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Reading 61: Risks Associated with Investing in Bonds- LO

 

Q7. Why do bond portfolio managers use the concept of duration?

A)   It allows structuring a portfolio to take advantage of changes in credit quality.

B)   It enables direct comparisons between bond issues with different levels of risk.

C)   It assesses the time element of bonds in terms of both coupon and term to maturity.

 

Q8. Which of the following statements about duration is least accurate?

A)   There is an inverse relationship between coupon and duration.

B)   There is a direct relationship between yield to maturity and duration.

C)   The effective duration of a zero coupon bond is equal to its maturity.

 

Q9. With an option-free zero-coupon bond the effective duration is:

A)   unrelated to its time to maturity.

B)   approximately equal to the number of semiannual periods to maturity.

C)   approximately equal to its years to maturity.

 

Q10. Which of the following statements concerning bond duration is least accurate? Duration:

A)   increases as market yields rise.

B)   decreases as the coupon increases.

C)   is the weighted-average maturity of the cash flows of the bond.

 

Q11. In December 2004, an investor purchases a zero-coupon bond issued in 1998 and maturing in December 2008. What is the bond's approximate duration?

A)   4 years.

B)   10 years.

C)   Cannot be determined.

 

Q12. All else held equal, the duration of bonds selling at higher yields compared to bonds selling at lower yields will be:

A)   cannot be determined with the information given.

B)   lower.

C)   greater.

 

Q13. For coupon-paying bonds, duration and years to maturity:

A)   are unequal with duration less than years to maturity.

B)   may be equal depending on the coupon rate.

C)   are equal.

 

[2009] Session 15 - Reading 61: Risks Associated with Investing in Bonds- LO

Q7. Why do bond portfolio managers use the concept of duration? fficeffice" />

A)   It allows structuring a portfolio to take advantage of changes in credit quality.

B)   It enables direct comparisons between bond issues with different levels of risk.

C)   It assesses the time element of bonds in terms of both coupon and term to maturity.

Correct answer is C)        

Portfolio managers are very interested in a bond’s sensitivity to changes in interest rates. Bonds can be different in terms of maturity and coupon level, while both characteristics impact the change in the bond’s price given changes in interest rates. Duration is a measure that can assesses the time element of bonds in terms of both coupon and term to maturity.

 

Q8. Which of the following statements about duration is least accurate?

A)   There is an inverse relationship between coupon and duration.

B)   There is a direct relationship between yield to maturity and duration.

C)   The effective duration of a zero coupon bond is equal to its maturity.

Correct answer is B)

Bonds with larger coupons have a smaller duration, all other things the same. A zero coupon bond has an effective duration equal to its maturity. Duration measures the approximate change in price given a change in interest rates. Therefore, the duration of the bond does not change with the yield to maturity of the bond.

 

Q9. With an option-free zero-coupon bond the effective duration is:

A)   unrelated to its time to maturity.

B)   approximately equal to the number of semiannual periods to maturity.

C)   approximately equal to its years to maturity.

Correct answer is C)

For an option-free zero coupon bond, effective and modified duration will be almost identical and both will be approximately equal to the bond's years to maturity.

 

Q10. Which of the following statements concerning bond duration is least accurate? Duration:

A)   increases as market yields rise.

B)   decreases as the coupon increases.

C)   is the weighted-average maturity of the cash flows of the bond.

Correct answer is A)

Duration decreases as market yields rise.

 

Q11. In December 2004, an investor purchases a zero-coupon bond issued in 1998 and maturing in December 2008. What is the bond's approximate duration?

A)   4 years.

B)   10 years.

C)   Cannot be determined.

Correct answer is A)

For a zero-coupon bond duration is approximately equal to the number of years to maturity. Here, there are 4 years until maturity, so the effective duration is approximately equal to 4 years. We use the term approximately because this ignores the curvature of the price/yield curve.

 

Q12. All else held equal, the duration of bonds selling at higher yields compared to bonds selling at lower yields will be:

A)   cannot be determined with the information given.

B)   lower.

C)   greater.

Correct answer is B)

Duration is inversely related to yield to maturity (YTM). The higher the YTM, the lower the duration. This is because the change in the bond's price (or present value) is inversely related to changes in interest rates. When market yields rise, the value (or cash flow) of a bond decreases without decreasing the time to maturity.

Duration is also a function of volatility (risk).  Higher volatility (risk) = higher duration.  A higher coupon bond has a lower duration relative to a similar bond with a lower coupon because the bond holder is getting more of their cash value sooner (because of the higher coupon).  This lowers the overall risk of the bond resulting in a lower duration.

 

Q13. For coupon-paying bonds, duration and years to maturity:

A)   are unequal with duration less than years to maturity.

B)   may be equal depending on the coupon rate.

C)   are equal.

Correct answer is A)

For coupon paying bonds, duration is less than maturity.

Duration is approximately equal to the point in years where the investor receives half of the present value of the bond's cash flows. Since zero-coupon bonds only have one cash flow at maturity, the duration is approximately equal to maturity. Any coupon amount will shorten duration because some cash flow is received prior to maturity.

 

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