Portfolio / Fixed Income Basics: Fixed Income Basics
Net Present Value takes each annual cash flow projected to be received from an investment and discounts it back to today's present value, typically using the risk-free rate of return as the discount factor and adds them up. This computes the aggregate present value of those cash flows. Then, the initial cash outflow (the investment) is subtracted. If the net result (as in net present value) is positive, then the investment should be made. If it is negative, there would be a loss on the investment.
Assume that an investor makes a $1,000 investment that will return $100 in the first year; $100 in the second year; and $1,100 in the third year. (Basically, this investment is returning 10% per year over 3 years.) Also assume that the risk-free rate of return is 5%, so this is the discount factor used in the formula. A $100 cash flow to be received 1 year from now would have a present value of: $100/1.05 = $95.24 A $100 cash flow to be received 2 years from now would have a present value of: $100/(1.05)^2 = $90.70 A $1,100 cash flow to be received 3 years from now would have a present value of: $1,100/(1.05)^3= $950.22 The sum of the present values is: $95.24 + $90.70 + $950.22 = $1,136.16. If we subtract the initial investment of $1,000, we get a net present value of +$136.16. (Also note that, logically, since the rate of return on the investment of 10% is more than the discount factor of 5%, the net present value would have to be positive.)
Finding the present value of a TIPS (Treasury Inflation Protection Security) is the same thing as calculating the market price of a TIPS using discounted cash flows. The coupon rate (nominal rate) on a TIPS is the interest rate at issuance that will price the instrument at par. This is the same as the "real rate" of return at that point in time (the real rate has the current inflation deducted out, because there is no "inflation risk" on a TIPS). Assume that the 30-year Treasury Bond is issued with a 3% coupon rate when the inflation rate is 1%. The "real" rate of return is 2%, and this would be the interest rate on a 30-year TIPS issued at that time.
Assuming that this interest rate is 2% for a 30 year TIPS. If there is no inflation, the annual cash flow received for each of the next 29 years will be 2% of $1,000 = $20; and in year 30, the customer will receive $1,020 ($1,000 principal without any inflation adjustment plus another $20 of interest). If these cash flows are discounted at the coupon rate of 2%, the price of the bond will be par. If there is inflation, then the principal amount is adjusted upwards in that year for the CPI increase, and the cash flow received in that year also increases, since the 2% coupon is applied against the increased principal amount. Because the cash flows are increasing due to inflation, when they are discounted at the 2% coupon rate, this means that the bond will be valued above par. Conversely, if there is deflation, then the principal amount is adjusted downwards in that year for the CPI decrease, and the cash flow received in that year also decreases, since the 2% coupon is applied against the decreased principal amount. Because the cash flows are decreasing due to deflation, when they are discounted at the 2% coupon rate, this means that the bond will be valued below par.
Net Present Value
If the rate of interest placed on a bond issuance by the issuer is the current market rate of interest then the net present value of those cash flows will be par if net present value is below par then the bond is trading at a discount - in order to increase the yield on the bond above the stated coupon rate, dealer had to lower the price below par so that bond gives competitive yield to current market rates if net present value above par then bond trading at a premium - in order to decrease the yield on the bond to the prevailing market rates, the dealer raises the price above par so that the bond gives a competitive yield to current market rates
Finding the present value of a TIPS (Treasury Inflation Protection Security) is the same thing as calculating the market price of a TIPS using discounted cash flows. The coupon rate on a TIPS is the interest rate at issuance that will price the instrument at par. Assume that this interest rate is 2% for a 30 year TIPS. If there is no inflation, the annual cash flow received for each of the next 29 years will be 2% of $1,000 = $20; and in year 30, the customer will receive $1,020 ($1,000 principal without any inflation adjustment plus another $20 of interest). If these cash flows are discounted at the coupon rate of 2%, the price of the bond will be par.
If there is inflation, then the principal amount is adjusted upwards in that year for the CPI increase, and the cash flow received in that year also increases, since the 2% coupon is applied against the increased principal amount. Because the cash flows are increasing due to inflation, when they are discounted at the 2% coupon rate, this means that the bond will be valued above par. Conversely, if there is deflation, then the principal amount is adjusted downwards in that year for the CPI decrease, and the cash flow received in that year also decreases, since the 2% coupon is applied against the decreased principal amount. Because the cash flows are decreasing due to deflation, when they are discounted at the 2% coupon rate, this means that the bond will be valued below par.
Tangible asset
an asset such as machinery or equipment that is moveable. Such assets are valued on a company's balance sheet at net depreciated value. In addition to tangible assets, companies can also have intangible assets and real estate assets
A customer buys a 6.50% municipal bond at par in the State. The customer is in the 30% Federal Tax Bracket and the 10% State Tax Bracket. After considering taxes, the customer's yield will be: A 6.50% B 5.90% C 4.60% D 3.90%
answer: A) 6.50% The question is not explicit about whether the municipal bond was issued by the State in which the customer has his or her primary residence. But this should be assumed, based on the "nature" of the question. The interest earned on municipal bonds is exempt from Federal income tax; and also from State and Local income taxes when the bond is purchased by a resident of the State of issuance. So a municipal bond yielding 6.50% will not be taxable at the Federal or State level if purchased by a resident of the issuing State.
If market interest rates increase, which statement is TRUE? A Current yields will increase B Dividend yields will decrease C Price-earnings ratios will increase D Bond prices will increase
answer: A) Current yields will increase f market interest rates increase, the prices of fixed income securities will drop, raising their yields in the marketplace to current higher levels. Thus, current yields will increase. A change in market interest rates does not have a direct effect on dividend yields - company earnings and growth prospects are the major determinant of the amount of dividends that a company's Board of Directors chooses to pay. Similarly, price-earnings ratios are not directly affected by a market interest rate increase (though, if interest rates rise a lot, company earnings will go down as interest costs rise for those issuers that issue bonds and their P/E ratios may decline over time; and vice-versa). However, the best choice is A.
An investor believes that interest rates will be flat or falling into the future; and that prices may deflate. The MOST appropriate investment is: A Long term U.S. Government bonds B Real estate C Gold D Large Capitalization stocks
answer: A) Long term U.S. Government bonds In periods of deflation, interest rates fall. A fixed income security's price will go up as interest rates fall. Furthermore, since prices are deflating, the fixed interest payments received are able to buy more and more over time. This is the best investment choice. In times of deflation, real estate prices fall; as do gold prices. Stock prices tend to fall as well, since companies are forced to cut their prices to maintain sales volume.
What is the BEST investment recommendation for an individual in a high tax bracket who is risk averse? A Municipal bonds B Direct participation programs C U.S. Government bonds D Sovereign government bonds
answer: A) Municipal bonds The income from municipal bonds is exempt from federal income tax, and historically, these have been very safe investments. Thus, municipal bonds are the best recommendation for this customer. Direct participation programs (limited partnership tax shelters) do not meet the objective of low risk - these can be very risky investments. The income from U.S. Government bonds and sovereign government bonds is federally taxable, so these are not the best of the choices offered for an individual that is in a high tax bracket.
A customer has won $1,000,000 in a lottery. The customer has the choice of taking $1,000,000 today or $65,000 per year for the next 20 years. To evaluate the best option, the customer would use: A Net Present Value B Total Return C Rule of 72 D Expected Rate of Return
answer: A) Net Present Value This person has the choice of taking $1,000,000 now or can take $65,000 a year for the next 20 years. To find the best choice, each $65,000 payment over each of the next 20 years must be discounted back to today's net present value, using the risk-free interest rate as the discount factor. If the net present value of these payments is more than $1,000,000, then the 20 payments of $65,000 would be the better choice.
What rate would be used to find the present value of a TIPS? A Real Rate of Return at the time the bond was issued B Risk-Free Rate of Return at the time the bond was issued C Internal Rate of Return of the bond's cash flows D LIBOR
answer: A) Real Rate of Return at the time the bond was issued
Over the past 4 years, a customer's fixed income portfolio value has dropped by 2%. During the same period, the Consumer Price Index has dropped by 5%. Based on these facts, which statement is TRUE? A The customer's purchasing power has increased B The customer's purchasing power has decreased C The customer's purchasing power is unaffected D The effect on the customer's purchasing power cannot be determined
answer: A) The customer's purchasing power has increased The customer's portfolio value has dropped by 2%; and prices have dropped by 5%; so this customer is gaining purchasing power. If prices are falling faster than the portfolio value, then each $1 in the portfolio can buy proportionately more.
Years ago, a bond was issued at par with a 7% coupon. This year, new issue bonds of similar credit quality are being issued at 10%. Which statement is TRUE? A The new bonds will be issued at a premium to the current price of the 7% bonds B The new bonds will be issued at a discount to the current price of the 7% bonds C The new bonds will be issued at the same price as the current price of the 7% bonds D There is no relationship between the prices of the 2 bond issues
answer: A) The new bonds will be issued at a premium to the current price of the 7% bonds Because interest rates have risen from 7% to 10%, any new issue bonds will come out at par with a 10% coupon; while the prices of outstanding bonds with lower coupons will drop in the market. Thus, new bonds will be selling at a premium to the current price of existing bonds that have lower coupons.
Which of the following will equal the face value of a bond? A The present value of the payments to be received from the issuer discounted by the bond coupon rate B The present value of the payments to be received from the issuer discounted by the market rate of interest C The future value of the payments to be received from the issuer discounted by the bond coupon rate D The future value of the payments to be received from the issuer discounted by the market rate of interest
answer: A) The present value of the payments to be received from the issuer discounted by the bond coupon rate If the annual interest payments and final principal repayment to be received from a bond are discounted back to present value using the coupon rate, the present value of those payments will be $1,000 = the face value of the bond.
A customer wishes to make an investment that provides liquidity, marketability and current income. The BEST recommendation is: A Treasury Note B Bank CD C Preferred Stock D Growth stock
answer: A) Treasury Note This customer is looking for current income, so growth stocks are inappropriate. This customer is looking for ready marketability and CDs are not very marketable - they are typically held to maturity. Both preferred stock and Treasury notes provide current income, but Treasuries are more marketable and more liquid. This is the best of the choices offered.
A customer wishes to maximize liquidity and minimize interest rate risk. The BEST recommendation is: A bonds with short term maturities B bonds with long term maturities C callable bonds D non callable bonds
answer: A) bonds with short term maturities Short term bonds do not fluctuate much in value as interest rates move since they will be redeemed shortly at par. (The longer the maturity, the greater the price movement in response to market interest rate changes). Short term maturities are also the most liquid - that is, there is great market depth, making them easy to trade.
A 5% coupon bond is being offered on a 6% basis. If interest rates for similar bonds rise above 6%, the basis for this bond will: A increase B decrease C be unaffected D be volatile
answer: A) increase This is pretty simple. A basis quote is a yield to maturity quote. If market yields are rising, the basis quote will rise, forcing the bond's price down. If market yields are falling, the basis quote will fall, forcing the bond's price up.
During a period of steep economic decline, equity investments fall out of favor with investors, who rotate their investments out of equities into safe investments such as Treasury Bills. This is an example of: A market risk B business risk C regulatory risk D opportunity cost
answer: A) market risk When investors like stocks, they buy them and stock prices rise. When investors don't like stocks, they either sell them or don't buy them and prices fall. This is market risk. Business risk is the risk that a negative event, bad management or bad products cause a company to become unprofitable. Regulatory risk is the risk of law change negatively affecting a company's operations. Opportunity cost is the return "lost" by making a suboptimal investment
Investment A requires a $10,000 initial investment with a 3 year investment time horizon. It is expected to generate $4,000 of positive cash flow in Year 1, $4,000 of positive cash flow in Year 2, and $4,000 of positive cash flow in Year 3. Assuming that the market rate of return for investments of similar risk and investment time horizon is 6%, the NPV of this investment is: A +$666.66 B +$692.05 C +$2,000.00 D +$6,000.00
answer: B) +$692.05 Net Present Value takes the cash flows from an investment and discounts them back to today's present value. The "Net" part of the formula, is that the initial investment outlay ($10,000 in this case) is deducted from the present value of the positive future cash flows. If the NPV is positive, this is a good investment. In this example, in Year 0, -$10,000 is the initial cash outlay. At the end of Year 1, $4,000 of cash flow is received, discounted to today's present value using the 6% market rate of return = $4,000/1.06 = $3,773.58. At the end of Year 2, $4,000 of cash flow is received, discounted to today's present value using the 6% market rate of return = $4,000/(1.06 x 1.06) = $3,559.99. At the end of Year 3, $4,000 of cash flow is received, discounted to today's present value using the 6% market rate of return = $4,000/(1.06 x 1.06 x 1.06) = $3,358.48. The NPV is -$10,000 + $3,773.58 + $3,559.99 + $3,358.48 = +$692.05 Because the NPV is positive, this indicates that the investment is generating a return greater than the market rate of return for similar investments and that the investment should be made.
Investment A requires a $15,000 initial investment with a 3 year investment time horizon. It is expected to generate $8,000 of positive cash flow in Year 1, $6,000 of positive cash flow in Year 2, and $3,000 of positive cash flow in Year 3. Assuming that the market rate of return for investments of similar risk and investment time horizon is 4%, the NPV of this investment is: A +$666.66 B +$906.64 C +$2,000.00 D +$6,000.00
answer: B) +$906.64 Net Present Value takes the cash flows from an investment and discounts them back to today's present value. The "Net" part of the formula, is that the initial investment outlay ($15,000 in this case) is deducted from the present value of the positive future cash flows. If the NPV is positive, this is a good investment. In this example, in Year 0, -$15,000 is the initial cash outlay. At the end of Year 1, $8,000 of cash flow is received, discounted to today's present value using the 4% market rate of return = $8,000/1.04 = $7,692.31. At the end of Year 2, $6,000 of cash flow is received, discounted to today's present value using the 4% market rate of return = $6,000/(1.04 x 1.04) = $5,547.34. At the end of Year 3, $3,000 of cash flow is received, discounted to today's present value using the 4% market rate of return = $3,000/(1.04 x 1.04 x 1.04) = $2,666.99. The NPV is -$15,000 + $7,692.31 + $5,547.34 + $2,666.99 = +$906.64 Because the NPV is positive, this indicates that the investment is generating a return greater than the market rate of return for similar investments and that the investment should be made.
A customer buys a 2-year maturity, 10% coupon bond at par. If market interest rates rise to 12%, then the bond's price will fall by approximately: A 1.7% B 3.4% C 8.8% D 9.7%
answer: B) 3.4% The customer bought this 2-year bond at par with a coupon rate of 10%. If market interest rates rise to 12%, then the present value of the bond's cash flows will fall as follows (rounded): Year 1:$100 / 1.12 = $89.29 Year 2:$1,100 / (1.12)^2 = $876.91 Total Present Value = $89.29 + $876.91 = $966.20 The bond will fall in price by $33.80 from $1,000 par, for a fall of 3.4%.
A bond portfolio consists of: $100,000 par value of 1-year zero coupon bonds $100,000 par value of 3-year zero coupon bonds $100,000 par value of 5-year zero coupon bonds $100,000 par value of 9-year zero coupon bonds The duration of the portfolio is: A 1 year B 4.5 years C 5 years D 9 years
answer: B) 4.5 years Duration is the number of years until the $1,000 par principal of a bond is paid back. Since a zero-coupon bond makes no interest payments, the entire $1,000 par principal amount is paid back at the maturity date, making the duration the same as the number of years to maturity. To calculate portfolio duration, the weighted average of the bond durations in the portfolio is calculated. In this example, each bond position has the exact same weight ($100,000 par), so taking the arithmetic average of the 4 maturities ( 1 + 3 + 5 + 9 = 18 / 4) gives a portfolio duration of 4.5.
A customer buys a 3-year maturity, 6% coupon bond at par. If market interest rates rise to 8%, then the bond's price will fall by: A 2% B 5% C 10% D 25%
answer: B) 5% The customer bought this 3-year bond at par with a coupon rate of 6%. If market interest rates rise to 8%, then the present value of the bond's cash flows will fall as follows: Year 1: $60 / 1.08 = $55.55 Year 2: $60 / (1.08)^2 = $51.44 Year 3: $1,060 / (1.08)^3 = $841.46 Total Present Value = $55.55 + $51.44 + $841.46 = $948.45 The bond will fall in price by $51.55 from $1,000 par, for a fall of 5.155%.
A customer invests $50,000. 10 years later, the investment is worth $100,000. The customer's annual compounded rate of return is: A 5.00% B 7.20% C 10.00% D 12.50%
answer: B) 7.20% The "Rule of 72" can be used here. To find the number of years that it takes to double an investment's value, divide the yield into 72. Since the question gives 4 answers, one way to get the answer is to take each choice and divide it into 72. Taking 72 / 7.20 = 10 years to double the investment value - which is the number of years given in the question.
Regulatory risk for a municipal bond would be characterized by: A the Federal Reserve pursuing an "easy money" policy of lowering interest rates B Congress pursuing an economic stimulus policy of lowering tax rates C export quotas being placed on U.S. goods by foreign countries that are trading partners with the United States D the European Economic Union pursuing a policy of increasing the value of the Euro versus the value of the U.S. Dollar
answer: B) Congress pursuing an economic stimulus policy of lowering tax rates Regulatory risk (also called legislative risk) is usually the risk of a tax law change. For municipals, if tax rates are lowered, the relative attractiveness of buying a "tax-free" municipal bond is diminished, reducing the market value of outstanding municipal bonds compared to the value of taxable bonds.
A $1,000 par zero coupon bond with 5 years to maturity can be purchased for $750. How is the bond's rate of return calculated? A Find the Internal Rate of Return that discounts that bond's final payment to "0" in 5 years B Find the Internal Rate of Return that discounts the bond's final payment to $750 in 5 years C Multiply the initial cost of the bond by the discount rate D Divide the $1,000 redemption price of the bond by the discount
answer: B) Find the Internal Rate of Return that discounts the bond's final payment to $750 in 5 years To find the bond's yield, the interest rate must be found that takes the $750 purchase price and grows it to $1,000 in 5 years. This interest rate is about 6%. This is the bond's yield to maturity (which is also the Internal Rate of Return for a zero coupon bond). $750 x 1.06 x 1.06 x 1.06 x 1.06 x 1.06 = $1,004 Conversely, if the $1,000 payment to be received in 5 years is discounted by the rate of return that will bring its present value to $750, that is the bond's yield. This would be: $1,000 / (1.06 x 1.06 x .1.06 x 1.06 x 1.06)
For bonds trading at a premium, rank the yield measures from lowest to highest? I Nominal II Current III Basis IV Yield to Call Basis A I, II, III, IV B IV, III, II, I C II, I, III, IV D I, III, II, IV
answer: B) IV, III, II, I When bonds are trading at a premium, the yield to call will be the lowest measure since the annual return is reduced by the annual amortized portion of the premium that will be "lost" over the life of the bond to the call date. The next highest yield will be the yield to maturity, since the premium will be lost over a longer "life" than if the bond is called early. Current yield will be higher than yield to maturity, since it does not include the annual premium loss. Stated yield will be the highest since it is the return based on par value.
An investor that buys securities issued by companies based in Third World countries would be MOST concerned with: A Currency exchange risk B Political risk C Purchasing power risk D Interest rate risk
answer: B) Political risk Investing in any Third World country is risky. The major risk of investing in a Third World country is political risk. For example, the country changes its laws and "nationalizes" your private investment - without compensating you! Currency exchange risk is always an issue with a foreign investment, but it typically is not a risk that will bankrupt an investor. Any security can have purchasing power risk - the risk that inflation devalues your investment's value. Finally, any fixed income security has interest rate risk - the risk that if market interest rates rise, the value of the fixed income security will fall.
Which investment offers the BEST protection against inflation risk? A Common stocks B Tangible assets C Long-Term Corporate Bonds D Treasury Bonds
answer: B) Tangible assets When there is a lot of inflation, market interest rates rise, causing long-term bond prices to drop steeply. This is purchasing power risk and high credit quality (e.g., Treasury bonds) does not protect a bond issue from this. When inflation rates and interest rates rise, corporate earnings suffer greatly, causing common stock prices to fall. When there is steep inflation, the best investments are money market instruments and tangible assets (e.g., precious metals, real estate). Money market instruments do not suffer inflation risk and because interest rates are high when there is inflation, they give a nice rate of return. However, this is not offered as a choice! Tangible assets tend to hold their value (or increase in value) when there is inflation, usually because investors are afraid to put their money into stocks or bonds!!! Review
Two 20-year corporate bonds are issued at par, with stated interest rates of 10%. One issue is callable at par in 5 years, while the other is callable at par in 10 years. If interest rates drop by 200 basis points shortly after issuance, which statement is TRUE? A The bond callable in 5 years will appreciate more than the bond callable in 10 years B The bond callable in 10 years will appreciate more than the bond callable in 5 years C Both bonds will appreciate by equal amounts D The rate of appreciation depends on the credit rating of the bonds
answer: B) The bond callable in 10 years will appreciate more than the bond callable in 5 years If a bond is callable at par in the near future, any price rise due to falling interest rates will be suppressed since the issuer is likely to call in the debt and refund at lower interest rates. Thus, the bond callable in 10 years will appreciate more than the bond callable in 5 years if interest rates fall.
If a callable bond is purchased at a premium, and is then called at par which of the following is TRUE? A The yield to call is higher than the nominal yield B The yield to call is lower than the nominal yield C The yield to call is the same as the nominal yield D The yield to call moves inversely to the nominal yield
answer: B) The yield to call is lower than the nominal yield The yield to call will be lower than the yield to maturity if the bond was purchased at a premium (which will be lost faster if the bond is called early). Since the bond is purchased at a premium, both yield to call and yield to maturity must be lower than the nominal yield.
Which statement is TRUE? A The current yield of a bond is the same as the bond's yield to maturity B The yield to maturity of a bond is the same as the internal rate of return C The nominal yield of a bond is the same as net present value D The yield to call of a bond is the same as the yield to maturity
answer: B) The yield to maturity of a bond is the same as the internal rate of return The internal rate of return on a bond is the interest rate that will discount the bond's cash flows to the purchase price of the bond. It is the same as the bond's yield to maturity.
A customer who is retired wants to select an investment that is liquid, marketable, and that provides regular income. The BEST choice would be to recommend: A Treasury Bills B Treasury Notes C Preferred Stock D Certificates of Deposit
answer: B) Treasury Notes Certificates of Deposit are non-negotiable - they are non-marketable, so this does not meet the client's needs. Preferred stock is marketable, but not as marketable as Treasury securities, making Treasury securities the better choice. So we are left with either a T-Bill or a T-Note. Treasury notes pay interest semi-annually; while Treasury Bills do not provide a regular income stream, so a T-Note is the better choice. (One could argue that buying T-Bills at a discount and letting them mature at par and then rolling over the original investment amount into a new T-Bill purchase will also provide an income stream, but this requires continuous reinvestment on the part of the customer. Buying a T-Note is a completely passive investment in terms of the customer's needs.)
A 7% coupon bond is being offered on an 8% basis. If interest rates for similar bonds fall below 8%, the basis for this bond will: A increase B decrease C be unaffected D be volatile
answer: B) decrease This is pretty simple. A basis quote is a yield to maturity quote. If market yields are rising, the basis quote will rise, forcing the bond's price down. If market yields are falling, the basis quote will fall, forcing the bond's price up.
If an individual sells the shares of a stock included in the Standard and Poor's 500 Index and uses the proceeds to buy SPDRs, then the individual has: A increased business risk B decreased business risk C increased regulatory risk D decreased regulatory risk
answer: B) decreased business risk Since this customer is liquidating a single stock position, and investing the proceeds in an index ETF (which is diversified), the customer is reducing the unsystematic risk or business risk inherent in a single stock position.
The best description of the "term" of a bond is the: A yield to maturity offered by the security B end date of the bond when the final payment will be received C period of time that the purchaser has held the bond D frequency with which the bond will make interest payments to the holder
answer: B) end date of the bond when the final payment will be received The "term" of the bond is the length of time between bond issuance and bond maturity. At maturity, the final interest payment is made, along with the repayment of principal. Therefore, Choice B is the best offered.
When prices in an economy are adjusted with relation to a price index by force of contract, this is called: A hyper inflation B inertial inflation C loop inflation D stagflation
answer: B) inertial inflation Inertial inflation is inflation that is contractually embedded in the economy. For example, COLAs (Cost of Living Adjustments) in union and government employment contracts are tied to increases in the inflation rate. Inertial inflation can be "self-fulfilling" because as wages rise due to COLAs, this creates inflationary pressure on prices of goods and services, so their prices rise, which triggers another COLA increase, etc. In periods of sustained inflation, bonds do terribly because interest rates rise, and stocks don't fare well either. Tangible assets such as real estate are the best investments in periods of sustained inflation.
The primary risk associated with investing in an index fund is: A liquidity risk B market risk C business risk D regulatory risk
answer: B) market risk Index funds are fully diversified - so business risk is minimized. There is little liquidity risk because index fund shares can be redeemed at Net Asset Value daily. Diversification does not protect against market risk. If the market falls in general, so will the value of the securities in the index fund. Market risk is the risk that cannot be diversified away (but one can hedge against it by using the appropriate option contract).
The risk that is unique to mortgage backed securities is: A credit risk B prepayment risk C interest rate risk D purchasing power risk
answer: B) prepayment risk Mortgage backed securities pass through the monthly mortgage payments to the certificate holders. Because the homeowners have the right to prepay their mortgages without penalty, when market interest rates drop, the homeowners refinance their mortgages, and these early principal repayments are passed-through to the certificate holders. Thus, the certificates pay off much earlier than expected as the expected maturity shortens (this is also called contraction risk). The certificate holders that receive the early principal payments will now have to reinvest them in new MBSs, which will be yielding less because market interest rates have declined. All securities have credit risk (risk of default) with the possible exception of U.S. Government debt (the safest debt in the world and credit risk-free for test purposes). All fixed rate securities have interest rate risk (the risk of rising interest rates forcing the value of outstanding lower-rate issue downwards to bring their yields up to current market rates) and purchasing power risk (inflation risk, which will increase interest rates and depress bond prices).
A drug manufacturer is ordered by the FDA to recall its product due to a reported increase in patient deaths. This is an example of: A market risk B regulatory risk C opportunity cost D political risk
answer: B) regulatory risk A government agency ordered a recall of the drug, so this is an example of regulatory risk. One could also argue that this is an example of "business risk" because of the defective product, but this is not offered as a choice. It is not political risk - which is the risk of investing in foreign countries that have weak political systems (such as investing in Venezuela!).
A customer has purchased three different bonds, each yielding 9%, with 5 year, 10 year, and 15 year maturities. If prevailing interest rates drop by 20 basis points, which will show the greatest percentage price change? A 5 year maturity B 10 year maturity C 15 year maturity D The bonds will all move by the same percentage
answer: C) 15 year maturity As interest rates move, long term maturities will change in price at a faster rate than will short term obligations. This is due to the fact that the "compounding effect" is more acute as maturities lengthen. As interest rates move up, long term maturities fall faster in price than do short-term maturities.
A 20-year Zero-Coupon Treasury bond has a duration of: A 0 B 10 C 20 D This cannot be determined
answer: C) 20 Duration is the number of years until the $1,000 par principal of a bond is paid back. Since a zero-coupon bond makes no interest payments, the entire $1,000 par principal amount is paid back at the maturity date, making the duration of a 20-year zero coupon bond equal to 20.
If market interest rates rise, which statement is TRUE? A A bond's price will rise B A bond's current yield will fall C A bond's yield to maturity will rise D A bond's nominal yield will fall
answer: C) A bond's yield to maturity will rise If market interest rates rise, then bond prices will fall. This will increase the bond's current yield and yield to maturity, bringing them in line with the current higher interest rate environment. The bond's nominal yield (coupon) is unaffected.
Duration would NOT be an appropriate measure for: A Treasury bonds B Corporate bonds C Corporate common stock D Corporate preferred stock
answer: C) Corporate common stock Duration measures the anticipated price movement of a fixed income security for a given change in market interest rate levels. Bonds and preferred stocks are fixed income securities. Common stock is not a fixed income security.
All of the following risks are essentially equivalent for long term corporate bonds EXCEPT: A Interest rate risk B Market risk C Default risk D Inflation risk
answer: C) Default risk Interest rate risk is the risk that market interest rates rise, forcing bond prices down. This is the same as market risk for bonds. In an inflationary environment, market interest rates rise, so bond prices are forced down. Thus, these 3 risks are very similar for bonds. Default risk is specific to each corporate bond issuer, so it is the exception in this question.
If an investor believes that inflation rates will be rising in the foreseeable future, he might rebalance his portfolio to include: A Fixed annuities B 5 year certificates of deposit C Tangible assets D U.S. Government bonds
answer: C) Tangible assets In times of inflation, interest rate levels rise, so bond prices fall; and stock prices fall as well, since companies typically cannot raise prices to consumers fast enough to cover their increasing costs, causing profits to suffer. In times of inflation, any security that gives a fixed return, such as fixed annuities and certificates of deposit, are a bad bet. The payout on these instruments remains fixed over time, yet costs are rising. Tangible assets, such as real estate, collectibles, etc. tend to keep pace with inflation; as overall prices inflate, their prices inflate as well. This is the best choice of the ones offered.
The definition of Net Present Value of an investment is: A The sum of annual cash flows discounted by the cost of capital B The sum of annual cash flows compounded by the cost of capital C The sum of annual cash flows discounted by the cost of capital minus initial investment D The sum of annual cash flows compounded by the cost of capital minus initial investment
answer: C) The sum of annual cash flows discounted by the cost of capital minus initial investment
An investor buys a $100,000, 10% corporate bond maturing in 2033 for $125,000. The bond is callable starting in the year 2023. What is the most appropriate measure for calculating yield? A Total Return B Current Yield C Yield to Call D Yield to Maturity
answer: C) Yield to Call This investor is paying $125,000 for a 10% bond with a face value of $100,000. Thus, the investor is paying a 25% premium for the bond. If the bond is called prior to maturity (which is very likely, since current market interest rates must be lower than the coupon rate, otherwise the bond would not be trading at a premium, and the issuer, by calling in the bond, can refinance the issue at lower current market rates), then the premium will be lost more quickly than if the bond were held to maturity, reducing the effective yield. Thus, this bond's yield to call will be lower than yield to maturity. Furthermore, this bond is likely to be called, so using the call date is the appropriate time frame for computing the yield for this bond. By the way, this is a tough question!
Inertial inflation is: A demand driven B money supply based C contractually based D employment driven
answer: C) contractually based Inertial inflation is inflation that is contractually embedded in the economy. For example, COLAs (Cost of Living Adjustments) in union and government employment contracts are tied to increases in the inflation rate. Inertial inflation can be "self-fulfilling" because as wages rise due to COLAs, this creates inflationary pressure on prices of goods and services, so their prices rise, which triggers another COLA increase, etc. In periods of sustained inflation, bonds do terribly because interest rates rise, and stocks don't fare well either. Tangible assets such as real estate are the best investments in periods of sustained inflation.
The interest rate applied to a loan represents the: A money multiplier B opportunity cost C cost of money D velocity of money
answer: C) cost of money The interest rate charged on loans is the "cost" of money. The higher the interest rate, the higher the "cost" of borrowing money, and vice-versa.
2 brothers, Joe and Bob get equal dollar amounts of securities as a gift. Joe immediately sells his securities and deposits the money to a bank account. On the other hand, Bob keeps his securities positions and holds them in a brokerage account. After 5 years, Joe has $10,000 in his bank account, while Bob has $30,000 in his brokerage account. The $20,000 difference between the account balances is explained by: A duration B standard deviation C opportunity cost D reinvestment risk
answer: C) opportunity cost "Opportunity cost" is the return on investment that is forgone by choosing an underperforming asset class. Both Joe and Bob started with the same investment amount at the same time, but at the end of 5 years, Joe only has a $10,000 account value while Bob has a $30,000 account value. By choosing better-performing investments, Bob earned $20,000 more than Joe. The $20,000 difference is the "opportunity cost" that Joe suffered by choosing an under-performing investment.
An investor that purchases 10 year zero-coupon Treasury bonds with the intention of holding them to maturity should be MOST concerned with: A market risk B interest rate risk C purchasing power risk D reinvestment risk
answer: C) purchasing power risk Market risk (which is the same as interest rate risk for bonds) is the risk that market interest rates rise, forcing bond prices down. This is a major issue for zero-coupon bonds, but it is not an issue if the investor is holding them to maturity. At maturity, the investor receives par, with almost no credit risk.
An individual buys a multiple dwelling apartment house for investment purposes. He is hoping that the real estate market will increase in value; however, real estate prices decline by 20% due to an unfavorable tax ruling. This is an example of: A market risk B political risk C regulatory risk D business risk
answer: C) regulatory risk Regulatory risk is another name for legislative risk - and this is primarily the risk of tax law change negatively affecting the value of an investment. This is an issue for purchasers of tax-advantaged investments, where a negative tax law change could reduce the investment's value.
Which security would be expected to have the greatest duration? A 5 year; 5% coupon bond B 5 year; zero-coupon bond C 20 year; 6% coupon bond D 20 year; zero-coupon bond
answer: D) 20 year; zero-coupon bond Duration is a measure of price volatility of a fixed income security. As maturity lengthens or the coupon rate drops, duration increases. These are the securities which are most greatly affected by interest rate risk. Of the choices given, the security that would have the greatest duration is the 20 year, zero-coupon bond - it has the longest maturity and lowest coupon rate.
An investor has $100,000 to invest. She allocates about half of her portfolio to the purchase of a municipal bond with 1 year to maturity that has a 4% coupon, paying $50,465 for the bond. The investor's approximate rate of return (current) is: A 2.75% B 3.00% C 3.25% D 4.00%
answer: D) 4.00% This is easy. A 4% coupon on a $50,000 par value bond will yield $2,000 of annual income. $2,000 Annual Income / $50,465 Purchase Price = 3.96% Current Yield = 4.00% rounded.
A customer with $50,000 to invest needs $100,000 in 10 years to pay for his child's college education. The minimum interest rate needed to meet this goal is: A 10.8% B 9.4% C 8.6% D 7.2%
answer: D) 7.2% This question is basically asking the "Rule of 72." This is a "rule of thumb" method to determine how long it takes to double one's money. By dividing the rate of return earned on an investment into 72, the length of time needed to double one's investment value can be roughly determined. 72/7.2% = 10 years to double investment value
When making a recommendation of corporate commercial paper to a customer, which risk is the MOST important consideration? A Inflation (purchasing power) risk B Call risk C Market risk D Credit risk
answer: D) Credit risk Credit risk is the risk that the issuer cannot make interest and principal payments as due. Since Commercial Paper is unsecured, investors are buying a security backed only by "faith and credit" - so credit quality is the major consideration. Because commercial paper is short term, there is minimal purchasing power risk and market risk. Over a short term time horizon, short term interest rates cannot rise much. Commercial Paper, like all money market instruments, is non-callable so this risk is not a factor.
What rate would NOT be used to find the present value of a TIPS? A Real Rate of Return at the time the bond was issued B Nominal Rate of the bond C Coupon Rate of the bond D Internal Rate of Return of the bond's cash flows
answer: D) Internal Rate of Return of the bond's cash flows
A customer wishes to sell shares of her S&P 500 Index Fund and use the sale proceeds to purchase a non-callable agency bond. Which risk is NOT associated with this transaction? A Interest rate risk B Inflation risk C Opportunity cost risk D Prepayment risk
answer: D) Prepayment risk The purchase of a fixed income bond means that the investment will have interest rate risk - if market interest rates rise, the price of the bond will fall. Any long-term fixed income investment has purchasing power (inflation risk). If prices are rising due to inflation, the fixed payments received over many years become less and less valuable because of inflation. Opportunity cost risk is the risk that making an alternative investment would have yielded a better return - this risk is inherent to any investment decision. There is no prepayment risk for a non-callable bond - the bond cannot be called (prepaid) early by the issuer if market interest rates fall. If the bond were callable, then this risk would be present.
Which recommendation is suitable for an investor who believes that the economy will experience an extended period of inertial inflation? A Growth equities B Value equities C Long Term Government Bonds D Real Estate
answer: D) Real Estate Inertial inflation is inflation that is contractually embedded in the economy. For example, COLAs (Cost of Living Adjustments) in union and government employment contracts are tied to increases in the inflation rate. Inertial inflation can be "self-fulfilling" because as wages rise due to COLAs, this creates inflationary pressure on prices of goods and services, so their prices rise, which triggers another COLA increase, etc. In periods of sustained inflation, bonds do terribly because interest rates rise, and stocks don't fare well either. Tangible assets such as real estate are the best investments in periods of sustained inflation.
A customer who is concerned with social and environmental issues would minimize which risk when making an investment decision? A Market B Opportunity C Financial D Regulatory
answer: D) Regulatory This customer believes in socially responsible investing, and thus would avoid companies such as tobacco, alcohol, fossil fuels, etc. These are companies that are under increasing regulatory pressure, and more stringent regulation is "regulatory risk." Financial risk is simply the risk that a company goes bankrupt. Market risk is the risk that the market falls, taking all stocks with it. There is no such thing as Opportunity Risk - rather there is Opportunity Cost - which is the amount of an investment return that is not earned when an inferior investment is chosen.
Which statement is FALSE about convertible bonds? A The conversion price is set at bond issuance B The par value is set at bond issuance C The parity price changes as the stock price moves D The par value changes as the stock price moves
answer: D) The par value changes as the stock price moves Assume that a bond is issued at $1,000 par and that it is convertible based on a conversion price of $50. At that time, the price of the common is $25. The par value of the bond does not change - it is fixed at $1,000 at issuance. At issuance, the bond can be converted into 20 shares (based on $50 conversion price and $1,000 par). If the common stock moves to $60, the parity price of the bond is now $1,200, since it is equivalent to 20 shares of stock. Therefore, the parity price of the bond moves with the market value of the common stock, while the par value is fixed at $1,000.
To determine the present value of an investment, which of the following is NOT considered? A The interest rate to be used to discount the annual payments received B The amount of cash expected to be generated each year by the investment C The time horizon of the expected investment returns D The required sum needed at the end of the investment's life
answer: D) The required sum needed at the end of the investment's life Present value takes the annual cash flows that are expected to be generated by an investment and discounts them at the market rate of interest to their "present value." Thus, the present value formula determines what those cash flows are worth today. In contrast, future value takes the cash flows generated by an investment and compounds them at the market rate of interest to their value at a set future date.
Which investment cash flows for an investment with a 3 year time horizon would have the highest net present value? A Year 1 - $500; Year 2 - $1,000; Year 3 - $1,500; Total = $3,000 B Year 1 - $1,000; Year 2 - $1,000; Year 3 - $1,000; Total = $3,000 C Year 1 - $1,000; Year 2 - $500; Year 3 - $1,500; Total = $3,000 D Year 1 - $1,500; Year 2 - $1,000; Year 3 - $500; Total = $3,000
answer: D) Year 1 - $1,500; Year 2 - $1,000; Year 3 - $500; Total = $3,000 Each of these investments is returning $3,000 over a 3-year time frame. Net present value discounts these annual cash flows to today's value (the reverse of compound interest). Using net present value, the investment that returns the cash earlier is more valuable - Choice D. To illustrate this, assume that the market rate of interest is 10%. The net present value of Choice A's cash flows is: Year 1: $500 / (1.1) Year 2: $1,000 / (1.1)^2 Year 3: $1,500 / (1.1)^3 = $2,408 The net present value of Choice D's cash flows is: Year 1: $1,500 / (1.1) Year 2: $1,000 / (1.1)^2 Year 3: $500 / (1.1)^3 = $2,566
An investor buys a $25,000, 8% corporate bond maturing in 2048 for $20,000. The bond is callable starting in the year 2023. What is the most appropriate measure for calculating yield? A Total Return B Current Yield C Yield to Call D Yield to Maturity
answer: D) Yield to Maturity This investor is paying $20,000 for an 8% bond with a face value of $25,000. Thus, the investor is paying 20% less than par for the bond. Because of the discount, these bonds are currently yielding 10% ($80 annual interest received / $800 purchase price per bond = 10%). This issuer would not call these bonds, since the issuer is only paying 8%; yet if the issuer were to sell new bonds in the current market, it would have to pay 10%. This bond is not likely to be called, so using the call date is not the appropriate time frame. Rather, this bond will probably remain outstanding until its maturity, and this is the time frame that should be used to compute the yield on the bond.
An investor buys a $100,000, 7% corporate bond maturing in 2043 for $70,000. The bond is callable starting in the year 2023. What is the most appropriate measure for calculating yield? A Total Return B Current Yield C Yield to Call D Yield to Maturity
answer: D) Yield to Maturity This investor is paying $70,000 for a 7% bond with a face value of $100,000. Thus, the investor is paying 30% less than par for the bond. Because of the discount, these bonds are currently yielding 10% ($70 annual interest received / $700 purchase price per bond = 10%). This issuer would not call these bonds, since the issuer is only paying 7%; yet if the issuer were to sell new bonds in the current market, it would have to pay 10%. This bond is not likely to be called, so using the call date is not the appropriate time frame. Rather, this bond will probably remain outstanding until its maturity, and this is the time frame that should be used to compute the yield on the bond.
Bond A and Bond B both have an 8% coupon. Bond A matures in 2 years, while Bond B matures in 10 years. If market interest rates fall: A the price of both bonds will fall at the same rate B the price of Bond B will fall faster than the price of Bond A C the price of both bonds will rise at the same rate D the price of Bond B will rise faster than the price of Bond A
answer: D) the price of Bond B will rise faster than the price of Bond A As market interest rates fall, the prices of fixed income securities rise, but not at equal rates. As market interest rates fall, the longer the maturity of the bond, the faster the price will rise; and the lower the coupon rate, the faster the price of the bond will rise. Since the coupon is the same for both bonds, the price of the longer maturity bond (B) will rise faster as market interest rates fall.
A U.S. investor purchasing foreign securities trading on the LSE (London Stock Exchange) will benefit when the: I U.S. Dollar weakens II U.S. Dollar strengthens III British Pound weakens IV British Pound strengthens
answer: I and IV If the U.S. Dollar weakens; or if the British Pound strengthens; then when the investment made in British Pounds is converted back into U.S. Dollars, it buys "more" U.S. Dollars. Thus, the value of the holding in U.S. Dollars will go up.
What happens to the rate of return calculation on a non-callable bond if the rate of interest stays the same and the time intervals are changed? I Shortening the time intervals will increase the rate of return II Shortening the time intervals will decrease the rate of return III Lengthening the time intervals will increase the rate of return IV Lengthening the time intervals will decrease the rate of return
answer: I and IV When the question is stating that the "time intervals shorten," this means that the time period between each interest payment received shortens. When the question is stating that the "time intervals lengthen," this means that the time period between each interest payment received lengthens. For example, assume that a 10% bond will pay interest semi-annually, instead of annually. At the end of each 6 months, $50 of interest will be received, instead of receiving $100 every 12 months. Because the first $50 interest payment received can immediately be reinvested over the next 6 months until the second $50 payment is received, this will produce a higher rate of return than receiving the $100 payment at the end of the year. Thus, the actual rate of return will increase if time intervals shorten, because the interest is actually being received more quickly, and can be reinvested faster, increasing the rate of return. Conversely, if the time intervals lengthen, because the actual interest payments are being received more slowly and are reinvested more slowly, the rate of return declines.
Internal rate of return
in a direct participation program (DPP) offering, the computation of the real investment yield considering the time value of money; calculated by finding the implicit interest rate that discounts that program's projected annual cash flows to a present value of "0."
Net present value
takes the expected annual cash flows from an investment over the years and discounts them, using the market rate of interest compounded over time, to today's "present value." This is basically the opposite of future value.
Return on investment (ROI)
the percentage return given by an investment, computed by taking the annual cash flows generated by the investment, averaging them, and then dividing the average annual cash flow by the initial investment amount. the annual compounded investment return necessary to increase the value of an asset to a specified future amount. This considers the time value of money, and is the same as internal rate of return.
Opportunity cost
the rate of return forgone, as compared to investing in an alternative security. For example, an investor that is currently earning 5% on a given security; and who could earn 7% on another comparable security in the same risk class; is incurring an opportunity cost of 2%.
Regulatory risk
the risk that new laws, especially tax laws, will result in the decline in the value of a security. This is a particularly important risk consideration for tax advantaged investments such as municipal bonds and direct participation programs. (also known as legislative risk)
Time horizon
when creating a portfolio for the customer, the time period necessary to achieve the desired investment return.
What rate would be used to find the present value of a TIPS? A Risk-Free Rate B Coupon Rate of TIPS C Inflation Rate D LIBOR
answer: B) Coupon Rate of TIPS
The quantitative method of evaluating investments that finds the interest rate that discounts periodic cash inflows and outflows to a present value of "0" is: A inflation-adjusted return B net present value C total return D internal rate of return
answer: D) internal rate of return The internal rate of return of an investment is the implicit interest rate that discounts the cash flows generated by the investment to a value of "0." This is the true "yield" of the investment, considering the time value of money.
Which statements are TRUE when a bond sells at a premium? I The nominal yield is less than the yield to maturity II The nominal yield is more than the yield to maturity III The current yield is less than the yield to maturity IV The current yield is more than the yield to maturity
answer: II and IV This one is worded in a tricky manner. For premium bonds, the relationship of yields from highest to lowest is: Nominal (Highest) Current Yield Yield To Maturity (Lowest) Therefore, nominal yield is higher than current yield (Choice II) and current yield is higher than yield to maturity (Choice IV). Yield to maturity is lowest for a premium bond because it reflects both the fact that the bond was purchased for more than par and that the premium will be lost over the life of the bond. Current yield only reflects the fact that the bond was purchased for more than par; it does not include the annual loss of the premium. Finally, nominal yield is the yield based on purchasing the bond at its original par value - it is the highest yield of the choices offered because it neither reflects the premium price nor the annual amortization of that premium.
