Book 4_Fixed_READING 58_INTEREST RATE RISK AND RETURN Flashcards

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1
Q

Sources of return from a bond investment

A
  • Coupon and principal payments
  • Reinvestment of coupon payments
  • Capital gain or loss if bond is sold before maturity
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2
Q

Changes in yield to maturity (YTM) produce

A
  • Price risk (uncertainty about a bond’s price)
  • Reinvestment risk (uncertainty about income from reinvesting coupon payments)
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3
Q

An increase (a decrease) in YTM

A

decreases (increases) a bond’s price but increases (decreases) its reinvestment income.

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4
Q

Over a short investment horizon

A

price risk > reinvestment risk: a change in YTM affects price more than it affects reinvestment income

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5
Q

Over a long investment horizon

A

reinvestment risk > price risk: a change in YTM affects reinvestment income more than it affects price

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6
Q

A fixed-rate bond that has a reinvestment rate equal to the YTM

A

an investor who holds the bond until maturity will earn a rate of return equal to the YTM at purchase.

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7
Q

Unchanged YTM, Bond Sold Before Maturity

A
  • The value of a bond at the same YTM as when it was purchased is its carrying value
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8
Q

Capital gains or losses at the time a bond is sold

A

= Price - the carrying value

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9
Q

Changed YTM, Bond Held to Maturity

A
  • If rates rise (fall) before the first coupon date, an investor who holds a bond to maturity will earn a rate of return greater (less) than the YTM at purchase
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10
Q

Changed YTM, Bond Sold Before Maturity

A

The investor had bigger price risk, so an increase in yield decreased the rate of return over the one-year holding period because the sale price was lower

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11
Q

The Macaulay duration

A

may be interpreted as the investment horizon for which a bond’s price risk and reinvestment risk offset each other

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12
Q

Macaulay duration calculation

A
  • is calculated as the weighted average of the number of years until each of the bond’s promised cash flows is to be paid,
  • where the weights are the present values of each cash flow as a percentage of the bond’s full value.
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13
Q

duration gap

A

= Macaulay duration − investment horizon
- A positive duration gap: exposes the investor to price risk from increasing interest rates.
- A negative duration gap exposes the investor to reinvestment risk from decreasing interest rates.

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