Question 1

The risk that investors are forced to place earnings from a bond into a lower yielding investment is known as

Accepted Answer

Reinvestment risk is the risk that an investor will have to reinvest cash flows from an investment at a lower rate of return. This risk is particularly relevant for bonds with a fixed coupon rate, as interest rates can fluctuate over time. If interest rates fall, the bondholder may be forced to reinvest their coupon payments at a lower rate of return, reducing the overall yield on their investment.

Question 2

Immunization works by offsetting ________ risk and ________ risk.

Accepted Answer

Immunization is a strategy used by investors to protect against interest rate risk. It involves matching the duration of the portfolio with the investor's desired investment horizon, which offsets reinvestment risk (risk that future cash flows will have to be reinvested at lower rates) and interest rate risk (risk that interest rates will change, causing the value of bonds to fluctuate). Therefore, the correct answer is B, reinvestment risk and interest rate risk.

Question 3

When a callable bond is selling at a premium, investors should expect to earn the ________ over the time they hold the bond.

Accepted Answer

When a callable bond is selling at a premium, investors should expect to earn the yield to call over the time they hold the bond, as the issuer is more likely to call the bond before maturity to refinance at a lower interest rate.

Question 4

A discount bond

Accepted Answer

A discount bond has a coupon rate that is less than the market rate of interest. This means that the bond is sold at a price lower than its face value, resulting in a higher yield-to-maturity for investors.

Question 5

Which of the following is commonly a dedicated portfolio?

Accepted Answer

A pension fund is commonly a dedicated portfolio, as it is specifically designed to support a specific group of retirees and is managed by professionals to ensure the fund is able to meet the group's long-term financial needs. Bond mutual funds, money market funds, savings accounts, and hybrid funds are not necessarily dedicated portfolios, as they may serve a variety of investors with different financial objectives.

Question 6

Your company will owe a single payment of $20 million dollars to a pension fund in 10 years. The current yield to maturity for investment grade bonds with 10 years to maturity is 7 percent. What is the best method to immunize this portfolio? Buy bonds with:

Accepted Answer

According to immunization theory, we should match the duration of the bond portfolio with the duration of the pension fund payment. Therefore, buying bonds with a duration of 10 years is the best method to immunize the portfolio. None of the other options (average coupon rate, maturity, yield to maturity, and face value) necessarily match the duration of the payment.

Question 7

Reinvestment risk occurs when interest rates:

Accepted Answer

Reinvestment risk occurs when interest rates decrease, making it difficult for investors to reinvest income or principal at a rate comparable to their current investment's rate.

Question 8

As a bond's yield increases, its price ________. As a bond's yield decreases, its price ________.

Accepted Answer

As a bond's yield increases, its price decreases. As a bond's yield decreases, its price increases. This is due to the inverse relationship between bond prices and yields.

Question 9

All else the same, a bond's interest rate risk is most dependent on the bond's:

Accepted Answer

The bond's maturity has the strongest impact on its interest rate risk. The longer the time to maturity, the greater the sensitivity of the bond's price to changes in interest rates. Bonds with shorter maturities have less interest rate risk.

Question 10

A bond has a yield-to-maturity that is equal to the coupon rate. Knowing this, you also know that the

Accepted Answer

When a bond's yield-to-maturity is equal to its coupon rate, it means the bond is selling at par value. This condition does not depend on the time to maturity, the frequency of interest payments, or comparisons between market and face values beyond the implication of par value trading.

Question 11

All else the same, as a premium bond approaches maturity its price ______, and the price of a discount bond ______.

Accepted Answer

As a premium bond approaches maturity, its price will decrease because the bond's price must approach its face value. Conversely, as a discount bond approaches maturity, its price will increase because the bond's price must also approach its face value.

Question 12

For a premium bond, the

Accepted Answer

For a premium bond, the price of the bond is above its par value because the coupon rate is higher than the prevailing interest rates. This means the coupon rate (the interest rate the bond pays) exceeds both the yield-to-maturity (the total return anticipated on a bond if held until it matures) and the current yield (the annual interest payment divided by the current price of the bond).

Question 13

For an absolute change in interest rates, the price gain on a bond caused by a decrease in yield is ________ the price loss caused by an increase in yield.

Accepted Answer

The price-yield relationship of bonds is convex, meaning that for a given absolute change in interest rates, the price increase from a decrease in yield is greater than the price decrease from an increase in yield.

Question 14

Modified duration is calculated as:

Accepted Answer

Modified duration is calculated as Macaulay duration divided by 1 plus half of the yield-to-maturity. Therefore, the correct formula is: Modified duration = Macaulay duration / (1 + YTM/2). Option D matches this formula.

Question 15

You had created a bond portfolio last year that had a portfolio duration of 12 years, which was your target date. Today, you revise your portfolio such that it now has a duration of 11 years. You are following a strategy known as

Accepted Answer

The strategy being followed in this scenario is dynamic immunization. This involves adjusting the portfolio's duration in response to changes in interest rates to maintain a desired level of immunization. By revising the portfolio to a duration of 11 years, the investor is ensuring that the portfolio is protected against interest rate risk for a period of 11 years. Portfolio matching involves matching the portfolio's cash flows to the investor's liabilities, maturity reduction involves reducing the portfolio's overall maturity, yield reduction involves reducing the portfolio's yield, and call protection involves protecting the portfolio from early redemption through the use of call options.

Question 16

To immunize your portfolio, you should

Accepted Answer

Matching your portfolio's duration to the target date helps to immunize your portfolio from interest rate fluctuations. This would involve investing in bonds with a similar term and yield to maturity as your investment horizon. Avoiding callable bonds and purchasing only par value bonds may not be practical or necessary, and only buying zero-coupon bonds may limit your investment choices. Matching the maturity dates of coupon bonds to your target date may also not provide sufficient protection from interest rate risks.

Question 17

For a given change in interest rates, the longer the bond's maturity, the ________ the price change.

Accepted Answer

The longer the bond's maturity, the greater the price change for a given change in interest rates. This is due to the fact that longer maturity bonds are more sensitive to changes in interest rates than shorter maturity bonds, which means their prices will change more in response to a given change in interest rates.

Question 18

All else the same, for a callable bond, an increase in the call premium will ________ the yield to call.

Accepted Answer

An increase in the call premium makes the bond more attractive to investors because they receive more money if the bond is called. This attractiveness leads to a lower yield to call as investors are willing to accept a lower return for the higher call premium.

Question 19

For a given change in interest rates, a bond's price change is _____ related to the bond's coupon rate.

Accepted Answer

The price change of a bond is inversely related to the bond's coupon rate. This means that as interest rates increase, the price of a bond with a higher coupon rate will decrease more than the price of a bond with a lower coupon rate, because the higher coupon rate bond is paying out more interest compared to the newly issued bonds at higher rates. On the other hand, a lower coupon rate bond will have a smaller decrease in price because its coupon payments are closer in line with the newly issued bonds at higher rates. Therefore, the coupon rate is an important factor to consider when analyzing bond price fluctuations caused by interest rate changes.

Question 20

You are buying a $1,000 face value bond from your dealer. The bond pays interest semiannually on February 1 and August 1. Assume that every month has 30 days only. Today is May 30. How many months of accrued interest must you pay when you make this purchase?

Accepted Answer

The bond pays interest on February 1 and August 1. Since today is May 30, the last interest payment was on February 1. From February 1 to May 30, there are 4 months (February, March, April, May) of accrued interest.

Quiz 11: Bond Prices and Yields