Ch.7 Bonds Part 2 of 2

Secondary markets in sukuk are extremely illiquid because most sukuk are:

bought and held to maturity

The bid-ask spread reprsents the _____.

dealer's profit

The liquidity premium compensates investors based on a bond's ____.

degree of marketability

If you are in the 15 percent federal 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%

In general, which will have a higher pretax yield? (Assume the bonds are comparable.)

A corporate bond

How is an original issue discount bond (OID) different from a zero coupon bond?

An OID has a very low coupon rate, while a zero coupon bond pays no coupon.

What are municipal bonds?

Bonds that have been issued by state or local governments.

Match each one of these bonds with their characteristic.

CAT bond: protects insurance companies from natural disasters Convertible bond: can be exchanged for shares of stock Put bond: owner can force issuer to repay prior to maturity at a stated price Structured note: based on financial securities, commodities, or currencies

What is the nominal rate of return on an investment?

It is the rate that has not been adjusted for inflation.

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 that market rate of interest is 5 percent.

Pay $800 today and receive $1000 at the end of 5 years.

If a $1,000 face value U.S Treasury bond is quoted at 99.5, then the bond can be purchased ______.

at 99.5% of face value plus any accrued interest

According to the approximation formula for the nominal rate of return (R), the nominal rate will ______ if inflation (h) increases.

increase

A market is considered transparent if _______?

its prices and trading volume are easily observed

Which six factors determine the yield on a bond?

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

The rates on financial securities are generally quoted as:

nominal rates

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

If a given set of cash flows is expressed in nominal terms and discounted at the nominal rate, the resulting present value will be the same as if the cash flows were expressed in real terms and discounted at the ___________ rate.

real

The taxability premium is the additional compensation demanded on ______.

taxable bonds

The Fisher effect decomposes the noimal rate into:

the inflation rate and the real rate

Most of the time, a floating-rate bond's coupon adjusts ___.

with a lag to some base rate

Suppose a bond's clean price is $1,050, and the bond currently has accrued interest of $30. What is the dirty price?

$1.080 ( 1,050+30)

What are three important features of Treasury notes and bonds?

- Default-free - Taxable - Highly liquid

Which is more transparent, the stsock market or the bond market?

The stock market is more transparent.

Suppose Depp Corporation issues a $1000 par value coupon bond with ten years to maturity and a YTM of 5%. What is the imputed interest in the third year of the bond? For calculation, assume semiannual period.

$34.10 Beginning of year 3 (8 years remaining): PV=1000/(1+0.05/2)^(8*2)= 673.62 End of year 3: Beginning of year 3 (7 years remaining): PV= 1000/(1+0.05/2)^(7*2)= 707.73 Imputed interest= 707.73-673.62= $34.10

What is the price of a U.S Treasury bond that is listed at 90 if the par value is $1,000?

$900 (1000 x 90%= 900)

What is a real rate of return?

- It is a rate of return that has been adjusted for inflation

All junk bonds typically have which of these features?

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

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

- Not very significant - Less significant than inflation.

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?

(yield) x (1 - tax rate) 0.08 x 1-0.20 6.4%

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

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

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

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

- Interest rate risk premium - Real interest rate - Inflation premium

What are the three components of the Treasury yield curve?

- Interest rate risk premium - Real rate of return - Expected inflation

What are some features of the OTC market for bonds?

- The OTC has no designated physical location. - OTC dealers are connected electronically

Which two prices can be found in the Wall Street Journal's daily Treasury bond listing?

- The asked price - The bid price

Which of the following are features of municipal bonds?

- They are issued by state and local governments - The interest on municipal bonds is exempt from state taxes in the state of issue

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 US government while corporate bonds are issued by corporations.

When the US government wants to borrow money for the long-term (more than one year) it issues:

- treasury notes - treasury bonds

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+nominal rate)/(1+h)] - 1

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 - in this case the appreciation is the observered rate. It includes inflation

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

9% + 3% = 12%

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

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

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

The real rate of return is adjusted for the effect of inflation whereas nominal rate is not adjusted for the effect of inflation.

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

- Downward sloping - Upward sloping - Humped

What are the sources of information for generating bond ratings?

- Information from the corporation being rated - Information collected by the bond rating agency

True or false: The real rate of return will generally be higerh than the nominal rate of return.

False Since the inflation rate is generally positive, the nominal rate is generally higher than the real rate.

The interest from a municipal bond is exempt from _____ income taxes.

federal

The correlation between the real rate of interest and every interest rate is:

high

The price that represents what a dealer is willing to pay for a security is

the bid price

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.

What are the two unique features of the U.S. federal government bond?

- US Treasury issues are considered to be a default-free - US Treasury issues are exempt from state income taxes

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

- Zero coupon bonds make no interest payments - Zero coupon bonds are always issued at a discount

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%

At what tax rate will you be indifferent between a muni that yields 7 percent and a comparable corporate bond yielding 9 percent? Assume no state taxes.

1-.07/.09= 22.2%

What are crossover bonds?

Bonds that have both an investment grade and a junk bond rating

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 is the largest security market in the world in terms of trading volume?

The U.S. Treasuries market

What is the bid price?

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

What does a Moody's bond rating of C typically indicate?

The issuer is in default

What does the clean price for a bond represent?

The quoted price, which excludes interest accrued since the last coupon date.