Fixed Income【Reading 54】Sample 2012

clearlycanadian

Biggs, Inc., holds a bond portfolio that is, on average, trading below par value. They have faced some cash flow problems of late and have used the bond interest payments for operating expenses. The bonds are callable. Given the current situation, Biggs faces which types of risk?

A) Interest rate risk.

B) Interest rate risk and call risk.

C) Call risk.

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The bonds are trading below par, so rates have increased and, at this point, call risk is not significant. The firm faces interest rate risk because their bond portfolio has decreased in value due to increasing market interest rates.

clearlycanadian

Which of the following situations lead to short-term profit opportunities in the bond market?

A) Interest rates become more volatile.

B) Inflation is expected to rise.

C) Yields of all maturities start to rise.

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As interest rates become more volatile, accurate pricing of bonds becomes more difficult, and thus some bonds are likely to be priced incorrectly. This pricing discrepancy will allow for short-term profit opportunities by buying a bond that is priced too low and selling it at the market rate. Increases in inflation expectations or yield to maturities indicate increasing market required rates of returns for bonds. Bond prices typically have an inverse relationship to interest rates.

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The interest rate risk of a bond is the:

A) risk that arises from the uncertainty about the bond's return caused by changes in interest rates over time.

B) risk related to the possibility of bankruptcy of the bond's issuer.

C) risks related to the possibility of bankruptcy of the bond's issuer and that arises from the uncertainty of the bond's return caused by the change in interest rates.

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Interest rate risk is the probability of an increase in interest rates causing a bond's price to decrease.

clearlycanadian

Interest rate risk for a bond refers to the fact that when interest rates:

A) decrease, the realized yield on the bond will be less than the yield to maturity.

B) increase, the bond’s value decreases.

C) increase, prepayments of principal will decrease.

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Interest rate risk is the risk that the bond’s value will decrease because interest rates increase. Reinvestment risk is the risk that a bond’s cash flows will be reinvested at lower-than-expected rates. Prepayment risk refers to the fact that prepayments of a mortgage-backed security’s principal may differ from the expected rate.

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Gabrielle Daniels and Edin Roth, CFA candidates, are discussing the relationship between a bond’s coupon rate and the required market yield. Looking through the local newspaper, they see a new-issue, 10-year, $1,000 face value 8% semi-annual coupon bond priced at $950. Daniels makes the following statements. Which statement does Roth tell her is correct?

A) The bond is selling at a premium.

B) The current market required rate is less than the coupon rate.

C) The bond is selling at a discount.

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When the issue price is less than par, the bond is selling at a discount.
We also know that the current market required rate is greater than the coupon rate because the bond is selling at a discount.

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If the market rate of interest is greater than the coupon rate, the bond will be valued:

A) less than par.

B) at par.

C) greater than par.

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If the Coupon Rate > market yield, then bond will sell at a premium.
If the Coupon Rate < market yield, then bond will sell at a discount.
If the Coupon Rate = market yield, then bond will sell at par.

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Given that the coupon rate of a bond is higher than the market interest rate on bonds with similar maturities and payment structures, the bond will be trading:

A) at a discount.

B) at par value.

C) at a premium.

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If the bond provides investors with a higher coupon rate than the market interest rate the bond has to be trading at a premium relative to its par value otherwise there is an arbitrage opportunity.

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If a bond's coupon is greater than the prevailing market rate on new issues, the bond is called a:

A) discount bond.

B) term bond.

C) premium bond.

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When the coupon rate on a bond is higher than the prevailing market rate the bond will be selling at a premium.  This occurs because the bonds price will be higher than the face value because as interest rate goes down price goes up.

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Which of the following statements concerning the price volatility of bonds is most accurate?

A) Bonds with higher coupons have lower interest rate risk.

B) Bonds with longer maturities have lower interest rate risk.

C) As the yield on callable bonds approaches the coupon rate, the bond's price will approach a "floor" value.

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Bonds with higher coupons have lower interest rate risk. Note that the other statements are false. Bonds with longer maturities have higher interest rate risk. Callable bonds have a ceiling value as yields decline.

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Which of the following statements about how the features of a bond impact interest rate risk is CORRECT?

A) For a given change in yield, a higher coupon bond will experience a larger change in price than a lower-coupon bond.

B) Market yields are the most important determinant of bond price volatility.

C) Zero-coupon bonds have the highest price volatility.

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Zero-coupon bonds have the highest interest rate risk because they deliver all their cash flows at maturity. Another way to think about this: A zero-coupon bond has the lowest coupon (0.00%), so it has the highest price volatility, since the coupon rate is inversely related to price volatility.
In addition to market yields, the timing and magnitude of cash flows affect price volatility. For a given change in yield, a higher coupon bond will experience a smaller change in price than a lower-coupon bond. The relationship between maturity and price volatility (all else equal) is direct – a greater maturity results in greater price volatility.