Chapter 6

The bond demand curve slopes downward because: A. at lower prices the reward for holding the bond increases. B. as bond prices fall so do yields. C. as bond prices fall bonds are less attractive. D. as bond prices rise yields increase.

A. at lower prices the reward for holding the bond increases.

When the price of a bond is below the face value, the yield to maturity: A. is below the coupon rate. B. will be above the coupon rate. C. will equal the current yield. D. will equal the coupon rate.

B. will be above the coupon rate.

A 30-year Treasury bond as a face value of $1,000, price of $1,200 with a $50 coupon payment. Assume the price of this bond decreases to $1,100 over the next year. The one-year holding period return is equal to: A. -9.17%. B. -8.33%. C. -4.17%. D. -3.79%.

C. -4.17%. HPR = [( Current bond price - Bond price in last year ) + Coupon ] / Bond price in last year = [($1,100 - $1,200) + $50 ] / $1,200 = -4.17%

If the risk on foreign government bonds increases relative to U.S. government bonds, the price of U.S. government bonds should: A. not change since U.S. government bonds are free of default risk. B. decrease since people will bail out of all government bonds. C. increase as the demand for these bonds increases. D. not be affected because the two types of bonds are traded in different markets.

C. increase as the demand for these bonds increases.

Suppose that the return on assets other than bonds falls. In the bond market this will result in a(n): A. movement down the bond demand curve. B. shift to the left of the bond demand curve. C. increase in the price of bonds. D. shift to the left of the bond supply curve.

C. increase in the price of bonds.

The holding period return on a bond: A. can never be more than the yield to maturity. B. will equal the yield to maturity if the bond is purchased for face value and sold at a lower price. C. will be less than the yield to maturity if the bond is sold for more than face value. D. will be less than the yield to maturity if the bond is sold for less than face value.

D. will be less than the yield to maturity if the bond is sold for less than face value.

You are considering purchasing a consol that promises annual payments of $4. i. If the current interest rate is 5 percent, what is the price of the consol? ii. You are concerned that the interest rate may rise to 6 percent. Compute the percentage change in the price of the consol and the percentage change in the interest rate. Compare them. iii. Your investment horizon is one year. You purchase the consol when the interest rate is 5 percent and sell it a year later, following a rise in the interest rate to 6 percent. What is your holding period return?

a. P=$4/0.05= $80 b. newP=$4/0.06= $66.67 Change in P = (66.67 - 80)/80 = 16.7%; Change in interest rate = (6 - 5)/5 = 20% P falls by 16.7%; i rises by 20% c. ($4/$80)+(($66.67-$80)/$80)= -11.7% Alternatively, holding period return = current yield + capital gain = 5% + (-16.7%) = -11.7%

If the quantity of bonds supplied exceeds the quantity of bonds demanded, bond prices would: A. rise and yields would fall. B. fall and yields would rise. C. rise but yields will remain constant. D. fall and yields would fall.

B. fall and yields would rise.

A 10-year Treasury note as a face value of $1,000, price of $1,200, and a 7.5% coupon rate. Based on this information, we know the: A. present value is greater than its price. B. current yield is equal to 8.33%. C. coupon payment on this bond is equal to $75. D. coupon payment on this bond is equal to $90.

C. coupon payment on this bond is equal to $75. =1000 * 0.75= 75

The current yield of a bond: A. is another term for the coupon rate. B. is another term for the yield to maturity. C. equals zero for a zero-coupon bond since these bonds have no coupon payments. D. is the difference between its future value and its present value.

C. equals zero for a zero-coupon bond since these bonds have no coupon payments.

The bond supply curve slopes upward because: A. as bond prices rise people holding bonds are more tempted to hold them. B. as bond prices rise yields increase. C. for companies seeking financing, the higher the price of bonds the more attractive it is to sell bonds. D. as bond prices rise yields decrease.

C. for companies seeking financing, the higher the price of bonds the more attractive it is to sell bonds.

Interest rate risk refers to the risk that --------- and is greater for ---------. A. The bond issuer may not be able to make promised payments; long-term bonds B. Interest rate may rise in the near future; short-term bonds C. Inflation may rise in the near future; long-term bonds D. Interest rate may rise in the near future; long-term bonds

D. Interest rate may rise in the near future; long-term bonds

Once you buy a coupon bond, which of the following can change? A. Coupon rate B. Coupon payment C. Face value D. Yield to maturity

D. Yield to maturity

If interest rates are expected to fall, bond prices will: A. fall as the demand for bonds decreases. B. remain constant until interest rates actually change. C. increase due to an increase in the supply of bonds. D. increase due to the demand for bonds increasing.

D. increase due to the demand for bonds increasing.

What are the three major sources of risk to the bondholders? Explain.

1. Default risk-borrower might not make interest and/or principal payments in timely manner as promised 2.Inflation risk-investors facing a high inflation risk require a higher inflation premium, causing bond prices to be low and interest to be high where inflation is unstable 3. Interest rate risk-risk that interest may rise in future causing price of existing bonds to fall resulting in capital loss for investors whose investment horizon is shorter than maturity of the bond

Which of the following would lead to a decrease in bond demand? A. An increase in expected inflation. B. An increase in wealth. C. A decrease in risk. D. A decrease in liquidity.

A. An increase in expected inflation.

When the price of a bond is above face value, the yield to maturity: A. is below the coupon rate. B. will be above the coupon rate. C. will equal the current yield. D. will equal the coupon rate.

A. is below the coupon rate.

As general business conditions deteriorate, all other factors constant: A. the bond supply curve will shift left. B. there will be a movement down the existing bond supply curve. C. the bond demand curve shifts left. D. the price of bonds will decrease.

A. the bond supply curve will shift left.

If the quantity of bonds demanded exceeds the quantity of bonds supplied, bond prices: A. would rise and yields would fall. B. would fall and yields would increase. C. will rise and yields will remain constant. D. will rise and yields would increase.

A. would rise and yields would fall.

A $1,000 face value bond purchased for $965.00, with an annual coupon of $60, and 20 years to maturity has a: A. current yield and coupon rate equal to 6.22% and a coupon rate above this. B. current yield equal to 6.22% and a coupon rate below this. C. coupon rate equal to 6.00% and a current yield below this. D. A yield to maturity and current yield equal to 6.00%.

B. current yield equal to 6.22% and a coupon rate below this. The exact yield is found using excel function RATE(20,60,-965,1000)

In calculating the current yield for a bond the: A. coupon payment is ignored. B. present value of the capital gain/loss is ignored. C. present value of the final payment is the only important consideration. D. present value of the coupon payments is the only important consideration.

B. present value of the capital gain/loss is ignored.

Fly-By-Night Inc. issues $100 face value, zero-coupon, one-year bonds. The current return on one-year, zero-coupon U.S. government bonds is 3.5%. If the Fly-By-Night bonds are selling for $92.00, what is the risk premium for these bonds? A. 8.7% B. 1.5% C. 5.2% D. 8.0%

C. 5.2% risk premium = (100/92-1) - (3.5%) = 5.2%

As general business conditions improve, all other factors constant, the bond prices will ------ and yield -----. A. Decrease; decrease B. Increase; increase C. Decrease; increase D. Increase; decrease

C. Decrease; increase

A consol is: A. another name for a zero-coupon bond. B. a bond with a maturity date exceeding 10 years. C. a bond that makes periodic interest payments forever. D. a form of a bond that is issued quite often by the U.S. Treasury.

C. a bond that makes periodic interest payments forever.

An increase in the interest rate ------ A. does not affect existing bondholders, only affects the investors looking to buy new bonds B. causes capital gain for existing bondholders who are planning to sell the bond before maturity C. causes capital loss for existing bondholder who are planning to sell the bond before maturity D. causes an increase in the price of a consol.

C. causes capital loss for existing bondholder who are planning to sell the bond before maturity

When expected inflation decreases for any given nominal interest rate, all of the following occur except the: A. real interest rate decreases. B. bond supply curve shifts to the left. C. cost of borrowing increases and the desire to borrow decreases. D. price of bonds increases.

C. cost of borrowing increases and the desire to borrow decreases.

U.S. government bonds that provide for bondholders to receive a fixed rate of interest plus the change in the consumer price index were designed to remove: A. default risk. B. liquidity risk. C. inflation risk. D. interest-rate risk.

C. inflation risk.

Bond prices and yields: A. move together in the same direction. B. do not change if the coupon is fixed. C. move together inversely. D. are independent of each other.

C. move together inversely

Explain what happens to bond prices and interest rates if U.S. Treasury faces a huge budget deficit and increases its borrowings. Use diagram to show your answers.

Can lead to higher interest rate and lower bond prices, as investors demand higher yields to compensate for increased risk of holding more debt.

The price of a coupon bond can best be described as the: A. present value of the face value. B. future value of the coupon payments. C. future value of the coupon payments and the face value. D. present value of the face value plus the present value of the coupon payments.

D. present value of the face value plus the present value of the coupon payments.

Explain the relationship between coupon rate (or coupon yield) and current yield.

The coupon rate is simply the annual coupon divided by the face value. The current yield is the annual coupon divided by the price of the bond. The only time these should equal each other is when the price of the bond equals the face value. If the price is greater than the face value the current yield should be less than the coupon rate. If the price of the bond is less than the face value, the current yield should be greater than the coupon rate.

If, after one year, the yield to maturity on a multi-year coupon bond that was issued at par is higher than the coupon rate, what happened to the price of the bond during that first year?

The price of the bond fell below par. When a bond is at par, the yield to maturity equals the coupon rate. If the yield to maturity rises, the price of the bond falls. If you buy the bond below par, the capital gain you receive by holding it to maturity is included along with the coupon payments, so the yield to maturity is higher than the coupon rate alone.

Consider a coupon bond with a $1,000 face value and a coupon payment equal to 5 percent of the face value per year. If there is one year to maturity, find the yield to maturity if the price of the bond is $990.

The yield to maturity can be found by equating the current price of the bond to the present value of the coupon payment plus the present value of the face value when both payments are due in one year. Specifically, Bond price = (coupon. payment/1+I)+(FV/1+i) 990=(50/1+i)+(1000/1+i)=1050/1+i 1+I= 1050/990 i=6.1%

Consider a 2-year, 5% coupon bond with a face value equal to $1,000. You purchase this bond when the yield to maturity (YTM) is 5%. Immediately after you purchase the bond, the YTM increases to 6%. What is your capital gain/loss should you decide to sell the bond?

When YTM is 5%, price of the bond = $1,000 (remember Price of the bond = Face value when YTM = coupon rate). Alternatively you can calculate the price of the bond, which is equal to the sum of the present values of all its future cash flows (see equation 6.3 in the notes). Bond price = Coupon payment/(1+i)1 + Coupon payment/(1+i)2 + Face vale/(1+i)2 = 50/(1.05) + 50/(1.05)2 + 1,000/(1.05)2 = 1,000 Since YTM and bond price are inversely related, we know that an increase in the YTM causes the bond price to fall and hence you suffer a capital loss. The new bond price is = 50/(1.06)1 + 50/(1.06)2 + 1,000/(1.06)2 = 981.67 The capital loss is therefore given by (981.67-1,000)/1,000 = -1.83%