12 Questions
What is the primary characteristic of a zero coupon bond?
It does not offer any coupon payments over the life of the bond
What is the effect of a rise in market interest rates on the price of a bond?
The bond price decreases
What is the characteristic of a callable bond that makes it distinct from other types of bonds?
The seller can buy the bond back from the buyer in the future
What is the relationship between the coupon rate and YTM of a bond that is sold at a premium?
The coupon rate is higher than the YTM
What is the effect of a decrease in time to maturity on the price of a bond that is sold at a premium?
The bond price decreases
What is the primary characteristic of a treasury bond?
It is issued by a federal government
What is the effect on the bond price when the yield to maturity (YTM) decreases?
The bond price increases
What is the typical shape of a yield curve when investors expect stronger economic growth and higher inflation in the future?
Normal, upward sloping
What is the purpose of forward rates in the context of bonds?
To hedge against interest rate risk
What happens to the bond price when the coupon rate is lower than the yield to maturity?
The bond is sold at a discount
What does an inverted yield curve suggest about the market's expectations for future interest rates?
Interest rates will fall in the future
What is the relationship between the time to maturity and the bond price?
As time to maturity increases, bond price decreases
Study Notes
Types of Bonds
- Zero-coupon bonds: no coupon payments over the life of the bond, only receive face value when bond matures
- Convertible bonds: can convert bonds into a pre-determined number of stocks in the future
- Indexed bonds: rate of return eroded by inflation, coupon of bonds is related to movements in inflation
- Callable bonds: seller can buy the bond back from the buyer in the future
- Perpetual bonds: last forever
- Treasury bonds: issued by the federal government
- Municipal bonds: issued by state government or government agencies
Bond Pricing and YTM
- YTM reflects the market's required return on the bond
- If the market requires a higher return than the bond's coupon rate, the bond's price will drop (discount)
- If the market requires a lower return than the bond's coupon rate, the bond's price will increase (premium)
- Changes in market interest rates affect YTM
- When market interest rates rise, YTM increases, and bond prices fall
- When market interest rates fall, YTM decreases, and bond prices rise
Relationship Between YTM, Coupon Rate, and Time to Maturity
- Expensive/Premium bond:
- If coupon rate is higher than YTM, sold at price above face value
- As time to maturity decreases, bond price decreases
- As time to maturity increases, bond price increases
- When YTM decreases, bond price increases, decreasing effective annual return
- If interest rates go down, YTM decreases, increasing bond price
- Cheap/Discount bond:
- If coupon rate is lower than YTM, sold at price below face value
- As time to maturity decreases, bond price increases
- As time to maturity increases, bond price decreases
- When YTM increases, bond price decreases, increasing effective annual return
- If interest rates go up, YTM increases, decreasing bond price
Yield Curve Shape
- Normal/Upward Sloping:
- Long-term bonds have higher yields compared to short-term bonds
- Investors expect stronger economic growth and potentially higher inflation in the future
- To compensate for these risks, investors demand higher yields for long-term bonds
- Indicates that market participants expect interest rates to rise in the future
- Inverted/Downward Sloping:
- Short-term bonds have higher yields compared to long-term bonds
- Investors expect slower economic growth or a recession in the future
- Investors prefer long-term bonds to lock in current yields, anticipating that interest rates will fall due to economic weakness
- Indicates that market participants expect interest rates to decrease in the future
Discount Factors/Spot Rates/Forward Rates
- Discount Factor is determined from the market price and cashflows of a bond
- Spot rates are used to create a yield curve
- Forward rates are market expectations of interest rates in the future
- Comparing forward rate to spot rate indicates what the market thinks will happen in the future
- Use the spot rate vs forward rate curve to give an indication of what the market is thinking in the future for bonds
Learn about the different types of bonds, including zero coupon bonds, convertible bonds, indexed bonds, and callable bonds. Understand their characteristics and features.
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