Book 4_Fixed_READING 58_INTEREST RATE RISK AND RETURN

Question 1

Sources of return from a bond investment

Answer 1

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

Question 2

Changes in yield to maturity (YTM) produce

Answer 2

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

Question 3

An increase (a decrease) in YTM

Answer 3

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

Question 4

Over a short investment horizon

Answer 4

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

Question 5

Over a long investment horizon

Answer 5

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

Question 6

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

Answer 6

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

Question 7

Unchanged YTM, Bond Sold Before Maturity

Answer 7

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

Question 8

Capital gains or losses at the time a bond is sold

Answer 8

= Price - the carrying value

Question 9

Changed YTM, Bond Held to Maturity

Answer 9

• 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

Question 10

Changed YTM, Bond Sold Before Maturity

Answer 10

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

Question 11

The Macaulay duration

Answer 11

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

Question 12

Macaulay duration calculation

Answer 12

• 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.

Question 13

duration gap

Answer 13

= 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.