What is a bond?
A fixed payment obligation. Called "Fixed-income Securities
What is a zero coupon bond?
A bond that pays only the face value at maturity (Investor return comes from buying the bond at a discount from its face value)
What is the relationship between market interest rates and market bond prices?
Interest Rates rise, Bond Prices Drop // Interest Rate drop, Bond Prices Rise
What is meant by Yield-to-Maturity (YTM)?
Total annualized return on a security, assuming no default and coupon reinvestment
What is interest rate risk?
Changing interest rates change the bond's return, both in terms of the price of the bond and the reinvestment of coupon payment. Therefore, the risk that arises from the uncertainty of the bond's return caused by changes in interest rates.
Prices and Yiel
What is meant by interest rate risk being non-linear and asymmetrical?
When the price gain for a drop in rate exceeds the price decline for rate increase of the same magnitude
Will a bond price rise more for a given % rate decrease, or fall more for the same % increase?
The bond price will fall more
How is price volatility related to length of time until maturity?
Price volatility increases with time to maturity (because there is higher duration, meaning more time required to recoup your investment value.)
Does the change in price sensitivity to change in maturity increase or decrease with increase in time to maturity?
Price sensitivity decreases with increase in time to maturity
Is interest rate sensitivity lower for high coupon rate bonds or low coupon rate bonds?
More sensitivity for 0 or lower coupon rates
Price sensitivity is higher for low coupon rates than for high coupon rates bonds
Which is more sensitive to a given change in market yield: low-yield bonds or high-yield bonds?
Lower YTM has higher sensitivity to change in yield of a given percent
Example: gain or drop of 1% more significant if current rates are at 4% than if at 5%
(bonds) What is duration? How is duration used to measure interest rate risk?
Weighted average of cash flows from coupons and redemption (maturity) payments
How is duration used to measure interest rate risk?
Higher duration = higher interest rate risk
What is bond portfolio immunization?
Strategy used to reduce interest rate risk in a bond portfolio
How is a bond portfolio immunized?
Matching duration with liabilities with duration of assets
What is the difference between price risk and reinvestment risk?
Price and Reinvestment risk work in opposite directions
If rate goes up, price goes down
If rate goes up, reinvestment goes up
What should a bond portfolio manager do about anticipated changes in interest rates using portfolio duration to maximize returns?
If interest rate is expected to fall, then you should invest in bonds with higher duration.
What is the difference between diversifiable and non-diversifiable risk?
Diversifiable Risk: Risk which can be reduced by diversification
Non-Diversifiable risk: Risk which cannot be reduced by diversification
Investors only buy high-risk investment if they are compensated through higher expected return, risk that can be elimi
What other names are used for diversifiable and non-diversifiable risk?
Diversifiable Risk, AKA:
Unique, asset specific, non-systematic, or idiosyncratic risk
Non-Diversifiable Risk, AKA:
Market, beta, or systematic risk
What is beta? What does beta measure?
Beta is the slope of the regression line
Beta is typically estimated by linear regression of the return on an individual asset v. the market return
Why is beta the only measure of risk that is rewarded in the competitive market (why is diversifiable risk
not
rewarded)?
Diversifiable risk is not rewarded because it is not taking the market risk. No incentive to take less risk.
What is the 'reward' for bearing higher risk in the competitive market?
As an asset's risk (beta) increases, so does the rate of return on that asset that is required by the competitive market. You get a higher expected return
What is a high beta? A low beta? The beta of the market? The beta of the risk-free asset?
High Beta - Higher than the market, Beta greater than 1, Riskier but potential greater profit
Low Beta - Lower than the market, Beta less than 1, Less risky, but lower returns
What is The beta of the market? The beta of the risk-free asset?
Beta of the market - Beta of .1 security will be less volatile than the market
Beta of the risk-free asset - Zero Beta. Would have the same expected return as the Risk Free Rate
What is the CAPM?
Capital Asset Pricing Model, a model that describes the relationship between systematic risk and expected return for assets, particularly stocks.
(IE. the formula that relates return to risk (Beta) and market parameters)
What is the Security Market Line?
Line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM), which shows the relationship between systematic risk and expected return in financial markets
What is the relationship between price and expected return?
The price of an asset in a liquid and competitive market is related to the return investors expect/ demand for that asset
Asset price is a function of expected future cash flows and require rate of return
Expected future cash flows will be discounted more