optiix

Which of the following statements about the yield curve is CORRECT?

A) A nonparallel shift occurs when rates change by the same number of basis points for all maturities.

B) A nonparallel shift is more common than a parallel shift.

C) The yield curve usually has a nonzero slope because rates change by approximately the same number of basis points across maturities.

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The definitions for parallel and nonparallel shifts are reversed. The first part of the statement that begins, "The yield curve usually has a nonzero slope,…" is correct. However, the second part is incorrect – the slope occurs because rates change by different basis points across maturities.

optiix

Which of the following statements is NOT correct? Compared to a callable bond, a noncallable bond:

A) is more attractive to an investor concerned with reinvestment risk.

B) has more predictable cash flows.

C) provides a higher yield.

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When compared to a callable bond, the yield on a noncallable bond is less. With a noncallable bond, the issuer does not have to compensate the investor for call risk/cash flow uncertainty with any premium.
The other choices are correct. Call risk is the combination of cash flow uncertainty and reinvestment risk. When a bond is called, the investor faces a disruption in cash flow and a reduced rate of return.

optiix

Price compression:

A) occurs when a bond's cap and floor are set close together.

B) occurs when demand for a bond is high near the first call date.

C) reduces the potential for price appreciation.

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When a bond has a call provision, the potential for price appreciation is reduced, because the call caps the price of the bond near the call price, even if interest rates fall considerably. It is unlikely that investors would pay a price that exceeds the call price.

optiix

Which of the following statements about callable bonds is CORRECT?

A) As interest rates fall, the value of a callable bond will exceed that of a similar straight bond.

B) When yields rise, the value of a callable bond is less sensitive and will exhibit less of a price change than a noncallable bond.

C) As interest rates decrease, the value to the investor of the call option increases.

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When yields rise, the value of callable bond may not fall as much as that of a similar straight bond because of the embedded call option feature. With a decrease in interest rates, the value of a callable bond can increase to only approximately the call value (the call price serves as a cap or “ceiling.”). Straight bonds will continue to exhibit the inverse relationship between yields and prices, as there is no “ceiling” call price.
The statement that begins, “As interest rates decrease…,” should continue, “.. the value to the issuer of the call option increases.” As interest rates decrease, the issuer values the call option more because the company has the potential to call the bond and replace existing debt with lower-coupon (and thus lower cost) debt.

optiix

Simone Girau holds a callable bond and Chi Rigazio holds a putable bond. Which of the following statements about the two investors is most accurate?

A) Girau's bond has less potential for price appreciation.

B) As the yield volatility increases, the value of both Girau's bond and the underlying option increases.

C) Both investors calculate the value of the bond held by adding the value of the option to the value of a similar straight bond.

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When a bond has a call provision, the potential for price appreciation is reduced, because the call caps the price of the bond near the call price. Even if interest rates fall considerably, it is unlikely that investors would pay a price that exceeds the call price.

The other statements are false. To calculate the value of a putable bond, it is correct to add the option value to the value of a similar straight bond. However, to calculate the callable bond value, subtract the option value from that of a similar straight bond. As a result, when yield volatility increases (thus increasing the option value), the value of a callable bond decreases and the value of a putable bond increases. A call option does benefit the issuer, but a put option benefits the holder.  Embedded options (puts and calls) increase in value when volatility increases.

jawz

Which of the following statements is CORRECT?

A) A bond with high reinvestment risk also has high price, or interest rate risk.

B) Mortgage backed and asset backed securities have lower reinvestment risk than straight coupon bonds.

C) The prepayment option on a mortgage loan benefits the issuer.

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In the case of a mortgage or auto loan, the issuer is the borrower and is the party that benefits from the prepayment option. In a declining interest rate environment, the issuer can retire higher cost debt and replace it with lower cost debt (i.e. refinancing a mortgage). When an issuer (borrower) calls, or prepays, the lending institution (the security holder) faces reinvestment risk because it must reinvest the proceeds at lower rates.
Mortgage backed and other asset backed securities have high reinvestment (or prepayment) risk because in addition to cash flows from periodic interest payments (like bond coupons), these securities have repayment of principal. The lower the interest rate, the higher chance that the loans underlying these assets will repay in full due to refinancings. A bond, such as a zero coupon bond, can have high interest rate risk (because its single cash flow subjects it to the full amount of discounting when interest rates change) and low reinvestment risk (the single cash flow minimizes prepayment risk).

jawz

Consider three bonds that are similar in all features except those shown. The bond with the greatest reinvestment risk is:

A) 15% coupon, callable.

B) 15% coupon, non-callable.

C) 5% coupon, callable.

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Reinvestment risk is higher with high-coupon bonds because a larger proportion of their realized yield depends on reinvestment of the coupon interest payments. Callable bonds have more reinvestment risk than noncallable bonds, since their principal may be repaid earlier than the stated maturity date.

jawz

Which of the following statements concerning reinvestment risk is most accurate?

A) Reinvestment risk is increased if there are prepayment provisions on the bond.

B) Reinvestment risk is highest for zero-coupon bonds.

C) Lower coupon bonds have more reinvestment risk.

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Reinvestment risk is increased if there are prepayment provisions that return a large amount of principal to the lender at a time when interest rates have declined. Note that the other statements are false. Reinvestment risk is lowest for zero coupon bonds – a corollary of this statement is that the lower the coupon, the less reinvestment risk there is for the bond.

jawz

Which of the following choices correctly places callable bonds, straight coupon bonds, mortgage-backed securities, and zero-coupon bonds in order from the type of security with the least reinvestment risk to the one with the most reinvestment risk?

A) zero-coupon bonds, mortgage-backed securities, straight coupon bonds, callable bonds.

B) callable bonds, straight coupon bonds, zero-coupon bonds, mortgage-backed securities.

C) zero-coupon bonds, straight coupon bonds, callable bonds, mortgage-backed securities.

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Of the three choices, zero-coupon bonds have the least reinvestment risk. An investor can nearly eliminate reinvestment risk by holding a noncallable zero-coupon bond until maturity because zero-coupon bonds deliver all cash flows in one lump sum at maturity.
Straight coupon bonds (no prepayment or other embedded options) have the next most reinvestment risk because of the periodic coupon payments. If interest rates decline, the bondholder will have to reinvest the coupons at a rate lower than that required to earn the original expected yield-to-maturity.
Callable bonds have more reinvestment risk because the right to prepay principal compounds reinvestment risk. A call option is one form of prepayment right that benefits the issuer, or borrower.
Mortgage backed and other asset backed securities have the most prepayment risk because in addition to cash flows from periodic interest payments (bond coupons, for example), these securities have periodic repayment of principal. The lower the interest rate, the higher chance that the loans underlying these assets will repay in full.

jawz

Which of the following statements relating to reinvestment risk for bonds is CORRECT?

A) Long-term bonds should be purchased if the investor anticipates higher reinvestment rates.

B) Unless the reinvestment rate equals the yield to maturity, the holding period return will be less than the yield to maturity.

C) Zero coupon bonds have no reinvestment risk over their term.

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This statement is correct only if the investor holds the bond until maturity. Reinvestment risk means that a bond investor risks having to reinvest bond cash flows (both coupon and principal) at a rate lower than the promised yield. Reinvestment risk increases with longer maturities and higher coupons, and decreases for shorter maturities and lower coupons. While a bond investor can eliminate price risk by holding a bond until maturity, he usually cannot eliminate bond reinvestment risk. One exception is zero-coupon bonds, since these bonds deliver payments in one lump sum at maturity. There are no payments over the life to reinvest.
The statement, "Long-term bonds should be purchased if the investor anticipates higher reinvestment rates," should read, "Short-term bonds...".If an investor expects interest rates to rise, he would want a bond with a shorter maturity so that he received his cash flows sooner and could reinvest at the higher rate. Also, there is less prepayment risk with shorter maturities.
The statement that begins, "Unless the reinvestment rate...," is partially true. However, the holding period return (covered in a later LOS) could be less or greater than the original yield to maturity (YTM). Over the investor's holding period, interest rates are likely to fluctuate both up and down; at some points the investor will reinvest at a higher rate than the original YTM and sometimes he will reinvest at a lower rate.