Chapter 12: Bond Valuation

Question 1

Relationship between yield and price:

Answer 1

Inverse relationship.

• Higher yield => lower price
• Lower yield => higher price

Question 2

7 Yield measures

Answer 2

Nominal Yield
Current Yield
Yield to maturity
Yield to call
Yield to put
Realised yield
Spot and forward rates

Question 3

Nominal yield

Answer 3

Coupon rate of an issue.

Question 4

Current yield

Answer 4

Interest income only.

CY = Annual Coupon payment / bond price

Question 5

Yield to maturity

Answer 5

An annualised internal rate of return based on a bond’s price, coupon payments and par value.
= single discount rate used to price a bond.

Question 6

Yield to call calc.

Answer 6

Call price is substituted for the par value.

Number of periods to the call substituted for the time to maturity.

Question 7

Yield to put calc.

Answer 7

Put price is substituted for the par value.

Number of periods until the put date is substituted for the time to maturity.

Question 8

Realised yield

Answer 8

Takes account of the expected per-period reinvestment rates during the investment.

Question 9

Spot rates

Answer 9

derived from Treasury bonds of varying maturities and coupons effectively removing any coupon, reducing each bond to a zero-coupon bond at a particular maturity.

Question 10

Yield curve

Answer 10

Plot of the yields against their maturities.

Question 11

4 General shapes to the yield curve

Answer 11

Normal (upward sloping)
Inverted (downward sloping)
Flat
Humped

Question 12

Normal (upward sloping)

Answer 12

• Longer maturity bonds have higher yields due to investors requiring a higher rate of return for taking the added risk of lending money for a longer period of time.

Question 13

Inverted (downward sloping)

Answer 13

• Shorter-term yields are greater than longer-term, which can signal an upcoming recession.

Question 14

Flat

Answer 14

• Equal at every maturity.
• One in which the shorter- and longer-term yields are very close.
• Signifies that investors have no opinion on the movement of interest rates and are unsure about future economic growth and inflation.

Question 15

Humped

Answer 15

• Yields on intermediate-term issues are above the yields on the short-term issues and the rates on long-term issues decline to levels blow those for the short-term issues before levelling out.
• Precursor to a recession.

Question 16

3 Basic theories on the shape of the yield curve.

Answer 16

Expectations theory
Liquidity preference theory
Segmented Market theory

Question 17

Expectations theory

Answer 17

o Most widely accepted yield curve theory.
o Forward rates are solely a function of expected future spot rates.
o Expectations of rising short-term rates create a positive yield curve.

Question 18

Liquidity preference theory

Answer 18

o Forward rate reflect investors’ expectations of future rates plus a liquidity premium to compensate them for exposure to interest rate risk.

Question 19

Segmented Market theory

Answer 19

o Proposes that lenders and borrowers are confined to certain maturity segments due to restrictions on their maturity structure and will therefore not be enticed to shift out of these maturity ranges.
o Shape of yield curve is thus a function of supply and demand.

Question 20

Interest rate risk

Answer 20

Risk that changing market rates will impact negatively on the return of a bond.

Question 21

Duration of a bond

Answer 21

• Duration captures the risk attributes of a bond in a single number that measures the sensitivity of a bond’s market price to changes in the market rate.

Question 22

Generalisations to bonds’ interest rate risk:

Answer 22

o Long-term bonds are subject to more interest rate risk than short-term.
o Low-coupon bonds are subject to more interest rate risk than high-coupon.
o Low-yield bonds are subject to more interest rate risk than high-yield.

Question 23

Properties of bond duration

Answer 23

o Duration of zero-coupon bond = maturity

o Duration of coupon bond

Question 24

Effective duration

Answer 24

• Interpreted as the approximate percentage change in a bond’s price for one percent change in the market rate.
• Duration becoming longer implies higher interest rate sensitivity.

Question 25

Duration effect

Answer 25

• Approximates a change in price given a specific change in yield.
• %∆PD = – D(∆y)