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Questions and Answers
What is the primary benefit of using top-down analysis in valuation models?
What is the primary benefit of using top-down analysis in valuation models?
Which of the following is a weakness of bottom-up analysis?
Which of the following is a weakness of bottom-up analysis?
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?
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 key assumption of relative valuation?
What is a key assumption of relative valuation?
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When would you use relative valuation instead of discounted cash flow valuation?
When would you use relative valuation instead of discounted cash flow valuation?
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Which of the following is a limitation of using the median as a measure of central tendency?
Which of the following is a limitation of using the median as a measure of central tendency?
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What is the potential issue with using comparable companies in relative valuation?
What is the potential issue with using comparable companies in relative valuation?
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What is the term for a bond that can be converted into a pre-determined number of stocks in the future?
What is the term for a bond that can be converted into a pre-determined number of stocks in the future?
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What happens to the bond price when the market interest rates rise?
What happens to the bond price when the market interest rates rise?
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What is the implication of a negative forward rate in the yield curve?
What is the implication of a negative forward rate in the yield curve?
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What is the relationship between the coupon rate and the yield to maturity (YTM) for a premium bond?
What is the relationship between the coupon rate and the yield to maturity (YTM) for a premium bond?
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What is the effect of a decrease in YTM on the bond price?
What is the effect of a decrease in YTM on the bond price?
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According to the Liquidity Preference Theory, what do investors receive as compensation for investing for longer periods?
According to the Liquidity Preference Theory, what do investors receive as compensation for investing for longer periods?
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What is the relationship between Macaulay's Duration and a bond's coupon rate?
What is the relationship between Macaulay's Duration and a bond's coupon rate?
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What happens to a bond's price when interest rates increase?
What happens to a bond's price when interest rates increase?
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What is the purpose of comparing forward rates to spot rates?
What is the purpose of comparing forward rates to spot rates?
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What is the Modified Duration used for?
What is the Modified Duration used for?
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What is the relationship between duration and convexity?
What is the relationship between duration and convexity?
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What happens to the modified duration of a bond when yields decrease?
What happens to the modified duration of a bond when yields decrease?
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What is the main difference between active and passive trading strategies?
What is the main difference between active and passive trading strategies?
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What is the key condition for the rollover strategy to be effective?
What is the key condition for the rollover strategy to be effective?
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What is the main advantage of convexity?
What is the main advantage of convexity?
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What is the main characteristic of riding the yield curve strategy?
What is the main characteristic of riding the yield curve strategy?
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When interest rates increase, what happens to the bond price and effective annual return?
When interest rates increase, what happens to the bond price and effective annual return?
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What is the characteristic of a Premium Bond?
What is the characteristic of a Premium Bond?
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What is the condition for no arbitrage opportunities in the bond market?
What is the condition for no arbitrage opportunities in the bond market?
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What happens to the bond price when inflation increases, and the investor is subject to price risk?
What happens to the bond price when inflation increases, and the investor is subject to price risk?
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According to the Pure Expectations Theory, what determines long-term interest rates?
According to the Pure Expectations Theory, what determines long-term interest rates?
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What is indicated by an inverted yield curve?
What is indicated by an inverted yield curve?
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What is the primary motivation behind 'Riding the Yield Curve Down' strategy?
What is the primary motivation behind 'Riding the Yield Curve Down' strategy?
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Under which scenario is the barbell strategy more likely to outperform the bullet strategy?
Under which scenario is the barbell strategy more likely to outperform the bullet strategy?
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What is the key characteristic of a bullet strategy?
What is the key characteristic of a bullet strategy?
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What is the primary benefit of selling a bond before maturity?
What is the primary benefit of selling a bond before maturity?
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What is the primary advantage of a barbell strategy over a bullet strategy?
What is the primary advantage of a barbell strategy over a bullet strategy?
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Under which scenario would the bullet strategy tend to outperform the barbell strategy?
Under which scenario would the bullet strategy tend to outperform the barbell strategy?
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What happens to the bond's TTM as time progresses?
What happens to the bond's TTM as time progresses?
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What is the primary benefit of holding a bond as it becomes shorter-term?
What is the primary benefit of holding a bond as it becomes shorter-term?
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What is the main reason why a barbell strategy tends to be more successful than a bullet strategy for larger parallel changes in the yield curve?
What is the main reason why a barbell strategy tends to be more successful than a bullet strategy for larger parallel changes in the yield curve?
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When would you sell a bond before maturity?
When would you sell a bond before maturity?
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Study Notes
Top-Down and Bottom-Up Analysis
- Top-down analysis: starts with overall economy, then gradually observes a specific company
- Strengths of top-down analysis: comprehensive holistic view, incorporates industry trends and market dynamics, saves time
- Weaknesses of top-down analysis: may overlook firm-specific factors, sensitive to changes in economic conditions
- Bottom-up analysis: starts with specific company, then gradually observes overall economy
- Strengths of bottom-up analysis: comprehensive analysis of individual companies, focus on firm-specific fundamentals
- Weaknesses of bottom-up analysis: more time-consuming, may miss out on broader market trends
Relative Valuation
- Definition: comparing an asset's price to prices of similar assets
- Advantages: quicker than discounted cash flow valuation, reflects market perceptions and moods
- Issues in relative valuation: choice of comparable, market conditions, differences in growth rates, scale and size of companies
- End goal: determine if an asset is under or overvalued relative to its comparable group
Bonds
- Definition: long-term capital raised by corporations and governments
- Types of bonds: zero-coupon, convertible, indexed, callable, perpetual, treasury, municipal
- Bond pricing and YTM: YTM reflects market's required return, affects bond price
- Interest rate changes: affect YTM and bond price
- Relationship between YTM, coupon rate, and time to maturity:
- Premium bond: coupon rate > YTM, sold at price above face value
- Discount bond: coupon rate < YTM, sold at price below face value
- Characteristics of bonds:
- Par value bond: coupon rate = YTM
- Discount bond: coupon rate < YTM
- Premium bond: coupon rate > YTM
Strips and Arbitrage
- Definition of strips: separate trading of registered interest and principle securities
- Characteristics of strips: generally common in Treasury bonds
- Arbitrage: if PV of bond ≠ PV of strips, arbitrage opportunities present
Risk
- Reinvestment risk: occurs when interest rates decrease
- Price risk: occurs when interest rates increase
- Inflation risk: causes bond prices to decrease
- Liquidity risk: occurs when an investor needs to sell before maturity
Pure Expectations Theory
- Definition: assumes current yield curve reflects investors' expectations of future short-term interest rates
- Yield curve shape:
- Normal: upward-sloping, suggests stronger economic growth and higher inflation
- Inverted: downward-sloping, suggests slower economic growth or recession
- Flat: rare, suggests changing economy
- Discount factors, spot rates, and forward rates:
- Discount factor: determined from market price and cashflows of a bond
- Forward rates: market expectations of interest rates in the future
- Spot rate vs forward rate curve: indicators of market expectations for bonds
Interest Rates
- High interest rates: decrease bond prices, provide opportunities for investors
- Low interest rates: increase bond prices, make bonds more valuable
- Liquidity preference theory: investors are compensated for time, but get extra for longer-term investments
- Market segmentation theory: investors have preferences for specific bond maturities
- Preferred habitat theory: investors have preferred time maturity, but take opportunities if they arise
Duration and Convexity
- Macaulay's duration: measures sensitivity of bond price to changes in interest rates
- Modified duration: modified version of Macaulay's duration, adjusting for bond yield
- Convexity: measures sensitivity of bond duration to changes in interest rates
- Properties of duration and convexity:
- Positive relationship between duration and TTM
- Negative relationship between duration and coupon rate
- Positive relationship between convexity and TTM
- Negative relationship between convexity and coupon rate
Active and Passive Trading Strategies
- Active trading strategies: require forecasting yield curve changes or divesting
- Passive trading strategies: require little from the investor, aim to buy and hold bonds until maturity
- Duration management: increase or decrease portfolio duration based on forecasted changes in rates
- Rollover strategy: invest in a bond for a shorter period than the investment time horizon, then roll into a new investment
- Riding the yield curve: invest in a bond with a longer TTM than the investment time horizon, then sell before maturity for a capital gain
Barbell and Bullet Strategies
- Bullet: invest in bonds with similar maturity dates
- Barbell: invest in low-risk, low-maturity bonds and high-risk, high-maturity bonds
- Characteristics of barbell and bullet:
- Barbell tends to be more successful than bullet due to convexity
- Barbell outperforms bullet when the curve is flattening
- Bullet outperforms barbell when the curve is steepening
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Description
This quiz explores the two approaches to investment analysis: top-down and bottom-up. It covers the strengths and weaknesses of each approach, and their applications in finance.
