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Why Buy Bonds? 1. a. b. c. d. Bond investors can avoid the risk that interest rates will rise and drive bond prices down by: buying zero coupon bonds. buying Treasury bonds. holding bonds over one year. holding bonds till maturity.
(d, easy) 2. a. b. c. d. Which of the following is not a reason U.S.investors invest in foreign bonds? to gain diversification potentially higher returns than U.S. bonds lower transactions costs and taxes. All of the above are reasons U.S. investors invest in foreign bonds.
(c, moderate) 3. a. b. c. d. The introduction of the Euro is expected to: increase the transactions cost of trading foreign bonds. decrease the transactions cost of trading foreign bonds. have no effect on the transactions cost of trading foreign bonds. have a minimal effect on the transactions cost of trading foreign bonds.
(b, moderate) Important Considerations in Managing a Bond Portfolio 4. a. b. c. d. Which of the following is considered to have the biggest impact on bond yields? economic growth business cycles inflation Federal Reserve actions
Chapter Eighteen Bonds: Analysis and Strategy
( b. a. c. moderate) Chapter Eighteen Bonds: Analysis and Strategy 229 . b. b. yield curve. d. a. invest more now in corporate bonds rather than in Treasury bonds. skewed yield curve. stock market crash.5. e. yield differential. d. recession. c. Under the expectations theory. b. c. The term structure of interest rates is also known as the: yield to maturity. An inverted yield curve or flattening of the yield curve is considered a good predictor of a: rising economy. easy) 9. c. easy) 6. regardless of opportunities in other maturity segments? expectations theory liquidity preference theory market segmentation theory preferred habitat theory (c. (a. invest more now in long term bonds rather than in short term bonds. a. moderate) 8. c. (a. probability distribution. flat yield curve. depression. d. investors expecting interest rates to rise will: invest more now in short term bonds rather than in long term bonds. a. b. downward sloping yield curve. difficult) 7. the yield curve most likely to be seen has been the: upward sloping yield curve. (d. d. Since the 1930s. b. invest more now in Treasury bonds rather than in corporate bonds. d. Which of the following yield curve theories expect investors to stay in one maturity segment.
Yield spreads can change over time. d. regional corporate bond than on a large. d. it is easier to obtain accurate and complete data on them. Yield spreads are influenced by the level of interest rates in the market. equal the present value of the expected cashflows from the bonds involved. c. b. long-term rates must. According to the expectations theory. differences in maturity differences in quality. c. differences in tax treatments. it is easier to obtain historical data on them. always be higher than short-term rates. Yield spreads are often calculated by changing the maturity of the different bonds. a. (b. ( c. d. a. moderate) 11. differences in marketability. a. (c . Which of the following is not a reason for a yield spread? differences in call features. equal the geometric mean of a series of expected future short-term rates. (d . a. differences in quality. d. Investors would expect a higher yield on a smaller. Which of the following statements concerning yield spreads is not true? Yield spreads may be positive or negative. d. The yield curve is normally plotted using Treasury securities because: they have a wide range of maturities. differences in coupon rates. c. easy) 12. b. b. they have no default risk. national corporate bond mainly due to: differences in coupon rates. be an average of the present and future short-term rates. (d. difficult) 14. moderate) Chapter Eighteen Bonds: Analysis and Strategy 230 . b. c. c. a. b. moderate) 13.10.
15. liquidity preference theory recognizes that interest rate expectations are uncertain. According to the expectations theory. Expectations of future interest rates affects the shape of the yield curve. liquidity preference theory assumes investors are risk averse and the expectations theory does not. Borrowers and lenders do not go outside their preferred maturity segments. Forward rates: a. a. d. b. A major difference between the liquidity preference theory and the expectations theory is that the: liquidity preference theory only deals in short-term securities. b. are observable and unanticipated. which of the following is NOT true? Borrowers and lenders have preferred maturity sectors. a. interest rates to become negative in the future. c. b. c. a. are an average of current short-term and long-term rates. market segmentation theory. (c . (b. pecking order theory. an upward sloping curve indicates that investors expect: interest rates to become more volatile in the future. The preferred habitat theory is most similar to the: expectations theory. (b . liquidity preference theory only deals in long-term securities. c. The yield curve can take any shape. are unobservable and anticipated e. d. c. difficult) Chapter Eighteen Bonds: Analysis and Strategy 231 . d. liquidity preference theory. difficult) 19. c. are observable and anticipated. According to the preferred habitat theory. easy) 16. (c. a. moderate) 17. b. (d. moderate) 18. d. d. interest rates to fall in the future. interest rates to rise in the future. b.
indexing. a. b. . c. c. . Yield spreads tend to____ during recessions and ________ during times of economic prosperity. widen widen . b. c. expectations. b. . c. A bond strategy attempting to immunize the portfolio from interest rate risk is based on the concept of: buy and hold. b. . a. narrow stay constant . moderate) Bond Strategies 22. difficult) 23. narrow . . d. widen widen . duration concept. a. liquidity premium market segmentation economic value added (b. Which of the following is not a passive bond strategy? an immunization strategy a bond swap strategy a buy and hold strategy an indexing strategy (b. moderate) Chapter Eighteen Bonds: Analysis and Strategy 232 . d. . horizon analysis.20. . d. a. d. moderate) 21. (c . . stay constant (b. The _________ theory of yield curves states that investors will not invest long term unless they have an economic incentive.
c. (c. (a . horizon analysis. (d . b. a. It requires frequent rebalancing. b. c. b. b. time-series analysis. d. the present value of the cashflows is greater than the principal. d. moderate) 27. attempt to avoid call and convertible risk. a.24. moderate) Chapter Eighteen Bonds: Analysis and Strategy 233 . It is not a passive bond strategy. A portfolio is said to be immunized if: the present value of the cashflows equals the principal. a. duration planning. Immunization is a strategy in which bond investors: buy only high-quality bonds. moderate) 26. attempt to avoid default risk. c. Which of the following statements regarding classical immunization is false? It is easy to implement. One form of interest rate forecasting has the investor evaluating bonds being considered for purchase over a selected holding period in order to determine which will perform the best and is known as: holding-period analysis. the duration of the portfolio is equal to the investment horizon. attempt to avoid reinvestment and price risk. (d . the duration of the portfolio is equal to the term. c. d. a. difficult) 25. d. It faces real-world problems in its implementation.
d. A bond investor has $100. price risk and reinvestment risk.000 in three-year bonds. Longer maturities have a chance for larger gains. To immunize his portfolio. c. greater than (d . (b.10 years.000 in ten-year bonds. c. b. b. moderate) Chapter Eighteen Bonds: Analysis and Strategy 234 . c. (c. Interest rate risk is composed of: market risk and default risk. greater than.000 in one-year bonds. Which of the following statements regarding bond terms is FALSE? Short maturities protect investors when interest rates rise. easy) 31. Longer maturities have greater price fluctuations. $10. $10. price risk and credit risk. These bonds will have maturities -------. (c . d. 10 a. equal to equal to. b. a.000 to invest and has determined 10 years is his maximum term. James wants to invest in bonds and has a 10 year investment horizon. less than less than. c. This is an example of: bond equality bond laddering bond blending bond term management a.000 in two-year bonds. Longer maturities are more liquid than shorter maturies. d. etc. difficult) 29. d. less than equal to. all the way to $10. he must buy bonds with durations of ----years. He puts $10. b. a. default risk and money risk.28. moderate) 30.
all of the above are true. Speculation in the bond market has decreased significantly in the last 20 years. c. difficult) Chapter Eighteen Bonds: Analysis and Strategy 235 . moderate) 2. ability to shelter income from taxes. relatively low expense ratios.32. a. moderate) 34. Which of the following is not one of the strategies normally employed by conservative bond investors? flexible-income funds strategy buy-and-hold approach shorter-term Treasury bonds bond swaps (d. a. A major advantage of bond index funds is their: higher performance than regular bond funds. Which of the following often emphasize short-term European securities and have been popular in recent years? international money market fund short-term world multimarket income funds global short-term government securities funds foreign short-term index funds (b. (c. a. d. (F. moderate) Building a Fixed-Income Portfolio 33. c. b. A weaker dollar increases the value of dollar-denominated assets to foreign investors. moderate) True-False Questions Why Buy Bonds? 1. (F. d. d. c. b. b.
moderate) 8. The term structure of interest rates shows the relationship between yields of several categories of bonds. (T. A commercial bank that always invested in short-term bonds in order to meet deposit withdrawals is a a good example of the liquidity preference theory. (T. moderate) 10.Important Considerations in Managing a Bond Portfolio 3. The size of yield spreads tends to remain constant over time. The term structure of interest rates consists of a set of forward rates and a current known rate. The yield curve is considered one of the best ways to price a bond. An increase in expected inflation tends to decrease bond prices and bond yields. difficult) 6. such as municipals and corporates. easy) Chapter Eighteen Bonds: Analysis and Strategy 236 . (F. (F. (F. moderate) 9. difficult) 7. (F. easy) 4. (F. (T. Yield spreads were at their widest during the Great Depression. moderate) 5. A noncallable bond would be expected to have a higher yield to maturity than a comparable callable bond. and their maturities.
Market segmentation theory – investors have preferred maturity sectors but are unwilling to shift. Under the ladder approach. moderate) 12. Preferred habitat theory – investors have preferred maturity sectors but may shift if they expect adequate compensation. (T. A strong argument made for passive bond strategies is that it is very difficult to time bond transactions in order to take advantage of swings in the bond market. Why are upward sloping yield curves more consistent with the usual riskreturn tradeoff than downward sloping yield curves? (moderate) Answer: Long-term bonds have more interest-rate risk than short-term bonds. then price risk and reinvestment risk decline. difficult) 13.Bond Strategies 11. (F. If interest rates rise. bond investors purchase bonds with different maturities in order to gain some protection from default risk. moderate) Short-Answer Questions Important Considerations in Managing a Bond Portfolio 1. 2. Chapter Eighteen Bonds: Analysis and Strategy 237 . Liquidity preference theory – like expectations theory with a liquidity premium added. (F. Briefly explain the four theories explaining the term structure of interest rates. Thus the added risk of long-term is rewarded with higher returns on an upward sloping yield curve. (moderate) Answer: Expectations theory – long-term rates are the geometric average of the present yield on short term securities and expected short-term rates.
Together immunization can occur because they offset each other. If rates rise he will experience capital losses. 6. bond prices go up. When interest rates go down. What are the two components of interest-rate risk? How do they work to immunize a portfolio? (moderate) Answer: The two parts are price risk and reinvestment rate risk. (easy) What are two passive management strategies? Two active strategies? Answer: Passive – buy and hold and indexing. Generally. what would you suggest? What if he expected rates to rise? (difficult) Answer: He will get the biggest price increases from low-coupon. Why is immunization considered to be a hybrid strategy? (difficult) Chapter Eighteen Bonds: Analysis and Strategy 238 . What are the advantages of index funds for an individual bond investor? (moderate) Answer: Many aggressively managed funds do not beat the market performance. A client tells you that he strongly believes that interest rates in general will fall abruptly over the next six months. so he should hold cash or short-term securities. 4. 5. long-term bonds if rates fall.Bond Strategies 3. but the income from reinvestment goes down. He asks you to recommend bonds for a portfolio to provide capital gains on the interest rate move. 7. Active – forecasting interest rate changes and identifying mispricing. Index funds should have lower advisory fees and operating expenses because indexing is a passive management approach. The two offset one another.
5 0.50) = 2. It works because losses (gains) from price changes are offset by changes in income from reinvestment.Answer: Immunization is a hybrid between passive and active management strategies. Let W be the weight of bond A.36) + (1 – W)(6. The portfolio’s duration is the weighted average of the bonds' durations. Immunization is intended to protect a portfolio against interest rate risk.36 years. It must be actively managed. You are asked to invest $30 million in a bond portfolio consisting of only two bonds. Chapter Eighteen Bonds: Analysis and Strategy 239 . Bond A has a duration of 4.50 years. The portfolio is to have an investment horizon of 5 years. in that it must be rebalanced frequently to maintain the duration equal to the investment horizon. and bond B has a duration of 6.70 Invest in 70 percent bond A and 30 percent bond B. How much of each bond issue would you have to buy to immunize the portfolio? (moderate) Solution: The portfolio’s duration must equal the investment horizon. W(4. Problems 1. Then (1 – W) is the weight of bond B. What should be done? How does it work? (moderate) Answer: The portfolio duration should be set equal to a specified time horizon. however.14W = W = 5 1. Critical Thinking/Essay Questions 1. It appears passive in that the initial portfolio is chosen so that the portfolio duration is equal to the portfolio’s designated time horizon.