week 8

Question 1

Corporate bonds can:

 Be callable

Answer 1

allow the issuer to buy them back from the holder at a pre-determined call price prior to maturity

• If they buy bond at high coupon rate and later interest rates fall, the firm can retire the high-coupon debt and issue new bonds as a lower coupon rate to reduce interest payments

Question 2

puttable corporate bonds

Answer 2

allow the holder to extend or sell them to the issuer at the call date if they so choose

• if bond’s coupon rate> current market yields, bondholder will choose to extend bond’s life

Question 3

convertible corp bonds

Answer 3

bondholders the right to swap them for a pre-determined number of shares in the firm

Question 4

Bonds receiving relatively high ratings (eg an S&P rating of at least BBB or a Moody’s rating of at least Baa) are classed as

Answer 4

investment-grade bonds;

Question 5

Bonds receiving below (n S&P rating of at least BBB or a Moody’s rating of at least Baa)

Answer 5

speculative-grade or junk bonds

Question 6

Bonds are issued with indentures designed to

Answer 6

protect the purchaser against the risk of default, and can involve the issuer agreeing to:

 Establish a sinking fund;
 Subordinate further debt;
 Restrict dividend payments;
 Include collateral as part of the issue; and / or,

Maintain financial ratios such as leverage at pre- determined levels.

Question 7

YTM

Answer 7

YTM is the average rate of return if the bond is held to maturity. The measure implicitly assumes all coupon payments are reinvested at the YTM.

Question 8

When interest rate is constant over the life of the bond

Answer 8

YTM = interest rate

Question 9

relationship between bond price and YTM

Answer 9

inverse

Question 10

the realized yield is based on

Answer 10

the actual reinvestment rate in each period and the total cash received at maturity

Question 11

If interest rates fall, the price of a straight bond

the price of a callable blond

Answer 11

can rise considerably. However:

▪ The price of the callable bond is flat when interest rates are low as the risk of repurchase or call is high; and,

▪ If the bond is called, the bondholder will only receive the call price, not the market price.

Question 12

When interest rates are high,

Answer 12

the risk of call is small and the values of the straight and the callable bond converge.

Question 13

what do we calculate for callable bonds

Answer 13

calculate a yield to call rather than YTM for callable bonds; and,

The yield to call replaces time until maturity with time until call and par value with call price in the YTM calculation.

Question 14

The pure yield curve

Answer 14

describes the relationship between YTM and time to maturity for stripped or zero-coupon treasuries; and,

Question 15

on-the-run yield curve

Answer 15

describes the relationship between YTM and time to maturity for newly issued coupon-paying bonds selling at / close to par.

Question 17

Theories of Term Structure

The Expectation Hypothesis

Answer 17

the yield curve reflects the market’s expectations of future interest rates. In particular, it asserts that:

Investors are risk neutral, or there are equal numbers of short- and long-term investors;

The forward rate is an unbiased estimate of the future short rate, that is, E(r_n) = f_n; and,

An upward-sloping yield curve implies that the market believes interest rates will rise.

Question 18

Theories of Term Structure

Liquidity Preference Hypothesis

Answer 18

• There are more short-term investors than long-term investors, meaning long term bonds have lower liquidity than short-term bonds;

 To compensate buyers of long-term bonds for the lower liquidity, long-term bonds must offer a higher return; and,

 The forward rate is the expected future short rate plus a liquidity premium, or f_n = E(r_n) + liquidity premium.

Question 19

Theories of Term Structure

Market Segmentation Hypothesis

Answer 19

• Borrowers and lenders have strong preferences for particular maturities. Consequently, they do not hold or issue bonds at other maturities;

 Debt markets at different maturities are not linked, that is, they are segmented; and,

 The yield at a particular maturity is determined purely by supply and demand for bonds at that maturity.

Question 20

Shortcomings of current yield

Answer 20

does not account for capital gains or losses on bonds bought at prices other than par value. It also does not account for reinvestment income on coupon payments.

Question 21

shortcomings of yield to maturity

Answer 21

assumes the bond is held until maturity and that all coupon income can be reinvested at a rate equal to the yield to maturity.

Question 22

Realized compound yield

shortcomings

Answer 22

is affected by the forecast of reinvestment rates, holding period, and yield of the bond at the end of the investor’s holding period

Question 23

Under expectation hypothesis, if yield curive is upward sloping

Answer 23

the market must expect an increase in short-term interest rates b/c

there are no risk premia built into bond prices. The only reason for long-term yields to exceed short-term yields is an expectation of higher short-term rates in the future

Question 25

Segmentation hypothesis.

An upward sloping yield curve is

Answer 25

evidence of supply pressure in the long-term market and demand pressure in the short-term market.

Question 26

According to the segmentation hypothesis, expectations of future rates

Answer 26

have little to do with the shape of the yield curve

Question 27

liquidity preference hypothesis

Yields on long-term bonds are

Answer 27

Yields on long-term bonds are greater than the expected return from rolling-over short-term bonds in order to compensate investors in long-term bonds for bearing interest rate risk.

Thus bonds of different maturities can have different yields even if expected future short rates are all equal to the current short rate.

Question 28

liquidity preference hypothesis

Yields on long-term bonds are

Answer 28

Yields on long-term bonds are greater than the expected return from rolling-over short-term bonds in order to compensate investors in long-term bonds for bearing interest rate risk.

Thus bonds of different maturities can have different yields even if expected future short rates are all equal to the current short rate.

Question 29

Expectations hypothesis.

An upward sloping curve is explained by

Answer 29

expected future short rates being higher than the current short rate.

Question 30

Expectations hypothesis.

A downward-sloping yield curve implies

Answer 30

expected future short rates are lower than the current short rate.

Thus bonds of different maturities have different yields if expectations of future short rates are different from the current short rate.

Question 31

what is a good reason to believe that forward rates differ from expected short rates?

Answer 31

because of risk premium

Question 32

a positive liquidity premiu can cause

Answer 32

the yield curve to slope upward even if no incerease is short rates in anticipated

Question 33

under liquidity preference theory, if inflation is expected to be falling over teh next few years, long term interest rates will be higher than short term rates?

Answer 33

Uncertain. Lower inflation will usually lead to lower nominal interest rates. Nevertheless, if the liquidity premium is sufficiently great, long-term yields may exceed short-term yields despite expectations of falling short rates.