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Flashcards in Section 103 Unit 8 Deck (12):
1

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

2

Yield Curve

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.

3

Normal or Positive Yield Curve

Occurs during periods of economic expansion and generally predicts that market interest rates will rise in the future.

4

Flat Yield Curve

Occurs when the economy is peaking and, therefore, no change in future rates (particularly down) is expected

5

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.

6

Three Yield Curve Theories

Expectations theory, liquidity preference theory, and market segmentation theory.

7

Expectations 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

8

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.

9

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

10

Bond Duration

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.

11

Convexity

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

12

Modified Duration

Modified duration is a relative measure for comparing different durations of bonds.
= Macaulay Duration / 1 + Y
Y = yield to maturity