IF_L2

Question 1

What is a bond?

Answer 1

• A bond is a security obligating an issuer to pay specified amounts to the holder.
• Face Value: Amount paid at maturity.
• Coupon: Regular interest payment.
• Coupon Rate: Annual coupon ÷ face value.

Question 2

How do you calculate a bond’s price?

Answer 2

• Price = Present Value of all future coupons + Present Value of face value.
• Formula: PV = cpn/(1 + r)¹ + cpn/(1 + r)² + … + (cpn + par)/(1 + r)^t
• r is the required yield/discount rate.

Question 3

What happens to a bond’s price if interest rates rise?

Answer 3

• Its price falls.
• There is an inverse relationship between bond price and interest rates.

Question 4

What is yield to maturity (YTM)?

Answer 4

• The overall return an investor expects to earn if the bond is held to maturity.
• Equates the current price with the present value of future cash flows.

Question 5

When does a bond sell at a premium or discount?

Answer 5

• Premium: coupon rate > YTM, price > face value.
• Discount: coupon rate < YTM, price < face value.
• Par: coupon rate = YTM, price = face value.

Question 6

What is bond duration?

Answer 6

• Duration is the weighted average time to each cash flow.
• Measures interest rate sensitivity.
• Volatility ≈ Duration / (1 + yield).

Question 7

How do coupon rates affect duration?

Answer 7

• Lower coupon ⇒ longer duration ⇒ higher price volatility.
• Higher coupon ⇒ shorter duration ⇒ lower price volatility.

Question 8

What is the term structure of interest rates?

Answer 8

• Shows relationship between maturity and yield.
• Often represented by the yield curve.

Question 9

How do you distinguish between nominal and real interest rates?

Answer 9

• Nominal rate includes inflation.
• Real rate removes inflation’s effect.
• Formula: 1 + r_real = (1 + r_nominal) / (1 + inflation).

Question 10

What is default (credit) risk?

Answer 10

• The risk that a bond issuer may fail to make scheduled payments.
• Investors demand a default premium to compensate for this risk.

Question 11

What are bond ratings?

Answer 11

• Investment-grade: Rated BBB/Baa or above.
• Junk (speculative): Below BBB/Baa.
• Higher rating ⇒ lower default risk ⇒ lower yield.

Question 12

How are spot rates different from yields?

Answer 12

• Spot rates: The specific discount rates for each future cash flow.
• Yield to maturity: A single average rate capturing all bond cash flows.
• Bond prices derive from spot rates, then we infer yields.