Finance Exam Questions on Bonds and Interest Rates

Section A: Compulsory

a) Exactly one year ago you bought a 7% coupon bond with a face value of €100 and 4 years to maturity for a price of €97.34. The bond pays interest annually. In the meantime the yield to maturity for the bond has changed to 6%. If you sold the bond today what would have been your rate of return over the past year?  (5 marks) 

b) The current interest rates (yield to maturity) on one- to five-year bonds are 3.85%, 3.60%, 3.50%, 3.35% and 3.15%. Predict what the one-year interest rate will be three years from now if the term premiums for one- to five year bonds are 0%, 0.15%, 0.20%, 0.25% and 0.30%.  (5 marks) 

c) Using supply and demand analysis, demonstrate how the business cycle affects bond prices and hence interest rates.   (5 marks) 

d) Briefly describe two monetary policy tools used by the ECB.   (5 marks) 

e) In the context of equity market investment, what is meant by an ETF? Briefly outline the reasons for the growth in this product as a means to invest in the equity markets.   (5 marks) 

Total 25 marks 

Part a 
Calculate the Duration of a €1,000 four-year 3.5% coupon bond when the market interest rate (yield to maturity) is 4%. The bond pays interest annually. Using the calculated duration estimate the approximate change in the bond price if the market interest rate increases to 4.50%. 
Explain how the duration of a bond is affected by the coupon rate. What does this relationship tell you about the important link between a bond’s coupon and its interest rate sensitivity?   (9 marks) 

Part b 
Outline the impact of a change in expected inflation on the demand and supply for bonds? What does this relationship tell you about the relationship between expected inflation and bond yields?   (6 marks) 

Part c 
Explain the Expectations Theory of the term structure of interest rates. Are there facts about the term structure that the expectations theory helps explain? Outline any alterations that may be needed to the Expectations Theory in order to provide a more complete explanation  of the term structure of interest rates?   (10 marks) 

Total 25 marks 

Part a 
Some economists argue that the slope of the yield curve is a good predictor of future economic activity. What may explain the yield curve’s predictive power? Outline any evidence of which you are aware on the strength of the relationship between the shape of the yield curve and future economic activity.   (7 marks) 

Part b 
It is argued that the presence of moral hazard in financial markets influences firms’ choices between debt and equity contracts and the observed features of the financial structure of debt markets. Explain why this may be the case? What tools or features of financial markets and 
institutions can help to solve the problems associated with moral hazard?    (10 marks) 

Part c 
Outline how the mismanagement of financial liberalisation and innovation can play a leading role in the initiation of a financial crisis. Explain how such mismanagement may lead to the subsequent three stages of a financial crisis as they have tended to subsequently unfold in advanced economies.   (8 marks) 

Total 25 marks