Lecture 4

Question 1

When a bond is further from maturity, its price is __ sensitive to changes in yield

Answer 1

More sensitive

Question 2

Duration is a measure of what?

Answer 2

Risk

Question 3

How does a high coupon affect duration?

Answer 3

Reduces duration

Question 4

What are two measures of duration?

Answer 4

• Macaulay duration
• Modified duration

Question 5

Macaulay duration is measured in…

Answer 5

years

Question 6

How do you calculate modified duration?

Answer 6

change in price / change in yield

Question 7

Yield curves typically slope…

Answer 7

upwards

Question 8

Why do yield curves typically slope upwards?

Answer 8

Investors want higher yields to compensate for lower liquidity of long-maturity bonds

Question 9

When do yield curves invert?

Answer 9

When interest rates are very high & therefore expected to fall

Question 10

What is pure expectations theory?

Answer 10

Yield curves are determined entirely by interest rate expectations

Question 10

If the 1 year yield is 5% and the 2 year yield is 4%, what is the 1 year forward rate?

Answer 10

3%

Question 11

What is liquidity preference theory?

Answer 11

Yield curves slope upwards because high maturity = low liquidity

Question 12

What are the explanations for yield curves?

Answer 12

1. Pure expectations theory
2. Liquidity preference theory
3. Segmented markets

Question 13

What does ‘segmented markets’ mean?

Answer 13

Lenders have a ‘preferred habitat’ e.g. a bank that obtains funds from short-term borrowing may prefer short-term lending

Question 14

Are government or commercial bonds more liquid?

Answer 14

Government bonds = more liquid

Question 15

What does TIPS stand for?

Answer 15

Treasury Inflation Protection Securities

Question 16

What is included in a corporate bond contract?

Answer 16

• Trustee to ensure enforcement
• Covenants

Question 17

What do covenants include?

Answer 17

• Collateral (if any)
• Convertibility features (if any)
• Limits equal or higher seniority debt
• Limits ratios e.g. interest coverage

Question 18

What are some major bond rating agencies?

Answer 18

• Moody’s
• Standard & Poor’s
• Fitch

Question 19

What are the broad categories of corporate bond ratings?

Answer 19

• Investment grade
• Junk bonds

Question 20

What is the yield spread?

Answer 20

Difference between yield demanded for government vs corporate bonds

Question 21

What can increase yield spread?

Answer 21

Economic downturn = greater risk of default = higher spread

Question 22

If the central bank is expected to ease its policies, how does that affect the yield curve?

Answer 22

Slopes downward

Question 23

If the central bank is expected to tighten its policies, how does that affect the yield curve?

Answer 23

Slopes upwards