Fabozzi - 2 Flashcards
What is interest rate risk?
It refers to the adverse price movement of a bond as a result of a change in market interest rates.
What is call risk?
It is the risk that a security will be paid prior to the scheduled principal payment dates.
What is reinvestment risk?
It is the risk that interest and principal payments must be reinvested at a lower interest rate.
What is default risk?
It is the risk that the issuer will fail to satisfy the terms of indebtedness with respect to the timely payment of interest and principal.
What is credit spread risk?
It is the risk that the price of an issuer’s bond will decline due to an increase in the credit spread.
What is downgrade risk?
It is the risk that one or more of the rating agencies will reduce the credit rating of an issue or issuer.
What are the three main rating agencies in the U.S.?
Standard & Poor’s, Moody’s, and Fitch.
What does a credit rating represent?
It is an indicator of the potential default risk associated with a particular bond issue.
What is liquidity risk?
It is the risk that the investor will have to sell a bond below its indicated value.
What is the bid-ask spread?
It is the difference between the highest bid price and the lowest ask price from among dealers.
What is exchange rate risk?
It is the risk that the currency in which the bond’s payments are made will decline relative to the domestic currency.
What is inflation risk?
It is the risk that the cash flows of a security will decline in value due to inflation.
What is volatility risk?
It is the risk that the price of a bond with an embedded option will decline when expected yield volatility changes.
What is event risk?
It is the risk that the issuer’s ability to make payments changes dramatically due to unforeseen events.
What is sovereign risk?
It is the risk that a foreign government’s actions cause a default or adverse price decline on its bond issue.
How is the price of a callable bond calculated?
The price of a callable bond equals the price of an option-free bond minus the price of the embedded call option.
What is the relationship between interest rates and bond prices?
Bond prices change inversely with a change in market interest rates.
How does bond maturity affect interest rate risk?
The longer the bond’s maturity, the greater the price sensitivity to changes in interest rates.
How does the coupon rate affect interest rate risk?
The lower the coupon rate, the greater the bond’s price sensitivity to changes in interest rates.
What is the price sensitivity of a callable bond compared to an option-free bond?
The price of a callable bond will not fall as much as an option-free bond when interest rates rise.
How is duration defined in bond analysis?
Duration measures the price sensitivity of a bond to interest rate changes.
What does key rate duration measure?
It measures the approximate percentage price change for a 100 basis point change in the interest rate for one maturity.
What is a zero-coupon bond?
It is a bond that has no reinvestment risk but has greater interest rate risk than a coupon bond of the same maturity.
What is a rating transition matrix?
It shows the change in credit ratings over some time period.
What is cap risk in a floating-rate security?
It is the risk that the floater has a cap on interest rates, limiting potential increases.
What is yield curve risk?
It is the risk that a portfolio’s value will differ if interest rates increase by different amounts at different maturities.
What does a portfolio’s duration measure?
It measures the sensitivity of the portfolio’s value to changes in interest rates assuming a parallel yield curve shift.
What is parallel yield curve shift?
It is when interest rates change by the same amount for all maturities.
How is the price of a putable bond calculated?
It equals the price of an option-free bond plus the price of the embedded put option.
How is the percentage price change of a bond calculated?
By averaging the percentage price change due to the same increase and decrease in interest rates.
What is the relationship between interest rates and the price of an embedded call option?
As interest rates rise, the price of the embedded call option decreases.
What is the risk for a floating-rate security with a daily reset?
There is still interest rate risk because the margin required by the market may change.
What is the risk when a floater has a cap?
The interest rate cannot exceed the cap, limiting the investor’s potential returns.
What is the effect of yield volatility on a callable bond?
When expected yield volatility increases, the price of a callable bond decreases.
What is the effect of yield volatility on a putable bond?
When expected yield volatility decreases, the price of a putable bond decreases.
How does inflation risk affect a bond?
Inflation reduces the purchasing power of the bond’s cash flows.
What is the adverse effect of event risk?
It can dramatically and unexpectedly affect an issuer’s ability to make interest and principal payments.
What are the three forms of credit risk?
Default risk, credit spread risk, and downgrade risk.
What is the primary measure of liquidity risk?
The size of the spread between the bid and ask price quoted by dealers.
What is the relationship between the level of interest rates and a bond’s price sensitivity?
The higher the interest rate, the lower the price sensitivity to interest rate changes.
What is the main disadvantage of a callable bond to an investor?
The cash flow pattern is uncertain due to the possibility of early repayment.
What is the disadvantage of prepayable securities for investors?
They expose investors to greater reinvestment risk than nonamortizing securities.
What is the advantage of a zero-coupon bond regarding reinvestment risk?
It has no reinvestment risk.
What does a rating downgrade signify?
It indicates a reduction in the credit quality of the bond or issuer.
What is the risk of holding a bond in a foreign currency?
The bondholder faces exchange rate risk.
What is a bid price?
It is the highest price a buyer is willing to pay for a security.
What is an ask price?
It is the lowest price a seller is willing to accept for a security.
What happens to the price of an option-free bond when interest rates rise?
The price of the option-free bond decreases.
What is the impact of maturity on a bond’s interest rate risk?
Longer maturities increase the interest rate risk.
What is the purpose of using a duration calculation?
It helps approximate the percentage price change of a bond when interest rates change.
What happens to the price of a callable bond when interest rates rise?
The price of the callable bond does not fall as much as an option-free bond.
What is the price sensitivity of a bond?
It refers to how much the price of a bond changes when interest rates change.
How is the percentage price change of a bond measured?
It is measured by the percentage change from the bond’s initial price.
What is duration?
Duration is a measure of interest rate risk, showing how sensitive a bond’s price is to changes in interest rates.
How do you calculate the duration of a bond?
Duration is calculated by estimating the bond’s price for an increase and decrease in interest rates.
What does a portfolio’s duration assume?
It assumes that interest rates for all maturities change by the same amount.
What is prepayment risk?
It is the risk that a security will be paid off earlier than expected.
What is the relationship between reinvestment risk and prepayable securities?
Prepayable securities increase reinvestment risk because the proceeds must be reinvested at potentially lower rates.
What is the effect of a call provision on capital appreciation?
It reduces the capital appreciation potential of the bond.
What is a parallel yield curve shift?
It is when interest rates for all maturities change by the same amount.
What is the reinvestment risk for a zero-coupon bond?
Zero-coupon bonds have no reinvestment risk.
What is a rating upgrade?
It is when a bond’s credit rating is improved by a rating agency.
What is yield volatility?
It refers to changes in the expected yield and how it affects bond prices, especially for bonds with embedded options.
What is credit spread?
Credit spread is the difference in yield between a corporate bond and a government bond of the same maturity.
What is event risk?
Event risk refers to the possibility of dramatic changes in an issuer’s ability to make payments due to unexpected events.
What does sovereign risk refer to?
Sovereign risk is the risk of default or price decline due to actions taken by a foreign government.
What is the purpose of a rating transition matrix?
It shows how credit ratings change over a certain period.
What are the two components of liquidity risk?
The size of the bid-ask spread and the ease of trading the bond without affecting its price.
What is the primary characteristic of a floating-rate bond?
Its coupon payments adjust periodically based on a reference interest rate.
What is the main disadvantage of a prepayable security?
It exposes the investor to reinvestment risk.
How does yield volatility affect a bond with an embedded option?
Changes in yield volatility can affect the value of the embedded option, impacting the bond’s price.
What does exchange rate risk depend on?
It depends on changes in the value of the foreign currency relative to the domestic currency.
What is the impact of inflation risk on bond cash flows?
Inflation reduces the purchasing power of the bond’s future cash flows.
What does a rating downgrade signal to investors?
It indicates a higher risk of default or financial difficulty for the bond issuer.
What is the relationship between interest rates and bond prices?
There is an inverse relationship; as interest rates rise, bond prices fall.
What is the purpose of calculating duration?
It helps estimate the sensitivity of a bond’s price to interest rate changes.
What is key rate duration?
It measures the price sensitivity of a bond to changes in interest rates at specific maturities.
What is credit risk?
It refers to the risk that the issuer will not make timely payments of principal and interest.
What is downgrade risk?
It is the risk that a bond’s credit rating will be lowered by a rating agency.
What is the relationship between coupon rate and price sensitivity?
The lower the coupon rate, the higher the bond’s price sensitivity to interest rate changes.
How does bond maturity affect price sensitivity?
The longer the bond’s maturity, the greater its price sensitivity to interest rate changes.
What happens to the value of an embedded call option when interest rates rise?
The value of the embedded call option decreases.
What is a floating-rate security?
It is a bond whose coupon payments are adjusted based on changes in a reference interest rate.
What is the main feature of a callable bond?
A callable bond can be repaid by the issuer before its maturity.
What does liquidity risk imply for a bondholder?
It means the bondholder may have to sell the bond below its fair value due to low market liquidity.
What does prepayment risk refer to?
It is the risk that the issuer will repay the bond earlier than expected, affecting the investor’s returns.
How does a rating upgrade affect a bond?
It improves the bond’s creditworthiness and often increases its price.
What is the impact of a callable bond’s embedded option on price?
The price of a callable bond is lower than an option-free bond due to the value of the embedded call option.
What is reinvestment risk for a coupon bond?
It is the risk that coupon payments will have to be reinvested at a lower interest rate than the bond’s coupon rate.
What are the two main types of credit risk?
Default risk and downgrade risk.
What happens to a bond’s price if credit spreads widen?
The bond’s price will decrease.
How does exchange rate risk affect bondholders?
Bondholders may lose value if the foreign currency depreciates against their domestic currency.
What is the definition of inflation risk?
It is the risk that inflation will reduce the real value of a bond’s cash flows.
How does yield volatility affect a callable bond?
Higher yield volatility decreases the value of a callable bond.
What is sovereign risk?
It is the risk that a foreign government’s actions will negatively impact a bond’s value.
What happens when interest rates increase for a bond portfolio with a high duration?
The portfolio’s value will decline significantly.
What is the purpose of a callable bond?
It allows the issuer to repay the bond before maturity, typically when interest rates decline.
What does a bond’s coupon rate represent?
It represents the interest rate the issuer agrees to pay on the bond’s face value.
What is the inverse relationship between bond prices and interest rates?
When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.
What is a premium bond?
It is a bond selling above its face value because its coupon rate is higher than the market interest rate.
What is a discount bond?
A bond selling below its face value because its coupon rate is lower than the market interest rate.
What is a par value bond?
A bond that is selling at its face value.
How does a callable bond’s price react when interest rates rise?
The price of a callable bond decreases, but less than an option-free bond.
What is an embedded option in a bond?
It is a feature that allows the issuer or the bondholder to take certain actions, such as calling or putting the bond.
What is the impact of a bond’s maturity on interest rate risk?
The longer the maturity, the higher the interest rate risk.
What is a coupon bond?
A bond that pays periodic interest based on its coupon rate.
What is yield curve risk?
It is the risk that a bond portfolio’s value will be affected if interest rates change differently at various maturities.
What is call risk?
The risk that a callable bond will be repaid before its maturity, typically when interest rates fall.
What is a bond’s face value?
The principal amount of the bond that is repaid at maturity.
What is the bid-ask spread in bond trading?
It is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept.
What is credit spread risk?
It is the risk that a bond’s price will decrease due to an increase in the credit spread.
What is the purpose of a rating agency?
To assess the creditworthiness of bond issuers and assign credit ratings.
What is liquidity risk?
The risk that an investor may not be able to sell a bond at its market value due to a lack of buyers.
What is a callable bond?
A bond that can be repaid by the issuer before its maturity date.
How does inflation risk affect bondholders?
Inflation reduces the purchasing power of the bond’s future interest and principal payments.
What is the duration of a bond?
It is a measure of the bond’s sensitivity to interest rate changes, indicating the percentage price change for a 1% change in interest rates.
What does the term “yield” refer to in bonds?
Yield is the return on a bond based on its current market price and interest payments.
What is the relationship between a bond’s coupon rate and its price?
If the coupon rate is higher than market interest rates, the bond will trade at a premium; if lower, at a discount.
What does a floating-rate bond mean?
A bond where the interest payments fluctuate with changes in a reference interest rate.
What is reinvestment risk for an amortizing security?
It is the risk that periodic principal payments will have to be reinvested at lower interest rates.
