Question

23 Which of the following statements about duration is INCORRECT? a) Duration measures the average time between now and the time a bond's cash flows occur b) Bonds with longet duration have greater default risk c) The higher the face value the longer the duration, everything else equal d) The higher the coupon rate the lower the interest rate risk, everything else equal. (2 Marks) 24. Which of the following about yield to maturity (YTM) is incorrect? a) YTM may not be equal to the actual return to a bond holder b) YTM is determined in the bond market c) YTM is the effective rate of return to a bond investor upon exiting the investment d) YTM of a bond keeps changing over time (2 Marks) 25. Which of the followng statements about banking business is INCORRECT? Taking deposits and making loans is a basic banking business a) c) Facilitating payment is a basic banking business d) Investment banking business generates profits from returns to investments (2 Marks)

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Answer 1

23. (b) Bonds with longer duration have greater default risk

Default risk is the risk that the borrower will not be able to repay the debt.

The correct statement is Bonds with longer duration have greater interest rate risk. Interest rate risk is the risk that the investments will yield lesser return due to interest rate changes.

A bond whose duration is short will repay its 'true-cost' faster than the bond whose duration is longer.

Thus, the longer the maturity, the higher the duration, and the greater the interest rate risk.

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24. (c) YTM is the effective rate of return to a bond investor upon exiting the investment.

This is incorrect because YTM is the expected rate of return that the investor will earn if the bond is held till its maturity (and not if investment is exited before maturity).

Further, YTM may not be actual return to bondholder, as actual return is the coupon amount received and the capital gains on the bond at the time of sale or redemption. So, option (a) is correct.

Option (b) is self explanatory.

Option (d) is correct because as the market interest rates change for similar securities, the YTM also keeps changing in line with them.

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25. (d) Investment banking business generates profits from returns to investments.

Investment banks are intermediaries between investors and businesses which need capital to grow. They undertake capital raising activities including underwriting, mergers and acquisitions appraisals, finding right investors and investment options, and providing advisory services.

Thus option (b) is correct. Also Option (a) and (c) are also correct (self explanatory).