Volume 1- Chapter 7 Flashcards
What is the most accurate method used to determine the value of a bond?
Calculate the present value.
What does present value represent in bond pricing?
The amount an investor should pay today to invest in a security that offers a guaranteed sum of money on a specific date in the future.
If you want to receive $1,000 one year from today with an interest rate of 5%, what is the present value?
$952.38
List the four steps to calculate the present value of a bond with coupon payments.
- Choose the appropriate discount rate. * Calculate the present value of the income stream from the bond’s coupon payments. * Calculate the present value of the bond’s principal to be received at maturity. * Add these present values together to determine the bond’s worth today.
What is the general formula used to calculate the present value of a bond?
(C1 / (1+r)^1) + (C2 / (1+r)^2) + … + (Cn / (1+r)^n) + (FV / (1+r)^n)
What does the discount rate represent in bond valuation?
The rate at which you would discount a future value to determine the present value.
True or False: The discount rate and yield can be used interchangeably.
True
What must be adjusted if a bond pays interest more than once a year?
Coupon payments, compounding periods, and the discount rate must be adjusted.
In a four-year, semi-annual, 9% bond, what is the coupon payment per period?
$4.50
What is the fair price of a bond?
The present value of the bond’s principal and the present value of all coupon payments to be received over the life of the bond.
How is the present value of a bond calculated?
By discounting the cash flows (coupon payments and principal) back to the present.
What is the present value of the income stream for a bond with eight $4.50 coupon payments?
$29.08
What does a negative value in time value of money calculations denote?
An outflow of money.
What is the present value of the principal for a bond with a par value of $100?
$67.68
What is the present value of the bond if the present value of the coupons is $29.08 and the principal is $67.68?
$96.77
How do you calculate the present value of a series of coupon payments?
Using the formula for the present value of an annuity.
Fill in the blank: The appropriate discount rate changes with ______.
changing economic conditions.
What does the term ‘coupon rate’ refer to?
The income to be paid to the bondholder, set when the bond is issued.
What is the principal received at maturity in bond valuation?
The future value (FV) of the bond.
How many compounding periods are there in a four-year, semi-annual bond?
8 compounding periods.
What is the formula for calculating the present value of an annuity?
APV = C * [(1 - (1 + r)^-n) / r]
What is the present value of the income stream calculated in the example?
$29.084
What two sources of value make up the fair price of a bond?
- Present value of its principal
- Present value of its coupons
At a discount rate of 10%, what is the value of the bond calculated?
$96.77
What is a Treasury bill (T-bill)?
A very short-term security that trades at a discount and matures at par
How is the return on a T-bill generated?
From the difference between the purchase price and the sale price or maturity value
What is the formula for calculating the yield on a Treasury Bill?
Yield = (100 - Price) / Price × (365 / Term) × 100
What is the current yield of an investment?
The cash flows and the current market price of the investment
How is the current yield on a bond calculated?
Current Yield = (Annual Cash Flow / Current Market Price) × 100
What does yield to maturity (YTM) represent?
The total return expected over the life of a bond, assuming reinvestment of coupon payments
What factors are taken into account when calculating YTM?
- Current market price
- Term to maturity
- Par value at maturity
- Coupon rate
What is reinvestment risk?
The risk that coupon payments will earn a lower return than the YTM at the time of purchase
How does the purchase price of a bond affect reinvestment risk?
A zero-coupon bond has no reinvestment risk since there are no coupon cash flows
What is the Fisher Effect?
A theory explaining how interest rates are determined based on inflation, nominal, and real interest rates
What are the two components of the rate of return on a bond?
- Real rate of return
- Inflation rate
How is the nominal rate calculated?
Nominal Rate = Real Rate + Inflation Rate
What happens to the real interest rate during a recession?
The real rate falls along with the demand for funds
What is the average price of a bond based on its purchase and redemption values?
Average Price = (Purchase Price + Redemption Value) / 2
True or False: The current yield, approximate YTM, and YTM will be the same when a bond trades at par.
True
What is the formula for approximate YTM?
AYTM = (Interest Income + Price Change per Compounding Period) / Average Price
What information is included in a bond quote?
- Price
- Maturity date
- Coupon rate
- Yield to maturity
What is the annual YTM if the semi-annual YTM is 5%?
10%
What happens to the YTM if all coupon payments are reinvested at a rate higher than the bond’s YTM?
The overall return on the bond will be higher than the YTM quoted at purchase
What is the effect of purchasing a bond at a premium?
It guarantees a capital loss if held to maturity
How is the yield on a bond affected by market interest rates?
Excess demand for a bond pushes its price higher, causing YTM to fall
What is the formula for calculating the nominal rate?
Nominal Rate = Real Rate + Inflation Rate
What are the two factors that affect forecasts for the real rate?
- Business cycle impact on real interest rates
- Unexpected changes in inflation rate
What does the yield curve represent?
The relationship between short-term and long-term bond yields
What shape does a normal yield curve have?
Upward-sloping
What does the expectations theory imply about long-term interest rates?
Current long-term rates foreshadow future short-term rates
According to the expectations theory, what should the return on a two-year bond equal?
The combined return of two consecutive one-year bonds
True or False: An upward-sloping yield curve indicates expectations of lower future interest rates.
False
What does the liquidity preference theory suggest about investor preference?
Investors prefer short-term bonds due to higher liquidity and lower volatility
What does the market segmentation theory explain?
The yield curve represents the supply and demand for bonds influenced by institutional players
How do bond prices react to changes in interest rates?
Bond prices have an inverse relationship with bond yields; as interest rates rise, bond prices fall.
What happens to the price of a bond when interest rates rise?
The price of the bond falls
Fill in the blank: Longer-term bonds are more _______ in price than shorter-term bonds.
volatile
What is the relationship between coupon rates and bond price volatility?
Lower-coupon bonds are more volatile in price than higher-coupon bonds
What does a drop in yield from 12% to 10% represent in terms of percentage change?
17% change in yield
What is the impact of a 1% drop in yield on bond price compared to a 1% rise?
A 1% drop in yield leads to a greater price increase than a 1% rise leads to a price decrease.
What is the expected yield change when moving from a 4% yield to a 2% yield?
50% change in yield
What is the expected yield change when moving from a 3% yield to a 4% yield?
33.33% change in yield
What is the price of a 3% five-year bond when interest rates are at 3%?
100.00
What is the price change of a 3% ten-year bond when yield increases from 3% to 4%?
−8.18%
What does a downward-sloping yield curve indicate?
Expectations of falling interest rates
What theory suggests that the yield curve can explain all types of yield curves?
Market segmentation theory
What is the yield of a very short-term Government of Canada bond as shown in the hypothetical yield curve?
1%
What is the yield of long-term Government of Canada bonds in the hypothetical yield curve?
Around 4%
What effect does a higher-than-expected inflation rate have on an investor’s real rate of return?
It lowers the investor’s real rate of return.
How does a 1% drop in yield affect bond prices compared to a 1% rise in yield?
A 1% drop in yield leads to a greater price change than a 1% rise in yield.
For example, a 1% decrease in yield results in a price increase of 4.74%, while a 1% increase leads to a price decrease of 4.49%.
What happens to bond prices when interest rates rise?
Bond prices fall.
This is due to the inverse relationship between bond prices and interest rates.
What is the effect of higher coupon rates on bond price volatility?
Bonds with higher coupons are usually less volatile in price compared to those with lower coupons.
This is relevant when comparing bonds with the same term to maturity.
What does duration measure in the context of bonds?
Duration measures the sensitivity of a bond’s price to changes in interest rates.
It is defined as the approximate percentage change in the price of a bond for a 1% change in interest rates.
True or False: A bond with a longer term to maturity is usually more volatile in price than a bond with a shorter term to maturity, given the same coupon rate.
True.
This volatility is influenced by the bond’s term to maturity and coupon rate.
If a bond’s duration is 10, what is the expected price change for a 1% increase in interest rates?
The price is expected to drop by approximately 10%.
For example, if the bond is priced at 105, it could drop to 94.50.
What is the role of investment bankers on the sell side of fixed-income trading?
Investment bankers help structure new debt issues and bring them to the primary market.
Their clients are firms needing to raise funds.
What do inter-dealer brokers do in the bond market?
They act as agents to match trades between institutional buyers and sellers.
They perform price discovery, trade execution, clearing, and settlement.
Fill in the blank: The __________ is an electronic confirmation sent through secure systems detailing trade information.
[trade ticket].
It includes details such as bond identification, counterparties, and settlement amounts.
What is accrued interest?
Accrued interest is the amount of interest built up during the previous holding period of a bond.
It is paid by the buyer to the seller at the time of purchase.
What types of bonds typically pay interest twice a year?
Most corporate and provincial bonds.
Some Eurobonds may pay annually, and there are bonds that pay monthly.
What happens to the legal ownership of securities after a transaction is confirmed?
The change in legal ownership is effective immediately.
However, payment does not have to be made until the settlement period.
What are bearer bonds?
Bonds that signify ownership through physical possession of a certificate with detachable coupons.
They are at risk of loss since they can be sold by anyone with the certificate.
What are registered bonds?
Bonds that bear the name of the rightful owner and can only be transferred when the owner signs the back of the certificate.
Coupon payments are mailed to the registered owner.
What is the main advantage of trading bonds through firms with large institutional dealing desks?
Access to a wide range of securities in inventory.
This includes automatic execution of trades through proprietary trading systems.
What is accrued interest?
The amount of interest built up during the previous holding period
When does interest accrue for a bond?
From the day after the previous interest payment date up to and including the day of settlement
What does the client who buys a bond pay?
The purchase price plus the interest that has accumulated since the last interest date
What happens if a bond is sold before the next interest payment date?
The new buyer pays accrued interest to the current seller
How is accrued interest calculated?
Accrued Interest = (Coupon Rate * Time Period * Par Amount) / (100 * 365)
What is the basis for calculating accrued interest?
The par value of the bond, not its purchase price or yield
What is the significance of the coupon rate in the calculation of accrued interest?
It is the rate at which interest accrues
Calculate the accrued interest for a bond with an 8% coupon rate, purchased for $200,000 over 55 days.
$2,410.96
How are days counted when calculating accrued interest?
Include the first day after the last coupon payment and the settlement day, but not the last coupon payment day
In a leap year, what additional benefit does the seller receive?
An extra day’s accrued interest in February
What are bond indexes used for in the securities industry?
They measure the relative value and performance of a group of securities over time
List three uses of bond indexes.
- Guide to the performance of the overall bond market
- Performance measurement tool for bond portfolio managers
- Construct bond index funds
What is the FTSE Canada Universe Bond Index?
It tracks the broad Canadian bond market and includes all Canadian dollar-denominated investment-grade bonds with a term to maturity of one year or more
What does the FTSE Canada Universe Bond Index measure?
The total return on bonds in Canada, including realized and unrealized capital gains, and reinvestment of coupon cash flows
What type of index is the FTSE Canada Universe Bond Index?
A capitalization-weighted index
Name a global bond index.
FTSE World Government Bond Index
Which index tracks U.S. bonds?
Bloomberg U.S. Aggregate Bond Index
True or False: The FTSE Canada Universe Bond Index includes only corporate bonds.
False
