Markets & Institutions Exam 2 - Kuan Liu

Holding other features of a bond and the market interest rate constant, the higher the coupon rate is, the higher the bond price would be.

True or False

True

Holding the cash flow structure of a bond constant, the higher the market interest rate is, the lower the bond price would be.

True or False

True

Holding everything else constant, a bond's price will go up if the return rate for cash flow reinvestment goes up.

True or False

True

If the coupon rate of a bond equals the market interest rate, the bond will be selling at a discount.

True or False

False

A bond’s price will likely fall because of any of the following events except

A. the Federal Reserve conducting quantitative easing

B. the Fed increases their target for the fed funds rate

C. increases in demand for funding in the economy

D. decreases in the supply of finance in the financial system

A. the Federal Reserve conducting quantitative easing

Consider a $1,000 face value and 3-year maturity bond with a coupon rate of 5%. The bond pays coupon once a year. Assume the market interest rate is 5% and coupons may be re-invested at this rate. How much would you be willing to pay for this bond?

A. $980

B. $1,000

C. $1,050

D. $970

B. $1,000

The realized yield of a bond may be influenced by coupon reinvestment rates.

True or False

True

The duration of a zero-coupon bond is equal to its maturity.

True or False

True

Short-term bonds have a greater exposure to interest rate risk compared to long-term bonds.

True or False

False

Bonds with higher coupon frequencies have shorter durations.

True or False

True

An important difference between "yield to maturity (YTM)" and "expected yield" is that

A. YTM is affected by market interest rate while expected yield is not

B. YTM applies to long-term bonds while expected yield applies to short-term bonds

C. YTM assumes that the investor holds the bond to maturity while expected yield assumes that the investor sells the bond before maturity

D. the par value of a bond matters for YTM while it does not matter for expected yield

C. YTM assumes that the investor holds the bond to maturity while expected yield assumes that the investor sells the bond before maturity

Assume all the following bonds are issued at the same time with the same maturity by the same issuer, and that the market interest rate is now higher than coupon rates of all bonds. Which of the following bonds should trade at the deepest discount from par?

A. annual coupon bond

B. semiannual coupon bond

C. quarterly coupon bond

D. zero coupon bond

D. zero coupon bond

Suppose a U.S Treasury note with a 10-year maturity yields 2 percent. An AA rated corporate bond with the same maturity yields 3 percent. Their difference in yield is likely because of

A. liquidity premium

B. interest rate risk

C. default risk

D. purchasing power risk

C. default risk

Use the below interest rate data to answer following questions

90-day Treasury bills 8.36 percent

180-day Treasury bills 8.48 percent

2-year Treasury notes 9.10 percent

3-year Treasury notes 9.25 percent

90-day commercial paper 9.15 percent

3-year corporate bonds (AA) 10.10 percent

3-year municipal (AA) 7.07 percent

Which one of the following bonds does the market view as having the greatest default risk?

A. 90-day Treasury bills

B. 180-day Treasury bills

C. 2-year Treasury notes

D. 90-day commercial paper

D. 90-day commercial paper

With reference to the data above, what is the default risk premium on commercial paper?

A. 5.65%

B. 0.95%

C. 0.79%

D. 0.55%

C. 0.79%

A bank depositor must choose between purchasing a one-year CD paying 5% annually and a twoyear CD paying 5.5% annually. If the depositor is indifferent between the two, the depositor must expect the one-year interest rate for CDs one year from now to be:

A. 6.5%

B. 4.5%

C. 6.0%

D. 5.0%

C. 6.0%

Which of the following statements about callable bonds is NOT true?

A. Callable bonds have higher yields than comparable noncallable bonds.

B. The call price is usually above the bond's par value.

C. Call options usually benefit the bond investor.

D. Investors are notified when bonds are called.

C. Call options usually benefit the bond investor.

A 3-year zero coupon bond selling at $900 with a yield-to-maturity of 12.18 percent has a duration of

A. 3 years

B. 2.78 years

C. 2.50 years

D. 2 years

A. 3 years

As bond maturity _________, so do the _________ and ________

A. decreases; coupon rate; price volatility

B. decreases; duration; face value

C. increases; duration; price volatility

D. increases; risk; coupon rate

C. increases; duration; price volatility

All else equal, callable bonds pay a higher yield because

A. they usually carry higher default risk

B. the call option implies an expectation that interest rates will rise

C. the call option implies an expectation that bond prices will fall

D. the call option increases the bondholder's return risk

D. the call option increases the bondholder's return risk

The value of a conversion option from a bond to a stock should rise when

A. interest rates fall

B. price of the bond rises

C. the bond's credit rating is upgraded

D. interest rates are more uncertain

D. interest rates are more uncertain

When the annual market interest rate is 3%, how much would a $1,000 cash in 1-year time be worth to you today?

$970.87

Calculation: TVM

N=1

I=%3

PMT=0

FV=(1000)

Absent re-investment risk, if the coupon rate of a bond is equal to the market rate of interest, what is the price of the bond? What is this type of bond called?

Price is equal to the face value. It is called a par bond

Suppose you purchased a 5-year bond with a face value of $1,000. At the time you purchase it, the market interest rate was 5%. After one year of your investment, the Fed decided to cut the fed funds rate and the market interest rate followed to decline to 3.5%. What would be the price for your bond after the interest rate cut?

Opportunity costs are lower as the market interest rate gets cut after one year; but after one year, number of cash flows decreases by one, so benefit of bond also decreases.

How do interest rate changes affect bond prices and yields?

When interest rates go up, existing bond prices go down because new bonds offer better returns. When interest rates drop, existing bonds become more valuable since they offer better returns compared to new bonds

what is a coupon rate?

is the annual interest rate that a bond issuer promises to pay to the bondholder.

what does realized yield mean?

is the actual profit or loss an investor makes on a bond or investment after considering all factors over a specific period

what are the two economic channels that contribute to interest rate risk?

1. Price risk - risk of bond decreasing due to interest rate changes

2. Reinvestment risk - risk associated with reinvesting bond proceeds at potentially lower rates in the future

what is interest rate risk?

Risk that changes in interest rates will impact the value of investments, especially bonds, as their price move inversely to interest rates.

what is the difference between duration and the maturity of a bond?

Duration measures a bond's sensitivity to interest rate changes, accounting for both the timing and amount of its cash flows. Maturity, on the other hand, is simple the time until the bond's principal is repaid.

what are the two strategies for managing interest rate risk?

duration matching - matching the duration of assets with the duration of liabilities to reduce the impact of interest rate changes.

maturity matching - aligning the maturity dates of bond investments with financial obligations. For instance, if you have a liability due in ten years, you might invest in bonds that also mature in around ten years

what does the term structure of interest rates and the yield curve mean?

refers to the relationship between interest rates and the time to maturity of debt securities. The yield curve is a graphical presentation of this relationship, plotting yields against various maturities

what is the expectation theory and how does it relate to the shape of the yield curve?

it suggests that the shape of the yield curve depends on investment's expectations of future interest rate changes. assumes investors maximize profits and there are no arbitrage opportunities left

what is the liquidity-premium-augmented expectation theory?

states that longer-maturity bonds have higher liquidity premiums. longer bonds are riskier and less liquid, so investors demand compensation to hold them, which leads to an upward-sloping yield curve.

what is the market segmentation theory?

assumes investors have strong preferences for securities of certain maturities, creating segmented markets. investors only trade within their preferred maturity segment, which can lead to discontinuities and spikes in the yield curve

how does preferred habitat theory explain the shape of the yield curve

implies a smooth yield curve, but doesn't predict its slopes like other theories do

what are the factors that influence interest rates?

default risk, tax treatment, liquidity, options on debt securities

what are the theories that try to explain the shape of the yield curve?

the expectation theory, the liquidity-premium-augmented expectation theory, market segmentation theory and the preferred habitat theory