40 Questions
What is the primary benefit of using top-down analysis in valuation models?
It saves time by looking at broader market trends.
Which of the following is a weakness of bottom-up analysis?
It requires a lot of time to analyze individual companies.
What is the primary advantage of relative valuation over discounted cash flow valuation?
It is more likely to reflect market perceptions and moods.
Why is the median preferred over the mean in relative valuation?
The median is a more reliable comparison point.
What is a key assumption of relative valuation?
The market prices are converted into standardized prices.
When would you use relative valuation instead of discounted cash flow valuation?
When the objective is to buy or sell an asset and justify the decision.
Which of the following is a limitation of using the median as a measure of central tendency?
It is not suitable for non-symmetric distributions of scores.
What is the potential issue with using comparable companies in relative valuation?
The comparable companies are not truly similar to the asset being valued.
What is the term for a bond that can be converted into a pre-determined number of stocks in the future?
Convertible Bond
What happens to the bond price when the market interest rates rise?
The bond price decreases.
What is the implication of a negative forward rate in the yield curve?
There is an arbitrage opportunity available.
What is the relationship between the coupon rate and the yield to maturity (YTM) for a premium bond?
The coupon rate is higher than the YTM.
What is the effect of a decrease in YTM on the bond price?
The bond price increases.
According to the Liquidity Preference Theory, what do investors receive as compensation for investing for longer periods?
Extra returns for taking more risk
What is the relationship between Macaulay's Duration and a bond's coupon rate?
There is an inverse relationship between Dmac and coupon rate.
What happens to a bond's price when interest rates increase?
The bond's price decreases.
What is the purpose of comparing forward rates to spot rates?
To understand market expectations of future interest rates.
What is the Modified Duration used for?
To measure a bond's price sensitivity to interest rate changes.
What is the relationship between duration and convexity?
Duration and convexity have a positive relationship
What happens to the modified duration of a bond when yields decrease?
It decreases by a fixed percentage
What is the main difference between active and passive trading strategies?
Active strategies require forecasting yield curve changes, while passive strategies do not
What is the key condition for the rollover strategy to be effective?
Interest rates are forecast to increase
What is the main advantage of convexity?
It provides a more accurate estimate of price changes in response to interest rate movements
What is the main characteristic of riding the yield curve strategy?
Investing in a bond with a longer time to maturity than your investment time horizon
When interest rates increase, what happens to the bond price and effective annual return?
The bond price decreases, and the effective annual return increases
What is the characteristic of a Premium Bond?
Coupon rate is greater than YTM
What is the condition for no arbitrage opportunities in the bond market?
PV Bond = PV of all Strips
What happens to the bond price when inflation increases, and the investor is subject to price risk?
The bond price decreases, and the return decreases
According to the Pure Expectations Theory, what determines long-term interest rates?
Market's expectation of future short-term interest rates
What is indicated by an inverted yield curve?
Investors expect lower interest rates in the future
What is the primary motivation behind 'Riding the Yield Curve Down' strategy?
To benefit from the higher yields associated with shorter-term bonds
Under which scenario is the barbell strategy more likely to outperform the bullet strategy?
When the yield curve is flattening
What is the key characteristic of a bullet strategy?
Investing in bonds with similar maturity dates
What is the primary benefit of selling a bond before maturity?
To capture a capital gain if yields are stable or decrease
What is the primary advantage of a barbell strategy over a bullet strategy?
It is more convexity-adjusted for duration
Under which scenario would the bullet strategy tend to outperform the barbell strategy?
When the yield curve is steepening
What happens to the bond's TTM as time progresses?
It decreases
What is the primary benefit of holding a bond as it becomes shorter-term?
To benefit from the higher yields associated with longer-term bonds
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?
Due to its higher convexity
When would you sell a bond before maturity?
When yields are stable or decreasing
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
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.
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