honeycfa

Which of the following statements about the call feature is least accurate? The:

A) call feature exposes investors to additional reinvestment rate risk.

B) call feature lengthens the bond's duration, increasing price risk.

C) call feature reduces the bond's capital appreciation potential.

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A call provision decreases the bond's duration because a call provision introduces prepayment risk that should be factored in the calculation.

For the investor, one of the most significant risks of  callable (or prepayable) bonds is that they can be called/retired prematurely. Because bonds are nearly always called for prepayment after interest rates have decreased significantly, the investor will find it nearly impossible to find comparable investment vehicles. Thus, investors have to replace their high-yielding bonds with much lower-yielding issues. From the bondholder’s perspective, a called bond means not only a disruption in cash flow but also a sharply reduced rate of return.

Generally speaking, the following conditions apply to callable bonds:

• The cash flows associated with callable bonds become unpredictable, since the life of the bond could be much shorter than its term to maturity, due to the call provision.
• The bondholder is exposed to the risk of investing the proceeds of the bond at lower interest rates after the bond is called. This is known as reinvestment risk.
• The potential for price appreciation is reduced, because the possibility of a call limits or caps the price of the bond near the call price if interest rates fall (also known as price compression).

honeycfa

Maria Cavilero, a bond investor, is most concerned with price volatility. All else equal, which of the following fixed-coupon bonds would she most likely buy? A fixed coupon-bond with:

A) 10 years to maturity and a 6.5% coupon.

B) 10 years to maturity and an 8.5% coupon.

C) 15 years to maturity and an 8.5% coupon.

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This question is asking: given a change in yield, which of the bonds will exhibit the least price change? Of the four choices, Cavilero is most likely to buy the bond with the shortest maturity and highest coupon because it will have the least price volatility. Price volatility is directly related to maturity and inversely related to the coupon rate.

All else equal, the bond with the shorter term to maturity is least sensitive to changes in interest rates. Cash flows that are further into the future are discounted more than near-term cash flows, so the nearer to maturity the cash flows are received, the higher the present value. Here, this means that one of the 10-year bonds will have the least volatility. Similar reasoning applies to the coupon rate. A higher coupon bond delivers more of its total cash flow earlier than a lower coupon bond. All else equal, a bond with a higher coupon will exhibit less price volatility than a lower-coupon bond. Here, this means that of the 10-year bonds, the one with the 8.50% coupon rate will exhibit less price volatility than the bond with the 6.50% coupon.

honeycfa

Which of the following statements about the call feature is least accurate? The:

A) call feature lengthens the bond's duration, increasing price risk.

B) call feature exposes investors to additional reinvestment rate risk.

C) call feature reduces the bond's capital appreciation potential.

---

A call provision decreases the bond's duration because a call provision introduces prepayment risk that should be factored in the calculation.

For the investor, one of the most significant risks of  callable (or prepayable) bonds is that they can be called/retired prematurely. Because bonds are nearly always called for prepayment after interest rates have decreased significantly, the investor will find it nearly impossible to find comparable investment vehicles. Thus, investors have to replace their high-yielding bonds with much lower-yielding issues. From the bondholder’s perspective, a called bond means not only a disruption in cash flow but also a sharply reduced rate of return.

Generally speaking, the following conditions apply to callable bonds:

• The cash flows associated with callable bonds become unpredictable, since the life of the bond could be much shorter than its term to maturity, due to the call provision.
• The bondholder is exposed to the risk of investing the proceeds of the bond at lower interest rates after the bond is called. This is known as reinvestment risk.
• The potential for price appreciation is reduced, because the possibility of a call limits or caps the price of the bond near the call price if interest rates fall (also known as price compression).

honeycfa

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

A) An inverse relationship between interest rates and bond prices means that the greater the change in interest rates, the less the change in fixed-coupon bond prices.

B) A lower-coupon bond is more sensitive to interest rate movements than a higher-coupon bond (all else equal).

C) Bond price movements depend upon the direction and magnitude of changes in interest rates.

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The inverse relationship between interest rates and bond prices means that when interest rates increase, fixed-coupon bond prices decrease. In other words, the inverse relationship means that interest rates and bond prices move in opposite directions, it does not infer anything about the magnitude of the change.

The relationship between the coupon rate and price volatility (all else equal) is inverse – a greater coupon results in less price volatility. Remember, if you have a problem with this on the examination, keep in mind that a zero-coupon bond has the highest interest rate risk because it delivers all its cash flows at maturity. Since a zero-coupon bond has a 0.00% coupon, a low coupon equates to high price volatility.

honeycfa

Which of the following bonds has the highest interest rate sensitivity? A:

A) ten year, option-free 6% coupon bond.

B) five year, 5% coupon bond callable in one year.

C) ten year, option-free 4% coupon bond.

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If two bonds are identical in all respects except their term to maturity, the longer term bond will be more sensitive to changes in interest rates. All else the same, if a bond has a lower coupon rate when compared with another, it will have greater interest rate risk. Therefore, for the option-free bonds, the 10 year 4% coupon is the longest term and has the lowest coupon rate. The call feature does not make a bond more sensitive to changes in interest rates, because it places a ceiling on the maximum price investors will be willing to pay. If interest rates decrease enough the bonds will be called.

honeycfa

Which of the following five year bonds has the highest interest rate sensitivity?

A) Floating rate bond.

B) Zero-coupon bond.

C) Option-free 5% coupon bond.

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The duration of a zero-coupon bond is equal to its time to maturity. Its price is greatly affected by changes in interest rates because its only cash-flow is at maturity and is discounted from the time at maturity until the present.

honeycfa

Which of the following fixed-coupon bonds has the least price volatility? All else equal, the bond with a maturity of:

A) 10 years.

B) 5 years.

C) 20 years.

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If bonds are identical except for maturity, the one with the shortest maturity will exhibit the least price volatility. This is because a bond’s price is determined by discounting the value of the cash flows. A shorter-term bond pays its cash flows earlier than a longer-term bond, and near-term cash flows are not discounted as heavily. Another way to think about this: The relationship between maturity and price volatility (all else equal) is direct – a greater maturity results in greater price volatility.

honeycfa

Which of the following 10-year fixed-coupon bonds has the most price volatility? All else equal, the bond with a coupon rate of:

A) 6.00%.

B) 5.00%.

C) 8.00%.

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If bonds are identical except for the coupon rate, the one with the lowest coupon will exhibit the most price volatility. This is because a bond’s price is determined by discounting the cash flows. A lower-coupon bond pays more of its cash flows later (more of the cash flow is comprised of principal at maturity) than a higher-coupon bond does. Longer-term cash flows are discounted more heavily in the present value calculation. Another way to think about this: The relationship between the coupon rate and price volatility (all else equal) is inverse – a greater coupon results in less price volatility. Examination tip: If you get confused on the examination, remember that a zero-coupon bond has the highest interest rate risk because it delivers all its cash flows at maturity. Since a zero-coupon bond has a 0.00% coupon, a low coupon equates to high price volatility.

honeycfa

The factors that determine how changes in interest rates affect bond values include all of the following EXCEPT:

A) term to maturity.

B) embedded options.

C) issue price.

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The issue price determines whether a bond is said to trade at a premium or at a discount. The change in price of a fixed-coupon bond is inversely related to the direction of the change in interest rates whether the bond was sold at a discount or at a premium. The other choices are correct factors.

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

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

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

C) Market yields are the most important determinant of bond 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.