Sec.3 - Ch.6: Bond & Stock Valuation

Question 1

What is Bond Duration?

Answer 1

• The weighted average maturity of the bond’s cash flow on a present value basis
• They are a good measure of how risky a bond is because it measures their sensitivity to interest rate changes
• Allows investors to compare price volatility of bonds with equal coupons but different terms

Question 2

How is Duration related to Current Yield?

Answer 2

It is INVERSELY related to yield to maturity
- Market interest rates increase, duration decreases

Question 3

How is Duration related to Annual Coupon

Answer 3

It is INVERSELY related to coupon rate
- increase in coupon rate, decrease in duration

Question 4

How is Duration related to Years to Maturity?

Answer 4

They are positively related (time is on top)
- Maturity increases, Duration increases

Question 5

What duration lengths do risk adverse investors prefer?

Answer 5

Short Durations, only if they anticipate interest rates will rise

Question 6

What duration lengths do aggressive investors prefer?

Answer 6

Long durations, only when they anticipate interest rates will decline

Question 7

How do you immunize a bond portfolio?

Answer 7

The portfolio will be immunized if the duration of the overall portfolio is equal to the preselected time horizon
- This is considered a passive investment strategy

Question 8

When matching the duration of a bond/bond portfolio to the client’s time horizon, what risks are offset?

Answer 8

Interest rate and reinvestment rate risk

Question 9

What is the duration of a zero coupon bond?

Answer 9

zero coupon bonds have durations equal to their maturities
- Since they have no coupons, their prices fluctuate more than those of coupon bonds with the same maturities

Question 10

What are advantages of zero coupon bonds?

Answer 10

• They are attractive and conservative investments for retirement plans (produce phantom income, IRA’s avoid the tax on that)
• They are suitable and conservative investments for gifts to dependent children under age 23 (kiddie tax)

Question 11

What type of bonds should a person buy if interest rates are expected to rise? Think UPS

Answer 11

Buy higher coupon bonds with short maturities to shorten duration (interest rates UP, Shorten duration)

Question 12

What type of bonds should a person buy if interest rates are expected to fall? Think FALLEN

Answer 12

Buy low coupon bonds with long maturities to lengthen duration (interest rates, FALl, LENgthen duration)

Question 13

When the coupon is smaller, the relative price fluctuation is _____

Answer 13

When the coupon is smaller, the relative price fluctuation is greater

Question 14

When the term to maturity is longer, the relative price fluctuation is ______

Answer 14

When the term to maturity is longer, the relative price fluctuation is greater

Question 15

When the market interest rate is lower, the relative price fluctuation is ______

Answer 15

When the market interest rate is lower, the relative price fluctuation is greater

Question 16

Dividend Discount Model: If the market lowers the required rate of return (higher dividends) for a stock, the value of the stock will _____

Answer 16

Rise

Question 17

Dividend Discount Model: If the market increases the required rate of return (lower dividends) for a stock, the value of the stock will _____

Answer 17

Fall

Question 18

What happens to the investor if the intrinsic value is lower than the market value?

Answer 18

The investor will earn a lower rate of return than he requires

Question 19

Dividend Discount Model Shortcut for accelerating/decelerating growth rates: What do you do when the 1st growth rate is lower than the 2nd growth rate?

Answer 19

Choose the next lowest number in the answer

Question 20

Dividend Discount Model Shortcut for accelerating/decelerating growth rates: What do you do when the 1st growth rate is higher than the 2nd growth rate?

Answer 20

Choose the next highest number in the answer

Question 21

How do you calculate the current market price using the P/E ratio?

Answer 21

Current Market Price = Earnings * P/E ratio

Question 22

What is the Return on Equity equation?

Answer 22

ROE = Earnings available for common (EPS) / Common Equity (net worth or book value)

Question 23

What is the dividend payout ratio equation?

Answer 23

Dividend Payout Ratio = Common dividends paid / Earnings available for common (EPS)

Question 24

How do you calculate EPS?

Answer 24

EPS = ROE (per share) * Book Value or Net Worth (per share)

Question 25

T/F Utility stocks typically have high dividend payout ratios

Answer 25

True

Question 26

What is not a factor in the Dividend Discount Model?

Answer 26

Gross Earnings of the Company
- Beta, Dividends actually paid, and the risk-free return are all utilized at some point to solve this