Ch. 6

Question 1

What are the three types of bondholders/stockholders? Explain what each one does?

Answer 1

1) Arbitrageurs - attempt to profit off minor changes in prices of financial assets
2) Hedgers - someone who exposed to a certain risk and buys particular bonds/shares to offset that risk
3) Speculators - go in a risky position to try make profit

Question 2

Give an example of how someone may offset a risk by hedging?

Answer 2

Eg, a producer selling overseas might use a forwards contract to insure themselves against a change in exchange rate

Question 3

5 things that determine interest rates on securities?

Answer 3

1) Loan length
2) Riskiness of borrowers
3) Fundamental economic forces
4) Liquidity of loan contract
5) Expected inflation over loan period

Question 4

What is the principal?

Answer 4

The original sum that was lent

Question 5

4 characteristics of government bonds?

Answer 5

1) Liquidity (very high)
2) Special tax treatments (to encourage investors)
3) Restricted trading (only licensed institutions can trade them)
4) Coupon payments (tf stream of regular income)

Question 6

What are Gilt Edged Market Makers?

Answer 6

Market makers in government bonds; they both buy and sell new and existing stock and have an OBLIGATION to provide continuous 2-way (bid-offer) prices in gov. bonds

Question 7

Why do GEMMs have to both buy and sell stock of gov. bonds?

Answer 7

If only traded one way would be limited in their ability to make the market!

Question 8

What do GEMMs do if they are temporarily short on bonds OR funds?

Answer 8

Short on bonds: borrow from institutional investors

Short on funds to buy bonds: can borrow off brokers

Question 9

What is the principle of bond pricing?

Answer 9

A bond should be determined by the present value of the asset’s expected cash flow

Question 10

Define present-value?

Answer 10

The current value of a future sum of money/stream of payments given by a specified rate of return

Question 11

Strong assumption made with bond pricing?

Answer 11

We know the interest rates for certain

Question 12

Why is bond price equilibrium reached?

Answer 12

Because if it is not reached arbitrageurs will make transactions to make a riskless profit, therefore changing the prices in the market leading to equilibrium (ie. if above P(eq.) one will sell until is at P(eq.) and vice versa)

Question 13

How do bonds prices change with:

1) increase in coupon payments
2) increase in maturity value
3) decrease in interest rates?

Answer 13

1) increase
2) increase
3) increase (why? find out!)

Question 14

What is a perpetuity?

Answer 14

A bond that only pays coupon and has no maturity payment

Question 15

How are perpetuities affected by r? (2)

Answer 15

Strongly

If the time to maturity is very short effect of r on P(B) is smaller and vice versa

Question 16

What is a clean and a dirty price?

Answer 16

Clean price: price of bond excluding accrued interest

Dirty price: price of bond including the total accrued interest that BHs would be entitled to BETWEEN PAYMENTS

On day of coupon payment, DP=CP

Question 17

What would you notice when tracking dirty bond prices?

Answer 17

Drop in value on day of coupon payment

Question 18

Why is current yield an imprecise measure of bond value?

Answer 18

It takes not account of gains/losses resulting from the difference between current market price of the bond and its maturity value (TF most useful for bonds with long term to maturity)

Question 19

Define yield to maturity?

Answer 19

The return on a bond expressed as a %/yr IF held until maturity

Question 20

What does the yield to maturity account for?

Answer 20

coupon payments

gains/losses from maturity

Question 21

What does yield to maturity assume?

Answer 21

That coupon payments can be REINVESTED at the yield to maturity

Question 22

Why is it difficult to calculate yield to maturity?

Answer 22

When rearranged (see notes) if T>2 end up with lots of squared… terms so gets very complicated to solve

Question 23

What is usually the simplest way to solve for yield to maturity?

Answer 23

Trial and error approximation

Question 24

Explain Simple YTM?

Answer 24

Accounts for capital gains/losses, assuming they are acquired EVENLY over the remaining life of the bond

BUT take no account that coupons can be reinvested

Question 25

What does the volatility of bond prices rely on and how? (2)

Answer 25

1) Coupon payments (lower coupon means higher volatility since slight change in fundamental value will be amplified over time with interest rates (see notes?))
2) Term to maturity (greater term to maturity means greater volatility)

Question 26

Explain the relationship between bond price and yield? Draw diagram?

Answer 26

See notes:
increase in the yield coincides with a decrease in the price of bonds and vice versa

Investors constantly compare the returns on their current investments to what they could get elsewhere in the market. As market interest rates change, a bond’s coupon rate—which, remember, is fixed—becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself.

Question 27

What is Macaulay Duration? Mathematically what is it?

Answer 27

A measure of bond price volatility
(ie. how much a bond’s price may change when interest rates change!!!)

Weighted-average term to maturity of the cash flows on a bond

Question 28

How does the Macaulay Duration work?

Answer 28

It weights the different time periods in which payments are made by the discounted cash flow (therefore if a large payment happens it will have high weight in the volatility)

Question 29

What does modified duration measure?

Answer 29

The sensitivity of bond price to changes in the interest rate (ie. Slope of the price-yield curve)

Question 30

Why is the equation: change in P(b) approximately -D(mod)x(changein)y?

Answer 30

Because the equation assumes the price-yield curve is linear but in reality it is convex (tf larger the change the less accurate the approximation is!)

Question 31

Draw the price-yield curve?

Answer 31

See notes

Question 32

Summary: what 3 factors cause the Macaulay Duration to increase?

Answer 32

1) increase in term to maturity
2) decrease in coupon payment
3) decrease in initial yield

(can I explain WHY though???)

Question 33

What does a higher or lower MD tell us?

Answer 33

A higher MD tells us that the bonds price is more sensitive to changes in interest rates

A lower MD tells us that the bonds price is less sensitive to changes in interest rates

Question 34

For a bond with a duration of ‘x’, how much will the bonds price increase when the interest rates decrease by 1%?

Answer 34

x% (and vice versa)

Question 35

Explain how duration may be used by a portfolio manager to measure and manage interest rate risk?

Answer 35

If a manager believes interest rates, r, may rise, (tf causing a fall in P(b)) then they may DECREASE the duration of their portfolio to reduce the impact that falling bond prices will have on their portfolio a(and vice versa)

Question 36

2 main uses of duration?

Answer 36

1) Calculate volatility of portfolio

2) measure interest rate risk and manage it

Question 37

4 main risks associated with corporate bonds?

Answer 37

1) Risks common with Gov. bonds (ie. interest rate risk, inflation risk etc.)
2) CREDIT risk (credit issuer defaults)
3) CALL risk
4) EVENT risk

Question 38

What is CALL risk? When might it be exercised?

Answer 38

Risk that issuer may recall the bonds earlier than expected (only if specified on contract this can be done!)

May be exercised if the bank’s interest rate falls (ie. becomes cheaper to borrow in other ways!)

Question 39

What is EVENT risk?

Answer 39

Risk of a dramatic event (eg. FC) -> debt-service inability of the issuer (ie. step below complete default)

Question 40

What does the term ‘flight to quality’ refer to?

Answer 40

In a recession, the quality spread increases as investors sell risky assets and buy safe ones

Question 41

What is the quality spread?

Answer 41

The difference in yield between identical bonds from different companies