READING 56 INTEREST RATE RISK AND RETURN

Question 1

Describe the three sources of return for a fixed-rate bond investment.
A. Coupon payments, changes in interest rates, and duration.
B. Coupon and principal payments, reinvested interest, and capital gains/losses.
C. Accrued interest, inflation premium, and real return.

Answer 1

Correct Answer: B

Explanation:
The three sources of return are: (1) coupon and principal payments, (2) interest earned from reinvested coupons, and (3) any capital gain or loss if the bond is sold before maturity.
Option A is incorrect because duration is a measure of sensitivity, not a return source.
Option C is incorrect because it discusses inflation and real returns, not sources of bond return.

Question 2

Explain the role of reinvestment assumption in determining bond returns.
A. Returns depend only on the bond’s coupon and principal.
B. Assuming reinvestment at YTM simplifies calculation and ensures the return equals YTM if held to maturity.
C. Reinvestment income only matters if interest rates increase.

Answer 2

Correct Answer: B

Explanation:
Assuming reinvestment at the original YTM ensures total return matches the stated YTM if the bond is held to maturity.
Option A ignores reinvestment income, which is critical.
Option C is incorrect because reinvestment matters regardless of rate direction.

Question 3

Interpret the effect of holding a bond to maturity if the YTM remains unchanged.
A. Return will vary depending on changes in bond price.
B. Return will be lower than YTM due to reinvestment risk.
C. Return equals the YTM at the time of purchase.

Answer 3

Correct Answer: C

Explanation:
If the bond is held to maturity and coupons are reinvested at the YTM, the total return equals the original YTM.
Option A is incorrect because price fluctuations are irrelevant at maturity.
Option B is incorrect because we assumed reinvestment at YTM.

Question 4

Determine the investor’s return if a bond is sold before maturity and YTM is unchanged.
A. Return equals the bond’s coupon rate.
B. Return equals the YTM at the time of purchase.
C. Return will always be lower than the YTM.

Answer 4

Correct Answer: B

Explanation:
If the YTM hasn’t changed, the bond price is unchanged, and any coupons received plus sale proceeds deliver a return equal to the YTM.
Option A is incorrect because the coupon rate is not a return measure.
Option C is incorrect because return can equal YTM if price remains stable.

Question 5

Interpret the effect of an increase in YTM shortly after bond purchase and holding to maturity.
A. The return will be equal to the original YTM.
B. The return will be higher than the original YTM.
C. The return will be lower due to reinvestment risk.

Answer 5

Correct Answer: B

Explanation:
If rates rise and the bond is held to maturity, reinvested coupons earn a higher rate, increasing overall return.
Option A ignores the reinvestment benefit.
Option C misstates the relationship—higher rates help long-term reinvestment.

Question 6

Determine the likely return if rates fall after purchase and the bond is held to maturity.
A. Return exceeds the original YTM.
B. Return equals the bond’s coupon rate.
C. Return is lower than the original YTM due to reinvestment at lower rates.

Answer 6

Correct Answer: C

Explanation:
Falling YTM means coupons are reinvested at lower rates, reducing realized return.
Option A is incorrect—it would be true only if the bond were sold.
Option B confuses return with nominal coupon rate.

Question 7

Explain what happens when an investor holds a bond for a short time and YTM increases.
A. The investor benefits from capital gains.
B. The investor experiences a capital loss and lower return.
C. The investor’s return is unaffected.

Answer 7

Correct Answer: B

Explanation:
An increase in YTM causes bond prices to fall. Selling shortly after the rate increase results in a capital loss.
Option A reverses the outcome.
Option C ignores the price decline impact.

Question 8

Determine the likely result when a bond is held for a short period and interest rates fall.
A. Return exceeds the YTM at purchase due to a capital gain.
B. Return equals the coupon rate.
C. Return equals zero because of early sale.

Answer 8

Correct Answer: A

Explanation:
Falling rates increase bond prices. Selling early results in a capital gain, boosting the return above the original YTM.
Option B ignores capital gains.
Option C is false—returns are not zero unless proceeds match purchase price.

Question 9

Explain the reinvestment risk facing a long-term bondholder if YTM drops.
A. The investor’s realized return will fall due to lower reinvestment rates.
B. There is no impact because coupons are fixed.
C. The return will increase from price appreciation.

Answer 9

Correct Answer: A

Explanation:
Even though bond prices rise when YTM drops, the investor who holds to maturity doesn’t sell—so lower reinvestment rates drag down total return.
Option B is wrong because reinvestment income is key.
Option C applies to short-term holders who sell early.

Question 10

Define an investor’s investment horizon.
A. The time the investor expects to own the bond.
B. The bond’s time to maturity.
C. The expected duration of reinvestment.

Answer 10

Correct Answer: A

Explanation:
The investment horizon is how long the investor plans to hold the bond—this may be shorter than maturity.
Option B confuses maturity with investment horizon.
Option C is too vague and not a standard definition.

Question 11

Describe the components used to calculate horizon yield.
A. Price change, inflation, and coupon rate.
B. Purchase price, coupons, reinvested interest, and end value.
C. Face value, inflation adjustment, and tax impact.

Answer 11

Correct Answer: B

Explanation:
Horizon yield includes all cash flows over the holding period: coupon payments, reinvested income, and sale or principal value.
Option A includes irrelevant items like inflation.
Option C introduces tax and inflation, which are outside this assumption set.

Question 12

Calculate the horizon yield if the bond is held for 3 years, with reinvested coupons and known sale price. This return is:
A. The internal rate of return over the investment horizon.
B. The duration-adjusted YTM.
C. The average annual coupon rate.

Answer 12

Correct Answer: A

Explanation:
Horizon yield is a compound annual return (IRR) based on purchase price and total value at the end of the holding period.
Option B is incorrect terminology.
Option C ignores price changes and reinvestment.

Question 13

Interpret what happens if all assumptions hold (no credit risk, reinvestment at YTM), and a bond is held to maturity.
A. Investor earns coupon rate.
B. Investor earns YTM at time of purchase.
C. Investor earns return based on inflation expectations.

Answer 13

Correct Answer: B

Explanation:
With all assumptions in place, the realized return equals the original YTM if held to maturity.
Option A ignores reinvestment income.
Option C introduces inflation, which was not part of this model.

Question 14

What does the carrying value of a bond represent?
A. Market price after YTM changes
B. Price assuming original YTM remains unchanged
C. Coupon payments received

Answer 14

Correct Answer: B
Explanation:

Carrying value is the price of the bond assuming original YTM is constant.

Option A is incorrect because market price changes with YTM.

Option C is incorrect because coupons are separate cash flows.

Question 15

If an investor sells a bond before maturity at the carrying value, what is the capital gain or loss?
A. Capital gain
B. Capital loss
C. Neither gain nor loss

Answer 15

Correct Answer: C
Explanation:

Selling at carrying value means no capital gain or loss, as the price reflects amortized discount/premium.

Options A and B are incorrect as there is no price difference.

Question 16

An investor buys a bond at a discount and sells it before maturity at a price higher than carrying value. What does this imply?
A. Capital loss
B. Capital gain
C. No capital gain or loss

Answer 16

Correct Answer: B
Explanation:

Selling above carrying value results in a capital gain.

Option A is incorrect; loss would be selling below carrying value.

Option C is incorrect; price difference exists.

Question 17

Which factor causes the carrying value of a discount bond to increase over time?
A. Coupon payments received
B. Amortization of the discount
C. Changes in YTM

Answer 17

Correct Answer: B
Explanation:

Carrying value rises as discount amortizes towards par.

Option A relates to cash flows, not carrying value increase.

Option C affects market price, not carrying value assuming unchanged YTM.

Question 18

If coupons are reinvested at the bond’s original YTM, what is the expected return when holding the bond to maturity?
A. Equal to the coupon rate
B. Equal to the original YTM
C. Greater than the original YTM

Answer 18

Correct Answer: B
Explanation:

Reinvestment at original YTM ensures total return equals original YTM.

Option A is incorrect as total return includes coupon reinvestment.

Option C is incorrect unless reinvestment rate is higher than YTM.

Question 19

What is the future value of reinvested coupons from a 3-year, 6% annual coupon bond at 7% YTM?
A. Less than $18
B. Exactly $18
C. More than $18

Answer 19

Correct Answer: C
Explanation:

Coupons reinvested at 7% accumulate interest, exceeding simple sum $18.

Option A incorrect because reinvestment adds interest.

Option B incorrect; $18 is just total coupons without reinvestment.

Question 20

Which of the following statements is true about bond price changes when YTM remains unchanged?
A. Bond price fluctuates randomly
B. Bond price moves towards par value as maturity approaches
C. Bond price stays constant until maturity

Answer 20

Correct Answer: B
Explanation:

With unchanged YTM, bond price converges to par at maturity.

Option A is incorrect as movement is predictable.

Option C incorrect because price changes due to amortization of premium/discount.

Question 21

How is capital gain/loss calculated when selling a bond before maturity?
A. Selling price minus purchase price
B. Selling price minus carrying value
C. Carrying value minus purchase price

Answer 21

Correct Answer: B
Explanation:

Capital gain/loss is difference between selling price and carrying value at sale.

Option A ignores amortization effect.

Option C is incorrect; this measures amortized premium/discount, not capital gain/loss.

Question 22

If an investor sells a bond at a price below carrying value, what will be the impact on their holding period return?
A. Increase
B. Decrease
C. No impact

Answer 22

Correct Answer: B
Explanation:

Selling below carrying value causes capital loss, reducing HPR.

Option A incorrect as return falls.

Option C incorrect since capital loss affects total return.

Question 23

Why is carrying value often reported on balance sheets?
A. It reflects market price fluctuations
B. It represents amortized cost assuming original YTM
C. It equals the bond’s par value at all times

Answer 23

Correct Answer: B
Explanation:

Carrying value reflects amortized cost under original YTM assumption.

Option A incorrect; market value fluctuates.

Option C incorrect; carrying value changes over time.

Question 24

An investor holding a bond with original YTM of 7% sells it after 2 years when YTM is still 7%. If all coupons are reinvested at 7%, the investor’s return will be:
A. Equal to 7%
B. Greater than 7%
C. Less than 7%

Answer 24

Correct Answer: A
Explanation:

Holding period return equals original YTM when coupons reinvested at that rate and bond sold at carrying value.

Option B incorrect; return can only be higher if reinvestment rate is higher.

Option C incorrect if reinvestment at YTM.

Question 25

What does the phrase "constant-yield price trajectory" mean? A. Price path if YTM is constant B. Price path if coupon rates increase C. Price path if market rates vary

Answer 25

Correct Answer: A Explanation: Constant-yield price trajectory is the bond price path assuming YTM remains unchanged. Option B incorrect; coupon rates are fixed. Option C incorrect; market rate changes cause deviations.

Question 26

If an investor purchases a premium bond, what happens to the carrying value over time assuming unchanged YTM? A. It decreases towards par B. It increases towards par C. It stays constant

Answer 26

Correct Answer: A Explanation: Premium amortizes downward, so carrying value decreases to par. Option B incorrect; value does not increase. Option C incorrect; amortization changes value.

Question 27

Which cash flows must be considered when calculating the total holding period return of a bond sold before maturity? A. Coupons received only B. Selling price only C. Coupons received, reinvestment income, and selling price

Answer 27

Correct Answer: C Explanation: Total return includes coupon payments, reinvestment income, and capital gains/loss from sale. Options A and B incomplete.

Question 28

In the example, what does the future value of the annuity of coupons represent? A. The original bond price B. Total coupon payments reinvested at YTM C. Principal repayment at maturity

Answer 28

Correct Answer: B Explanation: It is the sum of coupon payments plus reinvested interest at YTM. Option A incorrect; bond price is present value. Option C incorrect; principal is separate.

Question 29

What is the effect of selling a bond before maturity at the market price different from carrying value? A. Realizes capital gain/loss B. No impact on return C. Resets YTM to original value

Answer 29

Correct Answer: A Explanation: Difference between selling price and carrying value causes capital gain or loss. Option B incorrect; return changes. Option C incorrect; YTM does not reset.

Question 30

Which of the following best describes why an investor holding a bond to maturity earns the YTM at purchase if reinvestment rate equals YTM? A. Coupon payments are reinvested at the same rate B. Bond price never changes C. Principal is received early

Answer 30

Correct Answer: A Explanation: Reinvestment at YTM ensures the total compound return equals YTM. Option B incorrect; bond price changes but irrelevant when held to maturity. Option C incorrect; principal is received at maturity.

Question 31

If interest rates rise after the purchase of a bond but before the first coupon is paid, and the bond is held to maturity, the investor’s rate of return will most likely be: A. Less than the YTM at purchase B. Greater than the YTM at purchase C. Equal to the YTM at purchase

Answer 31

Correct Answer: B Explanation: If interest rates rise, coupons will be reinvested at a higher rate, increasing total return. A is incorrect because higher rates improve reinvestment income, not lower it. C is incorrect because YTM = realized return only if reinvestment rate equals YTM.

Question 32

A bond is purchased at a YTM of 7%. If the reinvestment rate drops to 6% after purchase, the bond is held to maturity. The investor's realized return will be: A. Equal to 7% B. Greater than 7% C. Less than 7%

Answer 32

Correct Answer: C Explanation: Lower reinvestment rate = less interest earned on coupon reinvestments = lower total return. A is incorrect — reinvestment at a rate different from YTM changes the outcome. B is incorrect — return decreases with a lower reinvestment rate.

Question 33

What is the primary risk faced by an investor who plans to hold a bond to maturity? A. Price risk B. Credit risk C. Reinvestment risk

Answer 33

Correct Answer: C Explanation: Price risk is irrelevant when holding to maturity — bond will mature at par. Reinvestment risk affects total return due to uncertainty in reinvesting coupon payments. B is a general risk but not the focus of this specific concept.

Question 34

What is the main risk for an investor who plans to sell a bond before maturity? A. Reinvestment risk B. Duration risk C. Price risk

Answer 34

Correct Answer: C Explanation: If you sell early, price fluctuations caused by interest rate changes dominate the risk. A is incorrect — reinvestment risk is minimal or nonexistent in short horizons. B is more technical and not directly the key issue here.

Question 35

An investor buys a bond at a 7% YTM and sells it one year later after rates rise to 8%. The investor will most likely experience: A. A realized return equal to 7% B. A capital gain C. A realized return below 7%

Answer 35

Correct Answer: C Explanation: Higher rates → bond price drops → sells at a lower price → return falls below YTM. A is wrong — only happens if held to maturity with equal reinvestment. B is wrong — rising rates lead to a capital loss, not a gain.

Question 36

Which statement best explains why a bond’s realized return equals its YTM when held to maturity? A. Because YTM ignores reinvestment risk B. Because all coupons are reinvested at the original YTM C. Because bond prices are stable over time

Answer 36

Correct Answer: B Explanation: Holding to maturity with coupons reinvested at the original YTM leads to realized return = YTM. A is incorrect — YTM actually assumes reinvestment at that same rate. C is incorrect — price changes are irrelevant only if held to maturity.

Question 37

When comparing risks over investment horizons, which is most accurate? A. Short-term investors face more reinvestment risk B. Long-term investors are unaffected by reinvestment rates C. Long-term investors face greater reinvestment risk than price risk

Answer 37

Correct Answer: C Explanation: Longer holding periods mean more coupons to reinvest → more reinvestment risk. A is incorrect — short-term investors have more price risk, not reinvestment. B is incorrect — they are affected.

Question 38

Which of the following correctly describes the impact of a declining YTM on a bond sold before maturity? A. The bond’s price rises, increasing the realized return B. The bond’s price falls, decreasing the return C. There is no effect on the bond’s price or return

Answer 38

Correct Answer: A Explanation: Lower YTM → higher bond price → capital gain if sold → realized return ↑ B is opposite — wrong direction. C is false — interest rate movements directly affect price and return if sold before maturity.

Question 39

If the reinvestment rate is higher than the bond’s YTM, the bond’s total return if held to maturity is: A. Lower than the YTM B. Equal to the YTM C. Higher than the YTM

Answer 39

Correct Answer: C Explanation: Higher reinvestment rates improve total return. A is incorrect — this would happen if reinvestment rate was lower. B assumes reinvestment equals YTM, not higher.

Question 40

What is the value of reinvestment income for a 3-year bond with 6% annual coupons, if reinvestment rate is 8%? A. $18.00 B. $19.478 C. $21.00

Answer 40

Correct Answer: B Explanation: A is too low, and C is not based on time value of money.

Question 41

Which of the following causes a bond held to maturity to earn a realized return less than the YTM at purchase? A. Reinvestment of coupons at a lower rate B. A decrease in bond price C. A reduction in bond duration

Answer 41

Correct Answer: A Explanation: Return drops if reinvestment income drops due to lower rates. B doesn’t apply — price doesn’t matter at maturity. C is not directly relevant.

Question 42

For a bond sold after one year, which of the following scenarios leads to a realized return greater than YTM at purchase? A. Interest rates rise B. Interest rates fall C. Reinvestment rate increases

Answer 42

Correct Answer: B Explanation: If YTM falls, bond price rises → capital gain → realized return ↑ A is wrong — higher rates → capital loss. C applies to held-to-maturity cases, not sold early.

Question 43

In a 1-year holding period, which of the following is not present? A. Capital gains or losses B. Reinvestment income C. Price risk

Answer 43

Correct Answer: B Explanation: With just one coupon and immediate sale, no time to reinvest coupons. A and C are both present.

Question 44

Holding a bond to maturity protects the investor against: A. Reinvestment risk B. Credit risk C. Price risk

Answer 44

Correct Answer: C Explanation: Price changes don’t matter at maturity — return depends on coupons + par. A is wrong — reinvestment risk is still present. B is always a risk unless default-free bond (e.g., Treasury).

Question 45

Which outcome results when the reinvestment rate equals the bond’s YTM? A. The investor’s realized return exceeds YTM B. The investor’s realized return equals YTM C. The investor’s realized return is less than YTM

Answer 45

Correct Answer: B Explanation: This is the definition of YTM: assumes all coupons reinvested at YTM. A and C are outcomes of different reinvestment scenarios.

Question 46

For a bond held to maturity, as reinvestment rates rise: A. Price risk increases B. Realized return increases C. Coupon payments decrease

Answer 46

Correct Answer: B Explanation: Higher reinvestment income → higher total return. A is wrong — no price risk at maturity. C is unrelated — coupons are fixed.

Question 47

If an investor's time horizon is short, which of the following is most likely? A. Reinvestment risk dominates B. Price risk dominates C. Both risks are minimal

Answer 47

Correct Answer: B Explanation: Short-term = more affected by changes in bond prices at sale. A is wrong — reinvestment doesn't matter much in the short term. C is incorrect — price risk is real.

Question 48

Which of the following statements is true for a bond sold before maturity? A. Realized return equals the bond’s coupon rate B. Realized return depends on market YTM at sale C. The sale price is unaffected by interest rate changes

Answer 48

Correct Answer: B Explanation: Market YTM at the time of sale determines the bond’s price. A is false — coupon is not the return. C is clearly false — price is driven by YTM.

Question 49

Which best describes the relationship between YTM changes and bond prices? A. Direct relationship B. Inverse relationship C. No relationship

Answer 49

Correct Answer: B Explanation: YTM ↑ → Price ↓ YTM ↓ → Price ↑ A and C are false.

Question 50

For a bond held to maturity, an increase in the reinvestment rate results in: A. A lower total return B. A higher total return C. No effect on total return

Answer 50

Correct Answer: B Explanation: More interest earned on reinvested coupons = total return ↑ A and C contradict the core concept.

Question 51

What does the Macaulay duration of a bond represent? A. The weighted average time until receipt of the bond's cash flows B. The price change of a bond for a 1% change in interest rates C. The average time to maturity of a zero-coupon bond

Answer 51

Correct Answer: A Explanation: Macaulay duration is defined as the weighted average time until receipt of a bond’s cash flows. B refers to modified duration, not Macaulay duration. C is unrelated; a zero-coupon bond’s time to maturity is its duration, but this does not generalize to all bonds.

Question 52

Which of the following most accurately describes the relationship between Macaulay duration and investment horizon? A. If duration is longer than the investment horizon, the investor is exposed to reinvestment risk. B. If duration equals the investment horizon, price risk and reinvestment risk offset each other. C. If duration is shorter than the investment horizon, the investor is exposed to price risk.

Answer 52

Correct Answer: B Explanation: When the Macaulay duration equals the investment horizon, the investor earns the YTM regardless of changes in interest rates. A is incorrect because duration longer than the horizon exposes the investor to price risk. C is incorrect; duration shorter than the horizon exposes the investor to reinvestment risk.

Question 53

A bond has a Macaulay duration of 6 years. An investor plans to sell the bond in 4 years. This investor: A. Is exposed mainly to price risk B. Is exposed mainly to reinvestment risk C. Will be immune to changes in interest rates

Answer 53

Correct Answer: A Explanation: If investment horizon < duration, the investor faces price risk. B is incorrect because reinvestment risk is present when horizon > duration. C is incorrect because duration matching is not achieved.

Question 54

When interest rates rise immediately after bond purchase, what happens if the investment horizon equals Macaulay duration? A. The bondholder will experience a net capital loss B. The bondholder will earn more than the initial YTM C. The bondholder will earn exactly the initial YTM

Answer 54

Correct Answer: C Explanation: When investment horizon = Macaulay duration, the opposing effects of price loss and reinvestment gain offset. A is incorrect because the gain in reinvestment income offsets capital loss. B is incorrect; the return does not exceed original YTM.

Question 55

Which of the following correctly describes the reinvestment risk in relation to duration? A. It increases when duration equals the investment horizon B. It is minimized when the bond has a long time to maturity C. It is present when the investment horizon exceeds the duration

Answer 55

Correct Answer: C Explanation: Longer horizon than duration means coupons must be reinvested, creating reinvestment risk. A is incorrect; when duration = horizon, reinvestment and price risk are balanced. B is incorrect; long maturity increases exposure to reinvestment risk.

Question 56

Which type of bond would have a Macaulay duration closest to its time to maturity? A. Coupon-paying bond B. Floating rate bond C. Zero-coupon bond

Answer 56

Correct Answer: C Explanation: Zero-coupon bonds pay a single cash flow at maturity, making duration = maturity. A is incorrect because coupon payments shorten duration. B is incorrect because floating rates adjust and duration is much shorter.

Question 57

Which of the following would most likely increase Macaulay duration? A. A higher coupon rate B. A longer time to maturity C. A higher yield to maturity

Answer 57

Correct Answer: B Explanation: Longer time to maturity spreads the cash flows over a longer period, increasing duration. A is incorrect; higher coupon pulls duration forward. C is incorrect; higher yield decreases present values of distant flows.

Question 58

An investor faces reinvestment risk if: A. Bond’s duration exceeds investment horizon B. Bond’s duration equals investment horizon C. Investment horizon exceeds bond’s duration

Answer 58

Correct Answer: C Explanation: Longer holding period than duration increases reliance on reinvested coupon income. A is incorrect; this creates price risk. B is incorrect; this is the balance point.

Question 59

The difference between an investor’s investment horizon and a bond’s Macaulay duration is called: A. Yield spread B. Duration gap C. Price risk

Answer 59

Correct Answer: B Explanation: Duration gap measures the mismatch in timing between bond cash flows and investor horizon. A is unrelated to duration. C is a type of risk, not a metric.

Question 60

Which of the following best explains why Macaulay duration is useful to fixed income investors? A. It helps determine the default probability of a bond B. It identifies when reinvestment risk is maximized C. It identifies the investment horizon that balances reinvestment and price risk

Answer 60

Correct Answer: C Explanation: Duration = investment horizon means the investor earns the YTM regardless of interest rate changes. A is incorrect; default risk is unrelated. B is incorrect; duration minimizes reinvestment risk when matched.

Question 61

Which of the following best describes the investment horizon at which price risk and reinvestment risk exactly offset each other? A. The bond's time to maturity B. The bond's Macaulay duration C. The bond's modified duration

Answer 61

Correct Answer: B Explanation: The Macaulay duration is the point at which the gains/losses from reinvestment income changes are exactly offset by losses/gains from price changes. A is incorrect because time to maturity does not guarantee the offsetting of risks. C is incorrect because modified duration measures price sensitivity to interest rate changes, not the balancing point of reinvestment and price risk.

Question 62

A bondholder’s investment horizon is longer than the Macaulay duration of the bond. The investor is primarily exposed to: A. Price risk B. Reinvestment risk C. Default risk

Answer 62

Correct Answer: B Explanation: A longer horizon than the Macaulay duration means more reinvestment of coupons, increasing exposure to reinvestment rate uncertainty. A is incorrect because price risk dominates when the horizon is shorter. C is incorrect; default risk is unrelated to the duration gap concept.

Question 63

If a bond’s Macaulay duration is shorter than the investor’s investment horizon, a rise in interest rates will: A. Increase the investor’s realized return B. Decrease the investor’s realized return C. Have no impact on the investor’s return

Answer 63

Correct Answer: A Explanation: A rise in interest rates boosts reinvestment income when the horizon exceeds Macaulay duration, outweighing the initial price decline. B is incorrect because long horizons benefit from reinvestment at higher rates. C is incorrect; rates clearly affect returns unless the duration gap is zero.

Question 64

Which of the following statements best describes a bond with a zero duration gap? A. It is not sensitive to interest rate changes. B. The investor’s holding period return equals the YTM regardless of interest rate changes. C. Reinvestment risk and price risk are minimized.

Answer 64

Correct Answer: B Explanation: At zero duration gap (investment horizon = Macaulay duration), reinvestment and price risks offset, locking in the YTM. A is incorrect because the bond itself is still sensitive to rates. C is incorrect because risks are not minimized but are balanced.

Question 65

If interest rates fall immediately after bond purchase and the investor holds the bond to maturity, which risk is most relevant? A. Price risk B. Liquidity risk C. Reinvestment risk

Answer 65

Correct Answer: C Explanation: For held-to-maturity investors, price risk is irrelevant; only reinvestment risk affects realized return. A is incorrect because the price drop won’t be realized. B is incorrect because liquidity risk is not rate-sensitive and not addressed here.

Question 66

A positive duration gap means: A. The bondholder’s investment horizon is longer than the bond’s duration. B. The bondholder is primarily exposed to reinvestment risk. C. The bondholder is primarily exposed to price risk.

Answer 66

Correct Answer: C Explanation: When Macaulay duration > investment horizon, bond price is more sensitive to interest rate changes, exposing the investor to price risk. A is incorrect because it's the opposite. B is incorrect; reinvestment risk dominates with negative duration gaps.

Question 67

Which component of total bond return is most affected by interest rate changes over long investment horizons? A. Price change B. Coupon reinvestment C. Initial YTM

Answer 67

Correct Answer: B Explanation: Over longer horizons, reinvested coupons accumulate more, making the reinvestment rate a dominant return driver. A is incorrect because price change matters more in short horizons. C is incorrect; YTM is the initial estimate, not a component.

Question 68

For a bond priced below par with a Macaulay duration of 4.03 years, if held exactly 4 years, the investor will: A. Earn less than YTM if interest rates fall B. Earn more than YTM if interest rates rise C. Earn the YTM regardless of rate changes

Answer 68

Correct Answer: C Explanation: If the investment horizon ≈ duration, price and reinvestment risks offset, preserving the initial YTM. A and B are incorrect; these describe scenarios with a duration gap.

Question 69

The Macaulay duration of a bond can be interpreted as: A. The time it takes to recover the bond’s full price through cash flows B. The average time to receive cash flows, weighted by present value C. The time to maturity of a zero-coupon bond

Answer 69

Correct Answer: B Explanation: Macaulay duration = weighted average time of cash flows using PV as weights. A is incorrect; that's more in line with payback period. C is incorrect; while zero-coupon duration equals maturity, this is not the general definition.