Question 1

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

Accepted Answer

This is because fixed income contracts, such as bonds, have a fixed interest rate. When interest rates in the market increase, the fixed rate on the contract becomes less attractive and the value of the contract goes down. Conversely, when interest rates decrease, the fixed rate on the contract becomes more attractive and the value of the contract goes up.

Question 2

The coupon rate represents the most accurate measure of the bondholder's required return.

Accepted Answer

The coupon rate is only one component of a bondholder's required return. Other factors such as prevailing interest rates, credit risk, and time to maturity can also affect the required return.

Question 3

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

Accepted Answer

This is because if the coupon payment is less than the expected return, investors will require a higher yield to compensate for the lower coupon payment. This results in the bond being priced at a discount from its par value.

Question 4

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

Accepted Answer

This is known as bond price or bond duration risk, and it occurs because when interest rates fall, the present value of future fixed interest payments increases, making existing bonds more valuable. This is more pronounced for bonds with longer maturities and lower coupon rates.

Question 5

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 inversely related to its expected return. A premium bond has a higher price than its face value, while a discount bond has a lower price than its face value. Therefore, the discount bond would have a greater expected return than the premium bond.

Question 6

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

Accepted Answer

Bond convexity is a measure of the sensitivity of a bond's duration to changes in interest rates. As interest rates increase, the bond's price will fall, and its duration will shorten, resulting in lower convexity.

Question 7

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

Accepted Answer

This statement is true because the duration of a bond is always less than its maturity. The duration takes into account the timing of coupon payments and the principal repayment, whereas the maturity only reflects the time until the bond reaches its face value. Since the coupon payments provide some of the investor's return before the final payment, the duration is reduced. Therefore, a four-year maturity 10 percent coupon bond will have a duration of less than four years.

Question 8

The higher the interest rate is the higher the duration,all else being equal.

Accepted Answer

Duration, in the context of bonds, measures a bond's sensitivity to interest rate changes. A higher interest rate typically leads to a lower duration because the present value of the bond's future cash flows is discounted at a higher rate, making the bond less sensitive to further changes in interest rates.

Question 9

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 10

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 11

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 equals its expected rate of return, as the market prices the security to reflect all available information and investor expectations.

Question 12

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 is considered attractive to buyers, so it will sell at a premium to its par value. In this case, the 11 percent coupon rate is higher than the 9 percent required return, making the bond sell at a premium.

Question 13

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

Accepted Answer

Security that returns a greater percentage of the price sooner is less volatile because it provides a higher level of certainty and predictability in terms of the returns. On the other hand, securities that have a lower percentage of returns or take longer to generate returns are generally considered riskier and more volatile.

Question 14

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

Accepted Answer

The duration of a zero coupon bond is equal to its maturity because there are no coupon payments to shorten or lengthen the duration. However, the convexity of a zero coupon bond is not exactly zero, but close to zero. It is because convexity measures the curvature of the price-yield relationship, and the price-yield curve for a zero coupon bond is almost linear.

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

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

Accepted Answer

The higher the coupon, the greater the cash flow the bondholder receives, which in turn reduces the sensitivity of the bond's price to changes in interest rates. Therefore, a higher coupon bond will have lower price volatility compared to a lower coupon bond.

Question 17

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 10-year maturity zero coupon bond will have higher price volatility than a 10-year bond with a 10 percent coupon because it pays no intermediate cash flows and its entire value is sensitive to changes in interest rates, making its price more volatile.

Question 18

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 19

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

Accepted Answer

This statement is true. The higher the coupon, the more income the investor will receive, which reduces the security's price sensitivity to interest rate changes.

Question 20

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

A negative realized return indicates that the actual return was less than zero, which means that the expected return was lower than the required return. If the expected return was greater than the required return, then the realized return would have been positive.

Quiz 3: Interest Rates and Security Valuation