Question 1

Higher interest rates lead to lower bond convexity,ceteris paribus.

Accepted Answer

Higher interest rates result in lower bond prices, which in turn reduces the curvature (convexity) of the bond's price-yield relationship. Therefore, higher interest rates lead to lower bond convexity, ceteris paribus.

Question 2

All else equal,the holder of a fairly priced premium bond must expect a capital loss over the holding period.

Accepted Answer

A fairly priced premium bond has a coupon rate higher than the prevailing interest rate in the market, hence it is trading at a price higher than its par value. When interest rates rise, the bond's price will decline to adjust to the new prevailing rate. Therefore, the holder of a premium bond must expect a capital loss over the holding period.

Question 3

If interest rates increase,the value of a fixed income contract decreases and vice versa.

Accepted Answer

When interest rates increase, the rate of return on new fixed income contracts will increase. This means that the value of existing fixed income contracts with lower rates of return will decrease in comparison, making them less attractive to investors. Therefore, the value of a fixed income contract is inversely related to changes in interest rates.

Question 4

A bond with an 11 percent coupon and a 9 percent required return will sell at a premium to par.

Accepted Answer

A bond with a coupon rate higher than the required return will sell at a premium to par. In this case, the 11 percent coupon rate is higher than the 9 percent required return, making the bond more attractive to investors, and therefore it will sell at a premium to par.

Question 5

The longer the time to maturity,the lower the security's price sensitivity to an interest rate change,ceteris paribus.

Accepted Answer

The longer the time to maturity, the higher the security's price sensitivity to an interest rate change, ceteris paribus, because there is more time for the interest rate changes to impact the present value of future cash flows.

Question 6

Ignoring default risk,if a bond's expected return is greater than its required return,then the bond's market price must be greater than the present value of the bond's cash flows.

Accepted Answer

If a bond's expected return is greater than its required return, it indicates that the bond is undervalued, and thus, its market price would be less than the present value of its cash flows, as investors would be willing to pay more for its future cash flows than its current market price.

Question 7

The lower the level of interest rates,the greater a bond's price sensitivity to interest rate changes.

Accepted Answer

This is because when interest rates are low, there is less room for them to go down further, increasing the potential for them to go up. This makes investors more sensitive to interest rate changes, and therefore more likely to adjust their bond holdings accordingly. Additionally, as interest rates decrease, the future cash flows from a bond become more valuable, increasing the bond's price sensitivity.

Question 8

A 10-year maturity zero coupon bond will have lower price volatility than a 10-year bond with a 10 percent coupon.

Accepted Answer

A zero coupon bond pays no interest until maturity, so its price is mainly affected by changes in interest rates, whereas a bond with a coupon pays interest regularly, making it more sensitive to changes in both interest rates and the creditworthiness of the issuer. Therefore, the zero coupon bond has lower price volatility.

Question 9

Duration is
A)the elasticity of a security's value to small coupon changes.
B)the weighted average time to maturity of the bond's cash flows.
C)the time until the investor recovers the price of the bond in today's dollars.
D)greater than maturity for deep discount bonds and less than maturity for premium bonds.
E)the second derivative of the bond price formula with respect to the YTM.

Accepted Answer

Duration is the weighted average time to maturity of the bond's cash flows. Option A is describing a concept called "convexity", not duration. Option C is describing "break-even yield", not duration. Option D is incorrect as duration is always less than or equal to maturity. Option E is describing the concept of "convexity", not duration.

Question 10

Any security that returns a greater percentage of the price sooner is less price-volatile.

Accepted Answer

If a security returns more of its price sooner, it means that investors are receiving a higher return on their investment in less time, reducing the risk of the price fluctuating rapidly. This typically results in less price volatility.

Question 11

If a security's realized return is negative,it must have been true that the expected return was greater than the required return.

Accepted Answer

If a security's realized return is negative, it means that the actual return was lower than the expected return. The expected return may have been equal to or even lower than the required return.

Question 12

The higher a bond's coupon,the lower the bond's price volatility.

Accepted Answer

A bond's coupon rate represents the interest payments that the bondholder will receive. The higher the coupon rate, the higher the interest payments the bondholder will receive. This means that the bondholder is less susceptible to changes in interest rates, which in turn results in lower price volatility. Therefore, the statement is true.

Question 13

At equilibrium,a security's required rate of return will be less than its expected rate of return.

Accepted Answer

At equilibrium, a security's required rate of return will be equal to its expected rate of return, not less than it.

Question 14

The required rate of return on a bond is
A)the interest rate that equates the current market price of the bond with the present value of all future cash flows received.
B)equivalent to the current yield for non-par bonds.
C)less than the E(r)for discount bonds and greater than the E(r)for premium bonds.
D)inversely related to a bond's risk and coupon.
E)none of the options.

Accepted Answer

The answer of The required rate of return on a...

Question 15

For a given interest rate change,a 20-year bond's price change will be twice that of a 10-year bond's price change.

Accepted Answer

The price sensitivity of a bond to interest rate changes, known as duration, increases with the bond's maturity. However, the relationship is not linear, meaning a 20-year bond's price change will not be exactly twice that of a 10-year bond's price change. Factors such as coupon rate, yield, and the convexity of the bond also affect how its price responds to interest rate changes.

Question 16

Suppose two bonds of equivalent risk and maturity have different prices such that one is a premium bond and one is a discount bond. The premium bond must have a greater expected return than the discount bond.

Accepted Answer

The price of a bond is based on its coupon rate (interest payment) relative to the prevailing interest rate in the market. A premium bond has a coupon rate higher than the market interest rate, while a discount bond has a coupon rate lower than the market interest rate. Therefore, the expected return from a premium bond would be lower than that of a discount bond, as the higher coupon payments would partly offset the lower price of the discount bond.

Question 17

The greater a security's coupon,the lower the security's price sensitivity to an interest rate change,ceteris paribus.

Accepted Answer

This is known as the coupon effect, where higher coupon payments provide a larger buffer against interest rate changes and therefore result in a lower price sensitivity.

Question 18

A zero coupon bond has a duration equal to its maturity and a convexity equal to zero.

Accepted Answer

This is true because a zero coupon bond has only one cash flow at maturity and therefore its duration is equal to its maturity. Additionally, the formula for convexity includes a term for the coupon payments, which a zero coupon bond does not have, resulting in a convexity of zero.

Question 19

The duration of a four-year maturity 10 percent coupon bond is less than four years.

Accepted Answer

The duration of a bond is always less than its maturity, and the coupon payments reduce the effective maturity even further. Therefore, the duration of a four-year maturity 10 percent coupon bond is less than four years.

Question 20

A fairly priced bond with a coupon less than the expected return must sell at a discount from par.

Accepted Answer

This is true because if a bond's coupon rate is less than the expected return (yield), investors will demand a discount in order to achieve a competitive return on their investment. A discount from par means the bond sells for less than its face value, which compensates for the lower coupon rate and results in a yield that is in line with the market's expectations.

Quiz 3: Interest Rates and Security Valuation