Fabozzi Chapter09

Foundations of Financial Markets and Institutions, 4e (Fabozzi/Modigliani/Jones)
Chapter 9 Properties and Pricing of Financial Assets

Multiple Choice Questions
1 Properties of Financial Assets
1) Which of the below is NOT one of the eleven properties of financial assets?
A) moneyness
) multiplicity an! !enomination
C) reversibility
") cash flow
Answer#
Comment# The eleven properties of financial assets are $1) moneyness% $&) divisibility and
denoination% $') reversibility% $() cash flow% $)) term to maturity% $*) convertibility% $+)
currency% $,) li-ui!ity% $.) return pre!ictability% $1/) comple0ity% an! $11) ta0 status1
"iff# &
Topic# .11 2roperties of 3inancial Assets
Ob4ective# .11 the many 5ey properties of financial assets# moneyness6 !ivisibility an!
!enomination6 reversibility6 cash flow an! return6 term to maturity6 convertibility6 currency6
li-ui!ity6 return pre!ictability or ris56 comple0ity6 an! ta0 status
&) Which of the below is NOT one of the eleven properties of financial assets?
A) convertibility
) currency
C) li-ui!ity pre!ictability
") ta0 status
Answer# C
Comment# The eleven properties of financial assets are $1) moneyness% $&) !ivisibility an!
!enomination% $') reversibility% $() cash flow% $)) term to maturity% $*) convertibility% $+)
currency% $,) li!"idity% $.) ret"rn predictability% $1/) comple0ity% an! $11) ta0 status1
"iff# &
1
Copyri7ht 8 &/1/ 2earson 9!ucation :nc1 2ublishin7 as 2rentice ;all
') Which of the below are T;<99 of the eleven properties of financial assets?
A) return pre!ictability% comple0ity% an! ta0 status
) convertibility% currency% li-ui!ity
C) li-ui!ity% reversibility% an! cash flow
") money% !ivisibility% an! !enomination
Answer# "
Comment# The 11 properties of financial assets are $1) oneyness% $&) divisibility and
denoination (these are only #$% property and not &'#)% $') reversibility% $() cash flow%
$)) term to maturity% $*) convertibility% $+) currency% $,) li-ui!ity% $.) return pre!ictability% $1/)
comple0ity% an! $11) ta0 status1
"iff# &
() Which of the below statements is T<=9?
A) >Near money> is a financial asset that is use! as a me!ium of e0chan7e or in settlement of
transactions1
) :n the =nite! ?tates% money consists of currency an! a very few forms of !eposits that permit
chec5 writin71
C) >Near money> is very close to >money> in that it can be transforme! into money at little cost%
!elay% or ris51
") >3araway money>% in the case of the =nite! ?tates% inclu!es $i) time an! savin7s !eposits an!
$ii) a security issue! by the =1?1 7overnment calle! a Treasury bill1
Answer# C
Comment# Money is a financial asset that is use! as a me!ium of e0chan7e or in settlement of
transactions1 :n the =nite! ?tates% money consists of currency an! all fors of !eposits that
permit chec5 writin71 >$ear oney>% in the case of the =nite! ?tates% inclu!es $i) time an!
savin7s !eposits an! $ii) a security issue! by the =1?1 7overnment calle! a Treasury bill1
"iff# &
&
)) @@@@@@@@ relates to the minimum siAe in which a financial asset can be li-ui!ate! an!
e0chan7e! for money1
A) <eversibility
) "enomination
C) Convertibility
") "ivisibility
Answer# "
"iff# 1
*) <eversibility is referre! to as @@@@@@@@1
A) the cost of investin7 in a financial asset an! then 7ettin7 out of it but not bac5 into cash a7ain1
) the cost of investin7 in a financial asset instea! of investin7 in cash1
C) oneBway cost
") turnaroun! cost
Answer# "
Comment# <eversibility refers to the cost of investin7 in a financial asset an! then 7ettin7 out of
it an! bac5 into cash a7ain1 Conse-uently% reversibility is also referre! to as t"rnaro"nd cost or
roun!Btrip cost1
"iff# &
+) The @@@@@@@@% the 7reater the probability of the mar5et ma5er @@@@@@@@ in e0cess of a state!
boun! between the time of buyin7 an! resellin7 the financial asset1
A) 7reater the variability6 incurrin7 a loss
) lesser the variability6 incurrin7 a loss
C) lesser the variability6 incurrin7 a lar7e 7ain
") 7reater the variability6 incurrin7 no loss or 7ain
Answer# A
Comment# The greater the variability% the 7reater the probability of the mar5et ma5er
inc"rring a loss in e0cess of a state! boun! between the time of buyin7 an! resellin7 the
financial asset1
"iff# &
'
,) The return that an investor will realiAe by hol!in7 a financial asset !epen!s on all the
@@@@@@@@ that the financial asset will pay its owners6 this inclu!es !ivi!en!s on shares an!
coupon payments on bon!s1
A) stoc5 !istributions
) cash !istributions
C) cash convertibility
") li-ui! inventories
Answer#
"iff# 1
.) <eturn @@@@@@@@ is a basic property of financial assets% in that it is a ma4or !eterminant of
their value1
A) convertibility
) !ivisibility
C) pre!ictability
") comple0ity
Answer# C
"iff# 1
1/) A @@@@@@@@ asset is one that provi!es options for the issuer or the investor% or both% an! so
represents a combination of simpler assets1
A) comple0
) ta0able
C) pre!ictable an! !ivisible
") li-ui!
Answer# A
"iff# 1
(
( Principles of Pricing of Financial Assets
1) The fun!amental principle of finance is that the true or correct price of an asset e-uals the
@@@@@@@@ of all cash flows that the owner of the asset e0pects to receive !urin7 its life1
A) present value
) future value
C) pro4ecte! value
") asset value
Answer# A
"iff# 1
Topic# .1& 2rinciples of 2ricin7 of 3inancial Assets
Ob4ective# .1+ the principles that reveal how the properties of an asset affect its value% either
throu7h the !iscount rate or throu7h its e0pecte! cash flow
&) The correct price for a financial asset can be e0presse! as follows#
P C
1
1
) 1 $ r
CF
+
+
&
&
) 1 $ r
CF
+
+
'
'
) 1 $ r
CF
+
+
N
N
r
CF
) 1 $ +
where @@@@@@@@1
A) P C the price of the cash flow
) CF
t
C the financial asset in year t $t C 1% D %N)
C) N C the maturity of the financial asset
") r C the appropriate cash rate
Answer# C
Comment# The correct price for a financial asset can be e0presse! as follows#
P C
1
1
) 1 $ r
CF
+
+
&
&
) 1 $ r
CF
+
+
'
'
) 1 $ r
CF
+
+
N
N
r
CF
) 1 $ +
where
P C the prince of the financial asset6 CF
t
C the cash flow in year t $t C 1% D %N)6 N C the maturity
of the financial asset6 an!% r C the appropriate !iscount rate1
"iff# &
Ob4ective# .1) the principles of valuin7 comple0 financial assets
)
') The appropriate disco"nt rate% r% is the return that the mar5et or the consensus of investors
re-uires on the asset1 A convenient $but appro0imate) e0pression for the appropriate !iscount rate
is this# r C RR E IP E DP E MP E LP E EPP where @@@@@@@@1
A) IPC the real rate of interest% which is the rewar! for not consumin7 an! for len!in7 to other
users1
) MP C the maturity ris5 premium% which is the rewar! for ta5in7 on the ris5 of !efault in the
case of a loan or bon! or the ris5 of loss of principal for other assets1
C) LP C the li-ui!ity premium% which is the rewar! for not consumin7 an! for len!in7 to other
users1
") EPC the e0chan7eBrate ris5 premium% which is the rewar! for investin7 in an asset that is not
!enominate! in the investorFs home currency1
Answer# "
Comment# The appropriate disco"nt rate% r% is the return that the mar5et or the consensus of
investors re-uires on the asset1 A convenient $but appro0imate) e0pression for the appropriate
!iscount rate is this# r C RR E IP E DP E MP E LP E EP where
RR C the real rate of interest% which is the rewar! for not consumin7 an! for len!in7 to other
users6
IP C the inflation prei"% which is the compensation for the e0pecte! !ecline in the
purchasin7 power of the money lent to borrowers6
DP C the defa"lt ris) prei"% which is the rewar! for ta5in7 on the ris5 of !efault in the case
of a loan or bon! or the ris5 of loss of principal for other assets6
MP C the at"rity prei"% which is the compensation for len!in7 money for lon7 perio!s of
time6
LP C the li!"idity prei"% which is the rewar! for investin7 in an asset that may not be
rea!ily converte! to cash at a fair mar5et value6 an!%
EPC the e*change+rate ris) prei"% which is the rewar! for investin7 in an asset that is not
!enominate! in the investorGs home currency1
"iff# &
Ob4ective# .1& the components of an assetFs !iscount rate or re-uire! rate of return
*
() DP is the !efault ris5 premium% which is the @@@@@@@@1
A) rewar! for investin7 in an asset that may not be rea!ily converte! to cash at a fair mar5et
value1
) rewar! for ta5in7 on the ris5 of !efault in the case of a loan or bon! or the ris5 of loss of
principal for other assets1
C) compensation for len!in7 money for lon7 perio!s of time1
") rewar! for investin7 in an asset that is not !enominate! in the investorFs home currency1
Answer#
Comment# DP is the defa"lt ris) prei"% which is the rewar! for ta5in7 on the ris5 of !efault
in the case of a loan or bon! or the ris5 of loss of principal for other assets1
MP is the at"rity prei"% which is the compensation for len!in7 money for lon7 perio!s of
time1
LP is the li!"idity prei"% which is the rewar! for investin7 in an asset that may not be
rea!ily converte! to cash at a fair mar5et value1
EP is the e*change+rate ris) prei"% which is the rewar! for investin7 in an asset that is not
!enominate! in the investorGs home currency1
"iff# 1
Ob4ective# .1( how the !iscount rate is structure! to encompass the components of an assetFs ris5
)) Assume that the mar5et thin5s the real rate is &1//H% the inflation premium is &1+/H% the
bon!Fs !efault ris5 4ustifies a premium of &11/H% the maturity premium is /1)/H% an! the
li-ui!ity premium is 111/H1 ?ince the cash flows are !enominate! in euros% the forei7nBe0chan7e
rate premium is 11)/H1 What is the !iscount rate?
A) ,1./H
) .1+/H
C) .1./H
") None of these
Answer# C
Comment# We have# RR C &1//H% IP C &1+/H% DP C &1/1H% MP C /1)/H% LP C 11/1H% EP C
11)/H1 Thus% we have this value for the !iscount rate# r C &1/H E &1+H E &11H E /1)H E 111H E
11)H C 9,9-. or -,-99-1
"iff# &
+
*) ?uppose the cash flows for a bon!Fs coupon payment for years 1 throu7h ( are I1//1 That is%
CF
t
C I1// for t $t C 1% 111 %()1 3urther assume the the !iscount rate is .1//H an! at the en! of
year the bon! will pay bac5 the bon!Fs par value of I1%///1 To the nearest !ollar% what is the
correct price for this bon!?
A) I,**
) I.'&
C) I1%/1&
") I1%/'&
Answer# "
Comment# The correct price for the bon! can be e0presse! as follows#
P C
1
1
) 1 $ r
CF
+
+ ... +
N
N
r
CF
) 1 $ +
where P C the prince of thebon!6 CF
t
C the cash flow in year t $t C 1%
D % N)6 N C the maturity of the bon!6 an!% r C the appropriate !iscount rate1 :nsertin7 our 7iven
values% where CF
1
C CF
&
C CF
'
C I1//% CF
N
C CF
(
C I1%/// E I1// C I1%1// an! r C .1//H
or /1/.% we have#
P C
1
) /. 1 1 $
1// I
E
&
) /. 1 1 $
1// I
E
'
) /. 1 1 $
1// I
E
( ) /. 1 1 $
1// I
C I.11+('1 E ,(11*, E I++1&1,') E
I++.1&*++ C /10-1(,2-1
"iff# '
,
+) ?uppose the cash flows for a financial assetFs payment for years 1 throu7h ( are I1//1 That is%
CF
t
C I1// for t $t C 1% 111 %()1 3urther assume the the !iscount rate is ,1//H an! at the en! of
four years that the financial asset will pay I1%/// in a!!ition to the I1//1 3inally% assume a
bro5erFs commission of I'/ is impose! by bro5ers to buy or sell the bon!1 To the nearest !ollar%
what is the correct price for this financial asset?
A) I1%/1(
) I1%///
C) I..(
") None of these
Answer# A
P C
1
1
) 1 $ r
CF
+
+
&
&
) 1 $ r
CF
+
+
'
'
) 1 $ r
CF
+
+
(
(
) 1 $ r
CF
+
where P C the prince of the financial asset6 CF
t
C the
cash flow in year t $t C 1% D %4)6 ( years is the maturity of the financial asset6 an!% r C the
appropriate !iscount rate1 3or this case we must subtract I'/ at the be7innin7 $t C /) an! subtract
out I'/ at t C (1 :nsertin7 our 7iven values% where CF
1
C CF
&
C CF
'
C I1//% CF
(
C I1%/// E
I1// B I'/ C I1%/+/% an! r C ,1//H or /1/,% we have#
P C BI'/ E
1
) /, 1 1 $
1// I
+
&
) /, 1 1 $
1// I
+
'
) /, 1 1 $
1// I
+
(
) /, 1 1 $
1// I
C BI'/E I.&1).&). E I,)1+'',, E
I+.1','&& E I+,*1(,1. C /10-12,191
"iff# '
.
,) ?uppose the cash flows for a financial assetFs payment for years 1 throu7h ) are I,/1 That is%
CF
t
C I,/ for t $t C 1% 111 %))1 3urther assume the the !iscount rate is ,1//H an! at the en! of the
five years that the financial asset will pay bac5 I1%/// in a!!ition to the I,/1 3inally% assume a
bro5erFs commission of I'/ is impose! by bro5ers to buy or sell the financial asset an! that a
7overnment entity imposes a transfer ta0 of I&/ on each transaction1 To the nearest !ollar% what
is the correct price for this financial asset?
A) I.1&
) I.1(
C) I.1*
") I.1,
Answer# C
P C
1
1
) 1 $ r
CF
+
+
&
&
) 1 $ r
CF
+
+
'
'
) 1 $ r
CF
+
+
(
(
) 1 $ r
CF
+
+
)
)
) 1 $ r
CF
+
where P C the prince of the financial asset6
CF
t
is the cash flow in year t $t C 1% D %5)6 ) years is the maturity of the financial asset6 an!% r is
the appropriate !iscount rate1 3or this case we must subtract I'/ an! I&/ at the be7innin7 $t C /)
an! also subtract out I'/ an! I&/ at t C )1 :nsertin7 our 7iven values% where CF
1
C CF
&
C CF
'
C
CF
(
CI,/% CF
)
C I1%/// EI,/ B I'/ B I&/ C I1%/'/% an! r C ,1//H or /1/,% we have#
P C BI'/ BI&/ E
1
) /, 1 1 $
,/ I
+
&
) /, 1 1 $
,/ I
+
'
) /, 1 1 $
,/ I
+
(
) /, 1 1 $
,/ I
+
)
) /, 1 1 $
/'/ % 1 I
C BI'/ BI&/ E I+(1/+(1 E
I*,1),+1 E I*'1)/** E I),1,/&( E I+/11///+ C /913,941

"iff# '
1/
.) ?uppose the cash flows for a financial assetFs payment for years 1 throu7h ) are I./1 That is%
CF
t
C I./ for t $t C 1% 111 %))1 3urther assume the the !iscount rate is +1//H an! at the en! of the
five years that the financial asset will pay bac5 I1%/// in a!!ition to the I./1 3inally% assume a
bro5erFs commission of I(/ is impose! by bro5ers to buy or sell the financial asset an! that a
7overnment entity imposes a transfer ta0 of I&) on each transaction1 To the nearest !ollar% what
is the correct price for this financial asset?
A) I.*&
) I.+1
C) I.,*
") I1%//&
Answer#
P C
1
1
) 1 $ r
CF
+
+
&
&
) 1 $ r
CF
+
+
'
'
) 1 $ r
CF
+
+
(
(
) 1 $ r
CF
+
+
)
)
) 1 $ r
CF
+
where P C the prince of the financial
asset6 CF
t
is the cash flow in year t $t C 1% D %5)6 ) years is the maturity of the financial asset6
an!% r is the appropriate !iscount rate1 3or this case we must subtract I(/ an! I&) at the
be7innin7 $t C /) an! also subtract out I'/ an! I&/ at t C )1 :nsertin7 our 7iven values% where
CF
1
C CF
&
C CF
'
C CF
(
CI./% CF
)
C I1%/// EI./ B I(/ B I&) C I1%/&)% an! r C +1//H or
/1/+% we have#
P C BI(/ BI&) E
1
) /+ 1 1 $
./ I
E
&
) /+ 1 1 $
./ I
E
'
) /+ 1 1 $
./ I
E
(
) /+ 1 1 $
./ I
E
)
) /+ 1 1 $
/&) % 1 I
C BI(/ BI&) E I,(111&1
E I+,1*/.) E I+'1(**, E I*,1**/* E I+'/1,1/, C /94-,551
"iff# '
1/) ?uppose that a bon! is 7rante! a favorable ta0 treatment such that the interest an! any capital
7ain from this bon! woul! not be ta0e!1 ?uppose that the mar7inal ta0 rate on otherwise
e-uivalent ta0able bon!s is &)H an! the appropriate !iscount rate is +H1 What is the afterBta0
!iscount rate?
A) )1&)H
) )1')H
C) )1*)H
") )1+)H
Answer# A
Comment# The afterBta0 !iscount rate is# preta0 !iscount rate J $1 B mar7inal ta0 rate) C /1/. J $1
B /1&)) C /1/)&)// C 3,(3.1
"iff# &
11
11) Althou7h we use a sin7le !iscount rate to !iscount each cash flow% there are theoretical
reasons that su77est this is @@@@@@@@1
A) not practical1
) always correct but not practical1
C) suitable1
") inappropriate1
Answer# "
"iff# 1
1&) The appropriate @@@@@@@@ can often be appro0imate! as the sum of rewar!s for the various
ris5s an asset poses to its buyer1
A) rewar! premium
) !iscount rate
C) ris5 premium
") coupon rate
Answer#
"iff# &
1 Price 6olatility of Financial Assets
1) A fun!amental principle is that a financial assetFs price chan7es in @@@@@@@@1
A) the same !irection of the chan7e in the re-uire! rate of return1
) the same !irection of the chan7e in the re-uire! yiel!1
C) un5nown an! unpre!ictable ways compare! to the chan7e in the re-uire! yiel!1
") the opposite !irection of the chan7e in the re-uire! rate of return or the re-uire! yiel!1
Answer# "
"iff# 1
Topic# .1' 2rice Kolatility of 3inancial Assets
Ob4ective# .1* the inverse relationship between an assetFs price an! its !iscount rate
&) The @@@@@@@@ of a financial asset to a chan7e in the re-uire! yiel! will not be the same for all
assets1
A) price in!ifference
) price insensitivity
C) price sensitivity
") cash flow sensitivity
Answer# C
"iff# &
Ob4ective# .1, what factors affect the price sensitivity of a financial asset to chan7es in interest
rates
1&
') When we refer to chan7es in the re-uire! yiel!% it is convenient to measure a chan7e in yiel!
in terms of what mar5et participants refer to as @@@@@@@@1
A) a basis mo!ification rather than a yiel! mo!ification1
) a yiel! mo!ification rather than in terms of a basis mo!ification1
C) a percenta7e chan7e rather than a basis point1
") a basis point rather than in terms of a percenta7e chan7e1
Answer# "
Comment# When we refer to chan7es in the re-uire! yiel!% it is convenient to measure a chan7e
in yiel! in terms of what mar5et participants refer to as a basis point rather than in terms of a
percenta7e chan7e1
"iff# &
Ob4ective# .1' what is meant by a basis point
() Which of the below statements is T<=9?
A) 3ifty basis points are e-ual to oneBfifth percenta7e point% an! a yiel! chan7e from .H to .1&H
represents a )/ basis point chan7e in yiel!1
) One basis point is !efine! as /1///1% or e-uivalently% /1/1H1
C) A yiel! chan7e from +H to +1)H is a /1)/ basis point chan7e1
") A yiel! chan7e from *H to ,1')H is a &%')/ basis point chan7e in yiel!1
Answer#
Comment# One basis point is !efine! as /1///1% or e-uivalently% /1/1H1 Therefore% 1-- basis
points are e-ual to one percentage point% an! a yiel! chan7e from 9. to 1-. represents a 1--
basis point change in yield1 A yiel! chan7e from +H to +1)H is a 3- basis point change% an! a
yiel! chan7e from *H to ,1')H is a (13 basis point chan7e in yiel!1
"iff# &
Ob4ective# .1' what is meant by a basis point
)) 3or two bon!s with the same maturity an! with the same re-uire! yiel!% the lower the coupon
rate% the 7reater the price responsiveness for a 7iven chan7e in the re-uire! yiel!1 This is an
e0ample of @@@@@@@@ affectin7 a bon!Fs price sensitivity1
A) a bon!Fs maturity
) a bon!Fs coupon rate
C) a bon!Fs principal
") a chan7e in 3e! policy
Answer#
"iff# &
rates
1'
*) This measure of price sensitivity is popularly referre! to as @@@@@@@@1
A) basis point sensitivity1
) value sentiment1
C) !uration1
") saturation1
Answer# C
"iff# 1
Ob4ective# .1. what !uration means% an! how it is relate! to the price sensitivity of an asset to a
chan7e in interest rates
+) Appro0imate percenta7e chan7e in a financial assetFs price e-uals what?
A) :t e-uals B"uration 0 $Liel! chan7e in !ecimal forms) 0 1//1
) :t e-uals MB"uration N $Liel! chan7e in !ecimal forms)O 0 1//1
C) :t e-uals B"uration 0 M$Liel! chan7e in !ecimal forms) N 1//O1
") :t e-uals E"uration 0 $Liel! chan7e in !ecimal forms) 0 1//1
Answer# A
"iff# &
,) ?uppose that the re-uire! yiel! on a *H coupon% 1&Byear bon! increases from 1/H to 11H
$/1/1 in !ecimal form)1 :f this bon!Fs !uration is ,1.*% what is the appro0imate percenta7e chan7e
in price?
A) B(1(,H
) E+1(,H
C) B,1.*H
") E.1,*H
Answer# C
Comment# The appro0imate percenta7e chan7e in a financial assetGs price C B"uration J $Liel!
chan7e in !ecimal forms) J 1//1 :nsertin7 in our values% we 7et# appro0imate percenta7e chan7e
in price CB,1.* 0 $/1/1) 0 1// C+7,95.1
"iff# &
1(
.) Assume the price of a coupon bon! is I*)/1 3urther assume that if the yiel! is increase! by )/
basis points% then the price woul! be I*&/ an! if the yiel! is !ecrease! by )/ basis points% then
the price woul! be I+//1 What is the !uration?
A) about 1&1'
) about 1&1,
C) about 1'1'
") about 1'1*
Answer# A
Comment# We have these values# Py C /1//)% P
/
C I*)/% P_ C I+//% an! PEC I*&/1 The
!uration $or appro0imate percenta7e price chan7e for a 1// basis point chan7e in yiel!) is
) $ &
) $
/
y P
P P
+
.:nsertin7 in our values% we 7et#
) //) 1 / )$ *)/ $I &
) *&/ I +// $I
C 1(,111
"iff# &
1/) Which of the below statements is 3AQ?9?
A) The importance of bein7 able to measure the sensitivity of an in!ivi!ual asset% a portfolio of
assets% an! a liability cannot be overemphasiAe!1
) To control interest rate ris5% it is necessary to be able to measure it1
C) An investor with a portfolio of assets wants to be able to measure her e0posure to interest rate
chan7es in or!er to assess whether or not the e0posure is acceptable1 :f it is not% she can alter the
e0posure1
") When a !uration is calculate! un!er the assumption that the cash flows !o not chan7e when
interest rates chan7e% the resultin7 !uration is calle! effective !uration1
Answer# "
Comment# When a !uration is calculate! un!er the assumption that the cash flows !o not chan7e
when interest rates chan7e% the resultin7 !uration is calle! odified d"ration1 :n contrast% a
!uration calculate! assumin7 that the cash flow chan7es when interest rates chan7e is calle!
effective d"ration1 The !ifference between mo!ifie! !uration an! effective !uration for some
assets can be -uite !ramatic1
"iff# &
TrueN3alse Questions
1)
1) A useful way to thin5 of li-ui!ity an! illi-ui!ity% propose! by 2rofessor Rames Tobin% is in
terms of how much sellers stan! to lose if they wish to sell imme!iately as a7ainst en7a7in7 in a
costly an! timeBconsumin7 search1
Answer# T<=9
"iff# 1
&) Ta0 rates are constant from year to year% from country to country% an! even amon7 municipal
units within a country $as with state an! local ta0es in the =nite! ?tates)1
Answer# 3AQ?9
Comment# Ta0 rates differ from year to year% from country to country% an! even amon7
municipal units within a country $as with state an! local ta0es in the =nite! ?tates)1
"iff# 1
') A financial asset has many properties% an! each affects the assetFs value in a similar an!
important way1
Answer# 3AQ?9
Comment# A financial asset has many properties% an! each affects the assetGs value in a
distinctive an! important way1
"iff# 1
() ?ome properties are intrinsic to the asset% such as its maturity or promise! cash flow1
Answer# T<=9
"iff# 1
1*
1) The price of a comple0 asset is the sum of the prices of its component parts1
Answer# T<=9
"iff# 1
&) The price of an asset moves in the same !irection of a chan7e in its !iscount rate1
Answer# 3AQ?9
Comment# The price of an asset moves in the opposite !irection of a chan7e in its !iscount rate1
"iff# 1
Ob4ective# .1* the inverse relationship between an assetFs price an! its !iscount rate
') An assetFs price is the present value of its e0pecte! cash flows% !iscounte! at an appropriate
rate1
Answer# T<=9
"iff# 1
() The conversion privile7e of a convertible bon! is not value! by the mar5et1
Answer# 3AQ?9
Comment# The conversion privile7e of a convertible bon! is val"ed by the mar5et 1
"iff# 1
1) The term duration was first use! in 1.', by 3re!eric5 Macaulay as a measure of the wei7hte!
avera7e time to maturity of a bon!1
Answer# T<=9
"iff# 1
1+
&) :t is important to be able to measure the price sensitivity of an asset or liability to interest rate
chan7es an! the appropriate measure is the mo!ifie! !uration1
Answer# 3AQ?9
Comment# :t is important to be able to measure the price sensitivity of an asset or liability to
interest rate chan7es an! the appropriate measure is the effective d"ration1
"iff# 1
') The lar7er an assetFs coupon rate% the 7reater its price sensitivity to a chan7e in the !iscount
rate% other thin7s bein7 constant1
Answer# 3AQ?9
Comment# &he longer an asset8s at"rity0 the 7reater its price sensitivity to a chan7e in the
!iscount rate% other thin7s bein7 constant1
The lar7er an assetGs coupon rate% the lo9er its price sensitivity to a change in the disco"nt
rate0 if all else is the sae,
"iff# &
rates
() 3actors that influence an assetFs price sensitivity inclu!e its maturity% its coupon rate% an! the
initial level of the re-uire! yiel!1
Answer# T<=9
"iff# 1
1,
9ssay Questions
1) :t shoul! be un!erstoo! that even a financial asset with a state! maturity may terminate before
its state! maturity1 This may occur for several reasons1 "escribe some of these reasons1
Answer# <easons for the termination of a financial asset inclu!e ban)r"ptcy or reorganization1
:n a!!ition% a financial asset $li5e a bon!) may have a call provisions entitlin7 the !ebtor to
repay in a!vance% usually at some penalty an! only after a number of years from the time of
issuance1 ?ometimes the investor may have the privile7e of as5in7 for early repayment1 This
feature is calle! a p"t option1 ?ome assets have maturities that may be increased or e*tended at
the !iscretion of the issuer or the investor1 3or e0ample% the 3rench 7overnment issues a si0Byear
obligation renouvelable du Trsor% which allows the investor% after the en! of the thir! year% to
switch into a new si0Byear !ebt1 ?imilar bon!s are issue! by the ritish 7overnment1
"iff# '
&) 3or financial assets tra!e! with mar5et ma5ers% the most relevant component of roun!Btrip
cost is the bi!Bas5 sprea!1 The sprea! char7e! by a mar5et ma5er varies sharply from one
financial asset to another% reflectin7 primarily the amount of ris5 the mar5et ma5er is assumin7
by >ma5in7> a mar5et1 This ar)et+a)ing ris) can be relate! to two main forces1 "escribe
these t9o forces or !eterminants of this ris51
Answer# #ne force is the variability of the price as measure!% say% by some measure of
!ispersion of the relative price over time1 The 7reater the variability% the 7reater the probability of
the mar5et ma5er incurrin7 a loss in e0cess of a state! boun! between the time of buyin7 an!
resellin7 the financial asset1 The variability of prices !iffers wi!ely across financial assets1
Treasury bills% for e0ample% have a very stable price% while a speculative stoc5 will e0hibit much
lar7er shortBrun variations1
The second deterining factor of the bi!Sas5 sprea! char7e! by a mar5et ma5er is what is
commonly referre! to as the ti!"ness o# te $ar"et# by this is meant essentially the prevailin7
rate at which buyin7 an! sellin7 or!ers reach the mar5et ma5er $that is% the fre-uency of
transactions)1 A tin $ar"et is one that has few tra!es on a re7ular or continuin7 basis1 Clearly%
the 7reater the fre-uency of or!er flows% the shorter the time that the security will have to be hel!
in the mar5et ma5erFs inventory% an! hence the smaller the probability of an unfavorable price
movement while hel!1
"iff# '
1.
1) ?uppose that you have a bon! issue! by a Terman firm an! that all payments are in euros for
the maturity of the bon! which is four years1 Why is the cash flow in =1?1 !ollars that you will
receive as a =1?1 investor un!ertain? :n your answer illustrate the uncertainty in terms of an
e0chan7e rate premium an! the appropriate !iscount rate1
Answer# The cash flow in =1?1 !ollars that a =1?1 investor will receive is uncertain because the
!ollarBeuro e0chan7e rate will fluctuate over the four years1 ?uppose that the mar5et assi7ns an
e0chan7e premium of 'H1 This means that the appropriate !iscount rate increases from .H to
1&H1 To continue with the effect of currency ris5% suppose that imme!iately after the purchase of
this bon! the mar5et e0pects that the e0chan7e rate between the =1?1 !ollar an! the euro will
become more volatile1 The mar5et will a!4ust for this by increasin7 the forei7n currency ris5
premium% which% in turn% increases the appropriate !iscount rate an! !ecreases the price1
"iff# '
&) "efine what we mean by >an appropriate !iscount rate>1 "escribe four of the si0 components
that ma5e up this rate1
Answer# The appropriate disco"nt rate% r% is the return that the mar5et or the consensus of
investors re-uires on the asset1 A convenient $but appro0imate) e0pression for the appropriate
!iscount rate can be e0presse! in terms of si0 components1 This is shown below#
r C RR E IP E DP E MP E LP E EP where
<< C the real rate of interest% which is the rewar! for not consumin7 an! for len!in7 to other
users
:2 C the inflation prei"% which is the compensation for the e0pecte! !ecline in the
purchasin7 power of the money lent to borrowers
"2 C the defa"lt ris) prei"% which is the rewar! for ta5in7 on the ris5 of !efault in the case
of a loan or bon! or the ris5 of loss of principal for other assets
M2 C the at"rity prei"% which is the compensation for len!in7 money for lon7 perio!s of
time
Q2 C the li!"idity prei"% which is the rewar! for investin7 in an asset that may not be
rea!ily converte! to cash at a fair mar5et value
92C the e*change+rate ris) prei"% which is the rewar! for investin7 in an asset that is not
!enominate! in the investorFs home currency1
"iff# '
&/
1) An assetFs maturity is a factor that affects its price sensitivity to a chan7e in yiel!1 :n fact% a
bon!Fs price sensitivity to a chan7e in the !iscount rate is positively relate! to the bon!Fs
maturity1 Consi!er the case of two bon!s that have the same coupon rate% an! the same re-uire!
yiel! but !ifferent maturities1 :f the re-uire! rate were to chan7e% the price sensitivity of the bon!
with the lon7er maturity woul! be 7reater than that of the bon! with the shorter maturity1 Tive an
illustration of this1
Answer# An illustration of this lin5 between maturity an! price chan7e appears in Table .B&%
which shows the price of a bon! that pays I)/ annually an! I1%/// at maturityUa )H coupon
rateUfor various maturities an! !iscount rates1 Table .B'% which is base! on Table .B&% shows the
!ifferences across maturities in a bon!Fs !ollar price !ecline an! percenta7e price !ecline for an
increase in the !iscount rate of 1// basis points1 3or e0ample% if the !iscount rate rises from .H
to 1/H% the price of a fourByear bon! falls from I,+/1(1 to I,(11)1% which represents a price
!ecline of I&,1./ an! a percenta7e price !ecline of '1'&H1 :n contrast% a similar rise in the
!iscount rate causes the price of a &/Byear bon! to fall consi!erably more% from I*'(1,* to
I)+(1'&% which represents a price !ecline of I*/1)( an! a percenta7e price !ecline of .1)(H1
"iff# '
rates
&) 90plain the !ifference between mo!ifie! !uration an! effective !uration1 :n your also 7ive an
e0ample of when the !ifference can be !ramatic1
Answer# When a !uration is calculate! un!er the assumption that the cash flows !o not chan7e
when interest rates chan7e% the resultin7 !uration is calle! odified d"ration1 :n contrast% a
!uration calculate! assumin7 that the cash flow chan7es when interest rates chan7e is calle!
effective d"ration1 The !ifference between mo!ifie! !uration an! effective !uration for some
assets can be -uite !ramatic1 3or e0ample% with some of the more comple0 financial instruments%
the mo!ifie! !uration coul! be four while the effective !uration coul! be &)1 This means that an
investor mi7ht believe that the price of the asset will chan7e by appro0imately (H for a 1//
basis point chan7e in interest rates $mo!ifie! !uration) when% in fact% it woul! chan7e by
appro0imately &)H for a 1// basis point chan7e in interest rates $effective !uration)1
"iff# '
rates
&1

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Foundations of Financial Markets and Institutions, 4e (Fabozzi/Modigliani/Jones)

Chapter 9 Properties and Pricing of Financial Assets

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