Chapter 7 Fixed-Income Securities: Pricing and Trading RQ Flashcards
Sarifa is considering investing in an 8%, $1,000 par value, 5-year Government of Canada bond. Assuming a discount rate of 6%, and semi-annual coupon payments. What should she pay for this bond?
A. Not pay more than $1,000.
B. Not pay more than $1,060.
C. Not pay more than $1,084.25.
D. Not pay more than $1,085.30.
D. Not pay more than $1,085.30.
The present value of the coupon payments is found using the APV formula:
APV=C ((1-(1/(1+r)n))/r) = $40((1-(1/(1.03)10))/0.03 = $40(8.5302) = $341.21
The present value of the principal is found using the PV formula:
PV=FV/(1+r)n = $1,000/(1.03)10 = $744.09
The present value of this bond is simply the sum of these two present values:
PV = $744.09 + $341.21= $1,085.30
Note: The $40 in the formula represents one regular coupon payment. Since the bond has a coupon rate of 8% and a par value of $1,000, the interest paid each year is $80 (8% of $1,000). However, since bonds pay interest semi-annually, each regular interest payment would be $40 every six months. So, C = $40 in the APV formula.
Calculate the yield of a 92-day T-bill with a price of 98.75.
A. 3.19%.
B. 4.02%.
C. 4.96%.
D. 5.02%.
D. 5.02%.
T-bill yield is calculated as (100-price)/price x (365/term) x 100. In this example, the T-bill yield of 5.02% is determined as (100-98.75)/98.75 x (365/92) x 100.
Calculate the approximate yield to maturity (per $100 face value) for an annual bond with a 7% coupon, current market price of $107.50 and 5 years to maturity.
A. 5.30%.
B. 5.50%.
C. 6.15%.
D. 8.19%.
A. 5.30%.
The approximate yield to maturity is determined as (interest income +/- price change per compounding period)/((purchase price + 100)/2) × 100. In this example, the return is determined as ($7.00 - ($7.50/5 years))/((107.50 + 100)/2) × 100 = 5.30%. Keep in mind that using the functions of a financial calculator will lead to an answer that differs from 5.30%. The financial calculator is a different formula that makes different assumptions than the approximate yield to maturity formula. When asked to calculate the approximate yield to maturity, you need to use the formula noted in the text to calculate the correct answer. There are no functions on the financial calculator that calculate the approximate yield to maturity.
Dominique reads that the yield curve is currently downward sloping. Based on this observation, what does Dominique expect to happen to interest rates?
A. Investors expect rates to rise in the future.
B. Investors expect rates to fall in the future.
C. Investors expect rates to rise then fall.
D. Investors expect rates to remain fairly stable.
B. Investors expect rates to fall in the future.
A downward sloping yield curve, where short-term rates are higher than long-term rates, indicates that investors expect interest rates to decline in the future. They require a high short-term rate, perhaps because current inflation rates are high, but are willing to accept lower long-term rates due to the expected rate declines.
Select the statements about bonds that are correct.
Bond prices move inversely to interest rates.
The longer the term to maturity the greater the price volatility.
Bonds with low coupon rates have more price volatility than bonds with high coupon rates.
Bond prices are more volatile when interest rates are high.
A. 1 only.
B. 4 only.
C. 1, 2 and 3.
D. 2 and 4 only.
C. 1, 2 and 3.
There are some conventional rules regarding the price action of fixed-income securities. Each of these rules is explained separately below.
First it must be understood that there is very little difference between interest rates and yields. After all, each represents a rate of return on an investment. Therefore, as interest rates rise, the yields on competing investments must also rise, and vice versa. Since interest payments are fixed, the only way to increase yields must be to decrease the market price, and vice versa. Bonds with long terms to maturity have more volatile prices i.e., when interest rates change, the price of longer-term bonds change more than the price of shorter-term bonds.
Bonds with lower coupons have more volatile prices. When interest rates rise, bonds drop in price, but lower coupon bonds drop more than higher coupon bonds. This difference is material when larger coupon differences are considered, or when large sums of money are invested and even small price changes involve significant amounts of money. Bond prices are more volatile when interest rates are low. For example, a drop in yields from 12% to 10% will have a lesser impact on a bond’s price than a drop in yields from 4% to 2%. Although both represent a drop of 200 basis points, or 2 percent, the former is a 17% change in yields, and the latter is a 50% change in yields. Thus, bond prices are more volatile when interest rates are low.
If Salma expects market interest rates to decline, what type of bonds should she buy?
A. Short-term, low coupon.
B. Long-term, high coupon.
C. Short-term, high coupon.
D. Long-term, low coupon.
D. Long-term, low coupon.
If market interest rates decline, bond prices will increase and bondholders will earn capital gains. Salma should attempt to maximize the potential capital gain by purchasing bonds that are more volatile. Long-term bonds are more volatile than short-term bonds and low coupon bonds are more volatile than high coupon bonds. Therefore, a long-term, low coupon bond offers the greatest potential for capital gains if interest rates decline.
Why is the normal slope of the yield curve upward sloping to the right?
A. Yields increase with time to reflect the increased risk of longer terms to maturity.
B. Bond prices increase as the term to maturity of the bond increases.
C. Yields are higher for bonds with shorter terms to maturity to compensate for the short holding period.
D. Yields decrease as term to maturity increases.
A. Yields increase with time to reflect the increased risk of longer terms to maturity.
Bond yields normally increase as the term to maturity increases to reflect the risk of holding a bond with a longer term. The actual slope of the yield curve can vary significantly depending on economic conditions and other factors such as supply and demand.
Vitaliy has just sold his Government of Canada bonds. When will he receive his money?
A. The same day.
B. The third clearing day after the transaction takes place.
C. The second clearing day after the transaction takes place.
D. The first clearing day on or after the fifteenth calendar day of the month.
C. The second clearing day after the transaction takes place.
Government of Canada (GoC) Treasury Bills are settled the same day. All other bonds, debentures, and certificates of indebtedness settle on the second clearing day after the transaction takes place.
What must an investor pay when purchasing a bond?
A. The market price of the bond.
B. The bond’s market price plus interest accrued since the last interest payment.
C. The market price of the bond as of the settlement date.
D. The bond’s market price less interest accrued since the last interest payment.
B. The bond’s market price plus interest accrued since the last interest payment.
When a securities transaction takes place, the change in legal ownership of the securities is effective immediately. However, payment for purchased securities does not have to be made until some time later, and delivery of sold securities also does not have to be done until the end of this time period, called the settlement period. The length of the settlement period varies depending on the type of security being transacted. The client who purchases a bond pays the purchase or market price plus the interest which has accrued or accumulated since the last interest date. This interest is regained if the bond is held until the next interest payment date, or if the bond is sold in the meantime, resulting in accrued interest being paid to that seller.
Calculate the accrued interest on the following transaction. A 7% bond maturing on April 12 five years from now is purchased and settles on December 18th. The principal amount of the purchase is $100,000.
A. $642.47.
B. $1,227.40.
C. $1,284.93.
D. $4,794.42.
C. $1,284.93
Accrued interest is determined from the day after the last interest payment date up to and including the settlement date. Interest payments are semi-annual on the anniversary date of maturity (e.g. April 12) and exactly six months later (e.g. October 12). Accrued interest is calculated as (Par value x % coupon rate x (# days accrued/365). In this example, the accrued interest = $100,000 x 0.07 x (67/365) = $1,284.93. The number of days for accrual is:
October 13 - 31 = 19 days
November 1 - 30 = 30 days
December 1 - 18 = 18 days
Total 67 days
DDD Co. Inc. has an outstanding 12-year bond with a coupon of 8.75%. The financial press is quoting the bond with a yield of 6%. What does this imply?
A. The price of the bond will be above par.
B. The price of the bond will be below par.
C. The price of the bond will increase by approximately 2.75%.
D. The price of the bond will slowly increase to par as time to maturity approaches.
A. The price of the bond will be above par.
The most important bond pricing relationship to understand is the inverse relationship between bond prices and interest rates (or bond yields) — as interest rates rise, bond prices fall and as interest rates fall, bond prices rise. So, if the yield of the bond has fallen below the coupon rate, the price must have increased above par.
Sonoma is convinced that interest rates are going to drop. She wishes to buy a bond, hold it until rates have dropped, then sell it to earn a capital gain. Recommend a bond for her to purchase.
A. A 6-month T-bill.
B. A 9-month T-bill.
C. A 6% 8-year bond.
D. A 6% 10-year bond.
D. A 6% 10-year bond.
Longer-term bonds are more volatile in price than shorter-term bonds. If she wishes the price to move up more, she should choose the longer-term bond.
Neta has read that interest rates are expected to go up. She currently owns 4 bonds and is thinking of selling one before this happens. Which bond do you recommend she should sell?
A. A 6.5% 10-year bond with a duration of 9.
B. A 7% 9-year bond with a duration of 8.
C. A 6% 8-year bond with a duration of 7.
D. A 5% 7-year bond with a duration of 6.
A. A 6.5% 10-year bond with a duration of 9.
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. The higher the duration of the bond, the more it will react to a change in interest rates. If interest rates are going up, prices will fall. She should sell the bond which is the most volatile as its price will fall the most. That is the bond with the highest duration.
The inflation rate is expected to be 3% next year. Sharif buys a bond at par with a 7% coupon. Calculate his real rate of return.
A. 3%.
B. 4%.
C. 7%.
D. 10%.
B. 4%
Because inflation reduces the value of a dollar, the return that is received, known as the nominal rate, must be reduced by the inflation rate to arrive at the actual or real rate of return.
Real Rate = Nominal Rate - Inflation Rate.
Eduardo is planning to buy a bond. He wants a bond with low reinvestment risk as he has heard that interest rates will be volatile over the next few years. What bond do you recommend he purchase?
A. A 6% 10-year corporate bond.
B. A 4.2% 8-year Government of Canada bond.
C. A 5.5% 5-year strip bond.
D. A 3% 2-year corporate bond.
C. A 5.5% 5-year strip bond.
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 called reinvestment risk. Only a zero-coupon bond has no reinvestment risk because there are no coupon cash flows to reinvest before maturity.
