2. Fixed Interest Securities

Question 1

What is a yield curve?

Answer 1

The relationship between TIME TO MATURITY and YIELDS for a particular category of bonds at a given point in time (normal: the longer till maturity, the higher the yield)

Question 2

What are the two main hypotheses used to explain the shape of the yield curve?

Answer 2

1. Expectations hypothesis: the current interest rate (spot rate) reflects expectations about future interest (or forward) rates. However, reality is that central banks intervene.
2. Liquidity Preference Theory: interest rates are determined by adding a liquidity premium to the short term rates

Question 3

Macaulay Duration

Answer 3

Number of years required to recover the purchase price of a bond from the present value of its cash flows.
–measures the economic life of a bond, given the timing and magnitude of cash flows (similar to payback period)

Question 4

Four features of Duration

Answer 4

1. D is always LESS than its term to maturity
2. D EXPANDS with term to maturity at a decreasing rate
3. Coupon value is INVERSELY related to duration
4. YTM is INVERSELY related to duration

Question 5

Duration addresses two types of rate risk…

Answer 5

1. Price risk: from relationship between bond prices and rate
2. Reinvestment risk: results from uncertainty about the reinvestment rate for future coupon income

Question 6

Immunisation

Answer 6

Protecting a bond portfolio against two types of interest rate risk:

• -price risk and reinvestment risk cancel each other out
• -the Macaulay Duration of the portfolio is set to be equal to the investment horizon

Question 7

A bond with long maturity and low value coupons should give…

Answer 7

…best capital gains subject to the interest rate scenario

Question 8

If a decline in interest rate is expected, the bond portfolio manager should…

Answer 8

…increase the average duration of the bond portfolio to achieve the maximum capital gain

Question 9

If the interest rate is expected to increase, the bond portfolio manager should…

Answer 9

…reduce the average duration of the bond portfolio to minimise the price decline

Question 10

Convexity

Answer 10

• Duration assumes a linear relationship
• Holding maturity constant, a rate decrease will raise prices a greater percent than a corresponding increase in rates will lower prices (curve)
• Convexity refers to the degree to which duration changes as the yield to maturity changes (or degree to which price-yield curve deviates from linear approximation)
• Convexity is generally a desirable trait

Question 11

Relationship between bond features and duration

Answer 11

1. Inverse: COUPON and duration
2. Direct: MATURITY and duration
3. Inverse: YIELD and duration

Question 12

Relationship between bond features and convexity

Answer 12

1. Inverse: COUPON and convexity
2. Direct: MATURITY and convexity
3. Inverse: YIELD and convexity

Question 13

Modified convexity

Answer 13

Price change due to convexity

Question 14

Given two bonds with identical durations, the investor prefers…

Answer 14

…a bond with greater convexity since it gives a bigger capital gain if interest rates fall and a smaller price decline with an interest rate increase

Question 15

What is the difference between calling a bond and bond refunding?

Answer 15

• The bond is called when the issuer, at its own discretion, “calls” the bond, and purchases it from the holder at a price stipulated
• When a bond is refunded, it is called, but then reissued for the same amount with a lower coupon rate

Question 16

Relationships: (1) price and coupon, (2) price and yield, (3) price and maturity

Answer 16

1. Direct
2. Inverse
3. Unclear: price changes resulting from yield changes will be more pronounced the longer the term to maturity

Question 17

If you expect rates to decline, what sort of bonds do you want in your portfolio?

Answer 17

Bonds that will have the largest price increase, that is, bonds with long durations