FINC 302 Test 2

7-15. A bond's expected return is sometimes estimated by its YTM and sometimes by its YTC. Under what conditions would the YTM provide a better estimate, and when would the YTC be better?

7-15: Assuming a bond issue is callable, the YTC is a better estimate of a bond's expected return when interest rates are below an outstanding bond's coupon rate. The YTM is a better estimate of a bond's expected return when interest rates are equal to or above an outstanding bond's coupon rate. So, premium bonds are more likely to earn the YTC (because they're likely to be called) while par bonds and discount bonds are more likely to earn the YTM (because they're not likely to be called and thus the bondholder will be able to hold them to maturity).

7-16. Which of the following bonds has the most price risk? Explain your answer. (Hint: Refer to Table 7.2.) A. 7-year bonds with a 5% coupon B. 1-year bonds with a 12% coupon C. 3-year bonds with a 5% coupon D. 15-year zero coupon bonds E. 15-year bonds with a 10% coupon

7-16: The answer is D. The 15-year zero coupon bonds have the most price risk. Longer-maturity bonds have a high level of price risk as do lower-coupon bonds. Since the maturities of the bonds in A, B, and C are shorter than 15 years, they can be eliminated from consideration. Since coupon payments reduce the level of price risk and the zero coupon bonds have only their maturity value due at maturity, they have the most price risk. (You can consult Table 7.2 to help with this question).

7-17. Which of the bonds has the most reinvestment risk? Explain your answer. (Hint: Refer to Table 7.2.) A. 7-year bonds with a 5% coupon B. 1-year bonds with a 12% coupon C. 3-year bonds with a 5% coupon D. 15-year zero coupon bonds E. 15-year bonds with a 10% coupon

7-17: The answer is B. The 1-year bonds with a 12% coupon have the most reinvestment risk. Shorter-maturity bonds have more reinvestment risk than longer-maturity bonds. Also, high coupon bonds have more reinvestment risk than low coupon bonds. The 1-year, 12% coupon bonds have a shorter maturity than the other bonds as well as a higher coupon rate, so the reinvestment risk for those bonds is obviously the highest. (Also consult Table 7.2 to help with this question).

7-4. If interest rates rise after a bond issue, what will happen to the bond's price and YTM? Does the time to maturity affect the extent to which interest rate changes affect the bond's price? (Again, an example might help you answer this question.)

7-4: The price of the bond will fall and its YTM will rise if interest rates rise. If the bond still has a long term to maturity, its YTM will reflect long-term rates. Of course, the bond's price will be less affected by a change in interest rates if it has been outstanding a long time and matures soon. While this is true, it should be noted that the YTM will increase only for buyers who purchase the bond after the change in interest rates and not for buyers who purchased previous to the change. If the bond is purchased and held to maturity, the bondholder's YTM will not change, regardless of what happens to interest rates. For example, consider two bonds with an 8% annual coupon and a $1,000 par value. One bond has a 5-year maturity, while the other has a 20-year maturity. If interest rates rise to 15% immediately after issue the value of the 5-year bond would be $765.35, while the value of the 20-year bond would be $561.85.

7-6. If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain.

7-6: If interest rates decline significantly, the values of callable bonds will not rise by as much as the values of bonds without the call provision. It is likely that the bonds would be called by the issuer before maturity, so that the issuer can take advantage of the new, lower rates.

10. Cooley Company's stock has a beta of 1.28, the risk-free rate is 2.25%, and the market risk premium is 5.50%. What is the firm's required rate of return? Do not round your intermediate calculations. a. 9.29% b. 9.94% c. 10.96% d. 8.55% e. 11.52%

ANSWER: A Beta 1.28 Risk-free rate 2.25% Market risk premium 5.50% Required return 9.29%

10. A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is CORRECT? a. The bond's expected capital gains yield is zero. b. The bond's yield to maturity is above 9%. c. The bond's current yield is above 9%. d. If the bond's yield to maturity declines, the bond will sell at a discount. e. The bond's current yield is less than its expected capital gains yield.

ANSWER: A If the bond is selling at par, we know that its coupon rate is equal to the going market interest rate. Coupon rate = YTM. Both are 9% (you can plug values into a financial calculator to verify this). The current yield is 9% (this is just the coupon payment divided by the current price, which is 90/1000). There are no expected capital gains (you paid $1000 for the bond, and you expected to get back that same amount 10 years from now since the par value is also $1000). Thus, A is the correct answer.

7. Morin Company's bonds mature in 8 years, have a par value of $1,000, and make an annual coupon interest payment of $65. The market requires an interest rate of 6.1% on these bonds. What is the bond's price? a. $1,024.74 b. $1,147.71 c. $1,116.97 d. $1,096.47 e. $1,280.93

ANSWER: A N 8 I/YR 6.1% PMT $65 FV $1,000 Solve for PV: $1,024.74

5. Assume that interest rates on 20-year Treasury and corporate bonds are as follows: T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18%The differences in these rates were probably caused primarily by: a. Tax effects. b. Default and liquidity risk differences. c. Maturity risk differences. d. Inflation differences. e. Real risk-free rate differences.

ANSWER: B

7. Which of the following statements is CORRECT? a. The yield on a 3-year Treasury bond cannot exceed the yield on a 10-year Treasury bond. b. The yield on a 2-year corporate bond should always exceed the yield on a 2-year Treasury bond. c. The yield on a 3-year corporate bond should always exceed the yield on a 2-year corporate bond. d. The yield on a 10-year AAA-rated corporate bond should always exceed the yield on a 5-year AAA-rated corporate bond. e. The following represents a "possibly reasonable" formula for the maturity risk premium on bonds: MRP = -0.1%(t), where t is the years to maturity.

ANSWER: B

8. Dothan Inc.'s stock has a 25% chance of producing a 16% return, a 50% chance of producing a 12% return, and a 25% chance of producing a -18% return. What is the firm's expected rate of return? Do not round your intermediate calculations. a. 4.51% b. 5.50% c. 4.68% d. 4.29% e. 6.38%

ANSWER: B Conditions Prob. Return Prob. × Return Good 0.25 16.0% 4.00% Average 0.50 12.0% 6.00% Poor 0.25 -18.0% -4.50% 1.00 5.50% = Expected return

6. Which of the following statements is CORRECT? a. If the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. b. If the maturity risk premium (MRP) equals zero, the Treasury bond yield curve must be flat. c. If inflation is expected to increase in the future and the maturity risk premium (MRP) is greater than zero, the Treasury bond yield curve must be upward sloping. d. If the expectations theory holds, the Treasury bond yield curve will never be downward sloping. e. Because long-term bonds are riskier than short-term bonds, yields on long-term Treasury bonds will always be higher than yields on short-term T-bonds.

ANSWER: C

7. During the coming year, the market risk premium (rM - rRF), is expected to fall, while the risk-free rate, rRF, is expected to remain the same. Given this forecast, which of the following statements is CORRECT? a. The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0. b. The required return on all stocks will remain unchanged. c. The required return will fall for all stocks, but it will fall more for stocks with higher betas. d. The required return for all stocks will fall by the same amount. e. The required return will fall for all stocks, but it will fall less for stocks with higher betas.

ANSWER: C

8. Assume that you are considering the purchase of a 20-year, noncallable bond with an annual coupon rate of 9.5%. The bond has a face value of $1,000, and it makes semiannual interest payments. If you require an 10.7% nominal yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? a. $721.44 b. $910.81 c. $901.80 d. $874.74 e. $1,000.99

ANSWER: C Par value $1,000 Coupon rate 9.5% Periods/year 2 Yrs to maturity 20 Periods = Yrs to maturity Periods/year 40 Required rate 10.7% Periodic rate = Required rate / 2 = I/YR 5.35% PMT per period = Coupon rate/2 Par value $47.50 Maturity value = FV $1,000 Solve for PV: $901.80

5. You have the following data on three stocks: Stock Standard Deviation Beta A 20% 0.59 B 10% 0.61 C 12% 1.29 If you are a strict risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio. a. A; A. b. A; B. c. B; A. d. C; A. e. C; B.

ANSWER: C When held in isolation, the measure of risk we are concerned with is the standard deviation. The lower the better, so you would want to choose Stock B since it has the lowest standard deviation. However, when held as part of a well-diversified portfolio, the measure of risk that we are concerned with is Beta. Again, the lower the better, so you would choose Stock A since it has the lowest beta.

5. Tucker Corporation is planning to issue new 20-year bonds. The current plan is to make the bonds non-callable, but this may be changed. If the bonds are made callable after 5 years at a 5% call premium, how would this affect their required rate of return? a. Because of the call premium, the required rate of return would decline. b. There is no reason to expect a change in the required rate of return. c. The required rate of return would decline because the bond would then be less risky to a bondholder. d. The required rate of return would increase because the bond would then be more risky to a bondholder. e. It is impossible to say without more information.

ANSWER: D

9. Assume that you hold a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. You are in the process of buying 1,000 shares of Alpha Corp at $10 a share and adding it to your portfolio. Alpha has an expected return of 21.5% and a beta of 1.70. The total value of your current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Alpha stock? Do not round your intermediate calculations. a. 13.98%; 1.28 b. 12.29%; 1.48 c. 12.41%; 1.56 d. 12.05%; 1.25 e. 9.40%; 1.34

ANSWER: D Old portfolio return 11.0% Old portfolio beta 1.20 New stock return 21.5% New stock beta 1.70 % of portfolio in new stock = $ in New / ($ in old + $ in new) = $10,000/$100,000=10% New expected portfolio return = rp = 0.1 × 21.5% + 0.9 × 11% = 12.05%​ New expected portfolio beta = bp = 0.1 × 1.70 + 0.9 × 1.20 = 1.25​

11. Porter Inc's stock has an expected return of 12.50%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 2.00%, what is the market risk premium? Do not round your intermediate calculations. a. 10.50% b. 8.48% c. 7.98% d. 8.40% e. 6.80%

ANSWER: D Use the SML to determine the market risk premium with the given data. rs = rRF + bStock × RPM 12.50% = 2.00% + 1.25 × RPM 10.50% = RPM × 1.25 8.40% = RPM

6. Which of the following statements is CORRECT? a. All else equal, high-coupon bonds have less reinvestment risk than low-coupon bonds. b. All else equal, long-term bonds have less price risk than short-term bonds. c. All else equal, low-coupon bonds have less price risk than high-coupon bonds. d. All else equal, short-term bonds have less reinvestment risk than long-term bonds. e. All else equal, long-term bonds have less reinvestment risk than short-term bonds.

ANSWER: E

6. Which of the following statements is CORRECT? a. An investor can eliminate virtually all market risk if he or she holds a very large and well diversified portfolio of stocks. b. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio. c. It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock. d. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount. e. An investor can eliminate virtually all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks.

ANSWER: E

9. Keenan Industries has a bond outstanding with 15 years to maturity, an 8.25% nominal coupon, semiannual payments, and a $1,000 par value. The bond has a 6.50% nominal yield to maturity, but it can be called in 6 years at a price of $1,045. What is the bond's nominal yield to call? a. 6.77% b. 5.09% c. 4.42% d. 5.54% e. 5.59%

ANSWER: E First, use the given data to find the bond's current price. Then use that price to find the YTC. Coupon rate 8.25% YTM 6.50% Maturity 15 Par value $1,000 Periods/year 2 Determine the bond's price PMT/period $41.25 N 30 I/YR 3.25% FV $1,000.00 PV = Price $1,166.09 Yrs to call 6 Call price $1,045 Determine the bond's YTC N 12 PV $1,166.09 PMT $41.25 FV $1,045.00 I/YR 2.80% Nom. YTC 5.59%

. A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, companies call bonds if interest rates rise and do not call them if interest rates decline. a. True b. False

ANSWER: False

4. If the Treasury yield curve were downward sloping, the yield to maturity on a 10-year Treasury coupon bond would be higher than that on a 1-year T-bill. a. True b. False

ANSWER: False

1. If investors expect a zero rate of inflation, then the nominal rate of return on a very short-term U.S. Treasury bond should be equal to the real risk-free rate, r*. a. True b. False

ANSWER: True

1. Risk-averse investors require higher rates of return on investments whose returns are highly uncertain, and most investors are risk averse. a. True b. False

ANSWER: True

1. The price sensitivity of a bond to a given change in interest rates is generally greater the longer the bond's remaining maturity. a. True b. False

ANSWER: True

2. If investors expect the rate of inflation to increase sharply in the future, then we should not be surprised to see an upward sloping yield curve. a. True b. False

ANSWER: True

2. There is an inverse relationship between bonds' quality ratings and their required rates of return. Thus, the required return is lowest for AAA-rated bonds, and required returns increase as the ratings get lower. a. True b. False

ANSWER: True

2. When adding a randomly chosen new stock to an existing portfolio, the higher (or more positive) the degree of correlation between the new stock and stocks already in the portfolio, the less the additional stock will reduce the portfolio's risk. a. True b. False

ANSWER: True

3. Because the maturity risk premium is normally positive, the yield curve is normally upward sloping. a. True b. False

ANSWER: True

3. Market risk refers to the tendency of a stock to move with the general stock market. A stock with above-average market risk will tend to be more volatile than an average stock, and its beta will be greater than 1.0. a. True b. False

ANSWER: True

4. The Y-axis intercept of the SML represents the required return of a portfolio with a beta of zero, which is the risk-free rate. a. True b. False

ANSWER: True

4. You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on bonds with this risk is 12%. a. True b. False

ANSWER: True The bond's expected return (YTM) is 13.81%, which exceeds your 12% required return, so buy the bond.