Module 46.1: Sources of Returns, Duration Flashcards
What are the three sources of returns from a fixed rate bond?
1) coupon and principal payments
2) interest earned on coupon payments that are reinvested
3) any capital gain or loss if the bond is sold prior to maturity
If you assume that the investor will receive coupon and interest payment on time, interest is reinvested at the same YTM as the bond, what are five assumptions of fixed rate return?
1) the investor will earn an annualized rate of return equal to the YTM of the bond when purchased
2) if YTM has not changed at sale, then an investor will earn YTM
3) If the YTM increases after purchase before the first coupon payment, and the investor is a buy and hold, then YTM will be higher and vice versa.
4) If YTM increases after purchase but before the first coupon payment and the investor holds for short period, YTM will be lower
5) if YTM decreases after the bond is purchased but before the first coupon payment and the investor holds for long period of time, YTM will be lower.
What is the investment horizon of a bond?
the period of time an investor plans to hold the investment
When a bond is sold, are capital gains calculated off the market value of the carrying value?
carrying value
Is market risk greter than reinvestment risk in the short term? What about long term?
Yes - short term market price risk is greater, in long term, reinvestment risk is greater
What is duration?
used as a measure to calculate the bonds interest rate risk or sensitivity of a bonds full price to a change in its yield.
How do you calculate macaulay duration? what does it estimate?
Take the weighted average of the components of the NPV of a bond and then multiply by the years discounted.
Macaulay duration is used to estimate the weighted average time to the receipt of principal and interest payments.
What is Modified duration (ModDur) and how is it calculated?
ModDur = macaulay duration / 1 + YTM
How do you use ModDur to calculate the approximate percentage change in a bond’s price for a 1% change in YTM?
approximate percentage change in bond price = - ModDur x change in YTM
What is the formula for approximate modified duration?
V1 - V2 / 2 x V3 x change in YTM
V1 = the price of the bond if YTM is decreased V2 = the price of the bond if YTM is incresaed V3 = current price of the bond
Why does modified duration not give accurate measurements of change for larger changes in yield?
because the relationship is convex and not linear, although the formula is linear.
When is effective duration the most useful measurement of interest rate sensitivity?
when there is an embedded put, call, or prepayment option and we are given a benchmark yield, not YTM.
