Chapter 7 - Fixed Income Securities: Pricing and Trading

Question 1

What is the present value of a bond?

Answer 1

The present value is the amount an investor should pay today to invest in a security that offers a guaranteed sum of money on a specific date in the future.
Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate of return.

Question 2

What is the significance of the discount rate?

Answer 2

The discount rate is the rate at which you would discount a future value to determine the present value.
The discount rate is the investment rate of return that is applied to the present value calculation. In other words, the discount rate would be the forgone rate of return if an investor chose to accept an amount in the future versus the same amount today.

Question 3

What is the significance of the sum of the present value of a bond’s coupons and principal?

Answer 3

That’s how you calculate the fair price of a bond.

Question 4

If you were told that a Treasury Bill has a price of 97.45 and matures in 69 days, could you demonstrate how to calculate the annual yield?

Answer 4

Yield = 100-97.45 / 97.45 x 365/69 x 100 = 13.84%

Question 5

How would you define the current yield of a bond?

Answer 5

Current yield only looks at cash flows and the current market price of an investment, not the amount that was originally invested.

Question 6

What is the formula for the approximate yield to maturity?

Answer 6

This shows the total return you would expect to earn over the life of a bond starting today.

1. # N
2. # PMT
3. trading price +/- PV
4. 100 FV
5. COMP I/Y

Question 7

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

Answer 7

A bond’s current yield is an investment’s annual income, including both interest payments and dividends payments, which are then divided by the current price of the security.
Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until its maturation date.

Current yield, approximate YTM and YTM will differ because they apply different formulas based on different assumptions except when the bond trades at par they will all be the same.

Question 8

What is reinvestment risk?

Answer 8

The longer the term to maturity, the less likely it is that interest rates will remain constant over the term. The risk that the coupons will earn a return at a lower overall rate than the rate that prevailed at the time the bond was purchased is call reinvestment risk.

Question 9

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

Answer 9

The real rate of return adjusts profits to account for inflation.
The nominal rate of return is the amount of money generated by an investment before factoring in expenses such as taxes, investment fees, and inflation.

Question 10

Can you compare a normal yield curve to an inverted yield curve?

Answer 10

Upward sloping curve indicates an expectation of higher rates in the future whereas a downward sloping curve indicates rates are expected to fall.

Question 11

Can you describe in details the three theories proposed to describe the shape of the yield curve?

Answer 11

Liquidity Preference Theory
Investors prefer short term bonds because they are more liquid and less volatile in price.
Market Segmentation Theory
Yield curve represents the supply of and demand for bonds of various terms (5, 10yr) which are primarily influenced by the bigger players in each sector. (major banks invest in short term bonds, life insurance invest in longer term bonds.)
Expectations Theory
Current long term interest rates foreshadow future short term rates. Investors buying a single long term bond should expect to earn the same amount of interest as they would buying two short term bonds of equal combined duration.

Question 12

Can you describe the relationship between bond prices and interest rates?

Answer 12

There is an inverse relationship. As interest rates rise, bond prices fall. As interest rates fall, bond prices rise.

Question 13

Can you describe the impact of different maturity lengths on bond prices?

Answer 13

Longer term bonds are more volatile in price than shorter term bond.

Question 14

Can you describe the impact of different coupon rates on bond prices?

Answer 14

Lower coupon bonds are more volatile in price percentage change that high coupon bonds.

Question 15

Can you describe the impact of yield changes on bond prices?

Answer 15

The relative yield change is more important than the absolute yield change. For example, a drop in yield from 12% to 10% will have a smaller impact on a bond’s price than a drop in yield from 4% to 2%. First is a 17% change, second is a 50% change.

Question 16

What does the duration of a bond describe?

Answer 16

The calculation that combines the impact of both the coupon rate and the term to maturity is called duration. Duration is a measure of the sensitivity of a bond’s price to changes in interest rates. It is defined as the approximate percentage change in the price or value of a bond for a 1% change in interest rates.

Question 17

Can you explain how the sell side of the bond market differs from the buy side?

Answer 17

The sell side of fixed-income trading is the investment dealer side. Sell side services include everything related to creating, producing, distributing, researching, marketing and trading fixed-income products.

The buy side of fixed-income trading is the investment management side. Buy-side institutions are concerned with asset management and are typically engaged in the buying and holding of securities on behalf of their institutional clients. Their clients include entities such as mutual funds, insurance companies, and pension funds.

Question 18

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

Answer 18

Inter-dealer brokers are participants in the wholesale bond market. They act solely as agents, bringing together institutional buyers and sellers in matching trades.

Question 19

Can you name the information contained in the electronic information known as the trade ticket?

Answer 19

• specific details of the counterparts to the trade
• full identification of the bond
• amount of transaction
• price and yield
• settlement date
• name of the custodian where the trade will settle
• total settlement amount

Question 20

Can you describe the settlement rules for Government of Canada Treasury Bills?

Answer 20

T-bills settle on the day of the transaction.

Question 21

Can you describe the settlement rules for common shares?

Answer 21

Common shares settle on the second clearing day after the transaction takes place.

Question 22

What are the significant differences between bearer bonds and registered bonds?

Answer 22

A registered bond have the name of the rightful owner and can only be sold when the owner signs the back of the certificate.
Bearer bond is a paper copy where the coupons need to be detached and brought into a bank for payment. Ownership is signified by physical possession.

Question 23

How would you define accrued interest?

Answer 23

Accrued interest is the amount of interest built up during the previous holding period. For example, a bond paid interest August 1, it was sold October 1st. There are 2 months of accrued interest that should be included in sell price.

Question 24

You purchased a 7% Government of Canada $300,000 face value bond, due March 20, 2025 for a price of 98.425 on Monday May 22. Could you calculate the accrued interest?

Answer 24

$3739.73

Question 25

What is a bond index?

Answer 25

An index measures the relative value and performance of a group of securities over time. There are bond indexes and stock indexes.

Question 26

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

Answer 26

FTSE Global Debt Capital Markets.