Module 3 Conceptuals

Which of the following statements is not (or least) correct?

• If two bonds have the same coupon rate and maturity value, but one bond matures in 5 years while the other bond matures in 20 years, then the 20-year bond will have more interest rate (maturity) risk than the 5-year bond.

• You are said to be immunized against changes in interest rates when the duration of a bond is equal to your investment horizon (holding period). This is because if interest rates go up, the extra interest you earn from reinvesting your coupons at this higher rate is exactly offset by the capital loss when you sell the bond. On the other hand, if interest rates go down, the interest that you lose from reinvesting your coupons at a lower rate is exactly offset by the capital gain when you sell the bond.

• Assume that two bonds have the same time to maturity, but because of the pattern of their cash flows, one bond can be labeled an “earlier” bond while the other is labeled a “later” bond. If we observe a downward-sloping yield curve, then the “earlier” bond will have a lower yield-to-maturity than the “later” bond.

• Assume that an investor requires a return of 4 percent every six months or 8.16 percent per year. This investor would not be indifferent between a bond that paid a semi-annual coupon of $40 and a bond that paid an annual coupon of $80.

• A bond must sell at a discount when the investor’s required rate of return is above the coupon rate. In this case, assuming that the investor’s required rate of return remains constant over the life of the bond, the required rate of return each period will be equal to the yield generated by the coupon plus the yield generated by price appreciation.

Select the statement that is most correct.

• Bonds become more attractive to investors as interest rates increase. This increases demand, which, in turn, causes the prices of bonds to increase.

• Because of the shorter maturity used in the calculation, the yield to call (YTC) for a bond will always exceed its yield to maturity (YTM).

• A 10-year bond paying a 10 percent annual coupon payment will have, all other things equal, a longer duration than a 30-year bond paying the same 10 percent annual coupon payment.

• The longer the maturity of a bond, the more sensitive the bond will be to changes in the discount rate (i.e., the investors’ required rate of return). If interest rates go up, all other factors the same, a bond with a longer time to maturity will have a larger capital loss than an equivalent bond with a shorter time to maturity.

• Because they are fixed income securities with prices that vary over time, you will rarely observe the expected rate of return equal to the required rate of return on bonds.

You are considering investing in three different bonds. Each bond matures in 10 years and has a face value of $1,000. The bonds have the same level of risk, so the yield to maturity is the same for each (you may assume a flat term structure). Bond A has an 8 percent annual coupon, Bond B has a 10 percent annual coupon, and Bond C has a 12 percent annual coupon. Bond B sells at par. Assuming that interest rates are expected to remain at their current level for the next 10 years, which of the following statements is most correct?

• Bond A sells at a discount (its price is less than par), and its price is expected to increase over the next year.

• Since the bonds have the same yields to maturity, they should all have the same price, and since interest rates are not expected to change, their prices should all remain at their current levels until the bonds mature.

• Bond C sells at a premium (its price is greater than par), and its price is expected to increase over the next year.

• Bond A’s price is expected to decrease over the next year, Bond B’s price is expected to stay the same, and Bond C’s price is expected to increase over the next year.

• The yield to maturity for a bond arises from both an expected current yield and from an expected capital gains yield. Since the yield to maturity for Bond B will remain constant over time, we will observe an increase in the current yield and a decrease in the capital gains yield as Bond B gets closer to maturity.

You are considering buying one of two bonds, both of which are issued by the same company. Bond A has a 7 percent annual coupon, whereas Bond B has a 9 percent annual coupon. Both bonds have 10 years to maturity, face values of $1,000, and yields to maturity of 8 percent. Assume that the yield to maturity for both of the bonds will remain constant over the next 10 years. Which of the following statements is most correct?

• Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price

• Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price.

• Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature

• One year from now, Bond A's price will be higher than it is today.

• Bond A's current yield (not to be confused with its yield to maturity) is greater than 8 percent.

Which of the following statements is incorrect (least correct)?

• The price sensitivity of a bond increases with its maturity.

• An investor purchases a bond that has a given yield to maturity. Even if the bond is held until it matures, because of reinvestment rate risk, the investor’s realized yield may be less than or more than the original yield to maturity on the bond.

• In class we demonstrated that two bonds with the same maturity and the same level of risk may not have the same yield to maturity. For instance, an “earlier” bond (larger percentage of its cash flow during the early years) will have a lower yield to maturity than a “later” bond (larger percentage of its cash flows during the later years) if one-year rates are expected to increase in the future

• Regardless of the size of the coupon payment, the price of a bond moves in the same direction as interest rate movements (investors’ required rates of return).

• Given that the cash flows of fixed-income (debt) securities are known, we say that the debt market is always at or going towards a state of market equilibrium. That is, expected rates of return should be equal to required rates of return.

If interest rates fall from 8 percent to 7 percent, which of the following bonds will have the largest percentage increase in its value?

• A 10-year zero coupon bond.

• A 10-year bond with a 10 percent semiannual coupon.

• A 10-year bond with a 10 percent annual coupon.

• A 5-year zero coupon bond.

• A 5-year bond with a 12 percent annual coupon

Determine which of the following statements is most correct.

• Relative to short-term bonds, long-term bonds have less interest rate risk but more reinvestment rate risk.

• Relative to short-term bonds, long-term bonds have more interest rate risk and more reinvestment risk.

• Relative to coupon-bearing bonds, zero coupon bonds have more interest rate risk but less reinvestment rate risk.

• If interest rates increase, all bond prices will increase, but the increase will be greatest for bonds that have less interest rate risk.

• One advantage of zero coupon bonds is that you don’t have to pay any taxes until you sell the bond or it matures.

Select the statement that is most correct.

• A 20-year original maturity bond with 1 year left to maturity has more interest rate risk than a 10-year original maturity bond with 1 year left to maturity.(Assume that the bonds have equal default risk and equal coupon rates.)

• A firm with a low bond rating faces a less severe penalty when the Security Market Line (SML) is relatively steep than when it is not so steep.

• When a loan is amortized, the largest portion of the periodic payment goes to reduce principal in the early years of the loan such that the accumulated interest can be spread out over the life of the loan.

• The prices of high-coupon bonds tend to be less sensitive to a given change in interest rates than low-coupon bonds, other things equal and held constant. This is because, all other things equal, a high-coupon bond has a shorter duration than a low-coupon bond.

• The effective annual rate is always greater than the nominal annual rate.