What is the fundamental bond pricing principle?
A bond’s price equals the present value of its expected future cash flows (coupons + principal), discounted at the required yield.
What happens to bond prices when market yields rise? Why?
Prices fall because future fixed cash flows are discounted at a higher rate.
Why do bonds issued at a discount converge to par as maturity approaches (if yields unchanged)?
Pull-to-par effect. As maturity shortens, price must equal face value at maturity.
Why does a credit downgrade reduce bond price?
Higher perceived default risk → higher required yield → lower present value.
What components make up a corporate bond yield?
Risk-free rate
Credit spread
Liquidity premium
Possibly tax premium
Why is duration only an approximation?
It assumes a linear price-yield relationship.
What does duration measure?
Approximate sensitivity of bond price to small changes in yield.
What corrects the linear limitation of duration?
Convexity.
When is duration less accurate?
Large yield changes
Bonds with embedded options
Non-parallel yield curve shifts
why can two bonds with same duration react differently to rate changes?
Different convexity.
Do normal (option-free) bonds have positive or negative convexity?
Positive convexity.
Why do callable bonds exhibit negative convexity?
When rates fall, issuer calls bond, limiting price appreciation.
Why do putable bonds have high positive convexity?
Investors benefit when rates rise (can sell back at higher price).
Why is negative convexity bad for investors?
Price gains are capped when yields fall but losses remain when yields rise.
What does pure expectations theory state?
Long-term rates equal the average of expected future short-term rates.
Key assumption of pure expectations theory?
No risk premium; bonds of different maturities are perfect substitutes.
What does an upward-sloping yield curve imply under pure expectations?
Market expects future short rates to rise.
What does liquidity preference theory add?
Investors require a positive term premium for holding longer maturities.
Why does liquidity preference theory predict an upward bias in yield curves?
Term premium increases with maturity.
What is market segmentation theory?
Market segmentation theory states that bond markets are divided into separate maturity segments, where investors and borrowers have strong preferences for specific maturities. As a result, interest rates in each segment are determined independently by supply and demand, with little or no substitution between maturities.
What determines credit spread?
Default probability
Recovery rate
Liquidity
Economic outlook
Why do credit spreads widen in recessions?
Higher default risk and risk aversion.
What happens to bond price when spreads widen but risk-free rate unchanged?
Price falls.
What is the role of an SPV?
Bankruptcy-remote vehicle that holds assets and issues securities backed by them
