Business Finance Ch. 7 Bonds & Bond Valuation
Suppose a bond's clean price is $1,050, and the bond currently has accrued interest of $30. What is the dirty price?
$1,080
What are municipal bonds?
Bonds that have been issued by state or local governments
Which of the following is not a difference between debt and equity?
Equity is publicly traded while debt is not
True or false: Equity represents an ownership interest.
True
The longer the term, the ___ (smaller/greater) the interest rate sensitivity.
greater
The Treasury yield curve plots the yields on Treasury notes and bonds relative to ___ .
maturity
In case of default:
subordinated debt holders must give preference to other specified creditors
Most corporate bonds pay coupon interest payments ___ times per year.
two, 2, or twice
Most of the time, a floating-rate bond's coupon adjusts ____.
with a lag to some base rate
A Treasury yield curve depicts the _____.
yields for different maturities of Treasury securities
A firm decides to raise money by issuing 5 million bonds with a par value of $5,000 each for 10 years at a coupon rate of 7 percent. At the time of issue, the bonds were sold for $5,500 each. What will the par value of the bonds be in year 5?
$5,000 per bond
What is the formula to determine the price of a U.S. Treasury bond listed at 122 if the par value is $5,000?
$5,000 × 122%
A bond pays annual interest payments of $50, has a par value of $1,000, and a market price of $1,200. How is the coupon rate computed?
$50/$1,000
What is the price of a U.S. Treasury bond that is listed at 90 if the par value is $1,000?
$900
What is the value of a bond if the present value of interest cash flows is $200 and the present value of the par value to be received when the bond matures is $750?
$950 Reason: Total value = $200 + 750 = $950
What is a real rate of return?
-it is a rate of return that has been adjusted for inflation -it is a percentage change in buying power
If you are holding a municipal bond that is trading at par to yield 6 percent, by how much will your aftertax yield change if your income tax bracket increases from 15 percent to 20 percent. Assume there are no state or local taxes
0%
What is the coupon rate on a bond that has a par value of $1,000, a market value of $1,100, and a coupon interest payment of $100 per year?
10%
If the rate of inflation is 3 percent and the real rate of return is 9 percent, the nominal rate is approximately ____ percent.
12 Reason: 9% + 3% = 12%
In terms of time to maturity, U.S. Treasury notes and bonds have initial maturities ranging from ___ years.
2 to 30
If you are in the 20 percent tax bracket, what is your aftertax yield on a par value municipal bond yielding 5 percent? Ignore state and local taxes.
5%
What are original issue discount bonds?
Bonds that are issued with a very low coupon rate.
If an investment appreciates by 7 percent while the rate of inflation is 2 percent, what is the nominal rate of return?
7%
What is a premium bond?
A bond that sells for more than face value
In general, which will have a higher pretax yield? (Assume the bonds are comparable.)
A corporate bond
Which of the following is true about interest rate risk?
All else equal, the longer the time to maturity, the greater the interest rate risk. All else equal, the lower the coupon rate, the greater the interest rate risk.
Which of these are required to calculate the current value of a bond?
Applicable market rate Coupon rate Par value Time remaining to maturity
What are crossover bonds?
Bonds that have both an investment grade and a junk bond rating
What are "fallen angel" bonds?
Bonds that have dropped from investment grade to junk bond status
Match each one of these bonds with their characteristic.
CAT bond Protects insurance companies from natural disasters Convertible bond Can be exchanged for shares of stock Put bond Owner can force issuer to repay prior to maturity at a stated price Structured note Based on financial securities, commodities, or currencies
The __ price excludes interest accrued since the last coupon payment, while the __ price includes accrued interest.
Clean dirty
How is a conventional bond different from a zero coupon bond?
Conventional bonds can sell at par, at a discount from par, or at a premium over par while zeros must be offered at a discount from par A conventional bond pays periodic interest whiles zeros make no interest payments.
How has TRACE improved transparency in the corporate bond market?
Corporate bond dealers are now required to report trade information through TRACE.
What is a bond's current yield?
Current yield = annual coupon payment / current price
What are three important features of Treasury notes and bonds?
Default-free Highly liquid Taxable
What is a discount bond?
Discount bonds are bonds that sell for less than the face value
True or false: A bond's value is not affected by changes in the market rate of interest.
False
True or false: If you invest in junk bonds, there is a high likelihood that you will earn a very high return.
False
True or false: The inflation premium will be higher if the rate of inflation is low.
False
True or false: The real rate of return will generally be higher than the nominal rate of return.
False
What are some reasons why the bond market is so big?
Federal government borrowing activity in the bond market is enormous. Many corporations have multiple bond issues outstanding. Various state and local governments also participate in the bond market.
All junk bonds typically have which of these features?
High probability of default Less than investment-grade rating
What are the three components of the Treasury yield curve?
Interest rate risk premium Expected inflation Real rate of return
Which three components determine the shape of the term structure of interest rates?
Interest rate risk premium Inflation premium Real interest rate
What does the dirty price represent?
It includes the quoted price and interest accrued since the last coupon payment.
Which of the following is true about a typical multiple-year bond's coupon?
It is a fixed annuity payment.
What is accrued interest?
It is interest that has been earned but not yet received.
What is the definition of a bond's time to maturity?
It is the number of years until the face value is due to be repaid.
How is an APR computed?
Rate per period × Number of periods per year
Which of the following are true about a bond's face value?
It is the principal amount repaid at maturity. It is also known as the par value.
What is the nominal rate of return on an investment?
It is the rate that has not been adjusted for inflation.
What is the likely impact on all interest rates when the real rates are high?
It will increase
What will happen to the default risk premium during periods of economic uncertainty?
It will increase.
Which six factors determine the yield on a bond?
Liquidity Default risk Interest rate risk Real rate of return Expected future inflation Taxability
Why is the bond market less transparent than the stock market?
Many bond transactions are negotiated privately.
Which one of the following is the most important source of risk from owning bonds?
Market interest rate fluctuations
Click and drag on elements in order Place the following bonds in order of security as defined in the United States:
Mortgage bonds Debentures
How significant is the real rate of return in determining the shape of the term structure of interest rates?
Not very significant Less significant than inflation
What are some features of the OTC market for bonds?
OTC dealers are connected electronically. The OTC has no designated physical location.
What are the federal income tax implications of receiving $50 in interest income from a municipal bond versus a corporate bond?
Only the interest on the corporate bond will be taxed.
Which of the following terms apply to a bond?
Par value Coupon rate Time to maturity
Which of these is included in the calculation of a bond's yield to maturity?
Par value Current price Coupon rate
What are the cash flows involved in the purchase of a 5-year zero coupon bond that has a par value of $1,000 if the current price is $800? Assume the market rate of interest is 5 percent.
Pay $800 today and receive $1,000 at the end of 5 years
What are the two major forms of long-term debt?
Public issue and privately placed
What are the three components of the nominal rate of return?
Real rate of return Compensation for the inflation effect on the original investment Compensation for the inflation effect on the investment earnings
Which of the following variables are required to calculate the value of a bond?
Remaining life of bond Coupon rate Market yield
___ is the term that indicates preference in position over other lenders.
Seniority
What does historical data suggest about the nature of short-term and long-term interest rates?
Sometimes short-term rates are higher and sometimes long-term rates are higher.
Within the context of financial markets, complete the following equation: Bid − Ask = Bid-Ask ___ .
Spread
Corporate bond dealers are now required to report trade information through _____.
TRACE
If you are holding two identical bonds, except that one matures in 10 years and the other matures in 5 years, which bond's price will be more sensitive to interest rate risk?
The 10-year bond
Which is the largest security market in the world in terms of trading volume?
The U.S. Treasuries market
What is the asked price?
The asked price is the price at which a dealer is willing to sell.
Which has a higher value, the bid price quote or the asked price quote?
The asked price quote is higher.
What is the bid price?
The bid is the price at which a dealer is willing to buy securities.
What is the difference between a bond's "clean price" and its "dirty price"?
The clean price excludes interest accrued since the last coupon payment, while the dirty price includes accrued interest.
Why does a bond's value fluctuate over time?
The coupon rate and par value are fixed, while market interest rates change.
Why is the YTM of a discount bond greater than the bond's current yield?
The current yield does not include the capital gain from the price discount.
What does the AAA rating assigned by S&P mean?
The firm is in a strong position to meet its debt obligations
As a general rule, which of the following are true of debt and equity?
The maximum reward for owning debt is fixed Equity represents an ownership interest
What does the clean price for a bond represent?
The quoted price, which excludes interest accrued since the last coupon date.
How is the real rate of return different from the nominal rate of return?
The real rate of return is adjusted for the effect of inflation whereas nominal rate is not adjusted for the effect of inflation.
Which is more transparent, the stock market or the bond market?
The stock market is more transparent.
Which of the following are usually included in a bond's indenture?
The total amount of bonds issued The repayment arrangements
Which of the following are features of municipal bonds?
They are issued by state and local governments. The interest on municipal bonds is exempt from federal taxes.
Why did Disney issue 100-year bonds, dubbed "Sleeping Beauty" bonds, in the 1990s?
To lock-in historically low interest rates for a long time
When the U.S. government wants to borrow money for the long-term (more than one year) it issues:
Treasury bonds Treasury notes
Which of these correctly identify differences between U.S. Treasury bonds and corporate bonds?
Treasury bonds offer certain tax benefits to investors that corporate bonds cannot offer. Treasury bonds are issued by the US government while corporate bonds are issued by corporations. Treasury bonds are considered free of default risk while corporate bonds are exposed to default risk.
How is investing in U.S. Treasury bonds different from investing in corporate bonds?
Treasury issues have no default risk. Interest from U.S. Treasuries is exempt from taxes at the state level but corporate interest is not.
True or false: In general, the price that is paid for a bond will exceed its quoted price.
True
True or false: In general, the stock market is more transparent than the real estate market.
True
True or false: Interest earned on Treasury notes and bonds is taxable
True
True or false: The major difference between Western financial practices and Islamic law is that Islamic law does not permit charging or paying interest.
True
True or false: The price you actually pay to purchase a bond will generally exceed the clean price.
True
If you invest in a corporate bond, how many times can you expect, in general, to receive interest?
Twice a year
Which shape does the term structure of interest rates usually have?
Upward sloping
Which of the following is not one of the six factors used to determine the yield on a bond?
Voting rights
What is a corporate bond's yield to maturity (YTM)?
YTM is the expected return for an investor who buys the bond today and holds it to maturity. YTM is the prevailing market interest rate for bonds with similar features.
What will the impact be on your risk exposure if your bond has recently been categorized as a "fallen angel"?
Your risk will increase.
How is a zero coupon bond different from a conventional bond?
Zero coupon bonds are always issued at a discount. Zero coupon bonds make no interest payments.
A bond's YTM will exceed its current yield when the bond is selling at ____.
a discount
Bond yields __ (are/aren't) quoted like APRs.
are
If a $1,000 face value U.S. Treasury bond is quoted at 85, then the bond can be purchased _____.
at 85 percent of face value plus any accrued interest
If a $1,000 face value U.S. Treasury bond is quoted at 99.5, then the bond can be purchased _____.
at 99.5 percent of face value plus any accrued interest
In financial markets the difference between the ___ price and the ask price is known as the spread.
bid
The price that represents what a dealer is willing to pay for a security is the _____.
bid price
When an investor sells a bond, the price received by a dealer is always the ____.
bid price
When a corporation or government wishes to borrow money from the public on a long-term basis, it usually does so by issuing or selling debt securities that are generically called ___.
bonds or bond
Secondary markets in sukuk are extremely illiquid because most sukuk are:
bought and held to maturity
A corporate bond's yield to maturity ____.
can be greater than, equal to, or less than the bond's coupon rate changes over time
A bond with exotic features is often called a _____ bond.
cat
A bond's ___ rate is the stated interest payment made on a bond.
coupon
If a bond is rated Baa by Moody's and BB by Standard & Poor's, the bond will be regarded as a(n) _____ bond.
crossover
The ___ yield does not include the capital gain from the price discount, whereas the YTM does include it.
current
A ___ is an unsecured bond, for which no specific pledge of property is made.
debenture
If the market rate of interest (increases/declines), bond values increase.
declines
As the maturity of a bond increases, interest rate risk increases at a(n) ___(decreasing/increasing) rate.
decreasing
A firm's bond rating sheds light on its _________ risk.
default
Which of these risks is addressed by bond ratings?
default risk
A 10-year AAA corporate bond is most apt to have a yield that ____ the yield on a 10-year AAA state government bond.
exceeds
Longer-term bonds have (smaller/greater) interest rate sensitivity because a (smaller/larger) portion of a bond's value comes from the face amount.
greater larger
If a bond is selling at a discount from its par value, the YTM must be _____ the coupon rate.
greater than
In an inflationary environment, the nominal rate will be _________ the real rate.
greater than
The correlation between the real rate of interest and every interest rate is:
high
A bond with a BBB rating has a ______ than a bond with an A rating.
higher risk of default
If you were classified as a high income/high tax bracket investor, you might find municipal bonds an attractive investment because ____.
income from municipal bonds is exempt from federal taxes
According to the approximation formula for the nominal rate of return (R), the nominal rate will ________ if inflation (h) increases.
increase
As the maturity of a bond increases, interest rate risk ____.
increases at a decreasing rate
As the time to maturity increases, the interest rate risk premium ____.
increases at a decreasing rate
The written agreement between the corporation and the lender detailing the terms of the debt issue is the ___ .
indenture
One of the components of the nominal rate of return is the compensation for the ___ effect on the original investment.
inflation
The term structure of interest rates is determined by the real rate of interest, the interest rate risk premium, and the ___ premium.
inflation
The three components of the Treasury yield curve include the real rate, expected future ___, and the interest rate risk premium.
inflation
The ___ premium is the portion of a nominal interest rate that represents compensation for expected future ___ .
inflation inflation
When comparing a 1-year bond's price to a 30-year bond's price, the 1-year bond's price is relatively ___ (sensitive/insensitive) to interest rate changes.
insensitive
A bond's yield to maturity considers the interest earnings and the change in the bond's price while the current yield considers ____.
interest earnings only
The relationship between bond prices and the market rate of interest is ____.
inverse; if the market rate of interest rises, bond prices will fall
Interest on municipal bonds ___ (is/isn't) federally taxed.
isn't
The federal government can raise money from financial markets to finance its deficits by ___.
issuing bonds
What is an interest-only loan?
it's a loan which the borrower pays interest periodically and repays the principle when the bond matures
A market is considered transparent if ____.
its prices and trading volume are easily observed
The U.S. Treasuries market is the _____ in the world in terms of trading volume.
largest
If a $1,000 par value bond is trading at a discount, it means that the market value of the bond is ______ $1,000.
less than
The reason that interest rate risk is greater for ______ term bonds than for ______ term bonds is that the change in rates has a greater effect on the present value of the ______ than on the present value of the ______.
long; short; face value; coupon payments
The interest rate risk premium is the additional compensation demanded by investors for holding ____ bonds.
longer-term
A company may decide to issue bonds with maturities of greater than 30 years in order to lock in ___ (low/high) interest rates for a long time.
low or lower
All other things being equal, the ___ (lower/higher) the coupon rate, the greater the interest rate risk.
lower
When using trial and error to compute the yield to maturity (YTM) for a 6 percent coupon bond that trades at a premium, the process can be shortened if the initial guess is ____ 6 percent.
lower than
A zero coupon bond is a bond that ____.
makes no interest payments
There is a(n) ______ relationship between market interest rates and bond values.
negative
Protective covenants are classified into two types: ___ and ___ covenants.
negative positive
The OTC has _____ designated physical location.
no
The rates on financial securities are generally quoted as ___ rates.
nominal
The rates on financial securities are generally quoted as _____ rates.
nominal
If a given set of cash flows is expressed in ___ terms and discounted at the ___ rate, the resulting present value will be the same as if the cash flows were expressed in real terms and discounted at the real rate.
nominal nominal
The information needed to compute a bond's yield to maturity includes the bond's ___ , coupon rate, and maturity date. (Enter one word per blank.)
price, cost, or value
The two major forms of long-term debt are ___ issue and privately placed.
public
If a given set of cash flows is expressed in nominal terms and discounted at the nominal rate, the resulting present value will be the same as if the cash flows were expressed in real terms and discounted at the ____ rate.
real
The term structure of interest rates examines the ____.
relationship between short-term and long-term interest rates
A sinking fund is one type of:
repayment provision
The ___ premium is the portion of a nominal interest rate or bond yield that represents compensation for unfavorable ___ status.
taxability tax
The taxability premium is the additional compensation demanded on ____.
taxable bonds
Which of the following are common protective covenants?
the firm must limit dividends to equity holders the firm must maintain working capital at or above a specified level the firm cannot merge with any other firm
The Fisher effect decomposes the nominal rate into:
the inflation rate and the real rate
If you own corporate bonds, you will be concerned about interest rate risk as it affects ____.
the market price of the bonds
The degree of interest rate risk depends on ____.
the sensitivity of the bond's price to interest rate changes
If a $1,000 par value bond is trading at a premium, the bond is _____.
trading for more than $1,000 in the market
True or false: If you invest in a bond that is rated AAA by S&P, you can be reasonably assured that your investment has very little default risk.
True
The interest from a municipal bond is exempt from ____ income taxes.
federal
With ___-rate bonds, the coupon payments are adjustable.
floating
A bond's time to ___ is the number of years until the face value is due to be repaid.
maturity or mature
The interest rate risk ___ is the compensation investors demand for bearing interest rate risk.
premium
If the present value of the interest payments on a bond is $320 and the present value of the par value to be paid at maturity is $900, the total value of the bond must be ____.
$1,220
Which one of these correctly specifies the relationship between the nominal rate and the real rate?
(1 + R) = (1 + r) × (1 + h)
How is an original issue discount bond (OID) different from a zero coupon bond?
An OID has a very low coupon rate, while a zero coupon bond pays no coupon.
Suppose you own a 30-year bond issued by GE and a 2-year bond issued by PG with identical coupon rates and par values. Which bond will you decrease in value more as interest rates rise?
The GE bond will lose more because it has a longer maturity.
The main reason it is important to distinguish between debt and equity is that the benefits and risks _____.
are different
Assume you own a bond currently valued at $989. If the market rate of interest drops, the bond's current market value will _____.
increase
The ___ premium is the portion of a nominal interest rate or bond yield that represents compensation for lack of ___ .
liquidity liquidity
The _____ premium is the portion of a nominal interest rate or bond yield that represents compensation for lack of _____.
liquidity; liquidity
The default risk premium refers to the extra compensation demanded by investors for the possibility that the issuer might ____.
not make all the promised payments
A ___ provision allows the company to repurchase or "___" part or all of the bond issue at stated prices over a specified period.
call call
Which two prices can be found in the Wall Street Journal's daily Treasury bond listing?
The bid price The asked price
Assume you own a bond that was issued by a blue-chip company. If the market rate of interest rises, what will happen to the value of your bond?
The bond value will fall.
You own two bonds—one with a 5 percent coupon and one with a 6 percent coupon. Which one is more sensitive to interest rate risk, all other things being equal?
The bond with the 5 percent coupon rate is more sensitive.
What does a Moody's bond rating of C typically indicate?
The issuer is in default
The ___ yield is the bond's annual coupon divided by its price.
current
If the market rate of interest rises, the value of the bond will ___ (fall/rise).
fall
The amount by which the call price exceeds the par value of the bond is called the _____.
call premium
When the term structure of interest rates is downward sloping, ____.
short-term rates are higher than long-term rates
A ___ fund is an account managed by the bond trustee for the purpose of repaying the bonds.
sinking