Unit 2 quiz
The owner of a convertible debt issue A) is a creditor of the issuer. B) generally expects a higher current return than with a nonconvertible bond of the same quality and maturity. C) is generally in a senior position to other bondholders. D) has the choice of receiving the bond's interest or dividends on the underlying stock, whichever is higher.
A) is a creditor of the issuer. The owner of any bond is a creditor of the issuer. Dividends are paid only on stock, and the investor will have to convert in order to be a stockholder. Because of the growth potential of the common stock, holders of convertible securities invariably accept a lower coupon rate resulting in a lower current yield (return). In almost all cases, convertible debt securities are debentures and, therefore, junior to secured bonds.
Which of the following would you not expect to see issued at a discount? A) Treasury bill B) Zero-coupon bond C) Bank jumbo CD D) Commercial paper
C) Bank jumbo CD Of these securities, only the bank jumbo (negotiable) CDs are always interest bearing and issued at par or face value.
Probably the most significant characteristic of municipal bonds for investors is
their exemption from federal income tax.
Which of the following projects is most likely to be financed by a general obligation rather than a revenue bond? a. Public Library b. Municipal Hospital C. public golf course d. expansion of an airport
A. Public Library Hospitals, airports, and golf courses all generate revenue and can be financed with revenue bond issues. Public libraries are financed through general obligation (GO) bond sales with the backing of taxes.
A bond issued by the GEMCO Corporation has been rated BBB by a major bond-rating organization. This bond would be considered
an investment grade corporate bond
In general, among the advantages to investing in Brady bonds over those issued by countries classified as emerging economies is
increased liquidity Brady bonds are issued to take over the debt of failing commercial loans in emerging economies. They are secured by collateral—often U.S. Treasury zero-coupon bonds—thereby making them more secure than direct issues of that country. This backing also increases the liquidity as there is a larger pool of potential investors.
Which of the following is not a money market instrument? A) Treasury bills B) Commercial paper C) Newly issued Treasury notes D) Banker's acceptances
C) Newly issued Treasury notes Commercial paper, Treasury bills, and banker's acceptances are debt instruments with maturities of one year or less and are therefore money market instruments. A newly issued Treasury note would have a maturity of two to 10 years and therefore would not be a money market instrument.
A client has indicated that his primary objective is maximizing current income regardless of the risk. Which of the following mutual funds would probably be most suitable for achieving that goal? A) JKL Municipal Bond Fund B) ABC Growth and Income Fund C) DEF High-Yield Bond Fund D) GHI Index Fund
C. DEF High-Yield Bond Fund High-yield (junk) bonds, although carrying more risk, produce higher current income than other funds.
To secure the debt that a subsidiary is offering, a railroad holding company transfers to a trustee the common stock of another subsidiary. The offering is one of
collateral trust certificates. When a company uses the securities of one subsidiary to collateralize a bond issue of another subsidiary, the bonds are known as collateral trust certificates.
The GHIJ Corporation has a 3% convertible debenture outstanding with a conversion price of $40. The bond's current market price is 126. The most probable reason for this is A) GHIJ's earnings have risen since the debenture was issued. B) interest rates have risen since the debenture was issued. C) the current market price of the GHIJ common stock is approximately $50 per share. D) the current market price of the GHIJ common stock is approximately $35 per share.
C) the current market price of the GHIJ common stock is approximately $50 per share. With a conversion price of $40, the bond is convertible into 25 shares. Convertible securities generally sell at a slight premium to their parity price, which—at $1,260—would be $50.40 per share.
Although there are a number of risks to owning a debt security that are common to all investors, which specific risk is avoided when a U.S. resident purchases a Eurodollar bond?
currency rate risk Eurodollar bonds are denominated in dollars; therefore, no currency risk exists for a U.S. resident.
The DERP Corporation has an outstanding convertible bond issue with a conversion price of $125 per share. If the current market price of the bond is 80, the parity price of the stock is
$156.25 per share. What does parity mean? It means that two things have equal value. What two things do we have here? We have the convertible bond, and because it is convertible, it can be converted into common stock. There is a number where the value of the bond and the value of the stock are the same; this price is the parity price. The bond is currently valued at $800 (80% of par). Anytime the investor wishes, he can exchange (convert) that bond into DERP's stock at $125 per share. However, that conversion is not based on a market price, which can fluctuate every day; it is based on the amount of money initially borrowed—the $1,000 par value of the bond. DERP is saying that it will allow you to exchange the $1,000 they owe you for stock at $125 per share. Simple division results in the ability to convert into 8 shares. Now we have everything we need to compute the parity (equal) price. If the bond is currently valued at $800 and we can convert it into 8 shares, what does each of those shares have to be worth so that the stock is also valued at $800? Dividing 800 ÷ 8 = $100 per share. That means that if the stock is selling for $100 per share and we decide to convert the bond, we'll have the same $800 in value. Some students find the answer a quicker way. If the bond is selling at 80% of its par value, then to be equal, the stock must be selling at 80% of the conversion value (80% × $125 = $100).
Which of the following statements regarding U.S. government agency securities is true? A) They generally trade on the major stock exchanges. B)They generally offer higher yields than direct U.S. obligations. C) They are direct obligations of the U.S. government. D).Interest received on agency securities is exempt from federal income tax.
B)They generally offer higher yields than direct U.S. obligations. In most cases, securities issued by U.S. government agencies are obligations of that agency rather than the U.S. government. As such, they carry slightly higher risk, and that means investors demand a higher return. They do not trade on any exchange. Their interest, like that of all U.S. government securities, is taxable on the federal level while being tax exempt on the state level.
You are meeting with a relatively unsophisticated investor who doesn't understand very much about stocks and bonds. The investor asks, "Can you list the advantages of owning common stock as compared to bonds?" Among other reasons, you could reply that A) there is limited liability. B)income payments are more reliable. C) bonds must be surrendered at maturity or at a call while the owner of common stock can hold the investment as long as desired. D) bonds have priority over any equity security in the event of liquidation.
C) bonds must be surrendered at maturity or at a call while the owner of common stock can hold the investment as long as desired. One negative of owning bonds is that the bond will ultimately mature or be called and the bondholder has no choice but to surrender the security. With common stock, the investor has total control over the length of the holding period. Although there are many benefits to owning bonds compared to common stock, among them is priority in the event of liquidation and regular payment of interest. Yes, common stock has limited liability, but the same is true of bonds; if the company goes under, the bondholder's maximum loss is the investment. Even then, because of the seniority of bonds, it is less likely that the entire investment will be lost.
A TIPS bond is issued in the principal amount of $1,000, paying 3.5%. Over the security's 5-year term, the annual inflation rate is 6%. What is the principal value of the bond at the end of 4 years? A. $1,240 B. $ 1,344 C. $1,300 D. $1,267
D. 1,267 The unique feature of a TIPS bonds is its semiannual adjustment to principal based on the inflation rate. With an annual inflation rate of 6%, there is a 3% increase to the principal value every 6 months. The arithmetic is $1,000 multiplied by 103% consecutively 8 times (there are 8 semiannual periods in 4 years). Be sure to stop at 4 years—the question doesn't ask for the ending value for the 5th year. If this math is too challenging, there is a simple method that always works. That simple method has you take the annual inflation rate (6% = $60) for 4 years ($240) and add that to the original $1,000 face value. That is $1,240, and the correct answer on the exam will always be the next higher number ($1,267 in this case). This simple step means you are calculating the simple interest while the bond's principal growth is actually compounding.
