Question 1

The duration of a 5-year zero coupon bond is ________ years.

Accepted Answer

A zero coupon bond does not pay any coupons throughout its life, but it is issued at a discount to its face value. The duration of a zero coupon bond is equal to its time to maturity. Therefore, the duration of a 5-year zero coupon bond is 5.0 years.

Question 2

All other things equal, which of the following has the longest duration?

Accepted Answer

Duration is the measure of a bond's sensitivity to changes in interest rates. The longer the maturity and the lower the coupon rate, the greater the duration. Zero coupon bonds have the highest duration because they have no coupon payments to offset the impact of changing rates, and the investor has to wait until maturity to receive any cash flows. Therefore, the 21-year zero coupon bond yielding 10% has the longest duration.

Question 3

Banks and other financial institutions can best manage interest rate risk by ________.

Accepted Answer

Matching the durations of assets and liabilities is the best way for banks and financial institutions to manage interest rate risk, as it reduces the impact of changes in interest rates. This approach ensures that the cash flows from assets and liabilities mature or become due at around the same time, reducing the need to refinance or roll over debt frequently in response to changes in interest rates. Maximising or minimising the duration of assets or liabilities can both result in increased interest rate risk, as it can lead to an imbalance in cash flows and exposure to changes in interest rates. Matching the maturities of assets and liabilities is not as effective as matching the durations, as maturity dates do not necessarily align with the timing of cash flows.

Question 4

An increase in a bond's yield to maturity results in a price decline that is ________ the price increase resulting from a decrease in yield of equal magnitude.

Accepted Answer

The price-yield relationship for bonds is convex, meaning that the price increase from a yield decrease is larger than the price decrease from an equivalent yield increase.

Question 5

Because of convexity, when interest rates change the actual bond price will ________ the bond price predicted by duration.

Accepted Answer

Convexity causes the actual bond price to be higher than the price predicted by duration when interest rates change, because duration predicts a linear change in price, while convexity accounts for the curvature in the price-yield relationship, leading to a higher price adjustment.

Question 6

Target date immunisation would primarily be of interest to ________.

Accepted Answer

Target date immunisation is a strategy used by pension funds to manage risk by matching the maturities of fixed-income investments with their liabilities. It aims to ensure that the fund has sufficient assets to meet its obligations when they fall due. Therefore, pension funds would primarily be interested in this strategy.

Question 7

Bond portfolio immunisation techniques balance ________ and ________ risk.

Accepted Answer

Bond portfolio immunisation techniques aim to balance price risk with reinvestment risk. Price risk refers to the potential for changes in interest rates to cause fluctuations in the value of the bond portfolio, while reinvestment risk refers to the uncertainty about the future interest rates at which the cash flows from the bond portfolio can be reinvested. By balancing these two risks, investors can ensure that the bond portfolio will meet their future cash flow needs regardless of changes in interest rates. Choice A correctly identifies price and reinvestment risk as the two risks that need to be balanced. Choices B, C, and D are incorrect because they identify other risks that are not directly relevant to bond portfolio immunisation techniques.

Question 8

________ is an important characteristic of the relationship between bond prices and yields.

Accepted Answer

Convexity describes the curvature of the relationship between bond prices and yields. As yields decrease, bond prices increase at a decreasing rate and vice versa. This means that the relationship between bond prices and yields is not linear, but rather, it exhibits convexity. This characteristic is important for bond investors because it affects the sensitivity of bond prices to changes in yields and can impact their overall returns.

Question 9

A portfolio manager sells Treasury bonds and buys corporate bonds because the spread between corporate and Treasury bond yields is higher than its historical average. This is an example of ________ swap.

Accepted Answer

This is an example of an intermarket spread swap, where the portfolio manager is taking advantage of the difference in yield spreads between two different markets (in this case, Treasury and corporate bonds) that is higher than its historical average.

Question 10

All else equal, bond price volatility is greater for ________.

Accepted Answer

Lower coupon rates result in greater sensitivity of bond prices to changes in interest rates, leading to higher price volatility. Higher coupon rates make bonds less sensitive to interest rate changes, resulting in lower price volatility. Maturity and default risk also affect bond price volatility, but the question only asks for the best choice, which is option B.

Question 11

Bond prices are ________ sensitive to changes in yield when the bond is selling at a ________ initial yield to maturity.

Accepted Answer

When a bond is selling at a lower initial yield to maturity, it has a longer duration and is more sensitive to changes in yield. Therefore, bond prices are more sensitive to changes in yield when the bond is selling at a lower initial yield to maturity.

Question 12

Duration is a concept that is useful in assessing a bond's ________.

Accepted Answer

Duration is a useful metric to assess a bond's price volatility. It measures the sensitivity of a bond's price to changes in interest rates. The higher the duration, the more sensitive the bond's price will be to changes in interest rates.

Question 13

A bond's price volatility ________ at a/an ________ rate as maturity increases.

Accepted Answer

Bond price volatility increases at a decreasing rate as maturity increases. This is due to the fact that as bond maturity increases, the impact of changes in interest rates on the bond price decreases. Therefore, the percentage change in bond price for a given change in interest rates becomes smaller as maturity increases, leading to decreasing volatility. However, while the rate of increase in volatility decreases, volatility itself still increases with maturity, as the bond becomes more sensitive to changes in interest rates.

Question 14

A pension fund must pay out $1 million next year, $2 million the following year and then $3 million the year after that. If the discount rate is 8% what is the duration of this set of payments?

Accepted Answer

The duration of the set of payments can be calculated using the formula:
Duration = [(Present value of cash flows weighted by time) / Total present value of cash flows]
Using a financial calculator or spreadsheet, the present value of each cash flow can be calculated as follows:
PV of $1 million = $925,926.00
PV of $2 million = $1,735,053.16
PV of $3 million = $2,367,355.71
Total present value of cash flows = $4,028,334.87
Weighted present value of cash flows = ($925,926*1 + $1,735,053.16*2 + $2,367,355.71*3) = $11,735,000.10
Duration = $11,735,000.10 / $4,028,334.87 = 2.29 years (rounded to two decimal places)

Question 15

The duration of a perpetuity varies ________ with interest rates.

Accepted Answer

The duration of a perpetuity is inversely related to interest rates. This means that as interest rates increase, the duration of a perpetuity decreases and vice versa.

Question 16

A bank's liabilities have an average duration of 2 years. Its assets have an average duration of 3.5 years. The bank's market value of equity is at risk if ________.

Accepted Answer

The bank's market value of equity is at risk if interest rates rise. When interest rates rise, the value of long-term assets decreases more than the value of short-term liabilities. This can cause a negative gap, leading to a reduction in the bank's market value of equity.

Question 17

All other things equal, which of the following has the longest duration?

Accepted Answer

Duration is a measure of a bond's sensitivity to changes in interest rates. Longer maturity and lower coupon payments result in a longer duration. Therefore, out of the given options, the 30-year bond with a 10% coupon payment will have the longest duration.

Question 18

You own a bond that has a duration of 6 years. Interest rates are currently 7% but you believe the Reserve Bank is about to increase interest rates by 25 basis points. Your predicted price change on this bond is ________.

Accepted Answer

With a duration of 6 years, we can apply the approximate price change formula:
Price Change ≈ - Duration × (ΔYield / (1+Yield))
where ΔYield is the change in yield in decimal form (i.e. 0.0025 for 25 basis points) and Yield is the yield in decimal form before the change (i.e. 0.07 for 7%).
Using the given values, we get:
Price Change ≈ -6 × (0.0025 / (1+0.07)) ≈ -1.40%
Therefore, the predicted price change on this bond is -1.40%, which means the answer is B.

Question 19

A pension fund has an average duration of its liabilities equal to 15 years. The fund is looking at 5-year maturity zero coupon bonds and 4% yield perpetuities to immunise its interest rate risk. How much of its portfolio should it allocate to the zero coupon bonds to immunise if there are no other assets funding the plan?

Accepted Answer

To immunize the interest rate risk, the fund should match the duration of its assets to the duration of its liabilities. The duration of a zero-coupon bond is equal to its maturity, which is 5 years. The duration of a perpetuity is 1/yield, which is 1/0.04 = 25 years. Using the formula for duration matching: (Weight of zero-coupon bonds * Duration of zero-coupon bonds) + (Weight of perpetuities * Duration of perpetuities) = Duration of liabilities. Solving: (W * 5) + ((1-W) * 25) = 15, gives W = 0.52 or 52%.

Question 20

A forecast of bond returns based largely on a prediction of the yield curve at the end of the investment horizon is called a ________.

Accepted Answer

Horizon analysis is a forecast of bond returns based on predicting the yield curve at the end of the investment horizon. Contingent immunisation is a strategy using duration to match the present value of assets with eventual liabilities. Dedication strategy is a form of immunisation that invests in bonds with maturity matching the investor's future cash flow needs. Duration analysis is a method of measuring the sensitivity of a bond's price to changes in interest rates. None of these are specifically related to forecasting bond returns based on predictions of the yield curve.

Quiz 10: Managing Bond Portfolios

The duration of a 5-year zero coupon bond is ________ years.

All other things equal, which of the following has the longest duration?

Banks and other financial institutions can best manage interest rate risk by ________.

An increase in a bond's yield to maturity results in a price decline that is ________ the price increase resulting from a decrease in yield of equal magnitude.

Because of convexity, when interest rates change the actual bond price will ________ the bond price predicted by duration.

Target date immunisation would primarily be of interest to ________.

Bond portfolio immunisation techniques balance and risk.

________ is an important characteristic of the relationship between bond prices and yields.

A portfolio manager sells Treasury bonds and buys corporate bonds because the spread between corporate and Treasury bond yields is higher than its historical average. This is an example of ________ swap.

All else equal, bond price volatility is greater for ________.

Bond prices are sensitive to changes in yield when the bond is selling at a initial yield to maturity.

Duration is a concept that is useful in assessing a bond's ________.

A bond's price volatility at a/an rate as maturity increases.

A pension fund must pay out $1 million next year, $2 million the following year and then $3 million the year after that. If the discount rate is 8% what is the duration of this set of payments?

The duration of a perpetuity varies ________ with interest rates.

A bank's liabilities have an average duration of 2 years. Its assets have an average duration of 3.5 years. The bank's market value of equity is at risk if ________.

All other things equal, which of the following has the longest duration?

You own a bond that has a duration of 6 years. Interest rates are currently 7% but you believe the Reserve Bank is about to increase interest rates by 25 basis points. Your predicted price change on this bond is ________.

A forecast of bond returns based largely on a prediction of the yield curve at the end of the investment horizon is called a ________.