Chapter 7 - Fixed-Income Securities: Pricing and Trading (Done) Flashcards
What is the present value of a bond?
- The present value of a bond is the current worth of its future cash flows, which include periodic interest payments (coupons) and the principal repayment at maturity. Using the simplified formula, it is calculated as:
- PV = FV(1+IR/DR)
PV = present value
FV = future value
IR = interest rate
DR = discount rate
What is the significance of the discount rate?
The discount rate is the interest rate used to determine the present value of future cash flows. It reflects the opportunity cost of investing capital in a particular bond compared to other investments. A higher discount rate means a lower present value of the bond, indicating higher risk or higher returns expected from other investments.
What is the significance of the sum of the present value of a bond’s coupons and principal?
The sum of the present value of a bond’s coupons and principal represents the bond’s market price. This sum is essentially what investors are willing to pay today for the bond, considering the time value of money. It provides a measure of the bond’s value at the current market conditions.
How would you define the current yield of a bond?
The current yield of a bond is the annual income (interest or dividends) divided by the current price of the bond. It is a measure of the income provided by the bond relative to its current market price.
What is the primary difference between the current yield, the approximate yield to maturity, and YTM?
- Current Yield: Measures the annual income from the bond as a percentage of its current price. It does not account for the time value of money or capital gains/losses if held to maturity.
- Approximate Yield to Maturity: An estimate of the total return anticipated on a bond if held until it matures, including both interest income and capital gains/losses.
- Yield to Maturity (YTM): The exact total return anticipated on a bond if held until maturity, calculated using a complex formula that considers all future cash flows and the time value of money.
What is reinvestment risk?
Reinvestment risk is the risk that future proceeds from an investment, such as bond coupons or principal repayments, will have to be reinvested at a lower interest rate than the original investment. This can reduce the overall return on the investment.
What is the difference between the nominal rate of return and the real rate of return?
- Nominal Rate of Return: The rate of return on an investment without adjusting for inflation. It is the actual percentage increase in value.
- Real Rate of Return: The nominal rate of return adjusted for inflation. It reflects the true increase in purchasing power.
Can you compare a normal yield curve to an inverted yield curve?
- Normal Yield Curve: An upward-sloping curve indicating that longer-term bonds have higher yields than shorter-term bonds, reflecting higher risks over a longer period.
- Inverted Yield Curve: A downward-sloping curve indicating that shorter-term bonds have higher yields than longer-term bonds, often a sign of expected economic downturns or lower future interest rates.
Can you describe in detail the three theories proposed to describe the shape of the yield curve?
- Expectation Theory: The shape of the yield curve reflects investor expectations about future interest rates. A normal curve suggests rising rates, while an inverted curve suggests falling rates.
- Liquidity Preference Theory: Investors demand a premium for holding longer-term securities due to higher risk, leading to a normal upward-sloping yield curve.
- Market Segmentation Theory: The yield curve shape is determined by supply and demand within different maturity segments. Investors have specific maturity preferences and will not easily switch between them, creating distinct yield characteristics for each segment.
Can you describe the relationship between bond prices and interest rates?
Bond prices and interest rates have an inverse relationship. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This is because the fixed coupon payments become less attractive when new bonds are issued at higher rates.
Can you describe the impact of different maturity lengths on bond prices?
- Longer Maturity Bonds: More sensitive to interest rate changes (higher duration) because they have a longer period over which the fixed payments are received.
- Shorter Maturity Bonds: Less sensitive to interest rate changes due to a shorter period of fixed payments.
Can you describe the impact of different coupon rates on bond prices?
- Higher Coupon Rates: Make a bond more attractive, increasing its price, because they provide higher periodic income.
- Lower Coupon Rates: Make a bond less attractive, decreasing its price, due to lower periodic income.
Can you describe the impact of yield changes on bond prices?
- Rising Yields: Decrease bond prices because new bonds are issued at higher rates, making existing bonds with lower rates less valuable.
- Falling Yields: Increase bond prices because existing bonds with higher rates become more valuable compared to new bonds issued at lower rates.
What does the duration of a bond describe?
Duration measures the sensitivity of a bond’s price to changes in interest rates. It represents the weighted average time to receive all cash flows from the bond. Higher duration indicates greater sensitivity to interest rate changes.
Can you explain how the sell side of the bond market differs from the buy side?
- Sell Side: Refers to institutions like investment banks and brokers that facilitate the buying and selling of bonds. They provide liquidity, create markets, and offer research and advice.
- Buy Side: Refers to institutions like mutual funds, pension funds, and individual investors that buy bonds for investment purposes. They focus on asset management and investment strategies.
