Understanding Yields and Market Conditions

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Questions and Answers

What primarily determines the yield of a bond?

The issuer's credit rating

The marketplace conditions (correct)

The coupon rate of the bond

The maturity date of the bond

How often do most bonds typically pay interest?

Semi-annually (correct)

Monthly

Quarterly

Annually

Which of the following describes the relationship between discount rate and yield?

Yield is calculated without considering the discount rate

Yield can sometimes be lower than the discount rate

Discount rate and yield are the same thing (correct)

Discount rate is always lower than yield

What value does the coupon rate determine?

The income paid to the bondholder Signup and view all the answers

If a bond’s coupon rate is 9% and it pays interest twice a year, what is the amount of each coupon payment?

$4.50 Signup and view all the answers

When calculating the fair price of a bond, which of the following needs to be considered?

The present value of both principal and coupon payments Signup and view all the answers

What adjustment is necessary when bonds pay interest more than once a year?

The discount rate must be divided by the number of payments per year Signup and view all the answers

What is meant by a 'spread in basis points' in the context of yield?

The additional yield required for credit and liquidity risk Signup and view all the answers

What is the formula used to calculate a single coupon payment if the bond has a nominal value of $100 and a coupon rate of 9%?

$4.50 per payment Signup and view all the answers

How does a bond's coupon rate affect its price volatility compared to bonds of the same maturity?

Higher coupon bonds are usually less volatile than lower coupon bonds. Signup and view all the answers

What is primarily affected by a bond's duration?

The sensitivity of the bond’s price to interest rate changes. Signup and view all the answers

Given two bonds with the same coupon rate, how does the term to maturity affect their price volatility?

A bond with a longer maturity is usually more volatile. Signup and view all the answers

What is the impact of interest rate changes on different bond prices?

Interest rate changes affect bonds differently based on their coupons and maturities. Signup and view all the answers

What does a higher duration indicate about a bond?

The bond has a higher sensitivity to interest rate changes. Signup and view all the answers

What factors can be compared when evaluating bonds with different coupon rates and maturities?

Their duration, which combines coupon rates and terms to maturity. Signup and view all the answers

Under which condition will current yield, approximate YTM, and YTM be equal?

When the bond trades at par Signup and view all the answers

What risk arises when coupon payments may earn a lower return than the bond's YTM at purchase?

Reinvestment risk Signup and view all the answers

How does fluctuating interest rates affect reinvestment of coupon payments?

Reinvestment rates at the time of cash flows will likely differ from the purchase rate Signup and view all the answers

Which bond type has no reinvestment risk?

Zero-coupon bond Signup and view all the answers

What happens if coupon payments are reinvested at higher rates than the bond’s YTM at the time of purchase?

The overall return will exceed the quoted YTM Signup and view all the answers

What could potentially overstate the YTM at the time the bond was purchased?

Reinvesting coupon payments at lower rates Signup and view all the answers

What does the term 'YTM' stand for?

Yield to maturity Signup and view all the answers

When is it likely that interest rates will not remain constant over the bond's term?

When the bond has a long term to maturity Signup and view all the answers

What is the main concern during a fluctuating interest rate environment for bond investors?

Reinvestment of coupon payments Signup and view all the answers

What effect does purchasing a bond at a discount have on its reinvestment risk?

It has no effect on reinvestment risk Signup and view all the answers

What is the fair price of a bond at a discount rate of 10%?

$96.77 Signup and view all the answers

How is the yield on a Treasury bill calculated?

Using the formula: $100 - Price / Price × 365 × Term Signup and view all the answers

What aspect does current yield focus on for an investment?

Cash flows and the current market price only Signup and view all the answers

In the given formula for T-bill yield, what does the term 'Term' represent?

The total duration before maturity of the T-bill in days Signup and view all the answers

Which of the following is a key characteristic of Treasury bills?

They mature at par and trade at a discount Signup and view all the answers

What is the calculated yield on an 89-day T-bill purchased for a price of 99.5?

2.061% Signup and view all the answers

What does the sum of the present value of a bond's principal and its coupons represent?

The fair market value of the bond today Signup and view all the answers

Which of the following is NOT true about the current yield of an investment?

It takes into account future expected cash flows Signup and view all the answers

What happens to the yield of a T-bill if its purchase price increases?

The yield decreases as the price increases Signup and view all the answers

Which of the following accurately defines a T-bill's earnings for tax purposes?

They are classified as interest income Signup and view all the answers

What is the main reason that bond prices are more volatile at lower interest rates?

Relative yield changes have a greater impact than absolute yield changes. Signup and view all the answers

A yield change from 4% to 2% has what percentage change compared to a yield change from 12% to 10%?

50% vs 17% Signup and view all the answers

What occurs to a bond's price when its yield decreases by 1%?

It rises by a larger percentage than it would fall. Signup and view all the answers

How much does the price of a bond change when the yield increases from 3% to 4% according to the information provided?

Decreases by 4.49%. Signup and view all the answers

What is the relationship between interest rates and bond prices?

As interest rates rise, bond prices fall. Signup and view all the answers

Which of the following best illustrates the concept of absolute vs. relative yield change?

Drop from 4% to 2% is less impactful than drop from 12% to 10%. Signup and view all the answers

In the provided table, what is the price of a 3% bond when the yield is at 2%?

$104.74 Signup and view all the answers

What effect does a 1% decrease in yield have on a bond's price in comparison to a 1% increase?

The price increase is larger than the price decrease. Signup and view all the answers

What is the price change when the yield of a bond decreases to 2% from 3%?

Signup and view all the answers

What is the relative yield change when a bond's yield drops from 12% to 10%?

17% Signup and view all the answers

How does a 1% decrease in yield impact a bond's price compared to a 1% increase?

The price decrease is greater than the price increase. Signup and view all the answers

When does a bond's price exhibit greater volatility?

When interest rates are low. Signup and view all the answers

What is the percentage change in price when the yield decreases from 3% to 2%?

+4.74% Signup and view all the answers

Which statement about yield changes is true?

A decline in interest rates leads to higher bond prices. Signup and view all the answers

What is the correct price of a bond priced at $100 when the yield is at 3%?

$100.00 Signup and view all the answers

What happens to bond prices as interest rates rise?

Bond prices fall. Signup and view all the answers

What is the price change percentage when the yield increases from 3% to 4%?

-4.49% Signup and view all the answers

In the context of bond valuation, why is relative yield change more significant than absolute yield change?

It provides a clearer insight into price sensitivity. Signup and view all the answers

Study Notes

Yields and Pricing Bonds

Yields fluctuate based on market conditions and are typically compared to Government of Canada bonds for similar terms.
Yield often equals the discount rate, which should not be confused with the fixed coupon rate determined at bond issuance.
Coupon payments reflect interest paid to bondholders, adjusted for payment frequency: e.g., an annual coupon of 9% for a bond will yield $4.50 per semi-annual period.

Fair Price of a Bond

A bond's fair price equals the present value of its principal plus the present value of future coupon payments.
For a bond at a discount rate of 10%, the present value totals around $96.77, combining both coupon and principal values.

Treasury Bills (T-bills)

T-bills are short-term securities sold at a discount and do not pay interim interest; returns come from the difference between purchase price and maturity value.
Yield for T-bills can be calculated using the formula: ((100 - Price) \div Price \times \frac{365}{Term} \times 100).

Current Yield

Current yield focuses on current cash flows relative to the market price, rather than original investment amounts.
If a bond is trading at par, the current yield, approximate Yield to Maturity (YTM), and YTM will align.

Reinvestment Risk

YTM estimates return but can differ if future market interest rates fluctuate; reinvestment risk arises from potential lower rates at which coupons are reinvested.
Zero-coupon bonds have no reinvestment risk, as they don’t pay coupon cash flows before maturity.

Impact of Yield Changes

Relative yield changes affect bond prices more significantly than absolute changes; a drop from 12% to 10% (17% decrease) impacts prices less than a drop from 4% to 2% (50% decrease).
Price reactions vary: a 1% yield drop results in a larger price increase than a 1% yield rise.

Duration and Price Volatility

Bond prices inversely change with interest rates: rising rates decrease prices while falling rates increase them.
Bonds with higher coupons are less price volatile than those with lower coupons, while longer-term bonds are more volatile than shorter-term ones.
Duration measures bond price sensitivity to interest rate changes: a higher duration indicates greater price reaction for each 1% interest change, helping assess volatility in investment decisions.

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Description

This quiz explores the concepts of yields, discount rates, and their relation to market conditions, especially pertaining to Government of Canada bonds. It delves into how yields are determined by the marketplace and the importance of credit risk and liquidity in calculating spreads. Test your knowledge on these critical financial concepts.