Flashcards in Section 103 Unit 8 Deck (12):
Instrinsic Value of a Bond Formula
N = Number of periodic payments
i = Semiannual yield for comparable bonds
PMT = Semiannual coupon payment
FV = Par Value
Solve for PV
A yield curve is a graph of interest rate yields for bonds of the same quality, ranging in maturity from 31 days to 30 years. This curve has a tendency to slope upward and outward, denoting that as the maturity date of bonds lengthen, the corresponding bond yields increase.
Normal or Positive Yield Curve
Occurs during periods of economic expansion and generally predicts that market interest rates will rise in the future.
Flat Yield Curve
Occurs when the economy is peaking and, therefore, no change in future rates (particularly down) is expected
Inverted Yield Curve
Occurs when the Federal Reserve has tightened credit in an inflationary economy; predicts interest rates will fall and, sometimes, can signal an upcoming economic recession.
Three Yield Curve Theories
Expectations theory, liquidity preference theory, and market segmentation theory.
States that long-term rates consist of many short-term rates and that long-term rates will be the average (or geometric mean) of short-term rates. All years expected rates added and divided by the amount of years. An AVERAGE
Liquidity Preference Theory
Is based on the expectations theory but incorporates a liquidity premium into the model. Longer-term bonds are more price sensitive to interest rate changes than are shorter-term bonds. Thus, investors pay a premium (i.e., lower yields) for shorter maturity bonds to avoid the higher interest rate risk associated with long-term bonds. This theory explains only an upward-sloping (normal) yield curve.
Market Segmentation Theory
Relies on the laws of supply and demand for various maturities of borrowing and lending. Make up three different categories:
Short term < 1 year
Intermediate Term 1 - 5 years
Long Term > 5 years
The coupon rate of a bond and its duration have an inverse relationship.
The YTM of a bond and its duration have an inverse relationship.
The term to maturity of a bond and its duration have a direct relationship.
A zero-coupon bond will always have a duration equal to its term to maturity.
Convexity is a measure of the curvature of the relationship between a bond’s YTM and its market price (value). Specifically, convexity helps explain the change in bond prices that is not accounted for simply by the bond’s duration; in other words, convexity gives us a more precise measure of the change in the price of a bond, given a respective change in market interest rates.
Like duration, convexity is likely to be the greatest with the following types of bonds:
Low coupon bonds
Low YTM bonds
Long maturity bonds