Finance 408 Exam Set 2

Front 1

One difference between moral hazard and adverse selection is

Back 1

moral hazard occurs after the contract/arrangement is created and adverse selection occurs before

Front 2

What is the formula for after-tax rate of return?

Back 2

Rate(1-Tax Rate)

Front 3

Which is higher: promised or expected return?

Back 3

Promised

Front 4

Less liquid securities tend to have what type of spreads?

Back 4

Larger

Front 5

The excelmodeling.com site shows that the term structure graph usually slopes upward for the relation of what to what?

Back 5

relating yields to length of time to maturity

Front 6

The excelmodeling.com site shows that ______-term treasury rates are more volatile than ____-term securities

Back 6

Short-term rates are more volatile than longer-term rates

Front 7

If the on year rate is 4% and the 2yr rate is 5%, then the expected one year rate in one year should be what according to the expectations theory and then according to the liquidity premium theory?

Back 7

Expectations: 6%
Permium: Less than 6% because the longer term rate needs to be a little larger than the combined shorter term rates

Front 8

If you want to invest for 2 years, would it be riskier to invest money in a 2 year strip or a 4 year strip?

Back 8

4 year strip would be riskier

Front 9

What is the formula for finding bond value for a zero coupon bond and what is the formula for finding the bond value of a coupon bond?

Back 9

ZCB price= Par value/(1+rate)^n

Coupon price = C*AFnr + Par value/(1+rate)^n

Front 10

If a bond has a duration of 10 years and a market discount rate of 6%, how would you find the modified duration?

Back 10

Take the duration, 10, and divide by 1+mdr...so 10/1.06 = 9.43

Front 11

If a bond has a duration of 10 years and the mdr is 6%, then if the discount rate falls to 5.5%, how would you find the best approximation for the percentage price change of this bond?

Back 11

Modified duration is the best approximation. So modified duration equals 10/1.06 = 9.43. But that's for a 1% change. Since the MDR only fell 0.5%, then you only have a 9.43/2 change in price which is 4.71% increase.

Front 12

What is the duration of a 10 year treasury strip?

Back 12

The duration of a treasury strip is equal to the number year in which it is paid. So if it is the the 10th payment, the duration is 10. It would be less than 10 if this were a full coupon bond and not a strip.

Front 13

If there are 2 20yr bonds that both have par value of 100 and one has a coupon rate of 6% and the other has a coupon rate of 8%, then the bond with the higher duration with the one with which rate?

Back 13

6% because it will be more affected by a % change in mdr

Front 14

If a bond has a mdr of 6% and then the mdr for this bond rises to 6.5%, the duration increases, decreases or stays the same?

Back 14

It decreases because it is in the denominator. Note: if this question asked what happens to a bond's duration as the mdr increases, nothing would happen to the duration. This is because the first question phrases the question as though the bond has not been issued yet whereas in the second it has been...so the duration doesn't change, but the price does.

Front 15

Why is it not true that when comparing strips, the one with the later payment has a higher price?

Back 15

Because the payment is going to be made later in the future and thus the dollars and worth less then. You should have to pay less now for a payment farther into the future.

Front 16

Do newly issued TIPS tend to have higher or lower coupon rates in comparison to newly issued treasury bonds?

Back 16

Lower

Front 17

For a treasury strip, which is greater: the time to maturity or the duration?

Back 17

They are equal because the duration equals the time to maturity of a treasury strip

Front 18

For a typical coupon paying bond, which is greater: time to maturity or duration?

Back 18

Time to maturity is typically greater

Front 19

What are 3 reasons a buyer would pay points on their mortgage?

Back 19

1. They are more responsible
2. They want a lower interest rate
3. They believe they will have the loan for a long time

Front 20

Does GNMA or FNMA insure timely payment of federally insured mortgages?

Back 20

Ginnie Mae insures timely payment of federally insured mortgages

Front 21

In the supply and demand schedule of loanable funds, news of a weakening economy would...

Back 21

News of a weakening economy would shift demand curve to the left

Front 22

In the supply and demand schedule of loanable funds, a higher inflation rate would...

Back 22

shift demand to the right and shift supply to the left

Front 23

Would increased or decreased government spending cause the prices of existing bonds to increase?

Back 23

For the bond price to lower, we would have to increase the supply of bonds rather than decrease it. As such, increased gvt spending would decrease the bond price.

Front 24

When a corporation fails to make a promised payment on a bond issue, we say the bond is in

Back 24

default

Front 25

As the market rate increases, the duration of a ZCB _____.

Back 25

Stays the same. Here, it seems to be implied that the bond has already been issued. As such, the duration doesn't change but the price of the bond can change.

Front 26

Why is the duration of the individual payments of a coupon bond equal to the number of year it is paid in?

Back 26

Because the payments are essentially each zero coupon bonds and zcb have durations equal to their time to maturity.

Front 27

When the coupon rate and the mdr are the same, what else is the same?

Back 27

When the coupon rate and MDR are the same, the price (value of bond) is equal to par value

Front 28

For a coupon bearing bond, what will always be true about the duration?

Back 28

It will always be somewhat less than the time to maturity. Also, the higher the coupon rate, the lower the duration.

Front 29

What can be said about a bond whose coupon rate is lower than the MDR?

Back 29

the bond is below par value

Front 30

What can be said about a bond whose coupon rate is greater than the MDR?

Back 30

the bond is above par value

Front 31

For a coupon bearing bond (that has not been issued yet), what happens to modified duration as the interest rate rises?

Back 31

The modified duration gets smaller as the interest rate rises. This is easy to figure out because modified duration= duration/1+r ...so if r is rising, then the modified duration will be smaller.

Front 32

When the rate increases, what happens to supply and demand for the housing, corporate and foreign sectors?

Back 32

Demand decreases and supply increases

Front 33

What is the additive form of the Fisher Effect?

The multiplicative?

Back 33

Additive: Nominal - Inflationary = Real Rate

Multiplicative: (1+Nominal)/(1+Inflation)= Real Rate

Front 34

At a lower price, people demand ____ and corps supply ____.

Back 34

More; Less

Front 35

As default increases,

Back 35

required rate increases

Front 36

As liquidity decreases

Back 36

the trading cost (bid-ask spread) increases and so the required rate increases to cover this cost

Front 37

As the time to realize gains increases,

Back 37

the required rate increases

Front 38

As the tax increases,

Back 38

the required rate increases

Front 39

If a bond is callable,

Back 39

investors require a higher rate of return to cover the disadvantage of callability

Front 40

If a bond is convertible,

Back 40

investors require less of a rate of return because of the advantage of convertibility

Front 41

Promised return is always

Back 41

greater than or equal to expected return

Front 42

What are the 2 types of strips?

Back 42

Principle strips and interest/coupon strips

Front 43

What happens to the price of strips whose time to maturity is farther out in the future?

Back 43

The price decreases with selling later strips

Front 44

What is the bond price of a zero coupon bond?

Back 44

Price ZCB = Par Value/(1+MDR)^n

Front 45

If MDR > coupon rate, then price of bond ___ par value

If MDR < coupon rate, then price of bond ___ par value

Back 45

If MDR > coupon rate, then price of bond < par value

If MDR < coupon rate, then price of bond > par value

Front 46

When MDR increases, then the price of EXISTING bonds _____.

Back 46

Decreases

Front 47

With rate being the same, the lower the price of the asset,

Back 47

the higher the yield. (Yield, being mdr...an asset will be priced lower if the mdr is much higher than its rate)

Front 48

What are the risks associated with short-term and long-term investments?

Back 48

Short-term: reinvestment rate could be lower

Long-term: rate goes up over time and if you sell, you'll sell at lower price

Front 49

What is the expectations theory and what is the formula that coincides with it?

Back 49

Expectations theory says that for any given investment, the expected return is the same for all strategies.

1 yr rate = 4%
2 yr rate = 6%

Then the expected 1 yr rate next year should be:
(1.04)(1+r) = (1.06)(1.06)

Front 50

What is the liquidity premium theory? What are the 2 ways of looking at it?

Back 50

Most investors are short-termers; as such, longer term bonds need extra return premium to encourage investors to buy them.

The other way to look at it is that as this is an extension of the expectations theory, the expected 1 yr rate that you calculate should actually be a little less than the number you get because that side has to be a little lower than the long term side to account for the premium

Front 51

What's the deal with volatility?

Back 51

According to excelmodeling.com, the short term rates are more volatile.

However, when it comes to pricing and term % change, long-term is more volatile

Front 52

What is the quick definition of duration without using the formula?

Back 52

Duration is the % change in price of a bond for a 1% change in MDR

Front 53

What is the formula for duration of a zero coupon bond?

Back 53

% Price Change = - Duration/(1+MDR) * change in MDR

Front 54

What is the formula for modified duration?

Back 54

Modified Duration = Duration/1+MDR

Front 55

What is the duration of a STRIP?

Back 55

It's year #...so for the 6th year, a 1% change in MDR causes a 6% change in value of that 6th payment

Front 56

Duration of a portfolio <=> maturity of portfolio

Back 56

Duration of portfolio<maturity of portfolio

Front 57

The higher the duration, the what the price volatility, the what the return?

Back 57

If there is a higher duration, we know that the rate is lower, and if the rate is lower, we know that the price volatility is higher (higher duration means that the price will change more for a 1% change in MDR) and so the return must be higher to entice investors

Front 58

Bond with higher coupon rates have ____ durations

Back 58

Lower

Front 59

Why do longer-term ZCBs experience more price volatility than short term/

Back 59

Because the duration is equal to the time to maturity for a zero coupon bond. As the ZCB becomes longer, the time to maturity increases and so does the duration. When the duration increases, we know that the price volatility is greater.

Front 60

What is an ARM?

Back 60

ARM = Adjustable Rate Mortgage. A new rate is determined every 1 to 5 years depending on the treasury rate and then adds 1%

Front 61

What is securitization?

Back 61

Securitization is the process of bundling and selling loans

Front 62

What does FNMA do?

Back 62

Fannie Mae takes pass through securities and turns them into bonds backed by mortgages ("mortgage-backed securities")

Front 63

What does GNMA do?

Back 63

Ginnie Mae insures mortgages and insures timing as it can take time to sell a house. All of their handlings are pass-through securities unline FNMA who issues bonds

Front 64

If the interest rate increases or decreases, what happens to the GNMA fund?

Back 64

With an increase, the fund decreases because it could be charging more on the mortgages; with a decrease in rates, the fund also decreases because people refinance their loans. So in order for GNMA to make money, it has to have a higher interest rate than normal. That is what mortgage rates are generally higher.

Front 65

What is the proportion for a conforming mortgage rate?

What happens if a mortgage doesn't conform?

Back 65

The loan amount/house value must be less than or equal to 80%

If a mortgage doesn't conform, then the bank can't make any money. Additionally, the bank can't sell the loan to FNMA so it will charge a higher rate.

Front 66

What happens to the value of a house in a housing bubble?

What happens to lots of loans in housing bubbles?

Back 66

The value of the house decreases.

Lots of loans default in housing bubbles because people realize that their loan amount is worth more than their house value and so there is no collateral to cover the loan.