Chapter 5 Bonds and Interests Rate

What are some of the reasons the bond market is so big?

-Many corporations have multiple bond issues outstanding. -Federal government borrowing activity in the bond market is enormous -Various state and local governments also participate in the bond market.

What allows a company to repurchase a bond?

A call provision

Which of these are required to calculate the current value of a bond? (select 4) -Price at the time of bond issue -Applicable market rate -Time remaining to maturity -Coupon -Par value

Answer: -Applicable market rate -Time remaining to maturity -Coupon -Par value

All junk bonds typically have which of these features? (select 2) -High probability of default -Less than investment grade rating -Zero coupon rate -Time to maturity of 10 years or more

Answer: -High probability of default -Less than investment grade rating

Which six factors determine the yield on a bond? -Voting Rights -Real rate of return -Interest rate risk -Taxability -Liquidity -Default risk -Expected future inflation

Answer: -Real rate of return -Interest rate risk -Taxability -Liquidity -Default risk -Expected future inflation

Which of the following are features of municipal bonds? (select 2) -They are not subject to default risk. -The interest on municipal bonds is always exempt from state taxes. -They are issued by state and local governments. -The interest on municipal bonds is exempt from federal taxes.

Answer: -The interest on municipal bonds is exempt from federal taxes. -They are issued by state and local governments.

The term structure of interest rates examines the ____.

Answer: Relationship between long term and short term interest rates

A ________________ _________ __________________prevents a company from calling its bonds for a period of time during which the bond is ______ _______________.

Deferred call provision; call protected

True or false: If the term structure of interest rates is downward-sloping, short-term rates will be lower than long-term rates.

False Reason: Reason: Short-term rates will be higher than long-term rates when the term structure is downward-sloping

True or false: In an upward-sloping term structure, the long-term rates will be lower than the short-term rates.

False Reason: The long-term rates will be higher in an upward-sloping term structure.

In an inflationary environment, the nominal rate will be _________ the real rate. -Equal to -Greater than -Lower than

Greater than

Real Interest Rate=

Nominal Interest Rate - Inflation Rate

Which quote, asked or bid, would you expect to pay if you were buying a bond? -The bid price -The ask price -Average of the two prices

The ask price

What is the bid price?

The bid is the price at which a dealer is willing to sell securities.

How is the real rate of return different from the nominal rate of return?

The real rate of return adjusts the nominal rate to remove the effects of inflation.

True or false: The market value of a bond is the present value of the annuity combined with the present value of a lump sum

True

current yield =

annual coupon payment / price

When interest rates in the market rise, we can expect the price of bonds to ____.

decrease

The relationship between bond prices and the market rate of interest is ____.

inverse; if the market rate of interest rises, bond prices will fall

Which of the following are true regarding a corporate bond's yield to maturity (YTM)? (select 2) -YTM is also called simply yield -YTM is another term for the bond's coupon rate -YTM is the interest rate required in the bond market -YTM is the yield that will be earned if the bond is sold immediately

Answer: -YTM is also simply called yield -YTM is the interest rate required in the market on a bond

Investors demand _______ because they recognize that longer-term bonds have much greater risk of loss resulting from changes in interest rates than do shorter-term bonds. -a default risk premium -a nominal rate of return -an interest rate risk premium -an inflation premium

Answer: An interest rate risk premium

The inflation premium is the additional return demanded by investors to compensate for _____. -Time to maturity -Changing interest rates -Inflation -Default Risk

Answer: inflation

Which of the following is true about a multi-year typical bond's coupon? -It is a fixed annuity payment. -The interest payment will vary with the market rate of interest. -Interest payments are paid at the discretion of CFO. -It is a fixed interest payment paid at the time the bond matures.

Answer: It is a fixed annuity payment

When an investor sells a bond, the price received is always the _______ ________.

Bid price

What are the two main forms of long-term debt?

-Public issue and privately placed

The ______ tells us the pure time value of money for different lengths of time. -Real rate -Bond yield -Term structure -Nominal rate

-Term Structure

Which of the following are accurate statements? (Select 3) -Equity is publicly traded while corporate debt is not -Unlike dividend omissions to equity holders, unpaid debt obligations can lead to bankruptcy. -Equity represents ownership interest while debt does not. -Interest payments on debt are tax deductible but dividend payments on stock are not.

-Unlike dividend omissions to equity holders, unpaid debt obligations can lead to bankruptcy. -Equity represents ownership interest while debt does not. -Interest payments on debt are tax deductible but dividend payments on stock are not.

Which of the following variables are required to calculate the value of a bond? -coupon rate -market original issue price of bond -market yield -remaining life of bond

-coupon rate -market yield -remaining life of bond

A note is debt with an original maturity of ____ year(s) or less.

10

U.S. Treasury notes and bonds have initial maturities ranging from ___ years.

2 to 30

True or false: If you own corporate bonds, you will be concerned about interest rate risk as it affects the market price of the bond. Bonds with more interest rate risk (longer time to maturity and lower coupon rates) have larger price changes when market rates change. Par value is determined when the bond is issued.

True

A corporate bond's yield to maturity ____. (select 2) -Changes over time -can be greater than, equal to, or less than the bond's coupon rate -remains fixed over the life of the bond -is always equal to the bond's coupon rate

Answer: -Changes over time -can be greater than, equal to, or less than the bonds coupon rate

The sensitivity of a bond's price to interest rate changes is dependent on which of the following two variables? (select 2) -Time to maturity -Par value -Bond rating -Coupon rate

Answer: Time to maturity Coupon rate

ABC Co. issued 1 million 6 percent annual coupon bonds that mature in 10 years. The face value is $1,000 per bond. What are the expected cash flows from one of these bonds? -$1,060 at the end of 10 years. -$60 at the end of each year in interest and $100 at the end of each year in principal payments. -$60 in interest at the end of each year for 10 years and a $1,000 repayment of principal at the end of 10 years. -Interest at the end of each year, the amount of which is based on the current market rate of interest, and $1,000 at the end of 10 years.

Answer: $60 in interest at the end of each year for 10 years and a $1,000 repayment of principal at the end of 10 years.