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Questions and Answers
If a bond is trading at a premium, what can be inferred about the coupon rate and YTM?
If a bond is trading at a premium, what can be inferred about the coupon rate and YTM?
What happens to the bond price when YTM decreases?
What happens to the bond price when YTM decreases?
What type of bond is characterized by the coupon rate being equal to the YTM?
What type of bond is characterized by the coupon rate being equal to the YTM?
What is the result when PV Bond > PV of all Strips?
What is the result when PV Bond > PV of all Strips?
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What type of risk occurs when interest rates go down?
What type of risk occurs when interest rates go down?
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What happens to bond prices when inflation increases?
What happens to bond prices when inflation increases?
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What type of bond can be converted into a predetermined number of stocks in the future?
What type of bond can be converted into a predetermined number of stocks in the future?
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What is the result when PV Bond < PV of all Strips?
What is the result when PV Bond < PV of all Strips?
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What type of risk occurs when an investor is forced to sell a bond before maturity at a low price?
What type of risk occurs when an investor is forced to sell a bond before maturity at a low price?
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What is a characteristic of strips?
What is a characteristic of strips?
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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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Which of the following statements about Macaulay's Duration is true?
Which of the following statements about Macaulay's Duration is true?
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What is the effect of an increase in yield on a bond's Modified Duration?
What is the effect of an increase in yield on a bond's Modified Duration?
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What is the relationship between a bond's Time to Maturity and its duration?
What is the relationship between a bond's Time to Maturity and its duration?
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What is the purpose of Convexity in bond analysis?
What is the purpose of Convexity in bond analysis?
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What is the effect of an increase in TTM on a bond's convexity?
What is the effect of an increase in TTM on a bond's convexity?
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What is the benefit of having more convexity in a bond?
What is the benefit of having more convexity in a bond?
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What is the strategy of increasing or decreasing a portfolio's duration based on forecasted changes in rates?
What is the strategy of increasing or decreasing a portfolio's duration based on forecasted changes in rates?
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What is the relationship between a bond's coupon rate and its duration?
What is the relationship between a bond's coupon rate and its duration?
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What is the benefit of using Convexity in conjunction with Duration?
What is the benefit of using Convexity in conjunction with Duration?
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In relative valuation, why is the median preferred over the mean?
In relative valuation, why is the median preferred over the mean?
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What is the primary advantage of relative valuation over discounted cash flow valuation?
What is the primary advantage of relative valuation over discounted cash flow valuation?
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What is the main issue with selecting comparable assets in relative valuation?
What is the main issue with selecting comparable assets in relative valuation?
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What can happen when companies or assets with different growth rates are compared in relative valuation?
What can happen when companies or assets with different growth rates are compared in relative valuation?
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Why is relative valuation popular in the context of buying or selling an asset?
Why is relative valuation popular in the context of buying or selling an asset?
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What can influence the prices of comparable assets in relative valuation?
What can influence the prices of comparable assets in relative valuation?
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What is the primary purpose of standardizing prices in relative valuation?
What is the primary purpose of standardizing prices in relative valuation?
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Why may valuations based on comparable assets reflect temporary market conditions?
Why may valuations based on comparable assets reflect temporary market conditions?
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What is a common issue with relative valuation?
What is a common issue with relative valuation?
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What is the advantage of relative valuation in reflecting market perceptions and moods?
What is the advantage of relative valuation in reflecting market perceptions and moods?
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What is the primary assumption of the Pure Expectations Theory?
What is the primary assumption of the Pure Expectations Theory?
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What does an upward-sloping yield curve typically suggest?
What does an upward-sloping yield curve typically suggest?
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What is the purpose of forward rates in bond markets?
What is the purpose of forward rates in bond markets?
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According to the Liquidity Preference Theory, what is the primary reason for the upward slope of the yield curve?
According to the Liquidity Preference Theory, what is the primary reason for the upward slope of the yield curve?
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What is the primary assumption of the Market Segmentation Theory?
What is the primary assumption of the Market Segmentation Theory?
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What is the primary implication of a negative forward rate?
What is the primary implication of a negative forward rate?
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What determines the shape of the yield curve according to the Pure Expectations Theory?
What determines the shape of the yield curve according to the Pure Expectations Theory?
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What is the primary advantage of holding long-term bonds according to the Liquidity Preference Theory?
What is the primary advantage of holding long-term bonds according to the Liquidity Preference Theory?
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What is the primary difference between the spot rate and the forward rate?
What is the primary difference between the spot rate and the forward rate?
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What is the primary implication of an inverted yield curve?
What is the primary implication of an inverted yield curve?
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What is the primary advantage of relative valuation over discounted cash flow valuation?
What is the primary advantage of relative valuation over discounted cash flow valuation?
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What is the main issue with selecting comparable assets in relative valuation?
What is the main issue with selecting comparable assets in relative valuation?
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Why may valuations based on comparable assets reflect temporary market conditions?
Why may valuations based on comparable assets reflect temporary market conditions?
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What can happen when companies or assets with different growth rates are compared in relative valuation?
What can happen when companies or assets with different growth rates are compared in relative valuation?
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What is the primary purpose of standardizing prices in relative valuation?
What is the primary purpose of standardizing prices in relative valuation?
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Why is the median preferred over the mean in relative valuation?
Why is the median preferred over the mean in relative valuation?
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What is a common issue with relative valuation?
What is a common issue with relative valuation?
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According to the Pure Expectations Theory, what determines the shape of the yield curve?
According to the Pure Expectations Theory, what determines the shape of the yield curve?
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What is the primary implication of a negative forward rate?
What is the primary implication of a negative forward rate?
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According to the Liquidity Preference Theory, what is the primary reason for the upward slope of the yield curve?
According to the Liquidity Preference Theory, what is the primary reason for the upward slope of the yield curve?
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What is the primary difference between the spot rate and the forward rate?
What is the primary difference between the spot rate and the forward rate?
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What is the primary advantage of holding long-term bonds according to the Liquidity Preference Theory?
What is the primary advantage of holding long-term bonds according to the Liquidity Preference Theory?
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What is the primary assumption of the Market Segmentation Theory?
What is the primary assumption of the Market Segmentation Theory?
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What is the primary implication of an upward-sloping yield curve?
What is the primary implication of an upward-sloping yield curve?
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What is the relationship between a bond's duration and its Time to Maturity?
What is the relationship between a bond's duration and its Time to Maturity?
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What happens to a bond's duration when the coupon rate increases, all else being equal?
What happens to a bond's duration when the coupon rate increases, all else being equal?
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What is the effect of an increase in yield on a bond's Macaulay's Duration?
What is the effect of an increase in yield on a bond's Macaulay's Duration?
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What is the purpose of Convexity in bond analysis?
What is the purpose of Convexity in bond analysis?
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What is the benefit of having more convexity in a bond?
What is the benefit of having more convexity in a bond?
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What is the strategy of Duration Management?
What is the strategy of Duration Management?
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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 effect of an increase in yield on a bond's Modified Duration?
What is the effect of an increase in yield on a bond's Modified Duration?
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What is the benefit of using Convexity in conjunction with Duration?
What is the benefit of using Convexity in conjunction with Duration?
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What is the effect of a decrease in YTM on a bond that is currently trading at a discount?
What is the effect of a decrease in YTM on a bond that is currently trading at a discount?
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What is the primary difference between a callable bond and a perpetual bond?
What is the primary difference between a callable bond and a perpetual bond?
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What is the result of having more convexity in a bond?
What is the result of having more convexity in a bond?
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What is the primary advantage of using strips in bond markets?
What is the primary advantage of using strips in bond markets?
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What is the primary implication of a bond trading at a premium?
What is the primary implication of a bond trading at a premium?
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What is the primary difference between a municipal bond and a treasury bond?
What is the primary difference between a municipal bond and a treasury bond?
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What is the primary implication of arbitrage opportunities being present in the bond market?
What is the primary implication of arbitrage opportunities being present in the bond market?
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Study Notes
Relative Valuation
- In relative valuation, an asset's price is compared to the prices of similar or comparable assets in the market.
- Market prices are standardized to create price multiples.
- Relative valuation is popular due to its ease of use and ability to reflect market perceptions and moods.
Advantages of Relative Valuation
- 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
- Selecting comparable assets can be subjective and affect valuation accuracy.
- Market conditions can influence comparable prices, leading to inaccurate valuations.
- Differences in growth rates and company scale can lead to misleading conclusions.
Bonds
- Bonds are a type of debt security used to raise long-term capital.
- Bond characteristics:
- Par Value Bond: Coupon rate = YTM
- Discount Bond: Coupon rate < YTM
- Premium Bond: Coupon rate > YTM
Types of Bonds
- 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: Issuer can buy the bond back from the investor in the future.
- Perpetual bonds: Lasts forever.
- Treasury bonds: Issued by the federal government.
- Municipal bonds: Issued by state governments or government agencies.
Relationship Between YTM, Coupon Rate, and Time to Maturity
- Expensive/Premium bond: Sold at a price above face value, decreasing in price as time to maturity decreases.
- Cheap/Discount bond: Sold at a price below face value, increasing in price as time to maturity decreases.
Strips
- Separate trading of registered interest and principle securities.
- Common in Treasury bonds, allowing investors to sell components of their bonds.
Arbitrage
- No arbitrage opportunities if PV Bond = PV of all strips, indicating an efficient market.
- Arbitrage opportunities exist if PV Bond ≠ PV of all strips, indicating an inefficient market.
Risks Associated with Bonds
- Reinvestment risk: Occurs when interest rates decrease, affecting coupons and principal repayment.
- Price risk: Occurs when interest rates increase, affecting bond prices.
- Inflation risk: Causes bond prices to decrease, ultimately decreasing returns.
- Liquidity risk: Selling bonds before maturity at a discounted price due to high yields.
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.
Yield Curve Shape
- Normal/Upward Sloping: Indicates expectations of stronger economic growth and higher inflation in the future.
- Inverted/Downward Sloping: Indicates expectations of slower economic growth or recession.
Discount Factors/Spot Rates/Forward Rates
- Discount factor: Determined from market price and cashflows of a bond, used to obtain spot rates and create a yield curve.
- Forward rates: Market expectations of interest rates in the future, used to hedge risk.
Macaulay's Duration
- Measures sensitivity of bond price to changes in interest rates (yields).
- Properties:
- Dmac ≤ TTM
- Dmac is higher for bonds with lower coupon rates and lower YTM.
- Dmac is higher for bonds with higher TTM.
Modified Duration
- A modified version of Dmac, adjusting for the bond's yield.
- Represents a percentage change in bond price in response to a 1% change in yield.
Convexity
- Measures sensitivity of a bond's duration to changes in interest rates.
- Captures non-linear relationship between bond price and yield.
- Properties:
- Convexity is higher for bonds with lower coupon rates and lower YTM.
- Convexity is higher for bonds with higher TTM.
Active and Passive Trading Strategies
- Active management: Forecast yield curve changes and adjust portfolio accordingly.
- Passive management: Buy and hold bonds until maturity.
Duration Management
- Increase or decrease portfolio duration based on forecasted changes in interest rates.
Relative Valuation
- In relative valuation, the price of an asset is compared to the prices of similar or comparable assets to determine its value.
- Market prices are standardized to create price multiples, allowing for comparison between assets.
- Relative valuation is popular due to its ease of justification in buying or selling assets, and its ability to reflect market perceptions and moods.
Issues with Relative Valuation
- Selecting comparable assets can be subjective and significantly affect the valuation.
- Market conditions can influence the prices of comparable assets, leading to inaccurate valuations.
- Differences in growth rates between companies or assets can lead to misleading conclusions.
- Scale and size differences between comparable assets can result in valuation discrepancies.
Bonds
- Bonds are long-term debt securities issued by corporations and governments to raise capital.
- Investors pay the initial cost and receive coupon (interest) payments periodically, and the face value of the bond when it matures.
- Types of bonds include:
- Convertible bonds: can be converted into a predetermined number of stocks in the future.
- Indexed bonds: the coupon rate is related to movements in inflation.
- Callable bonds: the seller can buy the bond back from the investor in the future.
- Perpetual bonds: the bond has no maturity date.
- Treasury bonds: issued by the federal government.
- Municipal bonds: issued by state governments or government agencies.
Relationship Between YTM, Coupon Rate, and Time to Maturity
- If the coupon rate is higher than YTM, the bond is sold at a price above face value.
- As time to maturity decreases, the bond price decreases, and as time to maturity increases, the bond price increases.
- When YTM decreases, the bond price increases, decreasing the effective annual return.
- If interest rates go down, YTM decreases, increasing the bond price.
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, 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 present, and the market is efficient.
- If PV Bond > PV of all Strips, or PV Bond < PV of all Strips, arbitrage opportunities are present, and the market is inefficient.
Risks
- Reinvestment Risk: occurs when interest rates go down, and an investor can reinvest coupons at the market yield.
- Price Risk: occurs when interest rates go up, and investors are only subject to price risk if they need to sell before maturity.
- Inflation Risk: causes bond prices to decrease, decreasing the return of bonds.
- Liquidity Risk: suffers a loss if selling a bond before maturity 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.
Yield Curve Shape
- Normal (Upward Sloping): short-term yields are lower than long-term yields, indicating economic growth and potentially higher inflation.
- Inverted (Downward Sloping): short-term yields are higher than long-term yields, indicating slower economic growth or a recession.
Discount Factors, Spot Rates, and Forward Rates
- Discount Factor: determined from the market price and cash flows of a bond, used to obtain the corresponding spot rate and create a yield curve.
- Forward Rates: market expectations of interest rates in the future.
- Comparing forward rates to spot rates indicates what the market thinks will happen in the future.
Theories of the Term Structure
- Pure Expectations Theory: long-term interest rates are determined by the market's expectation of future short-term interest rates.
- Liquidity Preference Theory: investors are compensated for time, but get extra if they invest for longer.
- Market Segmentation Theory: investors have preferred time frames for bonds, and supply and demand shift the yield for each market segment.
- Preferred Habitat Theory: investors have a preferred time maturity to bonds, but may take other opportunities.
Macaulay's Duration and Convexity
- Macaulay's Duration: measures the sensitivity of a bond's price to changes in interest rates.
- Modified Duration: a modified version of Macaulay's duration, adjusting for the bond's yield.
- Convexity: measures the sensitivity of a bond's duration to changes in interest rates, capturing the non-linear relationship between price and yield.
Duration and Convexity Properties
- Duration is higher for bonds with lower coupon rates and lower yields.
- Duration is higher for bonds with longer maturity periods.
- Convexity is higher for bonds with lower coupon rates, lower yields, and longer maturity periods.
Active and Passive Trading Strategies
- Active management: requires investors to forecast yield curve changes or divest depending on the prediction.
- Passive management: aims to buy and hold bonds until maturity, with little involvement from the investor.
- Duration management: investors modify their portfolio allocation to increase or decrease its duration, depending on forecasted changes in interest rates.
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Description
This quiz covers the concept of relative valuation in finance, where the price of an asset is compared to similar assets to determine its value. It also explores why relative valuation is popular in finance.
