Ch. 6 Flashcards
What are the three types of bondholders/stockholders? Explain what each one does?
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
Give an example of how someone may offset a risk by hedging?
Eg, a producer selling overseas might use a forwards contract to insure themselves against a change in exchange rate
5 things that determine interest rates on securities?
1) Loan length
2) Riskiness of borrowers
3) Fundamental economic forces
4) Liquidity of loan contract
5) Expected inflation over loan period
What is the principal?
The original sum that was lent
4 characteristics of government bonds?
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)
What are Gilt Edged Market Makers?
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
Why do GEMMs have to both buy and sell stock of gov. bonds?
If only traded one way would be limited in their ability to make the market!
What do GEMMs do if they are temporarily short on bonds OR funds?
Short on bonds: borrow from institutional investors
Short on funds to buy bonds: can borrow off brokers
What is the principle of bond pricing?
A bond should be determined by the present value of the asset’s expected cash flow
Define present-value?
The current value of a future sum of money/stream of payments given by a specified rate of return
Strong assumption made with bond pricing?
We know the interest rates for certain
Why is bond price equilibrium reached?
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)
How do bonds prices change with:
1) increase in coupon payments
2) increase in maturity value
3) decrease in interest rates?
1) increase
2) increase
3) increase (why? find out!)
What is a perpetuity?
A bond that only pays coupon and has no maturity payment
How are perpetuities affected by r? (2)
Strongly
If the time to maturity is very short effect of r on P(B) is smaller and vice versa
What is a clean and a dirty price?
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
What would you notice when tracking dirty bond prices?
Drop in value on day of coupon payment
Why is current yield an imprecise measure of bond value?
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)
Define yield to maturity?
The return on a bond expressed as a %/yr IF held until maturity
What does the yield to maturity account for?
coupon payments
gains/losses from maturity
What does yield to maturity assume?
That coupon payments can be REINVESTED at the yield to maturity
Why is it difficult to calculate yield to maturity?
When rearranged (see notes) if T>2 end up with lots of squared… terms so gets very complicated to solve
What is usually the simplest way to solve for yield to maturity?
Trial and error approximation
Explain Simple YTM?
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
What does the volatility of bond prices rely on and how? (2)
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)
Explain the relationship between bond price and yield? Draw diagram?
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.
What is Macaulay Duration? Mathematically what is it?
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
How does the Macaulay Duration work?
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)
What does modified duration measure?
The sensitivity of bond price to changes in the interest rate (ie. Slope of the price-yield curve)
Why is the equation: change in P(b) approximately -D(mod)x(changein)y?
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!)
Draw the price-yield curve?
See notes
Summary: what 3 factors cause the Macaulay Duration to increase?
1) increase in term to maturity
2) decrease in coupon payment
3) decrease in initial yield
(can I explain WHY though???)
What does a higher or lower MD tell us?
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
For a bond with a duration of ‘x’, how much will the bonds price increase when the interest rates decrease by 1%?
x% (and vice versa)
Explain how duration may be used by a portfolio manager to measure and manage interest rate risk?
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)
2 main uses of duration?
1) Calculate volatility of portfolio
2) measure interest rate risk and manage it
4 main risks associated with corporate bonds?
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
What is CALL risk? When might it be exercised?
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!)
What is EVENT risk?
Risk of a dramatic event (eg. FC) -> debt-service inability of the issuer (ie. step below complete default)
What does the term ‘flight to quality’ refer to?
In a recession, the quality spread increases as investors sell risky assets and buy safe ones
What is the quality spread?
The difference in yield between identical bonds from different companies
