D.32 Investment Planning: Bond and stock valuation concepts Flashcards
(6 cards)
What is the definition of yield to maturity (YTM)?
A) The annual interest payment on a bond divided by its face value
B) The market value of a bond divided by its face value
C) The discount rate that equates a bond’s price with the present value of its future cash flows
The discount rate equates a bond’s price with the present value of its future cash flows.
Explanation: Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. It is the discount rate that equates the present value of a bond’s cash flows to its current market price. YTM takes into account the bond’s current market price, its par value, the coupon rate, and the time to maturity. It is also known as the promised yield or just yield.
D.32 Investment Planning: Bond and stock valuation concepts
Sarah is a financial advisor discussing bond investing with her client, John. She explains to John that the yield to maturity (YTM) is an important concept to understand when investing in bonds.
Question: John is confused about what yield to maturity (YTM) means. How can Sarah explain this concept to him?
A) The yield to maturity is the annual interest payment on a bond divided by its face value.
B) The yield to maturity is the market value of a bond divided by its face value.
C) The yield to maturity is the discount rate that equates a bond’s price with the present value of its future cash flows.
The yield to maturity is the discount rate that equates a bond’s price with the present value of its future cash flows.
Explanation: Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. It is the discount rate that equates the present value of a bond’s cash flows to its current market price. YTM takes into account the bond’s current market price, its par value, the coupon rate, and the time to maturity. Sarah can explain to John that YTM is a measure of the bond’s expected return and it is important to consider when selecting bonds for his investment portfolio.
D.32 Investment Planning: Bond and stock valuation concepts
Sarah, a financial planner, is reviewing the bond portfolio of one of her clients. She’s considering the interest rate sensitivity of different bonds in relation to their coupon rates and maturities. Based on her knowledge, which of the following statements is most accurate?
A) For two bonds with the same maturity and yield to maturity, the bond with the lower coupon rate will exhibit a higher duration and greater sensitivity to interest rate changes.
B) If two bonds have identical coupon rates, the bond with the shorter duration will be more sensitive to interest rate fluctuations.
C) A zero coupon bond’s duration is always shorter than its time to maturity.
D) The potential for reinvesting bond coupon payments doesn’t influence bond duration or sensitivity to bond price fluctuations.
For two bonds with the same maturity and yield to maturity, the bond with the lower coupon rate will exhibit a higher duration and greater sensitivity to interest rate changes.
Explanation: Duration is a measure of a bond’s interest rate sensitivity. Given two bonds with the same maturity and yield to maturity, the bond with the lower coupon rate will have a higher duration. This is because bondholders will receive a smaller portion of their total payments in the form of periodic coupon payments and a larger portion in the form of the principal repayment at maturity. Consequently, the bond with a lower coupon rate will be more sensitive to interest rate changes than the bond with a higher coupon rate.
D.32 Investment Planning: Bond and stock valuation concepts
Julia, a financial planner, is evaluating two bonds for a client’s portfolio. Bond A has a 5-year maturity, a yield to maturity of 4%, and a coupon rate of 2%. Bond B also has a 5-year maturity, a yield to maturity of 4%, but a coupon rate of 4%. Julia is concerned about interest rate sensitivity and wishes to understand how these factors impact the bonds’ duration and sensitivity. Based on the given scenario, which of the following statements is true?
A) Bond A, with the lower coupon rate, will have a higher duration and greater interest rate sensitivity than Bond B.
B) Given that both bonds have the same coupon rate, the bond with the shorter duration will exhibit higher interest rate sensitivity.
C) The duration of a zero coupon bond is shorter than its time to maturity.
D) Julia does not need to consider reinvestment opportunities when determining bond price sensitivity.
Bond A, with the lower coupon rate, will have a higher duration and greater interest rate sensitivity than Bond B.
Explanation: Duration measures the sensitivity of a bond’s price to changes in interest rates. All else being equal, a bond with a lower coupon rate will have a higher duration because it pays less interest over its life, making its cash flows more distant and sensitive to interest rate changes. Bond A, with the lower coupon rate, would be more affected by interest rate movements than Bond B. The other options either misstate principles of bond behavior or are irrelevant to the scenario.
D.32 Investment Planning: Bond and stock valuation concepts
Susan is considering investing in a bond to diversify her portfolio. She comes across a bond option known as the “Lakeside City 2035 Zero Coupon Bond” with a face value of $10,000. She’s unfamiliar with zero coupon bonds and asks her financial planner for more information. Based on what the financial planner tells her, which of the following statements about the “Lakeside City 2035 Zero Coupon Bond” is correct?
A) Susan will receive periodic interest payments throughout the life of the bond.
B) The bond will pay Susan $10,000 upon maturity in 2035.
C) Susan can expect annual dividend payments from the bond.
D) The bond is priced based on its annual coupon rate.
The bond will pay Susan $10,000 upon maturity in 2035.
Explanation: Zero coupon bonds do not pay periodic interest or dividends. Instead, they are issued at a discount to their face value, and upon maturity, the holder receives the full face value of the bond. In this scenario, Susan will receive the full $10,000 face value of the “Lakeside City 2035 Zero Coupon Bond” when it matures in 2035.
D.32 Investment Planning: Bond and stock valuation concepts
Sarah is reviewing her investment portfolio and considering adding some diversity. She’s looking at the Thompson Zero Coupon Bonds, priced at $400, maturing in 10 years at $1,000. As she goes through the terms, she recalls some characteristics of zero coupon bonds. Which of the following statements is accurate regarding zero coupon bonds?
A) Thompson Zero Coupon Bonds cannot be called back by the issuer before they mature.
B) Sarah can choose to defer tax on the bond’s imputed interest until she either sells it or it matures.
C) If Sarah sells the bond or it reaches maturity, she must include the accrued interest in her gross income.
D) Every year, Sarah has to report and pay tax on the bond’s imputed interest.
Every year, Sarah has to report and pay tax on the bond’s imputed interest.
Explanation: Zero coupon bonds are sold at a discount to face value and do not pay periodic interest. Instead, the bond’s yield is the difference between its purchase price and its face value at maturity. The IRS requires bondholders to report the annual imputed (or “phantom”) interest as income, even though the bondholder doesn’t receive any cash interest payments until the bond matures. This concept is known as “original issue discount” (OID), and the bondholder is required to report this OID as interest income annually.
D.32 Investment Planning: Bond and stock valuation concepts
