Stocks and Bond Valuation Concepts Flashcards
(40 cards)
a measure that helps investors understand how sensitive a bond’s price is to changes in interest rates. Think of it as a tool to gauge the risk associated with fluctuations in the financial environment.
Duration.
Definition: The weighted average time until a bond’s cash flows (interest and principal) are received.
Purpose: Helps in understanding the time aspect of a bond investment.
Macaulay Duration
measures the price sensitivity of a bond to interest rate changes.
Usage: Estimates the percentage change in bond price for a 1% change in interest rates.
Modified duration
Formula: Modified Duration = Macaulay Duration / (1 + Yield/Number of Periods)
The longer a bond investment’s duration, the more sensitive the investment is to changes in interest rates.
Duration gives us a measure of the approximate price volatility for bonds given a change in interest rates.
As such, it is a measure of interest rate risk. For example, if a bond has a duration of four and interest rates were to rise 1%, the bond would then decline in price about 4%.
If a bond has a duration of nine and interest rates were to fall 1%, the bond would rise in price about 9%.
Remember.
Although interest rate risk is a factor when purchasing individual bonds, the investor can always hold until maturity period. However, this is not the case if the investor has a bond fund because the fund itself does not mature.
This is one example of why holding individual bonds Reassure the investor that, as long as they hold it until maturity. They will receive their principal and the stated interest.
Bond funds, by comparison, offer no such safety of principle.
Each column on top of the seesaw in Figure 4.7 represents the present value of the cash flow to the investor. The small columns are the present values of the semiannual interest payments, and the larger column at the right end is the present value of the $1,000 par value of the bond plus the final semiannual coupon payment.
Coupon / price =
Current yield
if a bond has a duration of four and interest rates were to rise 1%, the bond would then decline in price about _ %
4%
if a bond has a duration of four and interest rates were to rise 1%, the bond would then decline in price about
4%
If a bond has a duration of nine and interest rates were to fall 1%, the bond would rise in price about _%.
9%
In a declining interest rate environment, what duration will result in the greatest total return?
Higher duration
In a declining interest rate environment, what happens to bond prices, and how does duration affect total return?
In a declining interest rate environment, bond prices increase. The higher the bond’s duration, the greater the total return an investor will realize, as longer-duration bonds are more sensitive to interest rate decreases, leading to larger price increases.
How do bond prices react in a rising interest rate environment, and what role does duration play?
In a rising interest rate environment, bond prices decrease. Bonds with higher durations experience the greatest losses, as they are more sensitive to interest rate increases, resulting in larger price declines.
If expectations are for declining interest rates, what type of duration should you seek in bond investments?
You should seek higher-duration investments because bond prices are expected to rise more significantly with higher duration when interest rates fall.
If expectations are for rising interest rates, what should you do with the duration of a fixed-income portfolio?
You should lower the overall duration to minimize the negative impact on bond prices when interest rates rise.
How does duration relate to a client’s risk tolerance in bond investments?
For a risk-averse client, you would keep the target duration lower to reduce the sensitivity to interest rate changes and minimize potential price volatility.
What is the role of duration in bond investing based on interest rate expectations?
Duration helps in selecting bonds or bond funds that align with interest rate forecasts: higher duration for expected rate declines to maximize price gains, and lower duration for expected rate increases to minimize price losses.
What is the approximate relationship between duration, interest rate changes, and bond price changes?
The percentage change in a bond’s price is approximately equal to the negative of its duration multiplied by the change in interest rates. For example, if a bond has a duration of 5 years and interest rates increase by 1%, the bond’s price is expected to decrease by approximately 5%.
Does duration apply to bond mutual funds, and if so, how?
Yes, duration applies to bond mutual funds as the weighted average duration of the bonds held in the fund. It indicates the fund’s overall sensitivity to interest rate changes.
What is the practical value of understanding duration in bond investing?
Understanding duration allows investors to:
• Select bonds or bond funds that align with their interest rate outlook (higher duration for expected rate declines, lower for expected rate increases).
• Manage interest rate risk according to their risk tolerance (lower duration for risk-averse investors).
•Make informed decisions when purchasing bonds or bond mutual funds.
PROFESSOR’S NOTE
The duration of a zero-coupon bond is equal to its maturity because the only cash flow from a zero-coupon bond is the $1,000 principal payment at maturity. The duration of a zero-coupon bond will always be greater than the duration of a coupon bond of the same maturity.
