Fixed Income Flashcards
Explain the relationship between duration and interest rate sensitivity
The value of a bond will decline by 1% for each year of duration for a rise of 1% in interest rates. If rates fall by 1%, then the price will rise 1% for each year of duration.
The Fisher equation decomposes bond interest rates into what two components?
Nominal rates of interest plus inflation expectations.
Which of the following are components or assumptions of the YTM calculation?
- The return from price change as the bond moves to par at maturity.
- Returns based on coupon payments
- Assumed interest earned by reinvestment of coupon payments at the YTM rate
All
Of all the inputs and assumptions used in the YTM calculation, which are subject to uncertainty?
- The assumption that coupons will be reinvested at the YTM rate is not only uncertain, it’s also unlikely. This is why the accuracy of YTM declines as the term lengthens.
- That the bond will actually be held to maturity.
Why is the YTM less reliable on longer maturities than shorter ones?
Because YTM assumes that all coupons are reinvested at the YTM rate. Due constant market interest rate fluctuation, this unlikely even on relatively short term bonds. It is very unlikely on longterm bonds.
Exception - Zero coupon bonds.
Why do zero coupon bonds have the longest durations of any type of bond?
Because there are no cash flows to reinvest.
For two bonds with the same term but different coupon rates, which will have the shorter duration?
The bond with the higher coupon.
Over long periods of time, what accounts for the majority of the return on a fixed income portfolio?
Interest on interest.
Which of the following components of bond return explains the largest component of the long-term return from a bond portfolio?
Interest payments
Bond price changes
Interest on interest payments
Interest on interest payments
