Investments Lesson 6 Flashcards by Lindsay Adams

Rising interest rates mean investors can __. Bond holders selling must do so __?

Get higher coupon on new investments

At a discount

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Drop in interest rates means coupons are __? Older bonds now worth __?

Lower

A premium

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Coupon Rate (Nominal Yield)

Coupon Payment / Par

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Current Yield

Coupon Payment / Price of the Bond

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Example Exam Question:
Considering buying bond with current yield of 8% & selling for $900. Assuming bond pays annual coupon, what is coupon rate of this bond?

A. 5.5%
B. 6.0%
C. 7.2%
D. 8.2%
E. 9.0%

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Example Exam Question:
What is yield to maturity on bond selling at 5% discount to par, paying 11.25% interest maturing in 7 years?

A. 11.23%
B. 12.34%
C. 13.10%
D. 13.79%

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Example Exam Question:
Purchased bond for $880 with 9% coupon. Sold after 1 year paying current yield of 10%. What is holding period return?

A. 9.0%
B. 9.5%
C. 10.0%
D. 11.0%
E. 12.5%

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Example Exam Question:
What is yield to call of bond selling at $1200, paying 12% interest semi annually, maturing in 10 years or bond callable in 5 years at 1050?

A. 3.96%
B. 7.91%
C. 10%
D. 12.91%

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Yield Ladder Discount

Highest to Lowest:
Yield to Call
Yield to Maturity
Current Yield
Nominal Yield
Call Mom’s Cell Now

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Yield Ladder Premium

Highest to Lowest:
Nominal Yield
Current Yield
Yield to Maturity
Yield to Call

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Example Exam Question:
Treasury zero coupon bonds are particularly suited to which of the following types of accounts?

A. IRA
B. Trust
C. Corporate
D. Joint

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Liquidity Preference Theory

Prefer liquidity & shorter term maturities

Higher maturities should have higher long term yield

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Market Segmentation Theory

Yield curve depends on supply & demand
When supply > demand, rates are low
When demand > supply, rates are high

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Expectations Theory

Yield curve reflects investor’s inflation expectations
When inflation expected to be lower in future, long term rates will be lower than short term resulting in inverted yield curve

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Unbiased Expectations Theory

Related to term structure of interest rates

*formula provided

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Bond Duration

Weighted average maturity of all cash flows
Bigger duration, more price sensitive/volatile to interest rate changes
Duration is moment in time investor immunized from interest rate risk & reinvestment rate risk
Modified duration is bond’s price sensitivity to changes in interest rates
Duration should equal investor’s time horizon to be effectively immunized

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Zero coupon bond’s duration

Will always equal maturiry

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As coupon rate increases, duration __?

Decreases

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As yield to maturity increases, duration __?

Decreases

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There is __ relationship between duration & term of bond?

Direct

There is __ relationship between coupon rate/yield to maturity & duration?

Inverse

Interest rates are Inverse

Example Exam Question:
Saving for child’s education 4 years from now. Which should invest in to immunize?
Bond A: AAA, 5 year maturity, 3.86 duration, 11% coupon, selling for $954
Bond B: AA, 4 year maturity, 3.2 duration, 12.5% coupon, selling for $982
Bond C, A, zero coupon, 5 year maturity, selling for $575

A. Bond B because maturity matched goal time frame
B. Bond A because higher credit rating than bond B
C. Bond C because zero coupon & duration is 5 years
D. Bond C because greater discount than bond A
E. Bond A because duration batched goal time frame

Example Exam Question:
Need cash at end of 8 years. Which will immunize portfolio?

A. 10 year maturity coupon bond
B. 8 year maturity coupon bond
C. Series of treasury bills
D. 15 year zero coupon bond

Example Exam Question:
Investor expects interest rates to increase, which type of bond would they prefer?
Bond A: AAA, 10 year maturity, 8.86 duration, 11% coupon, selling for $954
Bond B: AA, 5 year, 4.2 duration, 12.5% coupon selling for $982
Bond C: AA, zero coupon, 30 year maturity, selling for $575

A. A
B. B
C. C

Example Exam Question: Investor expects interest rates to decrease, which type of bond would they prefer? Bond A: AAA, 10 year maturity, 8.86 duration, 11% coupon, selling for $954 Bond B: AA, 5 year, 4.2 duration, 12.5% coupon selling for $982 Bond C: AA, zero coupon, 30 year maturity, selling for $575 A. A B. B C. C

Duration Assumptions:

Linear relationship between change in interest rates & bond prices It’s actually curve linear Convexity measures difference in price between duration estimate & actual price change Good job estimating small price changes Bad job estimating large price changes Understates appreciation when interest rates decrease Overstates depreciation when interest rates increase

Tax Swap

Sell bond at gain & bond at loss to offset each other | Also sell bond at loss & buying new bond

Barbells

Owning short & long term bonds | When interest rates move, only one set needs to be sold & restructured

Laddered Bonds

Purchasing bonds with varying maturities When bonds mature purchase new with longer maturities Helps reduce interest rate risk because bonds are held to maturity

Bullets

Very little payment then lump sum Most mature in/around same time period Zero coupon, treasuries, & corporates likely candidates Typically used when investor has balloon payment on liability at some future date

Preferred Stock

Debt features: stated par value, stated dividend rate Equity feature: price May move with price of common stock Dividend does not fluctuate No maturity date More closely tied with interest rates Tax advantage: corporations receive 50 or 65% deduction of dividends (pref & common) based on percentage of ownership

Example Exam Question: Which would investor benefit most from tax advantages of preferred stocks? ``` A. Government B. Individual C. Corporate D. Mutual funds E. Nonprofit institutions ```

Convertible Bonds

Investor has floor built in (par value of bond) | Conversion Value = par/conversion price x price of common stock

Example Exam Question: Purchased bond for $1050. Conversion price is $40. Market price of common stock is $35. What is conversion value of bond? A. $300 B. $400 C. $875 D. $1050

Capitalized Value

Capitalized Value = Net Operating Income / Capitalization Rate

Capitalized Rate = NOI / cost

NOI= | Gross income - vacancy/collection costs - expenses+interest expense+depreciation expense

Example Exam Question: Owns 20 condos. Rent for $9167/month. 10% vacancy. Total expenses $1500000. Pays $250000 on mortgage. $50000 interest. 10% required rate of return. How much would investor be willing to pay? A. $1000000 B. $5300720 C. $6300720 D. 7300720

Lesson 6 Review: Calculate new price when interest rates change. 10 year bond. Selling for $1071. Pays $80 annually. $1000 maturity value. If interest rates fall 100 basis points, new price of bond will: A. Fall $40 B. Rise $68 C. Fall $71 D. Rise $74

Lesson 6 Review: Client asks about article read about US govt securities & inverted yield curve. You explain that: A. Curve currently indicated long term rates lower than short term rates B. Curve indicates short term rates being lower than long term rates C. Indicates long term rates & short term rates are on par D. Indicates long term rates higher than short term rates

Lesson 6 Review: Yield to maturity of bond selling at 5% discount to par paying 11.25% in annual interest on semi annual basis & maturing in 7 years? A. 4.62 years B. 6.78 years C. 7.44 years D. 1

Lesson 6 Review: Yield to maturity of 10 year bond selling in market at $1148 is 6%. Coupon is 8% annually. What is duration? A. 4.62 years B. 6.78 C. 7.44 D. 9.93

Lesson 6 Review: Yield to maturity of bond selling at 5% discount to par paying 11.25% in annual interest on semi annual basis & maturing in 7 years? A. 11.23% B. 12.34% C. 13.10% D. 13.79%

Lesson 6 Review: Contemplating purchase of 10 unit building. Rent each out at $700/month. Annual vacancy 10%. Additional revenue of $500/month. Expenses $15,000 annually. Similar properties selling using equity capitalization rate of 8%, how much should you offer on building? A. $750000 B. $765000 C. $820000 D. $825000

Lesson 6 Review: Bonds paying 12% coupon selling for $1200. Which reflects lowest to highest yield relationship? A. YTC,YTM,CY,CR B. CR-CY,YTM,YTC C. YTM-YTC-CY-CR D. CY-CR-YTC-YTM

Lesson 6 Review: Bond is paying 9% coupon selling for $970. Which reflects lowest to highest yield relationship? A. YTC,YTM,CY,CR B. CR-CY,YTM,YTC C. YTM-YTC-CY-CR D. CY-CR-YTC-YTM

Lesson 6 Review: What is yield to maturity for 5 year term bond with 8% coupon selling for $930? A. 8% B. 9.8% C. 4.9% D. 4%

Lesson 6 Review: What is yield to call for 10 year bond with 6% coupon selling for $1200 callable in 5 years at $1050? A. 1.3% B. 2.6% C. 3% D. 6%

Lesson 6 Review: Which of following terms captures difference between duration’s estimate or bond’s price change & actual price change of a bond based on changes in interest rates? A. Modified duration B. Skewness C. Yield curve D. Convexity