finance 3050 final

What is a bond?

A security that offers the investor a series of fixed interest payments, along with a fixed payment of principal when it matures
*Fixed payment obligation
*Pays coupon interest
*A securitized loan

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 no interest

What is the relationship between market interest rates and market bond prices?

Inverse relationship, the higher a market interest rate is, the lower the bond price. vise versa

What is meant by yield to maturity?

The internal rate of return earned by an investor who buys the bond today at market price and assuming it is held until maturity and all payments are made on schedule

What is current yield?

Is a bonds annual coupon payment divided by its current market price
*dividing payments by the price of the bond

What is interest rate risk?

*The IRR is the risk that an investment's value will change due to a change in the 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 r

Discount bonds

YTM > Current Yield > Coupon Rate
Bonds with a price less than par value are said to be selling at a discount. The yield to maturity of a discount bond is greater than its coupon rate.

Premium Bonds

YTM < Current Yield < Coupon Rate
Bonds with a price greater than par value are said to be selling at a premium. The yield to maturity of a premium bond is less than its coupon rate.

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.

How is price volatility related to length of time until maturity?

Bonds with lower coupon rate will be more volatile than one with higher coupon rate. Longer term bonds are more volatile than shorter term bonds.
Volatility is the amount a bond's price changes in response to specific changes in interest rates.

What is duration?

Directly measures a bond's price sensitivity to interest rate changes (or changes in bond yields)
Effective maturity - weighted avg of cash flows from coupons and redemption (maturity) payments
Higher duration = higher interest rate
Bonds w/coupons - dura

How is duration used to measure interest rate risk?

Higher duration is higher interest rate risk. Duration is used as a tool to manage a portfolio

What is bond portfolio immunization?

Matching duration of liabilities with duration of assets
It means that whether interest rate risks go up or down, the risk associated with that is hedged. Negatively impacts the liabilities. Protecting your bond portfolio risk

How is a bond portfolio immunized?

The key to immunizing a dedicated portfolio is to match its duration to its target date.
If this is done, then the impacts of price and reinvestment rate risk will almost exactly offset, and interest rate changes will have a minimal impact on the target d

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 bond prices go up, but reinvestment prices go down.

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 because it has upside and downside. Risk is uncertain. If rates are expected to go up that's bad for prices, and manager can reduce impact by reduce 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-diversifiable = market-risk, systematic risk, Beta Risk
Diversifiable = Unique, non-systematic risk, Asset-specific risk or residual risk

What is beta?

Beta is a measure of systematic risk
tells us how much systematic risk a particular asset has relative to an average asset.
High beta is a beta > 1
Low Beta is < 1
An average Asset has a Beta = 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 with 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 a high beta?

Above 1
to the right of the security market line

What is a low beta?

Below 1
to the left of the security market line

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?

Security market line= Graphical representation of the linear relationship between systematic risk and expected return in financial markets.

Actual > Fair

Anything below the line is overpriced

Actual < Fair

Anything above the line is underpriced

What is the relationship between price and expected return?

Inversely related
Bc of this, the reward to risk ratio must be the same for every asset in the competitive market