Chapter 8 Interest Rates and Bond Valuation
True or false: In an upward-sloping term structure, the long-term rates will be lower than the short-term rates.
False
True or false: The real rate of return will generally be higher than the nominal rate of return.
False
What is the equation for approximating the nominal rate of return?
R = r + h
What is the real rate of return if the nominal rate is 5% and the rate of inflation is 0.5%?
Reason: (1.05/1.005) - 1 = 4.48%
The term structure of interest rates examines the ____.
Relationship between short-term and long-term interest rates
What is a discount bond?
A bond that sells for less than its face value
Bond ratings are based on the probability of default risk, which is the risk that ___.
The bond's issuer may not be able to make all the required payments
True or false: In general, the stock market is more transparent than the bond market.
True
True or false: If the term structure of interest rates is downward-sloping, short-term rates will be lower than long-term rates.
false
A bond rated AAA by Standard & Poor's is classified as a _______ grade bond.
high
A corporate bond's yield to maturity ____.
-Changes over time -Can be greater than, equal to, or less than the bond's coupon rate
Why is the bond market less transparent than the stock market?
many bond transactions are negotiated privately
The US government borrows money by issuing:
-Treasury Bonds -Treasury Notes
What is the aftertax yield on a U.S. Treasury bond yielding 7 percent if you are in the 20 percent tax bracket?
.07 x (1-.2)= 5.6%
What will your aftertax yield be on a corporate bond that is currently priced to yield 7% percent if you are in the 25 percent tax bracket?
.07 × (1 - .25) = 5.25%
All else held constant, the yield on a highly liquid bond will be ____ the yield on an illiquid bond.
lower than
If the term structure of interest rates is upward-sloping, then ____.
long-term rates are higher than short-term rates
True or false: If you invest in junk bonds, there is a high likelihood that you will earn a very high return.
False
Over time, the purchasing power of the cash flows from a bond decreases due to
inflation
What is an interest-only loan?
it's a loan which the borrower pays interest periodically and repays the principle when the bond matures
What is the bid price?
the price a dealer is willing to pay for a security
For a risk-free security, the promised and expected return are equal because:
the probability of default is zero
You received $100 in interest from a U.S. Treasury bond. If your state income tax rate is 5 percent, how much will you pay in state tax on this income?
$0
If you invest in a $1,000 corporate bond that has a 9 percent coupon and makes semi-annual payments, you can expect to receive ____ each six months.
$45 every 6 months
What is the value of a zero coupon bond that matures in 15 years if it promises to pay $5,000 at maturity, assuming an interest rate of 7.5 percent compounded annually?
$5000/(1.075)^15= $1689.83
What is the real value of an expected bond payment of $1,000 in 10 years if the rate of inflation is expected to be 5%? Multiple choice question.
$613.91
How is investing in U.S. Treasury bonds different from investing in corporate bonds?
- Internet from U.S. treasuries is exempt from taxes at the state level but corporate interest is not - Treasury issues have no default risk
Which of the following variables are required to calculate the value of a bond?
-Coupon Rate -Market Yield -Remaining Life of Bond
Which of these affect a bond's yield to maturity?
-Current price -Par value -Coupon rate
What are the two unique features of a U.S. federal government bond?
-US Treasury issues are considered to be default free -US Treasury issues are exempt from state income taxes
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
How is a zero coupon bond different from a conventional bond?
-Zeroes have no interest payments -Zeroes are offered at a discount rate
All junk bonds typically have which of these features?
-less than investment -grade rating -high probability of default
What is the real value of an expected bond payment of $1,000 in 7years if the rate of inflation is expected to be 3%?
1000/1.03^7= 813.09
What is the promised yield on a corporate bond that is currently priced at $975 and will pay $1,000 in 1 year?
2.56%
If you are in the 15 percent tax bracket, what will be your aftertax yield on a U.S. Treasury bond that is currently priced at par and yielding 5 percent?
4.25%= .05 x (1-.15)
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%
Assume you are holding a 1-year bond that is expected to pay $1075 if all goes well. However, there is a 75% probability that the corporation will file for bankruptcy and bondholders will receive only $400. If the required rate of return is 10%, what is the present value of the bond?
517.05
What will your aftertax yield be on a corporate bond that is currently trading at par and yielding 8 percent if you are in the 20 percent tax bracket?
6.4%= .08*(1-.2)
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?
750+200= 950
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 ____.
900+320= $1220 bond value
As an investor in the bond market, why should you be concerned about changes in interest rates?
Changes in interest rates cause changes in bond prices
How has TRACE improved transparency in the corporate bond market?
Corporate bond dealers are now required to report trade info through TRACE
In general, why is the yield on a corporate bond higher than the yield on a government bond?
Corporate bonds have default risk. Government bonds are considered default risk free. Corporate bonds are often publicly traded.
What is a bond's current yield?
Current yield = annual coupon payment / current price
What are the three components of the Treasury yield curve?
Expected inflation The interest rate risk premium The real rate of return
True or false: The inflation premium will be higher if the rate of inflation is low.
False
Which three components determine the shape of the term structure of interest rates?
Inflation premium, real interest rate, and interest rate risk premium.
The relationship between bond prices and the market rate of interest is ____.
Inverse; if the market rate of interest rises, bond prices will fall.
The federal government can raise money from financial markets to finance its deficits by ___.
Issuing Bonds
Why does a bond's value fluctuate over time?
The coupon rate and par value are fixed, while market interest rates change.
What does the clean price for a bond represent?
The quoted price excluding accrued interest
What is the difference between the quoted yield and the effective yield?
The quoted yield does not adjust for compounding, while the effective yield adjust for compounding
What information is needed to compute a bond's yield to maturity?
Time to maturity Coupon Rate The Bond's current price
Which of the following bonds have default risk?
-Corporate -Municipal
If an investment appreciates by 7 percent while the rate of inflation is 2 percent, what is the nominal rate of return?
7%,The nominal rate is the observed rate - the real rate is the nominal rate adjusted for inflation, or the percentage change in buying power.
The Fisher effect hypothesizes that the real rate of return ____.
Is invariant to the rate of inflation
What is the likely impact on the real rate if the economy is declining?
It will decline
What is the present value of the annual interest payments on a 20-year, $1,000 par value bond with a 5 percent coupon paid annually, if the yield on similar bonds is 10 percent?
PV= (.05 x $1,000) x (1-1/1.10^20)/.10= $425.68
How are TIPS different from traditional bonds?
Promised payments are specified in real terms
True or false: High grade bonds have Standard & Poor's ratings of AA or higher.
True
In general, which shape does the term structure of interest rates usually have?
Upward sloping
A Treasury yield curve depicts the _____.
Yields for different maturities of Treasury securities.
What is the effective annual yield for a bond that pays interest semiannually and has a quoted yield to maturity of 10 percent?
[1+(.10/2]^2-1= 10.25%
A treasury bond is:
debt issued by the US government with a typical maturity of between 2-30 years
If the liquidity of a bond increases then the bond's yield will _____.
decrease
The inflation premium is the additional return demanded by investors to compensate for _____.
inflation
Which of the following has great impact in determining the shape of the term structure of interest rates?
inflation
A market is considered transparent if ____.
its prices and trading volume are easily observed
When calculating the promised yield, one assumes ______.
no default
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
Historically, short-term rates are ______ higher than long-term interest rates.
sometimes
Which is more transparent, the stock market or the bond market?
stock market
The interest rate risk premium, real interest rate, and inflation premium all determine the shape of the term _____ of interest rates.
structure
The _____ structure of interest rates plots the relationship between short-term and long-term interest rates.
term
What is the present value of $500 to be received every year for the next 10 years if the interest rate is 5 percent?
$500 x (1-1/1.05^10)/.05= $3860.87
Which of the following institutions issue bonds that are traded in the bond market?
-Public corporations -The Federal Government -State Government
What is a premium bond?
A bond that sells for more than face value
Which of these risks is addressed by bond ratings?
Default risk
Which one of these correctly specifies the relationship between the nominal rate and the real rate?
(1 + R) = (1 + r) × (1 + h)
What is the effective annual rate for a bond with a 7 percent yield to maturity that makes semi-annual interest payments? (Hint: 7 percent annually is 3.5 percent per six-month period.)
(1.035)^2-1= 7.12%
What is the real rate of return if the nominal rate is 7 percent and the rate of inflation is 2 percent?
(1.07/1.02) - 1 = 4.90%
What is the expected return on a bond?
The return based on the current price and future cash flows adjusted for default risk.
If a $1,000 par value bond is trading at a premium, the bond is:
Trading for more than $1000 in the market
What does TIPS stand for?
Treasury Inflation-Protected Securities
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
A bond with a BBB rating has a ______ than a bond with an A rating.
higher risk of default
Which of the following terms apply to a bond?
-Coupon rate -Par value -Time to maturity
What does the dirty price represent?
it includes the quoted price and accrued interest
According to the Fisher effect hypothesis, the real rate of return ______ as inflation increases.
remains the same
True or false: In general, the price that is paid for a bond will exceed its quoted price.
true
True or false: Interest earned on Treasury notes and bonds is taxable
true
True or false: A bond's value is not affected by changes in the market rate of interest.
False
Which of these are required to calculate the current value of a bond?
The coupon rate, applicable market rate (market yield), and the time remaining to maturity, par value
What does the AAA rating assigned by S&P mean?
The firm is in a strong position to meet its debt obligations
In general, a corporate bond's coupon rate ____,
It's fixed until the bond matures
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
Which of the following are premiums determine the yield on a bond?
Expected future inflation Interest rate risk Taxability Default risk Liquidity
What is the present value of $1,000 to be received in 10 years if the interest rate is 12 percent, compounded semiannually?
$1,000/[1+(.12/2)]^10 x 2 = $311.80
What is the principal amount of a loan if the monthly payment on a 30-year mortgage is $1,600? Assume an annual interest rate of 6 percent, compounded monthly.
$266,866.58 PV= $1,600 x ({1-1/[1+(.06/12)]^30x12}/(.06/12))`
If you are holding a municipal bond that is trading at par to yield 6%, by how much will your after-tax yield change if your income tax bracket increases from 15% to 20%. Assume there are no state or local taxes
0%
What are municipal bonds?
Bonds that have been issued by state or local government
TRACE stands for "Trade Reporting and_______ Engine."
Compliance
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?
Coupon rate= $100/$1000= 10%
What are the sources of information for generating bond ratings?
Information from the corporation being rated, and information collected by the bond rating agency.
There is a(n) ______ relationship between market interest rates and bond values
Negative
Calculating the promised yield on a corporate bond is the same as calculating the yield to maturity on a government bond because:
The promised yield assumes no default
What key assumption makes the promised yield different from the expected return?
The promised yield assumes no default risk.
What are three important features of Treasury notes and bonds?
They are highly liquid, default-free, and taxable on the state or local level but not the federal level.
Which of the following are features of municipal bonds?
They are issued by state and local governments The interest on municipal bonds in exempt from federal taxes
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 false question.
True
The promised yield and the expected return for a risk-free security will be:
equal
According to the approximation formula for the nominal rate of return (R), the nominal rate will ________ if inflation (h) increases.
increase
The U.S. Treasuries market is the ______ security market in the world (based on trading volume).
largest
Inflation will _______ the value of a traditional bond's expected cash flows (interest and repayment of principal).
reduce
Which of the following accounts for compounding?
Effective annual rate Effective monthly rate
What is a bond's yield to maturity (YTM)?
YTM is the expected return on a bond that is held until it matures. Current yield is the coupon payment divided by market price.
Bond ratings are constructed by information ______ by the corporation and ______ by the rating agency.
supplied; collected
The real rate of return, expected inflation, and interest rate risk premium determine the Treasury ____ curve.
yield
What is the definition of a bond's time to maturity?
It is the number of years until the face values are paid off
What will happen to a bond's time to maturity as the years go by?
It will decline
What is the likely impact on the real rate if the economy is growing?
It will increase
What will happen to the default risk premium during periods of economic uncertainty?
It will increase
Which one of the following is the most important source of risk from owning bonds?
Market interest rate fluctuations
How significant is the real rate of return in determining the shape of the term structure of interest rates?
Not very significant and also less significant than inflation.
What is the present value of the annual interest payments on a 10-year, $1,000 par value bond with a coupon rate of 10 percent paid annually, if the yield on similar bonds is 9 percent?
PV=(.10 x $1000) x (1-1/1.09^10)/.09= $641.77
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 $1000 at the end of 5 years
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.
Which six factors determine the yield on a bond?
Taxability Default risk Expected future inflation Interest rate risk Real rate of return Liquidity
What is the nominal rate of return on an investment?
The actual percentage change in the dollar value of an investment unadjusted for inflation.
What is the asked price?
The asked price is the price at which a dealer is willing to sell.
A Treasury yield curve depicts the yields for different maturities of ____ securities.
treasury
What is the promised yield on a corporate bond that is currently priced at $950 and will pay $1,050 in 1 year?
($1,050 - $950)/$950 = 10.53%
What is the current yield on a $1,000 par value bond that sells for $900 if the coupon rate is 10 percent?
(.10 X 1000)/900= 11.11%
Which of these correctly identify differences between U.S. Treasury bonds and corporate bonds?
-Treasury bonds are issued by the US government will corporate bonds are issued by corporations. -Treasury bonds offered to certain tax benefits to investors the corporate bonds cannot offer -Treasury bonds are free of default risk while corporate bonds are exposed to default risk.
Assume you are holding a 1-year bond that is expected to pay $1050 if all goes well. However, there is a 90% probability that the corporation will file for bankruptcy and bondholders will receive only $200. If the required rate of return is 15%, what is the present value of the bond?
0.10×$1,050+0.9×$200/1.15 = $247.83
