chapter 6 sample questions

A decrease in the nation's wealth, all other factors constant, would cause: a. the bond demand curve to shift left. b. bond prices to rise. c. interest rates to decrease. d. the bond supply curve to shift left.

A

Which of the following would lead to an increase in bond supply? a. A decrease in government spending relative to revenue. b. An increase in corporate taxes. c. A decrease in expected inflation. d. An improvement in general business conditions.

D

In mid-2004 there was speculation that the Federal Reserve would be raising interest rates before the end of the year. How would this news affect the bond market and why?

The speculated increase in interest rates by the Federal Reserve would cause the value of bonds to decrease. As we saw in the text, an increase in the expected future interest rate makes bonds less attractive. This will lower the demand for bonds, causing bond prices to decrease and yields to increase. Moreover, the change in bond prices and yields will occur before the actual interest rate changes since existing and prospective bondholders will act on their expectations.

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

The larger the bond dealer's spread the: a. less liquid is the market for that bond. b. greater is the coupon rate for that bond. c. more liquid is the market for that bond. d. less risk there is for the dealer to hold that bond.

A

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

Calculate the holding period return for a $1,000 face value bond with a $60 annual coupon purchased for $970.00 and sold three years later for $1,060.00.

9.02%. Here we have to consider the present value of the three coupon payments as well as the present value of the capital gain that results from purchasing the bond for $970 and selling it for $1,060.

A decrease in expected inflation for any given nominal interest rate will cause: a. bond prices to increase and interest rates to decrease. b. bond prices to decrease and interest rates to increase. c. the bond demand curve to shift to the left. d. the bond supply curve to shift to the left.

A

An increase in expected inflation for any given nominal interest rate will cause: a. the real return to bondholders to decrease. b. a movement down the bond demand curve, but no change in the bond demand curve. c. the bond demand curve to shift right. d. the price of bonds to increase.

A

As bond prices increase: a. the quantity of bonds supplied increases. b. the quantity of bonds supplied decreases. c. the quantity of bonds demanded increases. d. yields increase.

A

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

As general business conditions deteriorate, all other factors constant: a. the demand for bonds will decrease. b. the supply of bonds will increase. c. bond prices will decrease. d. bond yields will increase

A

Consider a zero-coupon bond with a $1,100 payment in one year. Suppose the interest rate decreases from 10% to 8%. The price of this bond: a. increases from $1,000 to $1,018. b. increases from $1,000 to $1,375. c. decreases from $110 to $88. d. decreases from $1,210 to $1,188.

A

Default risk is the risk associated with: a. the bond issuer not being able to make the promised payments. b. the illiquidity associated with small issues. c. the effect on bond prices caused by changes in market rates of interest. d. changes in the expected inflation rate.

A

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

The bond dealer's spread is: a. the asking price less the bid price. b. the difference between the current yield and the yield to maturity. c. the bid price less the asking price. d. usually negative; the dealer makes a profit holding the bonds.

A

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

You win your state lottery. The lottery officials offer you the option of taking your winnings in one lump-sum payment, or fixed annual payments for the next 20 years. The sum of the 20 annual payments is larger than the lump-sum payment. Before deciding, what are the key factors you will want to consider that could influence your decision?

Although this is certainly a pleasant decision to think about, the options presented do require serious thought. You should start by finding the interest rate that equates the present value of the 20 payments with the lump sum. Next, compare this rate to the interest rate you think you could safely earn on the lump-sum if you invested it. If the market offers a higher interest rate, then this is a reason you may wish to take the lump sum. Although morbid, you should also consider your own life expectancy. If you do not think you are going to live another 20 years, you would certainly want to take your winnings early. Lifestyle is also important as is the degree of risk aversion you exhibit. One advantage to taking the payments over 20 years is that it is a form of expenditure discipline that may prevent you from going through the funds quickly (though it is highly likely that you will find plenty of sources that will loan you funds for the assignment of the winnings to them). If you are a person that benefits from external discipline, the 20-year payout may be more attractive. While this certainly is not an exhaustive list, it does show that many of the factors discussed in the chapter come into play in making a decision such as this on needs external discipline, the 20-year payout may be more attractive. While this certainly is not an exhaustive list, it does show that many of the factors discussed in the chapter come into play in making a decision such as this one.

A student receives a five-year loan to pay for a $2,000 used car. The lender and the student agree to an 8% interest rate on a fixed-rate loan. Expected inflation was estimated to equal 2.5%, but unexpectedly decreases to 2%. Which of the following is true? a. The real interest rate decreased. b. The student is made worse off because her real cost of borrowing is higher. c. The lender is made worst off because his real return on the car loan is lower. d. Both the student and the lender benefit.

B

As general business conditions improve, all other factors constant the: a. price of bonds will increase. b. yield on bonds will increase. c. bond demand curve shifts right. d. bond supply curve shifts left.

B

Consider the bonds below. Which is subject to the greatest interest-rate risk? a. A 30-year fixed-rate mortgage (fixed payment loan) b. A consol c. A Treasury bill d. A 20-year corporate bond

B

If interest rates are expected to rise, the bond prices will: a. not change until interest rates actually change. b. fall, due to the demand for bonds decreasing. c. rise, as people seek capital gains. d. move in the same direction as the expected change in interest rates.

B

If the U.S. government's borrowing needs increase, all other factors constant the: a. price of bonds will increase. b. supply of bonds will increase. c. demand for bonds will decrease. d. supply of bonds and the demand for bonds will both increase

B

If the U.S. government's borrowing needs increase, in the bond market this would be seen as the: a. bond demand curve shifting right. b. bond supply curve shifting right. c. bond demand curve shifting left. d. bond supply curve shifting left.

B

If the annual interest rate is 5% (.05), the price of a six-month Treasury bill would be: a. $97.50 b. $97.59 c. $95.25 d. $95.00

B

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

Interest-rate risk results from: a. bond prices being fixed over the life of the bond. b. a mismatch between an individual's investment horizon and a bond's maturity. c. the fact that most people hold bonds until they mature. d. inflation being uncertain.

B

Suppose there is a decrease in the price at which a bondholder sells her bond. In this case, the holding period return will: a. increase, since yields and prices are inversely related. b. decrease, since this lowers the capital gain. c. be negative. d. equal the coupon rate.

B

The bid price for a bond quote is: a. the price at which the bond dealer is willing to sell the bond. b. the price at which the bond dealer is willing to purchase the bond. c. fixed over the life of a bond. d. determined solely by the time left to maturity.

B

The impact of a decrease in expected inflation in the bond market will have a relatively large effect on the prices of bonds prices because the bond demand curve: a. will shift right as will the bond supply curve. b. will shift right but the bond supply curve shifts left. c. and supply curves will shift left. d. will shift left as the bond supply curve shifts right

B

When a loan is amortized, it means the: a. borrower is in default. b. principal and interest are paid off by the borrower over the life of the loan. c. interest is due entirely at the maturity date. d. principal in never repaid, only interest.

B

When expected inflation increases, for any given nominal interest rate the: a. bond demand curve shifts right. b. bond supply curve shifts right. c. price of bonds increases. d. yield on bonds will increase.

B

When the current yield and the coupon rate are equal, the bond is: a. purchased at a discount. b. purchased at a price that equals the face value. c. a zero-coupon bond. d. purchased at a price that exceeds its face value.

B

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

A $1,000 face value bond, with an annual coupon of $40, one year to maturity and a purchase price of $980 has a: a. current yield that equals 4.00%. b. coupon rate that equals 4.08%. c. current yield that equals 4.08% and a yield to maturity that equals 6.12%. d. A current yield that equals 4.08% and a yield to maturity that equals 4.0%.

C

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

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

An increase in expected inflation for any given nominal interest rate will cause the: a. bond supply curve to shift to the left. b. bond demand curve to shift to the right. c. price of bonds to decrease. d. price of bonds to increase.

C

As general business conditions improve, we would witness the following in the bond market: a. the bond demand curve shifting left. b. the bond supply curve shifting left. c. bond prices decreasing. d. bond prices increasing.

C

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

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

If a one-year zero-coupon bond has a face value of $100, is purchased for $94, and is held to maturity the: a. holding period return will exceed the yield to maturity. b. yield to maturity will exceed the holding period return. c. yield to maturity will be 6.38%. d. holding period return is 6.0%.

C

If the U.S. government's borrowing needs increase, all other factors constant the: a. demand for bonds will decrease. b. price of bonds will increase. c. supply of bonds will increase. d. yields on bonds will decrease.

C

If the federal government were to offer larger tax breaks on the purchase of new equipment for businesses, all other factors constant, we would expect to see the: a. bond demand curve shift right. b. bond supply curve shift left. c. bond supply curve shift right. d. bond demand curve shift left.

C

If the purchase price of a bond exceeds the face value, the yield to maturity: a. is greater than the coupon rate because the capital gain is positive. b. will equal the current yield. c. will be less than the coupon rate because the capital gain will be negative. d. will be greater than the current yield.

C

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 bailout 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

In reading bond quotes: a. the bid price is usually above the asked price. b. the asked price is fixed over the life of the bond. c. the asked price is usually above the bid price. d. bid and asked prices must be equal as set forth by SEC regulations.

C

Suppose that the expected return on bonds falls relative to other assets. In the bond market this will result in: a. the bond supply curve shifting left. b. a movement down the bond demand curve. c. a shift to the left of the bond demand curve. d. an increase in the price of bonds.

C

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

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

The difference in the prices of a zero-coupon bond and a coupon bond with the same face value and maturity date is simply: a. zero, since they are the same. b. the present value of the final payment. c. the present value of the coupon payments. d. the future value of the coupon payments.

C

The holding period return has relevance because: a. most bonds are held by the original purchaser until maturity. b. most bonds are held by the original purchaser until they mature. c. bonds are frequently traded. d. current yields are not that important to bondholders.

C

The relationship between the price and the interest rate for a zero coupon bond is best described as: a. volatile. b. fluctuating. c. inverse. d. non-existent.

C

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

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

When expected inflation increases, for any given nominal interest rate the: a. real cost of repayment for bond issuers increases. b. real return for bondholders increases. c. real cost of repayment for bond issuers decreases. d. bond demand curve shifts right.

C

When the price of a bond equals the face value the: a. yield to maturity will be above the coupon rate. b. yield to maturity will be below the coupon rate. c. current yield is equal to the coupon rate. d. yield to maturity is greater than the current yield.

C

A $1,000 face value bond, with one year to maturity that sells for $950 and has a $40 annual coupon has a: a. current yield and yield to maturity of 4.00%. b. yield to maturity that equals the current yield. c. coupon rate of 4.00% and a current yield that is below this. d. current yield of 4.21%.

D

An increase in the nation's wealth, all other factors constant, would cause the: a. bond supply curve to shift left. b. bond demand curve to shift left. c. bond supply curve to shift right. d. bond demand curve to shift right

D

An increase in the nation's wealth, all other factors constant, would cause: a. bond prices to fall and yields to increase. b. bond prices and yields to increase. c. bond prices to rise and yields to decrease. d. the bond supply curve to shift right.

D

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. fall as people fear capital losses in the future. d. increase due to the demand for bonds increasing.

D

If the U.S. government's borrowing needs decrease, all other factors constant the: a. supply of bonds will increase. b. demand for bonds will decrease. c. price of bonds will decrease. d. price of bonds will increase.

D

If the U.S. government's borrowing needs increase, in the bond market this would be seen as: a. the bond demand curve shifting right. b. a movement up the bond supply curve. c. the bond demand curve shifting left. d. the bond supply curve shifting right.

D

In considering the holding period return, the longer the term of the bond the: a. less important is the capital gain and the more important in the current yield. b. less important is the coupon rate and the more important is the current yield. c. less important is the capital gain. d. more important is the capital gain

D

Interest-rate risk would not matter to which of the following bondholders? a. A holder of a U.S. government bond. b. A holder of a U.S. government bond indexed for inflation. c. A holder of a U.S. government bond who plans on selling it in one year. d. A holder of a U.S. government bond that plans on holding it until it matures.

D

Suppose that general business conditions improve, and at the same time, wealth increases. Based on this information, we know that: a. bond prices increase. b. yield to maturity decreases. c. the real interest rate increases. d. the quantity of bonds increases.

D

The U.S. Treasury issues bonds where the return is indexed to the consumer price index. We should expect that these bonds, relative to other U.S. Treasury bonds, will have: a. lower price and lower return due to the decreased risk. b. lower price and a lower fixed return since the demand for them should be higher. c. higher price and higher fixed return since we always seem to have some inflation. d. higher price and lower return due to the decreased risk from inflation in holding these bonds.

D

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

The return on bonds rises relative to other assets, in the bond market this will result in: a. the price of bonds falling and the yields increasing. b. a rightward shift in the bond supply curve. c. a shift to the left of the bond demand curve. d. an increase in bond prices

D

When expected inflation increases, for any given nominal interest rate the: a. cost of borrowing increases and the desire to borrow decreases. b. real interest rate increases. c. bond supply curve shifts to the left. d. cost of borrowing decreases and the desire to borrow increases

D

Which of the following is not a reason why the yield to maturity can differ from the current yield? a. Because the yield to maturity considers the capital gain/loss. b. Because the current yield focuses only on the coupon payment and the purchase price. c. Because most bonds are not purchased for face value. d. Because the current yield moves in the opposite direction from price

D

Which of the following is true of interest-rate risk? a. It is the risk that the coupon rate for a bond will change, affecting current bondholders' coupon payments. b. It refers to the probability that a borrower will default on debt obligations. c. It is the risk that the face value of a bond will change before maturity. d. Individuals owning long-term bonds are exposed to greater interest-rate risk.

D

Which of the following statements about the result of a deterioration in business conditions that also causes a decrease in a nation's wealth is false? a. The impact on bond prices will be ambiguous since both the bond demand and supply curves shift left. b. The price of bonds will increase if bond supply decreases more than bond demand. c. Interest rates will increase if bond demand decreases more than bond supply. d. Neither bond demand nor bond supply will shift.

D

Which of the following statements is most accurate? a. Yield to maturity is equal to the coupon rate if the bond is held to maturity. b. Yield to maturity is the same as the coupon rate. c. Yield to maturity will exceed the coupon rate if the bond is purchased for face value. d. Yield to maturity is the same as the coupon rate if the bond is purchased for face value and held to maturity.

D

issue bonds, would you prefer to be in a country where the average inflation rate is 3% inflation but fluctuates wildly, or in a country with a higher, 4% expected inflation rate that is stable (meaning it's always 4%). Explain.

Even though the 4% expected rate is higher, it is stable. As we saw, the inflation risk isn't really the risk from inflation; it is the risk that results from unexpected changes in inflation which then can significantly alter the real interest rate, and therefore the real returns bondholders receive. Because bondholders tend to be risk-averse, they would want to be compensated for the inflation risk, and since the inflation risk results from the fluctuations in the rate of inflation, the returns required by bondholders in the country where the average expected rate is 3% but volatile are likely to be higher than the required returns on the bonds in the higher but stable inflation country. This explains, at least partially, why the central banks in many developed countries strive for inflation stability. Stable prices will lead to lower inflation risk and a more efficient bond market.

Suppose that a bond is purchased at a discount (meaning that it is sold for less than face value). Could the yield to maturity ever be less than the coupon rate? Could the holding period return be less than the coupon rate? Explain.

If a bond is purchased for less than face value, the yield to maturity will always exceed the coupon rate. For the yield to maturity to be less than the coupon rate the price of the bond would have to exceed the face value. On the other hand, the holding period return could be less than the coupon rate. Even if a bond is purchased for less than face value, there is no guarantee it will sell before the maturity date for an amount that is at or above the face value; in fact it could sell for an amount well below the actual purchase price.

Explain why holding period return, as an economic measure, does not have the same significance as current yield or yield to maturity.

One of the things economists do is try to explain behavior, or decisions people make. Current yield and yield to maturity are a priori measures, meaning we can calculate these prior to actually making the purchase of the bond. The holding period return cannot be calculated a priori, it is only calculated after the bond is purchased; to a certain degree it represents a "sunk" cost.

Compute the change in the price of a five-year (until maturity) $1,000 face value zero- coupon bond that currently yields 7% when expected inflation increases from 3% to 4%.

The bond currently will sell for $712.99. Once the expected inflation increases by 1%, the bondholders would want to keep the same real return, which would drive the bond yield up to 8%. This increase in bond yield will drive the price down to $680.58, or a decrease of more than 4.8% of the bond's price.

Which bond will have a higher yield to maturity, a $1,000 face value bond, with a 5.0% coupon rate that sells for $900; or a $1,000 face value bond, with a $50 annual coupon that sells for $1,050? Explain your choice.

The bond that is selling for $900 will. Both bonds have the same coupon rate, 5%, and they have the same maturity, so the bondholder's returns from the coupons are equal. What differentiates the two is that the bondholder who purchases the bond for $900 will also receive a capital gain which increases his/her yield to maturity.

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.

Notice the following model of a bond market. In each situation given, explain what happens to the bond price and yield and why. a) Expected inflation increases b) The return on bonds rises relative to other assets c) The federal government deficit increases

a) If expected inflation increases the demand for bonds will decrease and the supply will increase. Both of these will reinforce each other, causing the bond prices to fall and interest rates to increase. b) If the return on bonds rises relative to other assets, the bond demand curve will shift to the right, causing bond prices to increase and interest rates to decrease. c) If the federal budget deficit increases, the bond supply curve will shift to the right, causing the bond prices to fall and interest rates to increase.