Chap 006
Short Description
FINMAN...
Description
Chapter 006 Valuing Bonds
True / False Questions 1. A bond's payment at the maturity is referred to as its face value. TRUE
AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Easy Learning Objective: 6-1
2. When the market interest rate exceeds the coupon rate, bonds sell for less than face value to provide enough compensation to investors. TRUE
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
3. Current yield overstates the return of premium bonds since investors who buy a bond at a premium face a capital loss over the life of the bond. TRUE
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
4. A bond's rate of return is equal to its coupon payment divided by the price paid for the bond. FALSE
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1
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5. A Treasury bond's bid price will be lower than the ask price. TRUE
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1
6. A long-term investor would more likely be interested in current yield than internal rate of return. FALSE
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1
7. Bonds selling at a premium price offer a higher current yield (which overstates the true return)than bonds selling at par value. TRUE A bond that is priced above its face value is said to sell at a premium. Investors who buy a bond at a premium face a capital loss over the life of the bond, so the return on these bonds is always less than the bond's current yield. A bond priced below face value sells at a discount. Investors in discount bonds face a capital gain over the life of the bond; the return on these bonds is greater than the current yield: Because it focuses only on current income and ignores prospective price increases or decreases, the current yield does not measure the bond's total rate of return. It overstates the return of premium bonds and understates that of discount bonds.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Easy Learning Objective: 6-2
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8. Speculative-grade bonds have default risk; investment grade bonds do not. FALSE
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-4
9. TIPS are unlike most bonds in that their cash flows increase when the national unemployment rate increases. FALSE
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10. "Ask Yields" can be guaranteed only to investors who buy a bond and hold it until maturity. TRUE
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11. It would be realistic to read an "Ask Price" listed as 100:16 and a "Bid Price" of 100:18. FALSE
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1
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12. Indexed bonds were completely unknown in the United States till 1997 when the U.S. Treasury began to issue inflation-indexed bonds known as Treasury Inflation-Protected Securities, or TIPS. FALSE Indexed bonds were not completely unknown in the United States before 1997. For example, in 1780 American Revolution soldiers were compensated with indexed bonds that paid the value of "five bushels of corn, 68 pounds and four-sevenths part of a pound of beef, ten pounds of sheep's wool, and sixteen pounds of sole leather."
AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Medium Learning Objective: 6-3
13. The current yield measures the bond's total rate of return. FALSE
AACSB: Reflective Thinking Skills Bloom's: Understanding Learning Objective: 6-1
14. When a financial calculator or spreadsheet program finds a bond's yield to maturity, it uses a trial-and-error process. TRUE
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Chapter 006 Valuing Bonds 15. Even when the yield curve is upward-sloping, investors might rationally stay away from long-term bonds. TRUE
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
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16. Bonds with a rating of Ba or below by Moody's are referred to as speculative grade, highyield, or junk bond. TRUE
AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Medium Learning Objective: 6-4
17. Bonds rated BBB or above by Standard & Poor's are called investment grade. TRUE
AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Medium Learning Objective: 6-4
18. Bonds rated Ba by Moody's are of the same safety of the bonds rated BB by Standard & Poor's. TRUE
AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Medium Learning Objective: 6-4
19. Zero-coupon bonds are issued at prices considerably below face value, and the investor's return comes from the difference between the purchase price and the payment of face value at maturity. TRUE
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
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20. Catastrophe bonds (or Cat bonds) promise relatively high returns, and the payments on the bond are increased if a specified type of disaster occurs. FALSE
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21. Credit risk implies that the promised yield to maturity on the bond is higher than the expected yield. TRUE
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Easy Learning Objective: 6-4
22. Bond ratings measure the bond's credit risk. TRUE
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Easy Learning Objective: 6-4
Multiple Choice Questions
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Chapter 006 Valuing Bonds 23. The coupon rate of a bond equals: A. its yield to maturity. B. a percentage of its face value. C. the maturity value. D. a percentage of its price.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1
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24. Periodic receipts of interest by the bondholder are known as: A. the coupon rate. B. a zero-coupon. C. coupon payments. D. the default premium.
AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Easy Learning Objective: 6-1
25. Which of the following presents the correct relationship? As the coupon rate of a bond increases, the bond's: A. face value increases. B. current price decreases. C. interest payments increase. D. maturity date is extended.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Easy Learning Objective: 6-1
26. What happens when a bond's expected cash flows are discounted at a rate lower than the bond's coupon rate? A. The price of the bond increases. B. The coupon rate of the bond increases. C. The par value of the bond decreases. D. The coupon payments will be adjusted to the new discount rate.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
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27. When an investor purchases a $1,000 par value bond that was quoted at 97.16, the investor: A. receives 97.5% of the stated coupon payments. B. receives $975 upon the maturity date of the bond. C. pays 97.5% of face value for the bond. D. pays $1,025 for the bond.
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28. How much does the $1,000 to be received upon a bond's maturity in four years add to the bond's price if the appropriate discount rate is 6%? A. $209.91 B. $260.00 C. $760.00 D. $792.09 $1,000/(1.06)4 = $792.09
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29. The numerator of the rate of return formula for bond consists of the following: A. coupon income. B. bond price change. C. both A and B. D. neither A nor B.
AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Easy Learning Objective: 6-2
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30. How much should you pay for a $1,000 bond with 10% coupon, annual payments, and five years to maturity if the interest rate is 12%? A. $ 927.90 B. $ 981.40 C. $1,000.00 D. $1,075.82
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31. How much would an investor expect to pay for a $1,000 par value bond with a 9% annual coupon that matures in 5 years if the interest rate is 7%? A. $696.74 B. $1,075.82 C. $1,082.00 D. $1,123.01
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32. Which of the following statements is correct for a 10% coupon bond that has a current yield of 7%? A. The face value of the bond has decreased. B. The bond's maturity value exceeds the bond's price. C. The bond's internal rate of return is 7%. D. The bond's maturity value is lower than the bond's price.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
33. If an investor purchases a bond when its current yield is higher than the coupon rate, then the bond's price will be expected to: A. decline over time, reaching par value at maturity. B. increase over time, reaching par value at maturity. C. be less than the face value at maturity. D. exceed the face value at maturity.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Hard Learning Objective: 6-2
34. The current yield of a bond can be calculated by: A. multiplying the price by the coupon rate. B. dividing the price by the annual coupon payments. C. dividing the price by the par value. D. dividing the annual coupon payments by the price.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1
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35. What is the current yield of a bond with a 6% coupon, four years until maturity, and a price of $750? A. 6.0% B. 8.0% C. 12.0% D. 14.7% $60/750 = 8%
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36. A bond's par value can also be called its: A. coupon payment. B. present value. C. default value. D. face value
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37. A bond's yield to maturity takes into consideration: A. current yield but not price changes of a bond. B. price changes but not current yield of a bond. C. both current yield and price changes of a bond. D. neither current yield nor price changes of a bond.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1
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38. The discount rate that makes the present value of a bond's payments equal to its price is termed the: A. rate of return. B. yield to maturity. C. current yield. D. coupon rate.
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39. What is the coupon rate for a bond with three years until maturity, a price of $1,053.46, and a yield to maturity of 6%? A. 6% B. 8% C. 10% D. 11%
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40. What is the yield to maturity for a bond paying $100 annually that has six years until maturity and sells for $1,000? A. 6.0% B. 8.5% C. 10.0% D. 12.5%
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41. What happens to the price of a three-year bond with an 8% coupon when interest rates change from 8% to 6%? A. A price increase of $51.54 B. A price decrease of $51.54 C. A price increase of $53.47 D. No change in price
This represents a price change of $53.47, since the bond had sold for par.
AACSB: Reflective Thinking Skills Bloom's: Application Difficulty: Medium Learning Objective: 6-3
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42. Which of the following factors will change when interest rates change? A. The expected cash flows from a bond B. The present value of a bond's payments C. The coupon payment of a bond D. The maturity value of a bond
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43. What happens to the coupon rate of a bond that pays $80 annually in interest if interest rates change from 9% to 10%? A. The coupon rate increases to 10%. B. The coupon rate remains at 9%. C. The coupon rate remains at 8%. D. The coupon rate decreases to 8%.
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44. Which of the following is fixed (e.g., cannot change) for the life of a given bond? A. Current price. B. Current yield. C. Yield to maturity. D. Coupon rate.
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45. What is the rate of return for an investor who pays $1,054.47 for a three-year bond with a 7% coupon and sells the bond one year later for $1,037.19? A. 5.00% B. 5.33% C. 6.46% D. 7.00% Rate of Return = ($70.00 - $17.28)/$1,054.47 = $52.72/$1,054.47 = 5%
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46. Which of the following is correct when a bond investor's rate of return for a particular period equals the bond's coupon rate? A. The bond increased in price during the period. B. The bond decreased in price during the period. C. The coupon payment increased during the period. D. The bond price remained unchanged during the period.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
47. What is the relationship between an investment's rate of return and its yield to maturity for an investor that does not hold a bond until maturity? A. Rate of return is lower than yield to maturity. B. Rate of return is higher than yield to maturity. C. Rate of return equals yield to maturity. D. There is no predetermined relationship.
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48. If the coupon rate is lower than current interest rates, then the yield to maturity will be: A. lower than current interest rates. B. equal to the coupon rate. C. higher than the coupon rate. D. lower than the coupon rate.
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49. If a four year bond with a 7% coupon and a 10% yield to maturity is currently worth $904.90, how much will it be worth one year from now if interest rates are constant? A. $ 904.90 B. $ 925.39 C. $ 947.93 D. $1,000.00
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50. What price will be paid for a U.S. Treasury bond with an ask price of 135:20? A. $1,350.20 B. $1,350.31 C. $1,350.63 D. $1,356.25
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51. What price was reported in the financial press for a bond that was sold to an investor for $1,045.63? A. 95:14 B. 95:44 C. 104:18 D. 104:56
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Chapter 006 Valuing Bonds 52. How does a bond dealer generate profits when trading bonds? A. By maintaining bid prices lower than ask prices B. By maintaining bid prices higher than ask prices C. By retaining the bond's next coupon payment D. By lowering the bond's coupon rate
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53. Which of the following is correct for a bond priced at $1,100 that has ten years remaining until maturity, and a 10% coupon, with semiannual payments? A. Each payment of interest equals $50. B. Each payment of interest equals $55. C. Each payment of interest equals $100. D. Each payment of interest equals $110.
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54. The yield curve depicts the current relationship between: A. bond yields and default risk. B. bond maturity and bond ratings. C. bond yields and maturity. D. promised yields and default premiums.
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55. When the yield curve is upward-sloping, then: A. short-maturity bonds offer high coupon rates. B. long-maturity bonds are priced above par value. C. short-maturity bonds yield less than long-maturity bonds. D. long-maturity bonds increase in price when interest rates increase.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Easy Learning Objective: 6-2
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56. U.S. Treasury bond yields do not contain a: A. coupon interest payment. B. nominal interest rate. C. default premium. D. yield to maturity.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Easy Learning Objective: 6-4
57. When riskier corporations issue bonds that include a default premium, the promised yield will sometimes be: A. less than the actual yield. B. greater than the actual yield. C. less than the yield on a default-free bond. D. greater than the face value of the bond.
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58. The purpose of a floating-rate bond is to: A. save interest expense for corporate issuers. B. avoid making interest payments until maturity. C. shift the yield curve. D. offer rates adjusted to current market conditions.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-3
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59. Which of the following would not be associated with a zero-coupon bond? A. Yield to maturity B. Discount bond C. Current Yield D. Interest-rate risk
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60. Which of the following bonds would be likely to exhibit a greater degree of interest-rate risk? A. A zero-coupon bond with 20 years until maturity. B. A coupon-paying bond with 20 years until maturity. C. A floating-rate bond with 20 years until maturity. D. A zero-coupon bond with 30 years until maturity.
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61. Where does a "convertible bond" get its name? A. The option of converting into shares of common stock. B. The option of increasing its coupon payments when interest rates increase. C. The option of converting from zero-coupon to coupon-paying bond. D. The option of increasing yield without decreasing price.
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62. If the 7s of 2005 are offered at 102:23, then the price of a $1,000 bond would be: A. $1,020.23 B. $1,022.30 C. $1,025.00 D. $1,027.19 $1,000 + $20 + $10(23/32) = $1,027.19
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63. Which of the following identifies the distinction between a U.S. Treasury bond and a Treasury note? A. Bonds make coupon payments; notes do not. B. Bills have default risk; bonds do not. C. Bonds are priced in 32s; notes are not. D. Bonds initially have more than 10 years until maturity; notes have fewer than 10 years initially.
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64. Which of the following is correct for a bond currently selling at a premium to par? A. Its current yield is higher than its coupon rate. B. Its current yield is lower than its coupon rate. C. Its yield to maturity is higher than its coupon rate. D. Its default risk is extremely low.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
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65. What is the yield to maturity of a bond with the following characteristics? Coupon rate is 8% with semi-annual payments, current price is $960, three years until maturity. A. 4.78% B. 5.48% C. 9.57% D. 12.17%
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66. Capital losses will automatically be the case for bond investors who buy: A. discount bonds. B. premium bonds. C. zero-coupon bonds. D. junk bonds.
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67. Investors who own bonds having lower credit ratings should expect: A. lower yields to maturity. B. higher default possibilities. C. lower coupon payments. D. higher present value of cash flows.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-4
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68. By how much will a bond increase in price over the next year if it currently sells for $925, has five years until maturity, and an annual coupon rate of 7%? A. $8.26 B. $8.92 C. $12.55 D. $15.00
Then, solving for price with N = 4, price = $937.55, a gain of $12.55.
AACSB: Reflective Thinking Skills Bloom's: Application Difficulty: Hard Learning Objective: 6-2
69. If a bond is priced at par value, then: A. it has a very low level of default risk. B. its coupon rate equals its yield to maturity. C. it must be a zero-coupon bond. D. the bond is quite close to maturity.
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70. The existence of an upward-sloping yield curve suggests that: A. bonds should be selling at a discount to par value. B. bonds will not return as much as common stocks. C. interest rates will be increasing in the future. D. real interest rates will be increasing soon.
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71. What is the amount of the annual coupon payment for a bond that has six years until maturity, sells for $1,050, and has a yield to maturity of 9.37%? A. $87.12 B. $93.70 C. $100.00 D. $105.00
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72. Which of the following will not happen for an investor who owns TIPS during a period of inflation? A. The coupon payment will increase in real terms. B. The maturity value will increase in nominal terms. C. The investor's real rate of return is guaranteed. D. Payment increases depend on the level of the CPI.
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73. Many investors may be drawn to municipal bonds because of the bonds': A. speculative-grade ratings. B. high coupon payments. C. long periods until maturity. D. exemption from federal taxes.
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74. Two years ago bonds were issued with 10 years until maturity, selling at par, and a 7% coupon. If interest rates for that grade of bond are currently 8.25%, what will be the market price of these bonds? A. $917.06 B. $928.84 C. $987.50 D. $1,000.00
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75. Which of the following is correct for a bond investor whose bond offers a 5% current yield and an 8% yield to maturity? A. The bond is selling at a discount to par value. B. The bond has a high default premium. C. The promised yield is not likely to materialize. D. The bond must be a Treasury Inflation-Protected Security.
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76. What is the total return to an investor who buys a bond for $1,100 when the bond has a 9% coupon rate and five years remaining until maturity, then sells the bond after one year for $1,085? A. 6.82% B. 6.91% C. 7.64% D. 9.00% (90 - 15)/1,100 = 6.82%
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77. How much would an investor lose if she purchased a 30-year zero-coupon bond with a $1,000 par value and 10% yield to maturity, only to see market interest rates increase to 12% one year later? (Hint: How much would the price change from a year earlier?) A. $19.93 B. $20.00 C. $23.93 D. $25.66 Price = 1,000/(1.10)30 = 57.31 New Price = 1,000/(1.12)29= 37.38 Difference = 19.93
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78. Assume that a bond has been owned by four different investors during its 20-year history. Which of the following is not likely to have been shared by these different owners? A. Coupon rate B. Cash flows C. Par value D. Yield to maturity
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79. If an investor purchases a 3%, two-year TIPS and the CPI increases 3% over each of the next two years, how much does the investor receive at maturity? A. $1,000.00 B. $1,030.00 C. $1,060.90 D. $1,092.73 1,030 x (1.03)2 = 1,092.73.
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80. Which of the following is correct concerning real interest rates? A. Real interest rates are constant. B. Real interest rates must be positive. C. Real interest rates must be less than nominal interest rates. D. Real interest rates, if positive, indicate increased purchasing power.
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81. An investor holds two bonds, one with five years until maturity and the other with 20 years until maturity. Which of the following is more likely if interest rates suddenly increase by 2%? A. The five-year bond will decrease more in price. B. The 20-year bond will decrease more in price. C. Both bonds will decrease in price similarly. D. Neither bond will decrease in price, but yields will increase.
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82. How much should you be prepared to pay for a 10-year bond with a 6% coupon and a yield to maturity to maturity of 7.5%? A. $411.84 B. $897.04 C. $985.00 D. $1,000.00
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83. How much should you be prepared to pay for a 10-year bond with a 6% coupon, semiannual payments, and a semi-annually compounded yield of 7.5%? A. $895.78 B. $897.04 C. $938.40 D. $1,312.66
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84. A bond with 10 years until maturity, an 8% coupon, and an 8% yield to maturity increased in price to $1,107.83 yesterday. What apparently happened to interest rates? A. Rates increased by 2.0%. B. Rates decreased by 2.0% C. Rates increased by .72%. D. Rates decreased by 1.5%
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85. An investor buys a five-year, 9% coupon bond for $975, holds it for one year and then sells the bond for $985. What was the investor's rate of return? A. 9.00% B. 9.23% C. 9.65% D. 10.26% (90 + 10)/975 = 10.26%
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86. An investor buys a ten-year, 7% coupon bond for $1,050, holds it for one year and then sells it for $1,040. What was the investor's rate of return? A. 5.71% B. 6.00% C. 6.67% D. 7.00% (70 - 10)/1,050 = 5.71%
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87. Which of the following will reduce the yield to maturity from what the investor calculated at time of purchase? A. Increasing interest rates; bonds held to maturity. B. Decreasing interest rates; bonds held to maturity. C. Stable interest rates; bonds sold before maturity. D. Increasing interest rates; bonds sold before maturity.
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88. What price was quoted to an investor who paid $982.50 for a $1,000 par value bond? A. 82:50 B. 97:25 C. 98:08 D. 98:25 980 + (8/32 x 10) = 982.50
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89. By how much did the price of a $1,000 par-value bond decrease if The Wall Street Journal shows a change of -12 from the previous day? A. $0.88 B. $1.20 C. $3.75 D. $12.00 12/32 x 10 = $3.75
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90. By how much did the price of a $1,000 par-value bond increase if The Wall Street Journal shows a change of +6 from the previous day? A. $0.600 B. $1.875 C. $6.000 D. $18.75 6/32 x 10 = $1,875
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91. When market interest rates exceed a bond's coupon rate, the bond will: A. sell for less than par value. B. sell for more than par value. C. decrease its coupon rate. D. increase its coupon rate.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-3
92. Which of the following is likely to be correct for a CCC-rated bond, compared to a BBBrated bond? A. The CCC bond will sell for a higher price. B. The CCC bond will sell for a lower price. C. The CCC bond will offer a higher promised yield to maturity. D. The CCC bond will offer a lower promised yield to maturity.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Easy Learning Objective: 6-4
93. Which of the following bonds would be considered to be of investment-grade? A. A Caa-rated bond. B. A Ca-rated bond. C. A C-rated bond. D. A Baa-rated bond.
AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Easy Learning Objective: 6-4
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94. If a bond offers an investor 11% in nominal return during a year in which the rate of inflation was 4%, then the investor's real return was: A. 6.73% B. 7.00% C. 8.75% D. 10.56% 1 + real return = 1.11/1.04 real return = 6.73%
AACSB: Reflective Thinking Skills Bloom's: Application Difficulty: Medium Learning Objective: 6-3
95. How much would an investor need to receive in nominal return if she desires a real return of 4% and the rate of inflation is 5%? A. 4.20% B. 8.64% C. 9.00% D. 9.20% 1.04 = 1 + nominal return/1.05 9.2% = nominal return
AACSB: Reflective Thinking Skills Bloom's: Application Difficulty: Medium Learning Objective: 6-3
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96. If you purchase a five-year, zero-coupon bond for $500, how much could it be sold for three years later if interest rates have remained stable? A. $650.00 B. $723.05 C. $757.86 D. $800.00 500 = 1000/(1 + i)5 14.87% = i Three years later Price = 1000/(1.1487)2 Price = $757.86
AACSB: Reflective Thinking Skills Bloom's: Application Difficulty: Medium Learning Objective: 6-3
97. If you purchase a three-year, 9% coupon bond for $950, how much could it be sold for two years later if interest rates have remained stable? A. $964.95 B. $981.56 C. $983.33 D. $1,000.00
11.05% = i Two years later Price = 1000/1.1105 = $981.56
AACSB: Reflective Thinking Skills Bloom's: Application Difficulty: Easy Learning Objective: 6-3
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98. What causes bonds to sell for a premium compared to face value? A. The bonds have high ratings. B. The bonds have a long period until maturity. C. The bonds have a higher than market coupon rate. D. The bonds are of speculative grade.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-3
99. The current yield tends to overstate a bond's total return when the bond sells for a premium because: A. the bond's price will decline each year. B. coupon payments can change at any time. C. bonds selling for a premium have low default risk. D. taxes must be paid on the current yield.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
100. The current yield tends to understate a bond's total return when the bond sells for a discount because: A. increases in interest rates will increase the current yield. B. the bond's price will increase each year. C. current yields only show nominal returns. D. the bond may have a higher face value.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
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101. The value of a callable bond: A. is unlimited. B. is limited by its face value. C. is limited by its call price. D. is limited by high interest rates.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Easy Learning Objective: 6-2
102. Suppose a 30-year maturity bond currently selling for $1,040 is callable in 10 years at a call price of $1,060. If its yield to maturity is 8.14%, its yield to call is: A. less than 8.14%. B. 8.14%. C. more than 8.14%. D. could be any of these.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Hard Learning Objective: 6-2
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Essay Questions 103. Describe the process for calculating a yield to maturity for a bond, and tell what could cause the yield to maturity to change. The yield to maturity for a bond is calculated by finding that discount rate that equates the present value of the bond's payments to the bond's price. Because the bond's payments are fixed, the yield to maturity will change only with changes in interest rates that affect the price of the bond. When the bond is priced at par value, its yield to maturity is equal to its coupon rate and also to the current yield. When the bond is priced above par, yield to maturity is less than the coupon rate, and when the bond is priced below par, the yield to maturity is greater than the coupon rate. It is important to realize that although interest rates may change, the yield to maturity is set at the time of purchase for any investor who holds the bond until maturity (ignoring the possibility of default). Thus, while interest rates may change, it does not affect the yield to maturity for an investor that does not sell the bond prior to maturity. Difficulty: Medium
AACSB: Reflective Thinking Skills Bloom's: Understanding Learning Objective: 6-2
104. Determine the current yield, yield to maturity, and price of the following bond as of the date of purchase and on each anniversary date of its purchase until maturity: three-year bond with a 12% coupon and a purchase price of $1,100.
AACSB: Analytical Skills Bloom's: Evaluation Difficulty: Medium Learning Objective: 6-2
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105. Compare the price sensitivity to changes in interest rates for the following bonds: A fiveyear and a ten-year bond, both with a 7% coupon. Both bonds currently sell at par. How much will the price of each bond change if interest rates increase to 8%? Why is there a difference in the price change?
The five-year bond decreases $39.27 while the 10-year bond decreases $67.10. This illustrates that longer-term bonds display more interest rate risk.
AACSB: Analytical Skills Bloom's: Evaluation Difficulty: Medium Learning Objective: 6-3
106. Why are long-term bonds more sensitive to changes in interest rates than short-term bonds? A long-term bond is more sensitive to changes in interest rates simply because there are more coupon payments and longer time periods for each cash flow to be affected by the changed interest rate. Remembering that bond prices are determined by the sum of a present value of an annuity and the present value of a future amount, when those formulas experience different discount rates for longer periods, there is substantially more effect.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-3
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107. Explain why it is the case that bond prices fluctuate in response to changing interest rates. What adverse effect might occur if bond prices remain fixed prior to their maturity? Bonds are long-term debt instruments that are issued with fixed coupon interest rates. At the time of issue, it is likely that the coupon rate was approximately equal to the expected interest rate for a bond of this rating. However, as interest rates change during the period prior to maturity, investors may be unwilling to purchase the bond in the secondary market unless its price changes such that the investor can obtain a then-current yield to maturity on the investment. Thus, if bond prices were fixed, there may not be any opportunities for sale of the bond prior to maturity and investors would be required to make long-term, potentially disadvantageous investment decisions.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-3
108. Describe the shape of the current yield curve. Would you consider that to be fairly typical? This question can provide a good introduction to the topic for instructors who have discussed the current economic environment. The important facet will be for students to recognize that upward-sloping yield curves are more common than downward sloping curves.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-2
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109. Explain why bond investors may be interested in TIPS rather than traditional bonds. Why have TIPS not been popular lately? Treasury Inflation-Indexed Securities will be welcomed instruments by bond investors who wish to feel protected in their real rate of return. TIPS will lock in a real rate of return so that the purchasing power of bond investors can be maintained. Additionally, there is somewhat less price volatility in these bonds than in traditional bonds, which could prove to be an additionally welcome feature to investors who are experiencing volatility in other market segments. Since we have been in a low-inflation economic environment recently, TIPS have not received the popularity that they deserve in an inflationary economy.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-3
110. What is meant by "default risk" in bonds, and how do investors respond to it? Default risk refers to the probability of default by bond issuers. In the case of default, cash payments to bond investors may be delayed or omitted. Thus, investors walk a tightrope between wanting to receive as much yield as possible while still willing to bear the possibility of default. Rating agencies such as Standard & Poor's or Moody's evaluate the creditworthiness of bond issuers, and offer ratings of each issue. The lower the rating, the higher the likelihood of default and, therefore, the more of a default premium will be demanded by investors. Although bond ratings can change dramatically, it is often a case of gradual change such that investors have the opportunity of being forewarned.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-4
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111. Why should many investors be cautious when relying on yield to maturity? Is it a convenient measure of rate of return for investors who might not hold their bonds to maturity? Yield to maturity is an extremely popular metric and is highly quoted among investors and analysts. However, many bond investors do not intend or, even if they do intend, will not be able, to hold their bonds until maturity. In this case it is worthwhile to remember that a yield to maturity is promised only if: a) the bond is held until maturity, and b) the issuer does not default. Many investors might be better off in calculating or forecasting a total return based upon the time period they expect to hold the bond. While this calculation is obviously made with risk, it reminds investors that bond prices can change dramatically and, if you need to raise cash quickly, the once-calculated yields to maturity can be long forgotten.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-2
112. Why might a bond's current yield offer an incomplete idea of what return the investor is receiving? The current yield is only synonymous with yield to maturity in the coincidence that the bond price is selling at par. Therefore, capital gains and capital losses are a critical part of bond investors' analysis. A high current yield can draw suspicions that capital losses will be posted during the year. Unexpected changes in interest rates can render current yields to be of much less significance next to changes in the price of the investment itself.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-2
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113. What are some new types of bonds? List and describe at least two of them. Bond issuers are always trying to invent new types of bond that they hope will appeal to a particular clientele of investors. So, in addition to these fairly common types of bond, you may also encounter some more peculiar beasts. Here are a couple examples. Managers of insurance companies constantly worry about the possibility of a major hurricane or earthquake that could prompt a flood of costly claims. Some companies therefore shed part of the risk by issuing catastrophe (or Cat) bonds. Cat bonds promise relatively high returns, but the payments on the bond are reduced if a specified type of disaster occurs. Therefore the bondholders help to provide insurance against catastrophes. Most of us hope for a long life. But longevity can create a problem for pension funds that are committed to paying out a regular sum each year until we die. Therefore, pension funds might value an opportunity to protect themselves against an increase in life expectancy. That is the idea behind the longevity bond issued by a French bank in 2004. Each year payments on the bond are higher if more of the population survive the extra year. If life expectancy increases, a pension fund may have to pay out for longer than it planned. But, if it also owned a longevity bond, it would have the consolation of a boost to its investment income. Cat bonds are fairly rare and longevity bonds even rarer; most corporate bonds are of the common or garden variety. But bond issuers are always on the lookout for innovative forms of debt that they hope will attract investors.
AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Medium Learning Objective: 6-1
114. What are catastrophe (or Cat) bonds? Managers of insurance companies constantly worry about the possibility of a major hurricane or earthquake that could prompt a flood of costly claims. Some companies therefore shed part of the risk by issuing catastrophe (or Cat) bonds. Cat bonds promise relatively high returns, but the payments on the bond are reduced if a specified type of disaster occurs. Therefore the bondholders help to provide insurance against catastrophes.
AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Medium Learning Objective: 6-1
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115. What is a longevity bond? Should a pension fund invest in such bonds? Most of us hope for a long life. But longevity can create a problem for pension funds that are committed to paying out a regular sum each year until we die. Therefore, pension funds might value an opportunity to protect themselves against an increase in life expectancy. That is the idea behind the longevity bond issued by a French bank in 2004. Each year payments on the bond are higher if more of the population survive the extra year. If life expectancy increases, a pension fund may have to pay out for longer than it planned. But, if it also owned a longevity bond, it would have the consolation of a boost to its investment income.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1
116. What are the differences between the bond's coupon rate, current yield, and yield to maturity? A bond is a long-term debt of a government or corporation. When you own a bond, you receive a fixed interest payment each year until the bond matures. This payment is known as the coupon. The coupon rate is the annual coupon payment expressed as a fraction of the bond's face value. At maturity the bond's face value is repaid. In the United States most bonds have a face value of $1,000. The current yield is the annual coupon payment expressed as a fraction of the bond's price. The yield to maturity measures the average rate of return to an investor who purchases the bond and holds it until maturity, accounting for coupon income as well as the difference between purchase price and face value.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-1
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117. How can one find the market price of a bond given its yield to maturity and find a bond's yield given its price? Why do prices and yields vary inversely? Bonds are valued by discounting the coupon payments and the final repayment by the yield to maturity on comparable bonds. The bond payments discounted at the bond's yield to maturity equal the bond price. You may also start with the bond price and ask what interest rate the bond offers. The interest rate that equates the present value of bond payments to the bond price is the yield to maturity. Because present values are lower when discount rates are higher, price and yield to maturity vary inversely.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-2
118. Why do bonds exhibit interest rate risk? Bond prices are subject to interest rate risk, rising when market interest rates fall and falling when market rates rise. Long-term bonds exhibit greater interest rate risk than short-term bonds.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-3
119. Why do investors pay attention to bond ratings and demand a higher interest rate for bonds with low ratings? Investors demand higher promised yields if there is a high probability that the borrower will run into trouble and default. Credit risk implies that the promised yield to maturity on the bond is higher than the expected yield. The additional yield investors require for bearing credit risk is called the default premium. Bond ratings measure the bond's credit risk.
AACSB: Reflective Thinking Skills Bloom's: Understanding Difficulty: Medium Learning Objective: 6-4
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120. Why might have caused investors to rationally stay away from long-term bonds even when the yield curve is upward-sloping? Even when the yield curve is upward-sloping, investors might rationally stay away from long-term bonds for two reasons. First, the prices of long-term bonds fluctuate much more than prices of short-term bonds. Long-term bond prices are more sensitive to shifting interest rates. A sharp increase in interest rates could easily knock 20 or 30 percent off long-term bond prices. If investors don't like price fluctuations, they will invest their funds in short-term bonds unless they receive a higher yield to maturity on long-term bonds. Second, short-term investors can profit if interest rates rise. Suppose you hold a 1-year bond. A year from now when the bond matures you can reinvest the proceeds and enjoy whatever rates the bond market offers then. Rates may be high enough to offset the first year's relatively low yield on the 1-year bond. Thus you often see an upward-sloping yield curve when future interest rates are expected to rise.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Medium Learning Objective: 6-3
121. One-year Treasury bonds yield 5%, while 2-year bonds yield 6%. You are quite confident that in 1 year's time 1-year bonds will yield 8%. Would the higher yield on 2-year bonds cause you to prefer them? If you invest in a 2-year bond, you will have $1,000 x 1.07 2 = $1,123.60. If you are right in your forecast about 1-year rates, then an investment in 1-year bonds will produce $1,000 x 1.05 x 1.08 = $1,134.00 by the end of 2 years. You would do better to invest in the 1-year bond.
AACSB: Analytical Skills Bloom's: Analysis Difficulty: Easy Learning Objective: 6-2
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122. What are mortality bonds? Bond issuers are always trying to invent new types of bonds that they hope will appeal to a particular clientele of investors. Managers of life insurance companies agonize about the possibility of a pandemic or other disaster that results in a sharp increase in the death rate. In 2006 the French insurance company Axa sought to protect itself against this danger by issuing nearly €350 million of mortality bonds. Axa's bonds offered a tempting yield but the bondholders will lose their entire investment if death rates for 2 consecutive years are 10% or more above expectations.
AACSB: Communication Abilities Bloom's: Knowledge Difficulty: Easy Learning Objective: 6-1
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