What is a bond? "Fixed-income securities
-A bond essentially is a security that offers the investor a series of fixed interest payment during its life, along with a fixed payment of principal when it matures
-A fixed payment obligation
-Pays coupon interest
-Securitized loan
-When interest rates
What is a zero coupon bond?
-Pays only the face value at maturity
-a bond that is issued at a deep discount to its face value but pays to interest
-Investor return come from buying the bond at a discount from its face value
What is the relationship between market interest rates and market bond prices?
-Its an inverse relationship - the higher a market interest rate is, that lower the bond price and vice versa
What is meant by yield-to-maturity?
-The discount rate that equates a bond price with the present value of its future cash flows (also called promise yield or just yield)
-Is the internal rate of return earned by an investor who buys the bon today at market price and assuming it is held to
What is the current yield?
-a bonds current yield is its annual coupon payment divided by its current market price
-the rate of return that is found by dividing current payments (coupons) by the price of the bond
What is the Relationship between YTM, coupon rate, and current yield if a bond is selling at a discount/premium?
-Par bonds: bonds with a price equal to par value are said to be selling at par. The yield to maturity of a par bond is equal to its coupon rate
Discount: if YTM>Current yield>Coupon rate
-Bonds with a price less than par value are said to be selling at a
What is interest rate risk?
-The IRR is the risk that an investments value will change due to a change in absolute level of interest rates, in the spread between two interest rates, in the shape of the yield curve, or in any other interest rate relationship
-it is an inverse relatio
How is price volatility related to length of time to maturity?
-bonds with lower coupon rate will be more volatile than ones with hight coupon rate. Longer term bonds are more volatile than shorter term bonds
-Volatility is the amount a bonds price changes in response to specific changes in interest rates
What is duration?
-to account for differences in interest rate risk across bonds with different coupon rates and maturities, the concept of duration is widely applied. Duration measures a bonds sensitivity to interest rate changes. Widely used measure of a bonds price sens
How is duration used to measure interest rate risk?
-higher duration is higher interest rate risk. Duration is used as a tool to manage portfolio
What is bond portfolio immunization?
-Constructing a dedicated portfolio to minimize the uncertainty in its target date value is called immunization.
-It means that whether interest rate risks go up or down, the risk associated with that is hedged. Negatively impacts the liabilities. Protect
How is a bond portfolio immunized?
-To immunize a bond portfolio, you need to know the duration of the bonds in the portfolio and adjust the portfolio so that the portfolio's duration equals the investment time horizon.
-The key to immunizing a dedicated portfolio is to match its duration
What is the difference between price risk and reinvestment risk?
-Price risk and reinvestment risk work in opposite direction.
-Prices and rates move in opposite directions
-Rates go down and bond prices go up but reinvestment prices go down -To understand how immunization is accomplished, suppose you own a bond with e
What should a bond portfolio manager do about anticipated changes in interest rates using portfolio duration to maximize returns?
-to manage their interest rate risk it has upside and downside
-Risk is uncertain
-if rates are expected to go up thats bad for prices and managers can reduce impact by reducing duration of portfolio
What is the difference between diversifiable and non diversifiable risk?
-Risk that is diversifiable can be eliminated through a diversified portfolio (non-systematic risk)
-non diversifiable risk (market risk) or (systematic risk) or (beta risk) is risk that is not eliminated through diversification
What other names are used for diversifiable and non diversifiable risk?
Non: market risk, systematic risk, beta risk
Diversifiable: unique, unsystematic risk, specific risk or residual risk
What is a beta?
-Measure of systematic risk
-High beta is a beta > 1
-Low beta is < 1
What does beta measure?
Systematic risk or the riskiness of an asset compared to the market
Why is beta the only measure of risk that is rewarded in the competitive market (why is diversifiable risk not rewarded?
-Risk which cannot be eliminated should be compensated for either a higher expected return
-diversifiable risk will not be compensated for
What is the reward for bearing higher risk in the competitive market?
-Reward is a higher expected rate of return, higher beta is higher expected rate of return
What is the beta of the market?
1
The beta of a risk free asset?
0
What is the CAPM?
-Capital asset pricing model = relationship between risk and return using beta (fair rate of return)
What is the security market line?
-Line on a graph that represents the capital asset pricing model
-Anything below the line is overpriced (actual > fair)
-Anything above the line is underpriced (actual < fair)
-Low (<1) betas to the left, high betas (>1) to the right
What is the relationship between price and expected return?
-price and expected return are inversely related.
-Because of this, the reward to risk ratio must be the same for every asset in a competitive market
Underpriced Investment
-If underpriced the actual is less than the expected price
-When underpriced the price is too low and the risk is too high
-On graph it is above the Risk free line
Overpriced Investment
-If overpriced the actual is greater than the expected price
-When overpriced the price is too high and the risk is too low
-On graph it is below the Risk free line