optiix

Which of the following statements about duration of a bond is least accurate?

A) The dollar change in price for a 1% change in yield is approximately equal to the product of the duration and the current value of the bond divided by 100.

B) The duration of a floater is equal to the time to the next reset date.

C) If a bond has an effective duration of 7.5, it means that a 1% change in rates will result in a 7.5% change in price.

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Because of convexity, it will be approximately a 7.5% change in price, not an actual 7.5% change in price. The readings are very explicit about this distinction.

optiix

Duration of a bond normally increases with an increase in:

A) time to maturity.

B) yield to maturity.

C) coupon rate.

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Duration is directly related to maturity and inversely related to the coupon rate and yield to maturity (YTM). Duration is approximately equal to the point in years where the investor receives half of the present value of the bond's cash flows. Therefore, the later the cash flows are received, the greater the duration.  
The longer the time to maturity, the greater the duration (and vice versa). A longer-term bond pays its cash flows later than a shorter-term bond, increasing the duration.The lower the coupon rate, the greater the duration (and vice versa). A lower coupon bond pays lower annual cash flows than a higher-coupon bond and thus has less influence on duration.The lower the YTM, the higher the duration. This is because the bond's price (or present value) is inversely related to interest rates. When market yields fall, the value (or cash flow) of a bond increases without increasing the time to maturity.

optiix

Portfolio duration is best described as the:

A) sensitivity of a portfolio’s value to changes in the term structure of interest rates.

B) sensitivity of a portfolio’s value to equal changes in yield for all the bonds in the portfolio.

C) arithmetic mean of the durations of each bond in a portfolio.

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Portfolio duration is a measure of a portfolio’s interest rate risk. It measures the sensitivity of the portfolio’s value to an equal change in yield for all the bonds in the portfolio. It can be calculated as the weighted average of the individual bond durations using the proportions of the total portfolio value represented by each of the bonds. Portfolio duration does not capture the effect of changes in the yield curve (term structure).

optiix

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

A) Parallel shifts in the yield curve are not of concern to bond investors.

B) If long-term rates are low, the present value of cash flows far into the future will be low,and the bond's value will be low.

C) In a typical upward sloping yield curve, short and intermediate term rates are lower than long term rates.

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The statement, "If long-term rates are low, the present value of cash flows far into the future will be low,and the bond’s value will be low," should read, "If long-term rates are low, the present value of cash flows far into the future will be high,and the bond’s value will be high." The value of a bond is comprised of discounted cash flows, and a lower discount rate translates to higher cash flows. Any shift in the yield curve creates uncertainty and is of concern to bond investors.

optiix

The structure of interest rates results from all the following EXCEPT:

A) assuming that individual discount rates do not change by the same amount.

B) creating the yield curve by plotting term to maturity against the coupon rate.

C) viewing each bond coupon payment as a separate zero coupon bond.

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The yield curve plots term to maturity and yield to maturity. The other choices are true.

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.