Chapter 10 - Analysis of Debt Securities II - Price Volatility and Investment Strategies Flashcards
What are Debt Securities Strategies?
For debt securities, there are generally three broad strategy classifications:
• Active strategies are based on forming expectations and shifting assets around to take full advantage of these expectations.
• Passive strategies generally lead to a portfolio that approximates a market index or is designed to reduce the requirement to make decisions based on expectations.
• Dedicated strategies are designed to meet specific targets and goals.
Which of the following semi-annual pay 2-year bonds has the greatest modified duration? A. 5% coupon yielding 4%. B. 5% coupon yielding 5%. C. 6% coupon yielding 4%. D. 6% coupon yielding 5%.
A is correct.
All else being equal, the lower the coupon rate and the lower the yield, the greater the modified duration. Since all of the bonds are 2-year bonds, the one with the lowest coupon and yield has the greatest modified duration.
Why are government bonds normally used in active interest rate strategies?
A. Because they are non-callable.
B. Because they have good liquidity.
C. Because they have the highest credit ratings.
D. Because they have terms to maturity of less than 10 years.
B is correct.
Active interest rate strategies may result in frequent trading. Therefore, to keep trading costs down, active interest rate strategies require bonds with good liquidity. Government bonds have the best liquidity.
Your bond desk recommends selling XYZ Corp. senior secured debentures and buying XYZ Corp. subordinated debentures, which yield 40 basis points more than the senior debentures. What is this strategy called? A. Yield curve strategy. B. Interest rate strategy. C. Intermarket spread strategy. D. Intramarket spread strategy.
D is correct.
Intramarket spread strategies involve swapping bonds that are largely similar, including two bonds from two different issuers in the same business sector or two bonds of the same issuer at different locations on the issuer’s capital structure. The swap recommended by the bond desk in this question is an example of the latter.
When calculating a bond's Macaulay duration, what interest rate is used to determine the present value of the bond's cash flows? A. The bond's coupon rate. B. The bond's yield to best. C. The bond's yield to worst. D. The bond's yield to maturity.
D is correct.
The bond‘s yield to maturity is used to determine the present value of the bond’s cash flows. By definition, the present value is determined by discounting the bond’s cash flows at an interest rate that reflects the bond’s risk. The best measure of this rate is the bond’s yield to maturity.
For which of the following clients is a laddered portfolio likely appropriate?
A. Joe, a single 25-year old with a good job and a greater than average risk tolerance.
B. Mary, a 65-year old widowed pensioner needing regular income from her portfolio.
C. Jim, a 55-year old executive with plans to retire in relative comfort in 10 years’ time.
D. Sanjay, a 35-year old husband and father of three, saving for his children’s education.
B is correct.
Laddering involves building a portfolio of debt securities with staggered maturities, so that a portion of the portfolio matures at regular intervals. Generally, this approach is used for income-oriented portfolios, as the ladder provides a good indication of future cash flows, the income stream remains relatively constant, and only a small portion of the portfolio is re-invested every year. Thus, a laddered portfolio is most likely appropriate for Mary, the widowed pensioner.
An active investor swaps bonds of different maturities in and out of her portfolio in order to decrease the duration of her portfolio. Make an inference about her intentions.
A. She expects interest rates to increase.
B. She wants to create a barbell portfolio.
C. She intends to position the portfolio to ride the yield curve.
D. She is using intermarket spread strategies.
A is correct.
By adjusting the duration of their debt securities portfolios, active investors endeavour to take advantage of the changes in interest rates they expect. Active investors who expect interest rates to rise will lower their overall portfolio duration; if they expect rates to fall, they will increase the duration. The duration of a portfolio is changed by swapping bonds of different durations into and out of a portfolio.
Which of the following statements is true regarding intramarket spread strategies for debt securities?
A. It involves swapping securities of different issuers of different sectors only.
B. It attempts to take advantage of the yield spreads between different sectors of the bond market.
C. It is also called complement swaps.
D. It typically involves swapping bonds that are largely similar.
D is correct.
Intramarket spread strategies, also known as substitution swaps, involve swapping bonds that are largely similar. This strategy can also be applied to swapping securities of the same issuer.
What is the shape of the price-yield line for instantaneous changes in the yield of an option-free bond? A. Linear. B. Convex. C. Concave. D. Parabolic.
B is correct.
The price-yield line is convex for instantaneous changes in the yield of an option-free bond. This means that, as the bond’s yield rises, its price falls at a decreasing rate, and as its yield falls, its price rises at an increasing rate. This property holds for all option-free bonds.
What weight is given to a bond’s cash flows in the calculation of Macaulay duration?
A. The present value of the cash flow divided by the price of the bond.
B. The future value of the cash flow divided by the price of the bond.
C. The price of the bond divided by the present value of the cash flow.
D. The price of the bond divided by the future value of the cash flow.
A is correct.
What is the Macaulay duration of a strip bond with exactly 4 years and 9 months remaining until maturity? A. 4 B. 4.25 C. 4.75 D. 5
C is correct.
The Macaulay duration of a strip coupon (or zero-coupon bond) is its term to maturity in years. A term to maturity of 4 years and 9 months is equal to 4.75 years.
A 5-year Government of Canada bond with a semi-annual coupon rate of 6% is trading at a price of $104.38 to yield 5%. If its Macaulay duration is 4.41, what is its modified duration? A. 4.16 B. 4.20 C. 4.28 D. 4.30
D is correct.
The modified duration of a bond is equal to its Macaulay duration divided by [1 plus (its yield divided by the number of coupon payments per year)]. In this case, the modified duration is equal to 4.41 / (1.025) or 4.30.
