103-8 Bond Valuation Concepts Flashcards
Duration
Essentially the weighted average # of years that it takes for a bond owner to receive a return of the initial investment on a present value basis
CY, YTM, YTC when bond sold at par
CY = YTM = YTC
CY, YTM, YTC when bond sold at premium
CY > YTM > YTC
CY, YTM, YTC when bond sold at discount
CY < YTM < YTC
Yield Curve
A graph of IR yields for bonds of the same quality, ranging in maturity from 31 days to 30 years
This curve has a tendency to slope upward and outward, denoting that as the maturity date of bonds lengthen, the corresponding bond yields increase
Most important point: their shape varies according to changes in the economic cycle; therefore, they may be used to make predictions about the future state of the economy
Normal (positive) yield curve
Occurs during periods of economic expansion and generally predicts that market IR will rise in the future
Flat yield curve
Occurs when the economy is peaking and, therefore, no change in future IR (particularly down) is expected
Inverted yield curve
Occurs when the Federal Reserve has tightened credit in an inflationary economy; it predicts IR will fall and, sometimes, can signal an upcoming recession
3 Predominant Theories Used to Explain Various Yield Curves
1) Unbiased expectations theory
2) Liquidity Preference theory
3) Market Segmentation theory
Unbiased Expectations Theory
States that long-term rates consist of many short-term rates and that long-term rates will be the average (or geometric mean) of short-term rates
Liquidity Preference Theory
Based on the expectations theory but incorporates a liquidity premium into the model
This theory holds that long-term bonds should provide higher returns than shorter-term bonds in order to avoid the higher price volatility of longer-term issues
The theory argues that the yield curve should always slope upward and that any other shape is only a temporary aberration
Market Segmentation Theory
Relies on the laws of supply and demand for various maturities of borrowing and lending
This theory asserts that different institutional investors have different maturity needs that lead them to restrict their bond selections to only pre-determined maturity segments
In its strongest form, this theory maintains that the maturity preferences of these investors are so fixed that they never purchase securities outside their preferred maturity range to take advantage of yield differentials
Duration
The average time for a bondholder to receive the interest and principal payments from a bond in PV dollars
Duration measures a bond’s sensitivity to changes in IR
The greater the bond’s duration, the greater the bond’s price volatility
Coupon Rate, Duration have inverse relationship
YTM and duration have an inverse relationship
Term to maturity of a bond and its duration have a direct relationship
Zero-coupon bond will always have a duration equal to its term to maturity
Convexity
A measure of the curvature of the relationship between a bond’s YTM and its market price (value)
Convexity helps explain the change in bond prices that is not accounted for simply by the bond’s duration
Convexity gives us a more precise measure of the change in the price of a bond, given a respective change in market IR
Convexity relationships are the same as those for duration and are summarized in the table below
Modified Duration
A relative measure for comparing different durations of bonds
