Financial Analysis - USCA MBA - Ch8 SB

The inflation premium is the additional return demanded by investors to compensate for ______.

inflation

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.

Which six factors determine the yield on a bond?

-real rate of return -interest rate risk -expected future inflation -liquidity -default risk -taxability

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% 0.05 × (1 − 0.15) = 4.25%.

What is a bond's current yield?

Current yield = Annual coupon payment/Current price

What is a discount bond?

Discount bonds are bonds that sell for less than the face value.

What is the nominal rate of return on an investment?

It is the actual percentage change in the dollar value of an investment.

Which of the following terms apply to a bond?

Par value Coupon rate Time to maturity

How are TIPS different from traditional bonds?

Promised payments are specified in real terms

Why does a bond's value fluctuate over time?

The coupon rate and par value are fixed, while market interest rates change.

What does TIPS stand for?

Treasury Inflation Protected Securities

When the U.S. government wants to borrow money for the long-term (more than 1 year), it issues ______.

Treasury notes Treasury bonds

True or false: High-grade bonds have Standard & Poor's ratings of AA or higher.

True

In general, why is the yield on a corporate bond higher than the yield on a government bond?

because corporate bonds have default risk

If the liquidity of a bond increases, then the bond's yield will ______.

decrease

Which of these risks is addressed by bond ratings?

default risk

What are the sources of information for generating bond ratings?

information from the corporation being rated information collected by bond rating agency

Inflation will ______ the value of a traditional bond's expected cash flows (interest and repayment of principal).

reduce

The term structure of interest rates examines the ______.

relationship between short-term and long-term interest rates

If you invest in a corporate bond, how many times can you expect, in general, to receive interest?

twice a year

How significant is the inflation premium on the shape of the term structure of interest rates?

very significant more significant than the real rate of return

Given positive inflation, the expected payments in nominal terms ______ over time for a TIPS bondholder.

will change

Given positive inflation, the expected payments in real terms ______ over time for a TIPS bondholder.

will not change

The coupon rate, par value, and maturity are all needed to compute the promised _____ on a bond.

yield

The real rate of return, expected inflation, and interest rate risk premium determine the Treasury _____ curve.

yield

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 ______.

$45 every 6 months $1,000 (0.09/2) = $45.

Which of the following bonds have default risk?

municipal bonds corporate bonds

When calculating the promised yield, one assumes ______.

no default

Bond ratings are based on the probability of default risk, which is the risk that ______.

the bond's issuer may not be able make all the required payments

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?

$1,689.83. $5,000/(1.075)^15 = $1,689.83.

What is the aftertax yield on a U.S. Treasury bond yielding 7 percent if you are in the 20 percent tax bracket?

5.6% 0.07 × (1 − 0.2) = 5.6%.

What is the effective annual rate on a bond with a yield to maturity of 6 percent that pays semiannual interest?

6.09% [1 + (0.06/2)]^2 − 1 = 6.09%.

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%

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

decrease

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

A humped term structure of interest rates indicates that interest rates are expected to ______ as the time to maturity increases.

increase and then decline

Over time, the purchasing power of the cash flows from a bond decreases due to _____.

inflation

Which of these is the least important component of the nominal rate of return?

inflation loss on investment earnings

Which three components determine the shape of the term structure of interest rates?

interest rate risk premium inflation premium the real interest rate

The Fisher effect hypothesizes that the real rate of return ______.

is invariant to the rate of inflation

The federal government can raise money from financial markets to finance its deficits by ______.

issuing bonds

What is the likely impact on the real rate if the economy is declining?

it will decline

How significant is the real rate of return in determining the shape of the term structure of interest rates?

less significant than inflation not very significant

According to the Fisher effect hypothesis, the real rate of return ______ as inflation increases.

remains the same

Historically, short-term rates are ______ higher than long-term interest rates.

sometimes

The interest rate risk premium, real interest rate, and inflation premium all determine the shape of the term _____ of interest rates.

structure

What is the effective annual yield for a bond that pays interest semiannually and has a quoted yield to maturity of 10 percent?

10.25% [1 + (0.10/2)]^2 − 1 = 10.25%.

If the rate of inflation is 3 percent and the real rate of return is 9 percent, the nominal rate is approximately ______ percent.

12% 9% + 3% = 12%.

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%

What is the real rate of return if the nominal rate is 5 percent and the rate of inflation is 0.5 percent?

4.48% (1.05/1.005) − 1 = 4.48%.

What is the real rate of return if the nominal rate is 7 percent and the rate of inflation is 2 percent?

4.90% (1.07/1.02) − 1 = 4.90%.

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 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?

5.25% 0.07 × (1 − 0.25) = 5.25%.

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 the effective annual rate for a bond with a 7 percent yield to maturity that makes semiannual interest payments? (Hint: 7 percent annually is 3.5 percent per six-month period.)

7.12% Effective annual rate = [1 + (0.07/2)]^2 − 1 = 7.12%.

What are municipal bonds?

Bonds that have been issued by state or local governments

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 real rate of return will generally be higher than the nominal rate of return.

False

What is an interest-only loan?

It's a loan in which the borrower pays interest periodically and repays the principal when the bond matures.

A bond's YTM will exceed its current yield when the bond is selling at ______.

a discount

How is a zero coupon bond different from a conventional bond?

Zeroes make no interest payments. Zeroes are always issued at a discount.

Assume you are holding a 1-year bond that is expected to pay $1,075 if all goes well. However, there is a 75 percent probability that the corporation will file for bankruptcy and bondholders will receive only $400. If the required rate of return is 10 percent, what is the present value of the bond?

$517.05

What is the real value of an expected bond payment of $1,000 in 7 years if the rate of inflation is expected to be 3 percent?

$813.09

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 Total value = $200 + 750 = $950.

Which one of these correctly specifies the relationship between the nominal rate and the real rate?

(1 + R) = (1 + r) × (1 + h)

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 to 20 percent. Assume there are no state or local taxes.

0 percent Interest income from munis is exempt from federal income tax.

What is the promised yield on a corporate bond that is currently priced at $950 and will pay $1,050 in 1 year?

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?

11.11% (0.10 × $1,000)/$900 = 11.11%.

True or false: The inflation premium will be higher if the rate of inflation is low.

FAlse

True or false: A bond's value is not affected by changes in the market rate of interest.

False

What is a premium bond?

a bond that sells for more than face value

A corporate bond's yield to maturity ______.

changes over time can be greater than, equal to, or less than the bond's coupon rate

What are three important features of Treasury notes and bonds?

default-free highly liquid taxable

Which of the following are common shapes for the term structure of interest rates?

downward sloping flat upward sloping

Which of the following accounts for compounding?

effective annual rate effective monthly rate

The promised yield and the expected return for risk-free security will be ______.

equal

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

What are the three components of the Treasury yield curve?

expected inflation interest rate risk premium the real rate of return

A limitation of bond ratings is that they ______.

focus exclusively on default risk

If the term structure of interest rates is upward sloping, then ______.

long-term rates are higher than short-term rates

All else held constant, the yield on a highly liquid bond will be ______ the yield on an illiquid bond.

lower than

There is a(n) ______ relationship between market interest rates and bond values.

negative 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 degree of interest rate risk depends on ______.

the sensitivity of the bond's price to interest rate changes

A TIPS bondholder will not know ______.

the size of expected payments in nominal terms

What information is needed to compute a bond's yield to maturity?

time to maturity coupon rate the bond's current price

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 percent?

$613.91

What is the definition of a bond's time to maturity?

It is the number of years until the face value is paid.

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.

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.

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 is the equation for approximating the nominal rate of return?

R = r + h

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 of the following institutions issue bonds that are traded in the bond market?

State Governments Federal Governments Public Corporations

What does the AAA rating assigned by S&P mean?

The firm is in a strong position to meet its debt obligations

A Treasury yield curve depicts the yields for different maturities of _____ securities.

Treasury

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

True or false: Interest earned on Treasury notes and bonds is taxable.

True

What is a bond's yield to maturity (YTM)?

YTM is the expected return on a bond that is held until it matures.

What is a corporate bond's yield to maturity (YTM)?

YTM is the prevailing market interest rate for bonds with similar features. YTM is the expected return for an investor who buys the bond today and holds it to maturity.

A Treasury yield curve depicts the ______.

Yields for different maturities of Treasury securities.

Taxable bonds have ______ rate of return than non-taxable bonds, all else equal.

a higher

Which of these are required to calculate the current value of a bond?

coupon applicable market rate par value time remaining to maturity

A conventional bond's cash flows consist of ______.

coupon interest payments repayment of the bond's par value at maturity

Which of the following has a great impact in determining the shape of the term structure of interest rates?

inflation

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

In general, a corporate bond's coupon rate ______.

is fixed until the bond matures

Which of the following are premiums in the determination of the yield on a bond?

lack of liquidity default risk taxability expected future inflation interest rate risk

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 The YTM is less than the coupon rate for a premium bond.

A zero coupon bond is a bond that ______.

makes no interest payments

Which one of the following is the most important source of risk from owning bonds?

market interest rate fluctuations

Which of the following variables are required to calculate the value of a bond?

market yield coupon rate remaining life of bond

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

Bond ratings are constructed by information ______ by the corporation and ______ by the rating agency.

supplied; collected

The taxability premium is the additional compensation demanded on ______.

taxable bonds

The _____ structure of interest rates plots the relationship between short-term and long-term interest rates.

term

If you own corporate bonds, you will be concerned about interest rate risk as it affects ______.

the market price of the bonds

For risk-free security, the promised and expected returns are equal because ______.

the probability of default is zero

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 Bond value = $320 + 900 = $1,220.

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% Coupon rate = $100/$1,000 = 10%.

Assume you are holding a 1-year bond that is expected to pay $1,050 if all goes well. However, there is a 90 percent probability that the corporation will file for bankruptcy and bondholders will receive only $200. If the required rate of return is 15 percent, what is the present value of the bond?

$247.83 (0.10×$1,050+0.9×$200)/1.15 = $247.83.

What is the present value of $1,000 to be received in 10 years if the interest rate is 12 percent, compounded semiannually?

$311.80 $1,000/[1 + (0.12/2)]^(10 × 2) = $311.80.

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?

$425.68 PV = (0.05 × $1,000) × (1 − 1/1.10^20)/0.10 = $425.68.

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?

$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.

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?

$641.77 PV = (0.10 × $1,000) × (1 − 1/1.09^10)/0.09 = $641.77.

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 zeroes cannot. - A conventional bond pays periodic coupon interest, while zeroes make no interest payments.

Which of these correctly identify differences between U.S. Treasury bonds and corporate bonds?

- Treasury bonds are considered free of default risk, while corporate bonds are exposed to default risk. - Treasury bonds offer certain tax benefits to investors that corporate bonds cannot offer. - Treasury bonds are issued by the U.S. government, while corporate bonds are issued by corporations.

What are the three components of the nominal rate of return?

- compensation for the inflation effect on the original investment - real rate of return - compensation for the inflation effect on the investment earnings

Which of the following are features of municipal bonds?

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

What key assumption makes the promised yield different from the expected return?

The promised yield assumes no default risk.

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 is the difference between the quoted yield and the effective yield?

The quoted yield does not adjust for compounding, while the effective yield adjusts for compounding

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.

What is the expected return on a bond?

The return based on the current price and future cash flows adjusted for default risk.

Which of these affect a bond's yield to maturity?

current price coupon rate par value

If a bond is selling at a discount from its par value, the YTM must be ______ the coupon rate.

greater than

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

All junk bonds typically have which of these features?

less than investment-grade rating high probability of default

What information is needed to compute the promised yield on a bond?

par value maturity coupon rate

If a $1,000 par value bond is trading at a premium, the bond is ______.

selling for more in the market