FM/2 Conceptual Questions Flashcards
The internal rate of return of an investment is the interest rate that equates the present value of all related cash flows to:
a) the opportunity cost of the cash flows
b) the initial investment amount
c) the investment value of the cash flows
d) zero
e) the sum of all positive cash flows
d) zero
Select the condition that is not a requirement of Redington immunization:
a) The term structure of interest rates is flat.
b) The convexity of liabilities is greater than the convexity of assets.
c) The duration of the liabilities is equal to the duration of the assets.
d) The present value of liabilities is equal to the present value of the assets.
e) All of the above are required.
b) The convexity of liabilities is greater than the convexity of the assets.
This is false because it should read that “the convexity of liabilities is LESS than the convexity of the assets”.
When the interest rate on a loan changes, the new remaining term of the loan (assuming one can be found) may be calculated by:
a) calculating the outstanding loan balance at the date of the change using the old interest rate and then calculating the new term using the old interest rate and the existing repayment.
b) calculating the outstanding loan balance at the date of the change using the new interest rate and then calculating the new term using the old interest rate and the existing repayment.
c) calculating the outstanding loan balance at the date of the change using the new interest rate and then calculating the new term using the new interest rate and the existing repayment.
d) calculating the outstanding loan balance at the date of the change using the old interest rate and then calculating the new term using the new interest rate and the existing repayment.
e) none of the above
d) calculating the outstanding loan balance at the date of the change using the old interest rate and then calculating the new term using the new interest rate and the existing repayment.
For a coupon-paying bond that sells at par, the coupon rate curve under a normal term structure is always situated:
a) above both the forward yield curve and spot yield curve
b) above the forward yield curve and below the spot yield curve
c) below both the forward yield curve and spot yield curve
d) above the spot yield curve and below the forward yield curve
e) none of the above
c) below both the forward yield curve and spot yield curve
An upward sloping yield curve can best be described as a:
a) direct yield curve
b) normal yield curve
c) flat yield curve
d) inverse yield curve
e) increasing yield curve
b) normal yield curve
The distinction between Macaulay duration and modified duration:
a) exists when working with continuous interest.
b) exists when working with discrete interest.
c) always exists.
d) never exists.
e) only exists for coupon-paying bonds.
b) exists when working with discrete interest.
Explanation: as m approaches infinity, the difference | Dmod - Dmac | approaches 0.
(3) What are the conditions of Redington immunization and (1) what does it do?
Conditions:
1) PV(A) = PV(L)
2) DMac(A) = DMac(L)
3) Convexity(A) > Convexity(L)
What it does:
1) Immunizes against SMALL changes in i
(3) What are the conditions of full immunization and (1) what does it do?
Conditions:
1) PV(A) = PV(L)
2) DMac(A) = DMac(L)
3) Asset CFs before and after every liability.
What it does:
1) Immunizes against ANY changes in i
Exactly TWO of the numbered items are related to only ONE lettered item. Choose the related items.
X. Immunization
Y. Cash flow matching
- Risk minimization
- Cost minimization
- Portfolio rebalancing
a) 1 and 2 are only related to X
b) 2 and 3 are only related to X
c) 1 and 2 are only related to Y
d) 2 and 3 are only related to Y
e) none of the above
b) 2 and 3 are only related to X
Explanation
Immunization
1. Risk minimization - YES (risk minimized to small changes in i)
2. Cost minimization - YES (since PV(A) = PV(L)).
3. Portfolio rebalancing - YES (need to rebalance to keep immunized)
Cash flow matching
1. Risk minimization - YES (risk minimized to 0)
2. Cost minimization - NO (since you won’t always get the best yield rate by matching exactly)
3. Portfolio rebalancing - NO (will never need rebalancing)
Select the statement regarding bond pricing that is true in general (do not assume redemption value = face value).
a) The YTM is the interest rate at which the price is equal to the present value of all the coupon payments.
b) If the coupon rate is equal to the YTM, the price must be equal to the face value.
c) A bond that is redeemed at par must have a price equal to the face value.
d) The modified coupon rate is equal to the coupon payment divided by the redemption value.
e) If a bond is purchased at a premium, the purchase price is always greater than the face value.
a) FALSE - price also includes PV of redemption value.
b) FALSE - only true if the bond is redeemed at par.
c) FALSE - even if C = F the price still could be greater/less than the face value.
d) TRUE
e) FALSE - premium means P > C (redemption value), not P > F (face value).
An investment has a purchase price of $11,000 and it gives the holder the right to receive ten level annual payments of $1,300 each.
Based on this information alone, it is known that:
a) there is a unique positive solution for the IRR
b) there is a unique negative solution for the IRR
c) there are many positive solutions for the IRR
d) there are no solutions for the IRR
e) there is one positive and one negative solution
a) there is a unique positive solution for the IRR.
Explanation:
In general there will be a unique real solution to the IRR. Check if +/- by solving for IRR in the BAII.
Premium: name the
Conditions (2)
Amortization process (1)
Call date (1)
Conditions:
P > C
Fr > Ci
Amortization process:
Write-down
Call date:
First possible date
Discount: name the
Conditions (2)
Amortization process (1)
Call date (1)
Conditions:
P < C
Fr < Ci
Amortization process:
Write-up
Call date:
Last possible date
Which of the following statements is/are true about a loan paid back using the amortization method?
1) The amount of interest paid decreases with each payment, according to a geometric progression.
2) Using the retrospective method, the outstanding loan balance at any time is equal to the loan amount minus the accumulated value of the payments made up to that time.
3) The total interest paid is equal to the sum of the principal repaid payments minus the loan amount.
a) 1 only
b) 2 only
c) 2 and 3 only
d) none of 1, 2, or 3
e) the correct answer is not given by a), b), c), or d).
d) none of 1, 2, or 3
1 - FALSE (amount of principal follows a geometric progression but not interest)
2 - FALSE (outstanding loan balance = AV loan - AV payments made up to that time.
3 - FALSE (total interest = sum of payments (not just principal) minus loan amount)
Nita is depositing regular payments into a bank account. She is deliberately changing the size of these payments in order to account for inflation. It is most likely that Nita’s payments follow:
a) Geometric progression with increasing payments
b) Geometric progression with decreasing payments
c) Arithmetic progression with decreasing payments
d) Arithmetic progression with increasing payments
e) None of the above
a) Geometric progression with increasing payments
