Sec.3 - Ch.6: Bond & Stock Valuation Flashcards
What is Bond Duration?
- 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
How is Duration related to Current Yield?
It is INVERSELY related to yield to maturity
- Market interest rates increase, duration decreases
How is Duration related to Annual Coupon
It is INVERSELY related to coupon rate
- increase in coupon rate, decrease in duration
How is Duration related to Years to Maturity?
They are positively related (time is on top)
- Maturity increases, Duration increases
What duration lengths do risk adverse investors prefer?
Short Durations, only if they anticipate interest rates will rise
What duration lengths do aggressive investors prefer?
Long durations, only when they anticipate interest rates will decline
How do you immunize a bond portfolio?
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
When matching the duration of a bond/bond portfolio to the client’s time horizon, what risks are offset?
Interest rate and reinvestment rate risk
What is the duration of a zero coupon bond?
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
What are advantages of zero coupon bonds?
- 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)
What type of bonds should a person buy if interest rates are expected to rise? Think UPS
Buy higher coupon bonds with short maturities to shorten duration (interest rates UP, Shorten duration)
What type of bonds should a person buy if interest rates are expected to fall? Think FALLEN
Buy low coupon bonds with long maturities to lengthen duration (interest rates, FALl, LENgthen duration)
When the coupon is smaller, the relative price fluctuation is _____
When the coupon is smaller, the relative price fluctuation is greater
When the term to maturity is longer, the relative price fluctuation is ______
When the term to maturity is longer, the relative price fluctuation is greater
When the market interest rate is lower, the relative price fluctuation is ______
When the market interest rate is lower, the relative price fluctuation is greater