher yields are demanded for long-term bonds due to higher uncertainty and inflation risk.
Inverted - Downward Sloping
- Short-term yields are higher than long-term yields.
- Investors expect slower economic growth or recession in the future.
- Lower returns are expected for long-term bonds due to lower uncertainty and inflation risk.
Liquidity Preference Theory
- Investors are compensated for time and take on more risk with longer-term investments.
- Reinvestment risk is a concern for investors who don't need to sell, while price risk is a concern for those who need to sell.
Market Segmentation Theory
- Investors have a preferred time frame for investments.
- Supply and demand shift yields for each market segment.
Preferred Habitat Theory
- Investors have preferred time maturities, but may take other opportunities.
- Preferences include investment duration, price risk tolerance, and more.
Macaulay's Duration
- Measures a bond's price sensitivity to interest rate changes.
- Duration increases with time to maturity (TTM) and decreases with coupon rate and YTM.
- Properties: Dmac ≤ TTM, Dmac increases with lower Crate and YTM, and higher TTM.
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 Dmod have the same percentage price change sensitivity to yields.
Convexity
- Measures the sensitivity of a bond's duration to interest rate changes.
- Captures the non-linear relationship between a bond's price and yield.
- Properties: convexity increases with lower Crate and YTM, and higher TTM.
- More convexity means more curvature, which is desirable for investors.
Summary of Duration and Convexity
- Positive relationship between duration and convexity.
- Convexity is good, providing more gains when yields decrease and fewer losses when yields increase.
- Duration increases with TTM, but investors want more convexity without more duration.
Relative Valuation
- Relative valuation involves comparing the price of an asset to the prices of similar or comparable assets.
- Market prices are standardized to create price multiples.
Bond Pricing
- Bond price decreases as time to maturity decreases.
- Bond price increases as time to maturity increases.
- When yield to maturity (YTM) decreases, bond price increases, reducing the effective annual return.
- When YTM increases, bond price decreases, increasing the effective annual return.
Risks
Reinvestment Risk
- Occurs when interest rates decrease and bond prices are at a premium.
- Investors can reinvest coupons at the market yield.
Price Risk
- Occurs when interest rates increase and bond prices are low.
- Investors are only subject to price risk if they need to sell before maturity.
Inflation Risk
- Inflation causes bond prices to decrease, ultimately decreasing the return of bonds.
Liquidity Risk
- Occurs when investors need to sell their bond before maturity and cannot liquidate it at a reasonable price.
- Investors may have to sell at a discounted price.
Pure Expectations Theory
- Assumes the current yield curve solely reflects investors' expectations of future short-term interest rates.
- Predicts future short-term rates based on current long-term rates.
- If the market anticipates short-term rates will increase, the yield curve will slope upwards.
- If the market anticipates short-term rates will decrease, the yield curve will slope downwards.
Yield Curve
Normal (Upward Sloping)
- Short-term yields are lower than long-term yields.
- Long-term bonds have higher yields compared to short-term bonds.
- Indicates that investors expect stronger economic growth and potentially higher inflation in the future.
Inverted (Downward Sloping)
- Short-term bonds have higher yields compared to long-term bonds.
- Indicates that investors expect slower economic growth or a recession in the future.
Liquidity Preference Theory
- Investors are compensated for time but get extra if they invest for longer.
- Investors take more risk for longer-term investments.
Market Segmentation Theory
- Investors will never change their preference and will only invest in a bond for a certain time frame.
- 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 if available.
- Preference is based on investment duration, price risk, or tolerance.
Macaulay's Duration
- Measures the sensitivity of a bond's price to changes in interest rates.
- Duration is a measure of price risk.
- Properties:
- Duration is less than or equal to time to maturity (TTM).
- Duration is higher for bonds with lower coupon rates.
- Duration is higher for bonds with lower YTM.
- Duration is higher for bonds with higher TTM.
Implications of Duration
- Positive relationship between a bond's 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 duration have the same percentage price change sensitivity to yields.
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:
- Convexity is higher for bonds with lower coupon rates.
- Convexity is higher for bonds with lower YTM.
- Convexity is higher for bonds with higher TTM.
Summary of Duration and Convexity
- Duration and convexity have a positive relationship.
- Convexity is beneficial for investors.
- Duration increases interest rate risk, while convexity reduces price changes in response to interest rate movements.
- Investors want more convexity, but it requires taking on more duration.
Relative Valuation
- The price of an asset is compared to the prices of similar or comparable assets in the market.
- Market prices are standardized to create price multiples.
Bond Pricing
- As time to maturity decreases, bond price increases.
- As time to maturity increases, bond price decreases.
- When yield to maturity (YTM) decreases, the bond price increases, decreasing the effective annual return.
- When YTM increases, the bond price decreases, increasing the effective annual return.
Risks Associated with Bonds
Reinvestment Risk
- Occurs when interest rates go down, and bond prices are at a premium.
- Investors can reinvest coupons at the market yield, benefiting from increasing yields.
Price Risk
- Occurs when interest rates go up, and bond prices are low.
- Investors are only subject to price risk if they need to sell before maturity.
- Decreasing yields benefit investors, while increasing yields harm them.
Inflation Risk
- Inflation causes bond prices to decrease, ultimately decreasing the return of bonds.
Liquidity Risk
- Investors may suffer a loss if they need to sell their bond before maturity.
- They may not be able to liquidate their bond at a reasonable price, especially if yields are high and the price has dropped.
Pure Expectations Theory
- The current yield curve reflects investors' expectations of future short-term interest rates.
- Long-term interest rates are determined by the market's expectation of future short-term interest rates.
Yield Curve
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 indicates that investors expect stronger economic growth and potentially higher inflation 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.
Liquidity Preference Theory
- Investors are compensated for time and take on more risk.
- Reinvestment risk is a concern if interest rates decrease.
- Price risk is a concern if interest rates increase.
Market Segmentation Theory
- Investors will never change their preference and only invest in bonds with specific time frames.
Preferred Habitat Theory
- Investors have preferred time maturity for bonds, but may take other opportunities if available.
Macaulay's Duration
- Measures the sensitivity of a bond's price to changes in interest rates.
- Duration looks at price risk; if yields increase, price decreases.
- Properties: • Dmac is less than or equal to TTM • Dmac is higher for bonds with lower Crate (all else equal) • Dmac is higher for bonds with lower YTM (all else equal) • Dmac is higher for bonds with higher TTM (all else equal)
Implications of Duration
- Positive relationship between a bond's duration and price sensitivity to interest rate changes.
- Positive relationship between Time to Maturity (TTM) and Duration.
- Negative relationship between the coupon rate and duration.
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: • Convexity is higher for bonds with lower Crate (all else equal) • Convexity is higher for bonds with lower YTM (all else equal) • Convexity is higher for bonds with higher TTM (all else equal)
Summary of Duration and Convexity
- Duration and Convexity have a positive relationship.
- Convexity is beneficial as it provides more gains when yields decrease and fewer losses when yields increase.
- Duration increases interest rate risk, while Convexity reduces it.
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Description
This quiz covers the concepts of relative valuation, including standardizing prices and creating price multiples, as well as the relationship between bond prices and time to maturity.
