Question

Which of the following would be correct assuming that interest rates decrease?

A. The price of a bond will decrease while the reinvestment income will increase.

B. The price of a bond will decrease while the reinvestment income will decrease.

C. The price of a bond will increase while the reinvestment income will decrease.

D. The price of a bond will increase while the reinvestment income will increase.

E. none of the above is correct.

Which of the following is a false
statement?

A. The yield to maturity is also known as the total return for a bond.

B. The yield to maturity is also known as the internal rate of return of a bond.

C. The yield to maturity is composed of the capital gain yield and the current yield.

D. The yield to maturity assumes that the intermediate cash flows are invested at the YTM.

E. The yield to maturity assumes that the intermediate cash flows are invested at the current market rate of return.

Answer 1

Q1

The Bond Price of a bond, P = ∑(C_n / (1+YTM)^t)+ F / (1+YTM)^t

where C= coupon payments

YTM is yield to maturity or interest rate required

F is face value (or redemption value)

t is no. of periods

Assuming fall in interest rates,

Option A and Option B are wrong since the denominator is decreasing, therefore overall value of bond prices should increase.

Option C is correct as due to decrease in denominator, bond price will increase. Also, reinvestment rate of the coupons received will generate lesser income in other assets due to fall in market interest rates.

Option D is wrong as reinvestment income will not increase with decrease in market interest rates.

Q2

The Bond Price of a bond, P = ∑(C_n / (1+YTM)^t)+ F / (1+YTM)^t

where C= coupon payments

YTM is yield to maturity or interest rate required

F is face value (or redemption value)

t is no. of periods

Option A is wrong because YTM is also called total return of the bond as it takes into account all the income (coupon as well as redemption) and amount invested in buying the bond.

Option B is wrong because YTM is the required return at which present value of all future cash flows is equal to the price of the bond, therefore ) net present value (NPV). Internal rate is the return where NPV = 0.

Option C is wrong because YTM is the yield calculated using both coupon as well as redemption cashflows, i.e., Current yield and Capital gain yield.

Option D is wrong because YTM assumes the coupon payments (or intermediate payments) are reinvested at YTM rate.

Option E is correct because YTM doesn't assume that the coupon payments (or intermediate payments) are reinvested at current market interest rates.

*** Option is a false statement therefore it is correct