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Questions and Answers
What is the primary strength of top-down analysis?
What is the primary weakness of bottom-up analysis?
What type of bond can be converted into a predetermined number of stocks in the future?
What type of bond is issued by the federal government?
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What type of bond has a coupon rate that is less than its yield to maturity?
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What type of risk occurs when interest rates go up and investors are subject to price risk if they need to sell before maturity?
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What is the primary benefit of using top-down analysis?
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What type of bond has a coupon rate that is greater than its yield to maturity?
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What type of analysis is more comprehensive in terms of individual company analysis?
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What type of bond has a rate of return that is eroded by inflation?
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What type of risk is associated with a decrease in bond prices, ultimately decreasing the return of bonds?
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What type of yield curve is associated with short-term yields being lower than long-term yields?
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What property of Macaulay's Duration states that it is higher for bonds with lower Crate, all else equal?
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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 relationship between the coupon rate and duration?
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What property of Convexity states that it is higher for bonds with lower YTM, all else equal?
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What is the relationship between Duration and Convexity?
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What is the implication of a higher Duration on a bond's interest rate risk?
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What is the effect of higher yields on a bond's price, considering the bond's Convexity?
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What is the relationship between Time to Maturity (TTM) and a bond's Duration?
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What is the primary weakness of top-down analysis?
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What is the primary strength of bottom-up analysis?
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What is the primary characteristic of a Par Value Bond?
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What is the primary risk associated with callable bonds?
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What is the primary benefit of indexed bonds?
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What is the primary characteristic of a perpetual bond?
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What is the primary advantage of top-down analysis over bottom-up analysis?
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What is the primary difference between a municipal bond and a treasury bond?
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What is the primary implication of a decrease in bond yields?
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What is the primary advantage of bottom-up analysis over top-down analysis?
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Which type of risk is most likely to occur when an investor desperately needs to sell a bond before maturity, but the market is experiencing high yields?
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What is the relationship between a bond's Macaulay's Duration and its Time to Maturity?
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Which of the following statements is true about a bond's Convexity?
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What is the implication of a higher Modified Duration on a bond's price?
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Which type of yield curve is associated with slower economic growth or a recession in the future?
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What is the relationship between a bond's Coupon Rate and its Macaulay's Duration?
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What is the effect of a decrease in yields on a bond's price, considering the bond's Convexity?
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Which of the following statements is true about a bond's Duration and Convexity?
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What is the implication of a higher Convexity on a bond's interest rate risk?
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Which type of risk is associated with a decrease in bond prices, ultimately decreasing the return of bonds?
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Study Notes
Top-Down Analysis vs. Bottom-Up Analysis
- Top-Down Analysis: starts with the overall economy, focusing on macroeconomic factors and industry trends, providing a comprehensive holistic view of the market.
- Strengths of Top-Down Analysis: incorporates industry trends, economic factors, and market dynamics into valuation models, saves time by looking at broader market trends.
- Weaknesses of Top-Down Analysis: may overlook firm-specific factors, highly sensitive to changes in economic conditions.
- Bottom-Up Analysis: starts with a specific firm/company, focusing on firm-specific fundamentals, competitive positioning, growth aspects, and financial performance.
- Strengths of Bottom-Up Analysis: focuses on firm-specific fundamentals, competitive positioning, growth aspects, and financial performance.
- Weaknesses of Bottom-Up Analysis: takes more time, may have delays in missing out on returns.
Bonds
- Bonds raise long-term capital issued by corporations and governments.
- Characteristics of bonds: initial cost (price), coupon (interest) periodically, and 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.
- 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 (Dmac): measures the sensitivity of a bond's price to changes in interest rates, looking at price risk, increases as TTM goes up.
- Properties of Dmac:
- 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 of Convexity:
- 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.
Top-Down Analysis vs. Bottom-Up Analysis
- Top-Down Analysis: starts with the overall economy, focusing on macroeconomic factors and industry trends, providing a comprehensive holistic view of the market.
- Strengths of Top-Down Analysis: incorporates industry trends, economic factors, and market dynamics into valuation models, saves time by looking at broader market trends.
- Weaknesses of Top-Down Analysis: may overlook firm-specific factors, highly sensitive to changes in economic conditions.
- Bottom-Up Analysis: starts with a specific firm/company, focusing on firm-specific fundamentals, competitive positioning, growth aspects, and financial performance.
- Strengths of Bottom-Up Analysis: focuses on firm-specific fundamentals, competitive positioning, growth aspects, and financial performance.
- Weaknesses of Bottom-Up Analysis: takes more time, may have delays in missing out on returns.
Bonds
- Bonds raise long-term capital issued by corporations and governments.
- Characteristics of bonds: initial cost (price), coupon (interest) periodically, and 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.
- 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 (Dmac): measures the sensitivity of a bond's price to changes in interest rates, looking at price risk, increases as TTM goes up.
- Properties of Dmac:
- 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 of Convexity:
- 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
Compare and contrast top-down and bottom-up analysis approaches in finance, including their strengths and weaknesses. Learn how each method affects valuation models and market trends.
