Podcast Beta
Questions and Answers
Which of the following types of bonds does not provide periodic coupon payments?
What is a limitation of using a top-down analysis approach?
What is a characteristic of a Callable bond?
What is an advantage of using a top-down analysis approach?
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What is the primary difference between a Treasury bond and a Municipal bond?
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What is a limitation of using a bottom-up analysis approach?
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What happens to the price of a bond when the coupon rate is lower than the YTM?
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What is the main implication of an inverted yield curve?
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What is the main assumption of the Liquidity Preference Theory?
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What is the relationship between Macaulay's Duration and YTM?
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What happens to a bond's price when interest rates increase?
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What is the main characteristic of a Premium Bond?
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What is the relationship between Time to Maturity (TTM) and Duration?
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What is the implication of Modified Duration (Dmod) on a bond's price?
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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 interest rates on a bond's duration?
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What is the purpose of convexity in bond analysis?
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What is the relationship between a bond's convexity and its duration?
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Which of the following statements about convexity is true?
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What is the implication of higher convexity for an investor?
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Study Notes
Top-Down Analysis vs. Bottom-Up Analysis
- Top-Down Analysis: starts with the overall economy and gradually focuses on a specific company, providing a comprehensive holistic view of the market and macroeconomic factors.
- Strengths: incorporates industry trends, economic factors, and market dynamics into valuation models, saves time by looking at broader market trends.
- Weaknesses: may overlook firm-specific factors, highly sensitive to changes in economic conditions.
- Bottom-Up Analysis: starts with a specific firm/company and gradually looks at the overall economy, providing a comprehensive analysis of individual companies.
- Strengths: focuses on firm-specific fundamentals, competitive positioning, growth aspects, and financial performance.
- Weaknesses: takes more time, may have delays in missing out on returns.
Bonds
- Raise long-term capital issued by corporations and governments.
- As an investor, you pay the initial cost (price) and receive coupon (interest) periodically, and the face value of the bond when it matures.
- Types of bonds:
- Convertible bonds: can be converted into a predetermined number of stocks in the future.
- Indexed bonds: rate of return is eroded by inflation, coupon is related to movements in inflation.
- Callable bonds: the seller can buy the bond back from you in the future.
- Perpetual bonds: last forever.
- Treasury bonds: issued by the federal government.
- Municipal bonds: issued by state government or government agencies.
Bond Characteristics
- Par Value Bond: coupon rate = YTM (yield to maturity).
- Discount Bond: coupon rate is less than YTM, sold at a price below face value.
- Premium Bond: coupon rate is greater than YTM, sold at a price above face value.
Bond Risks
- Price Risk: occurs when interest rates go up, investors are subject to price risk if they need to sell before maturity, good for investors if yields decrease, and bad if yields increase.
- Inflation Risk: causes bond prices to decrease, ultimately decreasing the return of bonds, if subject to price risk.
- Liquidity Risk: suffers loss if desperately need to sell the bond before maturity, won't be able to liquidate the bond at a reasonable price if yields are high and the price has dropped.
Yield Curve
- Normal (Upward-Sloping): short-term yields are lower than long-term yields, long-term bonds have higher yields, suggests stronger economic growth and potentially higher inflation in the future.
- Inverted (Downward-Sloping): short-term bonds have higher yields compared to long-term bonds, suggests slower economic growth or a recession in the future.
Duration and Convexity
- Macaulay's Duration: measures the sensitivity of a bond's price to changes in interest rates, looking at price risk, increases as TTM goes up.
- 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).
- Modified Duration: a modified version of Dmac adjusting for the bond's yield, represents a percentage change in a bond price.
- 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 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 good, gives more gains when yields decrease and less losses when yields increase.
- Duration is not good, when duration increases, you have more interest rate risk, when duration decreases, you have less interest rate risk.
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Description
Learn about the top-down approach in finance, which involves analyzing the overall economy and market trends before focusing on a specific company. This approach provides a comprehensive view of the market and macroeconomic factors, but may overlook firm-specific factors.
