IA Week 11

What is convexity intuitively?

The curvature in the bond price yield relationship

Why is convexity called the friend of the bond investor?

Prices rise more when yields fall than they fall when yields rise

Why is duration only an approximation?

It assumes a linear price yield relationship even tho it is actually curved

When does duration become less accurate?

For large changes in interest rates

How does convexity affect price estimates?

It improves accuracy when yields change by a large amount.

What type of bonds have higher convexity?

Longer maturity and lower coupon bonds

What risk does duration primarily capture?

Price risk from interest rate changes

What is reinvestment risk?

The risk that coupons are reinvested at lower rates

What determines whether price risk or reinvestment risk dominates?

The investor’s holding horizon
Short horizon means price risk. Long horizon means reinvestment risk.

If holding period is shorter than duration what rate environment is preferred?

Falling interest rates

If holding period equals duration what is achieved?

Protection against interest rate changes

If holding period is longer than duration what risk dominates?

Reinvestment risk

Why do zero coupon bonds have no reinvestment risk?

Because they do not pay coupons to reinvest

What is credit risk?

The risk the issuer fails to make promised payments

What is credit spread risk?

The risk that a bond’s yield rises and its price falls because investors demand more compensation for credit risk.

Can spreads widen without a default?

Yes. Spreads widen when perceived risk increases, even if no default occurs.

What is downgrade risk?

The risk a bond’s credit rating is lowered

Why do downgrades hurt bond prices?

Investors demand higher yields

What does the interest coverage ratio measure?

Ability to meet interest obligations

Why are Treasuries considered low risk?

They are viewed as default free

How do corporate bonds compare to Treasuries?

Higher yield due to higher risk

How do municipal bonds differ from corporates?

Interest is often tax exempt

Why do investors accept lower yields on munis?

Tax advantages increase after tax return