IPT 1 Chapter 16

Question 1

What is time value of money and how it is impacted?

Answer 1

The return the average lender requires to postpone consumption today in exchange for consumption tomorrow and it impacted by:
1. Inflation expectations
2. Impatience/opportunity costs
3. Market interest rate

Question 2

How is interest rate risk of a bond increased?

Answer 2

1. Longer maturity
2. Lower coupon rate
3. Low initial yield

Question 3

What is the duration of a bond?

Answer 3

This captures how long, on average, our capital is tied up

Question 4

What are the three reasons that duration is a key concept in fixed-income portfolio management?

Answer 4

1. Simple summary statistic of the effective average maturity of the portfolio
2. Essential tool in immunizing portfolios from interest rate risk
3. Measure of the interest rate sensitivity of a portfolio

Question 5

What determines duration?

Answer 5

1. The duration of a zero-coupon bond equals its time to maturity
2. Holding maturity constant, a bonds duration is lower when the coupon rate is higher
3. Holding the coupon rate constant, a bonds duration generally increases with its time to maturity
4. Holding other factors constant, the duration of a coupon bond is higher when the bonds yield to maturity is lower
5. Formula for the duration of a perpetuity = (1+ y) / y

Question 6

Why do investors like convexity?

Answer 6

Bonds with greater curvature (more convex) gain more in price when yields fall than they lose when yields rise

Question 7

What is price compression?

Answer 7

There is a ceiling on the possible price

Question 8

What are the two types of passive bond management>

Answer 8

1. Indexing strategy: Attempts to replicate the performance of a given bond index
2. Immunization techniques: Designed to shield from interest rate fluctuations

Question 9

What are challenges in constructing a indexed bond portfolio?

Answer 9

1. Bond indexes include thousands of securites and difficult to purchase each security in the index in proportion to its market value
2. The compositions of the index changes daily

Question 10

What are solutions to the challenges in constructing a indexed bond portfolio?

Answer 10

1. Cellular approach
2. Purchase a bond Exchange-Traded fund

Question 11

What are other types of immunization?

Answer 11

1. Cash flow Matching
2. Dedication strategy: Cash flow-matching on a multi-period basis, its a once and-for all approach

Question 12

What are two types of active bond management?

Answer 12

1. Correctly forecasting interest rate changes
2. Finding fixed-income securities with mispriced credit risk