Chapter 7

Question 1

What is the PV of a bond?

Answer 1

Par value = face value, principal amount the issuer must pay back at maturity

Question 2

What is the significance of the discount rate?

Answer 2

Discount rate = rate at which you would discount a FV to determine the PV

Discount rate is chosen based on the risk of the particular bond

Question 3

What is the significance of the sum of the PV of a bond’s coupon and principal?

Answer 3

Fair price of a bond

Question 4

If you were told that a 7% semi-annual bond matures in 5 years at discount rate of 4%, demonstrate the price of the bond

Answer 4

PV OF THE INCOME STREAM:

PV OF THE PRINCIPAL:

PV OF THE BOND:

Question 5

T-bill has a price of 97.45 and matures in 69 days, demonstrate how to calculate annual yield

Answer 5

Yield = 100 - Price / Price X 365 / term X 100

Yield = 100 - 97.45 / 97.45 X 365 / 69 X 100

Question 6

Define the current yield of a bond

Answer 6

Current yield only looks at cash flows and the current market price of an investment. NOT what was originally invested

Current Yield = annual cash flow / current market price x 100

Question 7

What is the formula for the approximate YTM

Answer 7

A 4 year, semi-annual, 9% bond, trading at 96.77

N = 8
PMT = 4.50
PV = -96.77
FV = 100
COMP I/Y

I/Y = 4.9997

Question 8

What is the difference between current yield, approximate yield, and YTM?

Answer 8

Current yield: looks only at cash flows and current market price of an investment, NOT amount originally invested

Approximate yield:

YTM: reflects investors return in the form of coupon income + any capital gain from purchasing the bond at discount or capital loss from purchasing bond at premium. YTM takes into account; current market price, term to maturity, par value at maturity, and coupon rate

Question 9

What is reinvestment risk?

Answer 9

The risk that the coupons will earn a return at lower overall rate than the rate that prevailed at the time the bond was purchased is the reinvestment risk

Question 10

What is the difference between the nominal and real rate of return?

Answer 10

Nominal rate of return: includes inflation

Real rate of return: removes inflation

Question 11

Compare a normal yield curve to inverted yield curve

Answer 11

Normal yield curve; up right

Inverted yield curve ; down right

Question 12

Describe the 3 theories proposed to describe the shape of the yield curve

Answer 12

Expectations Theory: current long-term interest rates foreshadow future short-term rates. 1 long term bond = 2 short term bonds

Liquid Preference Theory: investors prefer short term bonds, they are more liquid and less volatile

Market Segment Theory: various institutional players concentrate in specific term sector

Question 13

Describe the relationship between bond prices and interest rates

Answer 13

Interest rates rise = bond yield rise + bond price falls

Interest rates fall = bond yield fall + bond price rises

Interest rates and bond yields match, bond price does opposite

Question 14

Describe the impact of different maturity lengths on bond prices

Answer 14

Long term bonds are more volatile than short term bonds

As bonds approach maturity, they become less volatile

Question 15

Describe the impact of different coupon rates on bond prices

Answer 15

Lower coupon bonds are more volatile in price change than high-coupon bonds

When yields rise, bond prices drop, but lower coupon bonds will drop significantly more

Question 16

Describe the impact of yield changes on bond prices

Answer 16

Bond prices are more volatile when interest rates are low

Relative yield change is more important than absolute yield change

Question 17

What does the duration of a bond describe?

Answer 17

Duration is the measure of the sensitivity of a bond’s price to change in interest rates

Duration helps investors to determine the bond’s volatility (amount of change)

Higher duration = higher percentage change for a yield

Question 18

Explain the buy side and sell side

Answer 18

Buy Side = investment management. buying and holding of securities on behalf of clients. PM/Trader

Sell Side = trading investment products for their own accounts. creating, producing, researching, marketing, and trading products. Investment banker/Trader/Sales representative

Question 19

What role does an inter-dealer broker play in the bond market?

Answer 19

Participants in the wholesale bond market

Act as agents, bringing together institutional buyers and sellers

Perform price discovery, trade execution, clearing and settlement

Inter-dealer brokers handle significant volumes

Provides anonymity

Question 20

Name the information contained in the electronic information known as the trade ticket

Answer 20

Electronic confirmation sent through secure system includes;

specific details of trade, identification of bond, CUSIP and ID number, value of transaction, price, settlement, etc.

Question 21

Describe the settlement rules for Government of Canada t-bills

Answer 21

Canadian T-bills settle the same day

Question 22

Describe the settlement rules for common shares

Answer 22

Securities, bonds, certificates and shares settle on second clearing day after transaction

Question 23

Differences between bearer bonds and registered bonds

Answer 23

Bearer bonds: certificate is produced, detachable coupons are attached to residual principal payment. Investor detaches coupons to submit to bank. Ownership is physical possession

Registered bonds: bear the name of the owner, and sold only when the owner signed the back of the certificate. Coupon payments mailed to owner

Question 24

Defined accrued interest

Answer 24

Accrued interest is the amount of interest built up during the previous holding period

Accrued interest = Par amount X Coupon rate / 100 X Time period / 365

Question 25

You purchased a 7% Government of Canada 300k face value bond, due March 20 2025, for price of 98.425 on Monday May 22. Calculate accrued interest

Answer 25

March 21 - 31 = 11 days
April = 30 days
May = 24 days (includes 2 days for settlement)

Total days = 65 days

300k X (7.00 / 100) X (65 days / 365)

Question 26

What is a bond index

Answer 26

Index measures the relative value and performance of a group of securities over time

Question 27

What is the best-known bond index that tracks broad Canadian bond markets

Answer 27

FTSE Global Debt Capital Markets: offers a comprehensive set of Canadian bond indexes