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Chapter 11 - Managing Bond Portfolios Chapter 11 Managing Bond Portfolios Multiple Choice Questions 1. All other things equal, which of the following has the longest duration? A. A 30 year bond with a 10% coupon B. A 20 year bond with a 9% coupon C. A 20 year bond with a 7% coupon D. A 10 year zero coupon bond 2. All other things equal, which of the following has the shortest duration? A. A 30 year bond with a 10% coupon B. A 20 year bond with a 9% coupon C. A 20 year bond with a 7% coupon D. A 10 year zero coupon bond 3. A pension fund must pay out $1 million next year, $2 million the following year and then $3 million the year after that. If the discount rate is 8% what is the duration of this set of payments? A. 2.00 years B. 2.15 years C. 2.29 years D. 2.53 years 4. All other things equal, which of the following has the longest duration? A. A 20 year bond with a 10% coupon yielding 10% B. A 20 year bond with a 10% coupon yielding 11% C. A 20 year zero coupon bond yielding 10% D. A 20 year zero coupon bond yielding 11% 11-1 Chapter 11 - Managing Bond Portfolios 5. The duration of a perpetuity varies _______ with interest rates. A. directly B. inversely C. convexly D. randomly 6. Because of convexity, when interest rates change the actual bond price will ____________ the bond price predicted by duration. A. always be higher than B. sometimes be higher than C. always be lower than D. sometimes be lower than 7. You find a 5 year AA Xerox bond priced to yield 6%. You find a similar risk 5 year Canon bond priced to yield 6.5%. To take advantage of this you should do which of the following? A. Short the Canon bond and buy the Xerox bond B. Buy the Canon bond and short the Xerox bond C. Short both the Canon bond and the Xerox bond D. Buy both the Canon bond and the Xerox bond 8. A forecast of bond returns based largely on a prediction of the yield curve at the end of the investment horizon is called a _________. A. contingent immunization B. dedication strategy C. duration analysis D. horizon analysis 9. A bond's price volatility _________ at a/an _________ rate as maturity increases. A. increases; increasing B. increases; decreasing C. decreases; increasing D. decreases; decreasing 11-2 Chapter 11 - Managing Bond Portfolios 10. As a result of bond convexity an increase in a bond's price when yield to maturity falls is ________ the price decrease resulting from an increase in yield of equal magnitude. A. greater than B. equivalent to C. smaller than D. The answer is indeterminate. 11. All else equal, bond price volatility is greater for __________. A. higher coupon rates B. lower coupon rates C. shorter maturity D. lower default risk 12. ______________ is an important characteristic of the relationship between bond prices and yields. A. Convexity B. Concavity C. Complexity D. Linearity 13. Bond prices are _______ sensitive to changes in yield when the bond is selling at a _______ initial yield to maturity. A. more; lower B. more; higher C. less; lower D. equally; higher or lower 14. The pioneer of the duration concept was _________. A. Eugene Fama B. John Herzog C. Frederick Macaulay D. Harry Markowitz 11-3 Chapter 11 - Managing Bond Portfolios 15. A portfolio manager sells treasury bonds and buys corporate bonds because the spread between corporate and Treasury bond yields is higher than its historical average. This is an example of __________ swap. A. a pure yield pick up B. a rate anticipation C. a substitution D. an intermarket spread 16. The duration of a 5-year zero coupon bond is ____ years. A. 4.5 B. 5.0 C. 5.5 D. 3.5 17. A portfolio manager believes interest rates will drop and decides to sell short duration bonds and buy long duration bonds. This is an example of __________ swap. A. a pure yield pick up B. a rate anticipation C. a substitution D. an inter-market spread 18. Target date immunization would primarily be of interest to _________. A. banks B. mutual funds C. pension funds D. individual investors 19. Duration is a concept that is useful in assessing a bond's _________. A. credit risk B. liquidity risk C. price volatility D. convexity risk 11-4 Chapter 11 - Managing Bond Portfolios 20. A pension fund has an average duration of its liabilities equal to 15 years. The fund is looking at 5 year maturity zero coupon bonds and 4% yield perpetuities to immunize its interest rate risk. How much of its portfolio should it allocate to the zero coupon bonds to immunize if there are no other assets funding the plan? A. 52% B. 48% C. 33% D. 25% 21. You own a bond that has a duration of 6 years. Interest rates are currently 7% but you believe the Fed is about to increase interest rates by 25 basis points. Your predicted price change on this bond is ________. A. +1.40% B. -1.40% C. -2.51% D. +2.51% 22. Given its time to maturity the duration of a zero coupon bond is _________. A. higher when the discount rate is higher B. higher when the discount rate is lower C. lowest when the discount rate is equal to the risk free rate D. the same regardless of the discount rate 23. An increase in a bond's yield to maturity results in a price decline that is ________ the price increase resulting from a decrease in yield of equal magnitude. A. greater than B. equivalent to C. smaller than D. The answer is indeterminate 11-5 Chapter 11 - Managing Bond Portfolios 24. All other things equal, a bond's duration is _________. A. higher when the yield to maturity is higher B. lower when the yield to maturity is higher C. the same at all yield rates D. indeterminable when the yield to maturity is high 25. A bank has an average duration of its liabilities equal to 2 years. The bank's average duration of its assets is 3.5 years. The bank's market value of equity is at risk if _______________________. A. interest rates fall B. credit spreads fall C. interest rates rise D. the price of all fixed income securities rises 26. All other things equal, a bond's duration is _________. A. higher when the coupon rate is higher B. lower when the coupon rate is higher C. the same when the coupon rate is higher D. indeterminate when the coupon rate is high 27. Banks and other financial institutions can best manage interest rate risk by _____________. A. maximizing the duration of assets and minimizing the duration of liabilities B. minimizing the duration of assets and maximizing the duration of liabilities C. matching the durations of their assets and liabilities D. matching the maturities of their assets and liabilities 28. In the context of a bond portfolio, price risk and reinvestment rate risk exactly cancel out at a time horizon equal to ____. A. the average bond maturity in the portfolio B. the duration of the portfolio C. the difference between the shortest duration and longest duration of the individual bonds in the portfolio D. the average of the shortest duration and longest duration of the bonds in the portfolio 11-6 Chapter 11 - Managing Bond Portfolios 29. Bond portfolio immunization techniques balance ________ and ________ risk. A. price; reinvestment B. price; liquidity C. credit; reinvestment D. credit; liquidity 30. You have purchased a Guaranteed Investment contracts (GICs) from an insurance firm that promises to pay you a 5% compound rate of return per year for 6 years. If you pay $10,000 for the GIC today and receive no interest along the way you will get __________ in 6 years (to the nearest dollar). A. $12,565 B. $13,000 C. $13,401 D. $13,676 31. The duration of a portfolio of bonds can be calculated as _______________. A. the coupon weighted average of the durations of the individual bonds in the portfolio B. the yield weighted average of the durations of the individual bonds in the portfolio C. the value weighed average of the durations of the individual bonds in the portfolio D. averages of the durations of the longest and shortest duration bonds in the portfolio 32. Pension fund managers can generally best bring about an effective reduction in their interest rate risk by holding ___________________. A. long maturity bonds B. long duration bonds C. short maturity bonds D. short duration bonds 33. Which of the following is not a type of bond swap used in active portfolio management? A. Inter-market spread swap B. Substitution swap C. Rate anticipation swap D. Asset-liability swap 11-7 Chapter 11 - Managing Bond Portfolios 34. The exchange of one bond for a bond with similar attributes but more attractively priced is called ______________. A. a substitution swap B. an intermarket spread swap C. rate anticipation swap D. pure yield pickup swap 35. Rank the interest sensitivity of the following from most sensitive to an interest rate change to the least sensitive. I. 8% coupon, noncallable 20 year maturity, par bond II. 9% coupon, currently callable 20 year maturity, premium bond III. Zero coupon, 30 year maturity bond A. I, II, III B. II, III, I C. III, I, II D. III, II, I 36. A bond swap made in response to forecasts of interest rate changes is called ______. A. a substitution swap B. an intermarket spread swap C. rate anticipation swap D. pure yield pickup swap 37. Moving to higher yield bonds, usually with longer maturities is called ________. A. a substitution swap B. an intermarket spread swap C. rate anticipation swap D. pure yield pickup swap 38. In a pure yield pickup swap, ________ bonds are exchanged for _________ bonds. A. longer duration; shorter duration B. shorter duration; longer duration C. high coupon; high yield D. low yield; high yield 11-8 Chapter 11 - Managing Bond Portfolios 39. The duration rule always ________ the value of a bond following a change in its yield. A. under-estimates B. provides an unbiased estimate of C. over-estimates D. The estimated price may be biased either upward or downward, depending on whether the bond is trading at a discount or a premium 40. Where Y = yield to maturity, the duration of a perpetuity would be _________. A. Y B. Y/(1 + Y) C. 1/Y D. (1 + Y)/Y 41. A bond currently has a price of $1,050. The yield on the bond is 6.00%. If the yield increases 25 basis points, the price of the bond will go down to $1,030. The duration of this bond is ____ years. A. 7.46 B. 8.08 C. 9.02 D. 10.11 42. A bond has a current price of $1,030. The yield on the bond is 8.00%. If the yield changes from 8.00% to 8.10%, the price of the bond will go down to $1,025.88. The modified duration of this bond is _________. A. 4.32 B. 4.00 C. 3.25 D. 3.75 11-9 Chapter 11 - Managing Bond Portfolios 43. A bank has $50 million in assets, $47 million in liabilities and $3 million in shareholders' equity. If the duration of its liabilities are 1.3 and the bank wants to immunize its net worth against interest rate risk and thus set the duration of equity equal to zero, it should select assets with an average duration of _________. A. 1.22 B. 1.50 C. 1.60 D. 2.00 44. A perpetuity pays $100 each and every year forever. The duration of this perpetuity will be __________ if its yield is 9%. A. 7 B. 9 C. 9.39 D. 12.11 A bond pays annual interest. Its coupon rate is 9%. Its value at maturity is $1,000. It matures in four years. Its yield to maturity is currently 6%. 45. The duration of this bond is _______ years. A. 2.44 B. 3.23 C. 3.56 D. 4.10 46. The modified duration of this bond is ______ years. A. 4.00 B. 3.56 C. 3.36 D. 3.05 11-10 Chapter 11 - Managing Bond Portfolios 47. A bond has a maturity of 12 years, a duration of 9.5 years at a promised yield rate of 8%. What is the bond's modified duration? A. 12 years B. 11.1 years C. 9.5 years D. 8.8 years 48. A 20-year maturity bond pays interest of $90 once per year and has a face value of $1,000. Its yield to maturity is 10%. Over the upcoming year, you expect interest rates to decline and that the yield to maturity on this bond will only be 8% a year from now. Using horizon analysis, the return you expect to earn by holding this bond over the upcoming year is _________. A. 10.0% B. 12.0% C. 21.6% D. 29.6% 49. A bond with a 9-year duration is worth $1,080.00 and its yield to maturity is 8%. If the yield to maturity falls to 7.84%, you would predict that the new value of the bond will be _________. A. $1,035 B. $1,036 C. $1,094 D. $1,124 50. When interest rates increase, the duration of a 20-year bond selling at a premium _________. A. increases B. decreases C. remains the same D. increases at first, then declines 11-11 Chapter 11 - Managing Bond Portfolios 51. Duration facilitates the comparison of bonds with differing ___________. A. default risk B. conversion ratios C. maturities D. yields to maturity 52. The historical yield spread between the AA bond and the AAA bond has been 25 basis points. Currently the spread is only 9 basis points. If you believe the spread will soon return to its historical levels you should ________________________. A. buy the AA and short the AAA B. buy both the AA and the AAA C. buy the AAA and short the AA D. short both the AA and the AAA 53. The duration of a bond normally increases with an increase in _________. I. term-to-maturity II. yield-to-maturity. III. coupon rate A. I only B. I and II only C. II and III only D. I, II and III 54. A fixed income portfolio manager sets a minimum acceptable rate of return on the bond portfolio at 5% per year over the next 4 years. The portfolio is currently worth $10 million. One year later interest rates are at 6%. What is the portfolio value trigger point at this time that would require him to immunize the portfolio? A. $12,155,063 B. $10,205,625 C. $9,627,948 D. $10,500,000 11-12 Chapter 11 - Managing Bond Portfolios 55. Compute the duration of an 8%, 5-year corporate bond with a par value of $1000 if yield to maturity of 10%. A. 3.92 B. 4.28 C. 4.55 D. 5.00 56. Compute the modified duration of a 9% coupon, 3-year corporate bond with a yield to maturity of 12%. A. 2.45 B. 2.75 C. 2.88 D. 3.00 57. An 8%, 30-year bond has a yield-to-maturity of 10% and a modified duration of 8.0 years. If the market yield drops by 15 basis points, there will be a __________ in the bond's price. A. 1.15% decrease B. 1.20% increase C. 1.53% increase D. 2.43% decrease 58. To create a portfolio with a duration of 4 years using a 5 year zero-coupon bond and a 3 year 8% annual coupon bond with a yield to maturity of 10%, one would have to invest ________ of the portfolio value in the zero-coupon bond. A. 50% B. 55% C. 60% D. 75% 11-13 Chapter 11 - Managing Bond Portfolios 59. Which of the following set of conditions will result in a bond with the greatest price volatility? A. A high coupon and a short maturity. B. A high coupon and a long maturity. C. A low coupon and a short maturity. D. A low coupon and a long maturity. 60. An investor who expects declining interest rates would maximize their capital gain by purchasing a bond that has a ___ coupon and a ___ term to maturity. A. low; long B. high; short C. high; long D. zero; long 61. If you choose a zero coupon bond with a maturity that matches your investment horizon which of the following statements is/are correct? I. You will have no interest rate risk on this bond. II. Absent default, you can be sure you will earn the promised yield rate. III. The duration of your bond is less than the time to your investment horizon. A. I only B. I and II only C. II and III only D. I, II and III 62. As compared with equivalent maturity bonds selling at par, deep discount bonds will have ________. A. greater reinvestment risk B. greater price volatility C. less call protection D. shorter average maturity 11-14 Chapter 11 - Managing Bond Portfolios Steel Pier Company has issued bonds that pay semiannually with the following characteristics: 63. The modified duration for the Steel Pier bond is ______. A. 6.15 years B. 5.95 years C. 6.49 years D. 9.09 years 64. If the bond's coupon was smaller than 10%, the modified duration would be _____ compared to the original modified duration. A. larger B. unchanged C. smaller D. There is not enough information to determine the direction of change 65. If the maturity of the bond was less than 10 years, the modified duration would be _____ compared to the original modified duration. A. larger B. unchanged C. smaller D. There is not enough information to determine the direction of change 66. If the yield to maturity decreases to 8.045% the expected percentage change in the price of the bond using Macauley's duration would be ____, while the expected percentage change in the price of the bond using modified duration would be ____. A. 11%, 12% B. 12%, 11% C. 12%, 12% D. 11%, 11% 11-15 Chapter 11 - Managing Bond Portfolios 67. A 20 year maturity corporate bond has a 6.5% coupon rate (the coupons are paid annually). The bond currently sells for $925.50. A bond market analyst forecasts that in five years yield rates on these bonds will be at 7.0%. You believe that you will be able to reinvest the coupons earned over the next five years at a 6% rate of return. What is your expected annual compound rate of return if you plan on selling the bond in five years? A. 7.37% B. 7.56% C. 8.12% D. 8.54% 68. When bonds sell above par, what is the relationship of price sensitivity to rising interest rates? A. Price volatility increases at an increasing rate B. Price volatility increases at a decreasing rate C. Price volatility decreases at a decreasing rate D. Price volatility decreases at an increasing rate 69. A zero coupon bond is selling at a deep discount price of $430.00. It matures in 13 years. If the yield to maturity of the bond is 6.7%, what is the duration of the bond? A. 6.7 years B. 8.0 years C. 10 years D. 13 years 70. You have an investment that in today's dollars returns 15% of your investment in year 1, 12% in year two, 9% in year 3 and the remainder in year 4. What is the duration of this investment? A. 4 years B. 3.50 years C. 3.22 years D. 2.95 years 11-16 Chapter 11 - Managing Bond Portfolios 71. If an investment returns a higher percentage of your money back sooner it will ______. A. be less price volatile B. have a higher credit rating C. be less liquid D. have a higher modified duration 72. Which one of the following statements correctly describes the weights used in the Macaulay duration calculation? The weight in year t is equal to ____________. A. the dollar amount of the investment received in year t B. the percentage of the future value of the investment received in year t C. the present value of the dollar amount of the investment received in year t D. the percentage of the total present value of the investment received in year t 73. The duration is independent of the coupon rate only for which one of the following? A. Discount bonds B. Premium bonds C. Perpetuities D. Short term bonds 74. You have an investment horizon of 6 years. You choose to hold a bond with a duration of 10 years. Your realized rate of return will be larger than the promised yield on the bond if ___________________. A. interest rates increase B. interest rates stay the same C. interest rates fall D. one can't tell with the information given 75. A bond portfolio manager notices a hump in the yield curve at the five year point. How might a bond manager take advantage of this event? A. Buy the 5 year bonds and short the surrounding maturity bonds B. Buy the 5 year bonds and buy the surrounding maturity bonds C. Short the 5 year bonds and short the surrounding maturity bonds D. Short the 5 year bonds and buy the surrounding maturity bonds 11-17 Chapter 11 - Managing Bond Portfolios 76. Market economists all predict a rise in interest rates. An astute bond manager wishing to maximize her capital gain might employ which strategy? A. Switch from low duration to high duration bonds. B. Switch from high duration to low duration bonds. C. Switch from high grade to low grade bonds. D. Switch from low coupon to high coupon bonds. 77. You have an investment horizon of 6 years. You choose to hold a bond with a duration of 4 years. Your realized rate of return will be larger than the promised yield on the bond if ___________________. A. interest rates increase B. interest rates stay the same C. interest rates fall D. one can't tell with the information given 78. What strategy might an insurance company employ to ensure that it will be able to meet the obligations of annuity holders? A. Cash flow matching B. Index tracking C. Yield pickup swaps D. Substitution swap 79. You have an investment horizon of 6 years. You choose to hold a bond with a duration of 6 years and continue to match your investment horizon and duration throughout your holding period. Your realized rate of return will be the same as the promised yield on the bond if I. interest rates increase II. interest rates stay the same III. interest rates fall A. I only B. II only C. I and II only D. I, II and III 11-18 Chapter 11 - Managing Bond Portfolios 80. Immunization of coupon paying bonds is not a passive strategy because I. the portfolio must be rebalanced every time interest rates change II. the portfolio must be rebalanced over time even if interest rates don't change III. convexity implies duration based immunization strategies don't work A. I only B. I and II only C. II only D. I, II and III 81. Advantages of cash flow matching and dedicated strategies include ______. I. once the cash flows are matched there is no need for rebalancing II. cash flow matching typically earns a higher rate of return than active bond portfolio management III. financial institution's liabilities often exceed the maturity of available bonds, making cash matching even more desirable A. I only B. II only C. I and III only D. I, II and III 82. Convexity implies that duration predictions _______. I. underestimate the % increase in bond price when the yield falls II. underestimate the % decrease in bond price when the yield rises III. overestimates the % increase in bond price when the yield falls IV. overestimates the % decrease in bond price when the yield rises A. I and III only B. II and IV only C. I and IV only D. II and III only 11-19 Chapter 11 - Managing Bond Portfolios 83. You have a 25 year maturity 10% coupon, 10% yield bond with duration of 10 years and a convexity of 135.50. If interest rate were to fall 125 basis points your predicted new price for the bond (including convexity) is _________. A. $1098.45 B. $1104.56 C. $1113.41 D. $1124.20 84. You have a 15 year maturity 4% coupon, 6% yield bond with duration of 10.5 years and a convexity of 128.75. The bond is currently priced at $805.76. If interest rate were to increase 200 basis points your predicted new price for the bond (including convexity) is _________. A. $638.85 B. $642.54 C. $666.88 D. $705.03 85. Convexity of a bond is ___________. A. the same as horizon analysis B. the rate of change of the price-yield curve divided by bond price C. a measure of bond duration D. none of the above Chapter 11 Managing Bond Portfolios Answer Key Multiple Choice Questions 11-20 Chapter 11 - Managing Bond Portfolios 1. All other things equal, which of the following has the longest duration? A. A 30 year bond with a 10% coupon B. A 20 year bond with a 9% coupon C. A 20 year bond with a 7% coupon D. A 10 year zero coupon bond Difficulty: Medium 2. All other things equal, which of the following has the shortest duration? A. A 30 year bond with a 10% coupon B. A 20 year bond with a 9% coupon C. A 20 year bond with a 7% coupon D. A 10 year zero coupon bond Difficulty: Medium 3. A pension fund must pay out $1 million next year, $2 million the following year and then $3 million the year after that. If the discount rate is 8% what is the duration of this set of payments? A. 2.00 years B. 2.15 years C. 2.29 years D. 2.53 years Difficulty: Hard 11-21 Chapter 11 - Managing Bond Portfolios 4. All other things equal, which of the following has the longest duration? A. A 20 year bond with a 10% coupon yielding 10% B. A 20 year bond with a 10% coupon yielding 11% C. A 20 year zero coupon bond yielding 10% D. A 20 year zero coupon bond yielding 11% Difficulty: Medium 5. The duration of a perpetuity varies _______ with interest rates. A. directly B. inversely C. convexly D. randomly Difficulty: Medium 6. Because of convexity, when interest rates change the actual bond price will ____________ the bond price predicted by duration. A. always be higher than B. sometimes be higher than C. always be lower than D. sometimes be lower than Difficulty: Easy 7. You find a 5 year AA Xerox bond priced to yield 6%. You find a similar risk 5 year Canon bond priced to yield 6.5%. To take advantage of this you should do which of the following? A. Short the Canon bond and buy the Xerox bond B. Buy the Canon bond and short the Xerox bond C. Short both the Canon bond and the Xerox bond D. Buy both the Canon bond and the Xerox bond Difficulty: Medium 11-22 Chapter 11 - Managing Bond Portfolios 8. A forecast of bond returns based largely on a prediction of the yield curve at the end of the investment horizon is called a _________. A. contingent immunization B. dedication strategy C. duration analysis D. horizon analysis Difficulty: Easy 9. A bond's price volatility _________ at a/an _________ rate as maturity increases. A. increases; increasing B. increases; decreasing C. decreases; increasing D. decreases; decreasing Difficulty: Easy 10. As a result of bond convexity an increase in a bond's price when yield to maturity falls is ________ the price decrease resulting from an increase in yield of equal magnitude. A. greater than B. equivalent to C. smaller than D. The answer is indeterminate. Difficulty: Medium 11. All else equal, bond price volatility is greater for __________. A. higher coupon rates B. lower coupon rates C. shorter maturity D. lower default risk Difficulty: Easy 11-23 Chapter 11 - Managing Bond Portfolios 12. ______________ is an important characteristic of the relationship between bond prices and yields. A. Convexity B. Concavity C. Complexity D. Linearity Difficulty: Medium 13. Bond prices are _______ sensitive to changes in yield when the bond is selling at a _______ initial yield to maturity. A. more; lower B. more; higher C. less; lower D. equally; higher or lower Difficulty: Easy 14. The pioneer of the duration concept was _________. A. Eugene Fama B. John Herzog C. Frederick Macaulay D. Harry Markowitz Difficulty: Easy 15. A portfolio manager sells treasury bonds and buys corporate bonds because the spread between corporate and Treasury bond yields is higher than its historical average. This is an example of __________ swap. A. a pure yield pick up B. a rate anticipation C. a substitution D. an intermarket spread Difficulty: Easy 11-24 Chapter 11 - Managing Bond Portfolios 16. The duration of a 5-year zero coupon bond is ____ years. A. 4.5 B. 5.0 C. 5.5 D. 3.5 Difficulty: Easy 17. A portfolio manager believes interest rates will drop and decides to sell short duration bonds and buy long duration bonds. This is an example of __________ swap. A. a pure yield pick up B. a rate anticipation C. a substitution D. an inter-market spread Difficulty: Easy 18. Target date immunization would primarily be of interest to _________. A. banks B. mutual funds C. pension funds D. individual investors Difficulty: Easy 19. Duration is a concept that is useful in assessing a bond's _________. A. credit risk B. liquidity risk C. price volatility D. convexity risk Difficulty: Easy 11-25 Chapter 11 - Managing Bond Portfolios 20. A pension fund has an average duration of its liabilities equal to 15 years. The fund is looking at 5 year maturity zero coupon bonds and 4% yield perpetuities to immunize its interest rate risk. How much of its portfolio should it allocate to the zero coupon bonds to immunize if there are no other assets funding the plan? A. 52% B. 48% C. 33% D. 25% Durperpetuity = = 26 years 15 = (wz)(5) + (1 - wz) 26; wz = 52.38% Difficulty: Hard 21. You own a bond that has a duration of 6 years. Interest rates are currently 7% but you believe the Fed is about to increase interest rates by 25 basis points. Your predicted price change on this bond is ________. A. +1.40% B. -1.40% C. -2.51% D. +2.51% %P = (-6) = -1.40% Difficulty: Medium 22. Given its time to maturity the duration of a zero coupon bond is _________. A. higher when the discount rate is higher B. higher when the discount rate is lower C. lowest when the discount rate is equal to the risk free rate D. the same regardless of the discount rate Difficulty: Easy 11-26 Chapter 11 - Managing Bond Portfolios 23. An increase in a bond's yield to maturity results in a price decline that is ________ the price increase resulting from a decrease in yield of equal magnitude. A. greater than B. equivalent to C. smaller than D. The answer is indeterminate Difficulty: Medium 24. All other things equal, a bond's duration is _________. A. higher when the yield to maturity is higher B. lower when the yield to maturity is higher C. the same at all yield rates D. indeterminable when the yield to maturity is high Difficulty: Medium 25. A bank has an average duration of its liabilities equal to 2 years. The bank's average duration of its assets is 3.5 years. The bank's market value of equity is at risk if _______________________. A. interest rates fall B. credit spreads fall C. interest rates rise D. the price of all fixed income securities rises Difficulty: Medium 26. All other things equal, a bond's duration is _________. A. higher when the coupon rate is higher B. lower when the coupon rate is higher C. the same when the coupon rate is higher D. indeterminate when the coupon rate is high Difficulty: Easy 11-27 Chapter 11 - Managing Bond Portfolios 27. Banks and other financial institutions can best manage interest rate risk by _____________. A. maximizing the duration of assets and minimizing the duration of liabilities B. minimizing the duration of assets and maximizing the duration of liabilities C. matching the durations of their assets and liabilities D. matching the maturities of their assets and liabilities Difficulty: Medium 28. In the context of a bond portfolio, price risk and reinvestment rate risk exactly cancel out at a time horizon equal to ____. A. the average bond maturity in the portfolio B. the duration of the portfolio C. the difference between the shortest duration and longest duration of the individual bonds in the portfolio D. the average of the shortest duration and longest duration of the bonds in the portfolio Difficulty: Easy 29. Bond portfolio immunization techniques balance ________ and ________ risk. A. price; reinvestment B. price; liquidity C. credit; reinvestment D. credit; liquidity Difficulty: Easy 11-28 Chapter 11 - Managing Bond Portfolios 30. You have purchased a Guaranteed Investment contracts (GICs) from an insurance firm that promises to pay you a 5% compound rate of return per year for 6 years. If you pay $10,000 for the GIC today and receive no interest along the way you will get __________ in 6 years (to the nearest dollar). A. $12,565 B. $13,000 C. $13,401 D. $13,676 (10,000)(1.05)6 = $13,401 Difficulty: Easy 31. The duration of a portfolio of bonds can be calculated as _______________. A. the coupon weighted average of the durations of the individual bonds in the portfolio B. the yield weighted average of the durations of the individual bonds in the portfolio C. the value weighed average of the durations of the individual bonds in the portfolio D. averages of the durations of the longest and shortest duration bonds in the portfolio Difficulty: Medium 32. Pension fund managers can generally best bring about an effective reduction in their interest rate risk by holding ___________________. A. long maturity bonds B. long duration bonds C. short maturity bonds D. short duration bonds Difficulty: Medium 11-29 Chapter 11 - Managing Bond Portfolios 33. Which of the following is not a type of bond swap used in active portfolio management? A. Inter-market spread swap B. Substitution swap C. Rate anticipation swap D. Asset-liability swap Difficulty: Easy 34. The exchange of one bond for a bond with similar attributes but more attractively priced is called ______________. A. a substitution swap B. an intermarket spread swap C. rate anticipation swap D. pure yield pickup swap Difficulty: Easy 35. Rank the interest sensitivity of the following from most sensitive to an interest rate change to the least sensitive. I. 8% coupon, noncallable 20 year maturity, par bond II. 9% coupon, currently callable 20 year maturity, premium bond III. Zero coupon, 30 year maturity bond A. I, II, III B. II, III, I C. III, I, II D. III, II, I Difficulty: Hard 36. A bond swap made in response to forecasts of interest rate changes is called ______. A. a substitution swap B. an intermarket spread swap C. rate anticipation swap D. pure yield pickup swap Difficulty: Easy 11-30 Chapter 11 - Managing Bond Portfolios 37. Moving to higher yield bonds, usually with longer maturities is called ________. A. a substitution swap B. an intermarket spread swap C. rate anticipation swap D. pure yield pickup swap Difficulty: Easy 38. In a pure yield pickup swap, ________ bonds are exchanged for _________ bonds. A. longer duration; shorter duration B. shorter duration; longer duration C. high coupon; high yield D. low yield; high yield Difficulty: Easy 39. The duration rule always ________ the value of a bond following a change in its yield. A. under-estimates B. provides an unbiased estimate of C. over-estimates D. The estimated price may be biased either upward or downward, depending on whether the bond is trading at a discount or a premium Difficulty: Medium 40. Where Y = yield to maturity, the duration of a perpetuity would be _________. A. Y B. Y/(1 + Y) C. 1/Y D. (1 + Y)/Y Difficulty: Medium 11-31 Chapter 11 - Managing Bond Portfolios 41. A bond currently has a price of $1,050. The yield on the bond is 6.00%. If the yield increases 25 basis points, the price of the bond will go down to $1,030. The duration of this bond is ____ years. A. 7.46 B. 8.08 C. 9.02 D. 10.11 P = = -0.019 P = -0.019 = -Dur ; Dur = 8.08 Difficulty: Medium 42. A bond has a current price of $1,030. The yield on the bond is 8.00%. If the yield changes from 8.00% to 8.10%, the price of the bond will go down to $1,025.88. The modified duration of this bond is _________. A. 4.32 B. 4.00 C. 3.25 D. 3.75 P = = -0.004 P = -0.004 = -Dur ; Dur = 4.32 DurMOD = =4 Difficulty: Hard 11-32 Chapter 11 - Managing Bond Portfolios 43. A bank has $50 million in assets, $47 million in liabilities and $3 million in shareholders' equity. If the duration of its liabilities are 1.3 and the bank wants to immunize its net worth against interest rate risk and thus set the duration of equity equal to zero, it should select assets with an average duration of _________. A. 1.22 B. 1.50 C. 1.60 D. 2.00 (50,000,000)(DA) = (47,000,000) (1.3); DA = 1.22 Difficulty: Medium 44. A perpetuity pays $100 each and every year forever. The duration of this perpetuity will be __________ if its yield is 9%. A. 7 B. 9 C. 9.39 D. 12.11 Difficulty: Medium A bond pays annual interest. Its coupon rate is 9%. Its value at maturity is $1,000. It matures in four years. Its yield to maturity is currently 6%. 11-33 Chapter 11 - Managing Bond Portfolios 45. The duration of this bond is _______ years. A. 2.44 B. 3.23 C. 3.56 D. 4.10 Duration = 3.56 Difficulty: Hard 46. The modified duration of this bond is ______ years. A. 4.00 B. 3.56 C. 3.36 D. 3.05 DurMOD = 3.56/1.06 = 3.36 years Difficulty: Hard 47. A bond has a maturity of 12 years, a duration of 9.5 years at a promised yield rate of 8%. What is the bond's modified duration? A. 12 years B. 11.1 years C. 9.5 years D. 8.8 years DurMOD = 9.5/1.08 = 8.8 years Difficulty: Easy 11-34 Chapter 11 - Managing Bond Portfolios 48. A 20-year maturity bond pays interest of $90 once per year and has a face value of $1,000. Its yield to maturity is 10%. Over the upcoming year, you expect interest rates to decline and that the yield to maturity on this bond will only be 8% a year from now. Using horizon analysis, the return you expect to earn by holding this bond over the upcoming year is _________. A. 10.0% B. 12.0% C. 21.6% D. 29.6% (use financial calculator to calculate PV10%, 20 and PV8%, 19) Difficulty: Hard 49. A bond with a 9-year duration is worth $1,080.00 and its yield to maturity is 8%. If the yield to maturity falls to 7.84%, you would predict that the new value of the bond will be _________. A. $1,035 B. $1,036 C. $1,094 D. $1,124 Difficulty: Hard 50. When interest rates increase, the duration of a 20-year bond selling at a premium _________. A. increases B. decreases C. remains the same D. increases at first, then declines Difficulty: Easy 11-35 Chapter 11 - Managing Bond Portfolios 51. Duration facilitates the comparison of bonds with differing ___________. A. default risk B. conversion ratios C. maturities D. yields to maturity Difficulty: Easy 52. The historical yield spread between the AA bond and the AAA bond has been 25 basis points. Currently the spread is only 9 basis points. If you believe the spread will soon return to its historical levels you should ________________________. A. buy the AA and short the AAA B. buy both the AA and the AAA C. buy the AAA and short the AA D. short both the AA and the AAA Difficulty: Medium 53. The duration of a bond normally increases with an increase in _________. I. term-to-maturity II. yield-to-maturity. III. coupon rate A. I only B. I and II only C. II and III only D. I, II and III Difficulty: Medium 11-36 Chapter 11 - Managing Bond Portfolios 54. A fixed income portfolio manager sets a minimum acceptable rate of return on the bond portfolio at 5% per year over the next 4 years. The portfolio is currently worth $10 million. One year later interest rates are at 6%. What is the portfolio value trigger point at this time that would require him to immunize the portfolio? A. $12,155,063 B. $10,205,625 C. $9,627,948 D. $10,500,000 Minimum terminal value = ($10 mill.)(1.05)4 = $12,155,062.50 Trigger point value = $12,155,062.50/1.063 = $10,205,625 Difficulty: Hard 55. Compute the duration of an 8%, 5-year corporate bond with a par value of $1000 if yield to maturity of 10%. A. 3.92 B. 4.28 C. 4.55 D. 5.00 Difficulty: Medium 11-37 Chapter 11 - Managing Bond Portfolios 56. Compute the modified duration of a 9% coupon, 3-year corporate bond with a yield to maturity of 12%. A. 2.45 B. 2.75 C. 2.88 D. 3.00 Difficulty: Medium 57. An 8%, 30-year bond has a yield-to-maturity of 10% and a modified duration of 8.0 years. If the market yield drops by 15 basis points, there will be a __________ in the bond's price. A. 1.15% decrease B. 1.20% increase C. 1.53% increase D. 2.43% decrease (P/P) = - 8.0 (0.0015) = - 0.012 Difficulty: Medium 11-38 Chapter 11 - Managing Bond Portfolios 58. To create a portfolio with a duration of 4 years using a 5 year zero-coupon bond and a 3 year 8% annual coupon bond with a yield to maturity of 10%, one would have to invest ________ of the portfolio value in the zero-coupon bond. A. 50% B. 55% C. 60% D. 75% Difficulty: Hard 59. Which of the following set of conditions will result in a bond with the greatest price volatility? A. A high coupon and a short maturity. B. A high coupon and a long maturity. C. A low coupon and a short maturity. D. A low coupon and a long maturity. Difficulty: Easy 60. An investor who expects declining interest rates would maximize their capital gain by purchasing a bond that has a ___ coupon and a ___ term to maturity. A. low; long B. high; short C. high; long D. zero; long Difficulty: Easy 11-39 Chapter 11 - Managing Bond Portfolios 61. If you choose a zero coupon bond with a maturity that matches your investment horizon which of the following statements is/are correct? I. You will have no interest rate risk on this bond. II. Absent default, you can be sure you will earn the promised yield rate. III. The duration of your bond is less than the time to your investment horizon. A. I only B. I and II only C. II and III only D. I, II and III Difficulty: Easy 62. As compared with equivalent maturity bonds selling at par, deep discount bonds will have ________. A. greater reinvestment risk B. greater price volatility C. less call protection D. shorter average maturity Difficulty: Easy Steel Pier Company has issued bonds that pay semiannually with the following characteristics: 11-40 Chapter 11 - Managing Bond Portfolios 63. The modified duration for the Steel Pier bond is ______. A. 6.15 years B. 5.95 years C. 6.49 years D. 9.09 years DurMOD = 6.76/1.10 = 6.15 years Difficulty: Medium 64. If the bond's coupon was smaller than 10%, the modified duration would be _____ compared to the original modified duration. A. larger B. unchanged C. smaller D. There is not enough information to determine the direction of change Difficulty: Easy 65. If the maturity of the bond was less than 10 years, the modified duration would be _____ compared to the original modified duration. A. larger B. unchanged C. smaller D. There is not enough information to determine the direction of change Difficulty: Easy 11-41 Chapter 11 - Managing Bond Portfolios 66. If the yield to maturity decreases to 8.045% the expected percentage change in the price of the bond using Macauley's duration would be ____, while the expected percentage change in the price of the bond using modified duration would be ____. A. 11%, 12% B. 12%, 11% C. 12%, 12% D. 11%, 11% %P = ; %P is the same using DurMOD Difficulty: Hard 67. A 20 year maturity corporate bond has a 6.5% coupon rate (the coupons are paid annually). The bond currently sells for $925.50. A bond market analyst forecasts that in five years yield rates on these bonds will be at 7.0%. You believe that you will be able to reinvest the coupons earned over the next five years at a 6% rate of return. What is your expected annual compound rate of return if you plan on selling the bond in five years? A. 7.37% B. 7.56% C. 8.12% D. 8.54% FV5coupons = P5Bond = Total Future Value5 = $366.41 + $954.46 = $1,320.87 PV0 = $925.50 ($925.50)(1 + r)5 = $1,320.87; r = 7.37% Difficulty: Hard 11-42 Chapter 11 - Managing Bond Portfolios 68. When bonds sell above par, what is the relationship of price sensitivity to rising interest rates? A. Price volatility increases at an increasing rate B. Price volatility increases at a decreasing rate C. Price volatility decreases at a decreasing rate D. Price volatility decreases at an increasing rate Difficulty: Medium 69. A zero coupon bond is selling at a deep discount price of $430.00. It matures in 13 years. If the yield to maturity of the bond is 6.7%, what is the duration of the bond? A. 6.7 years B. 8.0 years C. 10 years D. 13 years Duration of a zero-coupon bond is equal to its maturity. Difficulty: Easy 70. You have an investment that in today's dollars returns 15% of your investment in year 1, 12% in year two, 9% in year 3 and the remainder in year 4. What is the duration of this investment? A. 4 years B. 3.50 years C. 3.22 years D. 2.95 years Dur = (15%)(1) + (12%)(2) + (9%)(3) + (64%)(4) = 3.22 years Difficulty: Medium 11-43 Chapter 11 - Managing Bond Portfolios 71. If an investment returns a higher percentage of your money back sooner it will ______. A. be less price volatile B. have a higher credit rating C. be less liquid D. have a higher modified duration Difficulty: Easy 72. Which one of the following statements correctly describes the weights used in the Macaulay duration calculation? The weight in year t is equal to ____________. A. the dollar amount of the investment received in year t B. the percentage of the future value of the investment received in year t C. the present value of the dollar amount of the investment received in year t D. the percentage of the total present value of the investment received in year t Difficulty: Hard 73. The duration is independent of the coupon rate only for which one of the following? A. Discount bonds B. Premium bonds C. Perpetuities D. Short term bonds Difficulty: Medium 74. You have an investment horizon of 6 years. You choose to hold a bond with a duration of 10 years. Your realized rate of return will be larger than the promised yield on the bond if ___________________. A. interest rates increase B. interest rates stay the same C. interest rates fall D. one can't tell with the information given Difficulty: Medium 11-44 Chapter 11 - Managing Bond Portfolios 75. A bond portfolio manager notices a hump in the yield curve at the five year point. How might a bond manager take advantage of this event? A. Buy the 5 year bonds and short the surrounding maturity bonds B. Buy the 5 year bonds and buy the surrounding maturity bonds C. Short the 5 year bonds and short the surrounding maturity bonds D. Short the 5 year bonds and buy the surrounding maturity bonds Difficulty: Medium 76. Market economists all predict a rise in interest rates. An astute bond manager wishing to maximize her capital gain might employ which strategy? A. Switch from low duration to high duration bonds. B. Switch from high duration to low duration bonds. C. Switch from high grade to low grade bonds. D. Switch from low coupon to high coupon bonds. Difficulty: Medium 77. You have an investment horizon of 6 years. You choose to hold a bond with a duration of 4 years. Your realized rate of return will be larger than the promised yield on the bond if ___________________. A. interest rates increase B. interest rates stay the same C. interest rates fall D. one can't tell with the information given Difficulty: Medium 78. What strategy might an insurance company employ to ensure that it will be able to meet the obligations of annuity holders? A. Cash flow matching B. Index tracking C. Yield pickup swaps D. Substitution swap Difficulty: Medium 11-45 Chapter 11 - Managing Bond Portfolios 79. You have an investment horizon of 6 years. You choose to hold a bond with a duration of 6 years and continue to match your investment horizon and duration throughout your holding period. Your realized rate of return will be the same as the promised yield on the bond if I. interest rates increase II. interest rates stay the same III. interest rates fall A. I only B. II only C. I and II only D. I, II and III Difficulty: Medium 80. Immunization of coupon paying bonds is not a passive strategy because I. the portfolio must be rebalanced every time interest rates change II. the portfolio must be rebalanced over time even if interest rates don't change III. convexity implies duration based immunization strategies don't work A. I only B. I and II only C. II only D. I, II and III Difficulty: Medium 81. Advantages of cash flow matching and dedicated strategies include ______. I. once the cash flows are matched there is no need for rebalancing II. cash flow matching typically earns a higher rate of return than active bond portfolio management III. financial institution's liabilities often exceed the maturity of available bonds, making cash matching even more desirable A. I only B. II only C. I and III only D. I, II and III Difficulty: Medium 11-46 Chapter 11 - Managing Bond Portfolios 82. Convexity implies that duration predictions _______. I. underestimate the % increase in bond price when the yield falls II. underestimate the % decrease in bond price when the yield rises III. overestimates the % increase in bond price when the yield falls IV. overestimates the % decrease in bond price when the yield rises A. I and III only B. II and IV only C. I and IV only D. II and III only Difficulty: Hard 83. You have a 25 year maturity 10% coupon, 10% yield bond with duration of 10 years and a convexity of 135.50. If interest rate were to fall 125 basis points your predicted new price for the bond (including convexity) is _________. A. $1098.45 B. $1104.56 C. $1113.41 D. $1124.20 PV0 = $1,000 %P = PNew = ($1,000)(1 + 0.1242) = $1,124.20 Difficulty: Hard 11-47 Chapter 11 - Managing Bond Portfolios 84. You have a 15 year maturity 4% coupon, 6% yield bond with duration of 10.5 years and a convexity of 128.75. The bond is currently priced at $805.76. If interest rate were to increase 200 basis points your predicted new price for the bond (including convexity) is _________. A. $638.85 B. $642.54 C. $666.88 D. $705.03 PV0 = $805.76 %P = PNew = ($805.76)(1 + -0.1724) = $666.88 Difficulty: Hard 85. Convexity of a bond is ___________. A. the same as horizon analysis B. the rate of change of the price-yield curve divided by bond price C. a measure of bond duration D. none of the above Difficulty: Medium 11-48

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