Question 1

Under terminal wealth analysis, the greater the period to maturity,

Accepted Answer

Under terminal wealth analysis, the greater the period to maturity, the greater the effect of any shift in interest rates.

Question 2

What type of bond investor would probably be least concerned about a drop in market interest rates?

Accepted Answer

The type of bond investors who would be least interested in a drop in interest rates is individuals who spend their interest income.

Question 3

Volatile high interest rates have directly caused more emphasis on duration analysis because:

Accepted Answer

These volatile rates have caused more emphasis on concepts such as duration to measure bond price sensitivity and on total return as a measure of bond management success.

Question 4

Under which of the following circumstances would terminal wealth analysis NOT be relevant?

Accepted Answer

Terminal wealth analysis is a way of analyzing the reinvestment assumption when bonds are held to maturity, while the realized yield approach assumes bonds are actively traded to take advantage of interest rate swings.

Question 5

The process of measuring the effect of a shift in market interest rates on the value of an investment is called:

Accepted Answer

The process of measuring the effect of a shift in market interest rates on the value of an investment is called terminal wealth analysis.

Question 6

Compute the duration for the data in this problem using a discount rate of 12%.

$\begin{array}{c}
\begin{array}{|c|}
\hline
\
\hline
\text {Year, t} \
\hline
1\
\hline
2\
\hline
3\
\hline
3\
\hline
\end{array}
\begin{array}{c|}
\hline 
\text{Cash}\
\hline
\text {Flow}\
\hline
90\
\hline
90\
\hline
90\
\hline
1000\
\hline
\end{array}
\end{array}$

Accepted Answer

The answer of Compute the duration for the data in...

Question 7

For all bonds of equal risk, the type of bond that had the greatest duration, and therefore the greatest price sensitivity, is:

Accepted Answer

For all bonds of equal risk and maturity, the zero-coupon bond has the greatest duration and therefore the greatest price sensitivity.

Question 8

A terminal wealth table generates the ending value of the investment at the end of the year, assuming that the bond:

Accepted Answer

A terminal wealth table generates the ending value of the investment at the end of the year, assuming that the bond has a maturity date corresponding to that year. This is because the terminal wealth table is used to calculate the yield to maturity of the bond, which is based on the assumption that the bond will be held until maturity. Therefore, the ending value of the investment at the end of the year will be based on the maturity value of the bond in that year.

Question 9

Duration is:

Accepted Answer

The three factors that determine the value of duration are the maturity of the bond, the market rate of interest, and the coupon rate. Duration is positively correlated with maturity but moves in the opposite direction of market rates of interest and coupon rates; that is, the higher the market rate of interest or the coupon rate, the lower the duration.

Question 10

Duration represents the weighted average life of a bond where the weights are based on the:

Accepted Answer

Duration is calculated as the weighted average of the time (in years) of each cash flow, where the weights are the present values of the individual cash flows relative to the present value of the total cash flows. Therefore, the correct choice is C which describes the present value of the individual cash flows relative to the present value of the total cash flows.

Question 11

You are considering the purchase of two $1,000 bonds, both issued by Tranig Corp. Your expectation is that interest rates will drop, and you want to buy the bond which provides the maximum capital gains potential. The first Tranig bond has a coupon rate of 6% with five years to maturity, while the second has a coupon rate of 9% and comes due six years from now. If market rates of interest are 8% for both bonds, which bond has the best price potential? (Use duration to answer the question.)
Coupon rate 6%
 $\begin{array}{|c|c|c|r|r|r|}
\hline\text { (1) } & \text { (2) }&\text {(3) } & \text { (4) }&\text { (5) }&\text { (6) }\ 
\hline&& \text { PV Factor } & \text { PV of } &\text { Weights }&\ 
\hline\underline{ \text { Year } }&  \underline{ \text{ Cash Flow}} &\underline{ \text { @ } 10{\%}  }&\underline{ \text { Cash Flow } }&\underline{ (4) \text { Value }} &\underline{ (1) \times(5)} \
\hline1& \$ 60 & .926 & \$ 55.56 & .06035 & .06035 \
\hline 2 & 60 & .857 & 51.42 & .05585 & .11170 \
\hline 3 & 60 & .794 & 47.64 & .05175 & .15525 \
\hline 4 & 60 & .735 & 44.10 & .04790 & .19160 \
\hline 5 & 60 & .681 & 40.86 & .04438 & .22190 \
\hline 5 & 1,000 & .681 & \underline{681.00} & .73975 & \underline{3.69875} \
\hline
\end{array}$

$\quad $$\quad $$\quad $$\quad $$\quad $$\quad $$\quad $$\quad $$\quad $$\quad $$\quad $$\quad $$\text { PV of Bond }=\$ 920.58 \quad \text { Duration }=4.43955$ Coupon rate 9% $\begin{array}{|l|l|l|l|l|l|}
\hline\text { (1) } & \text { (2) }&\text {(3) } & \text { (4) }&\text { (5) }&\text { (6) }\ 
\hline&& \text { PV Factor } & \text { PV of } &\text { Weights }&\ 
\hline\underline{ \text { Year } }&  \underline{ \text{ Cash Flow}} &\underline{ \text { @ } 8{\%}  }&\underline{ \text { Cash Flow } }&\underline{ (4) \text { Value }} &\underline{ (1) \times(5)} \
\hline 1 & \$ 90 & .926 & \$ 83.34 & .07967 & .07967 \
\hline 2 & 90 & .857 & 77.13 & .07373 & .14746 \
\hline 3 & 90 & .794 & 71.46 & .06831 & .20493 \
\hline 4 & 90 & .735 & 66.15 & .06325 & .25292 \
\hline 5 & 90 & .681 & 61.29 & .05859 & .29295 \
\hline 6 & 90 & .630 & 56.70 & .05421 & .32526 \
\hline 6 & 1,000 & .630 & 630.00 & .60225 & .3 .61350 \
\hline
\end{array}$
$\quad $$\quad $$\quad $$\quad $$\quad $$\quad $$\quad $$\quad $$\quad $$\text { PV of Bond } = \$ 1046.07 \quad \text { Duration } = 4.91669$

Accepted Answer

The answer of You are considering the purchase of two...

Question 12

Duration is influenced by everything except:

Accepted Answer

The three factors that determine the value of duration are the maturity of the bond, the market rate of interest, and the coupon rate. Duration is positively correlated with maturity but moves in the opposite direction of market rates of interest and coupon rates; that is, the higher the market rate of interest or the coupon rate, the lower the duration.

Question 13

Assume you buy a 20-year, $1,000 par value zero-coupon bond that provides a 12% yield to maturity. Almost immediately after you buy the bond, yields decrease to 9%. What will be the percentage gain on the investment?

Accepted Answer

The answer of Assume you buy a 20-year, $1,000 par...

Question 14

Compute the duration for a bond with an 8% coupon rate, maturing in five years. A discount rate of 10% should be applied.

Accepted Answer

The answer of Compute the duration for a bond with...

Question 15

You have invested $1,000 in a 12% coupon bond that matures in three years. You are investing the interest income in a fund earning 8%. At the end of three years, what will be your portfolio sum?

Accepted Answer

First, let's calculate the coupon payment for each year:

Coupon payment = Coupon rate x Face value = 0.12 x $1,000 = $120

Since the bond matures in three years, you will receive three coupon payments. You will reinvest each of these payments at 8%. Therefore, your future value after three years will be:

FV = $1,000 x (1.12)^3 + $120 x (1.08)^2 + $120 x (1.08)^1 + $120 x (1.08)^0 
FV = $1,389.57

Therefore, your portfolio sum at the end of three years will be $1,389.57.

Quiz 18: Duration and Bond Portfolio Management